NMIH, a Delaware corporation, was incorporated in May 2011, and we began start-up operations in 2012 and wrote our first MI policy in 2013. Since formation, we have sought to establish customer relationships with a broad group of mortgage lenders and build a diversified, high-quality insured portfolio. As of December 31, 2017, we had master policies with 1,267 customers, including national and regional mortgage banks, money center banks, credit unions, community banks, builder-owned mortgage lenders, internet-sourced lenders and other non-bank lenders. We had total IIF of $51.7 billion and gross RIF of $11.9 billion as of December 31, 2017, compared to total IIF of $35.8 billion and gross RIF of $7.9 billion as of December 31, 2016, and total IIF of $19.1 billion and gross RIF of $3.7 billion as of December 31, 2015. Included in our total IIF as of December 31, 2017, 2016, and 2015 was $48.5 billion, $32.2 billion and $14.8 billion of primary IIF, respectively. As of December 31, 2017, our gross primary RIF was $11.8 billion, compared to $7.8 billion and $3.6 billion as of December 31, 2016 and 2015, respectively. For the year ended December 31, 2017, we generated NIW of $21.6 billion, compared to $21.2 billion and $12.4 billion for the years ending December 31, 2016 and 2015, respectively. As of December 31, 2017, we had 299 full-time employees.
Our strategy is to continue to build on our position in the private MI market, expand our customer base and grow our insured portfolio of high-quality residential loans by focusing on long-term customer relationships, disciplined and proactive risk selection and pricing, fair and transparent claims payment practices, responsive customer service, financial strength and profitability.
NIW is the aggregate unpaid principal balance of mortgages underpinning new policies written during a given period. Our NIW is affected by the overall size of the mortgage origination market and the volume of high-LTV mortgage originations, which tend to be generated to a greater extent in purchase originations as compared to refinancings. Our NIW is also affected by the percentage of such high-LTV originations covered by private versus public MI or other alternative credit enhancement structures and our share of the private MI market. NIW, together with persistency, drives our IIF. IIF is the aggregate unpaid principal balance of the mortgages we insure, as reported to us by servicers at a given date, and represents the sum total of NIW from all prior periods less principal payments on insured mortgages and policy cancellations (including for prepayment, nonpayment of premiums, coverage rescission and claim payments). RIF is related to IIF and represents the aggregate amount of coverage we provide on all outstanding policies at a given date. RIF is calculated as the sum total of the coverage percentage of each individual policy in our portfolio applied to the unpaid principal balance of such insured mortgage. RIF is affected by IIF and the LTV profile of our insured mortgages, with lower LTV loans generally having a lower coverage percentage and higher LTV loans having a higher coverage percentage. Gross RIF represents RIF before consideration of reinsurance. Net RIF is gross RIF net of ceded reinsurance.
We set our premium rates on individual policies based on the risk characteristics of the underlying mortgage loans and borrowers, and in accordance with our filed rates and applicable rating rules.
premium rates and the mix of premium payment type, which are either single, monthly or annual premiums, as described below;
cancellation rates of our insurance policies, which are impacted by payments or prepayments on mortgages, refinancings (which are affected by prevailing mortgage interest rates as compared to interest rates on loans underpinning our in force policies), levels of claims payments and home prices;
Premiums are paid either by the borrower (BPMI) or the lender (LPMI) in a single payment at origination (single premium), on a monthly installment basis (monthly premium) or on an annual installment basis (annual premium). Our net premiums written will differ from our net premiums earned due to policy payment type. For single premiums, we receive a single premium payment at origination, which is initially recorded as unearned premium and earned over the estimated life of the policy. A majority of our single premium policies in force as of December 31, 2017 were non-refundable under most cancellation scenarios. If non-refundable single premium policies are canceled, we immediately recognize the remaining unearned premium balances as earned premium revenue. Monthly premiums are recognized in the month billed and when the coverage is effective. Annual premiums are earned on a straight-line basis over the year of coverage. Substantially all of our policies provide for either single or monthly premiums.
NMIC entered into the 2016 QSR Transaction in September 2016. Under the terms of the 2016 QSR Transaction, NMIC (1) ceded 100% of the risk relating to our pool agreement with Fannie Mae, (2) ceded 25% of existing risk written on eligible policies as of August 31, 2016 and (3) ceded 25% of the risk relating to eligible primary insurance policies written between September 1, 2016 and December 31, 2017, in exchange for reimbursement of ceded claims and claims expenses on covered policies, a 20% ceding commission, and a profit commission of up to 60% that varies directly and inversely with ceded claims.
See, Item 8, "Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Note 6, Reinsurance" for further discussion of these third-party reinsurance arrangements.
The following table presents primary and pool NIW and IIF as of the dates and for the periods indicated. Unless otherwise noted, the tables below do not include the effects of our third-party reinsurance arrangements described above.
For the year ended December 31, 2017, primary NIW increased 2%, compared to the year ended December 31, 2016, primarily because of the growth in our monthly policy volume tied to increased penetration of existing customer accounts and new customer account activations, offset by a reduction in our single policy production tied to actions we initiated to reduce the concentration of single policies in our product mix. Primary NIW increased 71% for the year ended December 31, 2016, compared to the year ended December 31, 2015, primarily because of the growth within and an expansion of our customer base.
For the year ended December 31, 2017, 81% of our NIW related to monthly premium policies, as compared to 67% and 48% for the years ended December 31, 2016 and 2015, respectively. As of December 31, 2017, monthly premium policies accounted for 69% of our primary IIF, as compared to 60% at December 31, 2016 and 47% at December 31, 2015. We expect the break-down of monthly premium policies and single premium policies (which we refer to as "mix") in our primary IIF to continue to trend toward our current NIW mix over time. Our total IIF at December 31, 2017 increased 44% compared to December 31, 2016, which in turn increased 88% compared to December 31, 2015, primarily because of the NIW we generated between such measurement dates and higher persistency of our policies in force.
(1) Net premiums written and earned are reported net of reinsurance and premium refunds.
For the year ended December 31, 2017, net premiums written and earned increased 29% and 50%, respectively, compared to the year ended December 31, 2016. The increase in net premiums written is due to the growth of our IIF and increased monthly policy production, partially offset by a decrease in single premium NIW. The trend in net premiums written was also impacted by the inception of the 2016 QSR Transaction in September 2016, which entailed an initial cession of $35 million of premiums written on all covered singles policies written prior to the transaction effective date and had the effect of reducing net premiums written in 2016 by a like amount. The increase in net premiums earned is due to the growth of our IIF and increased monthly policy production, partially offset by decreases in our single premium NIW and earnings from cancellations, and the impact of cessions under the 2017 ILN transaction and 2016 QSR Transaction.
Pool premiums written and earned for the years ended December 31, 2017, 2016 and 2015, were $3.8 million, $4.4 million and $4.9 million, respectively, before giving effect to the 2016 QSR Transaction, under which all of our written and earned pool premiums have been ceded.
We consider a "book" to be a collective pool of policies insured during a particular period, normally a calendar year. In general, the majority of underwriting profit, calculated as earned premium revenue minus claims and underwriting and operating expenses, generated by a particular book year emerges in the years immediately following origination. This pattern generally occurs because relatively few of the claims that a book will ultimately experience typically occur in the first few years following origination, when premium revenue is highest, while subsequent years are affected by declining premium revenues, as the number of insured loans decreases (primarily due to loan prepayments), and by increasing losses.
The following table shows the distribution by state of our primary RIF as of the periods indicated. As of December 31, 2017, our RIF continues to be relatively more concentrated in California, primarily as a result of the size of the California mortgage market relative to the rest of the country and the location and timing of our acquisition of new customers.
Insurance claims and claims expenses incurred represent estimated future payments on newly defaulted insured loans and any change in our claim estimates for previously existing defaults. Claims incurred is generally affected by a variety of factors, including:
changes in housing values, as such changes may affect loss mitigation opportunities on loans in default, as well as borrowers' behaviors and willingness to default if the values of their homes are below or perceived to be below their mortgage balances;
DTI ratios, with higher DTIs generally tending to increase claims incurred;
the distribution of claims over the life of a book year.
Reserves are established by estimating the number of loans in default that will result in a claim payment, which is referred to as claim frequency, and the amount of the claim payment expected to be paid on each such loan in default, which is referred to as
The actual claims we incur as our portfolio matures are difficult to predict and depend on the specific characteristics of our current in-force book (including the credit score and DTI of the borrower, the LTV ratio of the mortgage and geographic concentrations, among others), as well as the profile of new business we write in the future. In addition, claims experience will be affected by future macroeconomic factors such as housing prices, interest rates and employment and other events, such as natural catastrophes. To date, our claims experience is developing at a slower pace than historical trends indicate, as a result of high quality underwriting, a strong macroeconomic environment and a favorable housing market. For additional discussion of our reserves, see Item 8, "Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Note 7, Reserves for Insurance Claims and Claim Expenses."
(1) Related to ceded losses recoverable on the 2016 QSR Transaction, included in "Other Assets" on the Consolidated Balance Sheets. See Item 8, "Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Note 6, Reinsurance," for additional information.
(2) Related to insured loans with their most recent defaults occurring in the current year. For example, if a loan had defaulted in a prior year and subsequently cured and later re-defaulted in the current year, that default would be included in the current year.
The "claims incurred" section of the table above shows claims and claim expenses incurred on NODs for current and prior years, including IBNR reserves. The amount of claims incurred for current year NODs represents the estimated amount to be ultimately paid on such loans in default. The decreases during the periods presented in reserves held for prior year defaults represent favorable development and are generally the result of NOD cures and ongoing analysis of recent loss development trends. We may increase or decrease our original estimates as we learn additional information about individual defaults and claims, and continue to observe and analyze loss development trends in our portfolio. Gross reserves of $1.0 million related to prior year defaults remained as of December 31, 2017.
The following table provides details of our claims paid, before giving effect to claims ceded under the 2016 QSR Transaction, for the periods indicated.
The increase in the number of claims paid for the year ended December 31, 2017 compared to the years ended December 31, 2016 and 2015, is due to an increase in our default inventory. We expect the severity of claims we receive to be between 85% and 95% of the coverage amount for the near-term.
Historically, our business has been subject to modest seasonality in both NIW production and default experience. Consistent with the seasonality of home sales, purchase origination volumes typically increase in late spring and peak during the summer months, leading to a rise in NIW volume during the second and third quarters of a given year. Refinancing volume, however, does not follow a set seasonal trend and instead is primarily influenced by mortgage rates. An increase in refinancing volume may limit the seasonal effect of home purchase patterns on mortgage insurance NIW. In addition, while macroeconomic factors in any given period may influence default experience to a greater extent than does seasonality, our industry has typically experienced a fourth quarter seasonal increase in the number of defaults and a first quarter seasonal decline in the number of defaults and increase in the number of cures.
requirements applicable to Approved Insurers. The PMIERs financial requirements prescribe a risk-based methodology whereby the amount of assets required to be held against each insured loan is determined based on certain risk characteristics, such as FICO, vintage (year of origination), performing vs. non-performing (i.e., current vs. delinquent), LTV and other risk features. An asset charge is calculated for each insured loan based on its risk profile. In general, higher quality loans carry lower charges.
Under the PMIERs financial requirements, Approved Insurers must maintain available assets that equal or exceed minimum required assets, which is an amount equal to the greater of (i) $400 million or (ii) a total risk-based required asset amount. The risk-based required asset amount is a function of the risk profile of an Approved Insurer's net RIF, calculated by applying on a loan-by-loan basis certain risk-based factors derived from tables set out in the PMIERs to the net RIF, and other transactional adjustments approved by the GSEs, such as with respect to our 2017 ILN Transaction and 2016 QSR Transaction. The risk-based required asset amount for primary insurance is subject to a floor of 5.6% of total, performing, primary RIF, and the risk-based required asset amount for pool insurance considers both the factors in the tables and the net remaining stop loss for each pool insurance policy. The PMIERs financial requirements also increase the amount of available assets that must be held by an Approved Insurer for LPMI policies originated on or after January 1, 2016.
By April 15th of each year, NMIC must certify it met all PMIERs requirements as of December 31st of the prior year. As of December 31, 2017, NMIC had sufficient available assets to meet the PMIERs financial requirements, and we expect to certify to the GSEs by April 15, 2018 that NMIC fully complied with the PMIERs as of December 31, 2017. NMIC also has an ongoing obligation to immediately notify the GSEs in writing upon discovery of its failure to meet one or more of the PMIERs requirements. We continuously monitor our compliance with the PMIERs.
We maintain cyber errors and omissions coverage to limit our exposure if an incident occurs. This insurance provides coverage for (i) claims related to, among other things, unauthorized network or computer access, unintentional disclosure or misuse of personally identifiable information in our possession, unintentional failure to disclose a breach and (ii) certain costs related to privacy notification, crisis management, cyber extortion, data recovery and business interruption.
As of December 31, 2017, NMIC's performing primary RIF, net of reinsurance, was approximately $7.3 billion. NMIC ceded 100% of its pool RIF pursuant to the 2016 QSR Transaction. Based on NMIC's total statutory capital of $524 million (including contingency reserves) as of December 31, 2017, NMIC's RTC ratio was 14.0:1. Re One had total statutory capital of $34 million as of December 31, 2017, with a RTC ratio of 0.8:1. We continuously monitor our compliance with state capital requirements.
(1) Loss ratio is calculated by dividing the provision for insurance claims and claims expenses by net premiums earned.
(2) Expense ratio is calculated by dividing other underwriting and operating expenses by net premiums earned.
For the year ended December 31, 2017, net investment income was $16.3 million compared to $13.8 million for the year ended December 31, 2016 and $7.2 million for the year ended December 31, 2015. The increase in both periods was due to an increase in the size of and improved yields on our total investment portfolio.
For the year ended December 31, 2017, insurance claims and claims expenses were $5.3 million compared to $2.4 million for the year ended December 31, 2016 and $0.7 million for the year ended December 31, 2015. Insurance claims and claims expenses increased $2.9 million in 2017, as a result of new defaults on insured loans in areas impacted by hurricanes Harvey and Irma and the California wildfires, as well as an increase in the overall number of policies in our portfolio and aging of earlier book years, offset by the partial release of reserves related to prior year defaults. Insurance claims and claims expenses increased $1.7 million in 2016 compared to 2015 primarily due to an increase in the overall number of policies in our portfolio and aging of earlier book years.
Underwriting and operating expenses were $107.0 million for the year ended December 31, 2017, compared to $93.2 million and $80.6 million for the years ended December 31, 2016 and 2015, respectively. Employee compensation accounts for the majority of our operating expenses. We increased the size of our workforce from 243 employees at December 31, 2015 to 276 employees at December 31, 2016 and to 299 employees at December 31, 2017 to support the growth of our business, particularly our sales and operating functions. Underwriting and operating expenses for the year ended December 31, 2017 also reflect $4.9 million of operating expenses related to the 2017 ILN Transaction and amendment of our Credit Agreement.
Income tax expense was $30.7 million for the year ended December 31, 2017 compared to income tax benefit of $52.5 million for the year ended December 31, 2016 and no income tax provision for the year ended December 31, 2015. The fluctuation of our income taxes is the result of significant events during each of periods presented. During the year ended December 31, 2017, we recorded a one-time non-cash charge of $13.6 million primarily due to the re-measurement of net deferred tax assets in connection with the enactment of the Tax Cuts and Jobs Act. During the year ended December 31, 2016, we recorded a one-time non-cash benefit of $58.8 million related to the release of the valuation allowance recorded against our federal and certain state net deferred tax assets. During the year ended December 31, 2015, we did not record an income tax expense due to the recognition of a valuation allowance against our federal and state net deferred tax assets. For further information regarding income taxes and their impact on our results of operations and financial position, see Item 8, "Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Note 11, Income Taxes."
Net deferred policy acquisition costs (DAC) were $37.9 million as of December 31, 2017, compared to $30.1 million as of December 31, 2016. The increase was driven by growth in the number of policies written during the year ended December 31, 2017 and the deferment of certain costs associated with the origination of those policies, partially offset by the amortization of previously deferred acquisition costs and the capitalization of ceding commissions associated with the 2016 QSR Transaction during the period.
Premiums receivable increased to $25.2 million as of December 31, 2017, compared to $13.7 million as of December 31, 2016 due to growth in the number of monthly policies in force.
Reserve for insurance claims and claims expenses increased $5.8 million to $8.8 million at December 31, 2017, due to an increase in our default inventory at December 31, 2017. See "- Insurance Claims and Claims Expenses," above for further details.
Reinsurance funds withheld was $34.1 million as of December 31, 2017, representing the net of our ceded reinsurance premiums written, less our profit and ceding commission receivables related to the 2016 QSR Transaction. The increase in reinsurance
funds withheld of $3.5 million from December 31, 2016, was a result of increased ceded premiums written. See, Item 8, "Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Note 6, Reinsurance."
Cash used in investing activities for the periods presented was driven by the purchase of fixed and short-term maturities during those periods.
Cash used in financing activities was $3.2 million and $1.7 million for the year ended December 31, 2017, and 2016, and primarily relates to taxes paid on the net share settlement of equity awards for certain employees. Cash provided by financing activities was $143.0 million for the year ended December 31, 2015, and primarily relates to proceeds from the Term Loan which we established in the fourth quarter of 2015.
NMIC's capital needs depend on many factors including its ability to successfully write new business, establish premium rates at levels sufficient to cover claims and operating costs and meet minimum required asset thresholds under the PMIERs and state capital requirements. NMIC's capital needs also depend on its decision to access the reinsurance markets. NMIH may require liquidity to fund the capital needs of its insurance subsidiaries.
Substantially all of our investment portfolio is held in fixed maturity instruments. As of December 31, 2017, the fair value of our investment portfolio was $715.9 million. We also had an additional $19.2 million of cash and equivalents as of December 31, 2017. Pre-tax book yield on the portfolio for the year ended December 31, 2017 was 2.3%. The book yield is calculated as period-to-date net investment income divided by average amortized cost of the investment portfolio. Yield on the investment portfolio is likely to change over time based on movements in interest rates, the duration or mix of our investment portfolio and other factors.
the middle rating for classification purposes, otherwise we assign the lowest rating.
As of December 31, 2017 and 2016, we held no other-than-temporarily impaired (OTTI) securities, and as of December 31, 2015, we held one OTTI security. For the year ended December 31, 2017, we recognized OTTI losses in earnings of $144 thousand on a single security with an unfavorable recovery forecast. The impaired security was liquidated during the year. There were no credit losses recognized in earnings for which a portion of an OTTI loss was recognized in accumulated other comprehensive income (loss).
For the year ended December 31, 2015, we recognized an OTTI loss in earnings of $89 thousand on a single security where we expected a planned sale would result in a loss. The impaired security was liquidated in 2016.
The Securities and Exchange Commission issued Staff Accounting Bulletin No. 118 (SAB 118) on December 23, 2017. SAB 118 provides a one-year measurement period from a registrant's reporting period that includes the Act's enactment date to allow the registrant sufficient time to obtain, prepare and analyze information to complete the accounting required under Accounting Standards Codification (ASC) 740.
The ultimate impact of the Act on our reported results in fiscal 2017 and beyond may differ from the estimates provided herein, possibly materially, due to, among other things, changes in interpretations and assumptions we have made, guidance that may be issued, and other actions we may take as a result of the Act differently from that presently contemplated.
Our effective income tax rate on our pre-tax income was 58.2% for the year ended December 31, 2017. Our effective income tax rate on our pre-tax loss was (459.0)% and 0.0% for the years ended December 31, 2016 and 2015, respectively. The difference between our statutory tax rate and our effective tax rate for the year ended December 31, 2017 is primarily due to tax expense of $13.6 million associated with the enactment of the Act, partially offset by a tax benefit of $3.3 million from excess share-based compensation for vested restricted stock units (RSUs) and exercised stock options. The difference between our statutory tax rate and our effective tax rate for the year ended December 31, 2016 is due to the release of the valuation allowance in 2016. Starting in 2018, we expect that our consolidated effective tax rate will approximate the statutory corporate tax rates.
Since inception and prior to December 31, 2016, we recorded a valuation allowance against deferred tax assets, and, as such, we generally did not record a benefit associated with the losses incurred in prior periods or other income tax benefits. At December 31, 2016, after weighing applicable evidence, we concluded that it was more-likely-than-not that our deferred tax asset would be realized. As a result, as of December 31, 2016, we released the valuation allowance on federal and certain state deferred tax assets. We continued to record a valuation allowance against net state deferred tax assets, primarily related to state net operating losses generated by NMIH that we do not expect to be utilized. NMIH operates at a loss and continues to only generate revenue from its investment portfolio.
The primary negative evidence that was considered was our cumulative losses in recent years. Although ASC 740 does not define the term or the length of time to consider when calculating the cumulative loss, practice and interpretations suggest that the guideline, not a "bright line", is to aggregate the pretax results as adjusted for permanent items for three years (i.e., the current and the two preceding years).
There is a tax sharing agreement between NMIH and its subsidiaries, dated August 23, 2012 and amended on September 1, 2016. Under this agreement, each of the parties mutually agreed to file a consolidated federal income tax return for 2012 and subsequent tax years, with NMIH as the direct tax filer. The tax liability of each subsidiary that is party to the agreement is limited to the amount of the liability it would incur if it filed separate returns.
(1) Long-term debt relates to our $150 million Credit Agreement and includes future interest payments using the minimum interest rate in effect at December 31, 2017 of 7.75%.
Our discussion and analysis of our financial condition and results of operation are based on our consolidated financial statements, which have been prepared in conformity with U.S. GAAP. In preparing our consolidated financial statements, management has made estimates, assumptions and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Because the use of estimates is inherent in GAAP, actual results could differ materially from those estimates. A summary of the accounting policies that management believes are critical to the preparation of our consolidated financial statements is set forth below.
Premiums for primary mortgage insurance policies may be paid in a single payment at origination (single premium), on a monthly installment basis (monthly premium) or on an annual installment basis (annual premium), with such election and payment type fixed at policy inception. Premiums written at origination for single premium policies are initially deferred as unearned premium reserve and amortized into earnings over the estimated policy life in accordance with the anticipated expiration of risk. Monthly premiums are recognized as revenue in the month billed as coverage is effective. Annual premiums are initially deferred and earned on a straight-line basis over the year of coverage. Premiums written on pool transactions are earned over the period that coverage is provided. Upon cancellation of a policy, all remaining non-refundable deferred and unearned premium is immediately earned, and any refundable premium is returned to the policyholder. Premiums returned to the policyholder are recorded as a reduction of written and earned premiums in the paid period.
We have designated our investment portfolio as available-for-sale and report it at fair value. The related unrealized gains and losses, after considering the related tax expense or benefit, are recognized as a component of accumulated other comprehensive income (loss) in shareholders' equity. Net realized investment gains and losses are reported in income based on specific identification of securities sold, and are reclassified out of accumulated other comprehensive income (loss).
Each fiscal quarter, we evaluate our investments to determine whether declines in fair value below amortized cost were considered other-than-temporary in accordance with applicable guidance. Under current guidance, a debt security impairment is deemed other-than-temporary if (i) we either intend to sell the security or it is more likely than not that we will be required to sell the security before recovery or (ii) we do not expect to collect cash flows sufficient to recover the amortized cost basis of the security. In evaluating whether a decline in fair value is other-than-temporary, we consider several factors including, but not limited to:
Costs directly associated with the successful acquisition of mortgage insurance policies, consisting of certain selling expenses and other policy issuance and underwriting expenses, are initially deferred and reported as DAC. DAC is reviewed periodically to determine that it does not exceed recoverable amounts and is adjusted as appropriate for policy cancellations to be consistent with our revenue recognition policy. We estimate the rate of amortization to reflect actual experience and any changes to persistency or loss development. For each book year of business, these costs are amortized to expense in proportion to estimated gross profits over the estimated life of the policies.
We account for income taxes using the liability method in accordance with ASC 740, Income Taxes. Under this method, we determine deferred tax assets and liabilities based on the expected future tax effects of temporary differences at the enacted tax rates applicable for the period in which the deferred tax assets or liabilities are expected to be realized or settled. Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements that would result in future increases or decreases in taxes owed on a cash basis as compared to amounts already recognized as tax expense in the consolidated statement of operations. Changes in tax laws, rates, regulations and policies, or the final determination of tax audits or examinations, could materially affect our tax estimates.
We are required to establish a valuation allowance against our deferred tax assets when it is more likely than not that all or a portion of our deferred tax assets will not be realized. We assess our need for a valuation allowance on a quarterly basis. In the course of our review, we assess all available evidence, both positive and negative, including future sources of income, tax planning strategies, future contractual cash flows and reversing temporary differences, and are required to exercise judgment and make assumptions in this regard.
To the Shareholders and Board of Directors of NMI Holdings, Inc.
NMI Holdings, Inc. (NMIH) is a Delaware corporation, incorporated in May 2011, to provide private mortgage guaranty insurance (which we refer to as mortgage insurance or MI) through its wholly owned insurance subsidiaries, National Mortgage Insurance Corporation (NMIC) and National Mortgage Reinsurance Inc One (Re One). In April 2012, we completed a private placement of our securities, through which we offered and sold an aggregate of 55,000,000 of our Class A common stock resulting in net proceeds of approximately $510 million (the Private Placement), and we completed the acquisition of our insurance subsidiaries for $8.5 million in cash, common stock and warrants, plus the assumption of $1.3 million in liabilities. In November 2013, we completed an initial public offering of 2.4 million shares of our common stock, and our common stock began trading on the NASDAQ exchange on November 8, 2013, under the symbol "NMIH."
For the year ended December 31, 2017, one customer represented 11% of our consolidated revenues. At December 31, 2017, approximately 14% of our total risk-in-force (RIF) was concentrated in California.
Consistent with industry practice, we establish reserves for claims based on our best estimate of ultimate claim costs for defaulted loans using the general principles contained in Accounting Standards Committee (ASC) 944, Financial Services - Insurance (ASC 944). We establish reserves for loans that have been in default for at least 60 days. Reserves for claims and allocated claims expenses, referred to as case reserves, are established when we are notified of defaults by loan servicers. Additional claims reserves, referred to as IBNR reserves, are established for loans that we estimate (based on actuarial review) have been in default for at least 60 days, but have not yet been reported to us as such by servicers. We also establish reserves for unallocated claims expenses not associated with specific claims. Claims expenses represent the estimated cost of the claim administration process, including legal and other fees, as well as other general expenses of administering the claims settlement process.
The establishment of claims and claims expense reserves is subject to inherent uncertainty and requires significant judgment by management. Reserves are established by estimating the number of loans in default that will result in a claim payment, which is referred to as claim frequency, and the amount of the claim payment expected to be paid on each such loan in default, which is referred to as claim severity. Claim frequency and severity estimates are established based on historical observed experience regarding certain loan factors, such as age of the default, size of the loan and LTV ratios, and are strongly influenced by prevailing economic conditions, such as mortgage rates, trends in unemployment and house price appreciation. We conduct an annual actuarial review to evaluate and, if necessary, update these assumptions.
We measure fair value and classify invested assets in a hierarchy for disclosure purposes consisting of three "levels" based on the observability of inputs available in the marketplace used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). See "Note 4, Fair Value of Financial Instruments" for further discussion.
Purchases and sales of investments are recorded on a trade date basis. Net investment income is recognized when earned, and includes interest and dividend income together with amortization of market premiums and discounts using the effective yield method, and is net of investment management fees and other investment related expenses. For asset-backed securities and any other holdings for which there is a prepayment risk, prepayment assumptions are evaluated and revised as necessary. Any adjustments required due to the change in effective yields and maturities are recognized on a prospective basis through yield adjustments.
Each quarter, we evaluate our investments to determine whether declines in fair value below amortized cost were considered other-than-temporary in accordance with applicable guidance. Under the current guidance, a debt security impairment is deemed other-than-temporary if (i) we either intend to sell the security or it is more likely than not that we will be required to sell the security before recovery or (ii) we do not expect to collect cash flows sufficient to recover the amortized cost basis of the security. In evaluating whether a decline in fair value is other-than-temporary, we consider several factors including, but not limited to:
recent credit downgrades of the applicable security or the issuer below investment grade; and
Costs directly associated with the successful acquisition of mortgage insurance policies, consisting of certain selling expenses and other policy issuance and underwriting expenses, are initially deferred and reported as deferred policy acquisition costs (DAC). DAC is reviewed periodically to determine that it does not exceed recoverable amounts and is adjusted as appropriate for policy cancellations to be consistent with our revenue recognition policy. We estimate the rate of amortization to reflect actual experience and any changes to persistency or loss development. For each book year of business, these costs are amortized to expense in proportion to estimated gross profits over the estimated life of the policies. Total amortization of DAC for each of the three years in the three-years period ended December 31, 2017, 2016 and 2015, net of a portion of ceding commission related to the 2016 QSR Transaction (see Note 6, "Reinsurance"), was $5.8 million, $4.3 million and $2.8 million, respectively.
We consider whether a premium deficiency exists at each fiscal quarter using best estimate assumptions as of the testing date. Per ASC 944, a premium deficiency reserve shall be recognized if the sum of expected claim costs and claim adjustment expenses, expected dividends to policyholders, unamortized acquisition costs and maintenance costs exceeds future premiums, existing reserves and anticipated investment income. We have determined that no premium deficiency reserves were necessary for any of the years in the three years period ended December 31, 2017.
We account for premiums, claims and claims expenses that are ceded to reinsurers on bases consistent with those we use to account for the original policies we issue and pursuant to the terms of our reinsurance contracts. We account for premiums ceded or otherwise paid to reinsurers as reductions to premium revenue.
We cede a portion of claims and claims expenses reserves to our reinsurers, which are accounted for as reinsurance recoverables in "Other Assets" on the consolidated balance sheets and as reductions to claims expense on the consolidated statements of operations. We remain directly liable for all loss payments in the event we are unable to collect from any reinsurer.
See Note 6, "Reinsurance" for further discussion of the reinsurance arrangement.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). This update requires that businesses recognize rights and obligations associated with certain leases as assets and liabilities on the balance sheet. The standard also requires additional disclosures regarding the amount, timing, and uncertainty of cash flows arising from leases. For public business entities, this update is effective for annual periods beginning after December 15, 2018 and interim periods therein. Early adoption is permitted in any period. We expect to adopt this guidance on January 1, 2019. In September 2017, ASU 2017-13, added guidance from an SEC Staff Announcement, "Transition Related to Accounting Standards Update No. 2016-02." We anticipate this standard will have an impact on our financial position, primarily due to our office space operating lease, as we will be required to recognize lease assets and lease liabilities on our consolidated balance sheet. We will continue to assess the potential impacts of this standard, including the impact the adoption of this guidance will have on our results of operations or cash flows.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230). This update is intended to reduce diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The standard will take effect for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. We have determined that the adoption of this update, effective January 1, 2018, will have no impact on our consolidated financial statements.
beginning after December 15, 2018. Early adoption is permitted. The guidance must be applied using a full or modified retrospective approach. We are currently evaluating the impact the adoption of this ASU will have, if any, on our consolidated financial statements.
During the first quarter of 2017, after filing the 2016 10-K, including the audited financial statements included therein, we discovered that $1.8 million of deferred taxes on vested options associated with employees terminated in previous years had not been reversed. Because our deferred tax asset (DTA) was subject to a valuation allowance prior to December 31, 2016, no expense would have been recognized in periods prior to December 31, 2016. However, at December 31, 2016, when we released the valuation allowance against the DTA, the DTA was overstated by $1.8 million and resulted in a $1.8 million overstatement of our 2016 income tax benefit and net income.
In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting (Topic 718), which intends to simplify various aspects of the accounting for and reporting of share-based payments. The new accounting is required to be adopted using a modified retrospective approach, with a cumulative-effect adjustment to opening retained earnings for any outstanding liability awards that qualify for equity classification under the new guidance.
The amortized cost and fair values of available-for-sale securities as of December 31, 2017 and December 31, 2016, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Because most asset-backed securities provide for periodic payments throughout their lives, they are listed below in a separate category.
As of December 31, 2017, the investment portfolio had gross unrealized losses of $3.7 million, $2.2 million of which has been in an unrealized loss position for a period of 12 months or greater. We did not consider these securities to be other-than-temporarily impaired as of December 31, 2017. We based our conclusion that these investments were not other-than-temporarily impaired as of December 31, 2017 on the following facts: (i) the unrealized losses were primarily caused by interest rate movements since the purchase date; (ii) we do not intend to sell these investments; and (iii) we do not believe that it is more likely than not that we will be required to sell these investments before recovery of our amortized cost basis, which may not occur until maturity. For those securities in an unrealized loss position, the length of time the securities were in such a position is as follows:
As of December 31, 2017 and 2016, we held no other-than-temporarily impaired securities. For the year ended December 31, 2017, we recognized OTTI losses in earnings of $144 thousand in the first quarter related to a single security with an unfavorable recovery forecast. The impaired security was liquidated in the second quarter. There were no credit losses recognized in earnings for which a portion of an OTTI loss was recognized in accumulated other comprehensive income (loss).
For the year ended December 31, 2015, we recognized an OTTI loss in earnings of $89 thousand due to a planned sale that we expected would result in a loss. The impaired security was liquidated in February 2016.
We revalue the warrant liability quarterly using a Black-Scholes option-pricing model, in combination with a binomial model, and we value the pricing protection features within the warrants using a Monte-Carlo simulation model. The following table outlines the key inputs and assumptions used in the option-pricing model as of the dates indicated.
On November 10, 2015, we entered into a credit agreement (the Credit Agreement) to obtain a $150 million three-year senior secured term loan (the Term Loan). On February 10, 2017, we amended the Credit Agreement (Amendment No. 1) to reduce the interest rate and extend the maturity date of the Term Loan from November 10, 2018 to November 10, 2019. On October 25, 2017, we further amended the Credit Agreement (Amendment No. 2) to remove a covenant that required NMIH to maintain liquidity (as defined therein) in an aggregate amount no less than all remaining interest payments due under the Term Loan. As modified by Amendment No. 2, the Credit Agreement retains a requirement that NMIH maintain liquidity in an aggregate amount no less than the sum of all remaining principal amortization payments due under the Term Loan, excluding principal scheduled to be paid on its maturity date. We have concluded that the amendments to the Credit Agreement should be treated as modifications.
As of December 31, 2017, the Term Loan bears interest at the Eurodollar Rate, as defined in the Credit Agreement and subject to a 1.00% floor, plus an annual margin rate of 6.75%, representing an all-in rate of 8.23%, payable monthly or quarterly based on our interest rate election. Quarterly principal payments of $375 thousand are also required. The outstanding balance of the Term Loan as of December 31, 2017 was $147 million.
We are subject to various covenants under the amended Credit Agreement, which include, but are not limited to the following: a maximum debt-to-total capitalization ratio (as defined therein) of 35%, maximum risk-to-capital (RTC) ratio of 22.0:1.0, minimum liquidity (as defined therein) of $2.6 million as of December 31, 2017, compliance with the PMIERs financial requirements (subject to any GSE-approved waivers), and minimum shareholders' equity requirements. This description is not intended to be complete in all respects and is qualified in its entirety by the terms of the amended Credit Agreement, including its covenants and events of default. We were in compliance with all covenants as of December 31, 2017.
At the time the 2017 ILN Transaction was entered into with Oaktown Re, we evaluated the applicability of the accounting guidance that addresses VIEs. As a result of the evaluation of the 2017 ILN Transaction, we concluded that Oaktown Re is a VIE. However, given that NMIC does not have significant economic exposure in Oaktown Re, we do not consolidate Oaktown Re in our consolidated financial statements.
Under the 2016 QSR Transaction, effective September 1, 2016, NMIC ceded premiums related to:
The following table shows the amounts related to the 2016 QSR Transaction:
December 31, 2016. In connection with the settlement of pool claims, we applied $368 thousand to the pool deductible through December 31, 2017. At December 31, 2017, the remaining pool deductible was $10.0 million. We have not paid any pool claims to date. 100% of our pool RIF is reinsured under the 2016 QSR Transaction.
(1) Related to ceded losses recoverable on the 2016 QSR Transaction, included in "Other Assets" on the Consolidated Balance Sheets. See Note 6, "Reinsurance" for additional information.
The "claims incurred" section of the table above shows claims and claim expenses incurred on NODs for current and prior years, including IBNR reserves. The amount of claims incurred relating to current year NODs represents the estimated amount of claims and claims expenses to be ultimately paid on such loans in default. We recognized $801 thousand, $65 thousand, and $49 thousand of favorable prior year development related to claims incurred in prior years during the year ended December 31, 2017, 2016 and 2015, respectively, due to NOD cures and ongoing analysis of recent loss development trends. We may increase or decrease our original estimates as we learn additional information about individual defaults and claims and continue to observe and analyze loss development trends in our portfolio. Gross reserves of $1.0 million related to prior year defaults remained as of December 31, 2017.
(2) The number of NODs outstanding as of December 31, 2017 is the total number of loans in default over 60 days for which we have established reserves.
Average annual percentage payout of incurred claims and allocated claims adjustment expenses by age, net of reinsurance
We issued 992 thousand warrants in connection with our Private Placement. Each warrant gives the holder thereof the right to purchase one share of common stock at an exercise price equal to $10.00. The warrants were issued with an aggregate fair value of $5.1 million.
During the year ended December 31, 2017, 55 thousand warrants were exercised resulting in 32 thousand common shares issued. No warrants were exercised during the years ended 2016 and 2015.
Share-based compensation includes stock options and restricted stock units (RSUs) granted under the 2012 Plan and the Amended 2014 Plan.
The 2012 Plan was approved by the Board on April 16, 2012 and authorized 5.5 million shares of common stock to be reserved for issuance, with 3.85 million shares available for stock options and 1.65 million shares available for RSUs. Options granted under the 2012 Plan are non-qualified stock options and may be granted to employees, directors and other key persons. The exercise price per share for options covered by the 2012 Plan is determined by the Board at the time of grant, but shall not be less than the fair market value of our common stock, defined as the closing price of our common stock, on the date of the grant. The term of the stock option grants is established by the Board, but no stock option shall be exercisable more than ten years after the date the stock option is granted. The vesting period of the stock option grants is also established by the Board at the time of grant and generally is for a three-year period. Upon the exercise of stock options, we issue shares from the authorized, unissued share reserve.
The 2014 Plan was approved by our stockholders at our annual meeting on May 8, 2014. The 2014 Plan authorized 4.0 million shares of common stock to be reserved for issuance. On May 11, 2017, our stockholders approved the Amended 2014 Plan at our annual stockholder meeting. The Amended 2014 Plan authorized an additional 2.0 million shares of common stock for issuance and, when taken together with the 2014 Plan, authorized a total of 6.0 million shares of common stock to be reserved for issuance. These shares may be either authorized but unissued shares or treasury shares.
A summary of option activity during the years ended December 31, 2017, December 31, 2016, and December 31, 2015 is as follows:
Scholes options pricing model. Compensation expenses are recognized over the requisite service period, which is generally the three-year vesting period of the options (vesting in one-third increments per year).
A summary of RSU activity during the years ended December 31, 2017, 2016 and 2015 are as follows:
At December 31, 2017, we had 2.1 million shares of granted and non-vested RSUs, consisting of 1.9 million shares that are subject to service condition vesting requirements and 0.2 million shares that are subject to service and performance condition vesting requirements. All RSUs subject to market and service condition vesting requirements vested prior to December 31, 2017. The total fair value of shares vested during the year ended December 31, 2017 was $18.1 million. The remaining weighted average contractual life of non-vested RSUs was 8.6 years. As of December 31, 2017, there was $7.0 million of total unrecognized compensation costs related to non-vested RSUs, compared to $4.2 million as of December 31, 2016. The weighted-average period over which total remaining compensation costs related to non-vested RSUs will be recognized was 1.6 years.
In July 2017, the Board approved a modification to the vesting terms of 29,818 granted and non-vested RSUs held by one employee. The modification accelerated the vesting date for all RSUs that would otherwise have vested in February 2018 to the date of the employee's retirement on July 31, 2017. We recognized an incremental compensation cost of $252 thousand in connection with this modification. The incremental compensation cost was measured as the excess of the fair value of the modified award over the fair value of the original award immediately before its terms were modified using relevant valuation inputs as of the modification date.
In May 2016, we granted 8,169 phantom stock units to one independent director with a grant date fair market value of $50 thousand. Each phantom unit entitled the holder to a cash award equal to the fair market value of the unit based on the price of our stock on the first anniversary of the grant date. We accounted for these units in accordance with ASC 718-30, Stock Compensation Awards Classified as Liabilities. These units vested in May 2017 and were settled for $89 thousand in cash. No phantom stock units were granted during the year ended December 31, 2017 and none remained outstanding as of December 31, 2017.
For the year ended December 31, 2017, we had income tax expense of $30.7 million, including amounts related to current year alternative minimum tax and changes to our net deferred tax asset. The changes to our net deferred tax asset reflect a one-time non-cash charge of $13.6 million primarily due to the re-measurement of our deferred tax assets and liabilities in connection with the enactment of the Tax Cuts and Jobs Act (the Act) on December 22, 2017.
The Act reduces the statutory U.S. federal corporate income tax rate from 35% to 21%. We have not completed our full assessment of the tax effects of the enactment of the Act on our December 31, 2017 deferred tax balances; however, in certain cases, as described below, we have made reasonable estimates of the effects on our deferred tax balances. We recognized a $13.6 million income tax expense in the year ended December 31, 2017 for the items we could reasonably estimate. We are still analyzing the Act and refining our calculations, which could impact the measurement of our existing deferred tax asset related to share-based compensation. For tax years beginning after December 31, 2017, the Act expanded the number of individuals whose compensation is subject to a $1 million cap on tax deductibility and includes performance-based compensation in the calculation. As a result, the Company recorded a provisional amount to reduce the future tax benefit related to share-based compensation. We will continue to make and refine our calculations as additional analysis is completed. In addition, our estimates may also be affected as we incorporate additional guidance that may be issued by the U.S. Treasury Department, the IRS, or other standard-setting bodies.
For the year ended December 31, 2016, we had income tax benefit of $52.5 million primarily related to the release of the valuation allowance recorded against our federal and certain state net deferred tax assets. At December 31, 2016, we determined that positive evidence of sufficient quantity and quality outweighed negative evidence, and supported a conclusion that it was more-likely-than-not that the Company would realize its federal and certain state net deferred tax assets. As a result, at December 31, 2016, we released the valuation allowance previously recorded against federal and certain state net deferred tax assets and recorded the effects of the change in income from continuing operations, generating financial statement benefits of $58.2 million and $0.3 million related to net federal and certain state net deferred tax assets, respectively. The 2016 provision for income taxes also included amounts for current year alternative minimum tax and changes to our net deferred tax asset.
periods. Our holding company files a consolidated U.S. federal and various state income tax returns on behalf of itself and its subsidiaries.
The following table presents a reconciliation between the federal statutory income tax rate and our effective income tax (benefit) rate:
At December 31, 2017, our net deferred tax asset decreased to $19.9 million from $51.4 million at December 31, 2016 due to the re-measurement of our deferred tax balances at the reduced statutory U.S. federal corporate income tax rate of 21% and the utilization of net operating loss carryforwards during 2017.
Following enactment of the Act, we re-measured our deferred tax balances based on the rate at which they are expected to reverse in the future, which is generally 21%. We have not, however, completed our full assessment of the impact the Act will have on our December 31, 2017 deferred tax balances. We are still analyzing certain aspects of the Act and refining our calculation on
our deferred tax asset balance related to share-based compensation, which could potentially affect the measurement of these balances or potentially give rise to further increases or decreases to our deferred tax amounts. The provisional amount recorded primarily related to the re-measurement of our deferred tax assets and liabilities was $13.6 million.
We recorded valuation allowances of $7.2 million and $6.9 million at December 31, 2017 and 2016, respectively, to reflect the amounts of state net deferred tax assets that may not be realized. The valuation allowance at December 31, 2017 primarily relates to state net operating losses generated by NMIH, as NMIH operates at a loss and currently only generates revenue from its investment portfolio.
Intangible assets and goodwill consist of identifiable intangible assets and goodwill we purchased in connection with the acquisition of our insurance subsidiaries, and at December 31, 2017 and December 31, 2016, were as follows for both years:
We test goodwill and intangible assets for impairment in the third and fourth quarter, respectively, of every year, or more frequently if we believe indicators of impairment exist. No impairments of indefinite-lived intangibles or goodwill were identified during the years ended December 31, 2017 and 2016.
As an Approved Insurer, NMIC is subject to ongoing compliance with the PMIERs. (Italicized terms have the same meaning that such terms have in the PMIERs, as described below.) The PMIERs establish operational, business, remedial and financial requirements applicable to Approved Insurers. The PMIERs financial requirements prescribe a risk-based methodology whereby the amount of assets required to be held against each insured loan is determined based on certain risk characteristics, such as FICO, vintage (year of origination), performing vs. non-performing (i.e., current vs. delinquent), LTV and other risk features. An asset charge is calculated for each insured loan based on its risk profile. In general, higher quality loans carry lower charges.
By April 15th of each year, NMIC must certify it met all PMIERs requirements as of December 31st of the prior year. We certified to the GSEs by April 15, 2017 that NMIC fully complied with the PMIERs as of December 31, 2016. NMIC also has an ongoing obligation to immediately notify the GSEs in writing upon discovery of its failure to meet one or more of the PMIERs requirements. We continuously monitor our compliance with the PMIERs
The company leases office space under a facilities lease in Emeryville, California. In December 2016, the Company amended its lease to extend its term through March 2023.
As of December 31, 2017, the future minimum lease payments under this lease are as follows:
Our insurance subsidiaries, NMIC and Re One, file financial statements in conformity with statutory accounting principles (SAP) prescribed or permitted by the Wisconsin OCI, NMIC's principal regulator. Prescribed SAP includes state laws, regulations and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners. The Wisconsin OCI recognizes only statutory accounting practices prescribed or permitted by the state of Wisconsin for determining and reporting the financial condition and results of operations of an insurance company and for determining its solvency under Wisconsin insurance laws.
NMIC and Re One's combined statutory net loss, statutory surplus, contingency reserve and RTC ratios for each of the years in the three-year period ended December 31, 2017 were as follows:
NMIH is not subject to any limitations on its ability to pay dividends except those generally applicable to corporations that are incorporated in Delaware, such as NMIH. Delaware corporation law provides that dividends are only payable out of a corporation's capital surplus or, subject to certain limitations, recent net profits. As of December 31, 2017, NMIH's shareholders' equity was approximately $509 million. NMIH's total assets, excluding investment and intercompany receivables for NMIC, Re One, and NMIS, were approximately $84 million at December 31, 2017.
As of December 31, 2017, the amount of restricted net assets held by our consolidated insurance subsidiaries totaled approximately $574 million. The amount of restricted assets used to determine any dividend to NMIH, once all restrictions expire, would be computed under SAP which may differ from the amount of restricted assets computed under GAAP.