At December 31, 2015, we leased office space in various cities throughout the United States under leases expiring between 2016 and 2021 and which required monthly rental payments that in the aggregate are immaterial.
In the third quarter of 2015 we reversed the valuation allowance against our deferred tax assets. See Note 14 - "Income Taxes" to our consolidated financial statements in Item 8 for a discussion of the reversal of the valuation allowance and impact on our consolidated financial statements.
The loss ratio is the ratio, expressed as a percentage of the sum of incurred losses and loss adjustment expenses to net premiums earned. The expense ratio is the ratio, expressed as a percentage, of the combined insurance operations underwriting expenses to net premium written.
Through our subsidiary Mortgage Guaranty Insurance Corporation (“MGIC”) we are a leading provider of private mortgage insurance in the United States, as measured by $174.5 billion of primary insurance in force on a consolidated basis at December 31, 2015.
We believe that housing fundamentals are solid and expect that household formations will continue to increase and that home sales will increase. Mortgage interest rates remain very low relative to historical norms and the level of unemployment has been decreasing. However, the private mortgage insurance industry will continue to be very competitive. Growing our insurance in
Based on our interpretation of the PMIERs, as of December 31, 2015, MGIC’s Available Assets are $5.0 billion and its Minimum Required Assets are $4.5 billion; and MGIC is in compliance with the financial requirements of the PMIERs and eligible to insure loans purchased by the GSEs. Our Available Assets do not include approximately $100 million of statutory capital at our subsidiary MGIC Indemnity Corporation ("MIC") in excess of the minimum policyholder position that remained after MIC repatriated $387 million to MGIC in the fourth quarter of 2015. Additional repatriation of funds from MIC to MGIC would be subject to regulatory approval. For information about the first quarter 2016 purchase by MGIC of a portion of our outstanding 9% Convertible Junior Subordinated Debentures, see “Debt at Our Holding Company and Holding Company Capital Resources” below.
The GSEs could make the PMIERs more onerous in the future; in this regard, the PMIERs provide that the tables of factors that determine Minimum Required Assets will be updated every two years and may be updated more frequently to reflect changes in macroeconomic conditions or loan performance. The GSEs will provide notice 180 days prior to the effective date of table updates. In addition, the GSEs may amend the PMIERs at any time.
While on an overall basis, the amount of Available Assets MGIC must hold in order to continue to insure GSE loans increased under the PMIERs over what state regulation currently requires, our reinsurance transaction mitigates the negative effect of the PMIERs on our returns. In this regard, see the first bullet point above.
The insurance laws of 16 jurisdictions, including Wisconsin, our domiciliary state, require a mortgage insurer to maintain a minimum amount of statutory capital relative to the risk in force (or a similar measure) in order for the mortgage insurer to continue to write new business. We refer to these requirements as the “State Capital Requirements.” While they vary among jurisdictions, the most common State Capital Requirements allow for a maximum risk-to-capital ratio of 25 to 1. A risk-to-capital ratio will increase if (i) the percentage decrease in capital exceeds the percentage decrease in insured risk, or (ii) the percentage increase in capital is less than the percentage increase in insured risk. Wisconsin does not regulate capital by using a risk-to-capital measure but instead requires a minimum policyholder position (“MPP”). The “policyholder position” of a mortgage insurer is its net worth or surplus, contingency reserve and a portion of the reserves for unearned premiums.
The NAIC previously announced that it plans to revise the minimum capital and surplus requirements for mortgage insurers that are provided for in its Mortgage Guaranty Insurance Model Act. A working group of state regulators is drafting the revisions, although no date has been established by which the NAIC must propose revisions to such requirements. Depending on the scope of revisions made by the NAIC, MGIC may be prevented from writing new business in the jurisdictions adopting such revisions.
rule requires the agencies that implemented the rule to review the QRM definition no later than four years after its effective date and every five years thereafter, and allows each agency to request a review of the definition at any time.
For additional information about the business practices of the GSEs, see our risk factor titled “Changes in the business practices of the GSEs, federal legislation that changes their charters or a restructuring of the GSEs could reduce our revenues or increase our losses” in Item 1A.
The GSEs’ Home Affordable Refinance Program (“HARP”), allows borrowers who are not delinquent but who may not otherwise be able to refinance their loans under the current GSE underwriting standards, to refinance their loans. We allow HARP refinances on loans that we insure, regardless of whether the loan meets our current underwriting standards, and we account for the refinance as a loan modification (even where there is a new lender) rather than new insurance written. As of December 31, 2015, approximately 13% of our primary insurance in force had benefitted from HARP and was still in force.
In each of 2014 and 2015, approximately 16% of our primary cures were the result of modifications, with HAMP accounting for approximately 67% and 66% of the modifications in each of those periods, respectively. Although the HAMP and HARP programs have been extended through December 2016, we believe that we have realized the majority of the benefits from them because the number of loans insured by us that we are aware are entering those programs has decreased significantly.
As of December 31, 2015 based on loan count, the loans associated with 97.7% of all HARP modifications, 77.0% of HAMP modifications and 71.4% of other modifications were current.
Premium rates, which are affected by product type, competitive pressures, the risk characteristics of the loans insured and the percentage of coverage on the loans. The substantial majority of our monthly mortgage insurance premiums are under a premium plan in which, for the first ten years of the policy, the amount of premium is determined by multiplying the initial premium rate by the original loan balance; thereafter, the premium declines because a lower premium rate is used for the remaining life of the policy. However, for loans that have utilized HARP, the initial ten-year period resets to begin as of the date of the HARP transaction. The remainder of our monthly premiums are under a premium plan in which premiums are determined by a fixed percentage of the loan’s amortizing balance over the life of the policy.
Premiums ceded, net of a profit commission, under reinsurance agreements. See Note 11 - “Reinsurance” to our consolidated financial statements in Item 8 for a discussion of our reinsurance agreements.
Premiums are generated by the insurance that is in force during all or a portion of the period. A change in the average insurance in force in the current period compared to an earlier period is a factor that will increase (when the average in force is higher) or reduce (when it is lower) premiums written and earned in the current period, although this effect may be enhanced (or mitigated) by differences in the average premium rate between the two periods, as well as by premiums that are returned or expected to be returned in connection with claim payments and rescissions, and premiums ceded under reinsurance agreements. Also, new insurance written and cancellations during a period will generally have a greater effect on premiums written and earned in subsequent periods than in the period in which these events occur.
The state of the economy, including unemployment and housing values, each of which affects the likelihood that loans will become delinquent and whether loans that are delinquent cure their delinquency. The level of new delinquencies has historically followed a seasonal pattern, with new delinquencies in the first part of the year lower than new delinquencies in the latter part of the year, though this pattern can be affected by the state of the economy and local housing markets.
Net realized gains for 2015 included $28.4 million in net realized gains on the sale of fixed income investments. Net realized gains for 2014 included $1.5 million in net realized gains on the sale of fixed income investments, slightly offset by $0.1 million in OTTI losses. As of December 31, 2015, the net unrealized losses in our investment portfolio were $26.6 million, which included $67.8 million of gross unrealized losses, partially offset by $41.3 million of gross unrealized gains.
Other revenue for 2015 increased compared to 2014 primarily due to an increase in our contract underwriting fees attributable to higher mortgage origination volumes.
Losses incurred for 2015 decreased compared to 2014 primarily due to a decrease in new delinquency notices received, a lower claim rate on new notices, and an increase in favorable development on prior year loss reserves compared to 2014.
During 2015 the premium deficiency reserve on Wall Street bulk transactions declined by $24 million and was eliminated during the second quarter of 2015. The decrease in the premium deficiency reserve represents the net result of actual premiums, losses and expenses as well as a change in net assumptions for the period. The change in net assumptions for 2015 is primarily related to lower estimated ultimate losses.
Underwriting and other expenses for 2015 increased when compared to 2014. The increase is due to a return of ceding commissions to reinsurers as a result of commuting our 2013 QSR Transaction and an increase in employee costs.
The effective tax rate (benefit) provision on our pre-tax income was (140.3%) and 1.1% in 2015 and 2014, respectively. During 2015, the effective tax rate provision was reduced and became an effective tax rate (benefit) due to the reversal of the deferred tax asset valuation allowance. During 2014, the effective tax rate provision was reduced by the change in the deferred tax asset valuation allowance.
The increase in new insurance written in 2014 compared to 2013 was primarily due to increases in the penetration rate of private mortgage insurance in the overall insured mortgage market, which was driven by a combination of factors including changes to the prices and fees of the FHA, the GSEs and the private mortgage insurers. The FHA also reversed a past FHA policy pursuant to which insurance premiums for borrowers were canceled once the borrower paid down their mortgage below a certain percentage. The combined effect of these pricing and policy changes increased the percentage of market share of private mortgage insurers versus the FHA. The increase in new insurance written in 2014 compared to 2013 was also due to a recapture of market share from our competitors throughout 2014.
Our persistency rate was 79.7% at December 31, 2015 compared to 82.8% at December 31, 2014 and 79.5% at December 31, 2013. Our persistency rate is affected by the level of current mortgage interest rates compared to the mortgage interest rates on our insurance in force, and home price appreciation, both of which affect the vulnerability of the insurance in force to refinancing. Due to refinancing activity in 2015, we experienced lower persistency on our 2004 through 2013 books of business compared to year-end 2014. During the 1990s, our year-end persistency ranged from a high of 87.4% at December 31, 1990 to a low of 68.1% at December 31, 1998. Since 2000, our year-end persistency ranged from a high of 84.7% at December 31, 2009 to a low of 47.1% at December 31, 2003.
We have written no new pool insurance since 2009, however, for a variety of reasons, including responding to capital market alternatives to private mortgage insurance and customer demands, we may write pool risk in the future. Our direct pool risk in force was $659 million ($271 million on pool policies with aggregate loss limits and $388 million on pool policies without aggregate loss limits) at December 31, 2015 compared to $808 million ($303 million on pool policies with aggregate loss limits and $505 million on pool policies without aggregate loss limits) at December 31, 2014. If claim payments associated with a specific pool reach the aggregate loss limit the remaining insurance in force within the pool would be cancelled and any remaining defaults under the pool are removed from our default inventory.
Net premiums written and earned during 2015 increased when compared to 2014. The increase was attributable to a commutation of our 2013 QSR Transaction and higher average insurance in force. The reinsurance commutation resulted in a return to us of written premiums previously ceded to reinsurers and an increase in our profit commission due to a related return of ceding commissions to the reinsurers.
Our net premiums written and earned are net of amounts ceded to reinsurers who assume a portion of the risk under the insurance policies we write that are subject to reinsurance. A substantial portion of our business is covered by a quota share reinsurance agreement that became effective July 1, 2015 and that protects us against a fixed percentage of losses arising from policies covered by the agreement. Under that agreement, we cede to reinsurers 30% of earned and received premiums and losses incurred on the following: policies in the 2013 QSR Transaction that was commuted; additional qualifying in force policies as of the agreement effective date which either had no history of defaults, or where a single default has been cured for twelve or more months at the agreement effective date; as well as all qualifying new insurance written through December 31, 2016. The premiums we cede are reduced by a profit commission, which primarily varies by the level of losses we cede. The 2015 quota share reinsurance agreement ("2015 QSR Transaction") increases the amount of our insurance in force covered by reinsurance and will result in an increase in the amount of premiums and losses ceded.
Our reinsurance affects premiums, underwriting expenses and losses incurred and should be analyzed by reviewing its total effect on our statement of operations, as discussed below under “Reinsurance agreements.”
The monthly premium program used for the substantial majority of loans we insured provides that, for the first ten years of the policy, the premium is determined by the product of the initial premium rate and the initial loan balance; thereafter, a lower premium rate is applied to the initial loan balance. The initial ten-year period is reset when the loan is refinanced under HARP. The premiums on many of the policies in our 2005 book that were not refinanced under HARP reset in 2015. As of December 31, 2015, approximately 24%, 28%, 36%, and 51% of our insurance in force from 2005, 2006, 2007, and 2008 respectively, has been refinanced under HARP.
Our reinsurance affects various lines of our statements of operations and therefore we believe it should be analyzed by reviewing its effect on our net income, as described below.
•We cede a fixed percentage of premiums on insurance covered by the agreement.
•We cede a fixed percentage of losses incurred on insurance covered by the agreement.
As discussed in Note 11 - “Reinsurance” to our consolidated financial statements in Item 8, MGIC reached a settlement with the CFPB in 2013 and reached an additional settlement in June 2015 with the Minnesota Department of Commerce (the "MN Department") to resolve their investigations. As part of the settlements we have agreed to not enter into any new captive reinsurance agreement or reinsure any new loans under any existing captive reinsurance agreement for a period of ten years subsequent to the respective settlements. In accordance with the CFPB settlement, all of our active captive agreements were placed into run-off. Further, the GSEs will not approve any future reinsurance or risk sharing transaction with a mortgage enterprise or an affiliate of a mortgage enterprise as outlined in the PMIERs. See Note 11 - “Reinsurance” to our consolidated financial statements in Item 8 for a description of our reinsurance agreements and the related reinsurance recoverable, as well as a description of our 2015 QSR Transaction.
Net investment income in 2014 was higher when compared to 2013. The increase in investment income was due to higher investment yields driven by a larger allocation of the investment portfolio to corporate debt securities, which produce yields above the U.S. government debt they replaced, and also reinvestment of proceeds into securities with longer time to maturity on average. The portfolio’s average pre-tax investment yield was 2.2% with duration of 3.9 years as of December 31, 2014 compared to an average pre-tax investment yield of 1.7% and duration of 3.2 years as of December 31, 2013.
Our current investment policy emphasizes preservation of capital. Therefore, our investment portfolio consists almost entirely of high-quality, investment grade, fixed maturity securities. The investment policy also places an emphasis on maximizing net investment income. In order to maximize net investment income, the concentration of tax-exempt municipal securities has increased with sustained profitability of the company. Tax-exempt municipal securities represent 22% of the investment portfolio as of December 31, 2015 compared to 2% as of December 31, 2014.
Net realized gains for 2014 included $1.5 million in net realized gains on the sale of fixed maturity securities, slightly offset by $0.1 million of OTTI losses.
Net realized gains for 2013 included $6.1 million in net realized gains on the sale of fixed maturity securities, slightly offset by $0.3 million in OTTI losses.
Losses incurred for 2015 decreased by $153 million compared to 2014. The decrease was primarily due to a decrease in the number of new default notices received, net of cures, and favorable development on prior year losses. The primary default inventory decreased by 17,268 delinquencies in 2015 compared to a decrease of 23,427 in 2014. Substantially all of the new default notices received in 2015 are with respect to loans insured in 2008 and prior. As a result of improving housing and economic conditions the claim rate applied to new notices in 2015 has declined by approximately 1.5 percentage points compared to new notices in 2014. Regarding new notices in 2016, our expectation is for limited improvement in the 13% claim rate applied to new notices as of December 31, 2015.
Information about the composition of the primary insurance default inventory at December 31, 2015, 2014 and 2013 appears in the table below.
The primary and pool loss reserves as of December 31, 2015, 2014 and 2013 appear in the table below.
Jurisdictions in italics are those that predominately use a judicial foreclosure process, which generally increases the amount of time it takes for a foreclosure to be completed.
The average claim paid, as shown in the table below, can vary materially from period to period based upon a variety of factors, including the local market conditions, average loan amount, average coverage percentage, and loss mitigation efforts on loans for which claims are paid.
* Excludes claim payments associated with the implementation of the settlement agreement with Countrywide as discussed in Note 20 - "Litigation and Contingencies" to our consolidated financial statements in Item 8.
The primary average loan size of our insurance in force at December 31, 2015, 2014 and 2013 for the top 5 jurisdictions (based on 2015 paid claims) appears in the table below.
Information about net paid claims during the years ended December 31, 2015, 2014 and 2013 appears in the table below.
2015, 2014 and 2013 each include $42 million paid under the terms of our settlement with Freddie Mac as discussed in Note 9 - "Loss Reserves" to our consolidated financial statements in Item 8.
Primary claims paid for the top 15 jurisdictions (based on 2015 paid claims) and all other jurisdictions for the years ended December 31, 2015, 2014 and 2013 appear in the table below.
In 2013 the claims paid associated with our settlement agreement with Countrywide is included in "Other" above and not in the specific jurisdiction disclosure.
The primary default inventory by policy year at December 31, 2015, 2014 and 2013 appears in the table below.
On our primary business, the highest claim frequency years have typically been the third and fourth year after the year of loan origination. However, the pattern of claims frequency can be affected by many factors, including persistency and deteriorating economic conditions. Low persistency can accelerate the period in the life of a book during which the highest claim frequency occurs. Deteriorating economic conditions can result in increasing claims following a period of declining claims. As of December 31, 2015, 50% of our primary risk in force was written subsequent to December 31, 2012, 57% of our primary risk in force was written subsequent to December 31, 2011, and 59% of our primary risk in force was written subsequent to December 31, 2010.
See Note 10 - “Premium Deficiency Reserve” to our consolidated financial statements in Item 8 for a discussion of our premium deficiency reserve, as well as under “Critical Accounting Policies” below.
Underwriting and other expenses for 2015 increased when compared to 2014. The increase was primarily due to a return of ceding commissions to reinsurers as a result of commuting our 2013 QSR Transaction and an increase in employee costs.
Underwriting and other expenses for 2014 decreased when compared to 2013. The decrease primarily reflects an increase in ceding commissions related to our reinsurance agreements, a reduction in employee costs, and a decrease in legal expenses.
The chart below presents our GAAP loss and expense ratios for our combined insurance operations for the years ended December 31, 2015, 2014 and 2013.
The loss ratio is the ratio, expressed as a percentage, of the sum of incurred losses and loss adjustment expenses to net premiums earned. The loss ratio does not reflect any effects due to premium deficiency. The decrease in the loss ratio in 2015 compared to 2014 was due to lower losses incurred and an increase in premiums earned. The underwriting expense ratio is the ratio, expressed as a percentage, of the underwriting expenses of our combined insurance operations (which excludes the cost of non-insurance operations) to net premiums written. The increase in the expense ratio in 2015 compared to 2014 was due to an increase in employee costs and a decrease in ceding commissions, offset in part by an increase in net premiums written. The decrease in ceding commissions was attributable to the commutation of the 2013 QSR Transaction. The increase in net premiums written in 2015 was attributable to the commutation of our 2013 QSR Transaction, due to the return of ceded unearned premiums, as well as higher average insurance in force.
The decrease in the loss ratio in 2014 compared to 2013 was due to a decrease in losses incurred, somewhat offset by a decrease in net premiums earned. The decrease in the underwriting expense ratio in 2014 compared to 2013 was due to an increase in ceding commissions under our 2013 QSR Transaction and a decrease in other expenses of our combined insurance operations, offset in part by a decrease in net premiums written.
Interest expense for 2014 decreased when compared to 2013. The decrease is primarily related to a $10.5 million decrease in amortization of the discount on our junior debentures, which became fully amortized in the first quarter of 2013, and a decrease in interest expense on our Senior Notes due in 2015 resulting from repurchases in 2013 and 2014. These decreases were offset in part by an increase in interest expense from our Convertible Notes due in 2020 that were issued in the March of 2013.
Investments totaled $4.7 billion as of December 31, 2015, increasing from $4.6 billion as of December 31, 2014.
Net realized investment gains were $28.4 million in 2015 compared to $1.4 million in 2014.
The return on our investment portfolio is an important component of our financial results. Our main portfolio objectives are to maximize yield, protect principal, maximize statutory capital, and minimize losses. In that regard, we employ a strategic asset allocation approach which considers the risk and return parameters of the various asset classes in which we invest. This asset allocation is informed by our global economic and market outlook, as well as other inputs and constraints, including diversification effects, duration, liquidity and capital considerations. The credit risk of specific securities is evaluated through analysis of the underlying fundamentals that includes consideration of the issuer's sector, scale, profitability, debt cover, and ratings. The investment policy guidelines limit the amount of our credit exposure to any one issue, issuer and type of instrument. The investment portfolio is principally invested in marketable investment grade fixed maturity securities and targets an intermediate 5 to 7 year duration.
See Note 6 - “Investments” to our consolidated financial statements in Item 8 for additional disclosure on our investment portfolio.
As of December 31, 2015 and 2014 our investment portfolio was primarily made up of fixed maturity securities. Total investments increased to $4.7 billion as of December 31, 2015, from $4.6 billion as of December 31, 2014, primarily due to available capital from positive operating cash flows, partially offset by the repayment and repurchases of debt obligations in 2015 and a decrease in fair values. As of December 31, 2015, approximately 3% of the investment portfolio's fair value was in energy sector corporate bond holdings with net unrealized losses of $14.6 million.
The ratings above are provided by one or more of: Moody’s, Standard & Poor’s and Fitch Ratings. If three ratings are available the middle rating is utilized, otherwise the lowest rating is utilized. Approximately 2% of our investment portfolio is guaranteed by financial guarantors. As of December 31, 2015, less than 1% of our fixed maturity securities relied on financial guaranty insurance to elevate their rating.
Loss reserves are the primary liability on our balance sheet and they represent our estimated liability for losses and settlement expenses under MGIC's mortgage guaranty insurance policies, before considering offsetting reinsurance balances recoverable. Reinsurance balances recoverable on our estimated losses and settlement expenses, which serve to offset our loss reserves, were $44.5 million as of December 31, 2015.
The loss reserves can be split into two parts: (1) reserves representing estimates of losses and settlement expenses on known delinquencies and (2) IBNR reserves representing estimates of losses and settlement expenses on delinquencies that have occurred but have not yet been reported to us. Our gross liability for both is reduced by reinsurance balances recoverable on our estimated losses and settlement expenses to calculate a net reserve balance. The net reserve balance decreased to $1.8 billion as of December 31, 2015, from $2.3 billion as of December 31, 2014. This reflects incurred losses of $343.5 million in 2015 offset by paid losses of $833.6 million compared to incurred losses of $496.1 million offset by $1.2 billion paid losses in 2014. The overall decrease in our loss reserves between 2015 and 2014 was due to a higher level of losses paid relative to losses incurred in 2015. The primary driver of our lower level of losses incurred in 2015 compared to 2014 was the receipt of fewer delinquency notices and a higher cure rate.
We had convertible debt obligations outstanding as of December 31, 2015 totaling $1.2 billion. Our next scheduled debt maturity is in May 2017, with additional scheduled maturities in April 2020, and April 2063. In addition, see Note 7 - "Fair Value Measurements" and Note 8 - "Debt" to our consolidated financial statements in Item 8 for disclosures regarding our debt as of December 31, 2015.
During the first quarter of 2016 through February 26, 2016 we purchased $127.7 million in par value of our 5% Convertible Senior Notes due in 2017 with funds from our holding company and MGIC purchased $132.7 million of par value of our 9% Convertible Junior Subordinated Debentures due in 2063, which will be deemed retired on our consolidated financial statements,
using $155 million in funds obtained from the proceeds of a borrowing from the Federal Home Loan Bank of Chicago ("FHLBC"), of which it is a member. See "Liquidity and Capital Resources" and "Contractual Obligations" below for additional discussion of these 2016 debt transactions, our remaining outstanding debt obligations and supporting liquidity.
We had positive operating cash flow in 2015. For the years ended 2014 and 2013 our operating activities were a substantial use of cash due to negative underwriting results that required significant claim payments in excess of our premiums received. For the year ended 2015, our premiums received exceeded the level of claims paid. When we experience cash shortfalls, we can fund them through sales of investment portfolio securities. To the extent funds are required by an entity other than the seller of these securities, a transfer of capital from one entity to another would be required. Payment of a dividend would be subject to insurance regulatory requirements. A significant portion of our investment portfolio is held by our insurance subsidiaries.
Net cash flows used in investing activities in 2015 was primarily the result of purchasing securities in an amount that exceeded our proceeds from sales and maturities of fixed maturity securities during the year. This outflow was offset in part by a reduction of cash restricted in its use.
In 2014, net cash flows provided by investing activities was primarily the result of proceeds from sales and maturities of our fixed maturity securities exceeding our investment purchases.
In 2013, cash used in investment activities was primarily the result of purchases of fixed maturity securities using proceeds from our concurrent stock and convertible senior note offerings.
As of December 31, 2015, our capital structure consisted of $1.2 billion of long-term debt and $2.2 billion of shareholders' equity. Debt outstanding represented 35.4% of total capital as of December 31, 2015, which is a decrease from 55.6% as of December 31, 2014.
We currently have 1.0 billion shares of common stock authorized with approximately 340 million issued and outstanding.
The following table summarizes our capital structure as of December 31, 2015, 2014, and 2013.
As of December 31, 2015, we had approximately $402 million in cash and investments at our holding company. As of December 31, 2015, our holding company’s debt obligations were $1,223 million in par value consisting of:
The 9% Debentures are not extinguished; MGIC will hold them as an asset, will receive interest on them at the same time as interest is paid to other holders of the 9% Debentures and will be entitled to convert them into common stock of the holding company on the same terms as other holders. However, for GAAP accounting purposes, the 9% Debentures owned by MGIC will be considered retired and will be eliminated in our consolidated financial statements and the underlying common stock equivalents, approximately 9.8 million, will not be included in the computation of diluted shares.
During 2015 we repurchased $11.5 million of par value of the 5% Notes and paid total cash consideration of $12 million. We funded the purchases with cash at the holding company. The purchases of the 5% Notes were at a cost slightly above par, for which we recognized a loss of $0.5 million.
See Note 8 - “Debt” to our consolidated financial statements in Item 8 for additional information about this indebtedness, including our option to defer interest on our 9% Debentures. Any deferred interest compounds at the stated rate of 9%. The description in Note 8 - “Debt" to our consolidated financial statements in Item 8 is qualified in its entirety by the terms of the notes and debentures. The terms of our 5% Convertible Senior Notes are contained in a Supplemental Indenture, dated as of April 26, 2010, between us and U.S. Bank National Association, as trustee, which is included as an exhibit to our 8-K filed with the SEC on April 30, 2010, and in the 2000 Indenture. The terms of our 2% Convertible Senior Notes are contained in a Second Supplemental Indenture, dated as of March 12, 2013, between us and U.S. Bank National Association, as trustee, and the Indenture dated as of October 15, 2000, between us and the trustee. The terms of our Convertible Junior Debentures are contained in the Indenture dated as of March 28, 2008, between us and U.S. Bank National Association filed as an exhibit to our Form 10-Q filed with the SEC on May 12, 2008.
We may also contribute funds to our insurance operations to comply with the PMIERs or the State Capital Requirements. See “Overview - Capital” above for a discussion of these requirements. See the discussion of our non-insurance contract underwriting services in Note 20 - “Litigation and Contingencies” to our consolidated financial statements in Item 8 for other possible uses of holding company resources.
Based on our interpretation of the PMIERs, as of December 31, 2015, MGIC’s Available Assets are $5.0 billion and its Minimum Required Assets are $4.5 billion; and MGIC is in compliance with the financial requirements of the PMIERs and eligible to insure loans purchased by the GSEs. Our Available Assets do not include approximately $100 million of statutory capital in excess of MIC’s minimum policyholder position that remained after MIC repatriated $387 million to MGIC in the fourth quarter of 2015. Additional repatriation of funds from MIC to MGIC would be subject to regulatory approval.
We compute our risk-to-capital ratio on a separate company statutory basis, as well as on a combined insurance operations basis. The risk-to-capital ratio is our net risk in force divided by our policyholders’ position. Our net risk in force includes both primary and pool risk in force, and excludes risk on policies that are currently in default and for which loss reserves have been established. The risk amount includes pools of loans with contractual aggregate loss limits and in some cases without these limits. Policyholders’ position consists primarily of statutory policyholders’ surplus (which increases as a result of statutory net income and decreases as a result of statutory net loss and dividends paid), plus the statutory contingency reserve and a portion of the reserves for unearned premiums. The statutory contingency reserve is reported as a liability on the statutory balance sheet. A mortgage insurance company is required to make annual contributions to the contingency reserve of approximately 50% of net earned premiums. These contributions must generally be maintained for a period of ten years. However, with regulatory approval a mortgage insurance company may make early withdrawals from the contingency reserve when incurred losses exceed 35% of net earned premiums in a calendar year.
The premium deficiency reserve discussed in Note 10 - “Premium Deficiency Reserve” to our consolidated financial statements in Item 8 is not recorded as a liability on the statutory balance sheet and is not a component of statutory net income. The present value of expected future premiums and already established loss reserves and statutory contingency reserves, exceeds the present value of expected future losses and expenses on our total in force book, so no deficiency is recorded on a statutory or GAAP basis as December 31, 2015. On a GAAP basis, contingency loss reserves are not established and thus not considered when calculating premium deficiency reserve. When calculating a premium deficiency reserve on a GAAP basis, policies are grouped based on how they are acquired, serviced and measured.
Risk in force - net, as shown in the table above, is net of reinsurance and exposure on policies currently in default and for which loss reserves have been established.
Our other long-term liabilities represent the loss reserves established to recognize the liability for losses and loss adjustment expenses related to defaults on insured mortgage loans. The timing of the future claim payments associated with the established loss reserves was determined primarily based on two key assumptions: the length of time it takes for a notice of default to develop into a received claim and the length of time it takes for a received claim to be ultimately paid. The future claim payment periods are estimated based on historical experience, and could emerge significantly different than this estimate. Due to the uncertainty regarding how certain factors, such as loss mitigation protocols established by servicers and changes in some state foreclosure laws that may include, for example, a requirement for additional review and/or mediation process, will affect our future paid claims it is difficult to estimate the amount and timing of future claim payments. See Note 9 - “Loss Reserves” to our consolidated financial statements in Item 8 and “Critical Accounting Policies” below. In accordance with GAAP for the mortgage insurance industry, we establish loss reserves only for loans in default. Because our reserving method does not take account of the impact of future losses that could occur from loans that are not delinquent, our obligation for ultimate losses that we expect to occur under our policies in force at any period end is not reflected in our financial statements or in the table above.
In considering the potential sensitivity of the factors underlying our best estimate of loss reserves, it is possible that even a relatively small change in estimated claim rate or a relatively small change in estimated claim amount could have a significant impact on reserves and, correspondingly, on results of operations. For example, a $1,000 increase in the average severity reserve factor combined with a 1 percentage point increase in the average claim rate reserve factor would change the reserve amount by approximately $68 million as of December 31, 2015. Historically, it has not been uncommon for us to experience variability in the development of the loss reserves through the end of the following year at this level or higher, as shown by the historical development of our loss reserves in the table below:
Estimation of losses is inherently judgmental. The actual amount of the claim payments may be substantially different than our loss reserve estimates. Our estimates could be adversely affected by several factors, including a deterioration of regional or national economic conditions, including unemployment, leading to a reduction in borrower income and thus their ability to make mortgage payments, and a drop in housing values, that could result in, among other things, greater losses on loans, and may affect borrower willingness to continue to make mortgage payments when the value of the home is below the mortgage balance. Our estimates are also affected by any agreements we enter into regarding our claims paying practices, such as the settlement agreements discussed in Note 20 - “Litigation and Contingencies” to our consolidated financial statements in Item 8. Changes to our estimates could result in a material impact to our results of operations and capital position, even in a stable economic environment.
The establishment of premium deficiency reserves is subject to inherent uncertainty and requires judgment by management. The actual amount of claim payments and premium collections may vary significantly from the premium deficiency reserve estimates. Similar to our loss reserve estimates, our estimates for premium deficiency reserves could be adversely affected by several factors, including a deterioration of regional or economic conditions leading to a reduction in borrowers’ income and thus their ability to make mortgage payments, and a drop in housing values that could expose us to greater losses. Changes to our estimates could result in material changes in our operations, even in a stable economic environment. Adjustments to premium deficiency reserves estimates are reflected in the financial statements in the years in which the adjustments are made.
Because our insurance premiums are earned over time, changes in persistency result in deferred insurance policy acquisition costs being amortized against revenue over a comparable period of time. At December 31, 2015, the persistency rate of our primary mortgage insurance was 79.7%, compared to 82.8% at December 31, 2014. This change did not significantly affect the amortization of deferred insurance policy acquisition costs for the period ended December 31, 2015. A 10% change in persistency would not have a material effect on the amortization of deferred insurance policy acquisition costs in the subsequent year.
Corporate Debt & U.S. Government and Agency Bonds are evaluated by surveying the dealer community, obtaining relevant trade data, benchmark quotes and spreads and incorporating this information into the evaluation process.
There were no OTTI losses recognized in earnings for 2015. During 2014 and 2013 we recognized OTTI losses in earnings of $0.1 million and $0.3 million, respectively. There were no OTTI losses recognized in shareholders’ equity for the years ending December 31, 2015, 2014, and 2013.
At December 31, 2015, our direct domestic primary insurance in force was $174.5 billion, which represents the principal balance in our records of all mortgage loans that we insure, and our direct domestic primary risk in force was $45.5 billion, which represents the insurance in force multiplied by the insurance coverage percentage.
During the second quarter of 2013, approximately $60.3 million was placed in escrow in connection with the two agreements we entered into to resolve our dispute with Countrywide Home Loans (“CHL”) and its affiliate, Bank of America, N.A., as successor to Countrywide Home Loans Servicing LP (“BANA” and collectively with CHL, “Countrywide”) regarding rescissions. In the fourth quarter of 2013, approximately $42.9 million was released from escrow in connection with the BANA agreement and approximately $17.2 million remained in escrow in connection with the CHL agreement as of December 31, 2014. In the first quarter of 2015, the remaining escrow funds were disbursed to us pursuant to the amended and restated settlement agreement and release entered into with CHL on March 2, 2015. See additional discussion of these settlement agreements in Note 20 - “Litigation and contingencies.”
The independent pricing sources utilize these approaches based on type of investment:
Asset-Backed Securities are evaluated using spreads and other information solicited from market buy- and sell-side sources, including primary and secondary dealers, portfolio managers, and research analysts. Cash flows are generated for each tranche, benchmark yields are determined, and deal collateral performance and tranche level attributes including market color as available are used, resulting in tranche-specific spreads.
Level 3 - Valuations derived from valuation techniques in which one or more significant inputs or value drivers are unobservable or from par values for equity securities restricted in their ability to be redeemed or sold. Level 3 inputs reflect our own assumptions about the assumptions a market participant would use in pricing an asset or liability. Financial assets utilizing Level 3 inputs primarily include equity securities that can only be redeemed or sold at their par value and only to the security issuer and certain state premium tax credit investments. Our non-financial assets that are classified as Level 3 securities consist of real estate acquired through claim settlement. The fair value of real estate acquired is the lower of our acquisition cost or a percentage of the appraised value. The percentage applied to the appraised value is based upon our historical sales experience adjusted for current trends.
Our entire investment portfolio is classified as available-for-sale and is reported at fair value or, for certain equity securities carried at cost, amounts that approximate fair value. The related unrealized investment gains or losses are, after considering the related tax expense or benefit, recognized as a component of accumulated other comprehensive income (loss) in shareholders' equity. Realized investment gains and losses are reported in income based upon specific identification of securities sold. (See Note 6 - “Investments.”)
Based on our evaluation, we will record an other-than-temporary impairment adjustment on a security if we intend to sell the impaired security, if it is more likely than not that we will be required to sell the impaired security prior to recovery of its amortized cost basis, or if the present value of the discounted cash flows we expect to collect is less than the amortized cost basis of the security. If the fair value of a security is below its amortized cost at the time of our intent to sell, the security is classified as other-than-temporarily impaired and the full amount of the impairment is recognized as a loss in the statement of operations. Otherwise, when a security is considered to be other-than-temporarily impaired, the losses are separated into the portion of the loss that represents the credit loss and the portion that is due to other factors. The credit loss portion is recognized as a loss in the statement of operations, while the loss due to other factors is recognized in accumulated other comprehensive loss, net of taxes. A credit loss is determined to exist if the present value of the discounted cash flows, using the security’s original yield, expected to be collected from the security is less than the cost basis of the security.
Reserves are also established for estimated losses from defaults occurring prior to the close of an accounting period on notices of default not yet reported to us. These incurred but not reported (“IBNR”) reserves are also established using estimated claim rates and claim severities.
liability is included in “Premium deficiency reserves” on our consolidated balance sheets. Changes in these liabilities affect premiums written and earned and change in premium deficiency reserve, respectively. The actual return of premium for all periods affects premiums written and earned. Policy cancellations also lower the persistency rate which is a variable used in calculating the rate of amortization of deferred insurance policy acquisition costs.
Deferred income taxes are provided under the liability method, which recognizes the future tax effects of temporary differences between amounts reported in the financial statements and the tax bases of these items. The expected tax effects are computed at the enacted regular federal tax rate. Using this method, we have recorded a net deferred tax asset primarily due to net operating losses incurred in prior years. On a quarterly basis, we review the need to maintain a deferred tax asset valuation allowance as an offset to the net deferred tax asset, before valuation allowance. We analyze several factors, among which are the severity and frequency of operating losses, our capacity for the carryback or carryforward of any losses, the existence and current level of taxable operating income, operating results on a three year cumulative basis, the expected occurrence of future income or loss, the expiration dates of the carryforwards, the cyclical nature of our operating results, and available tax planning strategies. Based on our analysis, we reduced our benefit from income tax through the recognition of a valuation allowance from the first quarter of 2009 through the second quarter of 2015. In the third quarter of 2015, as discussed in Note 14 -“Income Taxes,” we concluded that it was more likely than not that our deferred tax assets would be fully realizable and that the valuation allowance was no longer necessary. Therefore, we reversed the valuation allowance.
Assets and liabilities denominated in a foreign currency are translated at the year-end exchange rates. Operating results are translated at average rates of exchange prevailing during the year. Unrealized gains and losses, net of deferred taxes, resulting from translation are included in accumulated other comprehensive loss in shareholders’ equity. Gains and losses resulting from transactions in a foreign currency are recorded in current period net income (loss) at the rate on the transaction date.
For the year ended December 31, 2015, all of our outstanding Convertible Senior Notes and Convertible Junior Subordinated Debentures are reflected in diluted earnings per share using the “if-converted” method. Under this method, if dilutive, the common stock related to the outstanding Convertible Senior Notes and/or Convertible Junior Debentures is assumed issued as of the beginning of the reporting period and the related interest expense, net of tax, is added back to earnings in calculating diluted EPS.
The year ended December 31, 2015 has been tax effected at a rate of 35%. Due to the valuation allowance recorded against deferred tax assets the year ended December 31, 2014 was not tax effected.
In May 2015, the FASB issued updated guidance requiring expanded disclosures for insurance entities that issue short-duration contracts. The expanded disclosures are designed to provide additional insight into an insurance entity's ability to underwrite and anticipate costs associated with claims. The disclosures include information about incurred and paid claims development, on a net of reinsurance basis, for the number of years claims incurred typically remain outstanding, not to exceed ten years. Each period presented in the disclosure about claims development that precedes the current reporting periods is considered supplementary information. The expanded disclosures also include more transparent information about significant changes in methodologies and assumptions used to estimate claims, and the timing, frequency, and severity of claims. The disclosures required by this update are effective for annual periods beginning after December 31, 2015, and interim periods within annual periods beginning after December 31, 2016, and is to be applied retrospectively. We are evaluating the impact, if any, of the new disclosure requirements.
In June 2014, the FASB issued updated guidance to resolve diversity in practice concerning employee shared-based compensation that contains performance targets that could be achieved after the requisite service period. The updated guidance requires that a performance target that affects vesting and that can be achieved after the requisite service period be treated as a performance condition. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the periods for which service has been rendered. If the performance target becomes probable of being achieved before the end of the service period, the remaining unrecognized compensation cost for which requisite service has not yet been rendered is recognized prospectively over the remaining service period. The total amount of compensation cost recognized during and after the service period should reflect the number of awards that are expected to vest and should be adjusted to reflect those awards that ultimately vest. This updated guidance is effective for annual and interim periods beginning after December 15, 2015. We will adopt this guidance in the first quarter of 2016, which will likely reduce the service periods utilized to recognize expense on certain share-based compensation awards granted in 2016 relative to the service period in the grant terms. The impact is not expected to be material to our consolidated financial statements.
There were no related party transactions during 2015, 2014 or 2013.
There were no other-than-temporary impairment (“OTTI”) losses in earnings during 2015. We recognized OTTI losses of $0.1 million and $0.3 million during 2014 and 2013, respectively.
For the years ended December 31, 2015, 2014, and 2013, there were no credit losses recognized in earnings for which a portion of an OTTI loss was recognized in accumulated other comprehensive loss.
Assets measured at fair value included those listed, by hierarchy level, in the following tables as of December 31, 2015 and 2014:
For assets and liabilities measured at fair value using significant unobservable inputs (Level 3), a reconciliation of the beginning and ending balances for the years ended December 31, 2015, 2014, and 2013 is shown in the following tables. There were no transfers into or out of Level 3 in those years and there we no losses included in earnings for those years attributable to the change in unrealized losses on assets still held at the end of each applicable year.
Interest payments on our debt obligations existing during 2015 and 2014 appear below.
As of December 31, 2014 we had outstanding $61.9 million of 5.375% Senior Notes due in November 2015, which we repaid with cash at the holding company on November 2, 2015. Interest on these notes was payable semi-annually in arrears on May 1 and November 1 each year. The repayment of our Senior Notes had no material impact on our financial position or liquidity.
As of December 31, 2015 and 2014 we had outstanding $333.5 million and $345.0 million, respectively, principal amount of 5% Convertible Senior Notes due in May 2017. During 2015 we repurchased $11.5 million of par value and paid total cash consideration of $12 million. We funded the purchases with cash at the holding company. Our purchases of the Convertible Senior Notes due 2017 resulted in a pretax charge of approximately $0.5 million.
Interest on the 5% Notes is payable semi-annually in arrears on May 1 and November 1 of each year. The 5% Notes will mature on May 1, 2017. The 5% Notes are convertible, at the holder's option, at an initial conversion rate, which is subject to adjustment, of 74.4186 shares per $1,000 principal amount at any time prior to the maturity date. This represents an initial conversion price of approximately $13.44 per share. These 5% Notes will be equal in right of payment to our other senior debt and will be senior in right of payment to our Convertible Junior Debentures. Debt issuance costs are being amortized to interest expense over the contractual life of the 5% Notes.
The provisions of the 5% Notes are complex. Covenants in the 5% Notes include a requirement to notify holders in advance of certain events and that we and the designated subsidiaries preserve our corporate existence, rights and franchises unless we or any such subsidiary determines that such preservation is no longer necessary in the conduct of its business and that the loss thereof is not disadvantageous to the 5% Notes. A designated subsidiary is any of our consolidated subsidiaries which has shareholders' equity of at least 15% of our consolidated shareholders' equity. Further, the notes are subject to the indenture between us and the trustee that, among other terms, includes provisions that would constitute an event of default under the indenture. Upon such a default, the trustee could accelerate the maturity of the notes independent of any action by holders of the 5% Notes. This description is not intended to be complete in all respect and is qualified in its entirety by the terms of the 5% Notes, including their covenants and events of default. We were in compliance with all covenants at December 31, 2015.
As of December 31, 2015 and 2014, we had outstanding $500 million principal amount of 2% Convertible Senior Notes due in 2020 which we issued in March 2013. We received net proceeds of approximately $484.6 million after deducting underwriting discount and offering expenses. See Note 15 - “Shareholders’ Equity” for information regarding the use of such proceeds. Interest on the 2% Notes is payable semi-annually in arrears on April 1 and October 1 of each year. The 2% Notes will mature on April 1, 2020, unless earlier repurchased by us or converted. Prior to January 1, 2020, the 2% Convertible Senior Notes are convertible only upon satisfaction of one or more conditions. One such condition is that during any calendar quarter commencing after March 31, 2014, the last reported sale price of our common stock for each of at least 20 trading days during the 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter be greater than or equal to 130% of the applicable conversion price on each applicable trading day. The 2% Notes are convertible at an initial conversion rate, which is subject to adjustment, of 143.8332 shares per $1,000 principal amount. This represents an initial conversion price of approximately $6.95 per share. 130% of such conversion price is $9.03. On or after January 1, 2020, holders may convert their notes irrespective of satisfaction of the conditions. These 2% Notes will be equal in right of payment to our other senior debt and will be senior in right of payment to our Convertible Junior Debentures. Debt issuance costs will be amortized to interest expense over the contractual life of the 2% Notes. Prior to April 10, 2017, the notes will not be redeemable. On any business day on or after April 10, 2017 we may redeem for cash all or part of the notes, at our option, at a redemption price equal to 100% of the principal amount of the notes being redeemed, plus any accrued and unpaid interest, if the closing sale price of our common stock exceeds 130% of the then prevailing conversion price of the notes for at least 20 of the 30 trading days preceding notice of the redemption.
The provisions of the 2% Notes are complex. Covenants in the 2% Notes include a requirement to notify holders in advance of certain events and that we and the designated subsidiaries (defined above) preserve our corporate existence, rights and franchises unless we or any such subsidiary determines that such preservation is no longer necessary in the conduct of its business and that the loss thereof is not disadvantageous to the 2% Notes. Further, the notes are subject to the indenture between us and the trustee that, among other terms, includes provisions that would constitute an event of default under the indenture. Upon such a default, the trustee could accelerate the maturity of the notes independent of any action by holders of the 2% Notes. This description is not intended to be complete in all respect and is qualified in its entirety by the terms of the 2% Notes, including their covenants and events of default. We were in compliance with all covenants at December 31, 2015.
As of December 31, 2015 and 2014 we had outstanding $389.5 million principal amount of 9% Convertible Junior Subordinated Debentures due in 2063. The 9% Debentures are currently convertible, at the holder's option, at an initial conversion rate, which is subject to adjustment, of 74.0741 common shares per $1,000 principal amount of the 9% Debentures at any time prior to the maturity date. This represents an initial conversion price of approximately $13.50 per share. If a holder elects to convert their 9% Debentures, deferred interest owed on the 9% Debentures being converted is also converted into shares of our common stock. The conversion rate for any deferred interest is based on the average price that our shares traded at during a 5-day period immediately prior to the election to convert. In lieu of issuing shares of common stock upon conversion of the 9% Debentures, we may, at our option, make a cash payment to converting holders for all or some of the shares of our common stock otherwise issuable upon conversion. The 9% Debentures rank junior to all of our existing and future senior indebtedness.
Interest on the 9% Debentures is payable semi-annually in arrears on April 1 and October 1 of each year. As long as no event of default with respect to the debentures has occurred and is continuing, we may defer interest, under an optional deferral provision, for one or more consecutive interest periods up to ten years without giving rise to an event of default. Deferred interest will accrue additional interest at the rate then applicable to the debentures. During an optional deferral period we may not pay or declare dividends on our common stock.
During the first quarter of 2016 through the date of this filing we completed the following debt transactions:
Purchased $127.7 million in par value of our 5% Notes due in 2017 with funds held at our holding company;
MGIC purchased $132.7 million of par value of our 9% Debentures using funds obtained from the proceeds of the borrowing from the Federal Home Loan Bank of Chicago (the "FHLBC") referred to below as the Advance; and
MGIC borrowed $155.0 million from the FHLBC in February 2016 in the form of a fixed rate advance (the "Advance"). Interest is payable monthly at an annual rate, fixed for the term of the Advance, of 1.91%. The principal of the Advance matures on February 10, 2023, but we may prepay the Advance at any time. Such prepayment would be below par if interest rates have risen since the origination date of the Advance, or above par if interest rates have declined.
The prior year development of the reserves in 2015, 2014 and 2013 is reflected in the table below.
The prior year loss development was based on the resolution of approximately 60%, 58% and 59% for the years ended December 31, 2015, 2014 and 2013, respectively, of the prior year default inventory, as well as a re-estimation of amounts to be ultimately paid on defaults remaining in inventory and estimated incurred but not reported items from the end of the prior year. In 2015, we recognized favorable development on our estimated claim rate as we experienced a higher cure rate on prior year default inventory. Additionally, during 2015 the claim rate was favorably impacted by re-estimations of previously recorded reserves relating to disputes on our claims paying practices and adjustments to incurred but not reported losses (IBNR). The favorable development for the year ended 2015 was offset, in part, by an increase in the estimated severity on prior year defaults remaining in the delinquent inventory. The decrease in the estimated severity in 2014 and 2013 was based on the resolution of the prior year default inventory.
The liability associated with our estimate of premiums to be refunded on expected claim payments is accrued for separately at December 31, 2015 and 2014 and approximated $102 million and $115 million, respectively. As of December 31, 2015, this liability was included in "Other liabilities" on our consolidated balance sheet. As of December 31, 2014, separate components of this liability are included in “Other liabilities” and “Premium deficiency reserve” on our consolidated balance sheet.
The decrease in the primary default inventory experienced during 2015 and 2014 was generally across all markets and all book years prior to 2012. In 2015 and 2014, the percentage of loans in the inventory that had been in default for 12 or more consecutive months had decreased compared to the prior years. Historically as a default ages it becomes more likely to result in a claim. The percentage of loans that have been in default for 12 or more consecutive months has been affected by our suspended rescissions discussed below.
Beginning in 2007, when we stopped writing Wall Street Bulk business, we began to separately measure the performance of these transactions and establish a premium deficiency reserve related to this business. The premium deficiency reserve reflects the present value of expected future losses and expenses that exceed the present value of expected future premiums and established loss reserves. Each quarter, we re-estimate the premium deficiency reserve on the remaining Wall Street bulk insurance in force. The premium deficiency reserve primarily changes from quarter to quarter as a result of two factors. First, it changes as the actual premiums, losses and expenses that were previously estimated are recognized. Each period such items are reflected in our financial statements as earned premium, losses incurred and expenses. The difference between the amount and timing of actual earned premiums, losses incurred and expenses and our previous estimates used to establish the premium deficiency reserves has an effect (either positive or negative) on that period’s results. Second, the premium deficiency reserve changes as our assumptions relating to the present value of expected future premiums, losses and expenses on the remaining Wall Street bulk insurance in force change. Changes to these assumptions also have an effect on that period’s results.
The decreases in the premium deficiency reserve for the years ended December 31, 2015, 2014 and 2013 were $24 million, $24 million, and $26 million, respectively. As of December 31, 2015, there was no premium deficiency reserve required. The decreases represent the net result of actual premiums, losses and expenses as well as a net change in assumptions for these periods. The change in assumptions for 2014 and 2013 are primarily related to higher estimated ultimate premiums resulting principally from an increase in the projected persistency rate, offset in part by higher estimated ultimate losses resulting principally from an increase in the number of projected claims that will ultimately be paid.
either had no history of defaults, or where a single default has been cured for twelve or more months at the agreement effective date; and all qualifying new insurance written through December 31, 2016. The agreement will provide coverage on losses incurred on or after the effective date with renewal premium through December 31, 2024, at which time the agreement expires. The 2015 QSR Transaction increases the amount of our insurance in force covered by reinsurance and will result in an increase in the amount of premiums and losses ceded. A higher level of losses ceded will reduce our profit commission and in turn will reduce our premium yield. Early termination of the agreement can be elected by us effective December 31, 2018 for a fee, or under specified scenarios for no fee upon prior written notice. Further, at our sole discretion we may elect to terminate the agreement if we will receive less than 90% of the full credit amount under the private mortgage insurer eligibility requirements ("PMIERs") of Fannie Mae and Freddie Mac (collectively, the "GSEs") for the risk ceded in any required calculation period. The structure of the 2015 QSR Transaction is a 30% quota share for all policies covered, with a 20% ceding commission as well as a profit commission. Generally, under the 2015 QSR Transaction, we will receive a profit commission provided that the loss ratio on the loans covered under the agreement remains below 60%.
A summary of our quota share reinsurance agreements, excluding captive agreements, for 2015, 2014 and 2013 appears below.
In the past, MGIC also obtained captive reinsurance. In a captive reinsurance arrangement, the reinsurer is affiliated with the lender for whom MGIC provides mortgage insurance. As part of our settlement with the Consumer Financial Protection Bureau (“CFPB”) in 2013 and with the Minnesota Department of Commerce in June 2015, discussed in Note 20 - “Litigation and Contingencies” MGIC has agreed to not enter into any new captive reinsurance agreement or reinsure any new loans under any existing captive reinsurance agreement for a period of ten years subsequent to the respective settlements. In accordance with the CFPB settlement, all of our active captive arrangements were placed into run-off. In addition, at the time PMIERs became effective on December 31, 2015, the GSEs will not approve any future reinsurance or risk sharing transaction with a mortgage enterprise or an affiliate of a mortgage enterprise.
Captive agreements were generally written on an annual book of business and each captive reinsurer is required to maintain a separate trust account to support its combined reinsured risk on all annual books. MGIC is the sole beneficiary of the trusts, and the trust accounts are made up of capital deposits by the captive reinsurers, premium deposits by MGIC, and investment income earned. These amounts are held in the trust account and are available to pay reinsured losses. The reinsurance recoverable on loss
The pretax components of our other comprehensive (loss) income and related income tax benefit (expense) for the years ended December 31, 2015, 2014 and 2013 are included in the table below:
(1) See Note 14 - “Income Taxes” for a discussion of the valuation allowance recorded against deferred tax assets.
(1) Increases (decreases) Net realized investment gains on the consolidated statements of operations.
A rollforward of accumulated other comprehensive loss for the years ended December 31, 2015, 2014, and 2013, including amounts reclassified from accumulated other comprehensive loss, are included in the table below.
We have a non-contributory defined benefit pension plan covering substantially all domestic employees, as well as a supplemental executive retirement plan. We also offer both medical and dental benefits for retired domestic employees and their
eligible spouses under a postretirement benefit plan. The following tables provide the components of aggregate annual net periodic benefit cost for each of the years ended December 31, 2015, 2014, and 2013 and changes in the benefit obligation and the funded status of the pension, supplemental executive retirement and other postretirement benefit plans as recognized in the consolidated balance sheet as of December 31, 2015 and 2014.
In the fourth quarter of 2014, the Society of Actuaries released new mortality tables as a result of their detailed study on the future life expectancies of pension plan participants. We have used these mortality tables, including updates to the mortality table projection scales, in calculating our year-end 2015 and 2014 retirement program obligations. We expect the mortality tables to receive regular annual updates that will impact our retirement plan obligations in future reporting periods. If all pension plan participants elected to receive their pension benefits in monthly payments, the new tables would have increased 2014 year-end obligations by $23.2 million. However, based on our experience, we estimate that 75% of our active pension plan participants will elect to receive their pension benefits in a lump sum, which under the terms of the pension plan, are calculated based on mortality assumptions prescribed by the IRS, not the Society of Actuaries. The combined effect of the new Society of Actuaries mortality tables and the 75% lump-sum election assumption was a net increase in 2014 year-end obligations of $14.6 million. In addition, the benefit obligation will also change due to changes in the actuarial assumptions applied, as shown in the table below, to determine the outstanding liability.
modeling was performed using a bond portfolio of noncallable bonds with at least $50 million outstanding. The average yield of these hypothetical bond portfolios was used as the benchmark for determining the discount rate. In selecting the expected long-term rate of return on assets, we considered the average rate of earnings expected on the classes of funds invested or to be invested to provide for the benefits of these plans. This included considering the trusts' targeted asset allocation for the year and the expected returns likely to be earned over the next 20 years.
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and inputs, other than quoted prices, that are observable in the marketplace for the financial instrument. The observable inputs are used in valuation models to calculate the fair value of the financial instruments. Financial assets utilizing Level 2 inputs include certain municipal, corporate and foreign bonds, obligations of U.S. government corporations and agencies, and pooled equity accounts.
The following table sets forth by level, within the fair value hierarchy, the pension plan assets at fair value as of December 31, 2015 and 2014. There were no securities that utilized Level 3 inputs.
The equity investments utilize combinations of mutual funds, ETFs, and pooled equity account structures focused on the following strategies:
Investment in international oriented funds is limited to a maximum of 30% of the equity range. The current international allocation is invested in two mutual funds with 3% of the equity allocation in a fund which has the objective of investing primarily in equity securities of emerging market countries, and 21% of the equity allocation in a fund investing in securities of companies based outside the United States. It invests in companies primarily based in Europe and the Pacific Basin, and primarily in equity investments although it may also hold cash, money market instruments, and fixed maturity securities depending on market conditions.
For measurement purposes, a 7.0% health care trend rate was used for benefits for retirees before they reach age 65 years for 2015. In 2016, the rate is assumed to be 7.0%, decreasing to 5.0% by 2020 and remaining at this level beyond.
We have a profit sharing and 401(k) savings plan for employees. At the discretion of the Board of Directors, we may make a contribution of up to 5% of each participant's eligible compensation. We provide a matching 401(k) savings contribution for employees on their before-tax contributions at a rate of 80% of the first $1,000 contributed and 40% of the next $2,000 contributed. For employees hired after January 1, 2014, the match is 100% up to 4% contributed. We recognized expenses related to these plans of $5.1 million, $5.0 million and $5.3 million in 2015, 2014 and 2013, respectively.
Net deferred tax assets and liabilities as of December 31, 2015 and 2014 are as follows:
We review the need to maintain the deferred tax asset valuation allowance on a quarterly basis. We analyze several factors, among which are the severity and frequency of operating losses, our capacity for the carryback or carryforward of any losses, the existence and current level of taxable operating income, operating results on a three year cumulative basis, the expected occurrence of future income or loss, the expiration dates of the carryforwards, the cyclical nature of our operating results, and available tax planning strategies. Based on our analysis, we reduced our benefit from income tax through the recognition of a valuation allowance from the first quarter of 2009 through the second quarter of 2015.
In the third quarter of 2015, based on our analysis, as described more fully below, we concluded that it was more likely than not that our deferred tax assets would be fully realizable and that the valuation allowance was no longer necessary. Therefore, we reversed the valuation allowance. For the year ended December 31, 2015, we reversed $161.1 million of our valuation allowance based on income from 2015. The portion of the valuation allowance reversed related to deferred tax assets that are expected to be realized in future years, totaling $747.5 million, is treated as a discrete period item and is recognized as a component of the tax provision in continuing operations in the period of release. Furthermore, in determining the discrete period impact from the reversal, we removed the prior period disproportionate tax effects that had arisen in other comprehensive income because of the valuation allowance. This reduced the amount of tax benefit included in net income and resulted in an allocation of tax benefit of $60.8 million to components of other comprehensive income.
In the fourth quarter of 2013, our net operating loss carryforward (“NOL”) for U.S. federal regular income tax purposes reached $2.6 billion, which was the highest amount it attained. As of December 31, 2015, the estimated remaining NOLs total $1.9 billion, a reduction of $670 million in two years. At this rate, and without taking into account any improvement in earnings, we would utilize the NOL within six years. In addition to this history of the utilization of our NOLs, we considered that the amount of income that we have been generating has been increasing over time. In 2015, we reduced our NOLs by $471 million, whereas in 2014 that amount was $199 million. At the 2015 rate, we would utilize the NOLs on our return by the end of 2020. The earliest current expiration date for our NOLs is 2029. This recent history of positive earnings trends indicates that it is more likely than not that the NOLs would be utilized well before they expire. Further, we currently have no limitations under the change in control provisions of Internal Revenue Code Section 382, which would reduce our ability to utilize our NOLs. We have taken steps, primarily through our Amended and Restated Rights Agreement, to attempt to prevent any change in control which would limit the utilization of our NOLs.
The change in the valuation allowance that was included in other comprehensive income was a decrease of $54.5 million, a decrease of $13.1 million, and an increase of $17.3 million for the years ended December 31, 2015, 2014 and 2013, respectively. The remaining valuation allowance was reversed in the third quarter of 2015. The total valuation allowance as of December 31, 2014 and 2013 was $902.3 million and $1,004.2 million, respectively.
We filed a petition with the U.S. Tax Court contesting most of the IRS' proposed adjustments reflected in the Notices of Deficiency and the IRS has filed an answer to our petition which continues to assert their claim. Litigation to resolve our dispute with the IRS could be lengthy and costly in terms of legal fees and related 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 and finalized. Depending on the outcome of this matter, additional state income taxes and state interest may become due when a final resolution is reached. As of December 31, 2015, those state taxes and interest would approximate $48.8 million. In addition, there could also be state tax penalties. Our total amount of unrecognized tax benefits as of December 31, 2015 is $107.1 million, which represents the tax benefits generated by the REMIC portfolio included in our tax returns that we have not taken benefit for in our financial statements, including any related interest. We continue to believe that our previously recorded tax provisions and liabilities are appropriate. However, we would need to make appropriate adjustments, which could be material, to our tax provision and liabilities if our view of the probability of success in this matter changes, and the ultimate resolution of this matter could have a material negative impact on our effective tax rate, results of operations, cash flows, available assets and statutory capital. In this regard, see Note 17 - “Capital Requirements - Capital-GSEs.”
In March 2013 we completed the public offering and sale of 135 million shares of our common stock at a price of $5.15 per share. We received net proceeds of approximately $663.3 million, after deducting underwriting discount and offering expenses. The shares of common stock sold were newly issued shares. In March 2013 we also concurrently completed the sale of $500 million principal amount of 2% Convertible Senior Notes due in 2020. For more information, see Note 8 - “Debt.”
The convertible senior notes and convertible debentures, discussed in Note 8 - “Debt,” are obligations of MGIC Investment Corporation, our holding company, and not of its subsidiaries. Our holding company has no material sources of cash inflows other than investment income, dividends from subsidiaries and capital raised in the public markets. MGIC is the principal source of dividend-paying capacity. Although MGIC has not paid any dividends to our holding company since 2008, we are discussing with the Office of the Commissioner of Insurance of the State of Wisconsin (the "OCI") the resumption of ongoing extraordinary dividends in 2016. During 2015, dividends of $38.5 million were paid to the holding company from other insurance subsidiaries.
Our insurance subsidiaries are subject to state insurance regulations as to maintenance of policyholders' surplus and payment of dividends. The maximum amount of dividends that the insurance subsidiaries may pay in any twelve-month period without regulatory approval by the OCI is the lesser of adjusted statutory net income or 10% of statutory policyholders' surplus as of the preceding calendar year end. Adjusted statutory net income is defined for this purpose to be the greater of statutory net income, net of realized investment gains, for the calendar year preceding the date of the dividend or statutory net income, net of realized investment gains, for the three calendar years preceding the date of the dividend less dividends paid within the first two of the preceding three calendar years.
Based on our interpretation of the PMIERs, as of December 31, 2015, MGIC’s Available Assets are in excess of its Minimum Required Assets; and MGIC is in compliance with the financial requirements of the PMIERs and eligible to insure loans purchased by the GSEs.
The statutory financial statements of our insurance companies are presented on the basis of accounting practices prescribed or permitted by the Office of the Commissioner of Insurance of the State of Wisconsin, which has adopted the NAIC statutory accounting practices as the basis of its statutory accounting practices ("SSAP"). For the years 2014 and 2013 we utilized a permitted practice approved by the OCI to recognize a portion of our net deferred tax assets as admitted assets, discussed further below. In converting from statutory to GAAP, typical adjustments include deferral of policy acquisition costs, the inclusion of net unrealized holding gains or losses in shareholders' equity relating to fixed maturities and the inclusion of statutory non-admitted assets.
In addition to the typical adjustments from statutory to GAAP, mortgage insurance companies are required to maintain contingency loss reserves equal to 50% of premiums earned under SSAP and practices prescribed by the OCI, Such amounts cannot be withdrawn for a period of ten years except as permitted by insurance regulations. With regulatory approval a mortgage guaranty insurance company may make early withdrawals from the contingency reserve when incurred losses exceed 35% of net premiums earned in a calendar year. For the year ended 2015, MGIC's losses incurred were 37% of net premiums earned. Changes in contingency loss reserves impact the statutory statement of operations. Contingency loss reserves are not reflected as liabilities under GAAP and changes in contingency loss reserves do not impact the GAAP statements of operations. A premium deficiency reserve that may be recorded on a GAAP basis when the present value of expected future losses and expenses exceeds the present value of expected future premiums and already established loss reserves, may not be recorded on a statutory basis if the present value of expected future premiums and already established loss reserves and statutory contingency reserves, exceeds the present value of expected future losses and expenses. On a GAAP basis, when calculating a premium deficiency reserve policies are grouped based on how they are acquired, serviced and measured. On a statutory basis, a premium deficiency reserve is calculated on all policies in force.
The dissolution of an MGIC non-insurance subsidiary in 2015 had no impact on statutory surplus as the equity value of the investment was fully reflected in surplus as an unrealized loss prior to 2015.
At December 31, 2015, the risk-to-capital ratio of our combined insurance operations (which includes reinsurance affiliates) was 13.6 to 1. Reinsurance agreements with affiliates permit MGIC to write insurance with a higher coverage percentage than it could on its own under certain state-specific requirements. A higher risk-to-capital ratio on a combined basis may indicate that, in order for MGIC to continue to utilize reinsurance agreements with its affiliates, additional capital contributions to the reinsurance affiliates could be needed.
If MGIC fails to meet the State Capital Requirements of Wisconsin and is unable to obtain a waiver of them from the OCI, MGIC could be prevented from writing new business in all jurisdictions. If MGIC fails to meet the State Capital Requirements of a jurisdiction other than Wisconsin and is unable to obtain a waiver of them, MGIC could be prevented from writing new business in that particular jurisdiction. It is possible that regulatory action by one or more jurisdictions, including those that do not have specific State Capital Requirements, may prevent MGIC from continuing to write new insurance in such jurisdictions. If we are unable to write business in all jurisdictions, lenders may be unwilling to procure insurance from us anywhere. In addition, a lender’s assessment of the future ability of our insurance operations to meet the State Capital Requirements or the PMIERs may affect its willingness to procure insurance from us. A possible future failure by MGIC to meet the State Capital Requirements or the PMIERs will not necessarily mean that MGIC lacks sufficient resources to pay claims on its insurance liabilities. While we believe MGIC has sufficient claims paying resources to meet its claim obligations on its insurance in force on a timely basis, you should read the rest of these financial statement footnotes for information about matters that could negatively affect MGIC’s claims paying resources.
We have an omnibus incentive plan that was adopted on April 23, 2015. When the 2015 plan was adopted, no further awards could be made under our previous 2011 plan. The purpose of the 2015 plan is to motivate and incent performance by, and to retain the services of, key employees and non-employee directors through receipt of equity-based and other incentive awards under the plan. The maximum number of shares of stock that can be awarded under the 2015 plan is 10.0 million. Awards issued under the plan that are subsequently forfeited will not count against the limit on the maximum number of shares that may be issued under the plan. The 2015 plan provides for the award of stock options, stock appreciation rights, restricted stock and restricted stock units, as well as cash incentive awards. No awards may be granted after April 23, 2025 under the 2015 plan. The vesting provisions of options, restricted stock and restricted stock units are determined at the time of grant. Shares issued under the 2015 plan will be newly issued shares.
As of December 31, 2015, there was $14.2 million of total unrecognized compensation cost related to non-vested share-based compensation agreements granted under the plans. Of this total, $10.6 million of unrecognized compensation costs relate to performance shares and $3.6 million relates to time vested shares. A portion of the unrecognized costs associated with the performance shares may or may not be recognized in future periods, depending upon whether or not the performance and service conditions are met. The cost associated with the time vested shares is expected to be recognized over a weighted-average period of 1.6 years.
In 2011, we granted 449,350 shares of restricted stock units that were to be settled as cash payments over the vesting period under our 2002 stock incentive plan. As of December 31, 2014, all shares granted under this award had either vested or been forfeited. Cash payments at vesting were $1.2 million in 2014.
At December 31, 2015, 9.97 million shares were available for future grant under the 2015 omnibus incentive plan.
When reviewing the loan file associated with a claim, we may determine that we have the right to rescind coverage on the loan. (We refer to insurance rescissions and denials of claims collectively as "rescissions" and variations of that term.) In recent quarters, approximately 5% of claims received in a quarter have been resolved by rescissions, down from the peak of approximately 28% in the first half of 2009. Our loss reserving methodology incorporates our estimates of future rescissions, reversals of rescissions and curtailments. A variance between ultimate actual rescission, reversal and curtailment rates and our estimates, as a result of the outcome of litigation, settlements or other factors, could materially affect our losses.
If the insured disputes our right to rescind coverage, we generally engage in discussions in an attempt to settle the dispute. As part of those discussions, we may voluntarily suspend rescissions we believe may be part of a settlement. Certain settlements require GSE approval. The GSEs consented to settlement agreements we entered into with Countrywide Home Loans, Inc. (“CHL”) and its affiliate, Bank of America, N.A., as successor to Countrywide Home Loans Servicing LP, but there is no guarantee they will approve others. We have reached and implemented settlement agreements that do not require GSE approval, but they have not been material in the aggregate.
Until a liability associated with a settlement agreement or litigation becomes probable and can be reasonably estimated, we consider our claim payment or rescission resolved for financial reporting purposes even though discussions and legal proceedings may have been initiated and are ongoing. Under ASC 450-20, an estimated loss from such discussions and proceedings is accrued for only if we determine that the loss is probable and can be reasonably estimated. The estimated impact that we have recorded is our best estimate of our loss from these matters. If we are not able to implement settlements we consider probable, we intend to defend MGIC vigorously against any related legal proceedings.
In addition to the probable settlements for which we have recorded a loss, we are involved in other discussions and/or proceedings with insureds with respect to our claims paying practices. Although it is reasonably possible that when these matters are resolved we will not prevail in all cases, we are unable to make a reasonable estimate or range of estimates of the potential
Mortgage insurers, including MGIC, have been involved in litigation alleging violations of the anti-referral fee provisions of the Real Estate Settlement Procedures Act, which is commonly known as RESPA, and the notice provisions of the Fair Credit Reporting Act, which is commonly known as FCRA. MGIC’s settlement of class action litigation against it under RESPA became final in October 2003. MGIC settled the named plaintiffs’ claims in litigation against it under FCRA in December 2004, following denial of class certification in June 2004. Since December 2006, class action litigation has been brought against a number of large lenders alleging that their captive mortgage reinsurance arrangements violated RESPA. Beginning in December 2011, MGIC, together with various mortgage lenders and other mortgage insurers, was named as a defendant in twelve lawsuits, alleged to be class actions, filed in various U.S. District Courts. The complaints in all of the cases alleged various causes of action related to the captive mortgage reinsurance arrangements of the mortgage lenders, including that the lenders’ captive reinsurers received excessive premiums in relation to the risk assumed by those captives, thereby violating RESPA. As of the end of the first quarter of 2015, MGIC had been dismissed from all twelve cases. There can be no assurance that we will not be subject to further litigation under RESPA (or FCRA) or that the outcome of any such litigation would not have a material adverse effect on us.
In 2015, MGIC executed a Consent Order with the Minnesota Department of Commerce that resolved that department’s investigation of captive reinsurance matters without making any findings of wrongdoing. The Consent Order provided, among other things, that MGIC is prohibited from entering into any new captive reinsurance agreement or reinsuring any new loans under any existing captive reinsurance agreement for a period of ten years.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, comprehensive income, shareholders’ equity and of cash flows present fairly, in all material respects, the financial position of MGIC Investment Corporation and its subsidiaries (the “Company”) at December 31, 2015 and 2014, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2015 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2015, 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, 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 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.