At its corporate headquarters in Philadelphia, the Company leases approximately 116,000 square feet of space under a lease that expires in August 2015, and approximately 26,000 square feet of temporary space under leases that expire in November 2005 and May 2006; the Company also subleases approximately 3,600 square feet of space at the Philadelphia headquarters under a sublease that expires in January 2005. In addition, the Company leases: (1) space for its mortgage insurance regional offices, service centers and on-site offices throughout the United States comprising approximately 42,000 square feet with leases expiring between 2003 and 2007; (2) space for its financial guaranty operations in New York comprising approximately 121,000 square feet, under a lease expiring in 2015, approximately 55,000 square feet of which the Company subleases to others; and (3) space for its U.K. operations in London comprising approximately 6,500 square feet, under a lease expiring in 2012. In the fourth quarter of 2003, the Company announced the cessation of operations of RadianExpress. The Company leases approximately 18,000 square feet of space for these operations under a lease that will terminate in April 2004. With respect to all facilities, the Company believes it will be able to obtain satisfactory lease renewal terms.
The Company currently maintains three data centers and two disaster recovery sites to support its businesses. Over the next eighteen months, the Company will be replacing its legacy systems that currently support accounting, claims, risk management, underwriting and other non-insurance operations. The Company’s strategic direction for all new system development is to deploy 100% web-based custom or off-the-shelf software on a UNIX, Linux and Windows 2000 platform. PeopleSoft Financial Systems is currently installed and operational for the Company. The Company built a new data center in Dayton, Ohio in 2002, for which it began leasing approximately 27,000 square feet of space in June 2002 under a 10-year lease. Two separate fiber-optic feeds serve this data center. The center is cabled for two separate power grids and has sufficient diesel standby generator power to power the data center and personal work areas for critical staff. During 2003, the Company built a new disaster recovery site in Philadelphia for which it began leasing approximately 15,000 square feet of space under a lease that expires in August 2015. The former Philadelphia disaster recovery site was relocated to this site in July 2003. Currently, the Company maintains its legacy systems that support claims, risk management and underwriting in the Philadelphia data center and the new disaster recovery site. Each data center is currently running at 40% of capacity. Either data center is capable of supporting all the legacy systems. The data centers are linked via a fiber-optic link allowing simultaneous data updates through disk shadowing. Each data center is part of a separate power grid. This redundant configuration provides disaster tolerance and automatic back-up, resource sharing and fail-over. In addition, the new Philadelphia disaster recovery site supports the development and testing of new systems and will operate as the disaster recovery center for all Dayton, New York and London operations. Over the next eighteen months, the Company will migrate its operations from the current New York data center to the data center in Dayton, Ohio and the existing New York disaster recovery site to the Philadelphia disaster recovery site. This will ensure continuous availability at the Dayton data center and full business recovery capability at the Philadelphia data center.
Diluted net income per share and average share information per Statement of Financial Accounting Standards No. 128, “Earnings Per Share.” See Note 2 of Notes to Consolidated Financial Statements.
All share and per-share data for periods prior to 2001 have been restated to reflect a 2-for-1 stock split in 2001.
The Company believes that its diversified credit enhancement strategy is sound and will continue to implement this strategy in the upcoming year. The Company’s challenges will be to solidify the AA financial guaranty business platform by continuing to demonstrate the ability to grow and write quality business. In the mortgage insurance business, the Company is hopeful that an economic recovery and job growth can positively impact performance and that modestly rising interest rates will help reduce the cancellation rate. The Company’s efforts in the European markets for both mortgage and financial guaranty business will be increased as the Company hopes to take advantage of its core competencies of credit risk analysis and capital allocation to write profitable business in Europe.
Consolidated earned premiums for 2003 of $1,008.2 million represented an increase of $161.1 million or 19.0% from $847.1 million in 2002. Mortgage Insurance contributed $99.1 million of this increase and Financial Guaranty contributed $62.0 million. Net investment income of $186.2 million for 2003 increased $7.4 million or 4.1% from $178.8 million in 2002. This increase was primarily due to a large increase in the investment portfolio balance as a result of continued operating cash flows and the proceeds from the issuance of $250 million of notes in the first quarter of 2003 offset by lower yields on investments. Other income increased to $63.3 million in 2003 from $44.4 million in 2002, primarily related to increased contract underwriting income in the mortgage insurance segment.
The provision for losses was $243.3 million for 2002, an increase of $35.2 million or 16.9% from $208.1 million in 2001. Approximately $15.3 million of this increase was related to Mortgage Insurance to support an increase in delinquencies and claims payments, and $19.9 million was due to loss reserve increases at Financial Guaranty to support business growth and an increase in trade credit reinsurance claims. Policy acquisition costs for 2002 were $100.8 million, up $16.5 million or 19.6% from $84.3 million in 2001. Other operating expenses of $175.3 million for 2002 increased $42.8 million or 32.3% from $132.5 million in 2001. This was primarily due to increases in salaries and benefits related to an increase in headcount to support higher volumes, increased professional fees, fees for outside services and increased depreciation and software costs due to increased capital expenditures in the information technology and infrastructure areas. Interest expense of $28.8 million for 2002 increased from $17.8 million in 2001 as a result of the issuance of $220 million of convertible debt in January 2002 and $250 million of long-term debt in May 2001. The Company’s effective tax rate was 29.0% for 2002 compared to 28.7% for 2001.
compared to 40.5% in 2002. The persistency rate, which is defined as the percentage of insurance in force that remains on the Company’s books after any 12-month period, was 46.7% for the 12 months ended December 31, 2003, as compared to 57.0% for the same period of 2002. This decrease was consistent with the increasing level of refinancing activity, which caused the cancellation rate to increase. The expectation for 2004 is a slowdown in the industry volume of new insurance written and an increase in persistency rates throughout the year, influenced by flat to slowly rising interest rates.
Net premiums earned in 2003 were $759.6 million, a $99.1 million or 15.0% increase from $660.5 million for 2002. The increase, which was greater than the increase in direct primary insurance in force, reflected a significant increase in non-traditional new insurance volume in Radian Insurance Inc. (“Radian Insurance”) and Amerin Guaranty, which is included in “other risk in force” and a higher percentage of non-prime business. Premiums earned in Radian Insurance and Amerin Guaranty, primarily from credit insurance on mortgage-related assets and second mortgages, were $99.8 million in 2003 compared to $35.2 million in 2002 and approximately $40.0 million in 2001. As further discussed below, non-prime business has higher premium rates, which are commensurate with the increased level of expected losses associated with the insurance. The insurance in force growth resulting from strong new insurance volume in 2003 was offset by a decrease in persistency levels. These lower persistency levels will continue to impact premiums earned in future periods to the extent that insurance in force growth slows. Direct primary insurance in force increased to $119.9 billion at December 31, 2003 from $110.3 billion a year ago. Total pool risk in force was $2.4 billion at December 31, 2003 compared to $1.7 billion at December 31, 2002.
The Office of Federal Housing Enterprise Oversight issued new risk-based capital regulations for Fannie Mae and Freddie Mac, which took effect September 13, 2002. The most relevant provision to the Company is a distinction between “AAA”-rated insurers and “AA”-rated insurers. The new regulations impose a credit haircut that Fannie Mae and Freddie Mac are given for exposure ceded to “AAA” insurers by 3.5% and to “AA” insurers by 8.75%. Currently, Radian Guaranty is rated “AA”; one other mortgage insurance provider is rated “AAA.” As a result, there may be an incentive for the GSEs to use private mortgage insurance provided by a “AAA” rated insurer. The provisions of the new regulations are to be phased in over a 10-year period commencing on the effective date of the regulation. There has been no impact on the Company as a result of this change.
Net investment income for 2003 was $107.7 million, compared to $107.1 million in 2002. This slight increase was a result of continued growth in invested assets, primarily due to positive operating cash flows during 2003 and the allocation of interest income from net financing activities, offset by declining investment yields that were experienced throughout the year. The Company has continued to invest some of its net operating cash flow in tax-advantaged securities, primarily municipal bonds, although the Company’s investment policy allows the purchase of various other asset classes including common stock and convertible securities. The Company’s common equity exposure is targeted at a maximum of 5% of the investment portfolio’s market value, while the investment- grade convertible securities and investment-grade taxable bond exposure are each targeted not to exceed 10%.
The total number of defaults increased from 43,773 at December 31, 2002 to 50,080 at December 31, 2003. The average loss reserve per default decreased from $11,073 at the end of 2002 to $10,253 at December 31, 2003. The slowing of the economy, as well as a higher mix of non-prime insured loans, contributed to the rising
Net income for 2002 was $293.8 million, an increase of $13.8 million or 4.9% from $280.0 million in 2001. This increase resulted from increases in earned premiums and investment income, partially offset by increases in the provision for losses, policy acquisition and other operating expenses and interest expense.
Mortgage Insurance’s top 10 lenders were responsible for 49.3% of the direct primary risk in force at December 31, 2002. The top 10 lenders were also responsible for 46.5% of primary new insurance written in 2002. The highest state concentration of risk is California. At December 31, 2002, California accounted for 16.2% of Mortgage Insurance’s total direct primary insurance in force and 18.7% of Mortgage Insurance is direct primary new insurance written for 2002. The largest single customer of Mortgage Insurance (including branches and affiliates of such customer), measured by new insurance written, accounted for 8.1% of new insurance written during 2002, compared to 12.6% in 2001.
throughout 2002, and contributed to relatively strong new insurance volume in 2002. Mortgage Insurance’s refinancing activity, as a percentage of primary new insurance written, was 40.5% for 2002 compared to 40.3% in 2001. The persistency rate was 57.0% for the 12 months ended December 31, 2002 as compared to 63.3% for the same period of 2001. This decrease was consistent with the increasing level of refinancing activity, which caused the cancellation rate to increase.
During 2002, non-prime business accounted for $16.2 billion or 33.1% of Mortgage Insurance’s primary new insurance written compared to $14.3 billion or 31.9% for the same period in 2001. Much of this business was written in the form of structured transactions. At December 31, 2002, non-prime insurance in force was $25.6 billion or 23.2% of total primary insurance in force as compared to $18.2 billion or 16.8% of primary insurance in force at December 31, 2001. Of the $16.2 billion of non-prime business in 2002, $11.8 billion or 72.8% was Alt-A.
The provision for losses was $194.5 million for 2002, an increase of $15.4 million or 8.6% from $179.1 million in 2001. Approximately 70.7% of the primary risk in force and approximately 31.9% of the pool risk in force at December 31, 2002 had not yet reached its highest claim frequency years. The combined default rate for both primary and pool insurance, excluding second lien insurance coverage, was 2.8% at December 31, 2002 compared to 2.2% at December 31, 2001, while the default rate on the primary business was 4.1% at December 31, 2002 compared to 3.5% at December 31, 2001. The change in the default rate on the primary business was caused principally by a 230-basis-point increase in the delinquency rate on the non-prime business as a result of that business seasoning, with the delinquency rate on the prime business down slightly from year to year.
The total number of defaults increased from 41,147 at December 31, 2001 to 43,773 at December 31, 2002. The average loss reserve per default decreased from $11,291 at the end of 2001 to $11,073 at December 31, 2002. The slowing of the economy, as well as the increased level of non-prime insured loans, contributed to the rising level of mortgage delinquencies. The loss reserve as a percentage of risk in force was 1.7% at December 31, 2002, up from 1.6% at December 31, 2001. The non-prime mortgage insurance business has experienced a consistent increase in the number of defaults. The number of non-prime loans in default at December 31, 2002 was 14,305, which represented 40% of the total primary loans in default, compared to 7,704 non-prime loans in default at December 31, 2001, which represented 24.8% of the total primary loans in default. The default rate on the Alt-A business was 5.2% at December 31, 2002 compared to 4.5% at December 31, 2001. The default rate on the A minus and below loans was 11.3% at December 31, 2002 compared to 6.4% at December 31, 2001. The default rate on the prime business was 3.1% at December 31, 2002 and December 31, 2001.
Direct claims paid for 2002 were $165.0 million compared to $97.7 million for 2001. The severity of loss payments has increased due to deeper coverage amounts and larger loan balances. In addition, claims paid in 2002 were impacted by the rise in delinquencies in 2001 that have proceeded to foreclosure.
The following table provides selected information as of and for the periods indicated for the Mortgage Insurance segment:
Policy acquisition costs and other operating expenses were $196.1 million in 2003, an increase of 11.5% compared to $175.9 million for 2002. Policy acquisition costs relate directly to the acquisition of new business and other operating expenses primarily consist of contract underwriting expenses, overhead and administrative costs. Policy acquisition costs were $70.2 million in 2003, an increase of 5.1% from $66.8 million in 2002. The amortization of these expenses is related to the recognition of gross profits over the life of the policies. Much of the amortization in the current year represents costs that were expended in 2002. Other operating expenses were $125.9 million for 2003, an increase of 15.5% from $109.0 million for 2002. This reflects an increase in expenses associated with the Company’s technological, administrative and support functions. Contract underwriting expenses for 2003, included in other operating expenses, were $55.7 million as compared to $46.2 million in 2002, an increase of 20.6%. The $9.5 million increase in contract underwriting expenses during 2003 reflected the higher demand for contract underwriting services as a result of higher volumes of new insurance written. Other income, which primarily includes income related to contract underwriting services, was $32.0 million for 2003 compared to $20.4 million for 2002. During 2003, loans underwritten via contract underwriting accounted for 26.8% of applications, 25.8% of commitments and 22.6% of certificates issued by Mortgage Insurance as compared to 30.4%, 28.7% and 23.0%, respectively, in 2002. Mortgage Insurance utilizes its underwriting skills to provide an outsourced underwriting service to its customers known as contract underwriting. For a fee, Mortgage Insurance underwrites loan files for secondary market compliance while concurrently assessing the file for mortgage insurance, if applicable. Mortgage Insurance gives recourse to its customers on loans it underwrites for secondary market compliance on which it has made a material error, by placing mortgage insurance coverage on the loan, by purchasing the loan, or by indemnifying the customer against future loss associated with the loan. Purchasing the loan would subject the company to credit risk and interest rate risk. Also, in a rising interest rate environment, the value of loans that Mortgage Insurance is required to purchase could decrease, and consequently, the costs of such purchases could increase. During 2003, less than 1% of all loans were subject to these remedies and the costs with these remedies were immaterial.
Interest expense for 2002 and 2001 was $17.2 million and $10.5 million, respectively. This primarily represented the allocation of interest on the Company’s long-term debt issued during 2002 and 2001.
The U.S. Department of Housing and Urban Development (“HUD”) proposed a rule under the Real Estate Settlement Procedures Act (“RESPA”) to create an exemption from the provisions of RESPA that prohibit the
giving of any fee, kickback or thing of value pursuant to any agreement or understanding that real estate settlement services will be referred. The proposed rule would have made the exemption available to lenders that, at the time a borrower submits a loan application, give the borrower a firm, guaranteed price for all settlement services associated with the loan. In 2003, HUD withdrew the proposed rule and submitted another rule to the Office of Management and Budget. The contents of the new rule have not been made public, although most commentators are assuming that the new rule is similar to the old rule. If the new rule is implemented, the premiums charged for mortgage insurance could be negatively affected.
On October 4, 2002, S&P announced that it had downgraded the Insurer Financial Strength rating of Radian Reinsurance from “AAA” to “AA.” On April 8, 2003, Fitch downgraded the Insurer Financial Strength rating of Radian Reinsurance from “AAA” to “AA” and removed it from “negative watch”. Radian Reinsurance and Radian Asset Assurance are parties to numerous reinsurance agreements with primary insurers which grant the primary insurers the right to recapture all of the business ceded to Radian Reinsurance or Radian Asset Assurance under these agreements if the financial strength rating of Radian Reinsurance or Radian Asset Assurance, as the case may be, is downgraded below the rating levels from specified rating agencies established in the agreements, and, in some cases, to increase the commissions in order to compensate the primary insurers for the decrease in credit the rating agencies give the primary insurers for the reinsurance provided by Radian Reinsurance and Radian Asset Assurance.
With respect to the primary insurer that has exercised its right, effective January 31, 2004, approximately $16.4 billion of par in force reinsurance ceded to Radian Reinsurance was recaptured. Radian Reinsurance returned approximately $96.4 million of Statutory (“STAT”) unearned premium reserves for which the carrying
The Company estimates that the amount of capital it is holding to support this recaptured insurance business approximates $170.0 million. Such capital could potentially be redeployed for additional reinsurance, including reinsurance of obligations primarily insured by Radian Asset Assurance, other opportunities with possibly higher returns to the Company than the reinsurance business recaptured by the primary insurer, or if the Potential Merger (as defined below) were to be consummated, to write additional direct financial guaranty insurance. Since the acquisition of Radian Reinsurance by the Company in February 2001, reinsurance assumed from this primary insurer resulted in $25.1 million of written premium and $20.6 million of earned premium in 2001, $30.8 million of written premium and $32.0 million of earned premium in 2002 and $33.1 million of written premium and $37.0 million of earned premium for 2003. The Company estimates that for 2004, the recapture of reinsurance business will reduce pre-tax income by $37.8 million or approximately $0.26 per share after tax. This results from the one-time loss related to the difference in STAT and GAAP unearned premiums on the recaptured business, as well as income lost in 2004 from the recaptured business.
Future downgrades could trigger the primary financial guaranty insurers to recapture additional financial guaranty business that was assumed by Radian Reinsurance. The estimated impact of potential downgrades, excluding the impact of the business that has already been recaptured, is as follows:
$18.5 billion of par is subject to recapture in the event of a one-notch downgrade.
$38.1 billion of par is subject to recapture in the event of a two-notch downgrade.
In addition, if the Potential Merger were to occur, the Company believes that its current and potential customers would view the combined entity more favorably since Radian Asset Assurance would have materially greater STAT capital. The customers’ credit exposure limits to Radian Asset Assurance should increase as a result of Radian Asset Assurance’s greater capital that could result in the ability of Radian Asset Assurance’s customers to enter into a greater number of and larger-sized transactions with Radian Asset Assurance, especially in its structured finance business, than they would without the Potential Merger. There can be no assurance, however, as to the effect the Potential Merger would have on the number and size of transactions that customers would enter into with Radian Asset Assurance.
Net income for 2003 was $63.6 million, a $29.5 million or 31.7% decrease from $93.1 million for 2002. In the fourth quarter of 2003, Financial Guaranty added $96.0 million to its loss reserves in anticipation of approximately $111.0 million in claims from a single manufactured housing transaction originated and serviced by Conseco Finance Corp. This transaction, along with several other transactions with investment-grade ratings, was originally written in Radian Insurance in 2001, but was reinsured by Radian Asset Assurance. The losses are expected to be paid out over the next several years. Net premiums written and earned for 2003 were $368.6 million and $248.6 million, respectively, compared to $286.3 million and $186.6 million, respectively, for 2002. Increases were achieved in earned premiums as a result of continued business growth in all areas of the business, net gains from changes in fair value of derivatives, investment income, equity in net income of affiliates and other income, offset by the increase in the provision for losses, policy acquisition costs, other operating expenses and interest expense. Included in net premiums written and earned for 2003 were $54.1 million and $42.0 million, respectively, of credit enhancement fees on derivative financial guaranty contracts, compared to $40.4 million and $19.8 million, for net premiums written and earned in 2002. In 2003, Financial Guaranty originated $8.8 billion of par in the public finance area, including $3.0 billion in general obligations, $1.5 billion in the healthcare sector, $1.5 billion in the utilities sector and $1.4 billion in the transportation sector. In the structured finance area, Financial Guaranty originated $10.9 billion of par for 2003, primarily in the form of guaranties on collateralized debt obligations and asset-backed securities. In 2002, Financial Guaranty originated $5.7 billion in par in the public finance area, including $1.9 billion in general obligations, $1.2 billion in the healthcare sector, $0.9 billion in the utilities sector and $0.6 billion in the higher education sector. In the structured finance area, Financial Guaranty originated $10.9 billion of par for 2002, primarily in the form of guarantees on collateralized debt obligations and asset-backed securities.
Sherman from 45.5% to 41.5%. The Company recorded a $1.3 million loss on this transaction. C-BASS is engaged in the purchasing, servicing and/or securitizing of special assets, including sub-performing/non-performing and seller-financed residential mortgages, real estate and subordinated residential mortgage-based securities. Sherman’s business focuses on purchasing and servicing delinquent, primarily unsecured consumer assets.
Net income for 2003 was $42.5 million, up from $40.3 million in 2002. Equity in net income of affiliates (pre-tax) was $95.5 million for 2003, up $13.6 million or 16.6% from the $81.9 million (pre-tax) in 2002. C-BASS accounted for $66.1 million (pre-tax) of the total income from affiliates in 2003 compared to $63.5 million (pre-tax) in 2002. These results could vary significantly from period to period due to a substantial portion of C-BASS’s income being generated from sales of mortgage-backed securities in the capital markets. These markets can be volatile, subject to change in interest rates, the credit environment and liquidity. During 2003, Sherman accounted for $29.4 million (pre-tax) of the total income from affiliates compared to $18.3 million (pre-tax) in 2002.
RadianExpress contributed $17.4 million of other income and $23.2 million of operating expenses for 2002 compared to $16.0 million and $17.4 million, respectively, in 2001. RadianExpress processed approximately 341,000 applications during 2002 compared to 402,000 during 2001.
A wholly-owned subsidiary of EFSG, Singer Asset Finance Company L.L.C. (“Singer”), which had been engaged in the purchase, servicing and securitization of assets including state lottery awards and structured settlement payments, is currently operating on a run-off basis. Its operations consist of servicing and/or disposing of Singer’s previously originated assets and servicing of Singer’s non-consolidated special-purpose vehicles. The results of these subsidiaries are not material to the financial results of the Company. At December 31, 2003, the Company has approximately $465 million and $447 million of non-consolidated assets and liabilities,
At December 31, 2003, the Company, through its ownership of EFSG, owned an indirect 36.0% equity interest in EIC Corporation Ltd. (“Exporters”), an insurance holding company that, through its wholly-owned insurance subsidiary licensed in Bermuda, insures primarily foreign trade receivables for multinational companies. Financial Guaranty provides significant reinsurance capacity to this joint venture on a quota-share, surplus-share and excess-of-loss basis. Prior to 2003, this ownership percentage was 36.5%. The Company’s reinsurance exposure at December 31, 2003 and 2002 was approximately $318 million and $400 million, respectively. The Company has reserves of $14.5 million for this exposure, which it believes is adequate to cover any losses.
The Company also has obligations with respect to its pension, postretirement and other benefit plans. See Note 13 to the Consolidated Financial Statements.
The Company has provided to Sherman a $100 million financial guaranty policy in connection with a structured financing of a pool of receivables previously acquired by Sherman.
The Company is required to group assets in its investment portfolio into one of three categories: held to maturity, available for sale, and trading securities. Fixed-maturity securities for which the Company has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Fixed-maturity and equity securities purchased and held principally for the purpose of selling them in the near term are classified as trading securities and are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as accumulated other comprehensive income. For securities classified as either available for sale or held to maturity, the Company conducts a quarterly evaluation of declines in market value of the investment portfolio asset basis to determine whether the decline is other than temporary. This evaluation includes a review of (1) the length of time and extent to which fair value is below amortized cost; (2) issuer financial condition; and (3) intent and ability of the Company to retain its investment over a period of time to allow recovery in fair value. The Company uses a 20% decline in price over four continuous quarters as a guide in identifying those securities that should be evaluated for impairment. If the decline in fair value is judged to be other than temporary, the cost basis of the individual security is written down to fair value through earnings as a realized loss and fair value becomes the new basis. At December 31, 2003 and 2002, there were no investments held in the portfolio that met these criteria.
Of the 355 securities that have been in an unrealized loss position for more than 12 months, none has an unrealized loss of more than 20% of that security’s amortized cost.
The Company’s sources of funds consist primarily of premiums and investment income. Funds are applied primarily to the payment of the Company’s claims and operating expenses.
Cash flows from operating activities for the year ended December 31, 2003 were $535.0 million as compared to $586.8 million for the same period of 2002. This decrease was primarily due to an increase in taxes paid and an increase in claims paid and operating expenses. Positive cash flows are invested pending future payments of claims and other expenses; excess cash flow needs, if any, are funded through sales of short-term investments and other investment portfolio securities.
In December 2003, Moody’s placed the Aa2 Insurance Financial Strength rating of Radian Reinsurance on review for possible downgrade. In January 2004, S&P revised its outlook for Radian Group, Radian Asset Assurance and Radian Reinsurance to negative from stable.
At December 31, 2003, the Company and its subsidiaries had plans to continue investing in significant information technology and infrastructure upgrades over the next two years at an estimated total cost of $40 million to $50 million. The Company moved its Data Center to Dayton, Ohio during the second quarter of 2003, which is now in full service. Cash flows from operations are being used to fund these expenditures, which are intended to benefit all of the Company’s business segments.
In September 2003, Radian Asset Assurance closed on $150 million of money market committed preferred custodial trust securities which provides the financial guaranty business with additional liquid capital to use in the case of an unforeseen event. In this transaction, Radian Asset Assurance entered into a series of three perpetual put options on its own preferred stock to Radian Asset Securities Inc. (“Radian Asset Securities”), a newly formed affiliate and wholly-owned subsidiary of the Company. Radian Asset Securities in turn entered into a series of three perpetual put options on its own preferred stock (on substantially identical terms to the Radian Asset Assurance preferred stock). The counterparty to the Radian Asset Securities put options are three trusts established by two major investment banks (the “Broker-Dealers”). The trusts were created as a vehicle for providing capital support to Radian Asset Assurance by allowing Radian Asset Assurance to obtain immediate access to additional capital at its sole discretion at any time through the exercise of one or more of the put options and the corresponding exercise of one or more of the corresponding Radian Asset Securities put options. If Radian Asset Assurance put options were exercised, Radian Asset Securities, through the Radian Asset Assurance preferred stock thereby acquired by Radian Asset Securities and investors, through their equity investment in the Radian Asset Securities preferred stock, would give Radian Asset Securities and the investors rights to the assets of Radian Asset Assurance of an equity investor in Radian Asset Assurance. Such rights would be subordinate to policyholder’s claims, as well as to claims of general unsecured creditors of Radian Asset Assurance, but ahead of those of the Company, through EFSG, as the owner of the common stock of Radian Asset Assurance. If all the Radian Asset Assurance put options were exercised, Radian Asset Assurance would receive up to $150 million in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose including payment of claims. Dividend payments on the preferred stock will be cumulative only if Radian Asset Assurance pays dividends on its common stock. Each trust will be restricted to holding high-quality, short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust will issue its own auction market perpetual preferred stock. Each trust is rated “A” by each of S&P and Fitch. The initial costs to issue this facility are recorded as a reduction in additional paid-in capital. Ongoing costs of the put premium are charged to other operating expenses.
The Company believes that all of its insurance subsidiaries will have sufficient funds to satisfy their claims payments and operating expenses and to pay dividends to the Company for at least the next 12 months. The Company also believes that it will be able to satisfy its long-term (more than 12 months) liquidity needs with cash flow from Mortgage Insurance and Financial Guaranty. As a holding company, the Company conducts its principal operations through Mortgage Insurance and Financial Guaranty. In connection with obtaining approval from the New York Insurance Department for the change of control of EFSG when the Company acquired EFSG, EFSG agreed not to declare or pay dividends for a period of two years following consummation of the acquisition. The agreement for Radian Reinsurance and Radian Asset Assurance to refrain from paying dividends to the Company expired on February 28, 2003. Based on the Company’s current intention to pay quarterly common stock dividends of approximately $0.02 per share, the Company will require approximately $7.5 million for 2004 to pay the dividends on the outstanding shares of common stock. At December 31, 2003, the Parent Company had cash and liquid investment securities of $221.3 million. The Company will also require approximately $38.4 million annually to pay the debt service on its long-term financing. The Company believes that it has the resources to meet these cash requirements for the next 12 months. There are regulatory and contractual limitations on the payment of dividends and other distributions from the Company’s insurance subsidiaries. The Company does not believe that any of these restrictions will prevent the payment by its subsidiaries or the Company of any necessary dividends or distributions in the foreseeable future.
The Company’s insurance subsidiaries have the ability to allocate capital resources within certain guidelines by making direct investments. In April 2003, Radian Guaranty invested $100 million in EFSG, for an approximate 11% ownership interest. This amount was subsequently contributed by EFSG to Radian Asset Assurance to support growth in the direct financial guaranty business. In January 2004, the Company contributed an additional $65 million in capital to EFSG that was subsequently contributed to Radian Asset Assurance.
In the mortgage insurance business, the incurred loss process is initiated by a borrower’s missed payment. The Company uses historical models based on a variety of loan characteristics, including the status of the loan as reported by the servicer of the loan, the economic conditions, and the estimated foreclosure period in the area where the default exists to help determine the appropriate loss reserve at any point in time. As the delinquency proceeds toward foreclosure, there is more certainty around these estimates as a result of the aged status of the delinquent loan and adjustments are made to loss reserves to reflect this updated information. With respect to delinquent loans that are in an early stage of delinquency, considerable judgment is exercised as to the adequacy of reserve levels. The Company relies on its historical models and makes adjustments to its estimates based on current economic conditions and recent trend information. These adjustments in estimates for delinquent loans in the early stage of delinquency are more volatile in nature than for loans that are in the later stage of delinquency. If a default cures, the reserve for that loan is removed from the reserve for losses and loss adjustment expenses (“LAE”). This curing process causes an appearance of a reduction in reserve from prior years. The Company also reserves for defaults that have occurred but have not been reported using historical information on defaults not reported on a timely basis by lending institutions. The estimates are continually reviewed and, as adjustments to these liabilities become necessary, such adjustments are reflected in current operations.
Reserves for losses and LAE in the financial guaranty business are established based on the Company’s estimate of specific and non-specific losses, including expenses associated with settlement of such losses on its insured and reinsured obligations. The Company’s estimation of total reserves considers known defaults, reports and individual loss estimates reported by ceding companies and annual increases in the total net par amount outstanding of the Company’s insured obligations. The Company records a specific provision for losses and related LAE when reported by primary insurers or when, in the Company’s opinion, an insured risk is in default or default is probable and the amount of the loss is reasonably estimable. In the case of obligations with fixed periodic payments, the provision for losses and LAE represents the present value of the Company’s ultimate expected losses, adjusted for estimated recoveries under salvage or subrogation rights. The non-specific reserves represent the Company’s estimate of total reserves, less provisions for specific reserves. Generally, when a case- basis reserve is established or adjusted, an offsetting adjustment is made to the non-specific reserve.
Management believes that reserves are adequate to cover expected losses. If the Company’s estimates are inadequate, it may be forced by insurance and other regulators or rating agencies to increase its reserves. Unanticipated increases to its reserves could lead to a reduction in the Company’s and its subsidiaries’ ratings. Such a reduction in ratings could have a significant negative impact on the Company’s ability to attract and retain business.
The Company accounts for derivatives under Statement of Financial Accounting Standards (“SFAS”) No. 133, as amended and interpreted. The two areas where gains and losses on derivative contracts are recognized are in the convertible debt securities contained in the Company’s investment portfolio and in certain financial guaranty contracts. The value of the derivative position of convertible debt securities is calculated by the Company’s outside convertible debt portfolio manager by determining the value of the readily ascertainable comparable debt securities and assigning a value to the equity (derivative) portion by subtracting the value of the comparable debt security from the total value of the convertible instrument. Changes in such values from period to period represent the gains and losses recorded. The gains and losses on direct derivative financial guaranty contracts are derived from internally generated models. The gains and losses on assumed derivative financial guaranty contracts are provided by the primary insurance companies. The estimated fair value amounts have been determined by the Company using market information to the extent available, and appropriate valuation methodologies. Significant differences may exist with respect to the available market information and assumptions used to determine gains and losses on derivative financial guaranty contracts. Considerable judgment is required to interpret available market data to develop the estimates of fair value. Accordingly, the estimates are not necessarily indicative of amounts the Company could realize in a current market exchange due to the lack of a liquid market. The use of different market assumptions and/or estimation methodologies may have an effect on the estimated fair value amounts.
The components of the change in fair value of derivative instruments are as follows:
In November 2003, the Emerging Issues Task Force (“EITF”) reached a consensus on certain disclosures required for securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” EITF issue 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” requires additional disclosure of quantitative and qualitative information for investments with unrealized losses at the balance sheet date that have not been recognized as other-than-temporary impairments. The Company has included the required disclosures in the Notes to Consolidated Financial Statements and in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 6.
Radian Group Inc. (the “Company”), provides through its subsidiaries and affiliates, insurance and financial services to financial institutions in the United States of America and globally. The principal business segments of the Company are mortgage insurance, financial guaranty and financial services.
The following unaudited pro forma information presents a summary of the consolidated operating results of the Company as if the acquisition of Financial Guaranty had occurred on January 1, 2001 (in thousands, except per-share information):
On November 9, 2000, the Company completed the acquisition of RadianExpress.com Inc. (“RadianExpress,” formerly Expressclose.com Inc.), an Internet-based settlement company that provides real estate information products and services to the first and second mortgage industry, for approximately $8.0 million consisting of cash, the Company’s common stock and stock options and other consideration. The acquisition was treated as a purchase for accounting purposes, and accordingly, the assets and liabilities were recorded based on their fair values at the date of acquisition. The excess of purchase price over fair value of net assets acquired of $7.4 million was allocated to goodwill. During 2000 and 2001, a portion of this amount was amortized against earnings. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” the Company ceased amortization of goodwill effective January 1, 2002 and evaluates goodwill quarterly for impairment.
The accompanying financial statements include the accounts of all subsidiaries. Investments in which the Company, or one of its subsidiaries, owns from 20% to 50% of those companies, or where the Company has
significant influence, are accounted for in accordance with the equity method of accounting (see Note 4). All significant intercompany accounts and transactions, and intercompany profits and losses, have been eliminated.
The consolidated financial statements are prepared in accordance with Accounting Principles Generally Accepted in the United States of America (“GAAP”).
The preparation of financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results may differ from these estimates.
In the financial guaranty business, insurance premiums are earned in proportion to the level of amortization of insured principal over the contract period or over the period that coverage is provided. Unearned premiums represent that portion of premiums which will be earned over the remainder of the contract period, based upon information reported by ceding companies and management’s estimates of amortization of insured principal on policies written on a direct basis. When insured issues are refunded or called, the remaining premiums are generally earned at that time, since the risk to the Company is eliminated. Credit enhancement fees on derivative financial guaranty contracts are included in premiums written and are earned over the period credit protection is provided.
The Company periodically evaluates its estimates for losses and LAE and adjusts such reserves based on its actual loss experience, mix of business and economic conditions. Changes in total estimates for losses and LAE are reflected in current earnings. The Company believes that its total reserves for losses and LAE are adequate to cover the ultimate cost of all claims net of reinsurance recoveries. Setting the loss reserves in both business segments involves significant reliance upon estimates with regard to the likelihood, magnitude and timing of a loss. The models and estimates the Company uses to establish loss reserves may not prove to be accurate, especially during an extended economic downturn. There can be no assurance that the Company has correctly estimated the necessary amount of reserves or that the reserves established will be adequate to cover ultimate losses on incurred defaults.
The gains and losses on direct derivative financial guaranty contracts are derived from internally generated models. The gains and losses on assumed derivative financial guaranty contracts are provided by the primary insurance companies. The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. Considerable judgment is necessarily required to interpret market data to develop the estimates of fair value. The fair value of derivative financial guaranty contracts is included in accounts payable and accrued expenses on the Consolidated Balance Sheets. Settlements under derivative financial guaranty contracts are charged to the fair value of derivative financial guaranty contracts.
Other restructurings in the financial guaranty business segment may consist of purchasing the insured debt security to mitigate losses. Insured debt securities purchased to mitigate losses are included in other assets on the Consolidated Balance Sheets at the lower of cost or net realizable value. Gains or losses from the holding or disposition of the securities acquired are recorded as net gains and losses on the disposition of securities. At December 31, 2003 and 2002, the Company held $11.2 million and $13.1 million, respectively, of insured debt securities purchased to mitigate losses.
gains and losses (net of tax) reported as a separate component of stockholders’ equity as accumulated other comprehensive income. For securities classified as either available for sale or held to maturity, the Company conducts a quarterly evaluation of declines in market value of the investment portfolio asset basis to determine whether the decline is other than temporary. This evaluation includes a review of (1) the length of time and extent to which fair value is below amortized cost; (2) issuer financial condition; and (3) intent and ability of the Company to retain its investment over a period of time to allow recovery in fair value. The Company uses a 20% decline in price over four continuous quarters as a guide in identifying those securities that should be evaluated for impairment. If the decline in fair value is judged to be other than temporary, the cost basis of the individual security is written down to fair value through earnings as a realized loss and the fair value becomes the new basis. At December 31, 2003 and 2002, there were no investments held in the portfolio that met these criteria. Realized gains and losses are determined on a specific identification method and are included in income. Other invested assets consist of residential mortgage-backed securities and are carried at fair value.
SFAS No. 133 requires that the Company split its convertible fixed-maturity securities into the derivative and fixed-maturity security components. Over the term of the securities, changes in the fair value of fixed-maturity securities available for sale are recorded in the Company’s Consolidated Statement of Changes in Common Stockholders’ Equity, through accumulated other comprehensive income or loss. Concurrently, a deferred tax liability or benefit is recognized as the recorded value of the fixed-maturity security increases or decreases. A change in the fair value of the derivative is recorded as a gain or loss in the Company’s Consolidated Statements of Income.
In April 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 149, “Amendment of FASB Statement No. 133 on Derivative Instruments and Hedging Activities.” This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” This Statement improves financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. This Statement is effective for contracts entered into or modified after June 30, 2003, except for the provisions of this Statement that relate to SFAS No. 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003 and for hedging relationships designated after June 30, 2003. All provisions have applied
The Company is the beneficiary of insurance policies on the lives of certain officers and employees of the Company. The Company has recognized the amount that could be realized under the insurance policies as an asset in its Consolidated Balance Sheets. At December 31, 2003 and 2002, the amount of Company-owned life insurance totaled $55.5 million and $53.2 million, and is included as a component of other assets.
On May 1, 2001, the Company’s board of directors authorized a stock split, paid June 20, 2001, in the form of a dividend of one additional share of the Company’s common stock for each share owned by stockholders of record on June 14, 2001. To effect the stock split, the Company’s stockholders approved an increase in the number of authorized shares of common stock, from 80 million to 200 million, on June 14, 2001. The dividend was accounted for as a two-for-one stock split and the par value of the Company’s common stock remained at $.001 per share. Accordingly, all references to common shares, except where noted otherwise, have been adjusted to give effect to the stock split. In conjunction with the stock split, the Company’s board of directors voted to increase the quarterly dividend from $.015 per share to $.02 per share of common stock outstanding after the split was effected.
The Company is required to disclose both “basic” net income per share and “diluted” net income per share. Basic net income per share is based on the weighted average number of common shares outstanding, while diluted net income per share is based on the weighted average number of common shares outstanding and common share equivalents that would arise from the exercise of stock options. Preferred stock dividends are deducted from net income in the net income per share computation. Diluted shares do not assume the conversion of the Company’s senior convertible debentures. Under the terms of the indenture governing the senior convertible securities, the conditions for holders to be able to convert the debentures to common stock have not been met.
The financial guaranty segment derives a substantial portion of its premiums written from a small number of direct insurers. In 2003, 20.8% of gross written premiums were derived from two primary insurers compared to 19.9% from the same two insurers in 2002. Four primary insurers were responsible for 30.9% of gross written premiums in 2003 compared to 26.7% in 2002. This customer concentration results from a significant concentration of business with the small number of primary financial guaranty insurance companies. Five trade credit insurers were responsible for 10.5% of premiums written in 2003 compared to one trade credit insurer that was responsible for 10.4% of premiums written in 2002.
The Company is seeking to sell or otherwise dispose of the remaining assets and operations of Singer Asset Finance Company, L.L.C. (“Singer”), an entity acquired in connection with the purchase of Financial Guaranty. During this process, any net servicing expenses will be charged against an existing servicing liability and any gains or losses on assets will be charged against an existing asset reserve. If and when these reserves become depleted, future results will be charged to current operations.
Singer, which had been engaged in the purchase, servicing and securitization of assets including state lottery awards and structured settlement payments, is currently operating on a run-off basis. Its operations consist of servicing and/or disposing of Singer’s previously originated assets and servicing of Singer’s non-consolidated special-purpose vehicles. The results of this subsidiary are not material to the financial results of the Company. At December 31, 2003, the Company had approximately $465 million and $447 million of non-consolidated assets and liabilities, respectively, associated with Singer special-purpose vehicles. The Company’s investment in
these special-purpose vehicles is $18.0 million at December 31, 2003. At December 31, 2002, the Company had approximately $505 million and $479 million of non-consolidated assets and liabilities, respectively, associated with Singer special-purpose vehicles. The Company’s investment in these special-purpose vehicles was $26.3 million at December 31, 2002. In May 2003, the Company restructured and combined approximately $80 million of assets of one of the special-purpose vehicles into another special-purpose vehicle. This transaction did not have a significant effect on the Company’s operations. In August 2002, the Company sold substantially all of the assets of a related subsidiary, Enhance Consumer Services LLC (“ECS”), which had been engaged in the purchase, servicing and securitization of viatical settlements, to an independent third party for an aggregate purchase price of $8.4 million, which approximated the carrying value.
The Company accounts for guaranties under FASB Interpretation (“FIN”) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others.” This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. This Interpretation also incorporates, without change, the guidance in FASB Interpretation No. 34, “Disclosure of Indirect Guaranties of Indebtedness of Others,” which was superseded. The initial recognition and initial measurement of provisions of this Interpretation are applicable on a prospective basis to guaranties issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements in this Interpretation were effective for financial statements of interim or annual periods ending after December 15, 2002. The Interpretation does not apply to the financial guaranty insurance policies issued by the Company. However, the Company has guaranteed the performance of an affiliate under a $25 million revolving credit facility that expires in December 2004.
In May 2003, the FASB issued SFAS No. 150, “Accounting For Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This Statement amends certain paragraphs of FASB Statements No. 128 and No. 133 and is effective for financial instruments entered into or modified after May 31, 2003. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires an issuer to classify a financial instrument that is within its scope as a liability (or an asset, in some circumstances). This Statement has not had a material impact on the Company’s financial statements. The FASB is addressing certain implementation issues associated with the application of SFAS No. 150. In October 2003, the FASB decided to defer certain provisions of SFAS No. 150 related to mandatorily redeemable financial instruments representing noncontrolling interests in subsidiaries included in consolidated financial statements. The Company will monitor the actions of the FASB and assess the impact, if any, that these actions may have on the Company’s financial statements.
Certain prior period amounts have been reclassified to conform to the current year’s presentation.
Fixed-maturity and equity investments at December 31, 2003 and 2002 consisted of (in thousands):
Net change in unrealized appreciation (depreciation) on investments consisted of (in thousands):
The contractual maturity of securities in an unrealized loss position at December 31, 2003 was as follows:
The Company owns a 36.0% interest in EIC Corporation Ltd. (“Exporters”), an insurance holding company that, through its wholly owned insurance subsidiary licensed in Bermuda, insures primarily foreign trade receivables for multinational companies. Prior to 2003, this ownership percentage was 36.5%. Financial Guaranty provides significant reinsurance capacity to this joint venture on a quota-share, surplus-share, and excess-of-loss basis. The Company’s reinsurance exposure at December 31, 2003 was approximately $317.9 million or 0.3% of net debt service outstanding. At December 31, 2003 and 2002, Exporters had total assets of $168.3 million and $172.9 million, respectively, and total liabilities of $109.7 million and $115.3 million, respectively. Exporters had income of $1.5 million for 2003 and a loss for 2002 and 2001 of $1.9 million and $2.2 million, respectively.
In March 2002, the Company invested $20 million for an approximate 12% interest in Primus Guaranty, Ltd., a Bermuda holding company and parent company to Primus Financial Products, LLC (“Primus”), a Company rated “Aaa” by Moody’s Investor Services Inc. (Moody’s”) and “AAA” by Standard & Poor’s Insurance Rating Service, a division of McGraw-Hill Companies, Inc. (“S&P”) that provides credit risk protection to derivatives dealers and credit portfolio managers on investment-grade entities. At December 31, 2003, Primus had total assets of $318.2 million and total liabilities of $6.2 million. Primus had net income for 2003 of $77.6 million. The results of Primus for 2002 were immaterial to the Company’s Consolidated Financial Statements. Radian Reinsurance provided Primus with an excess of loss insurance policy, which expired on March 30, 2003.
Provisional losses recoverable were $48.6 million for both 2003 and 2002, and represented amounts due under variable quota-share treaties entered into in 1997, 1996, 1995 and 1994, covering the books of business originated by Radian Guaranty in those years. The term of each treaty is 10 years and is non-cancelable by either party except under certain conditions. The treaties also include underwriting-year excess coverage in years four, seven and 10 of the treaty.
Under the terms of these treaties, Radian Guaranty cedes premium to the reinsurer based on 15% of the premiums received by Radian Guaranty on the covered business. Radian Guaranty is entitled to receive a commission ranging from 30% to 32% of the premium paid under the treaty provided that certain loss ratios are not exceeded. In return for the payment of premium, Radian Guaranty receives variable quota-share loss relief at levels ranging from 7.5% to 15.0% based upon the loss ratio on the covered business.
In addition, Radian Guaranty is entitled to receive, under the underwriting-year excess coverage, 8% of the ceded premium written under each treaty to the extent that this amount is greater than the total amount received under the variable quota-share coverage business.
Radian Guaranty has also entered into captive reinsurance arrangements with certain customers. The arrangements are typically structured on an excess-layer basis with insured loans grouped by loan origination year. Radian Guaranty retains the first layer of risk on a particular book of business, the captive reinsurer assumes the next layer, and Radian Guaranty assumes all losses above that point. The captive reinsurers are typically required to maintain minimum capitalization equal to 10% of the risk assumed. Risk ceded under captive reinsurance arrangements at December 31, 2003 and December 31, 2002, was $1.5 billion and $986.3 million, respectively. For the years ended December 31, 2003, 2002 and 2001, Radian Guaranty had ceded premiums written of $73.4 million, $57.1 million and $55.7 million, respectively, and ceded premiums earned of $72.8 million, $56.6 million and $52.5 million, respectively, under these various captive reinsurance arrangements.
In addition, Radian Guaranty reinsures most of its direct insurance in force under an excess of loss reinsurance program that is in a run-off period that will expire December 31, 2007. Under this program, the reinsurer is responsible for 100% of Radian Guaranty’s covered losses (subject to an annual and aggregate limit) in excess of an annual retention limit. Premiums are paid to the reinsurer on a quarterly basis, net of any losses due to Radian Guaranty. This treaty is accounted for under Statements of Position 98-7, “Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk” (“SOP 98-7”) and therefore, $5.6 million, $7.5 million and $5.3 million were included in incurred losses during 2003, 2002 and 2001, respectively, relating to the excess of loss reinsurance program.
As of December 31, 2003, Radian Asset Assurance reinsured approximately 17.5% of its direct insurance exposure to Radian Reinsurance and other highly rated insurers and reinsurers. Most of this exposure has been reinsured by Radian Reinsurance, principally in order to comply with applicable regulatory single risk limitations. Radian Asset Assurance has also reinsured a small portion of its direct insurance exposure to third parties in order to comply with applicable regulatory single risk limitations. Radian Asset Assurance has also reinsured a significant portion of its direct insurance exposure in transactions with one of its largest reinsurance customers pursuant to which the availability of such reinsurance was a condition for Radian Asset Assurance accepting the direct insurance exposure. Radian Reinsurance has historically retroceded relatively little of its financial guaranty reinsurance exposure for risk management reasons. In its specialty insurance businesses, Financial Guaranty in recent years has reinsured a portion of its direct insurance exposure, principally in order to comply with applicable regulatory single risk limitations.
In November 2001, Radian Reinsurance entered into a credit agreement with a group of highly rated European banks, which was amended in January 2004, under which Radian Reinsurance is entitled, upon reaching the greater of 8.5% of average annual debt service or $210 million of covered losses and subject to certain conditions, to draw from such banks up to $95 million under certain circumstances. The recourse to Radian Reinsurance under this credit agreement is limited to recoveries on the covered losses. The agreement has an initial term of seven years and may be extended annually for additional one-year periods.
As described in Note 2, the Company establishes reserves to provide for the estimated costs of settling claims in respect to loans reported to be in default that have not yet been reported to the Company.
Different regions of the country experience different default rates due to varying economic conditions and each state has different rules regarding the foreclosure process. These rules can impact the amount of time it takes for a default to reach foreclosure, so the Company has developed a reserving methodology that takes these different time periods into account in calculating the reserve.
In 2003, the Company provided approximately $111 million of reserves on a manufactured housing transaction originated by Conseco Finance Corp. The current reserve of $111 million represents the total par exposure on this transaction. Losses are expected to be paid out over the next several years. No claims have been paid as of December 31, 2003. This transaction had been performing within expectations until the beginning of 2003. The bankruptcy of Conseco Finance Corp. led to a deterioration in the transaction’s performance. When the Company performed its year-end review, it decided it was necessary to establish reserves for the entire exposure.
During 2002 and 2001 the Company incurred losses and LAE of $3.9 million and $11.4 million, respectively, in the financial guaranty insurance business related to prior years. The reduction in prior years’ reserves in 2003 is a result of favorable developments in the public finance reinsurance product. The amounts in 2002 and 2001 primarily related to trade credit business and are the result of obtaining additional information on the assumed reinsurance as well as changes in expected claims.
In January 2002, the Company issued, in a private placement, $220 million of 2.25% senior convertible debentures due 2022. Approximately $125 million of the proceeds from the offering was used to increase capital at Radian Asset Assurance. The remainder was used to redeem the preferred stock, to buy back the Company’s common stock and for general corporate purposes. Interest on the debentures is payable semi-annually on January 1 and July 1. Beginning in 2005, the Company may also be required to pay additional contingent interest in specified semi-annual periods, if the sale price of its common stock for a specified period of time is less than 60% of the conversion price. The debentures are convertible, at the purchaser’s option, into shares of common stock at prices and on dates specified in the offering. Upon conversion, the shares would become common shares for the purposes of calculating earnings per share. In July 2002, the Securities and Exchange Commission declared effective a shelf registration statement previously filed by the Company to register the resale of the debentures by the holders of the debentures.
The composition of short-term and long-term debt at December 31, 2003 and 2002 was as follows:
From February 2002 until May 2003, the Company maintained a $50 million Senior Revolving Credit Facility to be used for working capital and general corporate purposes. There were no drawdowns on this facility. The Company replaced this with a $250 million facility in December 2003 that is unsecured and expires in December 2004. The facility will be used for working capital and general corporate purposes. The facility bears interest on any amounts drawn at either the borrower’s base rate, or at a rate above LIBOR, as defined in the credit agreement. There have been no drawdowns on this facility.
The reconciliation of taxes computed at the statutory tax rate of 35% for 2003, 2002 and 2001, to the provision for income taxes is as follows (in thousands):
Prepaid federal income taxes includes tax and loss bonds (“TLs”) of $358.8 million and $294.1 million at December 31, 2003 and 2002, respectively. Under IRC Section 832(e), TLs are required to be purchased in an amount equal to the “tax benefit derived” from deducting any portion of the Company’s statutory contingency reserve. As such, the Company purchases and redeems TLs on a quarterly basis in the normal course of its
business. Cumulative TLs purchased and subsequent redemptions are reflected in the balance of “Prepaid Federal Income Taxes” on the Consolidated Balance Sheets. During 2003, the Company purchased approximately $64.7 million of TL bonds, net of redemption of TL bonds purchased in prior years.
The Company is a holding company whose principal source of income is dividends from its subsidiaries. The ability of Radian Guaranty to pay dividends on its common stock is restricted by certain provisions of the insurance laws of the Commonwealth of Pennsylvania, its state of domicile. The insurance laws of Pennsylvania establish a test limiting the maximum amount of dividends that may be paid by an insurer without prior approval by the Pennsylvania Insurance Commissioner. Under such test, Radian Guaranty may pay dividends during any 12-month period in an amount equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus or (ii) the preceding year’s statutory net income. In accordance with such restrictions, $247.7 million would be available for dividends in 2004. However, an amendment to the Pennsylvania statute requires that dividends and other distributions be paid out of an insurer’s unassigned surplus. Radian Guaranty has positive unassigned surplus at December 31, 2003 of $75 million which would hence represent the dividend limitation. The Pennsylvania Insurance Commissioner has approved all distributions by Radian Guaranty since the passage of this amendment.
In connection with the approval of the acquisition of EFSG, the Company, Radian Reinsurance and Radian Asset Assurance agreed that Radian Reinsurance and Radian Asset Assurance would refrain from paying any dividends to the Company for a period of two years from the date of acquisition of control without the prior written consent of the New York Insurance Department. The agreement for Radian Reinsurance and Radian Asset Assurance to refrain from paying dividends to the Company expired on February 28, 2003. Neither Radian Reinsurance nor Radian Asset Assurance has paid any dividends since the Company acquired EFSG in 2001.
Radian Guaranty’s statutory policyholders’ surplus at December 31, 2003 and 2002 was $255.6 million and $163.5 million, respectively. Radian Guaranty’s statutory net income for 2003, 2002 and 2001 was $247.7 million, $411.6 million and $252.8 million, respectively.
In March 1998, the NAIC adopted the Codification of Statutory Accounting Principles (“Codification”). The Codification, which is intended to standardize regulatory accounting and reporting for the insurance industry, was effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. The Commonwealth of Pennsylvania required adoption of the Codification for the preparation of statutory financial statements effective January 1, 2001. The Company’s adoption of the Codification increased statutory capital and surplus as of January 1, 2001 by $4.6 million in Radian Guaranty. The State of Illinois required adoption of the Codification for the preparation of statutory financial statements effective January 1, 2001. The Company’s adoption of the Codification increased statutory capital and surplus as of January 1, 2001 by $767,000 in Amerin Guaranty. The State of New York required adoption of the Codification, with certain exceptions, for the preparation of statutory financial statements effective January 1, 2001. The Company’s adoption of the Codification decreased statutory capital and surplus as of January 1, 2001 by $265,000 in Radian Reinsurance. There was no impact upon adoption for Radian Asset Assurance. In 2002, the State of New York adopted Statutory Accounting Practices 10 (“SAP 10”) of the Codification related to Income Taxes. The Company’s adoption of SAP 10 increased statutory capital and surplus as of January 1, 2002 by $6.4 million in Radian Reinsurance and by $1.6 million in Radian Asset Assurance.
Information with regard to the Company’s stock option plans is as follows:
The Company applies APB 25 in accounting for its stock-based compensation plans. No stock-based employee compensation cost is reflected in net income, as all options granted under the stock option plans had an exercise price equal to the market value of the underlying common stock on the date of grant.
The weighted average fair values of the stock options granted during 2003, 2002 and 2001 were $14.26, $21.50 and $15.74, respectively. The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants:
The Company’s option plans included a “reload” feature. The award of a “reload” option allows the optionee to receive the grant of an additional stock option, at the then current market price, in the event that such optionee exercises all or part of an option (the “original option”) by surrendering already owned shares of common stock in full or partial payment of the exercise price of such original option. The exercise of an additional option issued in accordance with the “reload” feature will reduce the total number of shares eligible for award under the stock option plan. While there are outstanding options with this “reload” feature, new options issued will not have this feature.
The funded status of the Pension Plan and SERP, the Postretirement Welfare Plan, and the EFSG Pension Plan and Restoration Plan were as follows (in thousands):
The accrued benefit cost for the Company’s and EFSG’s pension plans, the SERP, the Restoration Plan and postretirement plans is included in accounts payable and accrued expenses on the Consolidated Balance Sheets.
Weighted average assumptions used to determine net pension and net periodic postretirement benefit obligation at December 31, 2003 were as follows:
The Company expects to contribute $2.5 million to its pension plan and $16 thousand to its other postretirement benefit plans in 2004.
Due to the nature of the Postretirement Welfare Plan, no increase is assumed in the Company’s obligation due to any increases in the per capita cost of covered healthcare benefits.
The U.S. Department of Housing and Urban Development (“HUD”) proposed a rule under the Real Estate Settlement Procedures Act (“RESPA”) to create an exemption from the provisions of RESPA that prohibit the giving of any fee, kickback or thing of value pursuant to any agreement or understanding that real estate settlement services that will be referred. The proposed rule would have made the exemption available to lenders that, at the time a borrower submits a loan application, give the borrower a firm, guaranteed price for all settlement services associated with the loan. In 2003, HUD withdrew the proposed rule and submitted another rule to the Office of Management and Budget. The contents of the new rule have not been made public, although most commentators are assuming that the new rule is similar to the old rule. If the new rule is implemented, the premiums charged for mortgage insurance could be negatively affected.
In January 2004, a complaint was filed in the United States District Court for the Eastern District of Pennsylvania against Radian Guaranty Inc. by Whitney Whitfield and Celeste Whitfield seeking class action status on behalf of a nationwide class of consumers who allegedly were required to pay for private mortgage insurance provided by Radian Guaranty and whose loans allegedly were insured at more than Radian Guaranty’s “best available rate,” based upon credit information obtained by Radian Guaranty. The action alleges that the Fair Credit Reporting Act (known as FCRA) requires a notice to borrowers of such “adverse action” and that Radian Guaranty violated FCRA by failing to give such notice. The action seeks statutory damages, actual damages, or both, for the people in the class, and attorneys’ fees, as well as declaratory and injunctive relief. The action also alleges that the failure to give notice to borrowers in the circumstances alleged is a violation of state law applicable to sales practices and seeks declaratory and injunctive relief for this alleged violation. This litigation is aimed at practices commonly followed in the mortgage insurance industry, and similar cases are pending against several other mortgage insurers. The Company intends to vigorously defend against this action but cannot predict its outcome.
In addition to the above, the Company is involved in certain litigation arising in the normal course of its business. The Company is contesting the allegations in each such other action and believes, based on current knowledge and consultation with counsel, that the outcome of such litigation will not have a material adverse effect on the Company’s consolidated financial position or results of operations.
The Company has guaranteed payments of up to $25.0 million of a revolving credit facility issued to Sherman, a 41.5%-owned affiliate of Financial Guaranty. This facility expires December 31, 2004.
upon written notice (ranging from 90 to 120 days) prior to the specified deadline for renewal, (ii) at the option of the primary insurer if the Company fails to maintain certain financial, regulatory and rating agency criteria which are equivalent to or more stringent than those the Company is otherwise required to maintain for its own compliance with New York insurance law and to maintain a specified financial strength rating for the particular insurance subsidiary or (iii) upon certain changes of control of the Company. Upon termination under the conditions set forth in (ii) and (iii) above, the Company may be required (under some of its reinsurance agreements) to return to the primary insurer all unearned premiums, less ceding commissions, attributable to reinsurance ceded pursuant to such agreements. Upon the occurrence of the conditions set forth in (ii) above, whether or not an agreement is terminated, the Company may be required to obtain a letter of credit or alternative form of security to collateralize its obligation to perform under such agreement or it may be obligated to increase the level of ceding commission paid. See Note 18 for additional information regarding the potential impact that a ratings downgrade from S&P or Moody’s may have on the Company’s financial guaranty reinsurance business.
The Company leases office space for use in its operations. Net rental expense in connection with these leases total $9,574,000, $7,086,000 and $6,155,000 in 2003, 2002 and 2001, respectively. The commitment for non-cancelable operating leases in future years is as follows (in thousands):
Diluted net income per share and average shares outstanding per SFAS No. 128, “Earnings Per Share.” See Note 2.
Other Invested Assets-The fair value of other invested assets (residential mortgage-backed securities), is based on the present value of the estimated net future cash flows, including annual distributions and net cash proceeds from the exercise of call rights, using relevant market information.
On September 24, 2002, the Company announced that its Board of Directors had authorized the repurchase of up to 2.5 million shares of its common stock on the open market. Shares will be purchased from time to time depending on the market conditions, share price and other factors. These purchases will be funded from available working capital. At December 31, 2003 and 2002, 1.9 million and 1.4 million shares, respectively, had been repurchased under this program at a total price of approximately $61.2 million and $45.1 million, respectively. At December 31, 2003, there were 1.8 million treasury shares held by the Company. The remaining shares under this program were purchased in 2004.
On October 4, 2002, S&P announced that it had downgraded the Insurer Financial Strength rating of Radian Reinsurance from “AAA” to “AA.” On April 8, 2003, Fitch downgraded the Insurer Financial Strength rating of Radian Reinsurance from “AAA” to “AA” and removed it from “negative watch.” In December 2003, Moody’s placed the Aa2 Insurance Financial Strength rating of Radian Reinsurance on review for possible downgrade. In January 2004, S&P revised its outlook for Radian Group, Radian Asset Assurance and Radian Reinsurance from negative to stable. Radian Reinsurance and Radian Asset Assurance are parties to numerous reinsurance agreements with primary insurers which grant the primary insurers the right to recapture all of the business ceded to Radian Reinsurance or Radian Asset Assurance under these agreements if the financial strength rating of Radian Reinsurance or Radian Asset Assurance, as the case may be, is downgraded below the rating levels from specified rating agencies established in the agreements, and, in some cases, to increase the commissions in order to compensate the primary insurers for the decrease in credit the rating agencies give the primary insurers for the reinsurance provided by Radian Reinsurance and Radian Asset Assurance.
As a result of the downgrade by S&P, one of the primary insurers exercised their right to recapture the financial guaranty reinsurance ceded to Radian Reinsurance. None of the primary insurers have a similar right with respect to the downgrade by Fitch. Radian Reinsurance has now reached agreement with the remaining primary insurers whereby such primary insurers have agreed not to exercise their rights with respect to the downgrade of Radian Reinsurance by S&P, without additional cost to Radian Reinsurance.
The Company estimates that the amount of capital it is holding to support this recaptured insurance business approximates $170.0 million. Since the acquisition of Radian Reinsurance by the Company in February 2001, reinsurance assumed from this primary insurer resulted in $25.1 million of written premium and $20.6 million of earned premium in 2001, $30.8 million of written premium and $32.0 million of earned premium in 2002 and $33.1 million of written premium and $37.0 million of earned premium for 2003.