At our corporate headquarters in Philadelphia, we lease 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; we also sublease approximately 3,600 square feet of space at our Philadelphia headquarters under a sublease that expires in March 2005. This lease will be month-to-month until we get permanent space in December 2005. In addition, we lease: (1) space for our mortgage insurance regional offices, service centers and on-site offices throughout the United States comprising approximately 29,000 square feet with leases expiring between 2005 and 2009; (2) space for our 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 we sublease to others; (3) space for our U.K. operations in London comprising approximately 6,500 square feet, under a lease expiring in 2012; and space for our data centers in Philadelphia and Dayton comprising approximately 43,000 square feet with leases expiring in August 2015 and September 2012. We are currently negotiating early termination buy-outs for the service center leases expiring in 2005. In the fourth quarter of 2003, we announced the cessation of operations of RadianExpress. We leased approximately 18,000 square feet of space for these operations under a lease that terminated in April 2004. In the first quarter of 2005, we announced the closing of four field offices comprised of 8,800 square feet. All of these locations have leases that expire in 2005. With respect to all facilities, we believe we will be able to obtain satisfactory lease renewal terms.
(2) The prior period presentations have been conformed to the current period presentation by reclassifying gains and losses on sales of investments and change in fair value of derivative instruments as revenues and by reclassifying equity in net income of affiliates as a separate item following operating expenses.
(5) Calculated on a GAAP basis using provision for losses to calculate the loss ratio and policy acquisition costs and other operating expenses to calculate the expense ratio as a percentage of net premiums earned.
(6) Consists primarily of second lien mortgage insurance risk and other structured mortgage-related insurance risk.
The following analysis of the Company’s financial condition and results of operations should be read in conjunction with the Company’s financial statements and notes thereto included elsewhere in this report and the risk factors detailed in the section immediately preceding Part I of this report.
of the recapture by one of the primary insurer customers in the first quarter of 2004 of approximately $25.5 billion of net debt service outstanding that previously was ceded to the Company. Equity in net income of affiliates increased to $180.6 million from $105.5 million in 2003. Equity in net income of affiliates includes the results of Credit-Based Asset Servicing and Securitization LLC (“C-BASS”), Sherman Financial Services Group LLC (“Sherman”) and, until September 30, 2004, Primus Guaranty, Ltd., a Bermuda holding company and parent to Primus Financial Products, LLC, (“Primus”). In September 2004, Primus issued shares of its common stock in an initial public offering. The Company sold a portion of its shares in Primus as part of this offering and recorded a pre-tax gain of approximately $1.0 million on the sale. The sale of its shares reduced the Company’s investment in Primus to approximately 11%. As a result of the Company’s reduced ownership and influence over Primus after it became a public company, the Company moved its investment in Primus to its equity securities portfolio and, as such, began recording changes in market value from Primus securities as other comprehensive income rather than recording income or loss as equity in net income of affiliates beginning with the fourth quarter of 2004.
and 27.4% for 2004 and 2003, respectively. The lower effective tax rate for 2003 reflects a higher proportion of tax-exempt income to total income resulting from the overall decline in 2003 earnings as a result of the charge for Conseco Finance Corp.
Net income for 2003 was $385.9 million or $3.95 per share compared to $427.2 million or $4.27 per share for 2002. Net income per share for both periods reflects the inclusion of 3.8 million shares underlying the Company’s contingently convertible debt, as required by newly issued accounting rules. The impact of including these shares in the calculation was a reduction of $0.13 per share for 2003 and $0.14 per share for 2002. The overall decline in net income was principally a result of a $232.8 million increase in the provision for losses, as discussed below. Insurance in force for the mortgage insurance business segment increased from $110.3 billion at December 31, 2002 to $119.9 billion at December 31, 2003. Total net debt service outstanding (par plus interest) on transactions insured by Financial Guaranty increased from $104.8 billion at December 31, 2002 to $117.9 billion at December 31, 2003. These increases in business volumes produced increases in written and earned premiums, investment income and other income. Increased revenues were offset by increases in policy acquisition costs, other operating expenses and interest expense to support the higher business volumes. Equity in net income of affiliates increased by $23.8 million in 2003 to $105.5 million from the $81.7 million recorded in
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, some of which resulted from the issuance of $250 million of notes in the first quarter of 2003, partially offset by lower investment yields. 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 highest state concentration of risk is California at 13.0%. At December 31, 2004, California also accounted for 12.4% of Mortgage Insurance’s total direct primary insurance in force and 13.8% of Mortgage Insurance’s direct primary new insurance written for 2004.
by the reinsurance company is an excess layer of aggregate losses that would be penetrated only in a situation of adverse loss development, in effect providing the mortgage insurer with a form of stressed loss coverage. For 2004, premiums ceded under captive reinsurance arrangements were $87.3 million, or 11.3% of total premiums earned during 2004, compared to $73.6 million, or 10.0% of total premiums earned for 2003. New primary insurance written under captive reinsurance arrangements was $17.8 billion, or 39.7% of total new primary insurance written in 2004 compared to $21.9 billion, or 32.1% of total new primary insurance written in 2003. These percentages can be volatile as a result of increases or decreases in structured transactions, such as has occurred over the last several quarters. Primary insurance written in structured transactions is not typically eligible for captive reinsurance arrangements. Captive reinsurance arrangements continue to grow in popularity, and a larger percentage of the Company’s business participates in these arrangements at increasing percentage levels. Because of many factors, including the incentives for mortgage lenders to funnel relatively higher-quality loans through the captive reinsurer, the Company continues to evaluate the level of revenue sharing against risk sharing on a customer-by-customer basis as part of its customer profitability analysis.
Net investment income attributable to Mortgage Insurance for 2004 was $118.7 million, an increase of $11.0 million or 10.2% compared to $107.7 million for 2003. This increase was the result of continued growth in invested assets primarily due to positive operating cash flows and the allocation of interest income from the parent company.
The total number of loans in default decreased from 50,080 at December 31, 2003 to 48,940 at December 31, 2004. The average loss reserve per default increased from $10,253 at the end of 2003 to $11,435 at December 31, 2004. The loss reserve as a percentage of risk in force was 1.8% at December 31, 2004, compared to 1.6% at December 31, 2003. The non-prime mortgage insurance business has experienced a consistent increase in the number of defaults in the past. Although the default rate on this business is higher than on prime business, higher premium rates charged for non-prime business are expected to compensate for the increased level of expected losses associated with this business. The number of non-prime loans in default at December 31, 2004 was 21,017, which represented 52% of the total primary loans in default, compared to 19,840 non-prime loans in default at December 31, 2003, which represented 47% of the total primary loans in default. The default rate on the Alt-A business was 6.5% at December 31, 2004 compared to 5.3% at December 31, 2003. The default rate on the A minus and below loans was 12.1% at December 31, 2004 compared to 11.4% at December 31, 2003. It is too early to determine with certainty whether the increased premiums charged on non-prime business will compensate for the ultimate losses on the non-prime business. The default rate on the prime business was 3.2% and 3.5% at December 31, 2004 and December 31, 2003, respectively. The default rate on non-prime
Direct claims paid for 2004 were $364.4 million compared to $271.2 million for 2003. The average claim paid has increased over the past few years due primarily to deeper coverage amounts and larger loan balances. Alt-A loans have a significantly higher average claim payment due to higher loan balances and greater coverage percentages. In addition, claims paid in 2004 have been impacted by the rise in delinquencies in 2002 and 2003 that have proceeded to foreclosure. Claims paid on second-lien mortgages increased year over year as a result of the increase in the volume of business written in 2003, for which the Company began paying claims in 2004. A disproportionately higher incidence of claims in Georgia is directly related to what the Company’s risk management department believes to be questionable property value estimates in that state. The Company’s risk management department put into place several property valuation checks and balances to mitigate the risk of this issue recurring and applies these same techniques to all mortgage insurance transactions. The Company expects this higher incidence of claims in Georgia to continue until loans originated in Georgia prior to the implementation of these preventive measures become sufficiently seasoned. A higher level of claim incidence in Texas resulted, in part, from unemployment levels that were higher than the national average and from lower home price appreciation. The Company believes that claims in the Midwest and Southeast have been rising and will continue to rise due to the weak industrial sector of the economy. The Company anticipates that overall claim payments in 2005 will be in line with or slightly up from 2004.
Policy acquisition costs relate directly to the acquisition of new business. Other operating expenses consist primarily of contract underwriting expenses, overhead and administrative costs, some of which are allocated to the various business segments from the parent company. Policy acquisition costs and other operating expenses were $216.6 million in 2004, an increase of $20.5 million or 10.5% compared to $196.1 million for 2003. Policy acquisition costs were $75.5 million in 2004, an increase of $5.3 million or 7.5% from $70.2 million in 2003. The amortization of these expenses is related to the recognition of gross profits over the life of the policies and is influenced by such factors as persistency and estimated loss rates. During the third quarter and fourth quarter of 2004, the Company accelerated $11.6 million of the amortization of policy acquisition costs due to the substantial run-off in prior years’ books of business which impacted the projected future gross profits. Much of the amortization in 2004 represents costs that were incurred in 2003 or the effects of the acceleration described above. Other operating expenses were $141.1 million for 2004, an increase of $15.2 million or 12.1% from $125.9 million for 2003 primarily as a result of increased depreciation on IT projects that were put into service in the latter part of 2003 and during 2004 and costs related to the Company’s capital market reinsurance transactions with Smart Home.
Interest expense for 2004 was $20.1 million compared to $21.5 million for 2003. This decrease represents the allocation from the parent company of interest on long-term debt and includes the impact of the interest-rate swap. Net gains on sales of investments were $44.4 million for 2004 compared to gains of $8.1 million in 2003. This increase primarily related to sales of investments as a result of changes in asset allocation and investment execution strategies. Change in the fair value of derivative instruments was $11.9 million for 2004 compared to $3.3 million for 2003, primarily due to changes in the fair value of embedded options in convertible securities held in the investment portfolio.
Mortgage Insurance’s net income for 2003 was $279.8 million, a decrease of $14.0 million or 4.8% from $293.8 million in 2002. This net decrease resulted from increases in the provision for losses, policy acquisition costs, other operating expenses and interest expense, partially offset by higher earned premiums and other income.
During 2003, non-prime business accounted for $27.4 billion or 40.1% of Mortgage Insurance’s new primary insurance written compared to $16.2 billion or 33.1% for 2002. At December 31, 2003, non-prime insurance in force was $37.8 billion or 31.5% of total primary insurance in force compared to $25.6 billion or 23.2% of primary insurance in force at December 31, 2002. Of the $27.4 billion of non-prime business in 2003, $20.0 billion or 73.0% was Alt-A. Risk in force in Radian Insurance and Amerin Guaranty was $1.1 billion at December 31, 2003 compared to $0.5 billion at December 31, 2002.
Mortgage Insurance’s volume in 2003 was impacted by low interest rates that affected the entire mortgage industry. The continued low interest rate environment caused refinancing activity to remain high throughout 2003, and contributed to the industry’s significant volume of new insurance in 2003. Mortgage Insurance’s refinancing activity, as a percentage of primary new insurance written, was 49.8% for 2003 compared to 40.5% in 2002. The persistency rate was 46.7% for the 12 months ended December 31, 2003, 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.
For 2003, premiums ceded under captive reinsurance arrangements were $73.6 million, or 10.0% of total premiums earned during 2003, compared to $57.1 million, or 8.3% of total premiums earned for the same period of 2002. New primary insurance written under captive reinsurance arrangements was $21.9 billion, or 32.1% of total new primary insurance written in 2003 compared to $17.0 billion, or 34.8% of total new primary insurance written in 2002.
Net investment income attributable to Mortgage Insurance 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 the parent company, offset by declining investment yields.
Mortgage Insurance’s provision for losses was $309.3 million for 2003, an increase of $114.8 million or 59.0% from $194.5 million in 2002 primarily as a result of a higher mix of non-traditional insured loans. Approximately 82.9% of the primary risk in force and approximately 40.7% of the pool risk in force at December 31, 2003 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 3.2% at December 31, 2003, compared to 2.8% at December 31, 2002, while the default rate on the primary business was 4.7% at December 31, 2003 compared to 4.1% at December 31, 2002. The change in the default rate on the primary business was caused by a 15 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 up 39 basis points year over year. 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 level of mortgage delinquencies. The lower reserve per default was a result of a higher percentage of newer business, which had not reached peak delinquency. The loss reserve as a percentage of risk in force was 1.6% at December 31, 2003, compared to 1.7% at December 31, 2002. The number of non-prime loans in default at December 31, 2003 was 19,840, which represented 47% of the total primary loans in default, compared to 14,305 non-prime loans in default at December 31, 2002, which represented 40% of the total primary loans in default. The default rate on the Alt-A business was 5.3% at December 31, 2003 compared to 5.2% at December 31, 2002. The default rate on the A minus and below loans was 11.4% at December 31, 2003 compared to 11.3% at December 31, 2002. The default rate on the prime business was 3.5% at December 31, 2003 and 3.1% at December 31, 2002.
Direct claims paid for 2003 were $271.2 million compared to $165.0 million for 2002. The severity of loss payments has increased over the past few years due primarily to deeper coverage amounts and larger loan balances. In addition, claims paid in 2003 have been impacted by the rise in delinquencies in 2001 and 2002 that have proceeded to foreclosure.
Policy acquisition costs and other operating expenses were $196.1 million in 2003, an increase of 11.5% compared to $175.9 million in 2002. Policy acquisition costs were $70.2 million in 2003, an increase of 5.1% from $66.8 million in 2002. Much of the amortization in 2003 represented 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 increase reflected 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 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 compared to 30.4%, 28.7% and 23.0%, respectively, in 2002. During 2003, less than 1% of all loans were subject to contract underwriting remedies and the costs associated with these remedies were immaterial.
Interest expense for 2003 was $21.5 million compared to $17.2 million for 2002. These expenses represented the allocation from the parent company of interest on long-term debt issued during 2001, 2002 and 2003. The Company issued an additional $250 million of debt in February 2003, which accounts for the increase in interest expense in 2003 as compared to 2002. Net gains on sales of investments and changes in the fair value of derivative instruments were $8.1 million and $3.3 million, respectively, for 2003, compared to $4.6 million and $0.5 million, respectively, for 2002. These gains related to the change in the fair value of derivative instruments, primarily embedded derivatives in convertible debt securities, as well as an increase in gains on sales of investments.
The effective tax rate for 2003 was 27.1% compared to 27.6% in 2002 and 27.7% in 2001. The tax rate reflects the significant investment in tax-advantaged securities.
Financial Guaranty primarily involves the direct insurance and reinsurance of public finance obligations and structured financial obligations, including asset-backed securities, credit default swaps and certain other financial guaranty contracts. Financial guaranty and trade credit reinsurance (which protects sellers of goods under certain circumstances against non-payment of the receivables they hold from buyers of their goods) is assumed primarily from a limited number of direct insurers. The Company’s trade credit reinsurance may cover receivables as to which the buyer and seller are in the same country, as well as cross-border receivables.
Financial Guaranty also includes Radian Asset Assurance Limited (“RAAL”), a subsidiary of Radian Asset Assurance that is authorized to conduct an insurance business in the United Kingdom. The Company believes
that, through RAAL, it will have additional opportunities to write financial guaranty insurance in the United Kingdom and, subject to compliance with the European passporting rules, in seven other countries in the European Union. In July of 2004, RAAL received initial ratings of “AA” (negative outlook) from S&P and “AA” from Fitch. The Company expects that these ratings will better position RAAL to continue to build its structured products business in the United Kingdom and throughout the European Union through the European passport system. In September 2004, the Financial Services Authority granted a license to Radian Financial Products Limited, another subsidiary of Radian Asset Assurance, to trade as a Category A Securities and Futures Firm, allowing the Company to develop a range of derivatives-based solutions for clients in the United Kingdom and throughout the European Union.
In October 2002, S&P downgraded the Insurer Financial Strength rating of Radian Reinsurance, before its merger with and into Radian Asset Assurance, from “AAA” to “AA.” As a result of this downgrade, effective January 31, 2004, one of Financial Guaranty’s primary insurer customers exercised its right to recapture approximately $16.4 billion of par in force reinsurance ceded to Financial Guaranty, including $96.4 million of written premiums with a GAAP carrying value of approximately $71.5 million. The entire impact of this recapture of written premiums was reflected as a reduction of written premiums in the first quarter of 2004. Because the Company, in accordance with GAAP, already had reflected $24.9 million of these recaptured written premiums as having been earned, the Company was required to record the entire $24.9 million reduction in earned premiums in the first quarter of 2004. The Company estimates that the recapture of reinsurance business reduced 2004 pre-tax income by approximately $37.8 million or approximately $0.26 per share after tax, $0.11 per share of which was the immediate impact, and the balance was a result of recaptured written premiums that would have been earned over time and estimated losses.
The Company estimates that the amount of capital it was holding to support this recaptured insurance business approximated $170 million. Without cost to or concessions by the Company, the remaining primary insurer customers with recapture rights agreed not to exercise these recapture rights as a result of the October 2002 downgrade by S&P.
The gross par originated by Financial Guaranty in 2004, 2003 and 2002 is as follows:
(1) Amounts recorded related to the immediate impact of the recapture of previously ceded business by one of the primary insurer customers of Financial Guaranty reinsurance business in the first quarter of 2004.
The following schedule depicts the expected amortization of net unearned premiums for the existing Financial Guaranty portfolio, assuming no advance refundings, as of December 31, 2004, and includes the estimated impact of the first quarter 2005 recapture. The estimated impact on total premium earnings of the first quarter 2005 recapture on Financial Guaranty’s total premium earnings is $170.8 million, including approximately $14.1 million for 2005. Expected maturities will differ from contractual maturities because borrowers have the right to call or prepay financial guaranty obligations. Unearned premium amounts are net of prepaid reinsurance.
Net income attributable to Financial Guaranty for 2004 was $134.2 million, a $70.6 million or 111.0% increase from $63.6 million for 2003. The net income reported for 2004 reflects a $10.3 million after-tax reduction as a result of the recapture in the first quarter of 2004 of insurance business previously ceded to the Company by one of the primary insurers. The net income for 2003 reflects a charge of $111.0 million in anticipation of claims from a single manufactured housing transaction originated and serviced by Conseco Finance Corp. Net premiums written and earned for 2004 were $216.4 million and $214.9 million, respectively, compared to $368.6 million and $248.6 million, respectively, for 2003. Included in net premiums written and earned for 2004 were $66.1 million and $50.3 million, respectively, of credit enhancement fees on derivative financial guaranty contracts, compared to $54.1 million and $42.0 million, respectively, included in net premiums written and earned in 2003. Net premiums written and earned for 2004 reflect a reduction of $96.4 million and $24.9 million, respectively, that had been recorded by the Company as written and earned in prior periods related to the recapture that occurred in the first quarter of 2004.
Company paid $30.7 million in claims in 2004 related to this transaction. The Company expects that losses related to this transaction will be paid out over the next several years. The Company closely monitors troubled credits through its internal classification process. Credits classified as “intensified surveillance” are defined as obligations where continued performance is questionable and in the absence of a positive change may result in non-payment. At December 31, 2004, the Company had $261.1 million of exposure on five credits greater than $25 million that were classified as intensified surveillance compared to $367.0 million of exposure on four such credits at December 31, 2003.
operating expenses were $96.4 million for 2003 compared to $61.6 million in 2002. These expenses were increased to support the growth in business volumes. The operating expense ratio of 38.8% for 2003 was up from 33.0% in 2002, due to higher commissions associated with higher business volumes. In 2002, the Company recorded a $6.0 million gain on the curtailment of Financial Guaranty’s employee benefit plans, which offset an equal amount of other operating expenses. Included in other operating expenses for 2003 and 2002 were $6.6 million and $4.3 million, respectively, of origination costs related to derivative financial guaranty contracts. Interest expense was $12.9 million for 2003 compared to $9.6 million for 2002. This increase represented interest on the $75.0 million of short-term debt, which matured in March 2003, as well as interest on the Company’s outstanding indebtedness allocated to Financial Guaranty. Net gains on sales of investments were $11.5 million for 2003 compared to $2.4 million for 2002. The change in fair value of derivative instruments was a gain of $0.8 million in 2003 compared to a loss of $13.5 million in 2002. During 2003, Financial Guaranty received $11.5 million as settlement proceeds and paid out $14.0 million related to the settlement of derivative financial guaranty contracts that are considered to be credit derivatives. There were no such settlements in 2002.
RadianExpress recorded $19.8 million of revenues and $38.7 million of operating expenses for 2003 compared to $17.4 million and $23.2 million, respectively, in 2002. Included in operating expenses for 2003 is the $13.0 million described above, as well as a provision for uncollectible accounts of $2.3 million. RadianExpress processed approximately 271,000 applications during 2003 compared to 341,000 during 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”), a wholly owned subsidiary of EFSG. Singer had been engaged in the purchase, servicing, and securitization of assets including state lottery awards and structured settlement payments, and currently is operating on a run-off basis. Singer’s run-off operations consist of servicing and/or disposing of Singer’s previously originated assets and servicing its non-consolidated special purpose vehicles. The results of this subsidiary are not material to the financial results of the Company. At December 31, 2004, the Company had approximately $413 million and $392 million of non-consolidated assets and liabilities, respectively, associated with Singer special-purpose vehicles. The Company’s investment in these special-purpose vehicles was $20.8 million at December 31, 2004. At December 31, 2003, the Company had $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 at December 31, 2003 was $18.0 million. 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.
Another insurance subsidiary, Van-American Insurance Company, Inc., is engaged on a run-off basis in reclamation bonds for the coal mining industry and surety bonds covering closure and post-closure obligations of landfill operations. This business is not material to the financial results of the Company.
The following table summarizes the Company’s significant contractual obligations and commitments as of December 31, 2004 and the future periods in which such obligations are expected to be settled in cash. Although the majority of the Company’s loss reserves do not represent contractual obligations and commitments under the
The Company has provided to Sherman, in an arms-length transaction, a $150 million financial guaranty policy in connection with a structured financing of a pool of receivables previously acquired by Sherman.
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 expired December 31, 2004 and has been renewed until December 31, 2005. There have been no drawdowns on this facility.
The Company is required to group assets in its investment portfolio into one of three categories: held to maturity, available for sale or 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. Investments classified as available for sale are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity under accumulated other comprehensive income. Investments classified as trading securities are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of 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. For securities that have experienced rapid price declines or unrealized losses of less than 20% over periods in excess of four consecutive quarters, classification as other-than-temporary is considered. Factors influencing this consideration include an analysis of the security issuer’s financial
Of the 70 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 and none required recognition as other-than-temporary in the Company’s judgment.
As a holding company, the Company conducts its principal operations through Mortgage Insurance and Financial Guaranty. There are regulatory and contractual limitations on the payment of dividends and other distributions from the Company’s insurance subsidiaries, but these limitations are not expected to prevent the payment of necessary dividends or distributions to the Company during at least the next 12 months. The Company believes that it will be able to satisfy the majority of its long-term (more than 12 months) liquidity needs with cash flow from Mortgage Insurance and Financial Guaranty. Based on the Company’s current intention to pay quarterly common stock dividends of approximately $0.02 per share, the Company would require approximately $7.4 million for 2005 to pay the quarterly dividends on the shares of its common stock that were outstanding at December 31, 2004. At December 31, 2004, the parent company had cash and liquid
investment securities of $199.1 million. The Company will also require approximately $38.2 million annually to pay the debt service on its currently outstanding long-term financing. The Company believes that it has the resources to meet these cash requirements for at least the next 12 months.
The Company’s sources of working capital consist primarily of premiums and investment income. Working capital is applied primarily to the payment of the Company’s claims and operating expenses. Cash flows from operating activities for the year ended December 31, 2004 were $327.0 million compared to $535.0 million for 2003. This decrease resulted primarily from the payment of $76.9 million made as a result of the recapture of previously ceded business that occurred in the first quarter of 2004 coupled with higher claims paid and operating expenditures. Positive cash flows are invested pending future payments of claims and other expenses. The Company believes that the operating cash flows generated by each of its insurance subsidiaries will provide those subsidiaries with sufficient funds to satisfy their claim payments and operating expenses for at least the next 12 months. The Company believes that it has the ability to fund additional cash flow needs, if any, through sales of short-term investments. The weighted average duration of the assets in the Company’s investment portfolio as of December 31, 2004 was 4.33 years. In the unlikely event that the Company is unable to satisfy claims and operating expenses through the sale of short-term investments, the Company may be required to incur unanticipated capital losses or delays in connection with the sale of less liquid securities held by the Company. In any event, the Company does not anticipate the need for borrowings, under credit facilities or otherwise, to satisfy claims or other operating expenses.
The following table reconciles net income to cash flows from operating activities for the years ended December 31, 2004 and 2003:
Recently, the Company has experienced a trend toward a reduction in cash flow from operations compared to net income, primarily because an increasing portion of the Company’s net income has been derived from the Company’s equity in earnings of affiliates, which does not represent cash flow. This trend also has resulted because of rising costs imposed by infrastructure and regulatory requirements and because the Company has been required to use more operating cash to pay taxes currently. This trend is exaggerated in periods like the first quarters of 2004 and 2005, which experienced or will experience the immediate impact of the exercise of recapture rights by financial guaranty reinsurance customers. The Company does not expect net income to greatly exceed cash flows in periods that are not impacted by the exercise of such recapture rights.
On February 15, 2005, the Company announced that its Board of Directors had authorized the repurchase of up to 5.0 million shares of its common stock on the open market under a new repurchase plan. This plan has similar characteristics to the previous plans. Repurchases under this plan commenced upon approval in February of 2005. The Company may also begin purchasing shares on the open market to meet option exercise obligations, to fund 401(k) matches and purchases under the Company’s Employee Stock Purchase Plan, and the Company may consider future stock repurchase programs.
At December 31, 2004, 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 $20 million to $30 million. The Company moved its Data Center to Dayton, Ohio during the second quarter of 2003, which is now in full service. In addition, in 2004 the Company made significant investments in upgrading its business continuity plan. Cash flows from operations are being used to fund these expenditures, which are intended to benefit all of the Company’s business segments.
The Company owns a 46% interest in C-BASS. The Company has not made any capital contributions to C-BASS since the Company acquired its interest in C-BASS in connection with the acquisition of EFSG in February 2001. C-BASS paid $32.5 million and $15.0 million of dividends to an insurance subsidiary of the Company during 2004 and 2003, respectively. The distribution of these amounts to the Company by its insurance subsidiary is subject to regulatory limitations. In January of 2005, an additional dividend of $2.8 million was received from C-BASS.
The dividends from C-BASS and Sherman were used in part to fund the Company’s stock repurchase program and to bolster the Company’s investment portfolio.
The Company replaced its $250 million revolving credit facility that expired December 2004 with a $400 million unsecured facility comprised of a $100 million 364-day facility that expires on December 15, 2005, and a $300 million five-year facility that expires on December 16, 2009. The facility bears interest on any amounts drawn at a rate dependent on the Company’s credit rating at the time of such borrowing and will be calculated according to, at the Company’s option, a base rate or a Eurocurrency rate, plus an applicable margin and utilization fee. The facility will be used for working capital and general corporate purposes. There have been no drawdowns on this facility.
In March 2002, the Company made a $20 million investment in Primus. In 2004, the Company exercised warrants for an additional $5.5 million investment in Primus. In September 2004, Primus sold shares of its common stock in an initial public offering. The Company sold 177,556 shares of its Primus common stock in this offering and received approximately $2.2 million. The Company recorded a pre-tax gain of $1.0 million on this sale. The Company now owns 4,744,506 shares or approximately 11% of Primus, but these shares are subject to significant limitations on their sale.
In February 2003, the Company issued $250 million of unsecured senior notes. These notes bear interest at the rate of 5.625% per annum, payable semi-annually on February 15 and August 15, beginning August 15, 2003. These notes mature in February 2013. The Company has the option to redeem some or all of the notes at any time with not less than 30 days’ notice. The Company used a portion of the proceeds from the offering to repay the $75.0 million in principal outstanding on the 6.75% debentures due March 1, 2003 that EFSG had issued. The remainder was used for general corporate purposes. In April 2004, the Company entered into an interest-rate swap contract that effectively converted the interest rate on this fixed-rate debt to a variable rate based on a spread over the six-month LIBOR for the remaining term of the debt.
In September 2003, Radian Asset Assurance completed a transaction for $150 million of money market committed preferred custodial trust securities, pursuant to which it entered into a series of three perpetual put options on its own preferred stock to Radian Asset Securities Inc. (“Radian Asset Securities”), a 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 counterparties to the Radian Asset Securities put options are three trusts established by two major investment banks. The trusts were created as a vehicle for providing capital support to Radian Asset Assurance by allowing Radian Asset Assurance to obtain immediate access to additional capital at its sole discretion at any time through the exercise of one or more of the put options and the corresponding exercise of one or more corresponding Radian Asset Securities put options. If the Radian Asset Assurance put options were exercised, Radian Asset Securities, through the Radian Asset Assurance preferred stock thereby acquired, and investors, through their equity investment in the Radian Asset Securities preferred stock, would have rights to the assets of Radian Asset Assurance of an equity investor in Radian Asset Assurance. Such rights would be subordinate to policyholders’
claims, as well as to claims of general unsecured creditors of Radian Asset Assurance, but ahead of 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 would be usable for any purpose, including the payment of claims. Dividend payments on the preferred stock will be cumulative only if Radian Asset Assurance pays dividends on its common stock. 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 currently rated “A” by each of S&P and Fitch.
As described in Notes 2 and 6 to Consolidated Financial Statements, the Company establishes reserves to provide for losses and the estimated costs of settling claims in both the mortgage insurance and financial guaranty businesses. Setting loss reserves in both businesses involves significant use of estimates with regard to the likelihood, magnitude and timing of a loss.
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. 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. If a default cures, the reserve for that loan is removed from the reserve for losses and LAE. This curing process causes an appearance of a reduction in reserves from prior years if the reduction in reserves from cures is greater than the additional reserves for those loans that are nearing foreclosure or have become claims. The Company also reserves for defaults that the Company believes to have occurred but that have not been reported, using historical information on defaults not reported on a timely basis by lending institutions. All estimates are continually reviewed and adjustments are made as they become necessary. The Company does not establish reserves for mortgages that are in default if the Company believes it will not be liable for the payment of a claim with respect to that default. Consistent with GAAP and industry accounting practices, the Company does not establish loss reserves for expected future claims on insured mortgages that are not in default or believed to be in default.
- At December 31, 2004, the Company had case reserves of $98.4 million. Of this amount, $80.3 million was attributable to a single manufactured housing transaction originated and serviced by Conseco Finance Corp. The Company has a high degree of certainty that it will suffer losses with respect to this insured obligation equal to the amount reserved, which equals the total amount of the remaining insured obligation. The case reserves also include $10.0 million attributable to 29 reinsured obligations on which the Company’s total par outstanding is $39.3 million. These reserves are established based on amounts conveyed to the Company by the ceding companies and confirmed by the Company and the Company does not have any reasonable expectation that the ultimate losses will deviate materially from the amount reserved. The remaining $8.1 million of case reserves is attributable to two insured obligations with a total par outstanding of $17.6 million, and the Company does not have any reasonable expectation that the ultimate losses will deviate materially from the amount reserved.
At each balance sheet date, the Company also evaluates both the model-generated default factors and its unallocated non-specific reserves against management’s subjective view of qualitative factors to ensure that the default factors and the unallocated non-specific reserves represent management’s best estimate of the expected losses on the Company’s portfolio of credits for which it has not established a case reserve or an allocated non-specific reserve. These qualitative factors include existing economic and business conditions, overall credit quality trends resulting from industry, geographic, economic and political conditions, recent loss experience in particular segments of the portfolio, changes in underwriting policies and procedures and seasoning of the book of business. The macroeconomic factors that the Company evaluates are outside of the Company’s control and are subject to considerable variability. The Company-specific factors that the Company evaluates also require the Company to make subjective judgments. In addition, a significant change in the size of the Company’s portfolio underlying the unallocated non-specific reserves, such as through the expiration of policies or the refunding or recapture of insured exposures, could require an adjustment to the default factors or the Company’s level of unallocated non-specific reserves. To date, the Company’s evaluation of these qualitative factors has not led the Company to adjust the default factors or its level of unallocated non-specific reserves.
A summary of the Company’s derivative information as of and for the periods indicated is as follows:
The following table presents information at December 31, 2004 and 2003 related to net unrealized gains (losses) on derivative financial guaranty contracts (included in accounts payable and accrued expenses on the Consolidated Balance Sheets).
The application of SFAS No. 133, as amended, could result in volatility from period to period in gains and losses as reported on the Company’s Consolidated Statements of Income. These gains and losses result primarily from changes in corporate credit spreads, changes in the creditworthiness of underlying corporate entities, and the equity performance of the entities underlying the convertible investments. The Company is unable to predict the effect this volatility may have on its financial position or results of operations.
Deferred policy acquisition costs in the financial guaranty business are comprised of those expenses that vary with, and are primarily related to, the production of insurance premiums, including: commissions paid on reinsurance assumed, salaries and related costs of underwriting and marketing personnel, rating agency fees, premium taxes and certain other underwriting expenses, offset by commission income on premiums ceded to reinsurers. Acquisition costs are deferred and amortized over the period in which the related premiums are earned for each underwriting year. The amortization of deferred policy acquisition costs is adjusted regularly based on the expected timing of both upfront and installment-based premiums. The estimation of installment-based premiums requires considerable judgment and different assumptions could produce different results.
In December 2004, the FASB issued Statement 123 (revised 2004) (“SFAS No. 123R”) that will require compensation costs related to share-based payment transactions to be recognized in the financial statements. The compensation costs, with limited exceptions, will be measured based on the grant-date fair value of the equity or liability instrument issued. Liability awards will be required to be re-measured each reporting period. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. SFAS No. 123R replaces SFAS No. 123 and supersedes APB 25. This statement is effective for interim periods beginning after June 15, 2005 and applies to all awards granted after the effective date and requires the reporting of the cumulative effective of applying this statement as of this date. Management is in the process of reviewing this Statement and assessing the impact it will have on the Company’s financial statements.
The board of directors exercises its responsibility for the financial statements through its Audit and Risk Management Committee, which consists entirely of independent non-management board members. The Audit and Risk Management Committee meets periodically with management and with the independent auditors, both privately and with management present, to review accounting, auditing, internal control and financial reporting matters.
Although Radian’s internal control over financial reporting is effective in providing reasonable assurance regarding the matters described above, neither Radian’s nor any other system of internal control over financial reporting can provide absolute assurance regarding those matters. Inherent limitations in any set of internal controls, such as human failures, present a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting.
Deloitte & Touche LLP, independent registered public accounting firm that audited the financial statements included in this Annual Report on Form 10-K for the year ended December 31, 2004, has issued an attestation report on management’s assessment of Radian’s internal control over financial reporting. This report appears on page 102.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
We have audited the accompanying consolidated balance sheets of Radian Group Inc. and subsidiaries (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in common stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Radian Group Inc. and subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 7, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Radian Group Inc. (the “Company”) provides, through its subsidiaries and affiliates, credit 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 insurance and financial services.
Private mortgage insurance and risk management services are provided to mortgage lending institutions located throughout the United States through the Company’s principal mortgage guaranty subsidiaries, Radian Guaranty Inc. (“Radian Guaranty”), Amerin Guaranty Corporation (“Amerin Guaranty”) and Radian Insurance Inc. (“Radian Insurance”) (collectively referred to as “Mortgage Insurance”). Private mortgage insurance generally protects lenders from all or a portion of default-related losses on residential first- mortgage loans made to homebuyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgages in the secondary market. Radian Guaranty currently offers two principal types of private mortgage insurance coverage, primary and pool. At December 31, 2004, primary insurance comprised 88.3% of Mortgage Insurance’s risk in force and pool insurance comprised 7.8% of Mortgage Insurance’s risk in force. Amerin Guaranty writes mortgage insurance on second-lien mortgages and Radian Insurance writes credit insurance on non-traditional mortgage-related assets such as second mortgages, net interest margin securities (“NIMs”), and provides credit enhancement to mortgage-related capital market transactions. Other risk in force, primarily in Radian Insurance, was $1.2 billion at December 31, 2004, which represented 3.9% of the mortgage insurance risk in force.
Effective June 1, 2004, Financial Guaranty’s two main operating subsidiaries, Radian Asset Assurance Inc. (“Radian Asset Assurance”) and Radian Reinsurance Inc. (“Radian Reinsurance”), were merged, with Radian Asset Assurance as the surviving company. Through this merger, the financial guaranty reinsurance business formerly conducted by Radian Reinsurance was combined with the direct financial guaranty business conducted by Radian Asset Assurance. The merger combined the assets, liabilities and shareholder’s equity of the two companies.
Financial Guaranty also includes Radian Asset Assurance Limited (“RAAL”), a subsidiary of Radian Asset Assurance that is authorized to conduct an insurance business in the United Kingdom. In July 2004, RAAL received initial ratings of “AA” (negative outlook) from Standard and Poor’s Insurance Rating Service (“S&P”)
and “AA” from Fitch Ratings (“Fitch”). In September 2004, the Financial Services Authority granted a license to Radian Financial Products Limited, another subsidiary of Radian Asset Assurance, to trade as a Category A Securities and Futures Firm, allowing the Company to develop a range of derivatives-based solutions for clients in the United Kingdom and throughout the European Union.
The mortgage insurance reserve for losses and LAE consists of estimated losses from claims and the estimated cost of settling claims on defaults (or delinquencies) reported and defaults that have occurred but have not been reported. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the reserve for losses. Consistent with GAAP and industry accounting practices, the Company does not establish loss reserves for future claims on insured loans that are not currently in default or believed to be in default. In determining the liability for unpaid losses related to reported outstanding defaults, the Company establishes loss reserves on a case-by-case basis. The amount reserved for any particular loan is dependent upon the characteristics of the loan, the status of the loan as reported by its servicer and macroeconomic factors such as
regional economic conditions that involve significant variability over time, as well as more static factors such as the estimated foreclosure period in the area in which the default exists. With respect to known defaults, the Company does not establish reserves for losses until it is notified that a borrower has missed two payments. As the default progresses closer to foreclosure, the amount of loss reserve for that particular loan is increased, in stages, to approximately 100% of the Company’s exposure and that adjustment is included in current operations. With respect to delinquent loans that are in the 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 judgmental in nature than for loans that are in the later stage of delinquency. If the default cures, the reserve for that loan is removed from the reserve for losses and LAE. This curing process causes an appearance of a reduction in reserves from prior years if the reduction in reserves from cures is greater than the additional reserves for those loans that are nearing foreclosure or that have become claims. 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 Company does not establish reserves for mortgages that are in default if the Company believes it will not be liable for the payment of a claim with respect to that default. The estimates are continually reviewed and adjustments are made as they become necessary.
The Company establishes loss reserves on its financial guaranty contracts based on the estimated cost of settling claims and associated loss adjustment expenses (“LAE”), adjusted for estimated recoveries under salvage or subrogation rights. LAE consists of the estimated cost of the claims administration process, including legal fees and other associated fees and expenses. The Company’s financial guaranty loss reserves are comprised of specific reserves (which the Company refers to as “case reserves”) and non-specific reserves. As discussed below, the reserving policies used by the financial guaranty industry are continuing to evolve and are subject to change.
The Company records case reserves for losses and related LAE when a guaranteed obligation defaults in payment, which may be different from the way other financial guarantors establish case reserves. In the case of direct financial guaranty contracts, the Company determines the existence of payment default and records case reserves when the Company determines that a default has occurred, based on a report from the insured party or based on the Company’s surveillance efforts. In the case of financial guaranty reinsurance, the Company relies primarily on information provided by the primary insurer as confirmed by the Company, as well as on specific knowledge of the claim, in recording related case reserves. At December 31, 2004, the Company had case reserves of $98.4 million. Of this amount, $80.3 million was attributable to a single manufactured housing transaction originated and serviced by Conseco Finance Corp. The Company has a high degree of certainty that it will suffer losses with respect to this insured obligation equal to the amount reserved, which equals the total amount of the remaining insured obligation. The case reserves also include $10.0 million attributable to 29 reinsured obligations on which the Company’s total par outstanding is $39.3 million. These reserves are established based on amounts conveyed to the Company by the ceding companies and confirmed by the Company and the Company does not have any reasonable expectation that the ultimate losses will deviate materially from the amount reserved. The remaining $8.1 million of case reserves is attributable to two insured obligations with a total par outstanding of $17.6 million, and the Company does not have any reasonable expectation that the ultimate losses will deviate materially from the amount reserved.
The Company records non-specific reserves to reflect the deterioration of insured credits that have not yet defaulted. The Company determines this deterioration in two separate ways. First, the Company records non-
specific reserves for losses when it identifies through its surveillance procedures or, in the case of reinsurance, after the Company confirms information provided by the primary insurer regarding specific significant deterioration events that have occurred with respect to specific insured credits that have not yet defaulted. The Company refers to this category of its non-specific reserves as “allocated non-specific reserves.” At December 31, 2004, one credit was included in the Company’s allocated non-specific reserves. The Company has a high degree of certainty that it will suffer losses with respect to this insured obligation equal to the amount reserved, which is the total $9.8 million par amount of the insured obligation.
Second, because the Company believes that inherent deterioration begins immediately and continues over time on its remaining portfolio, the Company also records non-specific reserves for losses, on a portfolio basis, on the credits in its portfolio for which the Company does not have a case reserve or an allocated non-specific reserve. The Company refers to this category of non-specific reserves as “unallocated non-specific reserves.”
The Company’s unallocated non-specific reserves are established over time by applying expected default factors to the premiums earned during each reporting period on each credit for which the Company has not established a case reserve or an allocated non-specific reserve. The expected default factor for each credit is derived by dividing the expected losses on that credit over its life by the premiums expected to be earned on that credit over its life. The expected life-time losses for each credit are determined by multiplying the expected frequency of losses on that credit by the expected severity of losses on that credit and multiplying this number, the loss factor, by that credit’s outstanding par amount. The expected frequency and severity of losses for each credit are generated from three sources - two that are published by major rating agencies and one that is generated by a proprietary internal model - based on the product class, published rating and term to maturity for each credit. The Company sets the expected life-time losses for each credit at the approximate mid-point of the range between the highest and lowest expected life-time loss factors generated by the rating agency and internally generated models. The default factors for the years ended December 31, 2004, 2003 and 2002 approximated 10% of earned premiums on public finance credits and 20% of earned premiums on structured finance credits.
The Company’s unallocated non-specific loss reserve at December 31, 2004 was $56.7 million. The range between the unallocated non-specific reserves that would have resulted from applying the highest and lowest default factors generated by any of the three models was approximately $30 million to $80 million, which the Company believes provides a reasonably likely range of expected losses. None of the product types insured by the Company accounted for a materially disproportionate share of the variability within that range.
Once a case reserve is established with respect to an insured credit, an offsetting adjustment typically is made to the non-specific reserve. This offsetting adjustment may or may not be on a dollar-for-dollar basis, depending on the size of the necessary case reserve and the sufficiency of the non-specific reserve with respect to the other credits in the Company’s portfolio. In addition, the establishment of case reserves may require a provision beyond what is included in non-specific reserves. The establishment of reserves can reduce the Company’s net income when unallocated non-specific reserves are increased, when allocated non-specific reserves are established in an amount that exceeds unallocated non-specific reserves, or when case reserves are
established in an amount that exceeds non-specific reserves. Conversely, a reduction of reserves, due to improved economic conditions or a cure of a default with respect to a specific credit for which a case reserve has been established, or otherwise, can lead to an increase in the Company’s net income.
Reserves for losses and LAE for Financial Guaranty’s other lines of business, primarily trade credit reinsurance, are established solely under SFAS No. 60 because the Company believes that the nature of the trade credit business fits within the short-duration contract framework of SFAS No. 60. These reserves are based on reports and individual loss estimates received from ceding companies, net of anticipated estimated recoveries under salvage and subrogation rights. The time lag in receiving reports on individual loss estimates in trade credit reinsurance is generally three to six months. The Company uses historical loss information and makes inquiries to the cedants of known events as a means of validating its loss assumptions while awaiting more formal updated reports. Any differences in viewpoints are resolved expeditiously and have historically not resulted in material adjustments. In addition, a reserve is included for losses and LAE incurred but not reported (“IBNR”), on trade credit insurance. With respect to receiving reports on individual loss estimates in the other lines of reinsurance business, the Company has historically experienced prompt reporting and consistent results in determining reserves. In addition, the frequency of loss in the other lines of reinsurance business is low.
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 instruments on the Consolidated Statements of Income.
Real estate is acquired in the mortgage insurance business segment to mitigate losses. The real estate acquired is 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 real estate acquired are recorded as a decrease or increase to the provision for losses. At December 31, 2004 and 2003, the Company held $9.9 million and $8.0 million, respectively, of real estate acquired to mitigate losses.
Costs associated with the acquisition of mortgage insurance business, consisting of compensation and other policy issuance and underwriting expenses, are initially deferred and reported as deferred policy acquisition costs. Because SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the amortization of deferred policy acquisition costs, amortization of these costs for each underwriting year book of business is charged against revenue in proportion to estimated gross profits over the estimated life of the policies using the guidance provided by SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” This includes accruing interest on the unamortized balance of deferred policy acquisition costs. Estimates of expected gross profit including persistency and loss development assumptions for each underwriting year used as a basis for amortization are evaluated regularly, and the total amortization recorded to date is adjusted by a charge or credit to the statement of earnings if actual experience or other evidence suggests that earlier estimates should be
The Company provides for income taxes in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). As required under SFAS No. 109, the Company’s deferred tax assets and liabilities are recognized under the liability method which recognizes the future tax effect of temporary differences between the amounts recorded in the Consolidated Financial Statements and the tax bases of these amounts. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be realized or settled.
However, the guidance contained in paragraphs 10-20 of this Issue has been delayed by FASB Staff Position (“FSP”) EITF Issue 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” posted September 30, 2004. The delay of the effective date for paragraphs 10-20 will be superseded concurrent with the final issuance of proposed FSP EITF Issue 03-1-a, “Implication Guidance For the Application of Paragraph 16 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The proposed FSP would provide implementation guidance with respect to debt securities that are impaired solely due to interest rates and/or sector spreads and analyzed for other-than-temporary impairment. The disclosures continue to be effective for the Company’s consolidated financial statements for fiscal years ending after December 15, 2003, for investments accounted for under SFAS No. 115 and No. 124. For all other investments within the scope of this Issue, the disclosures continue to be effective for fiscal years ending after June 15, 2004. The additional disclosures for cost method investments continue to be effective for fiscal years ending after June 15, 2004.
The Company accounts for derivatives under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted (“SFAS No. 133”). In general, SFAS No. 133 requires that all derivative instruments be recorded on the balance sheet at their respective fair values. All derivative instruments are recognized in the Consolidated Balance Sheets as either assets or liabilities, depending on the rights or obligations under the contracts. Transactions that the Company has entered into that are accounted for under SFAS No. 133 include investments in convertible debt securities, interest rate swaps, selling credit protection in the form of credit default swaps and certain financial guaranty contracts that are considered credit default swaps. Credit default swaps and certain financial guaranty contracts that are accounted for under SFAS No. 133 are part of the Company’s overall business strategy of offering financial guaranty protection to its customers. The interest rate swaps qualify as hedges and are accounted for as fair value hedges. The embedded equity derivatives contained within the investment in convertible debt securities and the sale of credit protection in the form of credit default swaps do not qualify as hedges under SFAS No. 133, so changes in their fair value are included in the periods presented in current earnings in the Consolidated Statements of Income. Net unrealized gains and losses on credit default swaps and certain other financial guaranty contracts are included in accounts payable and accrued expenses on the Consolidated Balance Sheets. There is no reserve for losses recognized on derivative contracts. Any equivalent reserve would be embedded in the unrealized gains and losses. Settlements under derivative financial guaranty contracts are charged to accounts payable and accrued expenses. On a limited basis, the Company engages in derivative settlements to mitigate counterparty exposure and to provide additional capacity to its customers. During 2004, the Company received $2.9 million as settlement proceeds on derivative financial guaranty contracts and paid $14.6 million as settlement on derivative financial guaranty contracts. The Company received $11.5 million as settlement proceeds on derivative financial guaranty contracts in 2003 and paid $14.0 million as settlements on derivative financial guaranty contracts during 2003.
The following table presents information related to net unrealized gains or losses on derivative financial guaranty contracts (included in accounts payable and accrued expenses on the Consolidated Balance Sheets).
The application of SFAS No. 133 could result in volatility from period to period in gains and losses as reported on the Company’s Consolidated Statements of Income. These gains and losses result primarily from changes in corporate credit spreads, changes in the creditworthiness of underlying corporate entities, and the equity performance of the entities underlying the convertible investments. Any loss payments on such contracts would run through the change in fair value of derivatives. The Company is unable to predict the effect this volatility may have on its financial position or results of operations.
The Company has entered into derivatives to hedge the interest rate risk related to the issuance of certain long-term debt in accordance with the Company’s risk management policies. At December 31, 2004, there were two interest rate swaps. Interest rate swaps have been designed as fair value hedges and hedge the change in fair value of the debt arising from interest rate movements. During 2004, the fair value hedges were 100% effective. Therefore, the changes in the derivative instruments in the Consolidated Statements of Income were offset by the change in the fair value of the hedged debt.
(a) The December 31, 2004 six-month LIBOR forward rate at the next swap payment date plus 87.4 basis points.
In April 2003, the FASB issued SFAS No. 149, “Amendment of FASB Statement No. 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, except for the provisions of SFAS No. 149 that relate to SFAS No. 133 Implementation Issues that have been effective for fiscal quarters that began before June 15, 2003 and for hedging relationships designated after June 30, 2003. The Company has applied all of the provisions of SFAS No. 149 prospectively except for the provisions of SFAS No. 149 that relate to SFAS No. 133 Implementation Issues that have been effective for fiscal quarters that began before June 15, 2003, which are applied in accordance with their respective effective dates. The implementation of SFAS No. 149 did not have a material impact on the Company’s financial statements.
The Company accounts for stock-based compensation in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123 requires expanded disclosures of stock-based compensation arrangements with employees and encourages, but does not require, the recognition of compensation expense for the fair value of stock options and other equity instruments granted as compensation to employees and directors. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”
(“APB 25”) and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company’s stock at the date of the grant over the amount an employee must pay to acquire the stock. To date, there have been no options issued at a price that was less than the market price at the date of issuance.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123.” SFAS No. 148 amended SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation. In addition, this Statement amended the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement was effective for financial statements for fiscal years ending after December 15, 2002.
In accordance with the adoption of SFAS No. 123, the pro forma effect on net income for 2004, 2003 and 2002 is not representative of the pro forma effect on net income in future years because it does not take into consideration pro forma compensation expense related to grants made prior to 1995.
At December 31, 2004, 2003 and 2002, there were 274,810 options, 297,600 options and 770,000 options, respectively, excluded from the net income per share calculation because the options were anti-dilutive.
In the mortgage insurance segment, the highest state concentration of risk in force at December 31, 2004 was California at 13.0%. At December 31, 2004, California also accounted for 12.4% of Mortgage Insurance’s total direct primary insurance in force and 14.7% of Mortgage Insurance’s total direct pool risk in force. California accounted for 13.8% of Mortgage Insurance’s direct primary new insurance written in 2004. The largest single customer of Mortgage Insurance (including branches and affiliates of such customer), measured by new insurance written, accounted for 9.6% of new insurance written in 2004 compared to 10.4% in 2003 and 8.1% in 2002. The amount originated in 2003 for the largest single customer included a large structured transaction composed of prime mortgage loans originated throughout the United States.
The financial guaranty segment derives a substantial portion of its premiums written from a small number of direct primary insurers. Two primary insurers were responsible for 37.2% of the financial guaranty segment’s gross written premiums (including the impact of the recapture of business previously ceded to the Company by one of the primary insurer customers in the first quarter of 2004) and 25.9% of the financial guaranty segment’s gross written premiums (excluding this impact) for 2004, compared to 30.9% for 2003. Five trade credit insurers were responsible for 25.1% of the financial guaranty segment’s gross premiums written (including the impact of the recapture of business previously ceded to the Company by one of the primary insurer customers) and 17.5% (excluding this impact) for 2004 compared to 13.7% for 2003.
The Company evaluates operating segment performance based primarily on net income. Summarized financial information concerning the Company’s operating segments, as of and for the year-to-date periods indicated is as follows:
The results for Financial Guaranty for the year ended December 31, 2004 include the impact of the recapture of business previously ceded to the Company by one of the primary insurer customers that occurred in the first quarter of 2004. In October 2002, S&P downgraded the Insurer Financial Strength rating of Radian Reinsurance, before its merger with and into Radian Asset Assurance, from “AAA” to “AA.” As a result of this downgrade, effective January 31, 2004, one of Financial Guaranty’s primary insurer customers exercised its right to recapture approximately $16.4 billion of par in force reinsurance ceded to Financial Guaranty, including $96.4 million of written premiums with a GAAP carrying value of approximately $71.5 million. The entire impact of this recapture of written premiums was reflected as a reduction of written premiums in the first quarter of 2004. Because the Company, in accordance with GAAP, already had reflected $24.9 million of these recaptured written premiums as having been earned, the Company was required to record the entire $24.9 million reduction in earned premiums in the first quarter of 2004. The Company estimates that the recapture of reinsurance business reduced 2004 pre-tax income by approximately $37.8 million or approximately $0.26 per share after tax, $0.11 per share of which was the immediate impact and the balance was a result of recaptured written premiums that would have been earned over time, and losses that were expected on the recaptured business.
Singer had been engaged in the purchase, servicing and securitization of assets including state lottery awards and structured settlement payments. 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, 2004, the Company had approximately $413 million and $392 million of non-consolidated assets and liabilities, respectively, associated with Singer special-purpose vehicles. The Company’s investment in these special-purpose vehicles was $20.8 million at December 31, 2004. 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 was $18.0 million at December 31, 2003. 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
The Company accounts for guarantees 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 had guaranteed the performance of an affiliate under a $25 million revolving credit facility that expired in December 2004 and was renewed until December 31, 2005. There have been no drawdowns on this facility.
In May 2003, the FASB issued SFAS No. 150, “Accounting For Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 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. SFAS No. 150 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). SFAS No. 150 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 mandatory redeemable financial instruments representing non-controlling 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.
The current period presentation includes changes from prior period presentations that are consistent with the Securities and Exchange Commission’s interpretation of its rules regarding presentation. In particular, gains and losses on sales of investments and change in fair value of derivative instruments have been reclassified to revenues, and equity in net income of affiliates has been reclassified from revenues to a separate item following total expenses. These changes affect the presentation of the Consolidated Statements of Income, but do not alter total net income. Certain prior period balances have been reclassified to conform to the current period presentation.
For the years ended December 31, 2004, 2003 and 2002, the Company did not sell any fixed-maturity investments held to maturity.
(1) Includes mark-to-market adjustments for derivatives of affiliates not included in the Company’s Consolidated Balance Sheets.
At December 31, 2004, fixed-maturity investments available for sale had gross unrealized losses of $9.8 million. At December 31, 2004, there were no gross unrealized losses on equity securities available for sale. For these securities in an unrealized loss position at December 31, 2004, the length of time such securities had been in an unrealized loss position, as measured by their month-end fair values was as follows:
Of the 70 securities that had been in an unrealized loss position for more than 12 months, none had an unrealized loss of more than 20% of that security’s amortized cost and none qualified as other-than-temporary in the Company’s judgment.
The Company owns a 46.0% interest in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”) and a 41.5% interest in Sherman Financial Services Group LLC (“Sherman”). Effective January 1, 2003, Sherman’s management exercised its right to acquire additional ownership of Sherman, reducing the Company’s ownership interest from 45.5% to 41.5%. The Company recorded a $1.3 million loss on the transaction in 2003. C-BASS is engaged in the purchasing, servicing and/or securitization of special assets, including sub-performing/non-performing and seller-financed residential mortgages, real estate and subordinated residential mortgage-based securities. Sherman conducts a business that focuses on purchasing and servicing delinquent, primarily unsecured consumer assets. At December 31, 2004 and 2003, C-BASS had total assets of $4.0 billion and $3.2 billion, respectively, and total liabilities of $3.4 billion and $2.7 billion, respectively. C-BASS had net income for 2004, 2003 and 2002 of $208.1 million, $143.9 million and $138.3 million, respectively. At December 31, 2004 and 2003, Sherman had total assets of $484.2 million and $500.0 million, respectively, and total liabilities of $243.4 million and $340.9 million, respectively. Sherman had net income for 2004, 2003 and 2002 of $200.6 million, $70.9 million and $40.3 million, respectively. In January of 2005, an additional dividend of $2.8 million was received from C-BASS and an additional $51.9 million dividend was received from Sherman.
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 and “AAA” by S&P that provides credit risk protection to derivatives dealers and credit portfolio managers on investment-grade entities. In 2004, the Company exercised warrants for an additional $5.5 million investment in Primus. In September 2004, Primus issued common stock in an initial public offering of its common shares. The Company, which owned an approximate 15% interest in Primus prior to the offering, sold 177,556 shares of its Primus common stock in this offering, receiving approximately $2.2 million and recording a gain of $1.0 million. After this transaction, the Company owns 4,744,506 shares of Primus or approximately 11% of the common shares outstanding but these shares are subject to significant limitations on their sale. These shares had a market value of $64.1 million at September 30, 2004. The Company’s investment in Primus, which had previously been included in investment in affiliates on the Consolidated Balance Sheets, has now been reclassified to the equity securities available for sale category of investments. Beginning in the fourth quarter of 2004, the Company no longer reported earnings or loss from Primus as equity in earnings of affiliates. All changes in the fair value of the Primus stock after September 30, 2004 are recorded as accumulated other comprehensive income. The Company believes this treatment and presentation is appropriate because after the public offering the Company no longer has influence or control over Primus disproportionate to its percentage of equity ownership. At December 31, 2003, Primus had total assets of $318.2 million and total liabilities of $6.2 million. For the first nine months of 2004 and for the full year of 2003, Primus had net income of $million and $77.6 million, respectively. The results for Primus for 2002 were immaterial to the Company’s consolidated financial statements. Radian Reinsurance provided Primus with a financial guaranty insurance policy, which expired on March 30, 2003.
The following tables show selected financial information for C-BASS and Sherman and details of the Company’s investment in C-BASS and Sherman.
Effective December 31, 2004, Radian Guaranty canceled its excess of loss reinsurance program that was in a run-off period scheduled to expire in 2007. Under this program, the reinsurer was responsible for 100% of Radian Guaranty’s covered losses (subject to an annual and aggregate limit) in excess of an annual retention limit. Premiums were paid to the reinsurer on a quarterly basis, net of any losses due to Radian Guaranty. This treaty was 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, ($10.7) million, $5.6 million and $7.5 million were included in incurred losses during 2004, 2003 and 2002, respectively, relating to the excess of loss reinsurance program. In connection with the cancellation of the policy, $17.1 million of liabilities for withheld funds were released.
Holders of the Smart Home credit-linked notes bear the risk of loss from losses paid to the Company under the reinsurance agreement. Smart Home will invest the proceeds of the notes in high quality short-term investments approved by S&P and Moody’s. Income earned on those investments and a portion of the reinsurance premiums paid by the Company will be applied to pay interest on the notes as well as certain of Smart Home’s expenses. The liquidation proceeds from the investments will be used to pay reinsured loss amounts to the Company, and any remaining proceeds will be applied to pay principal on the notes.
In February 2005, the Company completed a second reinsurance arrangement under which it ceded a portion of the risk associated with a $1.68 billion portfolio of first-lien, non-prime residential mortgages insured by the Company.
The default and claim cycle on mortgage loans that the Company covers begins with the receipt from the lender of notification of a default on an insured loan. The master policy with each lender requires the lender to inform the Company of an uncured default on a mortgage loan within 75 days of the default. The incidence of default is influenced by a number of factors, including change in the borrower’s income, unemployment, divorce and illness, the level of interest rates, and general economic factors and borrower creditworthiness. Defaults that are not cured result in claims to the Company.
When a specific loan initially defaults, it is uncertain whether the default will result in a claim. Reserves are increased in stages, as the foreclosure progresses, to approximate the estimated total loss for each particular default. At the time of title transfer, the Company has approximately 100% of the estimated total loss reserved. At any time during the foreclosure process, until the lender takes title to the property, the borrower may cure the default, at which time the reserve for that loan is removed. This curing process causes an appearance of a reduction in reserves from prior years if the reduction in reserves from cures is greater than the additional reserves for those loans that are nearing foreclosure or that have become claims.
In 2003, the Company provided approximately $111.0 million of reserves on a manufactured housing transaction originated by Conseco Finance Corp. 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. The current reserve at December 31, 2004 of $80.3 million represents the total par exposure on this transaction less claims paid in 2004. Claims are expected to be paid out over the next several years.
The following tables present information relating to the liability for unpaid claims and related expenses (in thousands):
As a result of changes in estimates of insured events in prior years, the provision for losses and LAE in the mortgage insurance business increased by $14.0 million in 2004 primarily due to revised estimates of losses on the non-prime business. The provision for losses and LAE in the mortgage insurance business decreased by $19.7 million and $125.7 million in 2003 and 2002, respectively, due primarily to lower than anticipated aggregate claim payments compared to the amounts previously reserved, despite higher average claims paid per unit in those years that resulted from deeper coverage amounts and larger loan balances.
During 2004, the Company incurred losses and LAE in the financial guaranty insurance business of $5.2 million related to prior years due to changes in estimates in the surety business. The reduction in prior years’ reserves in 2003 was a result of favorable developments in the public finance reinsurance business. During 2002, the Company incurred losses and LAE of $3.9 million in the financial guaranty insurance business related to prior years. The amount in 2002 primarily related to trade credit business and was the result of obtaining additional information on the assumed reinsurance as well as changes in expected claims.
In February 2003, the Company issued $250 million of unsecured senior notes. These notes bear interest at the rate of 5.625% per annum, payable semi-annually on February 15 and August 15 beginning August 15, 2003. These notes mature in February 2013. The Company has the option to redeem some or all of the notes at any time with not less than 30 days’ notice. The Company used a portion of the proceeds from the offering to repay the $75.0 million in principal outstanding on the 6.75% debentures due March 1, 2003 issued by EFSG. The remainder was used for general corporate purposes. In April 2004, the Company entered into interest rate swap contracts that effectively converted the interest rate on this fixed-rate debt to a variable rate based on a spread over the six-month London Interbank Offered Rate (“LIBOR”) for the remaining term of the debt. See Note 2.
In September 2003, Radian Asset Assurance completed a transaction for $150 million of money market committed preferred custodial trust securities, pursuant to which it entered into a series of three perpetual put options on its own preferred stock to Radian Asset Securities Inc. (“Radian Asset Securities”), a 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
counterparties to the Radian Asset Securities put options are three trusts established by two major investment banks. The trusts were created as a vehicle for providing capital support to Radian Asset Assurance by allowing Radian Asset Assurance to obtain immediate access to additional capital at its sole discretion at any time through the exercise of one or more of the put options and the corresponding exercise of one or more corresponding Radian Asset Securities put options. If the Radian Asset Assurance put options were exercised, Radian Asset Securities, through the Radian Asset Assurance preferred stock thereby acquired, and investors, through their equity investment in the Radian Asset Securities preferred stock, would have rights to the assets of Radian Asset Assurance of an equity investor in Radian Asset Assurance. Such rights would be subordinate to policyholders’ claims, as well as to claims of general unsecured creditors of Radian Asset Assurance, but ahead of 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 would be usable for any purpose, including the payment of claims. Dividend payments on the preferred stock will be cumulative only if Radian Asset Assurance pays dividends on its common stock. 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 currently rated “A” by each of S&P and Fitch. The initial costs to issue this facility were recorded as a reduction to additional paid-in capital. Ongoing costs of the put premium are charged to other operating expenses. Ongoing costs in 2004 and 2003 were $1.7 million and $0.2 million, respectively.
The reconciliation of taxes computed at the statutory tax rate of 35% for 2004, 2003 and 2002, to the provision for income taxes is as follows (in thousands):
The significant components of the Company’s net deferred tax assets and liabilities are summarized as follows (in thousands):
Cumulative T&L bonds purchased and subsequent redemptions are reflected in the balance of Prepaid Federal Income Taxes on the Consolidated Balance Sheet. During 2004, the Company purchased approximately $101.3 million of T&L bonds, net of redemptions of T&L bonds purchased in prior years. Prepaid federal income taxes include T&L bonds of $460.1 million and $358.8 million at December 31, 2004 and 2003, respectively.
The Company is a holding company whose principal source of income is dividends from its subsidiaries and reimbursement of costs allocated to the subsidiaries. Radian Guaranty’s ability to pay dividends to the Company 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 this 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 these restrictions, $329.8 million would be available for dividends in 2005. 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, 2004 of $191.8 million, which represents the dividend limitation. The Pennsylvania Insurance Commissioner has approved all distributions by Radian Guaranty since the passage of this amendment.
Radian Guaranty’s excess of loss reinsurance arrangement, which was canceled effective December 31, 2004, prohibited the payment of any dividend that would have the effect of reducing the total of its statutory policyholders’ surplus plus its contingency reserve below $85 million. As of December 31, 2004, Radian Guaranty had statutory policyholders’ surplus of $426.6 million and a contingency reserve of $2.2 billion, for a total of $2.6 billion. As of December 31, 2003, Radian Guaranty had statutory policyholders’ surplus of $215.1 million, and a contingency reserve of $1.9 billion, for a total of $2.1 billion. During 2001, Radian Guaranty and Amerin Guaranty entered into an assumption agreement whereby Radian Guaranty assumed 100% of the rights, duties and obligations related to first-lien mortgage guaranty insurance written by Amerin Guaranty. Amerin Guaranty’s contingency reserve of $310.9 million was transferred to Radian Guaranty in accordance with the terms of the assumption agreement.
The Company prepares its statutory financial statements in accordance with the accounting practices required or permitted by the insurance departments of the respective states of domicile of the Company’s insurance subsidiaries. Required statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”) as well as state laws, regulations and general administrative rules.
Radian Guaranty’s statutory policyholders’ surplus at December 31, 2004 and 2003 was $426.6 million and $215.1 million, respectively. Radian Guaranty’s statutory net income for 2004, 2003 and 2002 was $329.8 million, $261.2 million and $383.9 million, respectively.
Radian Insurance’s statutory policyholders’ surplus at December 31, 2004 and 2003 was $71.8 million and $47.3 million, respectively. Radian Insurance’s statutory net income for 2004, 2003 and 2002 was $66.2 million, $31.4 million and $14.1 million, respectively.
New York insurance law requires financial guaranty insurers to maintain minimum policyholders’ surplus of $65 million. When added to the minimum policyholders’ surplus of $3.4 million separately required for the other lines of insurance that it is licensed to write, each of the financial guaranty insurance subsidiaries is required to have an aggregate minimum policyholders’ surplus of $68.4 million. Radian Asset Assurance had statutory policyholders’ surplus of $1,003.7 million and $823.1 million at December 31, 2004 and 2003, respectively, a contingency reserve of $251.7 million and $321.3 million at December 31, 2004 and 2003, respectively, and statutory net income of $42.4 million for 2004, $139.4 million for 2003 and $104.8 million for 2002. Under Statutory Accounting (“STAT”), the $111.0 million provision for the manufactured housing transaction with Conseco Finance Corp. was recorded in 2004.
The differences between the statutory net income and surplus and the consolidated net income and equity presented on a GAAP basis represent differences between GAAP and STAT for the following reasons:
(b) In accordance with New York insurance law, financial guaranty insurance companies are required to establish a contingency reserve in the amount prescribed by legislation. Such legislation requires that, for financial guaranty policies written after June 30, 1989, each primary insurer must establish a contingency reserve equal to the greater of 50% of premiums written or a stated percentage of the principal guaranteed, ratably over 15-20 years dependent upon the category of obligation insured. Reinsurers are required to establish a contingency reserve equal to their proportionate share of the reserve established by the primary insurer. Also under STAT, case reserves are required to be established in the year in which the default occurred. The Company establishes non-specific reserves under GAAP as described in Note 2.
(d) STAT financial statements only include a provision for current income taxes as a component of net income. Deferred taxes, subject to certain limitations set forth in SAP 10, are recorded in the STAT Balance Sheets with any changes thereto recognized via a change in statutory surplus. Purchases of tax and loss bonds are accounted for as investments under STAT. GAAP financial statements provide for current and deferred income taxes in the Consolidated Statements of Income, and purchases of tax and loss bonds are recorded as prepaid federal income taxes in the Consolidated Balance Sheets.
The Company currently 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.
On February 8, 2005, the Company’s board of directors approved the Radian Group Inc. Performance Share Plan. Key employees of the Company and its subsidiaries who, through their position or performance, can have a significant, positive impact on the Company’s financial results, are eligible to participate in the Performance Share Plan. The Compensation and Human Resources Committee may grant performance shares to eligible participants with respect to performance periods of varying and overlapping durations. At the beginning of each performance period, a target number of performance shares is established for each participant in the plan. The performance shares are denominated in shares of Company common stock and will be settled in shares, cash or a combination at the participant’s option, unless that participant has not yet reached the minimum stock ownership required of his or her position, in which case that participant’s performance shares will be settled in stock. Each performance share award becomes payable at a multiple of the target amount depending on a combination of the Company’s growth of earnings per share, growth of adjusted book value and return on equity over the performance period. For purposes of the deductibility requirements of Section 162(m) of the Internal Revenue Code, the maximum payout under any performance share award is 250,000 shares of Company common stock or its equivalent market value as of the payment date. A total of 30,900 target performance units were issued on February 8, 2005 with respect to the performance period that began January 1, 2005 and ends December 31, 2007. No other awards are outstanding under the Performance Share Plan.
The Company applies SFAS No. 123(R) in accounting for the performance shares granted under the Performance Share Plan. Compensation cost is accrued over the performance period based on the fair value of the number of awards that are expected to vest.
The Company currently maintains a noncontributory defined benefit pension plan (the “Pension Plan”) covering substantially all full-time employees of the Company, Radian Guaranty, RadianExpress, EFSG and its subsidiaries and, effective January 1, 2004, Singer. EFSG maintained a defined benefit pension plan, (the “EFSG Pension Plan”) for the benefit of all eligible employees until its termination on October 31, 2002. The Company recorded a gain of $3.0 million related to the termination of this plan in 2002. EFSG became a participating employer under the Pension Plan effective November 1, 2002. The Company granted past service credit for eligibility and vesting purposes under the Pension Plan for all such service credited under the EFSG Pension Plan on behalf of the eligible employees of EFSG who were active participants in the EFSG Pension Plan prior to its termination and who became participants in the Pension Plan effective November 1, 2002. Retirement benefits are a function of the years of service and the level of compensation. Assets of the plan are allocated in a balanced
fashion with approximately 40% in fixed-income securities and 60% in equity securities. As a result of the termination of the EFSG Pension Plan, those assets at December 31, 2003 were invested in short-term securities, awaiting distribution to plan participants.
The Company also provides a nonqualified executive retirement plan (the “SERP”) covering certain key executives designated by the Board of Directors. Under this plan, participants are eligible to receive benefits in addition to those paid under the Pension Plan if their base compensation is in excess of the current IRS compensation limitation for the Pension Plan. Retirement benefits under the SERP are a function of the years of service and the level of compensation and are reduced by any benefits paid under the Pension Plan. In December 2002, the Company agreed to fund the SERP through the purchase of variable life insurance policies pursuant to a split-dollar life insurance program called the Secured Benefit Plan. The Company purchases, on each participant (except as described below), a life insurance policy that is owned and paid for by the Company. The Company endorses to the participant a portion of the death benefit, for which the participant is imputed income each year. The Company owns the remainder of the death benefit and all of the cash values in the policy. At the participant’s retirement age, the policy’s cash value is projected to be sufficient for the Company to pay the promised SERP benefit to the participant. Non-executive officers who were participants in the Secured Benefit Plan prior to the issuance in October 2003 of regulations under the Internal Revenue Code regarding split dollar plans continue under the collateral assignment split dollar policies already in force. Under this arrangement, the participant owns the policy, and assigns a portion of the death benefits and cash values to the Company in amounts sufficient to reimburse the Company for all premium outlays by the Company. The eventual cash values above the aggregate premium amounts are designed, as in the endorsement method, to be sufficient to pay the promised SERP benefit to the participant. The participant has imputed income each year for the value of the death benefit provided to him or her, and also for any incidental benefits as provided under applicable tax law.
EFSG also maintained a non-qualified restoration plan (the “Restoration Plan”) for eligible employees, which was frozen effective October 31, 2002. The Company recorded a gain of $2.3 million in 2002 related to the curtailment of this plan. Participants in the Restoration Plan eligible for participation in the SERP began participating in the Company’s SERP effective November 1, 2002.
before January 1, 1990 under a postretirement welfare plan (the “Postretirement Welfare Plan”). Until its curtailment on August 31, 2002, EFSG had a plan that provided certain healthcare benefits for retired employees (the “Enhance Postretirement Medical Plan”). The plan was frozen effective August 31, 2002 so that only employees of EFSG and it subsidiaries hired before February 2, 1990 are eligible for the retirement benefits available under this plan, and the Company recorded a gain of approximately $0.7 million in 2002 from the curtailment of this plan. The expense for postretirement benefit costs for 2004 was $12.1 thousand as compared to a credit of $82 thousand for 2003, due to the curtailment of the Enhance Postretirement Medical Plan, and the expense for 2002 was $0.3 million. The Company accrues the estimated cost of retiree medical and life benefits over the period during which employees render the service that qualifies them for benefits. All of the Company’s plans together are referred to in the tables below as the “Radian Plans.”
The accumulated benefit obligation for the EFSG Pension Plan/Restoration Plan at December 31, 2004 and 2003 was $74 thousand and $7.3 million, respectively.
The selected long-term rate on assets (8.50%) was primarily based on the allocation of the Pension Plan’s assets (approximately 60% equities and 40% fixed-income investments) coupled with the actual expected returns provided by the Company’s investment advisor by asset type. This assumption is a long-term assumption that has been in place for more than seven years. The Company has periodically reviewed its assumptions against various capital market simulations to assure that its assumptions remain reasonable. The Company believes that an 8.5% long-term return assumption remains reasonable in calculating pension expense.
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 the Company. This facility expired December 31, 2004, but has been renewed until December 31, 2005. There have been no drawdowns under this facility.
The Company has provided to an affiliate of Sherman, in an arms-length transaction, a $150 million financial guaranty policy in connection with the structured financing of several pools of receivables previously acquired by Sherman.
Mortgage Insurance utilizes its underwriting skills to provide an outsourced underwriting service to its customers. Mortgage Insurance often gives recourse to its customers on loans it underwrites for compliance. If the loan does not meet agreed-upon guidelines and is not salable in the secondary market for that reason, Mortgage Insurance agrees to remedy the situation either by placing mortgage insurance coverage on the loan, by purchasing the loan, or by indemnifying the lender against future loss. During 2004, less than 1% of all loans were subject to these remedies and the costs associated with these remedies were immaterial. The Company had total losses from sales and remedies in 2004 of approximately $3.5 million. Providing these remedies means the Company assumes some credit risk and interest rate risk if an error is found during the limited remedy period in the agreements governing the Company’s provision of contract underwriting services. Rising mortgage interest rates or an economic downturn may expose the mortgage insurance business to higher losses. In 2003, the Company had provisions for contract underwriting remedies of $2.9 million. In 2004, the Company’s provisions were approximately $11.9 million and the Company’s reserve at December 31, 2004 was $7.3 million.
The Company has reinsurance agreements with its monoline financial guaranty primary insurance customers. These reinsurance agreements generally are subject to termination (i) upon written notice (ranging from 90 to 120 days) before the specified deadline for renewal, (ii) at the option of the ceding company if the Company fails to maintain certain financial, regulatory and rating agency criteria that 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 ceding company 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.
The commitment for non-cancelable operating leases in future years has not been reduced by future minimum sublease rental payments aggregating approximately $33,037,000. A portion of these payments relates to subleases to affiliates of the Company.
(1) Diluted net income per share and average shares outstanding per SFAS No. 128, “Earnings Per Share.” Amounts for the first three quarters of 2004 and all of 2003 have been revised to reflect the inclusion of shares underlying contingently convertible debt. See Note 1 and 2.
On February 15, 2005, the Company announced that its Board of Directors authorized the repurchase of up to 5.0 million shares of its common stock on the open market under a new repurchase plan. This plan has similar characteristics to the previous plans. Repurchases under this plan commenced upon approval in February of 2005. The Company may also begin purchasing shares on the open market to meet option exercise obligations, to fund 401(k) matches and purchases under the Company’s Employee Stock Purchase Plan and the Company and may consider future stock repurchase programs.
The Company may also begin purchasing shares on the open market to meet option exercise obligations, to fund 401(k) matches and purchases under the Company’s Employee Stock Purchase Plan, and the Company and may consider future stock repurchase programs.