Our pricing is risk-based and is intended to align with the capital requirements under the PMIERs, while considering pricing trends within the private mortgage insurance industry. As a result, our pricing is expected to generate relatively consistent returns across the credit spectrum and to provide relatively stable expected loss ratios regardless of further credit expansion. We monitor competitive and economic factors while seeking to balance both profitability and market share considerations in developing our strategies. We continued to generate strong NIW in 2017, and believe we remain well positioned to compete for the high-quality business being originated today, while at the same time maintaining projected returns on NIW within our targeted ranges.
Losses. Incurred losses represent the estimated future claim payments on newly defaulted insured loans as well as any change in our claim estimates for existing defaults, including changes in the estimates we use to determine our expected losses, and estimates with respect to the frequency, magnitude and timing of anticipated losses on defaulted loans. Other factors influencing incurred losses include:
Services Revenue. The sales volume in our Services segment is influenced by the demand for our services, which generally varies based on the overall activity in the mortgage, real estate and mortgage finance markets as well as the health of related industries. Sales volume is also affected by the number of competing companies and alternative products offered in the market. We believe the diversity of services we offer has the potential to produce fee income from the Services segment throughout various mortgage finance environments, although market conditions can significantly impact the amount of fee income we generate in any particular period.
Loss on induced conversion and debt extinguishment. During 2017, pursuant to cash tender offers, we purchased aggregate principal amounts of $141.4 million, $115.9 million and $152.3 million of our Senior Notes due 2019, 2020 and 2021, respectively, resulting in a loss on induced conversion and debt extinguishment of $45.8 million. During 2017, we also purchased an aggregate principal amount of $21.6 million of our outstanding Convertible Senior Notes due 2017 and settled our obligations on the remaining Convertible Senior Notes due 2019, resulting in losses on debt extinguishment of $1.2 million and $4.5 million, respectively.
Total adjusted pretax operating income consists of adjusted pretax operating income (loss) for each segment as follows:
A key component of our current business strategy is to grow our mortgage insurance business by writing insurance on high credit quality mortgages in the U.S. Consistent with this objective, we wrote $53.9 billion of primary new mortgage insurance in 2017, compared to $50.5 billion of NIW in 2016. The NIW written on a Flow Basis in 2017 was Radian’s highest volume in its history. The combination of our NIW and a higher Persistency Rate resulted in an increase in IIF, from $183.5 billion at December 31, 2016 to $200.7 billion at December 31, 2017, as shown in the chart below. Policy years represent the original policy years, and have not been adjusted to reflect subsequent HARP refinancing activity.
We believe total mortgage origination volume was lower for 2017, as compared to 2016, primarily due to a decrease in refinance mortgage originations resulting from the slightly higher interest rate environment, partially offset by an increase in home purchase mortgage volume due to favorable economic conditions. Because the penetration rate for mortgage insurance is generally three to five times higher on purchase originations than on refinancing transactions, the mortgage insurance market was slightly larger for 2017, compared to 2016, despite the decline in total mortgage origination volume.
In 2016 and 2017, represents the percentage of direct Single Premium Policies written, after consideration of the Single Premium NIW ceded under the 2016 Single Premium QSR Transaction prior to its amendment, effective December 31, 2017, which increased the amount of ceded risk on performing loans for 2015 through 2017 vintages under the agreement from 35% to 65%. After consideration of this increase in the cession percentage, net Single Premium Policies represented 8% of NIW during 2017. See Note 8 of Notes to Consolidated Financial Statements for additional information.
Our mortgage insurance provision for losses for 2016 increased by $5.8 million as compared to 2015. Reserves established for new default notices were the primary driver of our total incurred losses for 2016 and 2015. Current year primary new defaults decreased by 4.9% for 2016, compared to 2015. In addition, our gross Default to Claim Rate assumption for new primary defaults was 12% as of December 31, 2016, compared to 13% as of December 31, 2015. This reduction in estimated Default to Claim Rates, which was based on observed claim development trends, contributed to the reduction in the portion of our provision for losses related to new defaults in 2016, as compared to 2015.
Notwithstanding historical trends, our portfolio originated before 2009 experienced default and claim activity sooner and to a significantly greater extent than had been the case historically for our books of business prior to the financial crisis. For the periods indicated, the following tables show: (i) cumulative direct claims paid by us on our primary insured book of business at the end of each successive year after origination, expressed as a percentage of the cumulative premiums written by us in each year of origination and (ii) direct claims paid by policy origination year. Direct claims paid represent first-lien claims paid prior to reinsurance recoveries and captive termination payments, and exclude LAE expenses.
Other Operating Expenses. Other operating expenses for 2017, as compared to 2016, reflect an increase primarily due to: (i) increases in technology expenses associated with a significant investment in upgrading our systems; (ii) higher allocated corporate operating expenses, primarily due to expenses associated with the retirement and consulting agreements entered into with our former Chief Executive Officer; (iii) expenses accrued to defend and resolve certain outstanding legal matters; and (iv) a decrease in ceding commissions. These increases were partially offset by lower compensation expense in 2017, including variable incentive-based compensation.
Gross Profit on Services. For both the years ended December 31, 2017 and 2016 our gross profit on services represented 35% of total Services revenue. Gross profit in 2017 was primarily impacted by the shift in mix of services, including a decline in revenue related to REO asset management and a decline in servicer and loan surveillance revenue, partially offset by: (i) an increase in title and settlement services; (ii) an increase in valuation services; and (iii) a reduction in cost of services related to the restructuring actions taken during 2017. Gross profit on services decreased from 40% in 2015 to 35% in 2016 primarily due to a shift in the mix of services and a decrease in higher margin services revenue volumes.
Other Operating Expenses. Other operating expenses primarily consist of compensation costs not classified as cost of services because they are related to employees, such as sales and corporate employees, who are not directly involved in providing client services. Compensation-related costs for 2017 represented 50% of the segment’s other operating expenses, compared to 55% and 57% for 2016 and 2015, respectively. Compensation-related costs for 2017 compared to 2016 and 2015 decreased as a percentage of other operating expenses, primarily because of a reduction in force in 2016, combined with the restructuring actions taken in 2017.
Includes $158.6 million and $234.1 million of Senior Notes due 2019 and 2020 that may be redeemed, in whole or in part at any time prior to maturity.
We establish reserves to provide for losses and LAE, which include the estimated costs of settling claims in our Mortgage Insurance segment, in accordance with the accounting standard regarding accounting and reporting by insurance enterprises. Although this standard specifically excludes mortgage insurance from its guidance relating to the reserve for losses, because there is no specific guidance for mortgage insurance, we establish reserves for mortgage insurance as described below, using the guidance contained in this standard supplemented with other accounting guidance.
With respect to loans that are in default, considerable judgment is exercised as to the adequacy of reserve levels. For purposes of reserve modeling, loans are aggregated into groups using a variety of factors. The attributes currently used to define the groups for purposes of developing various assumptions include, but are not limited to, the Stage of Default, the Time in Default and type of insurance (i.e., primary or pool). We use an actuarial projection methodology referred to as a “roll rate” analysis that uses historical claim frequency information to determine the projected ultimate Default to Claim Rates based on the Stage of Default and Time in Default as well as the date that a loan goes into default. With respect to new defaults in FEMA Designated Areas associated with Hurricanes Harvey and Irma received subsequent to those two disasters, we assume a lower gross Default to Claim Rate than for new defaults with similar characteristics from other areas, due to our expectations based on past experience with other natural disasters, that a significant portion of these defaults will not result in claims. The Default to Claim Rate also includes our estimates with respect to expected Rescissions and Claim Denials, which have the effect of reducing our Default to Claim Rates. We forecast the impact of our Loss Mitigation Activity in protecting us against fraud, underwriting negligence, breach of representation and warranties, inadequate documentation of submitted claims and other items that may give rise to Rescissions or cancellations and Claim Denials, to help determine the Default to Claim Rate. Our Loss Mitigation Activities have resulted in challenges from certain lender and servicer customers, which have resulted in some reversals of our decisions regarding Rescissions, Claim Denials and Claim Curtailments in the ordinary course. Although we believe that our Loss Mitigation Activities are justified under our policies, certain challenges have resulted in disputes and litigation, which if resolved unfavorably to us, could require us to reassume the risk on, and increase loss reserves for, those policies or pay additional claims. See Note 7 for additional information. Our Master Policies specify the time period during which a suit or action arising from any right of the insured under the policy must be commenced. The assumptions embedded in our estimated Default to Claim Rate on our in-force default inventory include an adjustment to our estimated Rescissions and Claim Denials to account for the fact that we expect a certain number of policies to be reinstated and ultimately to be paid, as a result of valid challenges by such policy holders.
We group assets in our investment portfolio into one of three main categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which we have the positive intent and ability to hold to maturity, if any, are classified as held to maturity and are reported at amortized cost. Trading securities are securities that are purchased and held primarily for the purpose of selling them in the near term, and are reported at fair value, with unrealized gains and losses reported as a separate component of income. Investments in securities not classified as held to maturity or trading securities are classified as available for sale and are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as accumulated other comprehensive income (loss). Short-term investments consist of money market instruments, certificates of deposit and highly liquid, interest-bearing instruments with an original maturity of three months or less at the time of purchase. Amortization of premium and accretion of discount are calculated principally using the interest method over the term of the investment. Realized gains and losses on investments are recognized using the specific identification method. See Notes 5 and 6 for further discussion on the fair value of investments.
Securities lending agreements, in which we loan certain securities in our investment portfolio to third parties for short periods of time in exchange for collateral consisting of cash and other securities, are treated as collateralized financing arrangements on our consolidated balance sheets. In all of our securities lending agreements, the securities that we transfer to Borrowers (loaned securities) may be transferred or loaned by the Borrowers; however, we maintain effective control over all loaned securities, including: (i) retaining ownership of the securities; (ii) receiving the related investment or other income; and (iii) having the right to request the return of the loaned securities at any time. We report such securities within other assets in our consolidated balance sheets. We receive cash or other securities as collateral for such loaned securities. Any cash collateral may be invested in liquid assets. Cash collateral, which is reinvested for our benefit by the intermediary in accordance with the investment guidelines contained in the securities lending and collateral agreements, is reflected in short-term investments, with an offsetting liability recognized in other liabilities for the obligation to return the cash collateral to the Borrower. Securities collateral we receive from Borrowers is held on deposit for the Borrower’s benefit and we may not transfer or loan such securities collateral unless the Borrower is in default. Therefore, such securities collateral is not reflected in our consolidated financial statements given that the risks and rewards of ownership are not transferred to us from the Borrowers. See Note 6 for additional information.
Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding, while diluted net income per share is computed by dividing net income attributable to common stockholders by the sum of the weighted-average number of common shares outstanding and the weighted-average number of dilutive potential common shares. Dilutive potential common shares relate to our share-based compensation arrangements and our outstanding convertible senior notes. For all calculations, the determination of whether potential common shares are dilutive or anti-dilutive is based on net income from continuing operations.
The following number of shares of our common stock equivalents issued under our share-based compensation arrangements and convertible debt, if any, were not included in the calculation of diluted net income per share because they were anti-dilutive:
We have two strategic business units that we manage separately-Mortgage Insurance and Services. Adjusted pretax operating income (loss) for each segment represents segment results on a standalone basis; therefore, inter-segment eliminations and reclassifications required for consolidated GAAP presentation have not been reflected. See Note 18 for information related to discontinued operations.
Amortization or impairment of goodwill and other intangible assets. Amortization of intangible assets represents the periodic expense required to amortize the cost of intangible assets over their estimated useful lives. Intangible assets with an indefinite useful life are also periodically reviewed for potential impairment, and impairment adjustments are made whenever appropriate. These charges are not viewed as part of the operating performance of our primary activities and therefore are excluded from our calculation of adjusted pretax operating income (loss).
At December 31, 2017, there were no Level III assets measured at fair value, and no Level III liabilities. There were no investment transfers between Level I, Level II or Level III for the year ended December 31, 2017.
Long-Term Debt. At December 31, 2016, the carrying amount of long-term debt is net of the equity component of our convertible notes, which is accounted for under the accounting standard for convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement). At December 31, 2017, none of our convertible notes remained outstanding. The fair value is estimated based on the quoted market prices for the same or similar instruments. See Note 12 for further information.
In the first quarter of 2016, in order to proactively manage the risk and return profile of Radian Guaranty’s insured portfolio and continue managing its position under the PMIERs financial requirements in a cost-effective manner, Radian Guaranty entered into the 2016 Single Premium QSR Transaction with a panel of third-party reinsurers. Under the 2016 Single Premium QSR Transaction, effective January 1, 2016, Radian Guaranty began ceding the following Single Premium IIF and NIW, subject to certain conditions:
Interest expense (benefit) represents expense incurred, net of adjustments to accruals previously recorded.
On May 10, 2017, our stockholders approved the Amended and Restated Equity Compensation Plan, which amended and restated the 2014 Equity Plan by increasing the number of shares that may be issued under the plan and making certain other changes. In addition to the Amended and Restated Equity Compensation Plan, we also have awards outstanding under our 2008 Equity Plan and 1995 Equity Plan. The last awards granted pursuant to the 2008 and 1995 Equity Plans were granted in 2014 and 2008, respectively. All awards granted under the Equity Plans have been performance-based or time-vested awards in the form of non-qualified stock options, restricted stock, RSUs, phantom stock, or SARs. The maximum contractual term for all awards under the Equity Plans is 10 years, although awards have been granted with shorter terms.
Also in 2017, 123,496 performance-based RSUs to be settled in common stock were granted to the Company’s former chief executive officer (“CEO”) pursuant to the terms of his retirement agreement. Vesting for these performance-based RSUs only occurs if a stock price hurdle is met during the performance period, which begins 10 days prior to the first anniversary of the grant date and ends on the fifth anniversary of the grant date, or upon the death of the grantee or a change in control of the Company. The stock price hurdle requires that the closing price of our common stock on the New York Stock Exchange equals or exceeds 120% of the grant date share price, or $22.46, for 10 consecutive trading days during the performance period.
Time-Vested RSUs- Information with regard to grants of time-vested RSUs to be settled in common stock is as follows for the periods indicated:
Included in net gains (losses) on investments and other financial instruments on our consolidated statements of operations.