Claim activity is not spread evenly throughout the coverage period of a book of business. Historically, relatively few claims on prime business are received during the first two years following issuance of a policy and on non-prime business during the first year. Claim activity on prime loans has historically reached its highest level in the third through fifth years after the year of policy origination, and on non-prime loans this level is expected to be reached in the second through fourth years. Based on these trends, approximately 50.6% of our primary risk in force and approximately 27.2% of our pool risk in force at December 31, 2009 had not yet reached its highest claim frequency years. At December 31, 2008, the comparable percentages were 62.5% and 18.6%, respectively. The insurance we wrote from 2005 through the first half of 2008 has experienced default and claim activity sooner than has been the case for our historical books of business. Because it is difficult to predict both the timing of originating new business and the cancellation rate of existing business, it is also difficult to predict, at any given time, the percentage of risk in force that will reach its highest claim frequency years on any future date.
(2) Represents ceded losses on captive reinsurance transactions and Smart Home.
Change in Fair Value of Derivative Instruments. Change in fair value of derivative instruments was a gain of $608.8 million for 2008, compared to a loss of $746.8 million for 2007. Although credit spreads on underlying collateral, both corporate credit spreads and asset-backed spreads, widened significantly in 2008, our non-performance risk adjustment more than offset these unrealized losses, resulting in a net unrealized gain due to the adoption of the accounting standard regarding fair value measurements on January 1, 2008.
Radian Guaranty and Amerin Guaranty are parties to a cross-guaranty agreement. This agreement provides that if either party fails to make a payment to a policyholder, then the other party will step in and make the payment. The obligations of both parties are unconditional and irrevocable; however, no payments may be made without prior approval by the insurance department of the payor’s state of domicile.
In addition to the foregoing, we use reinsurance from affiliated companies to allow Radian Guaranty to remain in compliance with insurance regulations that limit the amount of risk that a mortgage insurance company may retain on a single loan to 25% of the indebtedness of the insured. In February 2010, Radian Guaranty, in order to further support its capital position and risk-to-capital ratio, entered into an excess-of-loss reinsurance agreement with Radian Insurance. Under this agreement, Radian Guaranty transferred approximately $1 billion of risk in force to Radian Insurance, consisting of policies on loans that are relatively high credit quality. This pool of loans consists of a higher concentration of fixed-rate, prime, high FICO loans than our overall portfolio.
The principal short-term and long-term liquidity requirements of our financial guaranty business include the payments of operating expenses, including those allocated from Radian Group, claim and commutation payments, taxes and dividends to Radian Guaranty. In addition, we have potential liquidity risk with respect to certain of our CDSs covering senior tranches of TruPs CDOs (representing a total net par outstanding of $863.5 million as of December 31, 2009). For more information regarding this potential liquidity risk, see “Results of Operations-Financial Guaranty-Financial Guaranty Exposure Information” above.
Our projected default to claim rate was 38% at December 31, 2007, 46% at December 31, 2008 and 36% at December 31, 2009. The increase from 2007 to 2008 was primarily as a result of higher defaults and severity caused by declining home prices and distress in the residential real estate and credit markets, while the decrease from 2008 to 2009 was primarily as a result of our estimate of rescissions and denials which is based on actual recent experience. A key assumption affecting our methodology is that future ultimate default to claim rates and severities will be consistent with our recent experience. Based on the results of our recent claims investigations, we expect our rescission and denial rates to remain at increased levels as long as defaults related to the poor underwriting periods of 2005 through the first half of 2008 represent a significant percentage of our total default portfolio. Our recent increase in the rate of rescissions and denials may lead to an increased risk of litigation by the lenders and policyholders challenging our right to rescind coverage or deny claims. Such challenges may be made several years after we have rescinded a certificate of insurance or denied a claim. Although we believe that all rescissions and denials identified are valid under our policies, if we are not successful in defending the rescissions and denials in any potential legal actions, we may need to reassume the risk, and reestablish loss reserves for those loans.
The following table shows the mortgage insurance range of loss and LAE reserves, and recorded reserves for losses and LAE, as of December 31, 2009 and 2008:
RMBS-The fair value of RMBS is estimated based on prices of comparable securities and spreads, and observable prepayment speeds. These securities are generally categorized in Level II of the fair value hierarchy or in Level III when market-based transaction activity is unavailable.
fair premium amount for a typical market participant for this transaction is derived directly from the observed spreads of this index. For our second RMBS CDO transaction, the underlying referenced obligations in this transaction have experienced significant credit deterioration, and we expect this deterioration ultimately will result in claims. Fair value for this transaction is determined using a discounted cash flow analysis. We estimate projected claims based on our internal credit analysis which is based on the current performance of each underlying reference obligation, and our estimate of the claim rate associated with the current delinquent loans. The expected cash flows from the underlying reference obligations are then present valued using a discount rate derived from the BBB- ABX.HE index. The insured cash flows are present valued using a discount rate that is equal to our CDS rate plus a risk-free rate.
As of December 31, 2009, the counterparties to 133 of our financial guaranty transactions currently have the right to terminate these transactions. If all of these counterparties had terminated these transactions as of December 31, 2009, our net par outstanding would have been reduced by $37.7 billion, with a corresponding decrease in unearned premium reserves of $11.5 million and a decrease in the present value of expected future installment premiums of $152.1 million. Net unrealized losses on derivatives of $192.1 million would also have been reversed had these transactions been terminated. We have no transaction where our counterparty currently has the right to terminate the transaction with settlement on a mark-to-market basis.
(1) Moody’s outlook for all our insurance subsidiaries is currently Negative.
We are required to establish a valuation allowance against our deferred tax asset (“DTA”) when it is more likely than not that all or some portion of our DTA will not be realized. At each balance sheet date, we assess our need for a valuation allowance and this assessment is based on all available evidence, both positive and negative. Future realization of our DTA will ultimately depend on the existence of sufficient taxable income of the appropriate character (ordinary income versus capital gains) within the applicable carryforward period as provided under the tax law.
The largest single mortgage insurance customer (including branches and affiliates), measured by primary new insurance written, accounted for 16.1% of new insurance written during 2009, compared to 26.4% and 25.0% in 2008 and 2007, respectively. In 2009, we received premium revenue from two of our mortgage insurance customers, each of which exceeded 10% of our consolidated revenues.
(1) All NIMS trusts required consolidation at December 31, 2009, and are reported as derivative assets and VIE debt. The fair value of the NIMS VIE debt was $288.0 million and $160.0 million at December 31, 2009 and 2008, respectively.
When an SPE does not meet the QSPE criteria or the scope exceptions, a consolidation analysis is performed. In accordance with this standard, a VIE is defined as an entity that: (1) lacks enough equity investment at risk to permit the entity to finance its activities without additional subordinated financial support from other parties; (2) has equity owners that lack the right to make significant decisions affecting the entity’s operations; and/or (3) has equity owners that do not have an obligation to absorb the entity’s losses or the right to receive the entity’s returns. This standard requires a variable interest holder (i.e., a counterparty to a VIE) to consolidate the VIE if that party will absorb a majority of the expected losses of the VIE, receive the majority of the expected residual returns of the VIE, or both. This party is considered the primary beneficiary.
In addition to California and Florida, approximately 12.2% of our primary mortgage insurance risk in force at December 31, 2009 was concentrated in the Midwestern states of Michigan, Illinois and Ohio. This region has continued to experience higher default rates in 2009, which we believe are largely attributable to the difficult operating environment facing the domestic auto industry. We expect that this trend may continue. See Note 3 for further information.
Upon continued performance deterioration, we may conduct additional or more frequent review of a credit, downgrade the internal credit rating for a credit or if appropriate, move the credit to the financial guaranty Watch List. All amendments, consents and waivers related to a transaction are also reviewed and evaluated by the appropriate risk manager. In addition to individual credit analysis, the risk management department is responsible for following economic, environmental and regulatory trends and for determining their potential impact on our insured portfolio.
credit and insured portfolio basis. The risk analytics team has developed quantitative tools and models to measure these risks which incorporate the risk assessments and internal ratings assigned by each of the teams within risk management. We use an internal economic capital methodology to attribute economic capital to each individual credit exposure within our insured portfolio. This methodology relies heavily on our ability to quantify the individual risks of default and prepayment underlying each transaction in our insured portfolio. Economic capital is also the basis for calculating risk-adjusted returns on our capital (“RAROC”), which allows us to establish criteria for weighing the credit risk relative to the premium received.
Our risk management department reviews both performing and under-performing transactions. Performing credits generally have investment-grade internal ratings, denoting nominal to moderate credit risk. However, claim liabilities may be established for performing credits if the expected losses on the credit exceed the unearned premium revenues for the obligation based on the present value of the expected net cash outflows. If our risk management department concludes that a directly insured transaction is underperforming, it is placed in one of three designated categories for deteriorating credits: Special Mention, Intensified Surveillance or Case Reserve. Assumed exposures in our reinsurance portfolio are generally placed in one of these categories if the ceding company for such transaction downgrades it to an equivalent watch list classification. However, if our financial guaranty risk management group disagrees with the risk rating assigned by the ceding company, we may assign our own risk rating rather than using the risk rating assigned by the ceding company.
non-investment grade obligations with increasing credit risk, but with the possibility of recovering and returning to investment grade levels;
On June 7, 2005, we issued $250 million of unsecured senior notes. These notes bear interest at the rate of 5.375% per annum, payable semi-annually on June 15 and December 15. The notes mature on June 15, 2015. We have the option to redeem some or all of the notes at any time with not less than 30 days’ notice at a redemption
Cumulative T&L Bonds purchased and subsequent redemptions are reflected in the balance of prepaid federal income taxes on our consolidated balance sheets. During 2009, we redeemed our remaining outstanding balance of approximately $248.8 million of T&L Bonds. Prepaid federal income taxes included T&L Bonds of $248.8 million at December 31, 2008.
For the years ended December 31, 2009, 2008 and 2007, we recorded stock-based compensation expense related to stock options of $2.8 million, $8.7 million and $9.8 million, respectively, of which $0.3 million, $1.4 million, and $3.4 million, respectively, was deferred as policy acquisition costs. The stock-based compensation expense related to stock options for the year ended December 31, 2009 caused loss before income taxes and net loss to increase by $2.5 million and $1.7 million, respectively, and both basic and diluted earnings per share to increase by $0.02 per share. The stock-based compensation expense related to stock options for the year ended December 31, 2008 caused loss before income taxes and net loss to increase by $7.3 million and $4.8 million, respectively, and both basic and diluted earnings per share to decrease by $0.06 per share. Cash provided by operating activities decreased and cash provided by financing activities for the year ended December 31, 2007 increased by $5.5 million, related to excess tax benefits from stock-based payment arrangements. There were no excess tax benefits from stock-based payment arrangements for 2008 or 2009.
We granted 375,500 shares of restricted stock under the Equity Plans during 2009, 170,400 shares of restricted stock during 2008, and 615,970 shares of restricted stock during 2007, with each grant vesting over
The amount recorded as stock-based compensation expense related to restricted stock for the years ended December 31, 2009, 2008 and 2007 was $2.8 million, $6.3 million and $7.0 million, respectively. The amount deferred as policy acquisition costs in 2009, 2008 and 2007, was $0.4 million, $1.1 million and $3.6 million, respectively.
permit the board to make discretionary, pro rata (based on eligible pay) cash allocations to each eligible participant’s account, with vesting upon completion of three years of service with us; and
Any unfunded benefit obligation is included in accounts payable and accrued expenses.
In March 2009, FGIC, Ambac, and MBIA served us with demands to arbitrate certain issues relating to the same three pool policies that are the subject of our declaratory judgment complaint. In July 2009, the court declined to dismiss our declaratory judgment action, but stayed the action to permit the arbitrations to proceed first. In August 2009, we settled our dispute with Ambac and Deutsche Bank with respect to one of the disputed pool policies, which policy represents approximately $27 million of the approximately $77 million in total claim liability. In January 2010, we settled our dispute with MBIA and Deutsche Bank with respect to another of the disputed pool policies, which policy represents approximately $21 million of the approximately $77 million in total claim liability. These settlements resolved the declaratory judgment action as it pertains to Ambac and MBIA, and the arbitrations commenced by Ambac and MBIA were dismissed with prejudice. An arbitration hearing with FGIC is expected to be held in the second and third quarters of 2010.