The financial services segment includes the credit-based businesses conducted through our affiliates, Credit-Based Asset Servicing and Securitization (“C-BASS”) and Sherman Financial Services Group LLC (“Sherman”). We own a 46% interest in C-BASS and an interest in Sherman, consisting of 40.96% of the Class A Common Units of Sherman (Class A Common Units represent 94% of the total equity in Sherman) and 50% of the Preferred Units of Sherman. Our preferred equity interest in Sherman entitles us to (1) three percent of the first $200 million of Sherman’s annual earnings, which amount is allocated to the Preferred Units on a cumulative basis before any amounts are allocated to the Class B Common Units (owned entirely by entities controlled by Sherman’s management), and 1.5% of Sherman’s annual earnings above $200 million; and (2) a preference in the proceeds received upon a liquidation or sale of Sherman equal to the tax basis in the preferred equity.
strategy of aligning with companies that have significant investments in mortgage securities, where C-BASS’s wholly-owned subsidiary, Litton Loan Servicing, as servicer, can enhance the underlying value of these securities. In addition, if approved, the transaction will provide C-BASS with a platform for loan originations.
Policy Acquisition Costs. Policy acquisition costs were $65.0 million for 2006, compared to $62.9 million for 2005. The 2006 amount includes the amortization of commissions relating to international business. This increase was also the result of the acceleration of the amortization of policy acquisition costs of $4.7 million and $5.1 million in 2006 and 2005, respectively. The acceleration relates to prior years’ books of business that canceled more quickly than anticipated due to repayments and pay-offs of the underlying mortgages, thus resulting in a reduction in the base asset.
Net Gains on Securities. Net gains on securities in our mortgage insurance business were $27.6 million for 2005, compared to $44.4 million for 2004. This decrease was principally related to the unusually high net gains on securities recorded in 2004 as a result of changes in asset allocation and investment execution strategies.
Change in Fair Value of Derivative Instruments. The change in the fair value of derivatives was a gain of $4.1 million for 2005, compared to a gain of $11.9 million for 2004, mainly due to the sale of convertible securities with mark-to-market gains in 2005 and changes in the fair value of embedded options in convertible securities held in the investment portfolio.
Direct primary insurance in force was $113.9 billion at December 31, 2006, compared to $109.7 billion at December 31, 2005 and $115.3 billion at December 31, 2004. At December 31, 2006, non-prime insurance in force was $37.0 billion or 32.5% of total primary mortgage insurance in force, compared to $34.7 billion or 31.7% at December 31, 2005 and $35.7 billion or 31.0% at December 31, 2004. Of the $37.0 billion of non-prime insurance in force at December 31, 2006, $25.6 billion or 69.0% was Alt-A. We anticipate that the mix of non-prime mortgage insurance business and non-traditional insurance products could continue to fluctuate as a result of structural changes, competitive pricing differentials and competitive products in the mortgage lending and mortgage insurance business.
A higher incidence of claims in Georgia is directly related to what our risk management department believes to be questionable property values. Several years ago, our risk management department implemented several property valuation checks and balances to mitigate the risk of this issue recurring, and now applies these same techniques to all mortgage insurance transactions. We expect this higher incidence of claims in Georgia to continue until loans originated in Georgia before the implementation of these preventive measures become sufficiently seasoned.
Change in Fair Value of Derivative Instruments. Change in the fair value of derivative instruments was a gain of $12.4 million for 2006 compared to a gain of $5.2 million for 2005. In the fourth quarter of 2005, we refined our mark-to-market model for valuing corporate collateralized debt obligations, to reflect actual credit spreads by individual name, when available, as compared to our previous version of the model which used average spreads for similarly rated names. While application of the new model resulted in minimal changes for most of our derivative transactions, one high-yield synthetic obligation showed a large difference due to greater spread volatility in the high-yield corporate names included in this transaction. At December 31, 2005, our refined model indicated that we had incurred a $50.8 million loss on this transaction, resulting in a $40.1 million mark-to-market adjustment in 2005. On March 2, 2006, Radian Asset Assurance and its counterparty to this transaction agreed to terminate this transaction and to amend the one other derivative financial guaranty contract that we have insured with this same counterparty. As a result, included in the change in the fair value of derivative instruments for 2006, was a $17.2 million charge in connection with the termination of this derivative contract. On February 14, 2007, the counterparty also terminated the transaction amended in March 2006, at no cost to either party. As a result of this termination, we will have a $10.2 million gain in the fair value of derivative instruments for the first quarter of 2007. The remaining change in fair value of derivatives instruments for 2006 was mostly a result of the moderate tightening of spreads related to synthetic collateralized debt obligations in 2006, compared to severe tightening in 2005, and a decrease in the duration until maturity on remaining deals. During 2006, the financial guaranty segment received $4.6 million in recoveries of previous default payments on derivative financial guaranty contracts and paid $68.0 million for early termination payments and $0.1 million for default payments. During 2005, the financial guaranty segment received $7.6 million of recoveries of previous default payments on derivative financial guaranty contracts and paid $0.1 million for default payments.
Other Income. Other income was $0.7 million for 2006, compared to $0.9 million for 2005. This decrease was mostly due to lower advisory fee income during 2006.
Provision for Losses. The provision for losses was $20.7 million for 2006, compared to $31.5 million for 2005. The year over year decrease was largely the result of the continued run-off in our trade credit reinsurance line of business. The provision for losses in 2006 represented 10.1% of net premiums earned for 2006, compared to 14.9% for 2005 (14.6% excluding the 2005 recapture). Our financial guaranty business paid $15.8 million in insurance claims for 2006 and $29.6 million in claims for 2005 related to a single manufactured housing transaction with Conseco Finance Corp.
Net Income. Our financial guaranty segment’s net income for 2005 was $118.1 million, a $16.1 million or 12.0% decrease from $134.2 million for 2004. The decrease in net income for 2005 mainly reflects a reduction in change in fair value of derivative instruments and an increase in policy acquisition costs and other operating expenses of $19.3 million, partially offset by a reduction in the provision for losses of $24.4 million. Net income for 2005 includes a $4.1 million immediate after-tax reduction as a result of the 2005 recapture. Net income for 2004 reflects a $10.3 million immediate after-tax reduction as a result of the 2004 recapture.
(1) Our reserve for losses and loss adjustment expenses reflects the application of accounting policies described below in “Critical Accounting Policies-Reserve for Losses.” As of December 31, 2006, we have financial guaranty non-specific reserves of $86.6 million that are not included in the table. The payments due by period are management’s estimates and assume that all of the loss reserves included in the table will result in claim payments.
potentially unsettled adjustment. We currently anticipate that funding the payment on account could occur during the fourth quarter of 2007 or the first quarter of 2008, and we estimate the capital requirement for such payment to be approximately $84.2 million. Any ultimate overpayment associated with the payment on account would be recovered through a formal claim for refund process.
Our liquidity needs over the next 12 months include funds for the payment of dividends on our common stock, debt service payments on our outstanding long-term debt, claim payments on our insured obligations, operating expenses and potentially, to fund a payment on account related to the IRS investigation described above. We expect to fund these requirements with amounts received under our expense-sharing arrangements or as dividends from our insurance operating subsidiaries, subject to regulatory requirements, which may include dividends to these subsidiaries from our affiliates (C-BASS and Sherman), and from working capital, all of which we expect to be sufficient to make such payments for at least the next 12 months.
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
In September 2006, the FASB issued SFAS No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS No. 158”). SFAS No. 158 requires us to recognize the funded status of a benefit plan-measured as the difference between plan assets at fair value (with limited exceptions) and the benefit obligation-in our consolidated balance sheets. For a pension plan, the benefit obligation is the projected benefit obligation; for any other postretirement benefit plan, such as a retiree health care plan, the benefit obligation is the accumulated postretirement benefit obligation. SFAS No. 158 also requires us to recognize as a component of accumulated other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost. Amounts recognized in accumulated other comprehensive income, including the gains or losses, prior service costs or credits, and the transition asset or obligation remaining, are adjusted as they are subsequently recognized as components of net periodic benefit cost pursuant to the recognition and amortization provisions of those statements. In addition, SFAS No. 158 requires us to measure defined benefit plan assets and obligations as of the date of our fiscal year-end statement of financial position (with limited exceptions), and to disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. Employers with publicly traded equity securities are required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. We adopted this statement effective December 31, 2006. The implementation of SFAS No. 158 had an immaterial affect on our Consolidated Financial Statements. See Note 11 of Notes to Consolidated Financial Statements.
We record case reserves for losses and related LAE when a guaranteed obligation defaults in payment. In the case of direct financial guaranty contracts, we determine the existence of payment default and record case reserves when we determine that a default has occurred, based on a report from the insured party or based on our surveillance efforts. In the case of financial guaranty reinsurance, we rely mostly on information provided by the primary insurer as confirmed by us, as well as specific knowledge of the claim, in recording related case reserves.
Deferred policy acquisition costs in the financial guaranty business are comprised of those expenses that vary with, and are principally 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 accordance with Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use”, we capitalize costs associated with internally generated software intended to be used for some functions related to our mortgage insurance data warehousing and, for the most part, mortgage insurance contract underwriting. In the fourth quarter of 2006, in conjunction with an evaluation of costs necessary to maintain some of the software, we determined that the replacement costs for this software would be significantly lower than the carrying value of the asset. In accordance with FASB Statement No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“FASB No. 144”), we analyze long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. In order to determine the best estimate of fair value, we obtained vendor quotes for the replacement cost of the software. As a result, we wrote down the capitalized costs of the software by $6.0 million, which is included in other operating expenses on our consolidated statements of net income.
Provisional losses recoverable under these quota share treaties were $12.5 million for 2006 and $25.4 million for 2005. The 2006 provisional losses recoverable represent amounts due to us under the variable quota-share treaty entered into in 1997. The 2005 provisional losses recoverable represent amounts due to us under the variable quota-share treaties entered into in 1997 and 1996. These recoverable amounts cover the books of business originated by Radian Guaranty in those years. The term of each treaty was 10 years and was non-cancelable by either party except under certain conditions. Under the terms of the treaties, Radian Guaranty ceded premiums to the reinsurer based on 15% of the premium received on the covered business. Radian Guaranty was entitled to receive a commission ranging from 30% to 32% of the premium paid under the treaty provided that certain loss rates were not exceeded. In return for the payment of the ceded premium, Radian Guaranty received variable quota-share loss relief at levels ranging from 7.5% to 15.0% based upon the loss ratio on the covered business. The treaties also included underwriting-year excess coverage that entitled Radian Guaranty to received 8% of the premium written on the covered business under each treaty at the end of the fourth, seventh and tenth years to the extent that this amount was greater than the total amount previously received under the variable quota-share coverage provision of the treaty. Premiums were payable to the reinsurer on a quarterly basis net of commissions due and any losses calculated under the variable quota-share coverage.
The composition of long-term debt at December 31, 2006 and 2005 was as follows:
The following table shows the affect of SFAS No. 158 on accumulated other comprehensive income as of the periods specified (in thousands):