Our financial guaranty segment has provided direct insurance and reinsurance on credit-based risks through Radian Asset Assurance Inc. ("Radian Asset Assurance"), a wholly-owned subsidiary of Radian Guaranty. Financial guaranty insurance typically provides an unconditional and irrevocable guaranty to the holder of a financial obligation of full and timely payment of principal and interest when due. Financial guaranty insurance may be issued at the inception of an insured obligation or may be issued for the benefit of a holder of an obligation in the secondary market.
The following table provides the expected impact on our consolidated financial statements in the first quarter of 2012 for the Assured Transaction. While we expect a statutory capital benefit as a result of this transaction as discussed above, under GAAP this transaction will result in a reduction in net income, and therefore, a reduction in retained earnings.
Statutory Capital. Under state insurance regulations, Radian Guaranty is required to maintain minimum surplus levels and, in certain states, a minimum amount of statutory capital relative to the level of risk in force, or "risk-to-capital." Sixteen states (the risk-based capital or "RBC States") currently have a statutory or regulatory risk-based capital requirement (a "Statutory RBC Requirement"), the most common of which (imposed by 11 of the RBC States) is a requirement that a mortgage insurer's risk-to-capital ratio may not exceed 25 to 1. As a result of ongoing incurred losses, Radian Guaranty's risk-to-capital ratio increased to 21.5 to 1 as of December 31, 2011 (after consideration of a recent $100 million contribution from Radian Group Inc. ("Radian Group")), compared to 16.8 to 1 at December 31, 2010 and 15.4 to 1 at December 31, 2009. Based on our current projections, which are derived from various assumptions that are subject to inherent uncertainty and require significant judgment by management, Radian Guaranty's risk-to-capital ratio is expected to continue to increase and, absent any further capital contributions from Radian Group, is expected to exceed 25 to 1 in 2012. We actively manage Radian Guaranty's risk-to-capital position in various ways, including: (1) through reinsurance arrangements; (2) by seeking opportunities to reduce our risk exposure through commutations or other negotiated transactions; (3) by contributing additional capital from Radian Group to our mortgage insurance subsidiaries; and (4) by monetizing gains in our investment portfolio through open market sales of securities. After the recent $100 million contribution to Radian Guaranty, Radian Group currently has unrestricted cash and liquid investments of $482.8 million (before giving consideration to Radian Group's Tender Offer commenced on February 23, 2012) that may be used to further support Radian Guaranty's risk-to-capital position. Depending on the extent of our future incurred losses, the amount of capital contributions required for Radian Guaranty to remain in compliance with the Statutory RBC Requirements could be substantial and could exceed amounts maintained at Radian Group. See "Risk Factors-Losses in our mortgage insurance and financial guaranty businesses have reduced Radian Guaranty's statutory surplus and increased Radian Guaranty's risk-to-capital ratio; additional losses in these businesses, without a corresponding increase in capital or capital relief would further negatively impact this ratio, which could limit Radian Guaranty's ability to write new insurance and increase restrictions and requirements placed on Radian Guaranty" and "Radian Group’s sources of liquidity may be insufficient to fund its obligations" in Part I, Item 1A of this Annual Report on Form 10-K.
As of December 31, 2011, we had an aggregate of $5.4 billion net par exposure to healthcare and long-term care credits. While these sectors were relatively stable in 2011, hospitals have begun to experience a decrease in patient revenues as a result of a significant decline in patient volumes, increased charity care and limited increases in commercial and government reimbursements. Many healthcare institutions are reporting that further expense reduction efforts are unrealistic and that operating losses are expected as healthcare inflation outpaces weak revenue growth. Further, long-term care facilities generally have been experiencing gradually declining occupancies, thinner debt service coverage margins and slowly eroding cash positions. If these trends continue, it could result in further credit deterioration and require increases in our loss reserves related to our healthcare and long-term care credits.
The results for 2011 and 2010 were mainly impacted by gains and losses on financial guaranty VIE debt. The widening of Radian Group's five-year CDS spread was the dominant driver of the gains in 2011, as discussed above. Radian's spread tightened during 2010, resulting in losses reported during that time period. Also impacting the results for 2011 were foreign currency translation gains resulting from the liquidation of a foreign subsidiary, which occurred during the second quarter of 2011. See “Results of Operations-Mortgage Insurance-Year Ended December 31, 2011 Compared to Year Ended December 31, 2010-Net Gains (Losses) on Other Financial Instruments” and “Results of Operations-Financial Guaranty-Year Ended December 31, 2011 Compared to Year Ended December 31, 2010-Net Gains (Losses) on Other Financial Instruments” below for further information.
Net (Losses) Gains on Other Financial Instruments. The results for 2010 were driven by losses on financial guaranty VIE debt. As a result of the adoption in 2010 of the accounting standard update regarding improvements to financial reporting by enterprises involved with VIEs, we identified and consolidated additional VIEs with the related fair value gains (losses) recorded in this line item. Also negatively impacting the results for 2010 were losses related to NIMS VIE debt, primarily caused by a tightening in Radian Group's CDS spread during the year, which had the effect of increasing the fair value liabilities of our VIEs. Our CDS spreads also tightened during 2009.
The following table illustrates the impact to our loss reserve estimates due to estimated insurance rescissions and claim denials as of the dates indicated:
Interest Expense. Interest expense includes an allocation to the mortgage insurance segment of interest on our long-term debt based on allocated capital. Our consolidated interest expense significantly increased during 2011 as a result of the issuance of $450 million of convertible notes at a large discount in November 2010. This increase more than offset the decrease in the allocation percentage to the mortgage insurance segment in 2011, which is based on relative equity for this segment calculated in accordance with accounting principles generally accepted in the United States of America ("GAAP").
Change in Reserve for Premium Deficiency. For 2010, the reserve for second-lien premium deficiency was impacted by the transfer of premium deficiency reserves to loss reserves and by updates to assumptions underlying our loss estimates. In 2009, we recorded a decrease in the reserve for second-lien premium deficiency due to the transfer of premium deficiency reserves to loss reserves and changes in estimates due to the settlement of certain second-lien transactions at less than our estimates of reserves.
If calculated before giving effect to deductibles and stop losses in pool transactions, the pool reserve per default at December 31, 2011, 2010 and 2009, would be $25,402, $28,265 and $17,007 respectively.
Includes $3.2 billion and $3.8 billion at December 31, 2011 and 2010, respectively, of international public finance insured obligations (which includes sovereign debt), of which $119.0 million and $118.0 million at December 31, 2011 and 2010, respectively, of such obligations were in the five Eurozone countries whose sovereign obligations have been under stress due to economic uncertainty, potential restructuring and ratings downgrades. We had no exposure to Ireland at either December 31, 2011 or 2010.
We have provided credit protection on the senior-most tranche of a CDO of ABS transaction (the "CDO of ABS") with $450.6 million net par outstanding at December 31, 2011. The underlying collateral consists predominantly of mezzanine tranches of mortgage-backed securities ("MBS”). As of December 31, 2011, $376.6 million (or 89.5%) of the underlying collateral was rated BIG by at least one rating agency, of which $263.5 million (or 62.6%) of the underlying collateral had defaulted. As of December 31, 2011, this transaction was rated D by Standard & Poor's Rating Service ("S&P") and Ca by Moody's Investor Service ("Moody's”). Our own internal rating for this transaction is D.
The Bankruptcy Court ruled that the system's net revenues are exempt from the automatic stay provisions of the U.S. Bankruptcy Code and may be paid to creditors, but may be paid only after the payment of operating expenses of the system. In addition, it has been reported that the relevant parties have agreed upon a monthly distribution amount of the net revenues to be paid to creditors, which reduces the risk of a deficiency in the payment of interest on the Obligations in the near future. The Bankruptcy Court did not rule on the issue of whether the County was eligible to file the Bankruptcy Petition, and the Bankruptcy Court's ruling on this issue is still pending.
Net Gains on Investments. The realized gains on investments in 2010 and 2009 reflected improved market conditions and activity related to the reallocation of our investment portfolio to investments with shorter duration.
The following table summarizes certain of our contractual obligations and commitments, including our expected claim payments on insurance policies, as of December 31, 2011, and the future periods in which such obligations are expected to be settled in cash. Additional details regarding these obligations are provided in the narrative following the table and in the Notes to Consolidated Financial Statements that are referenced in the table.
Each transaction began with the formation of an unaffiliated, offshore reinsurance company. We then entered into an agreement with the Smart Home reinsurer to cede to the reinsurer a portion of the risk (and premium) associated with a portfolio of loans. Each class of notes relates to the loss coverage levels on the reinsured portfolio and is assigned a rating by one or more of the three major rating agencies. We do not hold any of the credit-linked notes issued as part of this structure; therefore, we have no significant variable interests in the structures, and are not subject to consolidation under this standard.
As a provider of credit enhancement, we have entered into insurance contracts with VIEs and derivative contracts with counterparties in which we have provided credit protection directly on variable interests by VIEs or, in some cases, obtained the contractual rights of our counterparties with respect to the VIEs. See Note 6 of Notes to Consolidated Financial Statements for more information.
Moody's ratings for Radian Group and all our rated insurance subsidiaries are currently under review for possible downgrade.
Commutations, recaptures and other negotiated terminations of our insured risks in both our mortgage insurance and financial guaranty segments provide us with an opportunity to exit exposures to entire policies with insureds and reinsureds for an agreed upon payment, or payments, often at a discount to the previously estimated ultimate liability. As a result of exiting all exposures to such policies, all reserves for losses and LAE and other balances relating to the insured or reinsured policy are eliminated. Upon completion of a commutation, recapture or other negotiated termination, all such related balances, including deferred policy acquisition costs and unearned premiums, are reversed, with any remaining net gain or loss typically recorded through provision for losses. We take into consideration the specific contractual and economic terms for each individual agreement when accounting for our commutations, recaptures, or other negotiated terminations, which may result in differences in the accounting between transactions, or between our statutory financial statements and financial statements presented on a GAAP basis.
When evaluating whether we are the primary beneficiary of a VIE, we determine which activities most significantly impact the economic performance of the VIE. As part of our qualitative analysis, we consider whether we have any contractual rights that would allow us to direct those activities. As of December 31, 2011, we have determined that we are the primary beneficiary of our NIMS transactions, our CPS transactions and certain financial guaranty structured transactions, and we did not identify any new VIEs to be consolidated in 2011. Our control rights in these VIEs, which we obtained due to an event of default or breach of a performance trigger as defined in the transaction, generally provide us with either a right to replace the VIE servicer, or, in some cases, the right to direct the sale of the VIE assets. In those instances where we have determined that we are the primary beneficiary, we consolidate the assets and liabilities of the VIE. We have elected to carry the financial assets and financial liabilities of these VIEs at fair value.
In October 2010, the Financial Accounting Standards Board (“FASB”) issued an update to the accounting standard regarding accounting for costs associated with acquiring or renewing insurance contracts. This update is effective for fiscal years beginning after December 15, 2011, and redefines acquisition costs as costs that are related directly to the successful acquisition of new, or the renewal of existing, insurance contracts. Previously, acquisition costs were defined as costs that vary with and are primarily related to the acquisition of insurance contracts. The effect of this revised definition of acquisition costs will result in additional expenses being charged to earnings immediately, rather than being deferred. There is no change to amortization requirements due to this update. We have adopted this update on a prospective basis as of January 1, 2012. Since we have discontinued writing any new financial guaranty business, there will be no impact to our financial guaranty segment from this update. However, while we are currently still evaluating the impact this new guidance will have on our consolidated financial statements and disclosures, we expect that the implementation of this new guidance will materially reduce the amount of policy acquisition costs that we defer associated with acquiring new mortgage insurance contracts, which totaled $46.2 million and $42.2 million in initial deferred costs for the years ended December 31, 2011 and 2010, respectively, accelerating the recognition of certain expenses associated with these contracts. The lower amount of deferred acquisition costs will also result in decreased amortization expense, which should partially offset the effect to our net income. While the timing of when certain costs are reflected in our results of operations will change as a result of the adoption of this update, there will be no effect to the total acquisition costs to be recognized over time or to our cash flows.
We have engaged in a broad range of actions and transactions designed to increase our financial flexibility, conserve our holding company liquidity and preserve the risk-based capital position of Radian Guaranty, our primary mortgage insurance subsidiary.
The GSEs and state insurance regulators impose various capital requirements on our insurance subsidiaries. These include risk-to-capital ratios, risk-based capital measures and surplus requirements that potentially limit the amount of insurance that each of our insurance subsidiaries may write. The GSEs and our insurance regulators possess significant discretion with respect to our insurance subsidiaries.
Potential adverse effects on us if the capital and liquidity levels of Radian Group or our regulated subsidiaries' statutory capital levels are deemed inadequate to support current business operations and strategies.
The risk management function in our financial guaranty business is responsible for the identification, analysis, measurement and surveillance of credit, market, legal and operational risk associated with our financial guaranty insurance contracts. Risk management is also primarily responsible for claims prevention and loss mitigation strategies. This discipline is applied during the ongoing monitoring and surveillance of each exposure in the portfolio. See Note 12 for further information.
Represents the fair value of an interest rate swap included in the consolidation of one of our financial guaranty transactions. The notional amount of the interest rate swap does not represent additional par exposure, and therefore, is excluded from this table. See Note 5 for information on our maximum exposure to loss from our consolidated financial guaranty transactions.
The following table quantifies the impact of our non-performance risk on our derivative assets and liabilities (in aggregate by type, excluding assumed financial guaranty derivatives) and VIE liabilities presented in our consolidated balance sheets. Radian Group's five-year CDS spread is presented as an illustration of the market's view of our non-performance risk; the CDS spread actually used in the valuation of specific fair value liabilities is typically based on the remaining term of the instrument.
The following is a rollforward of our investment in Sherman prior to the sale and selected financial information for Sherman:
The reinsurance recoverable amounts on paid losses are considered to be financing receivables in accordance with the accounting standard regarding accounts receivable, which includes disclosure requirements regarding the credit quality of financing receivables and the allowance for credit losses. We do not record an allowance for credit losses on reinsurance recoverables, as the reinsurance recoverable amounts for both paid and unpaid losses are fully collateralized in the segregated trusts. Therefore, credit exposure is limited to the credit quality of investments held by the trust. Trust assets related to our captive and Smart Home arrangements are required to be invested in investment-grade securities. As of December 31, 2011, the trust assets for these trust accounts consist primarily of cash equivalents, money market investments and investment-grade securities.
The PDR in our mortgage insurance business at December 31, 2011 and 2010 relates to our second-lien business.
The following table shows the expected contractual premium revenue from our existing financial guaranty portfolio, assuming no prepayments or refundings of any financial guaranty obligations, as of December 31, 2011. See Note 21 for the financial impact of the Assured Transaction executed in January 2012.
The weighted-average risk-free rates used to discount the gross claim liability and gross potential recoveries were as follows, as of the dates indicated:
The premium paid for the capped call transactions is recorded in additional paid-in capital in accordance with the accounting standard for derivative financial instruments indexed to, and potentially settled in, an entity's own common stock, and the accounting standard for determining whether an instrument (or embedded feature) is indexed to an entity's own stock.
New York insurance law requires financial guaranty insurers to maintain minimum policyholders' surplus of $65 million. When added to the minimum policyholders' surplus of $1.4 million separately required for the other lines of insurance that it is licensed to write, our financial guaranty insurance subsidiary is required to have an aggregate minimum policyholders' surplus of $66.4 million. Radian Asset Assurance's statutory net income, statutory policyholders' surplus and contingency reserve as of and for the years ended December 31 were as follows:
(e) Under STAT, investment-grade fixed-maturity investments are valued at amortized cost, and below investment-grade securities are carried at the lower of amortized cost or market value. Under GAAP, those investments that the statutory insurance entities do not have the ability or intent to hold to maturity are considered to be either available for sale or trading securities, and are recorded at fair value, with the unrealized gain or loss recognized, net of tax, as an increase or decrease to stockholders' equity or current operations, as applicable.
Time-Vested RSUs-In 2011, the Compensation Committee granted a total of 323,866 shares of time-vested RSUs to be settled in common stock, including 77,027 shares awarded to employees and 246,839 shares awarded to non-employee directors. The grant date fair value of the time-vested RSUs was calculated based on the fair market value of our common stock on the NYSE on the date of grant and is recognized over the vesting period. The 2011 awards to employees vest at the end of four years, while the awards to non-employee directors vest at the end of three years.
We expect to contribute nominal amounts to Radian Group’s and EFSG’s other postretirement benefit plans in 2012. Due to the nature of the Postretirement Welfare Plan, no increase is assumed in our obligation due to any increases in the per-capita cost of covered healthcare benefits.