the implementation of the Single Premium QSR Transaction, which had the effect of increasing the amount by which Radian Guaranty’s Available Assets exceed its Minimum Required Assets under the PMIERs Financial Requirements; and
Approximately 60% of the loans in our total primary mortgage insurance portfolio at December 31, 2016 have Monthly Premium Policies that provide a level monthly premium for the first 10 years of the policy, followed by a reduced level monthly premium thereafter. If a loan is refinanced under HARP, the initial 10-year period is reset. Due to the borrower’s ability to cancel the policy generally when the LTV reaches 80% of the original unpaid principal balance, and the automatic cancellation of the policy when the LTV reaches 78% of the unpaid principal balance, the volume of loans that remain insured after 10 years and would be subject to the premium reset is generally not material in relation to the total loans originated. However, to the extent the volume of loans resetting from year to year varies significantly, the trend in earned premiums may also vary.
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 losses, and estimates with respect to the likelihood, magnitude and timing of anticipated losses on defaulted loans. Other factors influencing incurred losses include:
Services Revenue. Our Services revenue is primarily derived from: (i) loan review, underwriting and due diligence services; (ii) surveillance services, including RMBS surveillance, loan servicer oversight, loan-level servicing compliance reviews and operational reviews of mortgage servicers and originators; (iii) real estate valuation and component services, providing outsourcing and technology solutions for the SFR and real estate markets, as well as outsourced solutions for appraisal, title and closing services; and (iv) REO management services. See “Item 1. Business-Services-Services Business Overview-Services Revenue Drivers” for additional information regarding current and expected future revenue drivers.
Gross Profit on Services. In addition to the key factors affecting Services revenue and cost of services described above, our gross profit on services may fluctuate from period to period due to a shifting mix of services we provide due to changes in the relative demand for those services in the marketplace. Shifts in the business mix of our Services business can impact our gross profit because each product and service generally produces a different level of gross margin. These individual gross margins in turn can be impacted in any given period by factors such as the implementation of new regulatory requirements, our operating capacity, competition or other environmental factors.
The following table highlights selected information related to our consolidated results of operations for the years ended December 31, 2016, 2015 and 2014:
Net Income from Continuing Operations. As discussed in more detail below, our results for 2016 compared to 2015 reflect: (i) an increase in net investment income; (ii) a decrease in loss on induced conversion and debt extinguishment; (iii) a decrease in interest expense; and (iv) modestly higher net premiums earned-insurance. These items were partially offset by: (i) lower gross profit on Services; (ii) a decrease in net gains (losses) on investments and other financial instruments; and (iii) an increase in the provision for losses.
Total adjusted pretax operating income is not a measure of total profitability, and therefore should not be viewed as a substitute for GAAP pretax income. Our definition of adjusted pretax operating income may not be comparable to similarly-named measures reported by other companies.
Virtually all of our Post-legacy new mortgage insurance written has been prime business. These loans possess significantly improved credit characteristics compared to our Legacy Portfolio. FICO scores for the borrowers of these insured mortgages are higher, and there are fewer loans with LTVs greater than 95%, as compared to mortgages in our Legacy Portfolio.
Net Premiums Written and Earned. Despite the increase in NIW in 2016 compared to 2015, net premiums written decreased in 2016 compared to 2015, primarily due to $233.2 million of ceded premiums written under the Single Premium QSR Transaction. The Single Premium QSR Transaction was effective as of January 1, 2016. Net premiums written increased in 2015 compared to 2014 primarily due to an increase in NIW in 2015, compared to 2014. In addition, the volume of Single Premium Policies written in 2015 increased as a percentage of our total NIW, as Single Premium Policies were 31% compared to 28% for 2014.
The chart below provides the composition of services revenue on an annual basis for periods subsequent to the June 30, 2014 acquisition of Clayton.
Gross Profit on Services. For the years ended December 31, 2016, 2015 and 2014 our gross profit on services represented 35%, 40% and 43% of total services revenue, respectively. These decreases in gross profit margin were primarily due to: (i) a decrease in real estate valuation and component services revenue associated with the decrease in SFR securitizations and non-agency securitizations (which generally have relatively higher gross profit margins); (ii) a decline in loan review, underwriting and due diligence gross profit; and (iii) a shift in the mix of services. Slightly offsetting the decrease in 2016 was improved REO Management gross profit margin due to higher volumes and the mix of customers.
In November 2016, we announced our intent to exercise our redemption option for the remaining Convertible Senior Notes due 2019, of which $68.0 million aggregate principal was outstanding at December 31, 2016 and is reflected in the table above as an expected payment in 2017. The redemption was settled on January 27, 2017. Radian elected to redeem all of the notes surrendered for conversion or redemption with cash from available liquidity. Settlement of the obligation was funded with $110.1 million in cash. See Note 21 of Notes to Consolidated Financial Statements for additional details.
Corporate Expenses and Interest Expense. Radian Group has expense-sharing arrangements in place with its principal operating subsidiaries that require those subsidiaries to pay their allocated share of certain holding-company-level expenses, including interest payments on most of our outstanding long-term debt. Payments of such corporate expenses for the next 12 months, excluding interest payments on our long-term debt, are expected to be approximately $55 million, most of which is expected to be reimbursed by our subsidiaries under our existing expense-sharing arrangements. For the same period, payments of interest on our long-term debt are expected to be approximately $60 million, a significant portion of which is expected to be reimbursed by our subsidiaries under our existing expense-sharing arrangements. See “-Radian Group-Long-Term Liquidity Needs-Services.” The expense-sharing arrangements between Radian Group and our insurance subsidiaries, as amended, have been approved by the Pennsylvania Insurance Department, but such approval may be modified or revoked at any time.
Sources of Liquidity. In June 2016, Radian Guaranty repaid in full the $325 million Surplus Note due to Radian Group, which increased our holding company liquidity at June 30, 2016 by $325 million. We have since used a portion of this holding company liquidity in connection with our capital management transactions.
In August 2016, Radian Guaranty and Radian Reinsurance became members of the Federal Home Loan Bank of Pittsburgh (“FHLB”) and, as members, may borrow from the FHLB. Borrowings from the FHLB may be used to provide low-cost, supplemental liquidity. As of December 31, 2016, there were no FHLB borrowings outstanding.
Private mortgage insurers, including Radian Guaranty, are required to comply with the PMIERs to remain eligible insurers of loans purchased by the GSEs. See “-Radian Group-Short-Term Liquidity Needs” and Note 1 of Notes to Consolidated Financial Statements for additional information. Radian Guaranty currently is an approved mortgage insurer under the PMIERs and is in compliance with the PMIERs Financial Requirements.
Stockholders’ equity increased to $2.9 billion at December 31, 2016, from $2.5 billion at December 31, 2015. The increase in stockholders’ equity resulted primarily from: (i) our net income of $308 million for the year ended December 31, 2016 and (ii) the impact of our recently completed debt and equity transactions to strengthen Radian’s capital position, which increased stockholder’s equity by $42.9 million, excluding the $59.8 million after-tax impact from the loss on induced conversion and debt extinguishment already reflected in net income. See “Overview-2016 and Other Recent Capital Management Developments” for additional information.
Our estimated fair value measurements are intended to reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and the risks inherent in the inputs to the model. Changes in economic conditions and capital market conditions, including but not limited to, credit spread changes, benchmark interest rate changes, market volatility and changes in the value of underlying collateral, could cause actual results to differ materially from our estimated fair value measurements. We define fair value as the current amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
We are the beneficiary of insurance policies on the lives of certain of our current and past officers and employees. We have recognized the amount that could be realized upon surrender of the insurance policies in other assets in our consolidated balance sheets. See Note 9 for additional information.
Property and equipment is carried at cost, net of depreciation. For financial statement reporting purposes, computer hardware and software is generally depreciated over three or five years and furniture, fixtures and office equipment is depreciated over seven years. Leasehold improvements are depreciated over the lesser of the estimated useful life of the asset improved or the remaining term of the lease. For income tax purposes, we use accelerated depreciation methods. See Note 9 for additional information.
We report a business as held for sale when management is committed to a formal plan to sell the assets, the business is available for immediate sale and is being actively marketed at a price that is reasonable in relation to its fair value, an active program to locate a buyer and other actions required to complete the plan to sell the asset have been initiated, the sale is probable and expected to be completed within one year, and it is deemed unlikely that significant changes to the plan will be made or that the plan will be withdrawn. A business classified as held for sale is reflected at the lower of its carrying amount or estimated fair value less cost to sell. If the carrying amount of the business exceeds its estimated fair value, a loss is recognized. Assets and liabilities related to a business classified as held for sale are segregated in the consolidated balance sheets in the period in which the business is classified as held for sale. After a business is classified as held for sale, depreciation and amortization expense is not recognized on its assets.
In August and November 2016, the FASB issued updates to the accounting standard regarding the statement of cash flows. The updates reduce diversity in practice over the presentation and classification of certain cash receipts and cash payments. Specifically, the revisions provide guidance related to certain cash flow issues, including a requirement that a statement of cash flows explain the change during the period in the total of cash, cash equivalents and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash or restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning and ending amounts shown on the statement of cash flows. These updates are effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted, and we elected to early adopt these updates effective December 31, 2016. As a result of the early adoption of these updates, there were no changes in the presentation or classification of cash receipts and cash payments in the statement of cash flows; however, restricted cash is now included with cash and cash equivalents in the beginning and ending cash balances, retrospectively for all the periods presented.
Excludes net gains on investments and other financial instruments of $80.1 million, not included in adjusted pretax operating income.
Foreign government and agency securities. The fair value of foreign government and agency securities is estimated using observed market yields used to create a maturity curve and observed credit spreads from market makers and broker-dealers. These securities are categorized in Level II of the fair value hierarchy.
During the second quarter of 2015, we sold equity securities in our portfolio and reinvested the proceeds in assets that qualify as PMIERs-compliant Available Assets, recognizing pretax gains of $69.2 million.
We considered the sensitivity of first-lien loss reserve estimates at December 31, 2016 by assessing the potential changes resulting from a parallel shift in Claim Severity and Default to Claim Rate estimates for primary loans. For example, assuming all other factors remain constant, for every one percentage point change in primary Claim Severity (which we estimate to be 101.0% of risk exposure at December 31, 2016), we estimated that our loss reserves would change by approximately $6.3 million at December 31, 2016. Assuming all other factors remain constant, for every one percentage point change in our overall primary net Default to Claim Rate (which we estimate to be 42% at December 31, 2016, including our assumptions related to Rescissions and Claim Denials), we estimated a $14.5 million change in our loss reserves at December 31, 2016.
Redemption of Senior Notes due 2017. On August 12, 2016, we redeemed the remaining $195.5 million aggregate principal amount of our Senior Notes due 2017 for the price established in accordance with the indenture governing the notes. We paid $211.3 million in cash (including accrued interest through the redemption date) to holders of the notes at redemption and recorded a loss on debt extinguishment of $15.0 million.
Senior Notes due 2019. In May 2014, in anticipation of the Clayton acquisition, we issued $300 million principal amount of Senior Notes due 2019 and received net proceeds of $293.8 million. The notes bear interest at a rate of 5.500% per annum, payable semi-annually on June 1 and December 1 of each year, commencing on December 1, 2014. These notes mature on June 1, 2019.
See “-Convertible Senior Notes due 2017 and 2019” below for information on accounting considerations related to convertible debt instruments that may be settled in cash upon conversion, including the balance sheet classification of the equity component of certain convertible debt instruments, such as the Convertible Senior Notes due 2017, that require the issuer to settle the aggregate principal amount of the notes in cash. During the three-month period ended December 31, 2016, our closing stock price did not exceed the threshold required for the holders of our Convertible Senior Notes due 2017 to be able to exercise their conversion rights during the three-month period ending March 31, 2017.
On December 22, 2016, Ocwen Loan Servicing, LLC and Homeward Residential, Inc. (collectively, “Ocwen”) filed a complaint against Radian Guaranty (the “Complaint”). Ocwen has also initiated legal proceedings against several other mortgage insurers. The action filed against Radian Guaranty, titled Ocwen, et al. v. Radian Guaranty, is pending in the U.S. District Court for the Eastern District of Pennsylvania. The Complaint alleges breach of contract and bad faith claims and seeks monetary damages and declaratory relief in regard to certain claims handling practices on future insurance claims. On December 17, 2016, Ocwen separately filed an arbitration petition against Radian Guaranty (the “Petition”) before the American Arbitration Association that asserts substantially the same allegations as contained in the Complaint (the Complaint and the Petition are collectively referred to as the “Filings”). The Filings list 9,420 mortgage insurance certificates issued under multiple insurance policies, including Pool Insurance policies, as being the subject of these proceedings. Radian Guaranty believes that the claims in the Filings are without merit and plans to defend these claims vigorously. We are not able to estimate a reasonably possible loss, if any, or range of loss in this matter because of the preliminary stage of the proceedings.
On June 18, 2015, we authorized an ASR program to repurchase an aggregate of $202 million of Radian Group common stock. Under the ASR program, the total number of shares ultimately delivered to Radian Group was based on the average of the daily volume-weighted average price of Radian Group common stock during the term of the transaction, less a negotiated discount and subject to certain other adjustments pursuant to the terms and conditions of the program. During the three-month period ended June 30, 2015, 9.2 million shares were repurchased under this program. The counterparty delivered to Radian Group 1.8 million additional shares of Radian Group common stock at final settlement of the ASR program in August 2015, based on the calculated price of $18.32 during the term of the transaction. The shares of Radian Group common stock received pursuant to the ASR and the termination of the capped call transactions were retired, resulting in a decrease in shares issued and outstanding and a corresponding increase in unissued shares. All share repurchases pursuant to the ASR program were funded in the second quarter of 2015 from the proceeds of the Senior Notes due 2020.
Generally, all awards require the grantee to remain in service with us through the vesting period, except in the event of the grantee’s death, disability, retirement or upon a change of control (subject to certain conditions discussed below).
Average volatility of peer companies is used in the calculation of the grant date fair value of the portion of the awards based on the Relative TSR Measures, as described above.
Information with regard to stock options for the periods indicated is as follows:
The following are assumptions used in our calculation of ESPP compensation expense during 2016:
We contributed immaterial amounts to other postretirement benefit plans in 2016.
Under SAPP, premiums written on a multi-year basis are initially deferred as unearned premiums. A portion of the premium written, which corresponds to the insurance policy acquisition costs, is earned immediately and the remaining premiums written are earned over the policy term. Under GAAP, these premiums written on a multi-year basis are initially deferred as unearned premiums and are earned over the policy term.
Radian completed the sale of Radian Asset Assurance to Assured on April 1, 2015, pursuant to the Radian Asset Assurance Stock Purchase Agreement. Until the April 1, 2015 sale date, the operating results of Radian Asset Assurance were classified as discontinued operations for all periods presented in our consolidated statements of operations. See Note 18 for additional information.