Segment Reporting

Our mortgage insurance, financial guaranty and, effective with the June 30, 2014 acquisition of Clayton, mortgage and real estate services segments, are strategic business units that we manage separately. We allocate corporate income and expenses to our mortgage insurance and financial guaranty segments based on either an allocated percentage of time spent on each segment or internally allocated capital, which is based on the relative GAAP equity of each segment. We allocate corporate cash and investments to our mortgage insurance and financial guaranty segments based on internally allocated capital.

Because the Clayton acquisition occurred on June 30, 2014, we have included its results of operations from the date of acquisition. We allocate to our mortgage and real estate services segment: (i) corporate expenses based on an allocated percentage of time spent on the mortgage and real estate services segment; and (ii) all interest expense related to the Senior Notes due 2019. No corporate cash or investments are allocated to the mortgage and real estate services segment.

The results of operations for each segment for each reporting period can cause significant volatility in internally allocated capital based on relative GAAP equity, which can impact the allocations of income and expenses to our mortgage insurance and financial guaranty segments.

Adjusted Pretax Operating Income (Loss)

Our senior management, including our Chief Executive Officer (our chief operating decision maker), uses adjusted pretax operating income (loss) as our primary measure to evaluate the fundamental financial performance of the Company’s business segments and to allocate resources to the segments. Adjusted pretax operating income (loss) is defined as pretax income (loss) excluding the effects of net gains (losses) on investments and other financial instruments, acquisition-related expenses, amortization of intangible assets and net impairment losses recognized in earnings. It also excludes gains and losses related to changes in fair value estimates on insured credit derivatives and instead includes the impact of changes in the present value of expected insurance claims and recoveries on insured credit derivatives, based on our ongoing insurance loss monitoring, as well as premiums earned on insured credit derivatives. Management’s use of this measure as its primary measure to evaluate segment performance began with the quarter ended March 31, 2014. Accordingly, for comparison purposes, we also present the applicable measures from the corresponding periods of 2013 on a basis consistent with the current year presentation.

Although adjusted pretax operating income (loss) excludes certain items that have occurred in the past and are expected to occur in the future, the excluded items represent those that are: (1) not viewed as part of the operating performance of our primary activities; or (2) not expected to result in an economic impact equal to the amount reflected in pretax income (loss). These adjustments, along with the reasons for their treatment, are described below.

(1)

Change in fair value of derivative instruments. Gains and losses related to changes in the fair value of insured credit derivatives are subject to significant fluctuation based on changes in interest rates, credit spreads (of both the underlying collateral as well as our credit spread), credit ratings and other market, asset-class and transaction-specific conditions and factors that may be unrelated or only indirectly related to our obligation to pay future claims. With the exception of the estimated present value of net credit (losses) recoveries incurred and net premiums earned on derivatives, discussed in items 2 and 3 below, we believe these gains and losses will reverse over time and consequently these changes are not expected to result in economic gains or losses. Therefore, these gains and losses are excluded from our calculation of adjusted pretax operating income (loss).

(2)

Estimated present value of net credit (losses) recoveries incurred. The change in present value of insurance claims we expect to pay or recover on insured credit derivatives represents the amount of the change in credit derivatives from item 1 above, that we expect to result in an economic loss or recovery based on our ongoing loss monitoring analytics. Therefore, this item is expected to have an economic impact and is included in our calculation of adjusted pretax operating income (loss). Also included in this item is the expected recovery of miscellaneous operating expenses associated with our consolidated VIEs.


(3)	Net premiums earned on derivatives. The net premiums earned on insured credit derivatives are classified as part of the change in fair value of derivative instruments discussed in item 1 above. However, since net premiums earned on derivatives are considered part of our fundamental operating activities, these premiums are included in our calculation of adjusted pretax operating income (loss).

(4)

Net gains (losses) on investments and other financial instruments. The recognition of realized investment gains or losses can vary significantly across periods as the activity is highly discretionary based on the timing of individual securities sales due to such factors as market opportunities, our tax and capital profile and overall market cycles. Unrealized investment gains and losses arise primarily from changes in the market value of our investments that are classified as trading. These valuation adjustments may not necessarily result in economic gains or losses. We do not view them to be indicative of our fundamental operating activities. Trends in the profitability of our fundamental operating activities can be more clearly identified without the fluctuations of these realized and unrealized gains or losses. Therefore, these items are excluded from our calculation of adjusted pretax operating income (loss).

(5)

Acquisition-related expenses. Acquisition-related expenses represent the costs incurred to effect an acquisition of a business (i.e., a business combination). Because we pursue acquisitions on a limited and selective basis and not in the ordinary course of our business, we do not view acquisition-related expenses as a consequence of a primary business activity. Therefore, we do not consider these expenses to be part of our operating performance and they are excluded from our calculation of adjusted pretax operating income (loss).


(6)	Amortization of intangible assets. Amortization of intangible assets represents the periodic expense required to amortize the cost of intangible assets over their estimated useful lives. 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).

(7)

Net impairment losses recognized in earnings. The recognition of net impairment losses on investments can vary significantly in both size and timing, depending on market credit cycles. Intangible assets with an indefinite useful life are also periodically reviewed for potential impairment and impairment adjustments are made whenever appropriate. We do not view impairment losses on investments or intangibles to be indicative of our fundamental operating activities. Therefore, these losses are excluded from our calculation of adjusted pretax operating income (loss).

Summarized financial information concerning our operating segments as of and for the periods indicated, is as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
(In thousands)	2014			2013			2014			2013
Mortgage Insurance
Net premiums written—insurance	$	245,775		$	250,799		$	680,675		$	719,244
Increase in unearned premiums	(27,948		)	(50,679		)	(60,440		)	(138,180		)
Net premiums earned—insurance	217,827			200,120			620,235			581,064
Net premiums earned on derivatives	—			—			—			—
Net investment income	15,904			14,868			45,196			45,236
Other income	1,130			1,250			3,813			5,121
Total revenues	234,861			216,238			669,244			631,421

Provision for losses	48,942			149,687			163,216			418,675
Estimated present value of net credit (recoveries) losses incurred	(190		)	(74		)	129			(50		)
Policy acquisition costs	4,240			5,839			18,003			24,072
Other operating expenses	41,368			59,590			141,333			176,665
Interest expense	7,936			4,447			19,713			10,820
Total expenses	102,296			219,489			342,394			630,182

Adjusted pretax operating income (loss)	$	132,565		$	(3,251	)	$	326,850		$	1,239

NIW (in millions)	$	11,210		$	13,720		$	27,340		$	38,003



	Three Months Ended September 30,						Nine Months Ended September 30,
(In thousands)	2014			2013			2014			2013
Financial Guaranty
Net premiums written—insurance	$	(1,523	)	$	43		$	(350	)	$	(9,988	)
Decrease in unearned premiums	10,852			11,821			27,050			46,620
Net premiums earned—insurance	9,329			11,864			26,700			36,632
Net premiums earned on derivatives	2,882			4,170			9,673			14,019
Net investment income	10,274			11,864			30,948			35,984
Other income	41			64			302			198
Total revenues	22,526			27,962			67,623			86,833

Provision for losses	(6,416		)	5,162			4,311			9,146
Estimated present value of net credit (recoveries) losses incurred	(475		)	3,347			10,303			(116		)
Policy acquisition costs	1,794			2,119			5,066			11,087
Other operating expenses	6,663			11,384			25,426			35,390
Interest expense	11,629			15,123			42,127			44,051
Total expenses	13,195			37,135			87,233			99,558

Equity in net (loss) income of affiliates	—			—			(13		)	1

Adjusted pretax operating income (loss)	$	9,331		$	(9,173	)	$	(19,623	)	$	(12,724	)



	Three Months Ended September 30,		Nine Months Ended September 30,
(In thousands)	2014		2014
Mortgage and Real Estate Services
Services revenue	$	42,243	$	42,243
Direct cost of services	23,896		23,896
Gross profit on services	18,347		18,347

Operating expenses	8,663		8,663
Interest expense	4,424		4,424
Total expenses	13,087		13,087

Adjusted pretax operating income	$	5,260	$	5,260



	At September 30, 2014
(In thousands)	Mortgage Insurance		Financial Guaranty		Mortgage and Real Estate Services		Total
Cash and investments	$	3,017,737	$	1,978,972	$	10,600	$	5,007,309
Restricted cash	11,574		73		4,862		16,509
Deferred policy acquisition costs	27,595		32,545		—		60,140
Goodwill	2,095		—		191,931		194,026
Other intangible assets, net	154		—		99,452		99,606
Total assets	3,447,406		2,175,773		336,512		5,959,691
Unearned premiums	625,269		171,473		—		796,742
Reserve for losses and LAE	1,588,131		32,220		—		1,620,351
VIE debt	3,196		88,036		—		91,232
Derivative liabilities	—		185,258		—		185,258



	At September 30, 2013
(In thousands)	Mortgage Insurance		Financial Guaranty		Total
Cash and investments	$	2,767,160	$	2,293,485	$	5,060,645
Restricted cash	22,890		101		22,991
Deferred policy acquisition costs	29,158		39,303		68,461
Total assets	3,238,224		2,520,349		5,758,573
Unearned premiums	535,420		216,167		751,587
Reserve for losses and LAE	2,314,785		32,094		2,346,879
VIE debt	11,109		93,109		104,218
Derivative liabilities	—		344,870		344,870

The reconciliation of adjusted pretax operating income (loss) to consolidated pretax income (loss) and consolidated net income (loss) is as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
(In thousands)	2014			2013			2014			2013
Adjusted pretax operating income (loss):
Mortgage insurance	$	132,565		$	(3,251	)	$	326,850		$	1,239
Financial guaranty	9,331			(9,173		)	(19,623		)	(12,724		)
Mortgage and real estate services	5,260			—			5,260			—
Total adjusted pretax operating income (loss)	$	147,156		$	(12,424	)	$	312,487		$	(11,485	)

Change in fair value of derivative instruments	19,360			10,778			126,923			(70,357		)
Less: Estimated present value of net credit recoveries (losses) incurred	665			(3,273		)	(10,432		)	166
Less: Net premiums earned on derivatives	2,882			4,170			9,673			14,019
Change in fair value of derivative instruments expected to reverse over time	15,813			9,881			127,682			(84,542		)

Net (losses) gains on investments	(7,839		)	(7,132		)	103,831			(142,891		)
Net gains (losses) on other financial instruments	982			902			(229		)	(3,585		)
Acquisition-related expenses	432			—			(6,300		)	—
Amortization of intangible assets	(3,294		)	—			(3,294		)	—
Consolidated pretax income (loss)	153,250			(8,773		)	534,177			(242,503		)
Income tax (benefit) provision	(340		)	3,909			2,995			(9,149		)
Consolidated net income (loss)	$	153,590		$	(12,682	)	$	531,182		$	(233,354	)

On a consolidated basis, “adjusted pretax operating income (loss)” is a measure not determined in accordance with GAAP. Total adjusted pretax operating income (loss) is not a measure of total profitability, and therefore should not be viewed as a substitute for GAAP pretax income (loss). Our definition of adjusted pretax operating income (loss) may not be comparable to similarly-named measures reported by other companies.