-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, SBG7+SZWlXrLVgekpYTMGinOb26VxBT7udS5l+Lc6U4Xtb05fmZMSxCAbmLEPLyn I1/QEbXsxwWpF+QT7/xWig== 0001193125-06-049787.txt : 20060309 0001193125-06-049787.hdr.sgml : 20060309 20060309172732 ACCESSION NUMBER: 0001193125-06-049787 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20051231 FILED AS OF DATE: 20060309 DATE AS OF CHANGE: 20060309 FILER: COMPANY DATA: COMPANY CONFORMED NAME: RADIAN GROUP INC CENTRAL INDEX KEY: 0000890926 STANDARD INDUSTRIAL CLASSIFICATION: SURETY INSURANCE [6351] IRS NUMBER: 232691170 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-11356 FILM NUMBER: 06676970 BUSINESS ADDRESS: STREET 1: 1601 MARKET STREET STREET 2: 12TH FLOOR CITY: PHILADELPHIA STATE: PA ZIP: 19103 BUSINESS PHONE: 2155646600 MAIL ADDRESS: STREET 1: 1601 MARKET ST STREET 2: 12TH FLOOR CITY: PHILADELPHIA STATE: PA ZIP: 19103 FORMER COMPANY: FORMER CONFORMED NAME: CMAC INVESTMENT CORP DATE OF NAME CHANGE: 19960126 10-K 1 d10k.htm RADIAN GROUP INC--FORM 10-K Radian Group Inc--Form 10-K
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-K

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                  to                 

Commission file number 1-11356

 


RADIAN GROUP INC.

(Exact name of registrant as specified in its charter)

 

Delaware   23-2691170
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

 

1601 Market Street, Philadelphia, PA   19103
(Address of principal executive offices)   (Zip Code)

(215) 231-1000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Common Stock, $.001 par value per share   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

 


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES x NO ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES ¨ NO x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):

Large accelerated filer x                    Accelerated filer ¨                    Non-accelerated filer ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

State the aggregate market value of the voting and non-voting common equity held by non-affiliates, computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. As of June 30, 2005, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $4,012,075,963 based on the closing sale price as reported on the New York Stock Exchange. Excluded from this amount is the value of all shares beneficially owned by executive officers and directors of the registrant. These exclusions should not be deemed to constitute a representation or acknowledgement that any such individual is, in fact, an affiliate of the registrant or that there are not other persons or entities who may be deemed to be affiliates of the registrant.

(APPLICABLE ONLY TO CORPORATE REGISTRANTS)

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 83,159,404 shares of common stock, $.001 par value per share, outstanding on February 28, 2006.

DOCUMENTS INCORPORATED BY REFERENCE

List hereunder the following documents if incorporated by reference and the Part of the Form 10-K (e.g., Part I, Part II, etc.) into which the document is incorporated: (1) Any annual report to security holders; (2) Any proxy or information statement; and (3) Any prospectus filed pursuant to Rule 424(b) or (c) under the Securities Act of 1933. The listed documents should be clearly described for identification purposes (e.g., annual report to security holders for fiscal year ended December 24, 1980).

 

Document

  

Form 10-K Reference

Definitive Proxy Statement for the Registrant’s 2006 Annual Meeting of Stockholders
to be held on May 9, 2006.

   Part III
(Items 10 through 14)

 



Table of Contents

TABLE OF CONTENTS

 

             

Page

Number

    

Forward Looking Statements — Safe Harbor Provisions

   3

PART I

       
 

Item 1

  

Business

  
    

General

   5
    

Mortgage Insurance Business

   6
    

Financial Guaranty Business

   12
    

Financial Services Business

   19
    

Other

   19
    

Defaults and Claims

   20
    

Loss Mitigation

   23
    

Reserve for Losses

   25
    

Risk Management

   28
    

Risk in Force

   34
    

Customers

   40
    

Sales and Marketing

   41
    

Competition

   43
    

Ratings

   45
    

Investment Policy and Portfolio

   47
    

Regulation

   50
    

Employees

   56
 

Item 1A

  

Risk Factors

   57
 

Item 1B

  

Unresolved Staff Comments

   70
 

Item 2

  

Properties

   70
 

Item 3

  

Legal Proceedings

   71
 

Item 4

  

Submission of Matters to a Vote of Security Holders

   71

PART II

       
 

Item 5

   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   

72
 

Item 6

  

Selected Financial Data

   73
 

Item 7

   Management’s Discussion and Analysis of Financial Condition and Results of Operations   

74
 

Item 7A

  

Quantitative and Qualitative Disclosures About Market Risk

   131
 

Item 8

  

Financial Statements and Supplementary Data

   133
 

Item 9

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   

194
 

Item 9A

  

Controls and Procedures

   194
 

Item 9B

  

Other Information

   195

PART III

       
 

Item 10

  

Directors and Executive Officers of the Registrant

   195
 

Item 11

  

Executive Compensation

   195
 

Item 12

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   

195
 

Item 13

  

Certain Relationships and Related Transactions

   195
 

Item 14

  

Principal Accounting Fees and Services

   195

PART IV

       
 

Item 15

  

Exhibits and Financial Statement Schedules

   196

SIGNATURES

   197

INDEX TO FINANCIAL STATEMENT SCHEDULES

   198

INDEX TO EXHIBITS

   199

 

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Forward Looking Statements — Safe Harbor Provisions

All statements in this report that address events, developments or results that we expect or anticipate may occur in the future are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934 and the U.S. Private Securities Litigation Reform Act of 1995. In most cases, forward-looking statements may be identified by words such as “may,” “will,” “should,” “expect,” “intend,” “plan,” “goal,” “contemplate,” “believe,” “estimate,” “predict,” “project,” “potential,” “continue” or the negative or other variations on these words and other similar expressions. These statements are made on the basis of management’s current views and assumptions with respect to future events. The forward-looking statements, as well as our prospects as a whole, are subject to risks and uncertainties, including the following:

 

    changes in general financial and political conditions, such as extended national or regional economic recessions, changes in housing values, population trends and changes in household formation patterns, changes in unemployment rates, changes or volatility in interest rates, changes in the way investors perceive the strength of private mortgage insurers or financial guaranty providers, investor concern over the credit quality of municipalities and corporations and specific risks faced by the particular businesses, municipalities or pools of assets covered by our insurance;

 

    economic changes or catastrophic events in geographic regions where our mortgage insurance or financial guaranty insurance in force is more concentrated;

 

    the loss of a customer for whom we write a significant amount of our mortgage insurance or financial guaranty insurance;

 

    increased severity or frequency of losses associated with certain of our products that are riskier than traditional mortgage insurance or financial guaranty insurance policies;

 

    changes in persistency rates of our mortgage insurance policies caused by changes in refinancing activity, appreciating or depreciating home values and changes in the mortgage insurance cancellation requirements of mortgage lenders and investors;

 

    downgrades of, or other ratings actions with respect to, our credit ratings or the insurance financial strength ratings assigned by the major rating agencies to any of our rated operating subsidiaries at any time, which actions have occurred in the past;

 

    heightened competition for our mortgage insurance business from others such as the Federal Housing Administration and the Veterans’ Administration or other private mortgage insurers, from alternative products such as “80-10-10” loans or other forms of simultaneous second loan structures used by mortgage lenders, from investors using forms of credit enhancement other than mortgage insurance as a partial or complete substitution for private mortgage insurance and from mortgage lenders that demand increased participation in revenue sharing arrangements such as captive reinsurance arrangements;

 

    changes in the charters or business practices of Fannie Mae and Freddie Mac, the largest purchasers of mortgage loans that we insure;

 

    heightened competition for financial guaranty business from other financial guaranty insurers, from other forms of credit enhancement such as letters of credit, guaranties and credit default swaps provided by foreign and domestic banks and other financial institutions and from alternative structures that permit insurers to securitize assets more cost-effectively without the need for other credit enhancement of the types we offer;

 

    the application of existing federal or state consumer, lending, insurance and other applicable laws and regulations, or unfavorable changes in these laws and regulations or the way they are interpreted;

 

    the possibility that we may fail to estimate accurately the likelihood, magnitude and timing of losses in connection with establishing loss reserves for our mortgage insurance or financial guaranty businesses or to estimate accurately the fair value amounts of derivative financial guaranty contracts in determining gains and losses on these contracts;

 

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    increases in claim frequency as our mortgage insurance policies age; and

 

    vulnerability to the performance of our strategic investments.

For more information regarding these risks and uncertainties as well as certain additional risks that we face, you should refer to the risk factors detailed in Part I, Item 1A of this report. We caution you not to place undue reliance on these forward-looking statements, which are current only as of the date on which we filed this report. We do not intend to, and we disclaim any duty or obligation to, update or revise any forward-looking statements made in this report to reflect new information or future events or for any other reason.

 

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Part I

 

Item 1. Business

General

We are a global credit risk management company. Our strategic objective is to prudently grow our core mortgage credit enhancement business while providing value to our clients in the acquisition, management and distribution of credit risk, both in domestic and international markets. We develop and deliver innovative financial solutions by applying our credit risk expertise and structured finance capabilities to the credit enhancement needs of the capital markets worldwide.

Based on this foundation of credit risk evaluation and expertise, we offer products and services through three primary business lines: mortgage insurance, financial guaranty and financial services:

 

    Our mortgage insurance business provides credit protection for mortgage lenders and other financial services companies on residential mortgage assets through traditional mortgage insurance as well as other mortgage-backed structured products.

 

    Our financial guaranty business insures and reinsures credit-based risks and provides synthetic credit protection on various asset classes through the use of credit default swaps.

 

    Our financial services business consists mainly of our 46% ownership interest in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”)—a mortgage investment and servicing firm specializing in credit-sensitive, single-family residential mortgage assets and residential mortgage-backed securities—and our 34.58% ownership interest in Sherman Financial Services Group LLC (“Sherman”)—a consumer asset and servicing firm specializing in credit card and bankruptcy plan consumer assets.

The following shows the contribution to net income and equity created by our three business lines in 2005:

 

    

Net

Income

    Equity  

Mortgage Insurance

   51 %   57 %

Financial Guaranty

   23 %   34 %

Financial Services

   26 %   9 %

A summary of financial information for each of our operating segments and a discussion of net premiums earned attributable to our domestic and international operations for each of the last three fiscal years is included in “Segment Reporting” in Note 2 to our Consolidated Financial Statements.

We began conducting business as CMAC Investment Corporation, a Delaware corporation, following our spin-off from Commonwealth Land Title Insurance Company through an initial public offering on November 6, 1992. On June 9, 1999, we merged with Amerin Corporation and were renamed Radian Group Inc. As further described below, on February 28, 2001, we acquired Enhance Financial Services Group Inc. (“EFSG”), a New York-based insurance holding company that principally provides financial guaranty insurance and reinsurance. Our principal executive offices are located at 1601 Market Street, Philadelphia, Pennsylvania 19103, and our telephone number is (215) 231-1000.

We maintain a website with the address www.radian.biz. We are not including or incorporating by reference the information contained on our website into this report. We make available on our website, free of charge and as soon as reasonably practicable after we file with, or furnish to, the Securities and Exchange Commission (“SEC”), copies of our most recently filed Annual Report on Form 10-K, all Quarterly Reports on Form 10-Q and all Current Reports on Form 8-K, including all amendments to those reports. In addition, copies of our guidelines of corporate governance, code of business conduct and ethics (which includes the code of ethics applicable to our chief executive officer, principal financial officer and principal accounting officer) and the governing charters for each committee of our board of directors are available free of charge on our website, as well as in print to any stockholder upon request.

 

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Mortgage Insurance Business

Our mortgage insurance business provides credit-related insurance coverage, principally via private mortgage insurance, and risk management services to mortgage lending institutions located throughout the United States and select countries overseas. We provide these products and services through our wholly-owned subsidiaries, Radian Guaranty Inc. (“Radian Guaranty”), Radian Insurance Inc. (“Radian Insurance”) and Amerin Guaranty Corporation (“Amerin Guaranty”). Private mortgage insurance protects mortgage lenders from all or a portion of default-related losses on residential first mortgage loans made mostly to home buyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgage loans in the secondary mortgage market, some of which are sold to the Federal Home Loan Mortgage Corp. (“Freddie Mac”) and the Federal National Mortgage Association (“Fannie Mae”). We sometimes refer to Freddie Mac and Fannie Mae collectively as “Government Sponsored Enterprises” or “GSEs.”

Our mortgage insurance business, through Radian Guaranty, offers primary and pool private mortgage insurance coverage on residential first-lien mortgages. At December 31, 2005, primary insurance on first-lien mortgages made up 90% of our total first-lien mortgage insurance risk in force and pool insurance on first-lien mortgages made up 10% of our total first-lien mortgage insurance risk in force. We use Radian Insurance to provide credit enhancement for mortgage-related capital market transactions and to write credit insurance on mortgage-related assets that monoline mortgage guaranty insurers are not permitted to insure, including net interest margin securities (“NIMs”), international insurance transactions, second-lien mortgages and credit default swaps (collectively, we refer to the risk associated with these transactions as “other risk in force”). We also insure second-lien mortgages through Amerin Guaranty. At December 31, 2005, other risk in force was 25.5% of our total mortgage insurance risk in force.

Premiums written and earned by our mortgage insurance business for the periods indicated were as follows:

 

     Year Ended December 31
     2005    2004    2003
     (In thousands)

Net premiums written:

        

Primary and Pool Insurance

   $ 746,483    $ 751,604    $ 654,660

Seconds

     61,803      62,480      47,688

NIMs

     40,318      48,421      39,334

International

     25,612      3,546      158

Domestic credit default swaps

     3,132      —        —  

Financial guaranty wrap

     284      —        —  
                    

Net premiums written

   $ 877,632    $ 866,051    $ 741,840
                    

Net premiums earned:

        

Primary and Pool Insurance

   $ 710,361    $ 688,875    $ 670,098

Seconds

     52,220      64,777      40,970

NIMs

     39,877      59,555      48,394

International

     3,338      1,346      158

Domestic credit default swaps

     817      —        —  

Financial guaranty wrap

     284      —        —  
                    

Net premiums earned

   $ 806,897    $ 814,553    $ 759,620
                    

Traditional Types of Coverage

Primary Mortgage Insurance

Primary mortgage insurance provides mortgage default protection on prime and non-prime mortgages at a specified coverage percentage. When there is a claim, the coverage percentage is applied to the claim amount—

 

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which consists of the unpaid loan principal, plus past due interest and certain expenses associated with the default—to determine our maximum liability. We provide primary mortgage insurance on both a flow basis (which is loan by loan) and a structured basis (in which we insure a group of individual loans). See “Types of Transactions” in this Item 1 below. In 2005, we wrote $42.6 billion of primary mortgage insurance, of which 60.1% was originated on a flow basis and 39.9% was originated on a structured basis, compared to $44.8 billion of primary mortgage insurance written in 2004 of which 81.1% was originated on a flow basis and 18.9% was originated on a structured basis.

Persistency rates, defined as the percentage of insurance in force that remains on our books after any 12-month period, are a key indicator for the primary mortgage insurance industry. Because most of our insurance premiums are earned over time, higher persistency rates enable us to recover our policy acquisition costs. Therefore, higher persistency rates tend to increase the profitability of a mortgage insurer. At December 31, 2005, the persistency rate of our primary mortgage insurance was 58.2%, compared to 58.8% at December 31, 2004. Both of these figures are low relative to historical levels and reflect the high levels of refinancing that have occurred recently in the mortgage market.

Pool Insurance

We offer pool insurance on a selective basis. Generally, pool insured mortgages are similar to primary insured mortgages. Pool insurance differs from primary insurance in that our maximum liability is not limited to a specific coverage percentage on each individual mortgage. Instead, an aggregate exposure limit, or “stop loss,” generally between 1% and 10%, is applied to the initial aggregate loan balance on a group or “pool” of mortgages. In addition to a stop loss, many pool policies are “second to pay” or “second-loss” meaning that the insured must incur losses on the pool above a specified amount or deductible before any claim payments under the policy will be made. The deductible and stop loss features are effective in limiting our exposure on a specified pool. An insured pool of mortgages may contain mortgages that are already covered by primary mortgage insurance, and the pool insurance is secondary to any primary mortgage insurance that exists on mortgages within the pool.

We write the majority of our pool insurance in the form of credit enhancement on residential mortgage loans underlying residential mortgage-backed securities, whole loan sales and other structured transactions. We include our pool insurance on mortgages and on other mortgage-related assets in our financial results as well as other statistics related to our pool insurance.

Premium rates for our pool insurance business are generally lower than primary mortgage insurance rates due to the aggregate stop loss. Because of the generally lower premium rates and lack of exposure limits on individual loans associated with much of our pool insurance, the rating agency capital requirements for this product are generally more restrictive than for primary insurance. In 2005, we wrote $569 million of pool insurance risk, compared to $304 million of pool insurance risk written in 2004.

Modified Pool Insurance

We also write modified pool insurance, which differs from standard pool insurance in that it includes a stop loss feature for the entire pool as well as an exposure limit on each individual loan. Prior to 2005, modified pool insurance was classified as pool or primary insurance depending on the characteristics of the underlying loan. Beginning in 2005, all new insurance written as modified pool insurance was classified as primary insurance due to the nature of the loan.

 

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Non-Traditional Credit Enhancement

Second-Lien Mortgages

In addition to insuring first-lien mortgages, to a lesser extent, we also provide primary or modified pool insurance on second-lien mortgages. Beginning in 2004, we began focusing our participation in these transactions to situations where there is a loss deductible or other first-loss protection that precedes our loss exposure. We wrote $668 million of second-lien mortgage insurance risk in 2005. Most of this represents business in which we are in a second-loss or shared-loss position. At December 31, 2005, we had $591 million of risk in force on second-lien mortgages in a first-loss position and $638 million of risk in force where we are in a second-loss position, compared to $598 million of risk in force in a first-loss position and $75 million of risk in force in a second- or shared-loss position at December 31, 2004. We present certain of our financial results and other statistics related to second-lien mortgages separately from our presentation of financial results and other statistics related to primary insurance.

Credit Enhancement on Net Interest Margin Securities

We provide credit enhancement on NIMs. A NIM represents the securitization of the excess cash flow from a mortgage-backed security. The majority of this excess cash flow consists of the spread between the interest-rate on the mortgage-backed security and the interest-rate on the underlying mortgages. Historically, issuers of mortgage-backed securities would have earned this excess interest over time as mortgages age, but recent market efficiencies have enabled these issuers to sell their residual interests to investors in the form of NIM bonds. We provide credit enhancement on these bonds. In 2005, we wrote $99 million of insurance risk on NIMs. At December 31, 2005, we had $261 million of risk in force on NIMs, compared to $318 million at December 31, 2004. These transactions are typically rated BBB and are all rated between A- and BB by Standard and Poor’s Insurance Rating Service (“S&P”) and Fitch Ratings Service (“Fitch”).

Domestic Credit Default Swaps

In our mortgage insurance business, we sell protection on residential mortgage-backed securities via credit default swaps, which we classify as credit derivatives. A credit default swap is an agreement to pay our counterparty should an underlying security or the issuer of such security suffer a specified credit event, such as nonpayment, downgrade or a reduction of the principal of the security as a result of defaults in the underlying collateral. A credit default swap operates much like a financial guaranty insurance policy in that our obligation to pay is absolute. Unlike with most of our mortgage insurance and financial guaranty products, however, our ability to engage in loss mitigation is generally limited. Further, in a credit default swap structure, there is no requirement that our counterparty hold the security for which credit protection is provided. This has the effect of greatly increasing the volume and liquidity in the market. In 2005, our mortgage insurance business wrote $180 million in notional value of credit protection on residential mortgage-backed securities in credit default swap form.

International Mortgage Insurance Operations

We carefully review and assess international markets for opportunities to expand our mortgage insurance operations in areas where we believe our business would produce acceptable risk adjusted returns. Our primary geographical focus includes locations in Europe, Asia and Australia. International mortgage insurance transactions can take the form of primary or pool mortgage insurance or credit default swaps.

During 2005, we increased the level of mortgage insurance business that we have been writing internationally. On several occasions, we have provided credit protection on pools of mortgages (including mortgage-backed securities in credit default swap form) in the United Kingdom (“U.K.”) and in the Netherlands, and we have applied for authorization to conduct insurance operations in the U.K. In 2004 and early in 2005, we

 

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entered into two mortgage reinsurance transactions in Australia, and in the fourth quarter of 2005, we wrote $7.3 billion in notional value of credit protection in credit default swap form on two large AAA tranches of mortgage-backed securities, one in Germany and one in Denmark. We’ve also recently entered into a relationship with one of the largest mortgage lenders in Hong Kong to serve as its exclusive provider of mortgage insurance. We are in the process of applying for branch authorization in Hong Kong.

Types of Transactions

Our mortgage insurance business provides credit enhancement mainly through two forms of transactions. We write mortgage insurance on an individual loan basis, which is commonly referred to as “flow” business, and we also insure multiple mortgages in a single transaction, which is commonly referred to as “structured” business. In flow transactions, mortgages typically are insured as they are originated, while in structured deals, we typically provide insurance on mortgages after they have been originated and closed.

We also may issue a commitment to a customer to insure new loans as they are originated under negotiated terms and for a limited period of time. For 2005, our mortgage insurance business wrote $25.6 billion in flow business and $17.0 billion in structured transactions, compared to $36.3 billion in flow business and $8.5 billion in structured transactions for 2004.

In structured mortgage insurance transactions, we typically insure the individual mortgages included in the structured portfolio up to specified levels of coverage. Most structured mortgage insurance transactions that we insure involve non-traditional mortgages, such as non-prime mortgages or mortgages with higher than average balances. A single structured mortgage insurance transaction may include primary insurance or pool insurance, and an increasing number of structured transactions have both primary and pool components. We also insure mortgage-related assets, such as mortgage-backed securities in structured transactions. In our residential mortgage-backed securities transactions, similar to our financial guaranty insurance business, we insure the availability of funds sufficient for the timely payment of interest and ultimate payment of principal to the holders of debt securities, the payment for which is backed by a pool of residential mortgages. Unlike our traditional flow and structured transactions, in our residential mortgage-backed securities transactions, we do not insure the payment of the individual loans in the pool, but only that there will be aggregate payments on the pool of loans sufficient to meet the interest and principal payment obligations to the holders of the debt securities. Some structured transactions include a risk-sharing component under which the insured or a third-party assumes a first-loss position or shares in losses in some other manner.

Opportunities for structured transactions depend on a number of macroeconomic factors, and thus, the volume of structured transactions we close can vary significantly from year to year. We expect these fluctuations to continue. In 2005, we wrote $17.0 billion of primary mortgage insurance in structured transactions, consisting of approximately 33.3% prime loans and 66.7% non-prime loans, compared to $8.5 billion of primary new insurance written in structured transactions in 2004. Also in 2005, we wrote $20.8 billion of pool mortgage insurance in structured transactions, compared to $6.3 billion in 2004. Including both primary and pool insurance, we wrote $37.8 billion of mortgage insurance in structured transactions in 2005, compared to $14.8 billion written in 2004.

Types of Mortgage Risk

Prime Loans

We define prime loans as loans where the borrower’s Fair Isaac and Company (“FICO”) score is 620 or higher and the loan file meets “fully documented” standards of our credit guidelines and/or the GSE’s guidelines for fully documented loans. Prime loans represented 69.3% of our total primary mortgage risk in force at the end of 2005 and made up 58.3% of our primary new insurance written in 2005, compared to 63.4% of primary new insurance written in 2004. The default rate on prime loans was 3.6% at December 31, 2005, compared to 3.2% at December 31, 2004. Claims paid on prime loans were $121.3 million in 2005, compared to $140.8 million in 2004.

 

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Non-Prime Loans

We believe that non-prime lending programs represent an area of future growth in the mortgage insurance industry, and we have increased, and expect to continue to increase, our insurance written in this area. During 2005, non-prime business accounted for $17.8 billion or 41.7% of our primary new insurance written in our mortgage insurance business (63.3% of which was Alternative-A or “Alt-A”), compared to $16.4 billion or 36.6% in 2004 (61.9% of which was Alt-A). At December 31, 2005, non-prime insurance in force was $34.7 billion or 31.7% of total primary insurance in force (61.1% of which was Alt-A), compared to $35.7 billion or 31.0% of total primary insurance in force at December 31, 2004 (61.9% of which was Alt-A).

Within our non-prime mortgage insurance program, we have defined three categories of loans that we insure: Alt-A, A minus and B/C loans. We use our own proprietary statistical models to price our mortgage insurance business to produce appropriate risk-adjusted rates of return. We continue to limit our participation in these non-prime markets to mostly Alt-A and A minus loans rather than B/C loans, and we have targeted the business we insure to specific lenders that we believe have proven results and servicing experience in this area.

Alt-A Loans.    We define Alt-A loans as loans where the borrower’s FICO score is 620 or higher and where the loan documentation has been reduced or eliminated. Because of the reduced documentation, we consider Alt-A business to be more risky than prime business, particularly Alt-A loans to borrowers with FICO scores below 660. We insure Alt-A loans with FICO scores ranging from 620 to 660, but we have measures in place to limit this exposure, and we charge a significantly higher premium for the level of increased risk on these loans. Alt-A loans tend to have higher balances than other loans that we insure because they are often more heavily concentrated in high-cost areas. Alt-A loans represented 17.5% of total primary mortgage risk in force at the end of 2005 and made up 26.4% of our primary new insurance written in 2005, compared to 22.7% of primary new insurance written in 2004. The default rate on Alt-A loans was 6.4% at December 31, 2005, compared to 6.5% at December 31, 2004. Claims paid on Alt-A loans were $79.4 million in 2005, compared to $85.1 million in 2004.

A Minus Loans.    We define A minus loans as loans where the borrower’s FICO score ranges from 575 to 619. This product comes to us both through structured transactions in which the insurance typically is lender-paid and through flow business in which the borrower pays the insurance premium. We also classify loans with certain characteristics originated within the GSE’s automated underwriting system as A minus, regardless of the FICO score. Our pricing of A minus loans is tiered into four levels based on the FICO score, with increased premiums at each descending tier of FICO score. We receive a significantly higher premium for insuring this product that we believe is commensurate with the increased default risk. A minus loans represented 10.5% of our total primary mortgage risk in force at the end of 2005, compared to 10.4% at the end of 2004, and made up 11.7% of our primary new insurance written in 2005, compared to 11.2% of primary new insurance written in 2004. The default rate on A minus loans was 14.2% at December 31, 2005, compared to 11.2% at December 31, 2004. Claims paid on A minus loans were $67.5 million in 2005, compared to $69.6 million in 2004.

B/C Loans.    We define B/C loans as loans where the borrower’s FICO score is below 575. We have no approved programs to insure B/C loans. However, some pools of loans submitted for insurance as structured transactions contain a small percentage of B/C loans. We price these structured transactions to reflect a higher premium on B/C loans due to the increased default risk associated with these types of loans. B/C loans represented 2.7% of total primary mortgage risk in force at the end of 2005, compared to 2.4% at the end of 2004, and made up approximately 3.6% of total primary new insurance written during 2005, compared to 2.8% of total primary new insurance written in 2004. The default rate on B/C loans was 21.8% at December 31, 2005, compared to 15.7% at December 31, 2004. Claims paid on B/C loans were $18.5 million in 2005, compared to $25.8 million in 2004.

Premium Rates

We cannot change our premium rates after we issue coverage. Accordingly, we determine premium rates in our mortgage insurance business on a risk-adjusted basis that includes borrower, loan and property

 

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characteristics. We use proprietary default and prepayment models to project the premiums we should charge, the losses and expenses we should expect to incur and the capital we need to hold in support of our risk. We establish pricing in an amount that we expect will allow a reasonable return on allocated capital. Despite the analytical methods we employ, our premiums earned and the associated investment income on those premiums may ultimately prove to be inadequate to compensate for the losses that we may incur. An increase in the amount or frequency of claims beyond the levels contemplated by our pricing assumptions could have a material adverse effect on our business, financial condition and operating results.

Premiums for our mortgage insurance may be paid by the lender, which will in turn charge a higher interest-rate to the borrower, or directly by the borrower. We price our borrower-paid flow business based on rates that we have filed with the various state insurance departments. We generally price our structured business and some lender-paid business insurance based on the specific characteristics of the insured portfolio, which can vary significantly from portfolio to portfolio depending on a variety of factors, including the quality of the underlying loans, the credit history of the borrowers, the amount of coverage required and the amount, if any, of credit protection in front of our risk exposure.

Captive Reinsurance

We and other companies in the mortgage insurance industry participate in reinsurance arrangements with mortgage lenders commonly referred to as “captive reinsurance arrangements.” Under captive reinsurance arrangements, a mortgage lender typically establishes a reinsurance company that assumes part of the risk associated with the portfolio of that lender’s mortgages insured by us on a flow basis (as compared to mortgages insured in structured transactions, which typically are not eligible for captive reinsurance arrangements). In return for the reinsurance company’s assumption of a portion of the risk, we cede a portion of its mortgage insurance premiums to the reinsurance company. In most cases, the risk assumed by the reinsurance company is an excess layer of aggregate losses that would be penetrated only in a situation of adverse loss development, such as losses brought on by significant national or regional downturns in the real estate market.

Because of many factors, including the incentives for mortgage lenders to funnel relatively higher-quality loans through their captive reinsurers due to the risk-sharing feature, we continue to evaluate the level of revenue sharing against risk sharing on a customer-by-customer basis as part of our customer profitability analysis. We believe that all of our captive reinsurance arrangements transfer risk to the captive reinsurer at a premium level that is commensurate with the risk. We and other mortgage insurers have faced private lawsuits alleging, among other things, that our captive reinsurance arrangements constitute unlawful payments to mortgage lenders under the anti-referral fee provisions of the Real Estate Settlement Practices Act of 1974 (“RESPA”). We also have been subject to inquiries from the New York insurance department relating to our captive reinsurance arrangements. For more information, see “Regulation—Federal Regulation—RESPA” in this Item 1.

We had approximately 50 active captive reinsurance agreements in place at December 31, 2005, compared to 52 that were in place at December 31, 2004. We may enter into new agreements or modify existing agreements in 2006, which may include agreements with large national lenders. Premiums ceded to captive reinsurance companies in 2005 were $92.9 million, representing 11.5% of total direct mortgage insurance premiums earned, as compared to $87.3 million, or 11.3% in 2004. Primary new insurance written in 2005 that had captive reinsurance associated with it was $12.2 billion, or 28.7% of our total primary new insurance written, as compared to $17.8 billion, or 39.7% in 2004. These percentages can be volatile as a result of increases or decreases in the volume of structured transactions, which are not typically eligible for captive reinsurance arrangements, such as has occurred over the last several years.

We also have entered into risk/revenue-sharing arrangements with the GSEs whereby the primary insurance coverage amount on certain loans is recast into primary and pool insurance and our overall exposure is reduced in return for a payment made to the GSEs. Premiums ceded under these programs in 2005 and 2004 were not significant.

 

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Delegated Underwriting

We have a delegated underwriting program with a significant number of our customers. Our delegated underwriting program allows lenders to commit us to insure loans that meet agreed-upon underwriting guidelines. Delegated loans are submitted to us in various ways—fax, electronic data interchange and through the Internet. Our delegated underwriting program currently involves only lenders that are approved by our risk management area, and we routinely audit loans submitted under this program. Once we accept a lender into our delegated underwriting program, however, we generally insure all loans submitted to us by that lender even if the lender has not followed our specified underwriting guidelines. A lender could commit us to insure a number of loans with unacceptable risk profiles before we discover the problem and terminate that lender’s delegated underwriting authority. We mitigate this risk through periodic, on-site reviews of selected delegated lenders by our Portfolio Quality Assurance department. See “Risk Management—Mortgage Insurance—Portfolio Quality Assurance” in this Item 1. As of December 31, 2005, approximately 28% of the insurance in force on our books was originated on a delegated basis, compared to 30% as of December 31, 2004.

Contract Underwriting

Our mortgage insurance business also utilizes its underwriting skills to provide an outsourced underwriting service to its customers known as contract underwriting. For a fee, we underwrite fully documented loan files for secondary market compliance (i.e., for sale to GSEs), while concurrently assessing the file for mortgage insurance, if applicable. Contract underwriting continues to be a popular service to our mortgage insurance customers. During 2005, loans underwritten via contract underwriting accounted for 11.7% of applications, 11.4% of commitments for insurance and 10.1% of insurance certificates issued.

We give recourse to our customers on loans that we underwrite for compliance. Typically, we agree that if we make a material error in underwriting a loan, we will provide a remedy to the customer by repurchasing or placing additional mortgage insurance on the loan, or by indemnifying the customer against loss. Providing these remedies means we assume some credit risk and interest-rate risk if an error is found during the limited remedy period, which may be up to 7 years, but typically is only two years. Rising mortgage interest rates or an economic downturn may expose the mortgage insurance business to an increase in such costs. During 2005, we processed requests for remedies on less than 1% of the loans underwritten and sold a number of loans previously acquired as part of the remedy process. We paid losses for sales and remedies from reserves in 2005 of approximately $11.7 million. In 2004, we had provisions for contract underwriting remedies of $11.9 million. In 2005, our provisions were approximately $8.0 million, and our reserve for such expenses at December 31, 2005 was $3.6 million. We closely monitor this risk and negotiate our underwriting fee structure and recourse agreements on a client-by-client basis. We also routinely audit the performance of our contract underwriters to ensure that customers receive quality underwriting services. This audit function is performed by our Portfolio Quality Assurance department. See “Risk Management—Mortgage Insurance—Portfolio Quality Assurance” in this Item 1 below.

Financial Guaranty Business

We entered the financial guaranty business through our acquisition in 2001 of EFSG. Financial guaranty insurance generally provides an unconditional and irrevocable guaranty to the holder of a financial obligation of full and timely payment of scheduled principal and interest when due.

Our financial guaranty business offers the following products:

 

    insurance of municipal obligations, which include tax-exempt and taxable indebtedness of states, counties, cities, utility districts and other political subdivisions, bonds issued by sovereign and sub-sovereign entities and financings for enterprises such as airports, public and private higher education and health care facilities, where the issuers of such obligations are typically rated investment grade (BBB-/Baa3 or higher);

 

   

insurance of structured finance transactions, consisting of funded and non-funded or “synthetic” asset-backed obligations that are payable from or tied to the performance of a specific pool of assets and that

 

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offer a defined cash flow. Examples include residential and commercial mortgages, a variety of consumer loans, corporate loans and bonds, equipment receivables, real and personal property leases and collateralized corporate debt obligations, including obligations of counterparties under derivative transactions and credit default swaps. The insured obligations in our financial guaranty business are generally rated investment-grade, without the benefit of our insurance;

 

    financial solutions products included in our structured direct business, consisting of guaranties of securities exchanges, excess-SIPC insurance for brokerage firms and excess-FDIC insurance for banks; and

 

    reinsurance of public finance, structured finance, financial solutions and trade credit obligations in which we generally rely on the underwriting performed by the primary insurer.

In October 2005, we announced that we would be exiting the trade credit reinsurance line of business. Accordingly, this line of business has been placed into run-off and we have ceased initiating new trade credit reinsurance contracts going forward. We expect that our existing trade credit reinsurance business, including claims paid, will take several years to run off, although we expect that the bulk of the remaining premiums will be earned and losses incurred over the next two years. Management does not consider the trade credit line of business to be a core part of our financial guaranty business, and we do not expect that our move to exit the trade credit reinsurance line of business will materially impact the overall profitability or business position of our financial guaranty business in the long term. However, in the short term, our decision to exit the trade credit reinsurance line of business will likely have a negative impact on certain financial measures for our financial guaranty business as this business line continues to run off. Trade credit insurance protects sellers of goods under certain circumstances against non-payment of their receivables and covers receivables where the buyer and seller are in the same country, as well as cross-border receivables. In the latter instance, the coverage sometimes extends to certain political risks (foreign currency controls, expropriation, etc.) that potentially could interfere with the payment from the buyer. In 2005, trade credit reinsurance accounted for 15.7% of financial guaranty’s net premiums written, down from 27.4% of financial guaranty’s net premiums written in 2004.

The following table summarizes the net premiums written and earned by our financial guaranty segment’s various products for 2005, 2004 and 2003:

 

     Year Ended December 31
     2005     2004     2003
     (In thousands)

Net premiums written:

      

Public finance direct

   $ 73,117     $ 52,279     $ 85,178

Public finance reinsurance

     77,797       74,777       81,877

Structured direct

     71,211       94,423       88,053

Structured reinsurance

     20,649       32,112       48,702

Trade credit reinsurance

     35,023       59,262       64,827
                      
     277,797       312,853       368,637

Impact of recapture (1)

     (54,742 )     (96,417 )     —  
                      

Total net premiums written

   $ 223,055     $ 216,436     $ 368,637
                      

Net premiums earned:

      

Public finance direct

   $ 32,533     $ 26,643     $ 18,277

Public finance reinsurance

     34,413       41,651       51,118

Structured direct

     79,617       78,292       73,720

Structured reinsurance

     20,440       33,001       48,497

Trade credit reinsurance

     49,309       60,236       56,951
                      
     216,312       239,823       248,563

Impact of recapture (1)

     (4,539 )     (24,892 )     —  
                      

Total net premiums earned

   $ 211,773     $ 214,931     $ 248,563
                      

(1) Amounts represent the immediate impact of the recapture of previously ceded business by one of the primary insurer customers of our financial guaranty reinsurance business in the first quarter of 2005 and another primary insurer customer in the first quarter of 2004.

 

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In our financial guaranty business, the issuer of an insured obligation generally pays the premiums for our insurance either in full at the inception of the policy or, in the case of most structured finance transactions, in monthly, quarterly, semi-annual or annual installments from the cash flow of the related collateral. Premiums for synthetic credit protection are generally paid in monthly, quarterly, semi-annual or annual installments, but occasionally all or a portion of the premium is paid upfront at the inception of the protection. In synthetic credit protection transactions, payment is due directly from our counterparty and is generally not restricted to the cash flows from the underlying obligation or collateral supporting the obligation. Since we depend on the corporate creditworthiness of our counterparty rather than the cash flows from the insured collateral for payment, we generally have a right to terminate synthetic credit protection without penalty to us if our counterparty fails to make timely payments to us under the terms of the synthetic credit transaction.

For public finance transactions, premiums are typically paid upfront and premium rates typically are stated as a percentage of debt service, which includes total principal and interest. For structured finance transactions, premiums are paid in installments over time and premium rates are typically stated as a percentage of the total principal. Premiums are generally non-refundable. Premiums paid in full at inception are recorded as revenue “earned” over the life of the insured obligation (or the coverage period for such obligation if shorter). Premiums paid in installments are generally recorded as revenue in the accounting period in which coverage is provided. The long and relatively predictable premium earnings pattern from our public finance transactions provides us with a relatively predictable source of future “earned” revenues. The establishment of a premium rate for a transaction reflects some or all of the following factors:

 

    issuer-related factors, such as the issuer’s credit strength and sources of income;

 

    servicer-related factors, such as the ability of our counterparty or third-party servicer to manage the underlying collateral and the servicer’s credit strength and sources of income;

 

    obligation-related factors, such as the type of issue, the type and amount of collateral pledged, the revenue sources and amounts, the existence of structural features designed to provide additional credit enhancement should collateral performance not meet original expectations, the nature of any restrictive covenants and the length of time until the obligation’s stated maturity; and

 

    insurer- and market-related factors, such as rating agency capital charges, competition, if any, from other insurers and the credit spreads in the market available to pay premiums.

The majority of insured public finance and structured finance transactions are guaranteed by triple-A rated financial guaranty insurers. As a AA/Aa3-rated company, our financial guaranty business mainly targets distinct niches in the capital markets. There is generally a greater interest cost savings to an issuer by using triple-A rated credit enhancement as compared to our AA/Aa3 rated credit enhancement. However, financial guaranty insurance provided by a lower-rated provider also can provide significant value over uninsured executions in markets where the triple-A rated financial guaranty insurance is unavailable or uneconomical. In some markets, issuers and other counterparties receive no additional rating agency credit or regulatory relief from triple-A rated enhancement than they do with our AA/Aa3 enhancement, so our enhancement in these markets may be more economical.

Public Finance

Financial guaranty of municipal obligations provides credit enhancement of bonds, notes and other evidences of indebtedness issued by states and their political subdivisions (for example, counties, cities or towns), school districts, utility districts, public and private non-profit universities and hospitals, public housing and transportation authorities and other public and quasi-public entities. Municipal bonds can be categorized generally into tax-backed bonds and revenue bonds. Tax-backed bonds, which include general obligation bonds, are backed by the taxing power of the governmental agency that issues them, while revenue bonds are backed by the revenue generated by a specific project such as bridge or highway tolls, or by rents or hospital fees. Insurance

 

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provided to the public finance market has been and continues to be a major source of revenue for our financial guaranty business. Public finance direct business represented 32.8% of financial guaranty net premiums written in 2005 (26.3% excluding the impact of the recapture in the first quarter of 2005), up from 24.2% in 2004 (16.7% excluding the impact of the recapture in the first quarter of 2004). See “Ratings” in this Item 1 for information regarding these recaptures.

Structured Finance

The structured finance market includes the market for both synthetic and funded asset-backed or mortgage-backed obligations as well as collateralized debt obligations (“CDOs”), which generally consist of multiple pools of assets, each of which is typically of a different credit quality or possesses different characteristics with respect to interest rates, amortization, and level of subordination. At December 31, 2005, we had $20.7 billion of notional exposure related to the direct insurance of 114 credit default swaps in structured transactions, compared to $10.7 billion related to 71 transactions at December 31, 2004. Structured finance direct business represented 31.9% of financial guaranty net premiums written in 2005 (25.6% excluding the impact of the recapture in the first quarter of 2005), down from 43.6% in 2004 (30.2% excluding the impact of the recapture in the first quarter of 2004). Structured direct net premiums written and earned for 2005 included $50.5 million and $59.1 million, respectively, of credit enhancement fees on derivative financial guaranty contracts, compared to $66.1 million and $50.3 million, respectively, in 2004 and $54.1 million and $42.0 million, respectively, in 2003.

Funded asset-backed obligations usually take the form of a secured interest in a pool of assets, often of uniform credit quality, such as commercial mortgages, credit card or auto loan receivables. Funded asset-backed securities also may be secured by a few specific assets such as utility mortgage bonds and multi-family housing bonds. In low interest rate environments and when credit spreads are tight, as was the case in 2005, our ability to participate in the funded asset-backed market is limited.

Synthetic transactions are tied to the performance of a pool of assets, but are not secured by those assets. Most of the synthetic transactions we insure are CDOs, where we typically assume credit risk on defined portfolios of corporate credits. A portion of these CDOs consist of synthetic mortgage-backed securities or other synthetic consumer asset-backed securities. The transfer of this type of credit risk is typically performed through synthetic credit default swaps. Credit default swaps may require settlement of a credit event without financial loss actually being incurred by the counterparty and are accounted for as derivatives in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted (“SFAS No. 133”). See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies—Derivative Instruments and Hedging Activity” in Item 7 below.

With respect to CDOs for which we provide credit protection, we generally are required to make payments to our counterparty upon the occurrence of a failure to pay interest or principal over a specified amount or other specified credit-related events related to the unsecured debt obligations or the bankruptcy of obligors contained within pools of investment grade corporate or asset-backed obligations. These investment-grade pools can range in size from 50 to 500 or more obligors. Typically, we provide protection up to a specified exposure amount that tends to range from $10.0 million to $20.0 million per obligor (but may be up to $40.0 million per obligor in specific transactions), with an aggregate exposure of $20.0 million to $450.0 million per transaction, though the exposure amounts vary on a transaction-by-transaction basis. To manage the amount of risk we incur on these transactions, we have set internal limits as to the aggregate risk per obligor, industry sector and tranche size that we are willing to insure, and we comply with applicable insurance regulations limiting the size and composition of the pools we insure. We also have developed a methodology for aggregating risk across insured pools. See “Risk Management—Financial Guaranty” in this Item 1 for additional information regarding our risk management.

With respect to synthetic credit default swaps covering a specific obligation rather than a pool of debt obligations or reference entities (as in the case of the synthetic CDO’s we insure as described above), our payment obligations to our counterparties are generally the same as those we have when insuring the underlying obligations. We agree to pay our counterparty should an underlying security or the issuer of such security suffer a

 

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specified credit event, such as nonpayment, bankruptcy or a reduction of the principal of the security as a result of defaults in the underlying collateral. For example, when providing synthetic credit protection for one or more specified obligations in derivative form, if an event occurred resulting in the acceleration of principal and interest on an underlying obligation, we generally would be responsible for paying these amounts to our counterparty on their regularly scheduled dates, despite the counterparty’s not holding the obligation or directly suffering a loss for such amount.

In addition, under corporate CDO’s and some other secondary market transactions for which we provide synthetic credit protection, we generally do not have recourse or other rights and remedies against the issuer and/or any related collateral for amounts we may be obligated to pay under the synthetic credit protection. Even when we have recourse or rights and remedies in a synthetic credit protection transaction, they are generally much more limited than the recourse, rights and remedies we generally have in our more traditional financial guaranty transactions.

The same obligor may exist in a number of our structured finance transactions. The 10 largest corporate obligors, measured by gross nominal exposures, in our direct written book as of December 31, 2005 ranged from $865 million to $1.5 billion, compared to a range of $487.0 million to $640.0 million as of December 31, 2004. However, because each transaction has a distinct subordination requirement, prior credit events would have to occur with respect to several obligors in the pool before we would have an obligation to pay in respect of any particular obligor, meaning that our risk adjusted exposure to each corporate obligor in a CDO pool is significantly less than our nominal exposure. We monitor not only the nominal exposure for each obligor for which we provide protection, but also risk-adjusted measures, taking into account, among other factors, our assessment of the relative risk that would be represented by direct exposure to the particular obligor and the remaining subordination in the transactions in which we are exposed to a particular obligor. Initial subordination before we are obligated to pay a claim ranges from 2.0% to 30.7% of the initial total pool size.

The following table shows the gross par amounts of structured finance transactions we originated in each of the years presented:

 

Type

   2005    2004    2003
     (In millions)

Collateralized debt obligations

   $ 11,152    $ 4,630    $ 4,986

Asset-backed obligations

     2,534      2,010      5,507

Other structured

     1,197      379      395
                    

Total structured finance

   $ 14,883    $ 7,019    $ 10,888
                    

The following table shows the gross par outstanding on structured finance transactions for each of the years presented:

 

Type

   2005    2004    2003
     (In millions)

Collateralized debt obligations

   $ 22,736    $ 13,156    $ 10,187

Asset-backed obligations

     6,024      7,927      14,019

Other structured

     1,810      912      1,010
                    

Total structured finance

   $ 30,570    $ 21,995    $ 25,216
                    

The net par originated and outstanding on our structured finance transactions was not materially different from the gross par originated and outstanding at each period because we do not cede a material amount of business to reinsurers.

 

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Reinsurance

We provide reinsurance on direct financial guaranties written by other primary insurers or “ceding companies.” We have reinsurance agreements with several of the triple-A rated financial guaranty primary insurers. These reinsurance agreements generally are subject to termination: (i) upon written notice by either party (ranging from 90 to 120 days) before the specified deadline for renewal; (ii) at the option of the ceding company if we fail to maintain certain financial, regulatory and rating agency criteria that are equivalent to or more stringent than those that our financial guaranty operating subsidiaries are otherwise required to maintain for their own compliance with the New York insurance law and to maintain a specified financial strength rating for the particular insurance subsidiary; or (iii) upon certain changes of control. Upon termination under the conditions set forth in (ii) and (iii) above, we may be required (under some of the reinsurance agreements) to return to the ceding company all unearned premiums, less ceding commissions, attributable to reinsurance ceded pursuant to these agreements. Upon the occurrence of the conditions set forth in (ii) above, regardless of whether or not an agreement is terminated, we may be required to obtain a letter of credit or alternative form of security to collateralize our obligation to perform under that agreement, or we may be obligated to increase the level of ceding commissions paid. These and other matters associated with a downgrade in our subsidiaries’ ratings are discussed in further detail in “Ratings” in this Item 1.

Reinsurance allows a ceding company to write greater single risks and greater aggregate risks while remaining in compliance with the risk limits and capital requirements of applicable state insurance laws and rating agency guidelines. State insurance regulators allow ceding companies to reduce the liabilities appearing on their balance sheets to the extent of reinsurance coverage obtained from licensed reinsurers or from unlicensed reinsurers meeting certain solvency and other financial criteria. Similarly, the rating agencies permit a reduction in both exposures and liabilities ceded under reinsurance agreements, with the amount of credit permitted dependent on the financial strength rating of the reinsurer. Some of our competitors have greater financial resources than we have, are better capitalized than we are and/or have been assigned higher ratings by one or more of the major rating agencies. In 2004, the laws applicable to New York-domiciled monoline financial guarantors were amended to permit them to use certain default swaps meeting applicable requirements as statutory collateral (i.e., to offset their statutory single-risk limits, aggregate risk limits, aggregate net liability calculations and contingency reserve requirements). This regulatory change, which makes credit default swaps a more attractive alternative to traditional financial guaranty reinsurance, may result in a reduced demand for traditional monoline financial guaranty reinsurance in the future. If we are unable to compete for desirable financial guaranty business, our business, financial condition and operating results could be adversely affected.

Merger of Radian Asset Assurance and Radian Reinsurance

Effective June 1, 2004, EFSG’s two main operating subsidiaries, Radian Asset Assurance Inc. (“Radian Asset Assurance”) and Radian Reinsurance Inc. (“Radian Reinsurance”) were merged, with Radian Asset Assurance as the surviving company. Through this merger, the financial guaranty reinsurance business formerly conducted by Radian Reinsurance was combined with the direct financial guaranty business conducted by Radian Asset Assurance. The merger also combined the assets, liabilities and stockholders’ equity of the two companies. Prior to the merger, Moody’s Investor Service (“Moody’s”) downgraded the insurance financial strength rating of Radian Reinsurance from Aa2 to Aa3. See “Ratings” in this Item 1 for a discussion of the financial impact of this downgrade. The combined company is now rated Aa3 (with a stable outlook) by Moody’s, AA (with a negative outlook) by S&P and AA (with a negative outlook) by Fitch.

Treaty and Facultative Arrangements

The principal forms of reinsurance agreements are treaty and facultative. Under a treaty arrangement, the ceding company is obligated to cede to us, and we are obligated to assume, a specified portion of all risks, within ranges, of transactions deemed eligible for reinsurance by the terms of the treaty. Limitations on transactions deemed eligible for reinsurance typically focus on size, security and ratings of the insured obligation. Each treaty is entered into for a defined term, generally one year, with renewals upon mutual consent and rights to early termination (subject to reinsurance risk extending thereafter for the life of the respective underlying obligations)

 

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under certain circumstances. The termination rights described above under “Reinsurance” are typical provisions for the termination of treaty reinsurance arrangements. In treaty reinsurance, there is a risk that the ceding company may select weaker credits or proportionally larger amounts to cede to us. We mitigate this risk by requiring the ceding company to retain a sizable minimum portion of each ceded risk and we include limitations on individual transactions and on aggregate amounts within each type of transaction. Under a facultative agreement, the ceding company has the option to offer to us, and we have the option to accept, a portion of specific risks, usually in connection with particular obligations. Unlike under a treaty agreement, where we generally rely on the ceding company’s credit analysis, under a facultative agreement, we often perform our own underwriting and credit analysis to determine whether to accept the particular risk. The majority of our financial guaranty reinsurance is provided under treaty arrangements, although facultative reinsurance is growing as a percentage of the total.

Proportional or Non-Proportional Reinsurance

We typically accept reinsurance risk on either a proportional or non-proportional basis. Proportional relationships are those in which we and the ceding company share a proportionate amount of the premiums and the losses of the risk group subject to reinsurance. In addition, we generally pay the ceding company a commission, which typically is related to the ceding company’s underwriting and other expenses in connection with obtaining the business being reinsured. Non-proportional relationships are those in which the losses, and consequently, the premiums paid are not shared by the ceding company and us on a proportional basis. Non-proportional reinsurance can be based on an excess-of-loss or first-loss basis. Under excess-of-loss reinsurance agreements, we provide coverage to a ceding company up to a specified dollar limit for losses, if any, incurred by the ceding company in excess of a specified threshold amount. A first-loss reinsurance agreement is a form of structural credit enhancement that provides coverage to the ceding company on a first dollar of loss up to a specified dollar limit for losses. Generally, we do not pay a commission for non-proportional reinsurance (although the factors affecting the payment of a ceding commission in proportional arrangements may be taken into account to determine the proportion of the aggregate premium paid to us). The majority of our financial guaranty reinsurance business is originated on a proportional basis.

European Operations

Through Radian Asset Assurance Limited (“RAAL”), we have additional opportunities to write financial guaranty insurance in the U.K. and, subject to compliance with the European passporting rules, in other countries in the European Union. In particular, we expect that RAAL will continue to build its structured products business in the U.K. and throughout the European Union. RAAL accounted for $3.5 million of direct premiums written in 2005 (or 2.4% of financial guaranty’s 2005 direct premiums written), which is a $3.3 million increase from the $0.2 million of direct premiums written in 2004. In September 2004, the Financial Services Authority (the “FSA”) authorized Radian Financial Products Limited (“RFPL”), another subsidiary of Radian Asset Assurance, to transact as a Category A Securities and Futures Firm permitting it to act as a principal on credit default swap risk. Following receipt of this authorization, management decided that RFPL should focus its core business on arranging credit default swap risk for RAAL and Radian Asset Assurance. Accordingly, we expect to use RFPL solely for negotiating and arranging credit default swaps with counterparties located in the U.K. or other European countries with portions of the risk being assumed by RAAL and Radian Asset Assurance. As a result, we are in the process of lowering the category of authorization for RFPL commensurate with this more limited purpose.

Other Financial Guaranty Business

Through our ownership of EFSG, we owned a 36.0% interest in EIC Corporation Ltd. (“Exporters”), an insurance holding company that, through its wholly-owned insurance subsidiary licensed in Bermuda, insures mostly foreign trade receivables for multinational companies. In December 2004, we sold our interest in Exporters for $4.0 million, recording a loss of $1.2 million on the sale. Our financial guaranty business has provided significant reinsurance capacity to Exporters on a quota-share, surplus-share and excess-of-loss basis. We expect this business to run off over a period of approximately six years.

 

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Financial Services Business

The financial services segment includes the credit-based businesses conducted through our affiliates, C-BASS and Sherman. We own a 46% interest in C-BASS and a 34.58% interest in Sherman. C-BASS is a mortgage investment and servicing firm specializing in credit-sensitive, single-family residential mortgage assets and residential mortgage-backed securities. By using sophisticated analytics, C-BASS essentially seeks to take advantage of what it believes to be the mispricing of credit risk for certain assets in the marketplace. Sherman is a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets and charged-off high Loan-to-Value (“LTV”) mortgage receivables that it generally purchases at deep discounts from national financial institutions and major retail corporations and subsequently collects upon these receivables. In March 2005, Sherman acquired CreditOne, a credit card bank that provides Sherman with the ability to originate subprime credit card receivables. On June 24, 2005, we entered into agreements to restructure our ownership interest in Sherman. Before the restructuring, Sherman was owned 41.5% by us, 41.5% by Mortgage Guaranty Insurance Corporation (“MGIC”) and 17% by an entity controlled by Sherman’s management team.

As part of the restructuring, we and MGIC each agreed to sell a 6.92% interest in Sherman to a new entity controlled by Sherman’s management team, thereby reducing our ownership interest and MGIC’s ownership interest to 34.58% for each of us. In return, the new entity controlled by Sherman’s management team paid approximately $15.65 million (which resulted in a $3.3 million loss) to us and the same amount to MGIC. Regulatory approval for this transaction was received in August 2005, and our ownership interest was reduced to 34.58%, retroactive to May 1, 2005. Effective June 15, 2005, Sherman’s employees were transferred to the new entity controlled by Sherman’s management team, and this entity agreed to provide management services to Sherman. Sherman’s management team also agreed to reduce significantly its maximum incentive payout under its annual incentive plan for periods beginning on or after May 1, 2005. This has resulted in Sherman’s net income now being greater than it would have been without a reduction in the maximum incentive payout. We expect that our and MGIC’s share of Sherman’s net income will be similar to our respective shares before the restructuring because, although our percentage interest in Sherman is smaller than it was before the restructuring, Sherman’s net income is now greater than it would have been if the restructuring had not occurred.

In connection with the restructuring, we and MGIC each also paid $1 million for each of us to have the right to purchase, on July 7, 2006, a 6.92% interest in Sherman from the new entity controlled by Sherman’s management team for a price intended to approximate current fair market value. If either we or MGIC exercise our purchase right but the other fails to exercise its purchase right, the exercising party also may exercise the purchase right of the non-exercising party. Our and MGIC’s representation on Sherman’s board of managers will not change regardless of which party or parties exercise the purchase right.

The financial services segment formerly included the operations of RadianExpress.com Inc. (“RadianExpress”). In December 2003, we announced that we would cease operations at RadianExpress. Our decision followed our receipt in July 2003 of a decision by the California Commissioner of Insurance sustaining a California cease and desist order applicable to the offering of our Radian Lien Protection product. During the first quarter of 2004, RadianExpress, which was the entity through which Radian Lien Protection sales would have been processed, ceased processing new orders. RadianExpress completed the final processing of all remaining transactions in the first quarter of 2005 and was dissolved in the last quarter of 2005.

Other

We are seeking to sell or otherwise dispose of the remaining assets and operations of Singer Asset Finance Company L.L.C. (“Singer”), a wholly-owned subsidiary of EFSG. Singer had been engaged in the purchase, servicing and securitization of assets, including state lottery awards and structured settlement payments, and currently is operating on a run-off basis. Singer’s run-off operations consist of servicing and/or disposing of Singer’s previously originated assets and servicing its non-consolidated special purpose vehicles. The results of this subsidiary are not material to our financial results.

 

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Radian Asset Assurance is engaged on a run-off basis in reclamation bonds for the coal mining industry and surety bonds covering closure and post-closure obligations of landfill operations that were previously conducted through its subsidiary, Van-Am Insurance Company, Inc. (“Van-Am”). Van-Am was dissolved effective December 2005, and the business previously conducted by it has been novated to Radian Asset Assurance (most of which business had been previously reinsured by Radian Asset Assurance). This business is not material to our financial results.

Defaults and Claims

Mortgage Insurance

The default and claim cycle in our mortgage insurance business begins with our receipt of a default notice from the insured lender. Generally, our master policy of insurance requires the insured to notify us of a default within 15 days after the loan has become 60 days past due. In addition, the insured must notify us within 45 days if the borrower fails to remit his or her first payment. Defaults can occur due to a variety of factors, including death or illness, unemployment or other events reducing the borrower’s income, such as divorce or other marital problems.

The following table shows the number of primary and pool loans that we have insured, related loans in default and the percentage of loans in default (default or delinquency rate) as of the dates indicated:

 

     December 31  
     2005     2004     2003  

Primary Insurance:

      

Prime

      

Number of insured loans in force

   567,574     610,480     640,778  

Number of loans in default (1)

   20,685     19,434     22,156  

Percentage of loans in default

   3.6 %   3.2 %   3.5 %

Alt-A

      

Number of insured loans in force

   118,336     128,010     138,571  

Number of loans in default (1)

   7,510     8,339     7,343  

Percentage of loans in default

   6.3 %   6.5 %   5.3 %

A Minus and below

      

Number of insured loans in force

   101,414     104,672     110,054  

Number of loans in default (1)

   16,015     12,678     12,497  

Percentage of loans in default

   15.8 %   12.1 %   11.4 %

Total Primary Insurance

      

Number of insured loans in force

   787,324     843,162     889,403  

Number of loans in default (1)

   44,210     40,451     41,996  

Percentage of loans in default

   5.6 %   4.8 %   4.7 %

Pool Insurance (2):

      

Number of insured loans in force

   651,051     583,568     599,140  

Number of loans in default (1)

   10,194 (3)   6,749     5,738  

Percentage of loans in default

   1.6 %   1.2 %   1.0 %

(1) Loans in default exclude loans that are 60 or fewer days past due and loans in default for which we believe it is unlikely that we will be liable for a claim payment, in each case as of December 31 of each year.
(2) Includes traditional prime and non-prime first-lien mortgages. Prior to 2005, also included modified pool insurance. Beginning in 2005, all new insurance written as modified pool insurance was classified as primary insurance due to the nature of the loan.
(3) Includes approximately 2,400 defaults where we are in a second-loss position.

 

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The default rate in our mortgage insurance business is subject to seasonality. Historically, our mortgage insurance business experiences a fourth quarter seasonal increase in defaults as a result of higher defaults reported during the winter months. Regions of the United States may experience different default rates due to varying economic conditions. The following table shows the primary mortgage insurance default rates by our defined regions as of the dates indicated, including prime and non-prime loans:

 

     December 31  
     2005     2004     2003  

Southwest

   7.76 %   5.15 %   4.83 %

Southeast

   6.94     5.53     5.31  

Mid-Atlantic

   6.93     6.43     5.88  

Midwest

   5.57     5.00     4.70  

Florida and Georgia

   5.25     4.94     4.98  

Northeast

   5.06     4.84     4.87  

West

   2.87     3.16     3.43  

Other (1)

   5.70     5.64     5.55  

(1) Includes the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands.

As of December 31, 2005, the two states with the highest primary mortgage insurance default rates were Louisiana and Mississippi, at 19.6% and 11.7%, respectively. During the fourth quarter of 2005, we experienced a significant increase in defaults in areas affected by Hurricanes Katrina, Rita and Wilma. For more information, see the discussion below in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview.” As of December 31, 2005, our two largest states, measured by risk in force, were Florida and California, with default rates of 4.1% and 2.1%, respectively.

In our mortgage insurance business, the insured lender is required to complete foreclosure proceedings and obtain title to the property before submitting a claim. It can take anywhere from three months to five years for a lender to acquire title to a property via foreclosure, depending on the state. Therefore, on average, we are not required to pay a claim until 12 to 18 months following a default on a mortgage.

Mortgage insurance claim volume is influenced by the circumstances surrounding the default. Claim volume also is affected by local housing prices and housing supply, interest rates and unemployment levels. Claim volume in our mortgage insurance business is not evenly spread throughout the coverage period of our book of business. Historically, most claims under mortgage insurance policies on prime loans occur during the third through fifth year after issuance of the policies, and on non-prime loans during the second through fourth year after issuance of the policies. After those peak years, the number of claims that we receive historically has declined at a gradual rate, although the rate of decline can be affected by macroeconomic factors. Approximately 76.5% of the primary risk in force, including most of our risk in force on non-traditional products, and approximately 38.6% of the pool risk in force at December 31, 2005 had not yet reached its anticipated highest claim frequency years. Because it is difficult to predict both the timing of originating new business and the run-off rate of existing business, it also is 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.

Our Investigative Services Department is responsible for identifying and investigating insured loans involving non-compliance with the terms of our master policy of insurance (or commitment letter for structured transactions) to ensure that claims are ultimately paid for, as agreed upon, valid and insurable risks. Much of our efforts involve the identification, investigation and reporting of mortgage fraud schemes that impact us. We coordinate our activities with legal counsel, law enforcement and fraud prevention organizations, and work to promote mortgage fraud awareness, detection and prevention among our personnel and client lenders.

 

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The following table shows claims paid information for primary mortgage insurance for the periods indicated:

 

     Year Ended December 31
     2005    2004
     (In thousands)

Direct claims paid:

     

Prime

   $ 121,297    $ 140,822

Alt-A

     79,371      85,124

A minus and below

     85,980      95,438

Seconds

     33,699      42,969
             

Total

   $ 320,347    $ 364,353
             

States with highest claims paid:

     

Texas

   $ 33,312    $ 32,783

Georgia

     28,548      31,874

Michigan

     26,728      18,480

North Carolina

     22,326      21,127

Colorado

     20,889      18,681

Average claim paid:

     

Prime

   $ 24.1    $ 24.1

Alt-A

     36.5      38.6

A minus and below

     27.0      27.1

Seconds

     22.0      27.0

Total

   $ 26.9    $ 27.7

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. A higher level of claims in Texas resulted, in part, from unemployment levels that were higher than the national average and lower home price appreciation. We believe that claims in the Midwest and Southeast have been rising (and will continue to rise) due to the weak industrial sector of the economy. We also believe that increased claims in Michigan and North Carolina are a result of declining economic conditions in those areas and that in Colorado, increased claims are a result of a significant decline in property values in that area.

Financial Guaranty

In the event of default, payments under a typical financial guaranty insurance policy that we provide or reinsure may not be accelerated without our or the primary insurer’s approval, and without such approval, the policyholder is entitled to receive payments of principal and interest on their regularly scheduled dates as if no default had occurred. The insurer often has remedies against other parties to the transaction, which may be exercised both before and after making payment, if any payment is necessary.

In our direct financial guaranty business, and with respect to some of the mortgage-backed securities insured by our mortgage insurance business, we typically are obligated to pay claims in an amount equal to defaulted payments on insured obligations on their respective due dates. In certain transactions in which we insure mortgage-backed securities, we also are obligated to pay principal when and if due, but only to the extent the outstanding principal balance of the insured obligation exceeds the value of the collateral insuring the bonds at the end of a reporting period (either monthly or quarterly). In our financial guaranty reinsurance line of business,

 

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net claim payments due to the ceding companies are typically deducted from premium amounts due to us. For public finance, asset-backed and other structured products insured by our financial guaranty business, we underwrite to a remote-expected loss standard, which means that under historical economic and operating environments, the assets providing the cash flow to pay the obligations insured by us should perform within the range anticipated at origination and should mature without our having to pay any claims. However, in a stressed or unexpectedly negative economic and operating environment, losses may occur. Accordingly, the patterns of claim payments tend to fluctuate and may be low in frequency and high in severity. For our trade credit reinsurance line of business, which is currently in run-off, we underwrote and priced this business to encompass historical loss patterns experienced by us and by ceding companies in similar businesses. The claim payments in trade credit tend to follow the historical loss pattern of overall global economic conditions.

Loss Mitigation

Mortgage Insurance

Our mortgage insurance loss management department consists of approximately 20 full-time employees dedicated to avoiding or minimizing losses. These experienced specialists pursue opportunities to mitigate loss both before and after claims are received.

Upon receipt of a valid claim in our traditional mortgage insurance business, we generally have the following three settlement options:

 

  (1) pay the maximum liability—determined by multiplying the claim amount by the applicable coverage percentage—and allow the insured lender to keep title to the property;

 

  (2) pay the amount of the claim required to make the lender whole, commonly referred to as the deficiency amount (not to exceed our maximum liability), following an approved sale; or

 

  (3) pay the full claim amount and acquire title to the property.

In general, we base our selection of a settlement option on the value of the property. In 2005, we settled 77% of claims by paying the maximum liability, 22% by paying the deficiency amount following an approved sale and less than 1% by paying the full claim amount and acquiring title to the property. Strong property values over the past few years have presented us with increased loss mitigation opportunities, thereby allowing us to avoid paying the maximum liability in over one out of five cases. If housing values fail to appreciate or begin to decline, the frequency of loans going to claim may increase and our ability to mitigate our losses on defaulted mortgages may be reduced, which could have a material adverse effect on our business, financial condition and operating results.

For pre-claim default situations, our specialists focus on the following activities to reduce losses:

 

    communication with the insured or the insured’s servicer to assure the timely and accurate reporting of default information;

 

    prompt and appropriate responses to all loss mitigation opportunities presented by the mortgage servicer; and

 

    proactive communication with the borrower, realtor or other individuals involved in the loss mitigation process to maximize results and to increase the likelihood of a completed loss mitigation transaction.

For post-claim default situations, our specialists focus on:

 

    reviewing and processing valid claims in an accurate and timely manner;

 

    promptly responding to post-sale savings presented by the insured; and

 

    aggressively acting to dispose of real estate that we acquire through the payment of claims.

 

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Financial Guaranty

In our financial guaranty business, our surveillance risk management department is responsible for monitoring credit quality or changes in the economic or political environment that could affect the timely payment of debt service on an insured transaction and mitigating losses should they occur. Our surveillance procedures include periodic review of all exposures, focusing principally on those exposures with which we have concerns. The specific procedures vary depending on whether the risk is public finance or structured finance, funded or synthetic, or direct or reinsurance, but the general procedures we follow for surveillance of risks include:

 

    defining the scope and depth of individual transaction review based on the credit profile of the transaction, its size and the specific transaction characteristics;

 

    review of any changes to the ratings for those transactions that have been assigned a public rating by any of the major rating agencies;

 

    regular review of available news and other information, including subscription services and public sources, regarding the issuer, the specific insured transaction or the related industry;

 

    periodic internal meetings between risk management and the staff of the relevant business line to discuss potential issues related to the applicable risks;

 

    review of financial and other information, including periodic audited financial statements, that we require the relevant issuer to supply, and such other information that becomes publicly or otherwise available regarding the issuer or the specific insured transaction;

 

    the preparation of written reports that provide an internal credit scoring and a report on transaction performance against expectation. We also review compliance with transaction-specific covenants;

 

    classification of credits as “intensified surveillance credits” when we determine that continued performance is questionable and, in the absence of a positive change, may result in a claim. A summary of our exposures to credits classified as “intensified surveillance credits” at December 31, 2005 and 2004 is included below in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Financial Guaranty—Year Ended December 31, 2005 Compared to Year Ended December 31, 2004—Provision for Losses;” and

 

    additional scrutiny of transactions over a specified amount or for which a covenant or compliance breach has occurred, including consideration of additional monitoring, discussion with industry experts, investment bankers, and others, and discussions with management and/or site visits.

In our financial guaranty reinsurance business, the primary obligation for the determination and mitigation of claims rests with the primary insurer. As a result, we rely on the primary insurers for loss determination and mitigation. We and the rating agencies conduct extensive reviews of the ceding companies and their procedures for determining and mitigating losses. Moreover, to help align the ceding company’s interests with our interests, the ceding company typically is required to retain at least 25% of the exposure on any single risk that we reinsure. As a part of its surveillance for reinsurance transactions, our financial guaranty business periodically re-evaluates the risk underwriting and management of treaty customers and monitors the reinsured portfolio’s performance.

As soon as our risk management department detects a problem, it works with the appropriate parties in an attempt to avoid a default. Loss mitigation can consist of restructuring the obligation, enforcing available security arrangements, working with the issuer to solve management or potential political problems and, if appropriate, exercising applicable rights to replace problem parties. Issuers typically are under no obligation to restructure insured transactions to prevent losses, but oftentimes do not want to be associated with an obligation that experiences losses. When appropriate, we discuss potential settlement options, either at our behest or that of our counterparties, regarding particular obligations with appropriate parties. On occasion, loss mitigation may include an early termination of our obligations, which could result in payments to or from us. To determine the

 

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appropriate loss mitigation approach, we generally consider various factors relevant to such insured transaction, which may include the current and projected performance of the underlying obligation (both on an expected case basis and stressed for more adverse performance and/or market circumstances that we expect), the likelihood that we will pay a claim in light of credit deterioration and reductions in available payment reserves and existing subordination, our total exposure to the obligation, expected future premium payments and the cost to us of pursuing such remedies.

Included on our list of intensified surveillance credits at December 31, 2005 is a derivative financial guaranty contract, representing $247.5 million in exposure or approximately 38% of our total exposure to intensified surveillance credits at December 31, 2005. While Radian Asset Assurance had not been required to pay a claim with respect to this credit, given the deterioration of the credit quality of the portfolio of high-yield debt obligations underlying this transaction, the significant amount of time before the expiration of this risk in 2013 and our large notional exposure to this credit, Radian Asset Assurance recently engaged its counterparty in negotiations aimed at limiting our exposure arising from this credit. On March 2, 2006, Radian Asset Assurance entered into a settlement agreement with respect to this transaction and the one other derivative financial guaranty contract insured by Radian Asset Assurance with this same counterparty. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Financial Guaranty—Year Ended December 31, 2005 Compared to Year Ended December 31, 2004—Provision for Losses” in Item 7 below for more information regarding the settlement of this transaction.

We believe that early detection and continued involvement by our surveillance risk management department has reduced claims.

Reserve for Losses

We establish reserves to provide for losses and the estimated costs of settling claims in both our mortgage insurance and financial guaranty businesses. Setting loss reserves in both businesses involves significant use of estimates with regard to the likelihood, magnitude and timing of a loss. We have determined that the establishment of loss reserves in our businesses constitutes a critical accounting policy. Accordingly, a more detailed description of our policies is contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies—Reserve for Losses” included in Item 7 below and in Notes 2 and 6 to our Consolidated Financial Statements.

Mortgage Insurance

In our mortgage insurance business, reserves for losses generally are not established until we are notified that a borrower has missed two payments. We also establish reserves for associated loss adjustment expenses (“LAE”), consisting of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. Statement of Financial Accounting No. 60, “Accounting and Reporting by Insurance Enterprises, Standards (“SFAS No. 60”) specifically excludes mortgage guaranty insurance from its guidance relating to the reserve for losses. We maintain a database of claim payment history and use models, based on loan characteristics, including the status of the loan as reported by its servicer, as well as more static factors, such as the estimated foreclosure period in the area where a default exists, to help determine the appropriate loss reserve at any point in time. As a delinquency proceeds toward foreclosure, there is more certainty around these estimates as a result of the aging of the delinquent loan. If a default cures, the reserve for that loan is removed from the reserve for losses and LAE. This curing process causes an appearance of a reduction in reserves from prior years if the reduction in reserves from cures is greater than the additional reserves for those loans that are nearing foreclosure or have become claims. All estimates are continually reviewed and adjustments are made as they become necessary. We generally do not establish reserves for mortgages that are in default if we believe that we will not be liable for the payment of a claim with respect to that default. For example, for those defaults in which we are in a second-loss position, we calculate what the reserve would have been if there had been no deductible. If the existing deductible is greater than the reserve amount for any given default, we do not establish a reserve for the default. Consistent with accounting principles generally accepted in the United States of America (“GAAP”) and industry accounting practices, we do not establish loss reserves for expected future claims on insured mortgages that are not in default or believed to be in default.

 

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In January 2005, we implemented a revised modeling process to assist us in establishing reserves in the mortgage insurance business. In recent years, with the growth in the Alt-A and other non-prime business, the change in the portfolio mix required us to segment the portfolio and evaluate the reserves required for each product differently. The previous model had been designed for a prime product only and needed to be updated with years of additional data. The revised model differentiates between prime and non-prime products and takes into account the different loss development patterns and borrower behavior that is inherent in these products. The model calculates a range of reserves by product and a midpoint for each product based on historical factors. We then evaluate other conditions, such as current economic conditions, regional housing conditions and the reliability of historical data for new products, to determine if an adjustment to the midpoint calculated by the model is necessary. At December 31, 2005, we made a judgment to reserve at a level within this range, but slightly above the midpoint, given the uncertainty around the ultimate performance of our non–prime products and the potential overpricing in certain housing markets. The new model did not result in an adjustment to the overall reserve for losses that we recorded.

We do not establish reserves for losses on mortgage insurance derivatives. Mortgage insurance derivatives are recorded at fair value in accordance with SFAS No. 133. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies—Derivative Instruments and Hedging Activity” in Item 7 below.

The following table presents information relating to our liability for unpaid mortgage insurance claims and related expenses:

 

     2005     2004    2003  
     (In millions)  

Balance at January 1

   $ 559.6     $ 513.5    $ 484.7  

Add losses and LAE incurred in respect of default notices received in:

       

Current year

     445.9       386.9      329.0  

Prior years

     (86.8 )     14.0      (19.7 )
                       

Total incurred

     359.1       400.9      309.3  
                       

Deduct losses and LAE paid in respect of default notices received in:

       

Current year

     47.0       45.5      39.4  

Prior years

     275.5       309.3      241.1  
                       

Total paid

     322.5       354.8      280.5  
                       

Balance at December 31

   $ 596.2     $ 559.6    $ 513.5  
                       

The following table shows our mortgage insurance reserves by category:

 

     Year Ended December 31
     2005    2004    2003
     (In millions)

Primary Insurance

        

Prime

   $ 179.2    $ 165.9    $ 153.4

Alt-A

     137.4      160.8      148.7

A minus and below

     190.3      147.6      136.4

Pool Insurance

     44.1      43.0      39.8

Seconds

     35.9      37.6      35.2

NIMs/other

     9.3      4.7      —  
                    

Total

   $ 596.2    $ 559.6    $ 513.5
                    

 

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Financial Guaranty

We establish loss reserves on our non-derivative financial guaranty contracts. We establish case reserves for specifically identified impaired credits that have defaulted and allocated non-specific reserves for specific credits that we expect to default. In addition, we establish unallocated non-specific reserves for our entire portfolio based on estimated statistical loss probabilities. Generally, when a case reserve is established or adjusted, an offsetting adjustment is made to the non-specific reserves (allocated or unallocated, as applicable). We do not establish reserves on our derivative financial guaranty contracts. Instead, gains and losses on direct derivative financial guaranty contracts are derived from internally generated models that take into account both credit and market spreads and are recorded on our Consolidated Financial Statements. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies—Derivative Instruments and Hedging Activity” in Item 7 below for a discussion of how we account for derivatives under SFAS No. 133.

In January and February of 2005, we discussed with the SEC staff, both separately and together with other members of the financial guaranty industry, the differences in loss reserve practices followed by different financial guaranty industry participants. On June 8, 2005, the Financial Accounting Standards Board (the “FASB”) added a project to its agenda to consider the accounting by insurers for financial guaranty insurance. The FASB will consider several aspects of the insurance accounting model, including claims liability recognition, premium recognition and the related amortization of deferred policy acquisition costs. In addition, we also understand that the FASB may expand the scope of this project to include income recognition and loss reserving methodology in the mortgage insurance industry. Proposed and final guidance from the FASB regarding accounting for financial guaranty insurance is expected to be issued in 2006. When and if the FASB or the SEC reaches a conclusion on these issues, we and the rest of the financial guaranty and mortgage insurance industries may be required to change some aspects of our accounting policies. If the FASB or the SEC were to determine that we should account for our financial guaranty contracts differently, for example by requiring them to be treated solely as one or the other of short-duration or long-duration contracts under SFAS No. 60, this determination could impact our accounting for loss reserves, premium revenue and deferred acquisition costs, all of which are covered by SFAS No. 60. Management is unable to estimate what impact, if any, the ultimate resolution of this issue will have on our financial condition or operating results.

Our financial guaranty business generally experiences relatively higher loss levels in certain of its other insurance businesses, such as trade credit reinsurance, than in its public finance or structured products businesses. We believe that the higher premiums we receive in these businesses, as well as the lower relative capital charges, adequately compensate us for the risks involved. Reserves for losses and LAE for trade credit reinsurance are based on reports and individual loss estimates received from ceding companies, net of anticipated estimated recoveries under salvage and subrogation rights. In addition, a reserve is established for losses and LAE incurred but not reported on trade credit reinsurance.

 

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The following table shows information regarding the loss experience of our financial guaranty business for the years indicated:

 

     Year Ended December 31  
     2005     2004    2003  
     (In millions)  

Reserve for losses and LAE at January 1

   $ 241.4     $ 276.9    $ 139.9  

Less reinsurance recoverables

     2.3       2.3      2.2  
                       

Reserve for losses and LAE, net

     239.1       274.6      137.7  
                       

Provision for losses and LAE

       

Occurring in current year

     47.5       50.7      171.1  

Occurring in prior years

     (16.0 )     5.2      (4.3 )
                       

Total

     31.5       55.9      166.8  
                       

Payments for losses and LAE

       

Occurring in current year

     0.6       5.0      8.4  

Occurring in prior years

     64.1       88.5      21.5  
                       

Total

     64.7       93.5      29.9  
                       

Foreign exchange adjustment

     (3.8 )     2.1      —    
                       

Reserve for losses and LAE, net

     202.1       239.1      274.6  

Add reinsurance recoverables

     2.7       2.3      2.3  
                       

Reserve for losses and LAE at December 31

   $ 204.8     $ 241.4    $ 276.9  
                       

The provision for losses in 2005, 2004 and 2003 included $17.2 million, $34.3 million and $38.7 million, respectively, in connection with our trade credit reinsurance and surety businesses. In addition, the provision for losses in 2003 includes $111.0 million related to a single manufactured housing transaction originated and serviced by Conseco Finance Corp.

The following table shows our financial guaranty reserves by category:

 

     Year Ended December 31
      2005    2004    2003
     (In millions)

Financial Guaranty:

        

Case reserves

   $ 58.0    $ 98.4    $ 44.7

Allocated non-specific

     27.8      9.8      117.0

Unallocated non-specific

     54.9      56.7      46.7

Trade Credit Reinsurance and Other:

        

Case reserves

     22.1      34.1      43.4

IBNR (1)

     42.0      42.4      25.1
                    

Total

   $ 204.8    $ 241.4    $ 276.9
                    

(1) Incurred but not reported.

Risk Management

We consider effective risk management to be critical to our long-term financial stability. As such, we are looking to continuously enhance and integrate the risk management function across our business lines. Since the acquisition of EFSG, we have sought to take the best practices existing in each business line and integrate them into a company-wide risk management process. In 2005, we hired a Chief Risk Officer to enhance our corporate-wide

 

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credit processes, to further integrate our credit culture and to establish a single credit risk platform for analysis and valuation. The Chief Risk Officer is responsible for formulating corporate-wide credit policy, maintaining the economic capital methodology, assessing model integrity, establishing and monitoring risk limits, and insuring adequate supporting technological and human resources are in place. The respective heads of risk management in the mortgage insurance and financial guaranty businesses report directly to the Chief Risk Officer, with reporting responsibility to their business heads as well.

We have implemented a credit committee structure applicable to both our mortgage insurance and financial guaranty businesses. Overseeing this credit committee structure is the Enterprise Risk Credit Committee (the “ERC”), consisting mainly of members of company-wide senior management. The ERC oversees individual credit committees organized by product line. These product-line committees include representatives of the product line, along with members of our credit policy, finance and legal departments. We believe that this credit committee structure enables us to more fully utilize the intelligence, knowledge, experience and skills available throughout our company to evaluate the risk in each of our subsidiary’s insurance in force and in proposed transactions. In 2005, our board of directors formed a committee of independent directors to assist the board in its responsibilities related to the oversight of our credit and risk management policies and procedures, including, heightening board-level awareness of the impact of developing risk trends on our portfolio and plans. The Chief Risk Officer provides the committee with a quarterly review of all aspects of our credit risk, including notable transactions and a periodic assessment of the state of our risk management function.

In order to evaluate and review credit risk across the company, we have developed an internal economic capital methodology which allows us to attribute economic capital to each individual credit within our portfolio. As such, economic capital provides us with a uniform risk measure for analyzing and valuing risk that is consistent across the mortgage insurance and financial guaranty businesses. The ability to measure risk in the same units allows us to set company-wide position limits for our portfolio that account for both differences in loss probabilities for each credit and also for the correlation in loss probabilities across a portfolio of credits. 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 borne relative to the premium received.

Our economic capital methodology is heavily reliant on our models’ ability to quantify the underlying risks of default and prepayment. We have established a Model Review and Advisory Committee to address the issue of how well our models perform their respective risk assessments. This company-wide committee is made up of representatives of our quantitative modeling groups in each business line with the chairperson reporting directly to the Chief Risk Officer. The results of the committee’s model reviews are reported to and approved by the ERC.

In addition to credit risk, we evaluate our risk by reviewing market risk, currency risk, interest-rate risk, operational risk and legal risk across all of our businesses on a regular basis.

Mortgage Insurance

In 2005, in order to align the business to meet the needs of a changing business environment and to enhance credit risk awareness throughout the company, the mortgage insurance business moved to a business channel approach with four channels—Capital Markets, Strategic Accounts, Business Direct and International (see “Sales and Marketing—Mortgage Insurance” in this Item 1).

Our mortgage insurance business has a comprehensive risk management function that is imbedded in the channels as well as a separate department, Credit Policy & Compliance, with three distinct functions – Credit Policy, Portfolio Management and Risk Analytics and Portfolio Quality Assurance. The Credit Policy & Compliance group is focused on mortgage collateral and is responsible for overall credit policy creation and monitoring of compliance, portfolio management, limit setting and reporting, quantitative model creation and maintenance, comprehensive analytics and communication of credit related issues to management and our board of directors. This group reports directly to the Chief Risk Officer.

 

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Risk tolerance policies are established by our Credit Policy & Compliance group to allow each of the mortgage business channels to operate within a predetermined set of acceptable risk parameters. Compliance with these policies is enforced in two ways: first, all risk functions in each of the mortgage business channels indirectly report to our Credit Policy and Compliance group; and second, by direct monitoring and enforcement by our Portfolio Quality Assurance department and our Credit Policy department. Our Portfolio Management and Risk Analytics department provides further surveillance at the portfolio level and coordinates with the business channels, which provide surveillance at the lender and loan level.

Additionally, the Credit Policy & Compliance group chairs two of our credit committees—the Mortgage Credit Committee and the Mortgage Insurance Credit Committee. The Mortgage Credit Committee is responsible for approving all domestic and international financial guaranty and structured transactions that are conducted through Radian Insurance. The Mortgage Insurance Credit Committee is responsible for approving all mortgage insurance risks that are outside our published guidelines and for approving changes to our proprietary scoring models.

Credit Policy

The Credit Policy function is responsible for establishing and maintaining all mortgage insurance and financial guaranty credit risk policy around counterparty, portfolio, operational and structured risks secured by or involving mortgage collateral. Credit Policy is also responsible for approving policy exception requests from the business channels. Additional responsibilities include establishing and monitoring portfolio limits for product types, loan attributes, and geographic concentrations, maintaining the flow rate card pricing return policy, economic capital policy review, developing standard commitment contract provisions and administration of the credit committees.

Portfolio Management and Risk Analytics

Our Portfolio Management and Risk Analytics department is responsible for three major functions: Risk Analytics, Quantitative Models and Surveillance.

Risk Analytics is responsible for analyzing risk in the overall market and portfolio, building reserving models for the mortgage insurance business, and performing a data and systems management function for the mortgage insurance business. Risk analysis involves analyzing risks to the portfolio from the market (for example, analyzing the effects of changes in housing prices and interest rate movements) and analyzing risks from particular lenders, products, and geographic locales.

Quantitative Models estimates, implements and controls our proprietary Prophet Models® used to price any of our flow rate cards or structured transactions. Our proprietary Prophet Models® jointly estimate default and prepayment risk on all of our major product lines. These models and any changes to them are discussed in a Model Review Forum and ultimately are approved by the Mortgage Insurance Credit Committee. Quantitative Models also reviews and approves all third party models used to approve loans for delegated mortgage insurance.

Surveillance is responsible for providing an independent view of risks assumed in all structured transactions in our mortgage insurance business, among major lenders and on select deals. For all structured transactions in our mortgage insurance business, Surveillance rates the performance of each transaction by modeling cash flows and providing detailed analysis. Results are then shared with management in a quarterly committee review meeting.

Further responsibilities of Portfolio Management and Risk Analytics include economic research, presentations to our board of directors and assisting in financial reporting.

 

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Portfolio Quality Assurance

Our Portfolio Quality Assurance (“PQA”) department is responsible for ensuring that credit and related risks that impact the quality of our portfolio of insured loans, the quality of loans underwritten by us or our delegated lenders and the quality of critical data used within our business are assessed, investigated and communicated to management so that informed decisions can be made about loss prevention, mitigation, corrective action, pricing and/or other appropriate remedies.

The PQA group is responsible for ensuring that our underwriting procedures and guidelines (as well as those of lenders and the GSEs) are followed by service center, contract underwriting, and corporate operational support personnel through a loan re-underwriting and auditing program.

The PQA group also conducts risk-based reviews of our delegated underwriting business. The results of our reviews are used to improve the quality of the business the lender submits to us for insurance. Issues that are raised in our reports and not resolved within a time period acceptable to us will result in restriction or termination of the lender’s delegated underwriting authority.

The PQA group also identifies and recommends solutions for significant credit-related data integrity issues that do not meet our expectations for accuracy, consistency, ease of use, or availability. Under a continuous improvement program, the PQA group works with the technology area to resolve these data issues.

The PQA group also is responsible for executing a program of risk-based monitoring to evaluate the level of business channel and risk operations compliance with critical credit policies established by Credit Policy & Compliance, ensuring enforcement of credit policy and accountability on the part of the business channels and providing feedback to our Credit Policy department for continual review and improvement of existing policies.

Due Diligence on Structured Transactions

We believe that understanding our business partners is a key component of managing the risks posed by potential business transactions. Due diligence is performed by the business channels under policies issued by our Credit Policy & Compliance group. These due diligence reviews are precipitated either by a desire to develop an ongoing relationship with selected lenders, or by the submission of a proposed transaction by a given lender. Due diligence can take two forms: business-level and loan-level.

Our objective in business-level due diligence is to understand the lender’s business model in sufficient depth to determine whether we should have confidence in the lender as a potential long-term business partner and customer. Business-level due diligence may be performed on any prospective lender with whom a structured deal is contemplated and with whom we have had no recent business experience.

Loan-level due diligence is conducted on structured transactions (i) to determine whether appropriate underwriting guidelines have been adhered to and whether loans conform to our guidelines, (ii) to evaluate data integrity and (iii) to detect any fraudulent loans. The results of loan-level due diligence assist our mortgage insurance business in determining whether the pending transaction should be consummated and, in the event it is consummated, to provide data that can be used to determine appropriate pricing. The results also provide the mortgage insurance business with a database of information on the quality of a particular lender’s underwriting practices for future reference.

Reinsurance—Ceded

Radian Guaranty entered into variable quota-share treaties in each of the years 1994 through 1997 to reinsure its primary risk originated in each of these years and a portion of its pool risk written in 1997. Under these treaties, quota-share loss relief is provided to Radian Guaranty at varying levels ranging from 7.5% to

 

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15.0% based on the loss ratio on the reinsured book for a ten-year term on each origination year. The higher the loss ratio, the greater the potential reinsurance relief, which protects Radian Guaranty in adverse loss situations. A commission is paid by the reinsurer to Radian Guaranty, and the agreements are noncancelable during their ten-year terms by either party. As of December 31, 2005, the risk in force covered by the variable quota-share treaties was approximately $2.1 billion, or approximately 7.4% of our mortgage insurance business’s total primary and pool risk in force, and $52.8 million, or approximately 1.9% of our mortgage insurance business’s total pool risk in force on the remaining terms of the 1996 and 1997 origination years. We have not reinsured any additional business pursuant to variable quota-share treaties since 1998.

In addition, Radian Guaranty currently uses reinsurance from affiliated companies to remain in compliance with the insurance regulations of states that require that a mortgage insurer limit its coverage percentage of any single risk to 25%. These transactions have no impact on our Consolidated Financial Statements.

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 any of its policyholders, then the other party will step in and make the payment. The obligations of both parties under the agreement are unconditional and irrevocable; however, no payments will be made without prior approval by the insurance department of the payor’s state of domicile.

In 2004, we developed an approach for reinsuring our non-prime risk. The arrangement, which we refer to as “Smart Home,” effectively transfers risk from our portfolio to investors in the capital markets. Each transaction begins with the formation of an unaffiliated, offshore reinsurance company. We then enter into an agreement with the Smart Home reinsurer pursuant to which we agree to cede to the reinsurer a portion of the risk (and premium) associated with a portfolio of non-prime residential mortgage loans insured by us. The Smart Home reinsurer is funded in the capital markets through the issuance to investors of a series of separate classes of credit-linked notes. Each class 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 typically retain the risk associated with the first-loss coverage levels, and we may retain or sell, in a separate risk transfer agreement, the risk associated with the AAA rated or most remote coverage level. Holders of the Smart Home credit-linked notes bear the risk of loss from losses paid to us under the reinsurance agreement. The Smart Home reinsurer invests the proceeds of the notes in high-quality short-term investments approved by the rating agencies. Income earned on those investments and a portion of the reinsurance premiums that we pay are applied to pay interest on the notes as well as certain of the Smart Home reinsurer’s expenses. The rate of principal amortization of the credit-linked notes approximates the rate of principal amortization of the underlying mortgages.

Since August 2004, we have completed three Smart Home arrangements. Details of these transactions are as follows:

 

Date of Transaction

  

Pool of Non-prime

Mortgages

(Par Value)

  

Risk Ceded to

Reinsurer

(Par Value)

  

Notes Sold to
Investors

(Principal Amount)

December 2005 (1)

   $ 6.27  billion    $ 1.69  billion    $ 304.5 million

February 2005

   $ 1.68  billion    $ 495.6 million    $ 98.5 million

August 2004

   $ 882 million    $ 332.1 million    $ 86.1 million

(1) $172.9 million in principal amount of credit-linked notes was issued in December 2005. An additional $131.6 million in principal amount was issued in February 2006.

Smart Home allows us to continue to take on more non-prime risk and the higher premiums associated with insuring these types of products. As a result, we consider Smart Home arrangements to be important to our ability to effectively manage our risk profile and to remain competitive in the non-prime market. Approximately 13% of our non-prime risk in force is currently reinsured through Smart Home arrangements. Because the Smart Home arrangement ultimately depends on the willingness of investors to invest in Smart Home securities, we cannot be certain that Smart Home will always be available to us or will be available on terms that are acceptable

 

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to us. If we are unable to continue to use Smart Home arrangements, our ability to participate in the non-prime mortgage market could be limited, which could have a material adverse effect on our business, financial condition and operating results.

Premiums written (ceded) in 2005 and 2004 include $3.5 million and $1.0 million, respectively, related to the Smart Home transactions. There were no ceded losses in 2005 or 2004 as a result of the Smart Home transactions.

We and other companies in the mortgage insurance industry also participate in reinsurance arrangements with mortgage lenders commonly referred to as “Captive reinsurance arrangements.” See “Mortgage Insurance Business—Captive Reinsurance” in this Item 1.

Financial Guaranty

We consider effective risk management to be critical to our long-term financial stability and employ a comprehensive risk system. This incorporates the integration of company-wide risk management policies and processes as well as best practices of the financial guaranty industry. All transactions are subject to a thorough underwriting analysis, a comprehensive risk committee decision process, and if a transaction is booked, surveillance by an independent department.

Transaction underwriting includes the analysis of all credit and legal aspects as well as any specific risks that may be inherent in the transaction. Further, the financial guaranty business utilizes our proprietary internal economic capital model for risk analysis, valuation and as the basis for calculating RAROC. All transactions are subject to a credit committee decision process embedded in the business and governed by the ERC. Following documented protocols and voting rules, a transaction must be approved in order to qualify for financial guaranty insurance. For transactions that are approved and booked, responsibility transfers to the surveillance department for monitoring, review, feed back to underwriting and risk mitigation.

Underwriting

Our financial guaranty underwriting discipline incorporates a multi-discipline underwriting process for both direct transactions and reinsurance transactions.

Direct Transactions.    Direct transactions are sourced and screened by the financial guaranty business based upon established criteria and profitability requirements. Transactions that qualify for further analysis are subject to an underwriting process to determine the creditworthiness of the obligor. The underwriting analysis is performed at a transaction level, examining the fundamental ability and willingness of the obligor and/or issuer to meet the specified obligation. This analysis includes all aspects of the obligation ranging from the fundamental financial strength of the obligor to the structure of the transaction, which may dictate the payment structure. All transaction analysis is also subject to legal requirements.

Reinsurance Transactions.    The same disciplined approach and risk requirements are applied to our reinsurance transactions. As part of our ongoing business, the financial guaranty business assumes transactions from approved reinsurance companies on a treaty or facultative basis. The primary insurance company is subject to a review by us that involves an examination of its operating, underwriting and surveillance procedures, personnel, organization and existing book of business. Additionally, our long-standing relationships with these select companies provide for experience-based analysis and information. The treaty book of assumed business is governed by treaties, which specify the parameters of risk acceptance as well as other components. The facultative business is governed by agreements between the primary insurer and us, and each transaction is subject to individual underwriting, as outlined above. Moreover, the ceding company typically is required to retain at least 25% of the exposure on any single risk that we assume.

Surveillance

Financial guaranty also has a surveillance risk management department that is dedicated to the surveillance of our book of business. See “Loss Mitigation—Financial Guaranty” in this Item 1 for information regarding this department.

 

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Risk in Force

Mortgage Insurance

In recent years, we have faced increasing competition for traditional prime mortgages. As a result, we began offering mortgage insurance on increasing levels of non-prime mortgages, as well as new and emerging products such as interest-only loans and non-traditional products such as second mortgages, credit default swaps, NIMs and insurance of international mortgage transactions. Because we have limited historical data regarding these products and transactions, we attempt to limit our exposure to these transactions until we can perform rigorous risk analytics and generate enough data to assist us in predicting the attendant risks and adjust our pricing accordingly. We analyze our portfolio in a number of ways to identify any concentrations or imbalances in risk dispersion. We believe the performance of our mortgage insurance portfolio is affected significantly by:

 

    the geographic dispersion of the properties securing the insured loans;

 

    the quality of loan originations;

 

    the characteristics of the loans insured (including LTV, purpose of the loan, type of loan instrument and type of underlying property securing the loan); and

 

    the age of the loans insured.

Primary Risk in Force by Policy Year

The following table shows the percentage of our primary mortgage insurance risk in force by policy origination year as of December 31, 2005:

 

2000 and prior

   6.7 %

2001

   3.7  

2002

   7.7  

2003

   21.4  

2004

   27.6  

2005

   32.9  
      
   100.0 %
      

Geographic Dispersion

The following tables show the percentage of direct primary mortgage insurance risk in force by location of property for the top 10 states and top 15 metropolitan statistical areas (“MSAs”) in the United States as of December 31, 2005 and 2004:

 

     December 31  

Top Ten States

   2005     2004  

Florida

   9.5 %   9.1 %

California

   9.4     13.0  

Texas

   6.1     5.5  

New York

   5.7     5.7  

Georgia

   4.8     4.6  

Illinois

   4.5     4.3  

Ohio

   4.2     3.5  

Michigan

   3.5     3.0  

Arizona

   3.4     4.4  

New Jersey

   3.4     3.3  
            

Total

   54.5 %   56.4 %
            

 

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     December 31  

Top Fifteen MSAs

   2005     2004  

Chicago, IL

   3.6 %   3.7 %

Atlanta, GA

   3.4     3.4  

Phoenix/Mesa, AZ

   2.5     3.3  

New York, NY

   2.1     2.4  

Los Angeles – Long Beach, CA

   1.9     2.5  

Washington, DC – MD – VA

   1.8     2.1  

Philadelphia, PA – NJ

   1.8     1.7  

Detroit, MI

   1.8     1.6  

Riverside – San Bernardino, CA

   1.7     2.0  

Houston, TX

   1.7     1.6  

Miami – Hialeah, FL

   1.6     1.7  

Boston, MA – NH

   1.6     1.6  

Minneapolis – St. Paul, MN – WI

   1.6     1.7  

Nassau/Suffolk, NY

   1.5     1.5  

Tampa – St. Petersburg – Clearwater, FL

   1.4     1.3  
            

Total

   30.0 %   32.1 %
            

During 2005, we increased the level of mortgage insurance business that we have been writing internationally. We are now writing a product mix that varies according to location and includes mortgage insurance and reinsurance as well as credit enhancement for structured mortgage-backed transactions and credit default swaps. Our primary geographical focus includes locations in Europe, Asia and Australia. We have provided credit protection on pools of mortgages (including mortgage-backed securities in credit default swap form) in the U.K., the Netherlands, Germany and Denmark. In addition, we entered into two mortgage reinsurance transactions in Australia in 2004 and early in 2005. We’ve also recently entered into a relationship with one of the largest mortgage lenders in Hong Kong to serve as its exclusive provider of mortgage insurance. We are in the process of applying for branch authorization in Hong Kong.

Lender and Product Characteristics

Although geographic dispersion is an important component of overall risk diversification—our strategy has been to limit our exposure in the top 10 states and top 15 MSAs—we believe the quality of the risk in force should be considered in conjunction with other elements of risk diversification such as product distribution and our risk management and underwriting practices.

One of the most important indicators of claim incidence is the relative amount of borrower’s equity or down payment that exists in a home. The expectation of claim incidence on mortgages with LTVs between 90.01% and 95% (“95s”) is approximately two times the expected claim incidence on mortgages with LTVs between 85.01% and 90% (“90s”). We believe that the higher premium rates we charge on 95s adequately reflect the additional risk on these loans. We, along with the rest of our industry, have been insuring loans with LTVs between 95.01% and 97% (“97s”) since 1995 and loans with an LTV of between 97.01% and 100% (“100s”) since 2000. These loans are expected to have a higher claim incidence than 95s. Premium rates on 100s and 97s are higher than on 95s in an amount that we believe is commensurate with the additional risk and the higher expected frequency and severity of claims. We also insure loans having an LTV over 100%, although the amount that we insure is insignificant.

We believe that the risk of claim on non-prime loans is significantly higher than that on prime loans. Although higher premium rates and surcharges are charged to compensate for the additional risk, non-prime products are relatively new and have not been fully tested in adverse economic situations, so we cannot be certain that the premium rates we charge are adequate or that the loss performance will be at, or close to, expected levels. Our claim frequency on insured Adjustable-Rate Mortgages (“ARMs”) has been higher than on fixed-rate loans due to monthly payment increases that occur when interest rates rise.

 

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We believe that 15-year mortgages are less risky than 30-year mortgages, mainly as a result of the faster amortization and the more rapid accumulation of borrower equity in the property. Premium rates for 15-year mortgages are lower to reflect the lower risk.

The risk of claim also is affected by the type of property securing the insured loan. Loans on single-family detached housing are less likely to result in a claim than loans on other types of properties. Conversely, we generally consider loans on attached housing types, particularly condominiums and cooperatives, to be a higher risk due to the higher density of these properties. Our more stringent underwriting guidelines on condominiums and cooperatives reflect this higher expected risk.

We believe that the risk of claim on loans to borrowers who are relocating and loans originated by credit unions is low, and we offer lower premium rates on these loans commensurate with the lower risk. We also believe that loans on non-owner-occupied homes purchased for investment purposes are more likely to result in a claim and are subject to greater value declines than loans on either primary or second homes. Accordingly, we underwrite loans on non-owner-occupied investment homes more stringently, and we charge a significantly higher premium rate than the rate charged for insuring loans on owner-occupied homes.

It has been our experience that higher-priced properties experience wider fluctuations in value than moderately priced residences and that the high incomes of many people who buy higher-priced homes are less stable than those of people with moderate incomes. Underwriting guidelines for these higher-priced properties reflect this concern.

In addition, we insure interest-only mortgages, where the borrower pays only the interest charge on a mortgage for a specified period of time, usually five to ten years, after which the loan payment increases to include principal payments. These loans may have a heightened propensity to default because of possible “payment shocks” after the initial low-payment period expires and because the borrower does not automatically build equity as payments are made.

We also insure Option ARMs, a product that has recently become very popular in the market. Option ARMs offer a number of different monthly payment options to the borrower. One of these options is a minimum payment that is below the fully amortizing payment, which results in principal being added back to the loan balance and the loan balance continually increasing. This process is referred to as negative amortization. Additional premiums are charged against these Option ARMs as a result.

The following table shows the percentage of our direct primary mortgage insurance risk in force (as determined on the basis of information available on the date of mortgage origination) by the categories indicated as of December 31, 2005 and 2004:

 

     December 31  
     2005     2004  

Product Type:

    

Primary

     90.5 %     91.9 %

Pool (1)

     9.5       8.1  
                

Total

     100.0 %     100.0 %
                

Direct Primary Risk in Force (dollars in millions)

   $ 25,729     $ 27,012  

Lender Concentration:

    

Top 10 lenders (by original applicant)

     44.6 %     42.2 %

Top 20 lenders (by original applicant)

     56.7 %     58.0 %

LTV:

    

95.01% to 100.00%

     14.0 %     12.7 %

90.01% to 95.00%

     33.5       36.4  

85.01% to 90.00%

     37.1       38.1  

85.00% and below

     15.4       12.8  
                

Total

     100.0 %     100.0 %
                

 

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     December 31  
     2005     2004  

Loan Grade:

    

Prime

   69.3 %   68.2 %

Alt-A

   17.5     19.1  

A minus and below

   13.2     12.7  
            

Total

   100.0 %   100.0 %
            

Loan Type:

    

Fixed

   67.7 %   69.3 %

Adjustable-rate mortgage (“ARM”)(fully indexed)(2)

    

Less than 5 years

   21.7     22.2  

5 years and longer

   8.6     7.7  

ARM (potential negative amortization)(3)

    

Less than 5 years

   2.0     0.8  

5 years and longer

   —       —    
            
   100.0 %   100.0 %
            

FICO Score:

    

<=619

   12.3 %   12.2 %

620-679

   32.3     32.8  

680-739

   33.3     33.7  

>=740

   22.1     21.3  
            

Total

   100.0 %   100.0 %
            

Mortgage Term:

    

15 years and under

   3.2 %   3.6 %

Over 15 years

   96.8     96.4  
            

Total

   100.0 %   100.0 %
            

Property Type:

    

Non-condominium (principally single-family detached)

   93.1 %   93.9 %

Condominium or cooperative

   6.9     6.1  
            

Total

   100.0 %   100.0 %
            

Occupancy Status:

    

Primary residence

   92.3 %   92.7 %

Second home

   3.1     2.6  

Non-owner-occupied

   4.6     4.7  
            

Total

   100.0 %   100.0 %
            

Mortgage Amount:

    

Less than $300,000

   85.3 %   86.9 %

$300,000 and over

   14.7     13.1  
            

Total

   100.0 %   100.0 %
            

Loan Purpose:

    

Purchase

   63.4 %   63.2 %

Rate and term refinance

   19.6     19.3  

Cash-out refinance

   17.0     17.5  
            

Total

   100.0 %   100.0 %
            

(1) Includes traditional and, until 2005, modified pool insurance. Beginning in 2005, new insurance written on modified pool insurance was classified as primary insurance due to the nature of the loan.
(2) “Fully Indexed” refers to loans where payment adjustments are the same as mortgage interest-rate adjustments.
(3) Loans with potential negative amortization will not have increasing principal balances unless interest rates increase as contrasted with scheduled negative amortization where an increase in loan balance will occur even if interest rates do not change.

 

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Financial Guaranty

The following table shows the distribution of our financial guaranty insurance in force by type of issue and as a percentage of total financial guaranty insurance in force as of December 31, 2005 and 2004:

 

     Insurance in Force (1)  

Type of Obligation

   2005     2004  
     Amount    Percent     Amount    Percent  
     ($ in billions)  

Public finance:

          

General obligation and other tax-supported

   $ 31.9    28.9 %   $ 29.4    28.9 %

Healthcare and long-term care

     17.5    15.9       16.3    16.0  

Water/sewer/electric/gas and other investor-owned utilities

     12.7    11.5       13.6    13.4  

Airports/transportation

     8.2    7.4       9.1    9.0  

Education

     6.1    5.6       6.4    6.3  

Housing revenue

     1.2    1.1       1.3    1.3  

Other municipal (2)

     2.0    1.8       3.1    3.1  
                          

Total public finance

     79.6    72.2       79.2    78.0  
                          

Structured finance:

          

Collateralized debt obligations

     22.9    20.7       13.4    13.2  

Asset-backed obligations

     5.5    5.0       7.6    7.5  

Other structured

     2.3    2.1       1.4    1.3  
                          

Total structured finance

     30.7    27.8       22.4    22.0  
                          

Total

   $ 110.3    100.0 %   $ 101.6    100.0 %
                          

(1) Represents our proportionate share of the aggregate outstanding principal and interest payable on insured obligations.
(2) Represents other types of municipal obligations, none of which individually constitutes a material amount of our financial guaranty insurance in force.

 

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The following table shows information regarding our 10 largest single risks in financial guaranty by net par amounts outstanding as of December 31, 2005, and the credit rating assigned by S&P as of that date (in the absence of financial guaranty insurance) to each issuer:

 

Credit

  

Credit

Rating

  

Obligation Type

  

Aggregate

Net Par in

Force as of

December 31,

2005 (1)

               (In millions)

City of New York

   A+    General Obligation    $ 655.6

State of California

   A    General Obligation      545.1

New York & New Jersey Port Auth-Consolidated Bonds

   AA-    Transportation      474.2

U.S. Static Synthetic Investment-Grade CDO

   AAA    Collateralized Debt Obligation      450.0

U.S. Static Synthetic Investment-Grade CDO

   AAA    Collateralized Debt Obligation      450.0

U.S. Static Synthetic Investment-Grade CDO

   AAA    Collateralized Debt Obligation      450.0

U.S. Static Synthetic Investment-Grade CDO

   AAA    Collateralized Debt Obligation      450.0

U.S. Static Synthetic Investment-Grade CDO

   AAA    Collateralized Debt Obligation      416.0

U.S. Static Synthetic Investment-Grade CDO

   AAA    Collateralized Debt Obligation      416.0

City of Chicago

   AA-    General Obligation      404.6

(1) All of the above exposures on collateralized debt obligations are aggregate exposures whose underlying assets consist of a pool of a large number of corporate names. Our exposure to any individual corporate credit in the pool is typically between $10 and $20 million (although it could be as high as $40 million), and our exposure is subject to significant subordination.

The following table identifies our financial guaranty insurance in force as of December 31, 2005 and 2004 by credit ratings assigned by S&P to each issuer:

 

     As of December 31,  
     2005     2004  
    

Insurance

in Force

   Percent    

Insurance

in Force

   Percent  
     ($ in billions)  

AAA

   $ 22.6    20.5 %   $ 12.6    12.4 %

AA

     22.7    20.6       21.4    21.1  

A

     31.6    28.7       35.6    35.0  

BBB

     26.3    23.8       24.3    23.9  

IG

     1.3    1.2       1.1    1.1  

NIG

     2.8    2.5       3.1    3.1  

Not rated

     3.0    2.7       3.5    3.4  
                          

Total

   $ 110.3    100.0 %   $ 101.6    100.0 %
                          

 

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The following table shows the distribution by state of our financial guaranty insurance in force as of December 31, 2005 and 2004:

 

     December 31  

State

   2005     2004  

New York (1)

   23.9 %   18.7 %

California

   8.0     8.9  

Texas

   5.6     5.8  

Florida

   4.4     4.6  

Pennsylvania

   4.4     4.4  

Illinois

   4.0     4.2  

Massachusetts

   3.4     2.9  

New Jersey

   3.1     2.6  

Other (2)

   43.2     47.9  
            

Total

   100.0 %   100.0 %
            

(1) Includes a significant amount of structured products because they generally are issued in New York.
(2) Represents all remaining states, the District of Columbia and several foreign countries in which obligations insured and reinsured by our financial guaranty business arise, none of which individually constitutes greater than 3.1% and 2.6% of our financial guaranty net par outstanding as of December 31, 2005 or 2004, respectively.

For each of the years ended December 31, 2005, 2004 and 2003, financial guaranty premiums written attributable to foreign countries were approximately 4.2%, 6.2% and 5.9% of total financial guaranty premiums written. The decrease between 2004 and 2005 reflects our decision to exit the trade credit reinsurance line of business.

Customers

Mortgage Insurance

The principal customers of our mortgage insurance business are mortgage originators such as mortgage bankers, mortgage brokers, commercial banks and savings institutions. This is the case even though individual mortgage borrowers generally incur the cost of primary mortgage insurance coverage. We also offer lender-paid mortgage insurance, in which the mortgage lender or loan servicer pays the mortgage insurance premiums. The cost of the mortgage insurance is then passed on to the borrower in the form of higher interest rates. In 2005, approximately 70% of our primary mortgage insurance was originated on a lender-paid basis, compared to approximately 46% in 2004, much of which consisted of structured transactions. This lender-paid business is highly concentrated among a few large mortgage-lending customers.

To obtain primary mortgage insurance from us, a mortgage lender must first apply for and receive a master policy. Our approval of a lender as a master policyholder is based, among other factors, on our evaluation of the lender’s financial position and demonstrated adherence to sound loan origination practices. Our quality PQA function then monitors the master policyholder based on a number of criteria. See “Risk Management—Mortgage Insurance—Portfolio Quality Assurance” in this Item 1 for more information.

The number of individual primary mortgage insurance policies in force at December 31, 2005, was 787,324, compared to 843,162 at December 31, 2004, and 889,403 at December 31, 2003.

The top 10 mortgage insurance customers, measured by primary new insurance written, were responsible for 57.3% of our primary new insurance written in 2005, compared to 46.7% in 2004, and 53.3% in 2003. The

 

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largest single mortgage insurance customer (including branches and affiliates), measured by primary new insurance written, accounted for 10.6% of primary new insurance written during 2005, compared to 9.6% in 2004, and 10.4% in 2003. The amount of new business written in 2005 includes several structured transactions originated in the second and third quarter of 2005 composed of prime and non-prime mortgage loans originated throughout the United States.

Financial Guaranty

Our direct financial guaranty insurance customers consist of many of the major global financial institutions that structure, underwrite or trade securities issued in public finance and structured finance transactions. These institutions typically are large commercial or investment banks that focus on high-quality deals in the public finance and structured finance markets. Although we write financial guaranty insurance for obligations issued by or on behalf of many public finance and structured finance entities, these issuers are not our primary customers. Instead, the financial institutions underwriting or placing their securities generally are the ones who solicit the financial guaranty insurance for these transactions.

As a reinsurer of financial guaranty obligations, our financial guaranty business has maintained close and long-standing relationships with most of the primary financial guaranty insurers. We believe that these long-term relationships provide us with a comprehensive understanding of the market and of the financial guaranty insurers’ underwriting guidelines and reinsurance needs.

Our financial guaranty reinsurance customers consist mainly of the largest primary insurance companies licensed to write financial guaranty insurance and their foreign-based affiliates, including Ambac Assurance Corporation (“Ambac”); Financial Security Assurance Inc. (“FSAI”) and Financial Guaranty Insurance Company (“FGIC”). Primary trade credit insurers have also provided a significant portion of our financial guaranty insurance premiums in the past.

Our financial guaranty segment derives a substantial portion of its premiums written from a small number of direct primary insurers. In 2005, one primary insurer accounted for $43.3 million or 19.3% of the financial guaranty segment’s gross written premiums. Excluding the recapture in 2005, two primary insurers accounted for $74.9 million or 26.8% of the financial guaranty segment’s gross written premiums. In 2004, two primary insurers accounted for $82.1 million or 37.2% of the financial guaranty segment’s gross written premiums. Excluding the recapture in 2004, two primary insurers accounted for 25.9% of the financial guaranty segment’s gross written premiums. No other primary insurer accounted for more than 10% of the financial guaranty segment’s gross written premiums in either 2005 or 2004. The largest single customer of our financial guaranty business, measured by gross premiums written, accounted for 19.3% of gross premiums written during 2005 (15.5% excluding the recapture of business previously ceded to us by one of our primary insurer customers in 2005), compared to 21.8% in 2004 (15.2% excluding the recapture of business previously ceded to us by one of our primary insurer customers in 2004) and 12.1% in 2003.

Sales and Marketing

Mortgage Insurance

In 2005, in an effort to more appropriately align our mortgage insurance business to meet the needs of a changing business environment resulting from lender consolidation, centralization, and a movement towards a more capital markets risk-based approach, we reorganized our sales and marketing efforts to focus on four separate channels of customers: Business Direct, Strategic Accounts, Capital Markets and International. Customers are grouped into the above categories and they are serviced by each of the four separate business units. Each channel has a business manager with profit and loss responsibility and accountability. In addition, each channel has adopted a specific and focused approach to sustaining profitable growth. There is a priority of maximizing return on capital, enhancing top line and bottom line growth, and an ongoing pursuit of achieving efficiencies through cost reductions and increased productivity.

 

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Business Direct

The business direct channel focuses on small and mid-sized customers. We employ a mortgage insurance field sales force of approximately 55 persons, organized into two regions, that provides local sales representation throughout the United States. Each of the two regions is supervised by a divisional sales manager who is directly responsible for several regional sales managers. The divisional sales managers are responsible for managing the profitability of business in their regions, including premiums, losses and expenses. The regional sales managers are responsible for managing a small sales force in different areas within the region. Key account managers manage specific accounts within a region that are not national accounts, but need more targeted oversight and attention. In addition to securing business from small and mid-sized regional customers, the mortgage insurance business direct channel also provides field support for the large national accounts as necessary and appropriate.

Strategic Accounts

In recognition of the continued consolidation in the mortgage lending business and, as a result, the significant share of business directed by large national accounts, we have a focused strategic accounts team consisting of seven strategic account managers and a dedicated risk operations manager that are directly and solely responsible for supporting strategic accounts. Each strategic account manager is responsible for a select group of accounts and is compensated based on the results for those accounts as well as our overall results. There has been a trend among large national accounts to move to more centralized decision-making about mortgage insurance that is subject to captive reinsurance relationships and other services provided by the mortgage insurance companies, such as streamlined electronic delivery and transfer of data between lenders and mortgage insurance companies. Included within the strategic accounts channel is a strategic account manager who is principally responsible for relationships and programs implemented with the GSEs. Strategic accounts business represented approximately 59% of our primary new insurance written in 2005, compared to 57% in 2004.

Mortgage insurance sales personnel are compensated by salary, account profitability, commissions on new insurance written and a production incentive based on the achievement of various goals. During 2005, these goals were more focused on profitability and RAROC.

Capital Markets

Our capital markets channel focuses on providing credit solutions for non-prime collateral through five main products: structured primary mortgage insurance, pool insurance, second-lien mortgage insurance, financial guaranty of NIMs and credit default swaps. The capital markets team works with investment banks, originators and whole loan aggregators to develop the most cost-effective credit enhancement structure possible. This ensures better access to the capital markets, and in turn, produces a lower cost of capital for our clients. In order to provide the best customer service possible, the capital markets business operates a pricing desk that works in concert with its clients’ analysts, as well as transaction managers who shepherd particular deals through closing.

International

The international mortgage channel is responsible for the development of mortgage opportunities outside the United States. With teams located in London, Hong Kong and Philadelphia, the international mortgage group develops and underwrites both mortgage insurance and capital market products. The primary markets for international mortgage include Europe, Asia and Australia. The international mortgage group is comprised of 12 professionals and works with mortgage lenders and originators, investment banks and other market intermediaries to identify market opportunities and credit risk management solutions.

Financial Guaranty

Our financial guaranty business develops its public finance business mainly through relationships with investment banks, commercial banks and financial advisors that provide financial and debt management services

 

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to, and intermediate transactions with, public finance borrowers. We also have direct relationships with some issuers. A dedicated public finance business development team, which reports directly to the head of our financial guaranty business’s public finance group, markets directly to these intermediaries. We do not pay or otherwise reimburse these intermediaries for their services.

Our financial guaranty business originates its structured finance transaction flow principally by developing and maintaining strong relationships with the financial institutions, both in the United States and abroad, that are actively involved in the structured finance market. Our financial guaranty business develops its structured finance business through three primary business development units – asset-backed securities, CDOs and financial solutions. We have a dedicated structured finance business development team which reports directly to the head of our financial guaranty business’s structured products group, for the purpose of developing new clients. In addition, our financial guaranty business has a London-based team of structured finance professionals responsible for sales and marketing for European structured finance transactions.

Our financial guaranty reinsurance business markets directly to primary financial guaranty insurers that write credit enhancement business. Our financial guaranty business’s goal is to meet the needs of the primary insurers, subject to our internal underwriting and risk management requirements. We typically compensate primary financial guaranty insurers based on a percentage of premium assumed, which varies from agreement to agreement.

Competition

Mortgage Insurance

We compete directly with six other private mortgage insurers – Genworth Financial Inc., Mortgage Guaranty Insurance Corporation, PMI Mortgage Insurance Co., Republic Mortgage Insurance Company, Triad Guaranty Insurance Corporation and United Guaranty Corporation – some of which are subsidiaries of well-capitalized companies with stronger financial strength ratings and greater access to capital than we have. We also compete against various federal and state governmental and quasi-governmental agencies, principally the Federal Housing Administration (“FHA”), the Veterans’ Administration (“VA”) and state-sponsored mortgage insurance funds. The FHA recently has increased its competitive position in areas with higher home prices by streamlining its down-payment formula and reducing the premiums it charges. Governmental and quasi-governmental entities typically do not have the same capital requirements that we and other mortgage insurance companies have, and therefore, may have financial flexibility in their pricing and capacity that could put us at a competitive disadvantage. In the event that a government-owned or sponsored entity in one of our markets determines to reduce prices significantly or alter the terms and conditions of its mortgage insurance or other credit enhancement products in furtherance of social or other goals rather than a profit motive, we may be unable to compete in that market effectively, which could have an adverse effect on our financial condition and results of operations.

We compete for flow business with other private mortgage insurance companies more on the basis of service than on the basis of price. This service-based competition includes risk management services, loss mitigation efforts and management and field service organization and expertise. We also provide contract underwriting services and participate in arrangements such as captive reinsurance and affordable housing programs. We cede a significant portion of our mortgage insurance business to mortgage insurance companies through captive reinsurance arrangements. Premiums ceded to captive reinsurance companies in 2005 were $92.9 million, representing 11.5% of our total direct mortgage insurance premiums earned during 2005. Historically, these arrangements have reduced the profitability and return on capital in our mortgage insurance business.

We also face competition from an increasing number of alternatives to traditional private mortgage insurance, including:

 

    mortgage lenders structuring mortgage originations to avoid private mortgage insurance, mostly through “80-10-10 loans” or other forms of simultaneous second loans. The use of simultaneous second loans has increased significantly during recent years and is likely to continue to be a competitive alternative to private mortgage insurance;

 

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    investors using other forms of credit enhancement such as credit default swaps or securitizations as a partial or complete substitute for private mortgage insurance; and

 

    mortgage lenders and other intermediaries that forego third-party insurance coverage and retain the full risk of loss on their high-LTV loans.

Much of the competition described above is directed at prime loans, which has led us to shift more of our business to insuring riskier, non-prime loans.

We compete for structured transactions with other mortgage insurers as well as capital market executions such as senior/subordinated security structures. Competition for this business generally is based both on price and on the percentage of a given pool of loans that we are willing to insure.

Financial Guaranty

We are subject to competition from companies that specialize in financial guaranty insurance or reinsurance, including MBIA Insurance Corporation, Ambac, FGIC, FSAI, Assured Guaranty Corp., CDC IXIS Financial Guaranty, XL Capital Assurance Inc., XL Financial Assurance Ltd. and RAM Reinsurance Company. In the late 1990s, several multiline insurers increased their participation in financial guaranty reinsurance. The participation of multiline insurers in the financial guaranty insurance and reinsurance businesses has decreased due to the downgrade of certain of these multiline participants. Certain of these multiline insurers have formed strategic alliances with some of the U.S. primary financial guaranty insurers. We believe that competition from multiline reinsurers and new monoline financial guaranty insurers will continue to be limited due to (a) the lack of consistent dedication to the business from multiline insurers with the required financial strength; and (b) the barriers to entry for new reinsurers posed by state insurance law and rating agency criteria governing minimum capitalization.

Competition in the financial guaranty reinsurance business is based on many factors, including overall financial strength, financial strength ratings, pricing and service. The rating agencies allow credit to a ceding company’s capital requirements and single risk limits for reinsurance that is ceded. The amount of this credit is in part determined by the financial strength rating of the reinsurer. Some of our competitors have greater financial resources than we have and are better capitalized than we are and/or have been assigned higher ratings by one or more of the major rating agencies. In addition, the rating agencies could change the level of credit they will allow a ceding company to take for amounts ceded to us and/or similarly rated reinsurers.

The majority of insured public finance and structured finance transactions are guaranteed by triple-A rated financial guaranty insurers. As a AA/Aa3-rated company, our financial guaranty business mainly targets distinct niches in the capital markets. There is generally a greater interest cost savings to an issuer by using triple-A rated credit enhancement as compared to our AA/Aa3 rated credit enhancement. However, financial guaranty insurance provided by a lower-rated provider also can provide significant value over uninsured executions in markets where the triple-A rated financial guaranty insurance is unavailable or uneconomical. In some markets, issuers and other counterparties receive no additional rating agency credit or regulatory relief from triple-A rated enhancement than they do with our AA/Aa3 enhancement, so our enhancement in these markets may be more economical.

Our financial guaranty insurance business also competes with other forms of credit enhancement, including letters of credit, guaranties and credit default swaps provided in most cases by banks and other financial institutions, some of which are governmental entities or have been assigned the highest credit ratings awarded by one or more of the major rating agencies. Most of these forms of credit enhancement, however, serve to provide ceding companies with increased insurance capacity only for rating agency purposes. Unlike financial guaranty reinsurance, most do not qualify as capital for state regulatory purposes, nor do they constitute credit against specific liabilities that would allow the ceding company greater single risk capacity. In late 2004, however, the

 

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laws applicable to those ceding companies domiciled in New York were amended to permit such ceding companies to use certain credit default swaps meeting applicable requirements as collateral to offset statutory single limits, aggregate risk limits, aggregate net liability calculations and contingency reserve requirements. This regulatory change, which makes credit default swaps an attractive alternative to traditional financial guaranty insurance, may result in a reduced demand for traditional monoline financial guaranty reinsurance.

We also face competition from alternate transaction structures that permit issuers to securitize assets more cost-effectively without the need for other credit enhancement and from cash-rich investors seeking additional yield on their investments by foregoing credit enhancement. We are also seeing increased competition in our financial guaranty reinsurance business as a result of captive reinsurance arrangements involving our financial guaranty primary reinsurance customers.

Ratings

S&P, Moody’s and Fitch each rate the financial strength of our insurance subsidiaries. The rating agencies focus on the following factors: capital resources; financial strength; commitment of management to, and alignment of stockholder interests with, the insurance business; demonstrated management expertise in our insurance business; credit analysis; systems development; risk management; marketing; capital markets and investment operations, including the ability to raise additional capital; and a minimum policyholders’ surplus with initial capital sufficient to meet projected growth as well as access to additional capital as may be necessary to continue to meet standards for capital adequacy. As part of their rating process, S&P, Moody’s and Fitch could test our insurance subsidiaries by subjecting them to a “stress level scenario” in which losses over a stress period are tested against our capital level.

The financial strength rating assigned by the rating agencies to an insurance or reinsurance company is based on factors relevant to policyholders and is not intended to the protect the equity holders of such company. A financial strength rating is neither a rating of securities nor a recommendation to buy, hold or sell any security. Financial strength ratings are an indication to an insurer’s customers of the insurer’s present financial strength and its capacity to honor its future claims payment obligations. Therefore, ratings generally are considered critical to an insurer’s ability to compete for new insurance business. The financial strength rating assigned to our insurance subsidiaries should not be viewed as indicative of or relevant to any ratings that may be assigned to our outstanding debt securities by any rating agency and should not be considered an evaluation of the likelihood of timely payment of principal or interest on those securities.

We have been assigned a senior debt rating of A+ by Fitch, A by S&P and A2 by Moody’s. Our principal insurance subsidiaries have been assigned the following financial strength ratings:

 

     MOODY’S   

MOODY’S

OUTLOOK

   S&P   

S&P

OUTLOOK

   FITCH   

FITCH

OUTLOOK

Radian Guaranty

   Aa3    Stable    AA    Stable    AA    Stable

Radian Insurance

   Aa3    Stable    AA    Stable    AA    Stable

Amerin Guaranty

   Aa3    Stable    AA    Stable    AA    Stable

Radian Asset Assurance

   Aa3    Stable    AA    Negative    AA    Negative

Radian Asset Assurance Limited

   —      —      AA    Negative    AA    Negative

Moody’s and S&P have entered into an agreement with Radian Guaranty that obligates Radian Guaranty to maintain at least $30 million of capital in Radian Insurance as a condition of the issuance and maintenance of Radian Insurance’s ratings. In February 2006, we submitted a request to the Insurance Department of Pennsylvania to contribute approximately $500 million in capital from Radian Guaranty to Radian Insurance to support the additional risk that has been written in that entity, principally through non-traditional mortgage insurance transactions by our Capital Markets and International channels.

 

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On April 27, 2005, Fitch affirmed the “AA” insurance financial strength rating of Radian Asset Assurance and RAAL, a subsidiary of Radian Asset Assurance that is authorized to conduct insurance business in the U.K., but revised its ratings outlook for the two entities to Negative from Stable. Fitch’s ratings for us and our other rated subsidiaries are unchanged. None of the primary insurance customers of our financial guaranty business have any recapture rights as a result of this ratings action by Fitch.

In October 2002, S&P downgraded the insurer financial strength rating of Radian Reinsurance from AAA to AA. As a result of this downgrade, effective January 31, 2004, one of the primary insurer customers of our financial guaranty reinsurance business exercised its right to recapture approximately $16.4 billion of par in force ceded to our financial guaranty reinsurance business, including $96.4 million of net premiums written with a GAAP carrying value of approximately $71.5 million. The entire impact of this recapture was reflected as a reduction of net premiums written in the first quarter of 2004. Because, in accordance with GAAP, we already had reflected $24.9 million of these recaptured net premiums written as having been earned, we were required to record the entire $24.9 million reduction in net premiums earned in the first quarter of 2004. Also in connection with the recapture in the first quarter of 2004, we were reimbursed for policy acquisition costs of approximately $31.0 million for which the carrying value under GAAP was $21.3 million. In addition, the recapture included approximately $11.5 million that had been recorded as case reserves under GAAP. Finally, we took a charge of $0.8 million for mark-to-market adjustments related to certain insurance policies associated with the recapture. The sum of the above adjustments related to this recapture resulted in an immediate reduction of pre-tax income of $15.9 million. We estimate that the recapture of reinsurance business reduced 2004 pre-tax income by approximately $37.8 million or approximately $0.26 per share after tax, $0.11 per share of which was a result of the immediate impact of the recapture, and the balance was a result of recaptured net premiums written that would have been earned over time, and estimated losses.

The sum of the above adjustments related to this recapture is summarized as follows:

 

    

Cash Paid

(Received)

   

GAAP

Book

Basis

   

Initial

Gain

(Loss)

 
     (In thousands)  

Unearned Premium

   $ 96,417     $ 71,525     $ (24,892 )

Acquisition Costs

     (31,023 )     (21,257 )     9,766  

Case Reserves

     11,488       11,488       —    

Receivable from Unrealized Credit Derivatives Gain

     —         (791 )     (791 )
                        

Totals

   $ 76,882     $ 60,965     $ (15,917 )
                        

Without cost to or concessions by us, the remaining primary insurer customers with recapture rights agreed not to exercise those rights with respect to the October 2002 downgrade by S&P. None of the primary insurer customers of our financial guaranty reinsurance business have any remaining recapture rights as a result of the 2002 downgrade by S&P.

In May 2004, Moody’s provided Radian Asset Assurance with an initial financial strength rating of Aa3. Prior to the merger of Radian Reinsurance with and into Radian Asset Assurance, Moody’s downgraded the insurance financial strength rating of Radian Reinsurance from Aa2 to Aa3.

As a result of this downgrade, two of the primary insurer customers of our financial guaranty reinsurance business had the right to recapture previously written business ceded to our financial guaranty reinsurance business. Effective February 28, 2005, one of these customers recaptured approximately $7.4 billion of par in force that it had ceded to us, including $54.7 million of written premiums as of February 28, 2005, $4.5 million of which was recorded as an immediate reduction of premiums earned at the time of the recapture, which represents the difference between statutory and GAAP unearned premiums. This return of unearned premiums

 

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resulted in an increase in policy acquisition costs of $1.7 million. The aggregate was a reduction in pre-tax income of $6.2 million, or approximately $0.04 per share after tax on a GAAP basis. The amount of future lost premiums due to this recapture will be approximately $129.7 million, which consists of the unearned premium balance and the value of future installment premiums. Based on the February 28, 2005, recapture date, the total approximate reduction in pre-tax income for 2005, including the immediate impact, was approximately $12.3 million or approximately $0.08 per share after tax.

The sum of the above adjustments related to this recapture is summarized as follows:

 

    

Cash Paid

(Received)

   

GAAP

Book

Basis

   

Initial

(Loss)

 
     (In thousands)  

Unearned Premiums

   $ 54,742     $ 50,204     $ (4,538 )

Acquisition Costs

     (17,097 )     (18,791 )     (1,694 )
                        

Total

   $ 37,645     $ 31,413     $ (6,232 )
                        

Despite the recapture, this primary insurer customer renewed its reinsurance treaty with us for 2005, and again recently for 2006, on substantially the same terms as in 2004, prior to the May 2004 downgrade. In March 2005, without cost to or concessions by us, this customer waived all of its remaining recapture rights with respect to the May 2004 downgrade by Moody’s. The other customer with recapture rights as a result of the May 2004 downgrade agreed, without cost to or concessions by us, to waive its recapture rights. There are no remaining recapture rights with respect to the May 2004 Moody’s downgrade of Radian Reinsurance.

Investment Policy and Portfolio

Our income from our investment portfolio is one of our primary sources of cash flow to support our operations and claim payments.

We follow an investment policy that, at a minimum, requires:

 

    95% of our investment portfolio must consist of cash equivalents and debt securities (including redeemable preferred stock) that, at the date of purchase, were rated investment grade by a nationally recognized rating agency (e.g., “BBB” or better by S&P); and

 

    At least 50% of our investment portfolio must consist of cash, cash equivalents and debt securities (including redeemable preferred stock) that, at the date of purchase, were rated the highest investment grade by a nationally recognized rating agency (e.g., AAA by S&P).

We are permitted to invest in equity securities (including convertible debt and convertible preferred stock), provided our equity component does not exceed 20% of our total investment portfolio and at least 95% of the portfolio is investment grade.

We periodically review our investment portfolio for declines in the fair value of securities below the amortized cost basis of such securities that are considered to be other-than-temporary as defined by our policy, and we recognize declines in earnings if the security has not been sold. At December 31, 2005, there were no securities in the portfolio that had losses that were considered other-than-temporary.

At December 31, 2005, our investment portfolio had a cost basis of $5,311.3 million, a carrying value of $5,513.7 million and a market value of $5,518.0 million, including $361.9 million of short-term investments. Our investment portfolio did not include any real estate or mortgage loans. The portfolio included 61 privately placed, investment-grade securities with an aggregate carrying value of $61.7 million. At December 31, 2005, 98.4% of

 

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our investment portfolio (which includes fixed maturities and equity securities) consisted of cash equivalents and debt securities (including redeemable preferred stock) that were rated investment grade.

Our investment policies and strategies are subject to change depending on regulatory, economic and market conditions and our then-existing or anticipated financial condition and operating requirements, including our tax position. The management of the portion of our investments held at our insurance subsidiaries is also subject to insurance regulatory requirements applicable to such insurance subsidiaries.

Investment Portfolio Diversification

The diversification of our investment portfolio (other than short-term investments) at December 31, 2005, is as follows:

 

     December 31, 2005  
    

Amortized

Cost

   Fair Value    Percent (1)  
     (In thousands)  

Fixed maturities held to maturity (2):

        

State and municipal obligations

   $ 125,935    $ 130,227    100.0 %
                    

Total

     125,935      130,227    100.0 %
                    

Fixed maturities available for sale:

        

U.S. government securities (3)

     78,214      79,705    1.7 %

U.S. government-sponsored enterprises

     33,764      33,119    0.7  

State and municipal obligations

     3,433,891      3,542,090    76.4  

Corporate obligations

     101,709      104,335    2.3  

Convertible securities

     308,331      314,692    6.9  

Asset-backed securities

     268,698      263,615    6.0  

Redeemable preferred stocks

     106,192      104,539    2.4  

Private placements

     59,357      61,143    1.3  

Foreign governments

     103,633      105,222    2.3  
                    

Total

     4,493,789      4,608,460    100.0 %
                    

Equity securities

     258,768      325,117   

Trading securities

     68,078      89,440   

Other invested assets

     2,825      2,825   
                

Total

   $ 4,949,395    $ 5,156,069   
                

(1) Percentage of amortized cost.
(2) All security types listed, other than U.S. government securities, consist mostly of investment-grade securities.
(3) Substantially all of these securities are backed by the full faith and credit of the U.S. government.

 

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Investment Portfolio Scheduled Maturity (1)

The weighted average duration of the assets in our investment portfolio as of December 31, 2005, was 5.91 years. The following table shows the scheduled maturities of the securities held in our investment portfolio at December 31, 2005:

 

     December 31, 2005  
    

Carrying

Value

   Percent  
     (In
thousands)
      

Short-term investments

   $ 361,937    6.5 %

Less than one year (1)

     92,226    1.7  

One to five years (1)

     415,304    7.5  

Five to ten years (1)

     824,412    15.0  

Over ten years (1)

     3,034,299    55.0  

Asset-backed securities

     263,615    4.8  

Redeemable preferred stocks (2)

     104,539    1.9  

Equity securities (2)

     325,117    5.9  

Trading securities (2)

     89,440    1.6  

Other invested assets (2)

     2,825    0.1  
             

Total

   $ 5,513,714    100.0 %
             

(1) Actual maturities may differ as a result of calls before scheduled maturity.
(2) No stated maturity date.

Investment Portfolio by S&P Rating

The following table shows the ratings by S&P of our investment portfolio (other than short-term investments) as of December 31, 2005:

 

     December 31, 2005  
    

Carrying

Value

   Percent  
     (In
thousands)
      

Rating (1)

     

Fixed maturities:

     

U.S. government and agency securities

   $ 112,824    2.2 %

AAA

     2,798,734    54.3  

AA

     773,293    15.0  

A

     534,303    10.4  

BBB

     333,400    6.5  

BB and below and other (2)

     3    —    

Not rated (3)

     181,838    3.5  

Trading securities

     89,440    1.7  

Equity securities

     325,117    6.3  

Other invested assets

     2,825    0.1  
             

Total

   $ 5,151,777    100.0 %
             

(1) As assigned by S&P as of December 31, 2005.
(2) Securities in this category have been rated non-investment grade by S&P as of December 31, 2005.
(3) Securities in this category have not been rated by S&P as of December 31, 2005, but have been rated investment grade as of December 31, 2005, by at least one other nationally recognized securities rating agency.

 

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Regulation

State Regulation

We and our insurance subsidiaries are subject to comprehensive, detailed regulation principally designed for the protection of policyholders, rather than for the benefit of investors, by the insurance departments in the various states where we and our insurance subsidiaries are licensed to transact business. Insurance laws vary from state to state, but generally grant broad supervisory powers to agencies or officials to examine insurance companies and enforce rules or exercise discretion affecting almost every significant aspect of the insurance business.

Insurance regulations address, among other things, the licensing of companies to transact business, claims handling, reinsurance requirements, premium rates and policy forms offered to customers, financial statements, periodic reporting, permissible investments and adherence to financial standards relating to surplus, dividends and other criteria of solvency intended to assure the satisfaction of obligations to policyholders.

Mortgage insurers in the United States generally are restricted to writing residential mortgage guaranty insurance, and financial guaranty insurers generally are restricted to writing financial guaranty insurance. Our non-insurance businesses, which consist of mortgage insurance-related services, are not generally subject to regulation under state insurance laws.

Radian Guaranty is domiciled and licensed in the Commonwealth of Pennsylvania as a stock casualty insurance company authorized to carry on the business of mortgage guaranty insurance pursuant to the provisions of the Pennsylvania insurance law and related rules and regulations governing property and casualty insurers. In addition to Pennsylvania, Radian Guaranty is authorized to write mortgage guaranty insurance (or in certain states where there is no specific authorization for mortgage guaranty insurance, the applicable line of insurance under which mortgage guaranty is regulated), in each of the other states, the District of Columbia and Guam. Radian Guaranty must maintain both a reserve for unearned premiums and for incurred losses and a special, formulaically derived contingency reserve to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. The contingency reserve may be drawn on with the approval of the Pennsylvania insurance department under specified but limited circumstances.

Radian Insurance is domiciled and licensed in the Commonwealth of Pennsylvania as a stock casualty insurance company authorized to carry on the business of credit insurance or guaranty insurance pursuant to the provisions of the Pennsylvania insurance law and related rules and regulations governing property and casualty insurers. Radian Insurance must maintain both a reserve for unearned premiums and for incurred losses and a special, formulaically derived contingency reserve to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. The contingency reserve may be drawn on with the approval of the Pennsylvania insurance department under specified but limited circumstances.

Amerin Guaranty is domiciled and licensed in the State of Illinois as a mortgage guaranty insurer and is subject to the provisions of the Illinois insurance law and related rules and regulations governing property-casualty insurers. In addition to Illinois, Amerin Guaranty is authorized to write mortgage guaranty insurance (or in certain states where there is no specific authorization for mortgage guaranty insurance, the applicable line of insurance under which mortgage guaranty is regulated, in each of the other states except Rhode Island (Amerin operates under an industrial insured exemption in Rhode Island) and the District of Columbia. Amerin Guaranty must maintain both a reserve for unearned premiums and for incurred losses and a special, formulaically derived contingency reserve to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. The contingency reserve may be drawn on with the approval of the Illinois insurance department under specified but limited circumstances.

Radian Asset Assurance is domiciled and licensed in the State of New York as a financial guaranty insurer and is subject to all other provisions of the New York insurance law and related rules and regulations governing

 

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property-casualty insurers to the extent these provisions are not inconsistent with the New York financial guaranty insurance statute. Radian Asset Assurance is also licensed under the New York insurance law to write surety insurance and credit insurance. In addition to New York, Radian Asset Assurance is authorized to write financial guaranty and surety insurance (or in certain states where there is no specific authorization for financial guaranty insurance, credit insurance) in each of the other states, the District of Columbia and the United States Virgin Islands. Radian Asset Assurance must maintain both a reserve for unearned premiums and for incurred losses and a special, formulaically derived contingency reserve to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. The contingency reserve may be drawn on with the approval of the New York insurance department under specified but limited circumstances.

Each insurance subsidiary is required by its state of domicile and each other jurisdiction in which it is licensed to transact business to make various filings with those jurisdictions and with the National Association of Insurance Commissioners, including quarterly and annual financial statements prepared in accordance with statutory accounting practices.

Insurance Holding Company Regulation.    We are an insurance holding company and our insurance subsidiaries belong to an insurance holding company system. All states have enacted legislation regulating insurance companies in an insurance holding company system. These laws generally require each insurance company in the system to register with the insurance regulatory authority of its state of domicile and to furnish to this regulator financial and other information concerning the operations of companies within the system that may materially affect the operations, management or financial condition of insurers within the system.

Because we are an insurance holding company, and because Radian Guaranty and Radian Insurance are Pennsylvania insurance companies, Amerin Guaranty is an Illinois insurance company, and Radian Asset Assurance is a New York insurance company, the Pennsylvania, Illinois or New York insurance laws regulate, among other things, certain transactions in our common stock and certain transactions between us, our insurance subsidiaries and other parties affiliated with us. Specifically, no person may, directly or indirectly, offer to acquire or acquire “control” of us or our insurance subsidiaries, unless that person files a statement and other documents with the Commissioner of Insurance of the state in which the target company is domiciled and obtains the Commissioner’s prior approval. The Commissioner may hold a public hearing on the matter. “Control” is presumed to exist if 10% or more of the target company’s voting securities are owned or controlled, directly or indirectly, by a person, although “control” may or may not be deemed to exist where a person owns or controls a lesser amount of securities. In addition, material transactions between us, our insurance subsidiaries and our affiliates are subject to certain conditions, including that they be “fair and reasonable.” These restrictions generally apply to all persons controlling or under common control with us or our insurance subsidiaries. Certain transactions between us, our insurance subsidiaries or our affiliates may not be entered into unless the relevant Commissioner of Insurance is given 30 days’ prior notification and does not disapprove the transaction during that 30-day period.

Dividends.    Radian Guaranty’s and Radian Insurance’s ability to pay dividends on their common stock is restricted by certain provisions of the insurance laws of the Commonwealth of Pennsylvania, their state of domicile. The insurance laws of Pennsylvania establish a test limiting the maximum amount of dividends that may be paid without prior approval by the Pennsylvania Insurance Commissioner. Under this test, an insurer may pay dividends during any 12-month period in an amount equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus; or (ii) the preceding year’s statutory net income. In accordance with this test, $451.2 million and $50.0 million would be available for dividends from Radian Guaranty and Radian Insurance, respectively, in 2006. However, another provision of the Pennsylvania insurance laws provides that dividends and other distributions may only be paid out of an insurer’s unassigned surplus unless the Pennsylvania Insurance Commissioner approves additional dividends. Radian Guaranty and Radian Insurance had positive unassigned surplus at December 31, 2005 of $198.9 million and $96.2 million, respectively. The Pennsylvania Insurance Commissioner has approved all distributions by Radian Guaranty since the enactment of this insurance law provision. Radian Insurance has not paid any dividends to Radian Guaranty, its immediate parent company.

 

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Amerin Guaranty’s ability to pay dividends on its common stock is restricted by certain provisions of the insurance laws of the State of Illinois, its state of domicile. The insurance laws of Illinois establish a test limiting the maximum amount of dividends that may be paid from unassigned surplus by an insurer without prior approval by the Illinois Insurance Commissioner. Under this test, Amerin Guaranty may pay dividends during any 12-month period in an amount equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus; or (ii) the preceding year’s statutory net income. In accordance with this test, $19.7 million would be available for dividends in 2006 without prior regulatory approval. In January 2005, Amerin paid a $100 million dividend to us that was declared in December 2004, after receiving approval for a special dividend from the Illinois Insurance Commissioner.

Radian Asset Assurance’s ability to pay dividends is restricted by certain provisions of the insurance laws of the State of New York, its state of domicile. Under the New York insurance law, Radian Asset Assurance may only declare or distribute dividends from earned surplus. Unless the company has prior approval from the New York Superintendent of Insurance, the company can only pay a dividend, which when totaled with all other dividends declared or distributed by it during the next preceding twelve months, is the lesser of ten percent of its surplus to policyholders as shown by its last statement on file with the Superintendent, or one hundred percent of adjusted net investment income. At December 31, 2005, Radian Asset Assurance had $99.5 million available for dividends that could be paid in 2006 without prior approval. Radian Asset Assurance paid a $100 million dividend to us in 2005.

Risk-to-Capital.    A number of states limit a private mortgage insurer’s risk in force to 25 times the total of the insurer’s policyholders’ surplus plus the statutory contingency reserve, commonly known as the “risk-to-capital” requirement. As of December 31, 2005, the consolidated risk-to-capital ratio for our mortgage insurance business was 11.6 to 1 compared to 10.0 to 1 as of December 31, 2004. The cross guaranty agreement between Radian Guaranty and Amerin Guaranty makes it appropriate to look at risk-to-capital on a combined basis.

Reserves.    For statutory reporting, mortgage insurance companies are required annually to provide for additions to their contingency reserve in an amount equal to 50% of earned premiums. Such amounts cannot be withdrawn for a period of 10 years except under certain circumstances. The contingency reserve, designed to be a reserve against catastrophic losses, essentially restricts dividends and other distributions by mortgage insurance companies. We classify the contingency reserve as a statutory liability. At December 31, 2005, Radian Guaranty had statutory policyholders’ surplus of $412.7 million and a contingency reserve of $2.5 billion, Amerin Guaranty had statutory policyholders’ surplus of $197.1 million and a contingency reserve of $5.8 million and Radian Insurance had statutory policyholders’ surplus of $131.2 million and a contingency reserve of $76.9 million.

In accordance with New York insurance law, our financial guaranty business must establish a contingency reserve, in an amount equal to the greater of 50% of premiums written or a stated percentage of the principal guaranteed, ratably over 15 to 20 years depending on the category of obligation insured. Reinsurers are required to establish a contingency reserve equal to their proportionate share of the reserve established by the ceding company. At December 31, 2005, Radian Asset Assurance had statutory policyholders’ surplus of $994.5 million and a contingency reserve of $271.9 million.

Premium Rates and Policy Forms.    Each of our mortgage insurance and financial guaranty subsidiary’s premium rates and policy forms are generally subject to regulation in every state in which it is licensed to transact business. These regulations are intended to protect policyholders against the adverse effects of excessive, inadequate or unfairly discriminatory rates and to encourage competition in the insurance marketplace. In most states, premium rates and policy forms must be filed and, in some states approved, before their use. Changes in premium rates may be subject to justification, generally on the basis of the insurer’s loss experience, expenses and future trend analysis. The general default experience in the mortgage insurance industry also may be considered.

 

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Reinsurance.    Restrictions apply under the laws of several states to any licensed company ceding business to an unlicensed reinsurer. Under those laws, if a reinsurer is not admitted, authorized or approved in such state, the company ceding business to the reinsurer cannot take credit in its statutory financial statements for the risk ceded to the reinsurer absent compliance with certain reinsurance security requirements. In addition, several states also have special restrictions on mortgage insurance, and several states limit the amount of risk a mortgage insurer may retain with respect to coverage on an insured loan to 25% of the insured’s claim amount. Coverage in excess of 25% (i.e., deep coverage) must be reinsured.

Examination.    Our insurance subsidiaries are subject to examination of their affairs by the insurance departments of each of the states in which they are licensed to transact business.

Accreditation.    The National Association of Insurance Commissioners instituted the Financial Regulatory Accreditation Standards Program, known as “FRASP,” in response to federal initiatives to regulate the business of insurance. FRASP provides standards intended to establish effective state regulation of the financial condition of insurance companies. FRASP requires states to adopt certain laws and regulations, institute required regulatory practices and procedures, and have adequate personnel to enforce these items in order to become accredited. In accordance with the National Association of Insurance Commissioners’ Model Law on Examinations, accredited states are not permitted to accept certain financial examination reports of insurers prepared solely by the insurance regulatory agency in states not accredited by January 1, 1994. Although the State of New York is not accredited, no state where Radian Asset Assurance is licensed has refused to accept the New York Insurance Department’s Reports on Examination for Radian Asset Assurance. However, we cannot be certain that, if the New York insurance department remains unaccredited, other states that are accredited will continue to accept financial examination reports prepared solely by New York. We do not believe that the refusal by an accredited state to continue accepting financial examination reports prepared by New York would have a material adverse impact on our insurance businesses.

Federal Regulation

RESPA.    The origination or refinance of a federally regulated mortgage loan is a settlement service, and therefore, subject to RESPA. In December 1992, regulations were issued stating that mortgage insurance also is a settlement service. As a result, mortgage insurers are subject to the anti-referral provisions of Section 8(a) of RESPA, which provide, in essence, that that mortgage insurers are prohibited from paying anything of value to a mortgage lender in consideration of the lender’s referral of business to the mortgage insurer. Although many states prohibit mortgage insurers from giving rebates, RESPA has been interpreted to cover many non-fee services as well. The U.S. Department of Housing and Urban Development’s (“HUD”) interest in pursuing violations of RESPA has increased the awareness of both mortgage insurers and their customers of the possible sanctions resulting from a violation of RESPA. HUD, as well as the insurance commissioner or an attorney general of any state, may conduct investigations, levy fines and other sanctions or enjoin future violations of RESPA. We and other mortgage insurers have faced private lawsuits alleging, among other things, that our captive reinsurance arrangements, as well as pool insurance and contract underwriting services, constitute unlawful payments to mortgage lenders under RESPA. Although to date we have successfully defended against all such lawsuits on the basis that the plaintiffs lacked standing, we cannot be certain that we will have continued success defending against similar lawsuits.

The insurance law provisions of many states, including New York, also prohibit paying for the referral of insurance business and provide various mechanisms to enforce this provision. In February 1999, the New York Insurance Department issued Circular Letter No. 2 that discusses its position concerning various transactions between mortgage guaranty insurance companies licensed in New York and mortgage lenders. The letter confirms that captive reinsurance transactions are permissible if they “constitute a legitimate transfer of risk” and “are fair and equitable to the parties.” The letter also states that “supernotes/performance notes,” “dollar pool” insurance, and “un-captive captives” violate New York insurance law. In May 2005, we received a letter from the New York Insurance Department seeking information related to all of the captive mortgage reinsurance

 

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arrangements that we entered into since January 1, 2000, a list of the lenders associated with each captive along with each captive’s state of domicile and capital/surplus requirements. The letter also included a request for a description of any other arrangements through which we provide any payment or consideration to a lender in connection with mortgage insurance. We submitted our response and affirmed it as true under penalties of perjury to the New York insurance department by June 8, 2005. We are aware that other mortgage insurers have received similar requests from the New York insurance department.

In February 2006, we and other mortgage insurers received a second letter from the New York insurance department seeking documentation and a description of the due diligence that we perform in selecting reinsurers for our mortgage insurance risk. The letter indicates that the New York insurance department is seeking evidence from us to rebut the assertion that the premiums we pay under our captive reinsurance arrangements constitute an inducement or compensation to lenders for doing business with us and to bolster a claim that it is difficult or impossible to obtain mortgage reinsurance from non-captive reinsurers. We are considering our response to this request, which we intend to submit to the New York insurance department as requested.

In addition to the New York inquiry, other mortgage insurers recently have received subpeonas from the Minnesota Insurance Commissioner relating to their captive reinsurer arrangements, and public reports have indicated that both the Colorado and North Carolina Insurance Commissioners were considering investigating or reviewing captive mortgage reinsurance arrangements. Insurance departments or other officials in other states may also conduct such investigations or reviews. Although we believe that all of our captive reinsurance arrangements transfer risk to the captive reinsurer at a premium rate that is commensurate with the risk, we cannot be certain that we will be able to successfully defend against any alleged violations of RESPA or other laws.

HUD proposed a rule under RESPA to create an exemption from Section 8(a) of RESPA. The proposed rule would have made the exemption available to lenders that, at the time a borrower submits a loan application, give the borrower a firm, guaranteed price for all the settlement services associated with the loan, commonly referred to as “bundling.” In 2003, HUD withdrew the proposed rule and submitted another proposed rule to the Office of Management and Budget, which also was subsequently withdrawn. If bundling is exempted from RESPA, mortgage lenders may have increased leverage over us and the premiums we are able to charge for mortgage insurance could be negatively affected.

HMDA.    Most originators of mortgage loans are required to collect and report data relating to a mortgage loan applicant’s race, nationality, gender, marital status and census tract to HUD or the Federal Reserve under the Home Mortgage Disclosure Act of 1975 (“HMDA”). The purpose of the HMDA is to detect possible discrimination in home lending and, through disclosure, to discourage this discrimination. Mortgage insurers are not required pursuant to any law or regulation to report HMDA data, although under the laws of several states, mortgage insurers are currently prohibited from discriminating on the basis of certain classifications.

Several mortgage insurers, through their trade association, Mortgage Insurance Companies of America (“MICA”), entered into an agreement with the Federal Financial Institutions Examinations Council (“FFIEC”) to report the same data on loans submitted for insurance as is required for most mortgage lenders under HMDA. Reports of HMDA-type data for the mortgage insurance industry have been submitted by several mortgage insurers through MICA to the FFIEC since 1993. We are not aware of any pending or expected actions by governmental agencies in response to the reports submitted by MICA to the FFIEC. Since January 2004, we have been independently reporting HMDA data to the FFIEC, due to our withdrawal from MICA.

Mortgage Insurance Cancellation.    The Homeowners Protection Act of 1998 (the “HPA”) was signed into law on July 29, 1998. The HPA imposes certain cancellation and termination requirements for borrower-paid private mortgage insurance and requires certain disclosures to borrowers regarding their rights under the law. The HPA also requires certain disclosures for loans covered by lender-paid private mortgage insurance. Specifically, the HPA provides that private mortgage insurance on most loans originated on or after July 29, 1999, may be

 

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canceled at the request of the borrower once the LTV reaches 80%, provided that certain conditions are satisfied. Private mortgage insurance must be canceled automatically once the LTV reaches 78% (or, if the loan is not current on that date, on the date that the loan becomes current). The HPA establishes special rules for the termination of private mortgage insurance in connection with loans that are “high risk.” The HPA does not define “high risk” loans but leaves that determination to Fannie Mae and Freddie Mac for loans up to the conforming loan limit and to the mortgagee for any other loan. For “high risk” loans above the conforming loan limit, private mortgage insurance must be terminated on the date that the LTV is first scheduled to reach 77%. In no case, however, may private mortgage insurance be required beyond the midpoint of the amortization period of the loan if the mortgagor is current on the payments required by the terms of the mortgage. We do not believe that the HPA has had a material impact on the persistency rate of our insured loans or on our financial results.

Freddie Mac and Fannie Mae

As the largest purchasers and sellers of conventional mortgage loans, and therefore beneficiaries of private mortgage insurance, Freddie Mac and Fannie Mae impose requirements on private mortgage insurers so that they may be eligible to insure loans sold to Freddie Mac and Fannie Mae. Freddie Mac’s current eligibility requirements impose limitations on the type of risk insured, standards for the geographic and customer diversification of risk, procedures for claims handling, standards for acceptable underwriting practices, standards for certain reinsurance cessions and financial requirements that generally mirror state insurance regulatory requirements. These requirements are subject to change from time to time. Fannie Mae also has eligibility requirements, although those requirements are not published. Radian Guaranty is an approved first-lien mortgage insurer for both Freddie Mac and Fannie Mae.

In January 1999, Fannie Mae announced a program that allows for lower levels of required mortgage insurance coverage for low-down-payment 30-year fixed-rate loans approved through its Desktop Underwriter automated underwriting system. Under this program, Fannie Mae replaces some of the mortgage insurance coverage with a layer of investor mortgage insurance coverage provided by at least two mortgage insurers.

The Office of Federal Housing Enterprise Oversight issued new risk-based capital regulations for Freddie Mac and Fannie Mae, which took effect September 13, 2002. The most relevant provision to us is a distinction between AAA rated insurers and AA-rated insurers. The new regulations impose a lesser credit reduction for Fannie Mae and Freddie Mac for exposure ceded by them to AAA rated insurers as compared to AA-rated insurers. Currently, Radian Guaranty is rated AA; one other mortgage insurance provider is rated AAA. As a result, there may be an incentive for the GSEs to prefer private mortgage insurance provided by the AAA rated insurer, although this has not occurred to this point. The provisions of the new regulations are to be phased in over a 10-year period commencing on the effective date of the regulation.

Fannie Mae and Freddie Mac require that we participate in “affordable housing” programs that they maintain to provide for loans to low- and moderate-income borrowers. These programs usually include 95s, 97s and 100s, and may require the liberalization of certain underwriting guidelines to achieve the programs’ objectives. Our default experience on loans that we insure through these programs has been worse than on non-“affordable housing” loans, but our participation in these programs does not comprise a material amount of our risk in force.

Indirect Regulation

We also are indirectly, but significantly, impacted by regulations affecting originators and purchasers of mortgage loans, such as Freddie Mac and Fannie Mae, and regulations affecting governmental insurers such as the FHA and the VA. We and other private mortgage insurers may be significantly impacted by federal housing legislation and other laws and regulations that affect the demand for private mortgage insurance and the housing market generally. For example, legislation that increases the number of persons eligible for FHA or VA mortgages could have a material adverse effect on our ability to compete with the FHA or VA.

 

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The FHA single-family loan limits were raised effective January 1, 2005. The 2005 limits range from $172,632 in low-cost areas to $312,895 in high-cost areas. The limits were increased to a range from $200,160 to $362,790 effective January 1, 2006. We do not believe that demand for private mortgage insurance has been or will be materially adversely affected by this change.

Foreign Regulation

We also are subject to certain regulation in various foreign countries, namely the U.K. and Bermuda, as a result of our operations in those jurisdictions.

In the U.K., we are subject to regulation by the Financial Services Authority, or FSA. The FSA periodically performs a formal risk assessment of insurance companies or groups carrying on business in the U.K. After each risk assessment, the FSA will inform the insurer of its views on the insurer’s risk profile. This will include details of any remedial action that the FSA requires. The FSA also supervises the management of insurance companies through the approved persons regime, by which any appointment of persons to perform certain specified “controlled functions” within a regulated entity, must be approved by the FSA.

In addition, the FSA recently began to supervise the sale of general insurance, including payment protection insurance and mortgage insurance. Under FSA rules, persons who are involved in the sale of general insurance (including insurers and distributors) are prohibited from offering or accepting any inducement in connection with the sale of general insurance that is likely to conflict materially with their duties to insureds. Although the rules do not generally require disclosure of broker compensation, the insurer or distributor must disclose broker compensation at the insured’s request.

The FSA has extensive powers to intervene in the affairs of an insurance company or authorized person and has the power, among other things, to enforce, and take disciplinary measures in respect of, breaches of its rules. Under FSA rules, insurance companies must maintain a margin of solvency at all times, the calculation of which in any particular case depends on the type and amount of insurance business a company writes.

Our U.K. subsidiaries are prohibited from declaring a dividend to their shareholders unless they have “profits available for distribution.” The determination of whether a company has profits available for distribution is based on its accumulated realized profits less its accumulated realized losses.

The acquisition of “control” of any U.K. insurance company will require FSA approval. For these purposes, a party that “controls” a U.K. insurance company includes any company or individual that (together with its or his associates) directly or indirectly acquires 10% or more of the shares in a U.K. authorized insurance company or its parent company, or is entitled to exercise or control the exercise of 10% or more of the voting power in such authorized insurance company or its parent company. In considering whether to approve an application for approval, the FSA must be satisfied that the acquirer is both a fit and proper person to have such “control” and that the interests of consumers would not be threatened by such acquisition of “control.” Failure to make the relevant prior application could result in action being taken against our U.K. subsidiaries by the FSA.

Employees

At December 31, 2005, we had 1,079 employees, of which approximately 485 are located in our Philadelphia, Pennsylvania headquarters facility and approximately 100 are located in field offices throughout the United States. Approximately 180 of our employees work in our financial guaranty business located in New York City and London. Approximately 290 of our employees are contract underwriters that are hired on an “as-needed” basis. The number of contract underwriters can vary substantially from period to period, mainly as a result of changes in the demand for these services. Our employees are not unionized and management considers employee relations to be good.

 

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Item 1A. Risk Factors.

Risks Affecting Our Company

Deterioration in general economic factors may increase our loss experience and decrease demand for mortgage insurance and financial guaranties.

Our business tends to be cyclical and tends to track general economic and market conditions. Our loss experience on the mortgage and financial guaranty insurance we write is subject to general economic factors that are beyond our control, many of which we cannot anticipate, including extended national economic recessions, interest-rate changes or volatility, business failures, the impact of terrorist attacks or acts of war, or changes in investor perceptions regarding the strength of private mortgage insurers or financial guaranty providers and the policies or guaranties they offer. Deterioration of general economic conditions, such as increasing unemployment rates, negatively affects our mortgage insurance business by increasing the likelihood that borrowers will not pay their mortgages. Personal factors affecting individual borrowers, such as divorce or illness, also impact the ability of borrowers to continue to pay their mortgages. Depreciation of home prices also is a leading indication of an increase in our future losses. Our financial guaranty business also is impacted by adverse economic conditions due to the impact or perceived impact these conditions may have on the credit quality of municipalities and corporations. The same events that increase our loss experience in each business also generally lead to decreased activity in the market for mortgages and financial obligations, leading to decreased demand for our mortgage insurance or financial guaranties. An increase in our loss experience or a decrease in demand for our products due to adverse economic factors could have a material adverse effect on our business, financial condition and operating results.

Deterioration in regional economic factors could increase our losses or reduce demand for our insurance.

We could be affected by weakening economic conditions, catastrophic events, or acts of terrorism in specific regions of the United States where our business is concentrated. A majority of our primary mortgage insurance in force is concentrated in ten states, with the highest percentage being in Florida, California, Texas and New York. A large percentage of our second-lien mortgage insurance in force is concentrated in California and Florida. Our financial guaranty business also has a significant portion of its insurance in force concentrated in a small number of states, principally including California, New York, Texas, Pennsylvania and Florida. A continued and prolonged weakening of economic conditions, declines in home-price appreciation or catastrophic events or acts of terrorism in the states where our business is concentrated could have an adverse effect on our financial condition and results of operations.

Downgrade or potential downgrade of our credit ratings or the insurance financial strength ratings assigned to any of our operating subsidiaries could weaken our competitive position and affect our financial condition.

The insurance financial strength ratings assigned to our subsidiaries may be downgraded by one or more of S&P, Moody’s or Fitch if they believe that we or the applicable subsidiary has experienced adverse developments in our business, financial condition or operating results. These ratings are important to our ability to market our products and to maintain our competitive position and customer confidence in our products. A downgrade in these ratings, or the announcement of a potential for a downgrade, could have a material adverse effect on our business, financial condition and operating results. Our principal operating subsidiaries had been assigned the following ratings as of the date of this report:

 

     MOODY’S   

MOODY’S

OUTLOOK

   S&P   

S&P

OUTLOOK

   FITCH   

FITCH

OUTLOOK

Radian Guaranty

   Aa3    Stable    AA    Stable    AA    Stable

Radian Insurance

   Aa3    Stable    AA    Stable    AA    Stable

Amerin Guaranty

   Aa3    Stable    AA    Stable    AA    Stable

Radian Asset Assurance

   Aa3    Stable    AA    Negative    AA    Negative

Radian Asset Assurance Limited

   —      —      AA    Negative    AA    Negative

 

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If the financial strength ratings assigned to any of our mortgage insurance subsidiaries were to fall below “Aa3” from Moody’s or the “AA” level from S&P and Fitch, then national mortgage lenders and a large segment of the mortgage securitization market, including Fannie Mae and Freddie Mac, generally would not purchase mortgages or mortgage-backed securities insured by that subsidiary. Any downgrade of the ratings assigned to our financial guaranty subsidiaries would limit the desirability of their respective direct insurance products and would reduce the value of Radian Asset Assurance’s reinsurance, even to the point where primary insurers may be unwilling to continue to cede insurance to Radian Asset Assurance at attractive rates. In addition, many of Radian Asset Assurance’s reinsurance agreements give the primary insurers the right to recapture business ceded to Radian Asset Assurance under these agreements, and in some cases, the right to increase commissions charged to Radian Asset Assurance if Radian Asset Assurance’s insurance financial strength rating is downgraded below specified levels. Accordingly, Radian Asset Assurance’s competitive position and prospects for future financial guaranty reinsurance opportunities would be damaged by a downgrade in its ratings. For example, downgrades that occurred in October 2002 and in May 2004 triggered these recapture rights. See “Ratings” in Item 1 for more information regarding these downgrades. We cannot be certain that the impact on our business of any future downgrades would not be worse than the impact resulting from these prior downgrades.

In addition to the financial strength ratings assigned to our subsidiaries, we have been assigned a senior debt rating of A+ by Fitch, A by S&P and A2 by Moody’s. The credit ratings generally impact the interest rates that we pay on money that we borrow. Therefore, a downgrade in our credit ratings could increase our cost of borrowing which would have an adverse affect on our liquidity, financial condition and results of operations.

An increase in our subsidiaries’ risk-to-capital or leverage ratios may prevent them from writing new insurance.

Rating agencies and state insurance regulators impose capital requirements on our subsidiaries. These capital requirements include risk-to-capital ratios, leverage ratios and surplus requirements that limit the amount of insurance that these subsidiaries may write. For example, Moody’s and S&P have entered into an agreement with Radian Guaranty that obligates Radian Guaranty to maintain specified levels of capital in Radian Insurance as a condition of the issuance and maintenance of Radian Insurance’s ratings. A material reduction in the statutory capital and surplus of any of our subsidiaries, whether resulting from underwriting or investment losses or otherwise, or a disproportionate increase in risk in force, could increase that subsidiary’s risk-to-capital ratio or leverage ratio. This in turn could limit that subsidiary’s ability to write new business or require that subsidiary to lower its ratios by obtaining capital contributions from us, reinsuring existing business or reducing the amount of new business it writes, which could have a material adverse effect on our business, financial condition and operating results.

If the estimates we use in establishing loss reserves for our mortgage insurance or financial guaranty business are incorrect, we may be required to take unexpected charges to income and our ratings may be lowered.

We establish loss reserves in both our mortgage insurance and financial guaranty businesses to provide for the estimated cost of claims. However, our loss reserves may be inadequate to protect us from the full amount of claims we may have to pay. Setting our loss reserves involves significant reliance on estimates of the likelihood, magnitude and timing of anticipated losses. The models and estimates we use to establish loss reserves may prove to be inaccurate, especially during an extended economic downturn. Further, if our estimates are inadequate, we may be forced by insurance and other regulators or rating agencies to increase our reserves, which could result in a downgrade of the insurance financial strength ratings assigned to our operating subsidiaries. Failure to establish adequate reserves or a requirement that we increase our reserves could have a material adverse effect on our business, financial condition and operating results.

In our mortgage insurance business, in accordance with GAAP, we generally do not establish reserves until we are notified that a borrower has failed to make at least two payments when due. Upon notification that two

 

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payments have been missed, we establish a loss reserve by using historical models based on a variety of loan characteristics, including the status of the loan as reported by the servicer of the loan, economic conditions, the estimated amount recoverable by foreclosure and the estimated foreclosure period in the area where a default exists. These reserves are therefore based on a number of assumptions and estimates that may prove to be inaccurate.

It is even more difficult to estimate the appropriate loss reserves for our financial guaranty business because of the nature of potential losses in that business. We establish both case and non-specific reserves for losses. We increase case reserves when we determine that a default has occurred. We also establish non-specific reserves to reflect deterioration of our insured credits for which we have not provided specific reserves.

In January and February of 2005, we discussed with the SEC staff, both separately and together with other members of the financial guaranty industry, the differences in loss reserve practices followed by different financial guaranty industry participants. On June 8, 2005, the FASB added a project to its agenda to consider the accounting by insurers for financial guaranty insurance. The FASB will consider several aspects of the insurance accounting model, including claims liability recognition, premium recognition and the related amortization of deferred policy acquisition costs. In addition, we also understand that the FASB may expand the scope of this project to include income recognition and loss reserving methodology in the mortgage insurance industry. Proposed and final guidance from the FASB regarding accounting for financial guaranty insurance is expected to be issued in 2006. When and if the FASB or the SEC reaches a conclusion on these issues, we and the rest of the financial guaranty and mortgage insurance industries may be required to change some aspects of our accounting policies. If the FASB or the SEC were to determine that we should account for our financial guaranty contracts differently, for example by requiring them to be treated solely as one or the other of short-duration or long-duration contracts under SFAS No. 60, this determination could impact our accounting for loss reserves, premium revenue and deferred acquisition costs, all of which are covered by SFAS No. 60. Management is unable to estimate what impact, if any, the ultimate resolution of this issue will have on our financial condition or operating results.

Our success depends on our ability to assess and manage our underwriting risks.

Our mortgage insurance and financial guaranty premium rates may not adequately cover future losses. Our mortgage insurance premiums are based upon our expected risk of claims on insured loans, and take into account, among other factors, each loan’s LTV, type (e.g., prime vs. non-prime or fixed vs. variable payments), term, occupancy status and coverage percentage. Similarly, our financial guaranty premiums are based upon our expected risk of claim on the insured obligation, and take into account, among other factors, the rating and creditworthiness of the issuer of the insured obligations, the type of insured obligation, the policy term and the structure of the transaction being insured. In addition, our premium rates take into account expected cancellation rates, operating expenses and reinsurance costs, as well as profit and capital needs and the prices that we expect our competitors to offer.

We generally cannot cancel or elect not to renew the mortgage insurance or financial guaranty insurance coverage we provide, and because we generally fix premium rates for the life of a policy when issued, we cannot adjust renewal premiums or otherwise adjust premiums over the life of a policy. If the risk underlying a particular mortgage insurance or financial guaranty coverage develops more adversely than we anticipate, or if national and regional economies undergo unanticipated stress, we generally cannot increase premium rates on in-force business, cancel coverage or elect not to renew coverage to mitigate the effects of these adverse developments. Despite the analytical methods we employ, our premiums earned and the associated investment income on those premiums may ultimately prove to be inadequate to compensate for the losses that we may incur. An increase in the amount or frequency of claims beyond the levels contemplated by our pricing assumptions could have a material adverse effect on our business, financial condition and operating results.

 

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Our success depends, in part, on our ability to manage risks in our investment portfolio.

Our income from our investment portfolio is one of our primary sources of cash flow to support our operations and claim payments. If we incorrectly calculate our policy liabilities, or if we improperly structure our investments to meet those liabilities, we could have unexpected losses, including losses resulting from forced liquidation of investments before their maturity. Our investments and investment policies and those of our subsidiaries are subject to state insurance laws. We may be forced to change our investments or investment policies depending upon regulatory, economic and market conditions and the existing or anticipated financial condition and operating requirements, including the tax position, of our business segments.

We cannot be certain that our investment objectives will be achieved. Although our portfolio consists mostly of highly rated investments that comply with applicable regulatory requirements, the success of our investment activity is affected by general economic conditions, which may adversely affect the markets for interest-rate-sensitive securities, including the extent and timing of investor participation in these markets, the level and volatility of interest rates and, consequently, the value of our fixed-income securities. Volatility or illiquidity in the markets in which we directly or indirectly hold positions could have a material adverse effect on our business, financial condition and operating results.

As a holding company, we depend on our subsidiaries’ ability to transfer funds to us to pay dividends and to meet our obligations.

We act principally as a holding company for our insurance subsidiaries and do not have any significant operations of our own. Dividends from our subsidiaries and permitted payments to us under our expense- and tax-sharing arrangements with our subsidiaries, along with income from our investment portfolio and dividends from our affiliates (C-BASS and Sherman), are our principal sources of cash to pay stockholder dividends and to meet our obligations. These obligations include our operating expenses and interest and principal payments on debt. The payment of dividends and other distributions to us by our insurance subsidiaries is regulated by insurance laws and regulations. In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance regulatory approval. In addition, our insurance subsidiaries’ ability to pay dividends to us, and our ability to pay dividends to our stockholders, is subject to various conditions imposed by the rating agencies for us to maintain our ratings. If the cash we receive from our subsidiaries pursuant to dividend payment and tax-sharing arrangements is insufficient for us to fund our obligations, we may be required to seek capital by incurring additional debt, by issuing additional equity or by selling assets, which we may be unable to do on favorable terms, if at all. The need to raise additional capital or the failure to make timely payments on our obligations could have a material adverse effect on our business, financial condition and operating results.

Our reported earnings are subject to fluctuations based on changes in our credit derivatives that require us to adjust their fair market value as reflected on our income statement.

Our business includes the provision of credit enhancement in the form of derivative contracts. The gains and losses on these derivative contracts are derived from internally generated models, which may differ from other models. We estimate fair value amounts using market information, to the extent available, and valuation methodologies that we deem appropriate. The gains and losses on assumed derivative contracts are provided by the primary insurance companies. Considerable judgment is required to interpret available market data to develop the estimates of fair value. Accordingly, our estimates are not necessarily indicative of amounts we could realize in a current market exchange, due to, among other factors, the lack of a liquid market. Temporary market changes as well as actual credit improvement or deterioration in these contracts are reflected in the mark-to-market gains and losses. Because these adjustments are reflected on our income statement, they affect our reported earnings and create earnings volatility even though they might not have a cash flow effect.

The performance of our strategic investments could harm our financial results.

Part of our business involves strategic investments in other companies, and we generally do not have control over the way that these companies run their day-to-day operations. In particular, our financial services segment

 

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consists mostly of our strategic interests in C-BASS and Sherman. At December 31, 2005, we had investments in affiliates of $446.2 million. Our ability to engage in additional strategic investments is subject to the availability of capital and maintenance of our insurance financial strength ratings. The performance of our strategic investments could be harmed by:

 

    the performance of our strategic partners;

 

    changes in the financial markets generally and in the industries in which our strategic partners operate, including increased competition from new entrants in these industries;

 

    significant litigation involving the companies in which we hold a strategic interest or other significant costs incurred by such companies in complying with regulatory or other applicable laws; or

 

    changes in interest rates or other macroeconomic factors that might diminish the profitability of these businesses.

C-BASS’s results could vary significantly from period to period. As part of its business, C-BASS securitizes non-conforming mortgages into mortgage-backed securities. As a result, a portion of C-BASS’s income depends on its ability to sell different tranches of its securities in the capital markets, which can be volatile, depending on interest rates, credit spreads and liquidity. In addition, C-BASS also owns mortgage-backed securities, some of which can be called for redemption, particularly in low interest-rate environments. Redemptions can result in volatility in C-BASS’s quarterly results as can the application of accounting rules that require C-BASS to mark many components of its balance sheet to market. Although there has been growth in the volume of non-conforming mortgage originations in recent years, growth in this industry may not continue if interest rates continue to rise or competition in the industry continues to increase. If C-BASS is unable to continue to successfully grow its portfolio of non-conforming mortgages, its income could be negatively affected.

Sherman’s results could be adversely impacted by increased pricing competition for the pools of consumer assets they purchase, as well as a reduction in the success of their collection efforts due to macroeconomic or other factors. In addition, results of their credit card origination business are sensitive to interest-rate changes, charge-off losses and the success of their collection efforts.

As a result of their significant amount of collection efforts, there is a risk that either C-BASS or Sherman could be subject to consumer related lawsuits and other investigations related to fair debt collection practices, which could have an adverse effect on C-BASS’s or Sherman’s income, reputation and future ability to conduct business.

Our international operations subject us to numerous risks.

We have committed and may in the future commit additional significant resources to expand our international operations, particularly in the U.K. We also are in the process of applying to commence international mortgage operations in Hong Kong. Accordingly, we are subject to a number of risks associated with our international business activities, including:

 

    risks of war and civil disturbances or other events that may limit or disrupt markets;

 

    dependence on regulatory and third-party approvals;

 

    changes in rating or outlooks assigned to our foreign subsidiaries by rating agencies;

 

    challenges in attracting and retaining key foreign-based employees, customers and business partners in international markets;

 

    foreign governments’ monetary policies and regulatory requirements;

 

    economic downturns in targeted foreign mortgage origination markets;

 

    interest-rate volatility in a variety of countries;

 

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    the burdens of complying with a wide variety of foreign regulations and laws, some of which may be materially different than the regulatory and statutory requirements we face in our domestic business, and which may change unexpectedly;

 

    potentially adverse tax consequences;

 

    restrictions on the repatriation of earnings;

 

    foreign currency exchange rate fluctuations; and

 

    the need to develop and market products appropriate to the various foreign markets.

Any one or more of the risks listed above could limit or prohibit us from developing our international operations profitably. In addition, we may not be able to effectively manage new operations or successfully integrate them into our existing operations, which could have a material adverse effect on our business, financial condition or operating results.

Our business may suffer if we are unable to meet our customers’ technological demands.

Participants in the mortgage insurance and financial guaranty industries rely on e-commerce and other technologies to provide and expand their products and services. Our customers generally require that we provide aspects of our products and services electronically, and the percentage of our new insurance written and claims processing that we deliver electronically has continued to increase. We expect this trend to continue and, accordingly, we may be unable to satisfy our customers’ requirements if we fail to invest sufficient resources or otherwise are unable to maintain and upgrade our technological capabilities. This may result in a decrease in the business we receive, which could impact our profitability.

Our information technology systems may not be configured to process information regarding new and emerging products.

Many of our information technology systems have been in place for a number of years, and many of them originally were designed to process information regarding traditional products. As products such as reduced documentation or interest-only mortgages with new features emerge, or when we insure structured transactions with unique features, our systems may require modification in order to recognize these features to allow us to price or bill for our insurance of these products appropriately. Our systems also may not be capable of recording, or may incorrectly record, information about these products that may be important to our risk management and other functions. In addition, our customers may encounter similar technological issues that prevent them from sending us complete information about the products or transactions that we insure. Making appropriate modifications to our systems involves inherent time lags and may require us to incur significant expenses. The inability to make necessary modifications to our systems in a timely and cost-effective manner may have adverse effects on our business, financial condition and operating results.

Risks Particular to Our Mortgage Insurance Business

A decrease in the volume of high-LTV home mortgage originations or an increase in the volume of cancellations or non-renewals of our existing policies could have a significant effect on our revenues.

We generally provide private mortgage insurance on high-LTV home mortgages. Factors that could lead to a decrease in the volume of high-LTV home mortgage originations, and consequently, reduce the demand for our mortgage insurance products, include:

 

    a decline in economic conditions generally or in conditions in regional and local economies;

 

    the level of home mortgage interest rates;

 

    adverse population trends, lower homeownership rates and the rate of household formation; and

 

    changes in government housing policies encouraging loans to first-time homebuyers.

 

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Most of our mortgage insurance premiums earned each month are derived from the monthly renewal of policies that we previously have written. As a result, a decrease in the length of time that our mortgage insurance policies remain in force reduces our revenues and could have a material adverse effect on our business, financial condition and operating results. Fannie Mae and Freddie Mac generally permit homeowners to cancel their mortgage insurance when the principal amount of a mortgage falls below 80% of the home’s value. Factors that are likely to increase the number of cancellations or non-renewals of our mortgage insurance policies include:

 

    falling mortgage interest rates (which tends to lead to increased refinancings and associated cancellations of mortgage insurance);

 

    appreciating home values; and

 

    changes in the mortgage insurance cancellation requirements applicable to mortgage lenders and homeowners.

Because our mortgage insurance business is concentrated among relatively few major customers, our revenues could decline if we lose any significant customer.

Our mortgage insurance business depends to a significant degree on a small number of customers. Our top ten mortgage insurance customers are generally responsible for approximately half of both our primary new insurance written in a given year and our direct primary risk in force. This concentration of business may increase as a result of mergers of those customers or other factors. Our master policies and related lender agreements do not, and by law cannot, require our mortgage insurance customers to do business with us. The loss of business from even one of our major customers could have a material adverse effect on our business, financial condition and operating results.

A large portion of our mortgage insurance risk in force consists of loans with high-LTV ratios and loans that are non-prime, or both, which generally result in more and larger claims than loans with lower-LTV ratios and prime loans.

We generally provide private mortgage insurance on mortgage products that have more risk than conforming mortgage products. A large portion of our mortgage insurance in force consists of insurance on mortgage loans with LTVs at origination of more than 90%. Mortgage loans with LTVs greater than 90% are expected to default substantially more often than those with lower LTVs. In addition, when we are required to pay a claim on a higher LTV loan, it is generally more difficult to recover our costs from the underlying property, especially in areas with declining property values.

Due to competition for prime loan business from lenders offering alternative arrangements, such as simultaneous second mortgages, a large percentage of our mortgage insurance in force is written on non-prime loans, which we believe to be the largest area for growth in the private mortgage insurance industry. In 2005, non-prime business accounted for $17.8 billion or 41.7% of our new primary mortgage insurance written (63.3% of which was Alt-A), compared to $16.4 billion or 36.6% in 2004 (61.9% of which was Alt-A). At December 31, 2005, non-prime insurance in force was $34.7 billion or 31.7% of total primary insurance in force, compared to $35.7 billion or 31.0% of primary insurance in force at December 31, 2004. Although we historically have limited the insurance of these non-prime loans to those made by lenders with good results and servicing experience in this area, because of the lack of data regarding the performance of non-prime loans, and our relative inexperience in insuring these loans, we may fail to estimate default rates properly and may incur larger losses than we anticipate, which could have a material adverse effect on our business, financial condition and operating results. In general, non-prime loans are more likely to go into default and require us to pay claims. In addition, some of our non-prime business, in particular Alt-A loans, tends to have larger loan balances relative to our other loans. We cannot be certain that the increased premiums that we charge for mortgage insurance on non-prime loans will be adequate to compensate us for the losses we incur on these products.

We use Smart Home reinsurance arrangements as a way of managing our exposure to non-prime risk. Under these arrangements, we cede a portion of the risk associated with a portfolio of non-prime residential mortgage

 

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loans insured by us to an unaffiliated reinsurance company. The reinsurance company in turn issues credit-linked notes to investors in the capital markets. As a consequence of these arrangements, we are able to effectively transfer a portion of the non-prime risk that we would otherwise hold to investors that are willing to hold the risk in exchange for payments of interest and premium on the credit-linked notes. By ceding risk in this manner, we are able to continue to take on more non-prime risk and the higher premiums associated with insuring these types of products. As a result, we consider Smart Home arrangements to be very important to our ability to effectively manage our risk profile and to remain competitive in the non-prime market. Because the Smart Home arrangement ultimately depends on the willingness of investors to invest in Smart Home securities, we cannot be certain that Smart Home will always be available to us or will be available on terms that are acceptable to us. If we are unable to continue to use Smart Home arrangements, our ability to participate in the non-prime mortgage market could be limited, which could have a material adverse effect on our business, financial condition and operating results.

Some of our mortgage insurance products are riskier than traditional mortgage insurance.

We offer pool mortgage insurance, which exposes us to different risks than the risks applicable to primary mortgage insurance. Our pool mortgage insurance products generally cover all losses in a pool of loans up to our aggregate exposure limit, which generally is between 1% and 10% of the initial aggregate loan balance of the entire pool of loans. Under pool insurance, we could be required to pay the full amount of every loan in the pool within our exposure limits that is in default and upon which a claim is made until the aggregate limit is reached, rather than a percentage of the loan amount, as is the case with traditional primary mortgage insurance. At December 31, 2005, $2.7 billion of our mortgage insurance risk in force was attributable to pool insurance.

Approximately 32% of our mortgage insurance risk in force consists of adjustable-rate mortgages or ARMs. Our claim frequency on ARMs has been higher then on fixed-rate loans due to monthly payment increases that occur when interest rates rise. We believe that claims on ARMs will continue to be substantially higher than for fixed-rate loans during prolonged periods of rising interest rates. In addition, we insure interest-only mortgages, where the borrower pays only the interest charge on a mortgage for a specified period of time, usually five to ten years, after which the loan payment increases to include principal payments. These loans may have a heightened propensity to default because of possible “payment shocks” after the initial low-payment period expires and because the borrower does not automatically build equity as payments are made.

We also write credit insurance on non-traditional, mortgage-related assets such as second mortgages, home equity loans and mortgages with LTVs above 100%, provide credit enhancement to mortgage-related capital market transactions such as net interest margin securities and credit default swaps, and have in the past and may again write credit insurance on manufactured housing loans. These types of insurance generally have higher claim payouts than traditional mortgage insurance products. We have less experience writing these types of insurance and less performance data on this business, which could lead to greater losses than we anticipate. Greater than anticipated losses could have a material adverse effect on our business, financial condition and operating results.

An increasing concentration of servicers in the mortgage lending industry could lead to disruptions in the servicing of mortgage loans that we insure, resulting in increased delinquencies.

We depend on reliable, consistent third-party servicing of the loans that we insure. A recent trend in the mortgage lending and mortgage loan servicing industry has been towards consolidation of loan servicers. This reduction in the number of servicers could lead to disruptions in the servicing of mortgage loans covered by our insurance policies. This, in turn, could contribute to a rise in delinquencies among those loans and could have a material adverse effect on our business, financial condition and operating results.

We face the possibility of higher claims as our mortgage insurance policies age.

Historically, most claims under private mortgage insurance policies on prime loans occur during the third through fifth year after issuance of the policies, and under policies on non-prime loans during the second through

 

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fourth year after issuance of the policies. Low mortgage interest-rate environments tend to lead to increased refinancing of mortgage loans and to lower the average age of our mortgage insurance policies. On the other hand, increased interest rates tend to reduce mortgage refinancings and cause a greater percentage of our mortgage insurance risk in force to reach its anticipated highest claim frequency years. In addition, periods of growth in our business tend to reduce the average age of our policies. For example, the relatively recent growth of our non-prime mortgage insurance business means that a significant percentage of our insurance in force on non-prime loans has not yet reached its anticipated highest claim frequency years. If the growth of our new business were to slow or decline, a greater percentage of our total mortgage insurance in force could reach its anticipated highest claim frequency years. A resulting increase in claims could have a material adverse effect on our business, financial condition and operating results.

Our delegated underwriting program may subject our mortgage insurance business to unanticipated claims.

In our mortgage insurance business, we enter into agreements with our mortgage lender customers that commit us to insure loans using pre-established underwriting guidelines. Once we accept a lender into our delegated underwriting program, we generally insure a loan originated by that lender even if the lender has not followed our specified underwriting guidelines. Under this program, a lender could commit us to insure a material number of loans with unacceptable risk profiles before we discover the problem and terminate that lender’s delegated underwriting authority. Even if we terminate a lender’s underwriting authority, we remain at risk for any loans previously insured on our behalf by the lender before that termination. The performance of loans insured through programs of delegated underwriting has not been tested over a period of extended adverse economic conditions, meaning that the program could lead to greater losses than we anticipate. Greater than anticipated losses could have a material adverse effect on our business, financial condition and operating results.

We face risks associated with our contract underwriting business.

As part of our mortgage insurance business, we provide contract underwriting services to some of our mortgage lender customers, even with respect to loans for which we are not providing mortgage insurance. Under the terms of our contract underwriting agreements, we agree that if we make mistakes in connection with these underwriting services, the mortgage lender may, subject to certain conditions, require us to purchase the loans or issue mortgage insurance on the loans, or to indemnify it against future loss associated with the loans. Accordingly, we assume some credit risk and interest-rate risk in connection with providing these services. In a rising interest-rate environment, the value of loans that we are required to repurchase could decrease, and consequently, our costs of those repurchases could increase. In 2005, we underwrote $4.1 billion in principal amount of loans through contract underwriting. Depending on market conditions, a significant amount of our underwriting services may be performed by independent contractors hired by us on a temporary basis. If these independent contractors make more mistakes than we anticipate, the resulting need to provide greater than anticipated recourse to mortgage lenders could have a material adverse effect on our business, financial condition and operating results.

If housing values fail to appreciate or begin to decline, we may be less able to recover amounts paid on defaulted mortgages.

The amount of loss we suffer, if any, depends in part on whether the home of a borrower who has defaulted on a mortgage can be sold for an amount that will cover unpaid principal and interest on the mortgage and expenses from the sale. If a borrower defaults under our standard mortgage insurance policy, generally we have the option of paying the entire loss amount and taking title to a mortgaged property or paying our coverage percentage in full satisfaction of our obligations under the policy. In the strong housing market of recent years, we have been able to take title to the properties underlying certain defaulted loans and to sell the properties quickly at prices that have allowed us to recover most or all of our losses. If housing values fail to appreciate or begin to decline, the frequency of loans going to claim and our ability to mitigate our losses on defaulted mortgages may be reduced, which could have a material adverse effect on our business, financial condition and operating results.

 

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Our mortgage insurance business faces intense competition from other mortgage insurance providers and from alternative products.

The United States mortgage insurance industry is highly dynamic and intensely competitive. Our competitors include:

 

    other private mortgage insurers, some of which are subsidiaries of well-capitalized companies with stronger insurance financial strength ratings and greater access to capital than we have;

 

    federal and state governmental and quasi-governmental agencies, principally the VA and the FHA, which has increased its competitive position in areas with higher home prices by streamlining its down-payment formula and reducing the premiums it charges; and

 

    mortgage lenders that demand increased participation in revenue-sharing arrangements such as captive reinsurance arrangements.

Governmental and quasi-governmental entities typically do not have the same capital requirements that we and other mortgage insurance companies have, and therefore, may have financial flexibility in their pricing and capacity that could put us at a competitive disadvantage. In the event that a government-owned or sponsored entity in one of our markets determines to reduce prices significantly or alter the terms and conditions of its mortgage insurance or other credit enhancement products in furtherance of social or other goals rather than a profit motive, we may be unable to compete in that market effectively, which could have an adverse effect on our financial condition and results of operations.

In addition, there are an increasing number of alternatives to traditional private mortgage insurance, and new alternatives may develop, which could reduce the demand for our mortgage insurance. Existing alternatives include:

 

    mortgage lenders structuring mortgage originations to avoid private mortgage insurance, mostly through “80-10-10 loans” or other forms of simultaneous second loans. The use of simultaneous second loans has increased significantly during recent years and is likely to continue to be a competitive alternative to private mortgage insurance, particularly in light of the following factors:

 

    the potential lower monthly cost of simultaneous second loans compared to the cost of mortgage insurance in a low-interest-rate environment;

 

    the tax deductibility in most cases of interest on second mortgages compared to the non-deductibility of mortgage insurance payments; and

 

    possible negative borrower, broker and realtor perceptions about mortgage insurance.

 

    investors using other forms of credit enhancement such as credit default swaps or securitizations as a partial or complete substitute for private mortgage insurance; and

 

    mortgage lenders and other intermediaries that forego third-party insurance coverage and retain the full risk of loss on their high-LTV loans.

Much of the competition described above is directed at prime loans, which has led us to shift more of our business to insuring riskier, non-prime loans. In addition, the intense competition we face in the mortgage insurance industry requires that we dedicate time and energy to the development and introduction of competitive new products and programs. Our inability to compete with other providers and the various alternatives to traditional mortgage insurance, including the timely introduction of profitable new products and programs, or our incurring increased losses as a result of insuring more non-prime loans could have a material adverse effect on our business, financial condition and operating results.

Because many of the mortgage loans that we insure are sold to Fannie Mae and Freddie Mac, changes in their charters or business practices could significantly impact our mortgage insurance business.

Fannie Mae’s and Freddie Mac’s charters generally prohibit them from purchasing any mortgage with a loan amount that exceeds 80% of the home’s value, unless that mortgage is insured by a qualified insurer or the

 

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mortgage seller retains at least a 10% participation in the loan or agrees to repurchase the loan in the event of a default. As a result, high-LTV mortgages purchased by Fannie Mae or Freddie Mac generally are insured with private mortgage insurance. Fannie Mae and Freddie Mac are the beneficiaries of the majority of our mortgage insurance policies.

Changes in the charters or business practices of Fannie Mae or Freddie Mac could reduce the number of mortgages they purchase that are insured by us and consequently reduce our revenues. Some of Fannie Mae’s and Freddie Mac’s more recent programs require less insurance coverage than they historically have required, and they have the ability to further reduce coverage requirements, which could reduce demand for mortgage insurance and have a material adverse effect on our business, financial condition and operating results. Fannie Mae and Freddie Mac also have the ability to implement new eligibility requirements for mortgage insurers and to alter or liberalize underwriting standards on low-down-payment mortgages they purchase. We cannot predict the extent to which any new requirements may be implemented or how they may affect the operations of our mortgage insurance business, our capital requirements and our products.

Additionally, Fannie Mae and Freddie Mac could decide to treat more favorably mortgage insurance companies rated “AAA” rather than “AA.” Although this has not occurred to date, such a decision could impair our “AA”-rated subsidiaries’ ability to compete with “AAA”-rated companies (of which there currently is one) and could have a material adverse effect on our business, financial condition and operating results.

Fannie Mae’s and Freddie Mac’s business practices may be impacted by legislative or regulatory changes governing their operations and the operations of other government-sponsored enterprises. Fannie Mae and Freddie Mac currently are subject to ongoing investigations regarding their accounting practices, disclosures and other matters, and legislation proposing increased regulatory oversight over them is currently under consideration in the U.S. Congress. The proposed legislation encompasses substantially all of the operations of Fannie Mae and Freddie Mac and is intended to be a comprehensive overhaul of the existing regulatory structure. Although we cannot predict whether, or in what form, this legislation will be enacted, the proposed legislation could limit the growth of Fannie Mae and Freddie Mac, which could reduce the size of the mortgage insurance market and consequently have an adverse effect on our operations, financial condition and results of operations.

Legislation and regulatory changes and interpretations could harm our mortgage insurance business.

Our business and legal liabilities may be affected by the application of existing federal or state consumer lending and insurance laws and regulations, or by unfavorable changes in these laws and regulations. For example, recent regulatory changes have reduced demand for private mortgage insurance by increasing the maximum loan amount that the FHA can insure and reducing the premiums it charges. Also, we have been subject to consumer lawsuits alleging violations of the provisions of the RESPA that prohibit the giving of any fee, kickback or thing of value under any agreement or understanding that real estate settlement services will be referred.

In addition, proposed changes to the application of RESPA could harm our competitive position. HUD proposed an exemption under RESPA for lenders that, at the time a borrower submits a loan application, give the borrower a firm, guaranteed price for all the settlement services associated with the loan, commonly referred to as “bundling.” In 2003, HUD withdrew the proposed rule and submitted another rule to the Office of Management and Budget, the contents of which have not yet been made public. If bundling is exempted from RESPA, mortgage lenders may have increased leverage over us, and the premiums we are able to charge for mortgage insurance could be negatively affected.

 

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Risks Particular to Our Financial Guaranty Business

Our financial guaranty business may subject us to significant risks from the failure of a single company, municipality or other entity whose obligations we have insured.

The breadth of our financial guaranty business exposes us to potential losses in a variety of our products as a result of credit problems with one counterparty. For example, we could be exposed to an individual corporate credit risk in multiple transactions if the credit is contained in multiple portfolios of collateralized debt obligations that we have insured, or if one counterparty (or its affiliates) acts as the originator or servicer of the underlying assets or loans backing any of the structured securities that we have insured. Although we track our aggregate exposure to single counterparties in our various lines of business and have established underwriting criteria to manage aggregate risk from a single counterparty, we cannot be certain that our ultimate exposure to a single counterparty will not exceed our underwriting guidelines, due to merger or otherwise, or that an event with respect to a single counterparty will not cause a significant loss in one or more of the transactions in which we face risk to such counterparty. In addition, because we insure and reinsure municipal obligations, we can have significant exposures to individual municipal entities, directly or indirectly through explicit or implicit support of related entities. Even though we believe that the risk of a complete loss on some municipal obligations generally is lower than for corporate credits because some municipal bonds are backed by taxes or other pledged revenues, a single default by a municipality could have a significant impact on our liquidity or could result in a large or even complete loss that could have a material adverse effect on our business, financial condition and operating results.

Our financial guaranty business is concentrated among relatively few major customers, meaning that our revenues could decline if we lose any significant customer.

Our financial guaranty business derives a significant percentage of its annual gross premiums from a small number of customers. A loss of business from even one of our major customers could have a material adverse effect on our business, financial condition and operating results. In May 2004, Moody’s downgraded the financial strength rating of Radian Reinsurance Inc., our principal financial guaranty reinsurance subsidiary. As a result, one of the few primary insurer customers of our financial guaranty reinsurance business exercised its right, effective February 28, 2005, to recapture significant reinsurance ceded to us. After giving effect to this recapture, one single customer of our financial guaranty business accounted for over 19% of the premiums written by our financial guaranty business in 2005. The May 2004 downgrade followed an earlier downgrade by S&P of the same reinsurance subsidiary in October 2002 that resulted in the recapture by another of our customers of substantially all of the financial guaranty reinsurance business it had ceded to us. For more information regarding these downgrades, see “Ratings” in Item 1. Further downgrades could trigger similar recapture rights in our other primary insurer customers, or we may lose a customer for other reasons, which could have a material adverse effect on our business, financial condition and operating results.

Some of our financial guaranty products are riskier than traditional guaranties of public finance obligations.

In addition to the traditional guaranties of public finance bonds, we write guaranties involving structured finance transactions that expose us to a variety of complex credit risks and indirectly to market, political and other risks beyond those that generally apply to financial guaranties of public finance obligations. We issue financial guaranties connected with certain asset-backed transactions and securitizations secured by one or a few classes of assets, such as residential mortgages, auto loans and leases, credit card receivables and other consumer assets, obligations under credit default swaps, both funded and synthetic, and in the past have issued financial guaranties covering utility mortgage bonds and multi-family housing bonds. We also have exposure to trade credit reinsurance (which is currently in run-off), which protects sellers of goods under certain circumstances against nonpayment of their accounts receivable. These guaranties expose us to the risk of buyer nonpayment, which could be triggered by many factors, including the failure of a buyer’s business. These guaranties may

 

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cover receivables where the buyer and seller are in the same country as well as cross-border receivables. In the case of cross-border transactions, we sometimes grant coverage that effectively provides coverage to losses that could result from political risks, such as foreign currency controls and expropriation, which could interfere with the payment from the buyer. Losses associated with these non-public finance financial guaranty products are difficult to predict accurately, and a failure to properly anticipate those losses could have a material adverse effect on our business, financial condition and operating results.

We may be forced to reinsure greater risks than we desire due to adverse selection by ceding companies.

A portion of our financial guaranty reinsurance business is written under treaties that generally give the ceding company some ability to select the risks that they cede to us within the terms of the treaty. There is a risk under these treaties that the ceding companies will decide to cede to us exposures that have higher rating agency capital charges or that the ceding companies expect to be less profitable, which could have a material adverse effect on our business, financial condition and operating results. We attempt to mitigate this risk in a number of ways, including requiring ceding companies to retain a specified minimum percentage on a pro-rata basis of the ceded business, but we cannot be certain that our mitigation attempts will succeed.

Our financial guaranty business faces intense competition.

The financial guaranty industry is highly competitive. The principal sources of direct and indirect competition are:

 

    other financial guaranty insurance companies;

 

    multiline insurers that have increased their participation in financial guaranty reinsurance, some of which have formed strategic alliances with some of the U.S. primary financial guaranty insurers;

 

    other forms of credit enhancement, including letters of credit, guaranties and credit default swaps provided in most cases by foreign and domestic banks and other financial institutions, some of which are governmental enterprises, that have been assigned the highest ratings awarded by one or more of the major rating agencies or have agreed to post collateral to support their risk position;

 

    alternate transaction structures that permit issuers to securitize assets more cost-effectively without the need for credit enhancement of the types we provide; and

 

    cash-rich investors seeking additional yield on their investments by foregoing credit enhancement.

Competition in the financial guaranty reinsurance business is based on many factors, including overall financial strength, financial strength ratings, pricing and service. The rating agencies allow credit to a ceding company’s capital requirements and single risk limits for reinsurance that is ceded. The amount of this credit is in part determined by the financial strength rating of the reinsurer. Some of our competitors have greater financial resources than we have and are better capitalized than we are and/or have been assigned higher ratings by one or more of the major rating agencies. In addition, the rating agencies could change the level of credit they will allow a ceding company to take for amounts ceded to us and/or similarly rated reinsurers.

In 2004, the laws applicable to New York-domiciled monoline financial guarantors were amended to permit them to use certain default swaps meeting applicable requirements as statutory collateral (i.e., to offset their statutory single risk limits, aggregate risk limits, aggregate net liability calculations and contingency reserve requirements). This regulatory change, which makes credit default swaps a more attractive alternative to traditional financial guaranty reinsurance, may result in a reduced demand for traditional monoline financial guaranty reinsurance in the future. An inability to compete for desirable financial guaranty business could have a material adverse effect on our business, financial condition and operating results.

Legislation and regulatory changes and interpretations could harm our financial guaranty business.

The laws and regulations affecting the municipal, asset-backed and trade credit debt markets, as well as other governmental regulations, could be changed in ways that subject us to additional legal liability or affect the

 

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demand for the primary financial guaranty insurance and reinsurance that we provide. Any such change could have a material adverse effect on our business, financial condition and operating results.

Changes in tax laws could reduce the demand for or profitability of financial guaranty insurance, which could harm our business.

Any material change in the U.S. tax treatment of municipal securities, or the imposition of a “flat tax” or a national sales tax in lieu of the current federal income tax structure in the United States, could adversely affect the market for municipal obligations and, consequently, reduce the demand for related financial guaranty insurance and reinsurance. For example, the Jobs and Growth Tax Relief Reconciliation Act of 2003, enacted in May 2003, significantly reduced the federal income tax rate for individuals on dividends and long-term capital gains. This tax change may reduce demand for municipal obligations and, in turn, may reduce the demand for financial guaranty insurance and reinsurance of these obligations by increasing the comparative yield on dividend-paying equity securities. Future potential changes in U.S. tax laws, including current efforts to eliminate the federal income tax on dividends, might also affect demand for municipal obligations and for financial guaranty insurance and reinsurance of those obligations.

We may be unable to develop or sustain our financial guaranty business if it cannot obtain reinsurance or other forms of capital.

In order to comply with regulatory, rating agency and internal capital and single risk retention limits as our financial guaranty business grows, we need access to sufficient reinsurance or other capital capacity to underwrite transactions. The market for reinsurance recently has become more concentrated because several participants have exited the industry. If we are unable to obtain sufficient reinsurance or other forms of capital, we may be unable to issue new policies and grow our financial guaranty business.

 

Item 1B. Unresolved Staff Comments.

None.

 

Item 2. Properties.

At our corporate headquarters in Philadelphia, Pennsylvania, we lease approximately 159,500 square feet of office space under a lease that expires in August 2017 and approximately 23,500 square feet of temporary space under a lease that expires April 1, 2006. In addition, we also lease the following:

 

    Approximately 29,000 square feet of office space for our mortgage insurance regional offices, service centers and on-site offices throughout the United States. We negotiated early termination buy-outs for the service center leases that were expiring in 2005. The leases for this space now expire between 2006 and 2010;

 

    Approximately 121,000 square feet of office space (approximately 55,000 square feet of which we sublease to others) for our financial guaranty operations in New York City. The lease for this space expires in 2015;

 

    Approximately 7,500 square feet of office space for our mortgage insurance and financial guaranty operations in two separate locations in London. There are two separate leases for this space, one which expires in 2012 (with an early termination option in 2007) and one which is a one-year lease that will expire during the fourth quarter of 2006;

 

    Approximately 1,000 square feet of office space for our mortgage insurance operations in Hong Kong. The lease for this space will expire March 31, 2007; and

 

    Approximately 43,000 square feet of office space for our data centers in Philadelphia and Dayton, Ohio. The leases for these offices expire in September 2012 and August 2015.

On October 31, 2005, we amended the lease for our Philadelphia headquarters to add approximately 7,500 square feet to our total leased space in Philadelphia and to extend the lease until August 31, 2017. In connection

 

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with this amendment, we are entitled to receive $1.0 million in rent concessions and approximately $2.0 million in tenant allowance for construction in the additional leased space. In the first quarter of 2005, we announced the closing of four field offices for our mortgage insurance operations, comprising 8,800 square feet. All of these locations had leases that expired in 2005. In February 2006, we announced the closing of three additional field offices, comprising 10,400 square feet. Two of the three leases for this space expire in July 2006. The third lease expires in 2009, and we are attempting to sublease this space. With respect to all of our facilities, we believe we will be able to obtain satisfactory lease renewal terms. We believe our existing properties are well utilized, suitable and adequate for our present circumstances.

We currently maintain three Data Centers (Dayton, New York and Philadelphia) and two Disaster Recovery (“DR”) sites (Dayton and Philadelphia) to support all of our businesses. We have verified that these Data Centers and DR sites work properly. We have established “hot site” recovery plans for London, New York and Philadelphia from a business continuity standpoint. During 2005, we introduced a new contract underwriting system for underwriters at our Service Centers and On-Sites. This new system includes access through a web-based Portal and ordering, billing, fulfillment and payment functionality, along with integrated document management and reporting capabilities. Our strategic direction for all new application development continues to include deploying web-based custom or off-the-shelf software running on a UNIX, Linux and/or Windows platform. PeopleSoft Financial Systems is currently installed and operational. We maintain our current legacy systems that support claims, risk management and mortgage insurance underwriting in the Philadelphia data center and at the Philadelphia DR site. We will continue to fortify our legacy systems and adjunct components as appropriate through a policy enforcement and data interchange strategy. During the past twelve months, we migrated our data operations from the New York data center to the data center in Dayton. This will provide continuous availability at the Dayton data center and full business recovery capability at the Philadelphia data center.

 

Item 3. Legal Proceedings.

In January 2004, a complaint was filed in the United States District Court for the Eastern District of Pennsylvania against Radian Guaranty by Whitney Whitfield and Celeste Whitfield seeking class action status on behalf of a nationwide class of consumers who allegedly were required to pay for private mortgage insurance provided by Radian Guaranty and whose loans allegedly were insured at more than Radian Guaranty’s “best available rate,” based upon credit information obtained by Radian Guaranty. The action alleged that the Fair Credit Reporting Act (“FCRA”) requires a notice to borrowers of such “adverse action” and that Radian Guaranty violated FCRA by failing to give such notice. The action sought statutory damages, actual damages, or both, for the people in the class, and attorneys’ fees, as well as declaratory and injunctive relief. The action also alleged that the failure to give notice to borrowers in the circumstances alleged is a violation of state law applicable to sales practices and sought declaratory and injunctive relief for this alleged violation.

On October 21, 2005, the United States District Court granted Radian Guaranty’s motion for summary judgment. The court held that mortgage insurance transactions between mortgage lenders and mortgage insurers are not consumer credit actions and are not subject to the notice requirements of FCRA. On November 8, 2005, the plaintiffs in this case appealed the district court’s judgment. Similar cases, a number of which are still pending, have been brought against several other mortgage insurers. We intend to vigorously defend the appeal of this action and any future actions concerning FCRA that may be brought against us. We cannot be certain that we will have continued success defending this case on appeal or defending against similar lawsuits that may be brought against us.

In addition to the above litigation, we are involved in litigation that has arisen in the normal course of our business. We are contesting the allegations in each such pending action and believe, based on current knowledge and after consultation with counsel, that the outcome of such litigation will not have a material adverse effect on our consolidated financial position and results of operations.

 

Item 4. Submission of Matters to a Vote of Security Holders.

None.

 

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Part II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Our common stock is listed on the New York Stock Exchange (“NYSE”) under the symbol “RDN.” At February 28, 2006, there were 83,159,404 shares outstanding and approximately 109 holders of record. The following table shows the high and low sales prices of our common stock on the NYSE for the financial quarters indicated:

 

     2005    2004
     High    Low    High    Low

1st Quarter

   $ 53.36    $ 46.15    $ 51.43    $ 40.95

2nd Quarter

     48.08      42.90      48.77      43.86

3rd Quarter

     54.58      47.00      48.67      43.43

4th Quarter

     60.38      47.40      54.00      42.30

We declared cash dividends on our common stock equal to $0.02 per share in each quarter of 2005 and 2004. As a holding company, we depend mainly upon our subsidiaries’ ability to transfer funds to us in order to pay dividends. The payment of dividends and other distributions to us by our insurance subsidiaries is regulated by insurance rules and regulations. For more information on our ability to pay dividends, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” in Item 7 and Note 10 to our Consolidated Financial Statements.

The following table provides information about repurchases by us (and our affiliated purchasers) during the quarter ended December 31, 2005, of equity securities that are registered by us pursuant to Section 12 of the Exchange Act.

Issuer Purchases of Equity Securities

 

Period

  

Total Number of

Shares Purchased

  

Average Price Paid

per Share

  

Total Number of

Shares Purchased

as Part of Publicly

Announced Plans

or Programs (1)

  

Maximum Number of

Shares that May Yet

Be Purchased Under

the Plans or

Programs (2)

10/01/05 to 10/31/05

   —        —      —      423,300

11/01/05 to 11/30/05

   —        —      —      423,300

12/01/05 to 12/31/05

   423,300    $ 58.57    423,300    —  
               

Total

   423,300    $ 58.57    423,300    —  

(1) On August 9, 2005, we announced that our board of directors had authorized the repurchase of up to 3.0 million shares of our common stock on the open market under a new repurchase plan. Share purchases under this program were funded from available working capital and were made from time to time, depending on market conditions, share price and other factors. This program did not have an expiration date and is now completed.
(2) Amounts shown in this column reflect the number of shares remaining under the 3.0 million share repurchase program referenced in Note 1 above.

On February 7, 2006, we announced that our board of directors had authorized the repurchase of up to 4.0 million shares of our common stock on the open market under a new repurchase plan. Stock purchases under this program will be funded from available working capital and will be made from time to time, depending on market conditions, stock price and other factors. The board did not set an expiration date for this program.

 

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Item 6. Selected Financial Data.

The following table sets forth our selected financial data. This information should be read in conjunction with our Consolidated Financial Statements, related notes included in Item 8 of this report and the information included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

     2005     2004     2003     2002     2001(1)  
     (In millions, except per-share amounts and ratios)  

Condensed Consolidated Statements of Income

          

Net premiums written

   $ 1,100.7     $ 1,082.5     $ 1,110.5     $ 954.9     $ 783.6  
                                        

Net premiums earned

   $ 1,018.7     $ 1,029.5     $ 1,008.2     $ 847.1     $ 715.9  

Net investment income

     208.4       204.3       186.2       178.8       147.5  

Net gains on sales of investments

     36.6       50.8       17.4       10.5       6.8  

Change in fair value of derivative instruments

     9.2       47.1       4.1       (13.0 )     (5.8 )

Other income

     25.2       32.3       63.3       44.4       42.5  

Total revenues

     1,298.1       1,364.0       1,279.2       1,067.8       906.9  

Provision for losses

     390.6       456.8       476.1       243.4       208.1  

Policy acquisition costs and other operating expenses

     341.9       327.5       339.6       276.1       216.8  

Interest expense

     43.0       34.7       37.5       28.8       17.8  

Equity in net income of affiliates

     217.7       180.6       105.5       81.8       41.3  

Pretax income

     740.3       725.6       531.5       601.3       505.5  

Net income

     522.9       518.7       385.9       427.2       360.4  

Diluted net income per share (2)

   $ 5.91     $ 5.33     $ 3.95     $ 4.27     $ 3.88  

Cash dividends declared per share

   $ .08     $ .08     $ .08     $ .08     $ .075  

Average shares outstanding-diluted

     88.7       97.9       98.5       99.5       92.0  

Condensed Consolidated Balance Sheets

          

Total assets

   $ 7,230.6     $ 7,000.8     $ 6,445.8     $ 5,393.4     $ 4,438.6  

Total investments

     5,513.7       5,470.1       5,007.4       4,200.3       3,369.5  

Unearned premiums

     849.4       770.2       718.6       618.1       513.9  

Reserve for losses and loss adjustment expenses

     801.0       801.0       790.4       624.6       588.6  

Short-term and long-term debt

     747.5       717.6       717.4       544.1       324.1  

Redeemable preferred stock

     —         —         —         —         40.0  

Stockholders’ equity

     3,662.9       3,689.1       3,225.8       2,753.4       2,306.3  

Book value per share

   $ 44.11     $ 39.98     $ 34.31     $ 29.42     $ 24.54  

Selected Ratios—Mortgage Insurance (3)

          

Loss ratio

     44.5 %     49.2 %     40.7 %     29.4 %     29.4 %

Expense ratio

     26.7       26.6       25.8       26.6       25.3  
                                        

Combined ratio

     71.2 %     75.8 %     66.5 %     56.0 %     54.7 %

Selected Ratios—Financial Guaranty (3)

          

Loss ratio

     14.9 %     26.0 %     67.1 %     26.2 %     27.2 %

Expense ratio

     55.7       45.9       38.8       33.0       40.8  
                                        

Combined ratio

     70.6 %     71.9 %     105.9 %     59.2 %     68.0 %

Other Data—Mortgage Insurance

          

Primary new insurance written

   $ 42,592     $ 44,820     $ 68,362     $ 48,767     $ 44,754  

Direct primary insurance in force

     109,684       115,315       119,887       110,273       107,918  

Direct primary risk in force

     25,729       27,012       27,106       26,273       26,004  

Total pool risk in force

     2,711       2,384       2,415       1,732       1,571  

Total other risk in force (4)

     9,709       1,205       1,053       475       348  

 

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     2005    2004    2003    2002    2001(1)
     (In millions, except per-share amounts and ratios)

Other Data—Financial Guaranty (5)

              

Net premiums written

   $ 223    $ 216    $ 369    $ 286    $ 143

Net premiums earned

     212      214      249      187      106

Net par outstanding

     76,652      66,720      76,997      66,337      59,544

Net debt service outstanding

     110,344      101,620      117,900      104,756      97,940

(1) On February 28, 2001, we acquired Enhance Financial Services Group Inc. The results for 2001 include the results of operations for Enhance Financial Services Group Inc. from the date of acquisition. See Note 1 to our Consolidated Financial Statements.
(2) Diluted net income per share and average share information per Statement of Financial Accounting Standards No. 128, “Earnings Per Share.” Amounts reflect the inclusion of shares underlying contingently convertible debt, which was redeemed on August 1, 2005. See Note 2 to our Consolidated Financial Statements.
(3) Calculated on a GAAP basis using provision for losses to calculate the loss ratio and policy acquisition costs and other operating expenses to calculate the expense ratio as a percentage of net premiums earned.
(4) Consists mostly of international insurance risk, second-lien mortgage insurance risk and other structured mortgage-related insurance risk.
(5) Amounts for 2005 and 2004 reflect the recapture of previously ceded business by one of the primary insurer customers of our financial guaranty business in the first quarter of 2005 and 2004. See Note 2 to our Consolidated Financial Statements.

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and Notes thereto included in Item 8 and the risk factors detailed in Item 1A of Part I of this report.

Overview

We provide credit protection products and financial services to mortgage lenders and other global financial institutions. As a holder of credit risk, our results are subject to macroeconomic conditions and specific events that impact the credit performance of the underlying insured assets. We experienced good results for 2005, although the business production environment for mortgage insurance and financial guaranty insurance continued to present challenges. The results of our mortgage insurance business were generally good in 2005, but revenues decreased slightly from the prior year due mainly to a continued high level of refinancings. An increase in new structured transactions and non-traditional products has partially offset the effects of the continuing unprecedented refinance wave. This refinance wave has caused continued high cancellation rates which, along with production challenges due to the increased popularity of alternatives to mortgage insurance products, has negatively impacted insurance in force. Positively, credit performance was strong as mortgage insurance claims were very low in 2005, but this was offset by an increase in delinquencies, which is a leading indicator of future claims. The mortgage insurance mix of business has continued to include a higher percentage of lower credit profile business such as Alternative A (“Alt-A”) and A minus mortgages and new unproven products such as interest-only loans. This is considered a growth area of the market as some of the prime mortgage market continues to be absorbed by “80-10-10” arrangements and other hybrid products that do not typically include mortgage insurance. We expect to continue to increase our insurance of new and emerging products that we have less experience with both domestically and internationally, which adds to the uncertainty of future credit performance. However, premiums received for these products are higher than more traditional products and often have structuring features such as deductibles that benefit our risk position. As has been the case for the last several years, much of our business has not yet reached its peak claim period. In the financial guaranty business, new business production generally continued to be challenged by tight credit spreads, which impacted premium rates more than it did our ability to close transactions. Direct public finance production remained strong and

 

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credit performance was generally good. We have also been writing more of our structured business in a super senior, more remote risk area. For 2005, the financial services segment showed another period of strong earnings and return on investment, which was, in part, a result of the low interest rate and favorable credit environment and a strong demand from investors in asset-backed securities.

We believe that our diversified credit enhancement and prudent capital management strategies are sound, and we intend to continue to implement these strategies. We see a continued convergence between the mortgage insurance and financial guaranty markets, with an emphasis on structured credit enhancement products, including credit default swaps, becoming more common in the mortgage credit enhancement market. In the mortgage insurance business, we are hopeful that stability in the housing and job markets can continue to positively impact credit performance and that modestly rising interest rates will help reduce cancellation rates, although these macroeconomic factors remain outside of our control. We will continue to be challenged to solidify our unique AA financial guaranty business platform by continuing to demonstrate the ability to diversify our products, and to grow and write quality business, which will in turn solidify our franchise. This may be difficult in a competitive, tight credit-spread environment. We have begun to slowly see some success in our efforts to increase our presence in the global markets for both mortgage and financial guaranty business. This will allow us to take advantage of our core competencies of credit risk analysis and capital allocation to write profitable business in Europe and Asia, although we don’t expect this to be a significant source of earnings for several years.

During 2005, Hurricanes Katrina, Rita and Wilma struck and caused extensive property damage to the U.S. Gulf Coast in Alabama, Louisiana, Mississippi, Florida and Texas. Our total exposure in affected counties and parishes designated by FEMA for individual assistance as of January 2006 (“FEMA-designated areas”) is as follows:

 

    Mortgage Insurance.    Our mortgage insurance primary and pool exposure to first- and second-lien mortgages is approximately $2.5 billion of risk in force on approximately $13.5 billion of insurance in force. This exposure represents approximately 8.4% of our total mortgage insurance risk in force as of December 31, 2005. Approximately 35% of this exposure is on non-prime loans. Under our master policy of insurance, we are permitted to adjust a claim where the property underlying a mortgage in default is subject to unrestored physical damage.

 

    Public Finance.    Our total public finance exposure to FEMA-designated areas is approximately $581 million in direct net par exposure and $899 million in assumed net par exposure (including $17.8 million in assumed net par exposure to the city of New Orleans) through reinsurance from several Aaa/AAA rated monoline financial guarantors. This total net par exposure represents about 3.1% of our total net par public finance exposure as of December 31, 2005. In the event of a claim, we typically are obligated under our public finance insurance policies to continue making regularly scheduled payments of debt service as and when due; and therefore, we are not initially responsible for, and may never become liable for, the entire amount of such obligation. We believe that certain obligations in the affected areas will require principal and interest advances although the ultimate losses, if any, from such obligations are uncertain.

 

    Structured Finance.    Our total structured finance exposure to FEMA-designated areas is approximately $140.3 million, including $56.9 million in direct net par exposure and $83.4 million in assumed net par exposure to insured asset-backed and mortgage-backed obligations. In addition, we also are exposed to direct pooled corporate obligations and/or obligations of asset-backed securities; however, we believe there is significant diversification of assets, both as to type and geographical dispersion of the collateral in these pools, and as a result, we view our exposure in these structures to the affected areas as immaterial. We also reinsure pooled corporate obligations that include corporate credits affected by the hurricanes. Defaults of these credits would not likely result in a material claim against us given the degree of credit protection beneath our exposure.

 

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Since August 29, 2005, we have paid approximately $0.1 million in claims on insurance written in FEMA-designated areas. While we have experienced an increase in defaults in mortgage insurance in FEMA-designated areas—approximately 6,700 defaults (3,700 related to Katrina) as of December 31, 2005—it is too early to tell how many claims we ultimately may have to pay on these defaults. There are many factors that are contributing to the uncertainty surrounding these defaults. The organizations servicing these loans are reporting defaults, in some cases, despite the existence of forbearance agreements that permit homeowners to defer mortgage payments on these loans. In addition, we anticipate, but cannot be certain, that aid (both from private organizations and from federal, state and local governments) and payments from property and casualty insurers will help to reduce the number of potential claims in these areas by providing a direct source of cash to homeowners and also serving as an economic stimulus in these areas. Limitations also exist in our master policy of insurance that could prevent us from paying all or part of a claim. For example, we are permitted to adjust a claim where the property underlying a mortgage in default is subject to unrestored physical damage. The level of damage being reported in the areas where the defaulting loans are located varies significantly from region to region.

Until we have a better understanding of how many of the hurricane-related defaults are likely to result in claims, we intend to reserve for these mortgage insurance defaults as we would for any other non-hurricane-related delinquencies. We therefore, have not taken a view that these loans will perform better or worse than any other delinquencies. As of December 31, 2005, we had established a related mortgage insurance loss reserve of $58.5 million related to the 6,700 hurricane-related defaults, including a reserve of $27.6 million for the 3,700 defaults associated with Hurricane Katrina.

As part of our own comprehensive relief program initiated in response to these hurricanes, we are supporting more flexible mortgage payment terms in order to accommodate the financial needs of homeowners in affected areas.

Business Summary

Our principal business segments are mortgage insurance, financial guaranty and financial services. The following table shows the percentage contributions to net income and equity allocated to each segment for the year ended December 31, 2005:

 

     Net Income     Equity  

Mortgage Insurance

   51 %   57 %

Financial Guaranty

   23 %   34 %

Financial Services

   26 %   9 %

Mortgage Insurance

Our mortgage insurance business provides credit-related insurance coverage, principally through private mortgage insurance, and risk management services to mortgage lending institutions located throughout the United States and select countries overseas. We provide these products and services through our wholly-owned subsidiaries, Radian Guaranty Inc., Amerin Guaranty Corporation and Radian Insurance Inc. (which we refer to as “Radian Guaranty,” “Amerin Guaranty” and “Radian Insurance”). Private mortgage insurance protects mortgage lenders from all or a portion of default-related losses on residential first mortgage loans made mostly to home buyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgage loans in the secondary mortgage market, some of which are sold to the Federal Home Loan Mortgage Corp. (“Freddie Mac”) and the Federal National Mortgage Association (“Fannie Mae”). We sometimes refer to Freddie Mac and Fannie Mae collectively as “Government Sponsored Enterprises” or “GSEs.”

Our mortgage insurance business, through Radian Guaranty, offers primary and pool private mortgage insurance coverage on residential first-lien mortgages. At December 31, 2005, primary insurance on first-lien

 

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mortgages made up 90% of our total first-lien mortgage insurance risk in force, and pool insurance on first-lien mortgages made up 10% of our total first-lien mortgage insurance risk in force. We use Radian Insurance to provide credit enhancement for mortgage-related capital market transactions and to write credit insurance on mortgage-related assets that monoline mortgage guaranty insurers are not permitted to insure, including net interest margin securities (“NIMs”), international insurance transactions, second-lien mortgages, home equity loans and credit default swaps (collectively, we refer to the risk associated with these transactions as “other risk in force”). We also insure second-lien mortgages through Amerin Guaranty. At December 31, 2005, other risk in force was 25.5% of our total mortgage insurance risk in force.

We carefully review and assess international markets for opportunities to expand our mortgage insurance operations. During 2005, we increased the level of mortgage insurance business that we have been writing internationally. On several occasions, we have provided credit protection on pools of mortgages in the United Kingdom (“U.K.”) and in the Netherlands, and we have applied for authorization to conduct mortgage insurance operations in the U.K. In 2004 and early in 2005, we entered into two mortgage reinsurance transactions in Australia, and in the fourth quarter of 2005, we wrote $7.3 billion in notional value of credit protection in credit default swap form on two large AAA tranches of mortgage-backed securities, one in Germany and one in Denmark. We’ve also recently entered into a relationship with one of the largest mortgage lenders in Hong Kong to serve as its exclusive provider of mortgage insurance. We are in the process of applying for branch authorization in Hong Kong.

Premium rates for our mortgage insurance business are determined on a risk-adjusted basis that includes borrower, loan and property characteristics. We use proprietary default and prepayment models to project the premiums we should charge, the losses and expenses we should expect to incur and the capital we need to hold in support of our risk. Pricing is established in an amount that we expect will allow a reasonable return on allocated capital. We generally cannot cancel or elect not to renew the mortgage insurance that we provide and, because we generally establish premium rates for the life of the policy when issued, we cannot adjust renewal premiums or otherwise adjust premiums over the life of the policy to mitigate the effect of adverse developments.

Our mortgage insurance business depends on a small number of lenders for a substantial portion of its business. Our top 10 mortgage insurance customers measured by primary risk in force were responsible for 44.6% of the direct primary risk in force at December 31, 2005. The top 10 customers were also responsible for 57.3% of primary new insurance written in 2005. The largest single mortgage insurance customer (including branches and affiliates of such customer), measured by new insurance written, accounted for 10.6% of new insurance written during 2005, compared to 9.6% in 2004 and 10.4% in 2003. The concentration of business with our mortgage insurance customers may increase or decrease as a result of many factors. These customers may reduce the amount of business currently done with us or cease doing business with us altogether. Our master policies and related lender agreements do not, and by law cannot, require lenders to do business with us. The loss of business from a major lender could have a materially adverse affect on our business and financial results. We expect customer concentration to continue as a result of the ongoing consolidation in the financial services industry in general and the mortgage industry in particular.

In 2005, in an effort to more appropriately align our mortgage insurance business to meet the needs of a changing business environment resulting from lender consolidation, centralization, and a movement toward a more capital markets risk-based approach, we reorganized our sales and marketing efforts to focus on four separate channels of customers: Business Direct, Strategic Accounts, Capital Markets and International. Customers are grouped into the above categories and they are serviced by four separate business units. Each channel has a business manager with profit and loss responsibility and accountability. In addition, each channel has adopted a specific and focused approach to sustaining profitable growth. In each channel, there is a priority of maximizing return on capital, enhancing top line and bottom line growth, and an ongoing pursuit of achieving efficiencies through cost reductions and increased productivity.

 

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We and other companies in the mortgage insurance industry participate in reinsurance arrangements with mortgage lenders commonly referred to as “captive reinsurance arrangements.” Under captive reinsurance arrangements, a mortgage lender typically establishes a reinsurance company that assumes part of the risk associated with that lender’s mortgages that are insured by a mortgage insurer on an individual, mortgage-by-mortgage basis (as compared to mortgages insured in structured transactions, which typically are not eligible for captive reinsurance arrangements). In return for the reinsurance company’s assumption of a portion of the risk, the mortgage insurer cedes a portion of its mortgage insurance premiums to the reinsurance company. In most cases, the risk assumed by the reinsurance company is an excess layer of aggregate losses that would be penetrated only in a situation of adverse loss development, such as losses brought on by national or regional downturns in the real estate market.

Because of many factors, including the incentives for mortgage lenders to funnel relatively higher-quality loans through the captive reinsurer, we continue to evaluate the level of revenue sharing against risk sharing on a customer-by-customer basis as part of our customer profitability analysis. We believe that all of our captive reinsurance arrangements transfer risk to the captive reinsurer at a premium rate that is commensurate with the risk. For 2005, premiums ceded under captive reinsurance arrangements were $92.9 million or 11.5% of total premiums earned during the period, compared to $87.3 million or 11.3% of total premiums earned for the same period of 2004 and $73.6 million or 10.0% for 2003. New primary insurance written under captive reinsurance arrangements for 2005 was $12.2 billion or 28.7% of total primary new insurance written, compared to $17.8 billion or 39.7% of total primary new insurance written for 2004 and $21.9 billion or 32.1% for 2003. These percentages can be volatile as a result of increases or decreases in the volume of structured transactions, which are not typically eligible for captive reinsurance arrangements. We and other mortgage insurers have faced private lawsuits alleging, among other things, that our captive reinsurance arrangements constitute unlawful payments to mortgage lenders under the anti-referral fee provisions of the Real Estate Settlement Practices Act of 1974 (“RESPA”). We also have been subject to inquiries from the New York insurance department relating to our captive reinsurance arrangements.

We have delegated underwriting programs with a significant number of our customers. Our delegated underwriting programs allow lenders to commit us to insure loans that meet agreed-upon underwriting guidelines. Delegated loans are submitted to us in various ways—fax, electronic data interchange and through the Internet. Our delegated underwriting programs currently include only lenders that are approved by our risk management area, and we routinely audit loans submitted under this program. Once we accept a lender into our delegated underwriting program, however, we generally insure all loans submitted to us by that lender even if the lender has not followed our specified underwriting guidelines. Although we have not experienced this to date, a lender could commit us to insure a material number of loans with unacceptable risk profiles before we discover the problem and terminate that lender’s delegated underwriting authority. We mitigate this risk through periodic, on-site reviews of selected delegated lenders. As of December 31, 2005, approximately 28% of the insurance in force on our books was originated on a delegated basis, compared to 30% as of December 31, 2004. To date, there have been no significant issues with loans originated on a delegated basis.

Our mortgage insurance business also utilizes its underwriting skills to provide an outsourced underwriting service to its customers known as contract underwriting. For a fee, we underwrite loan files for secondary market compliance, while concurrently assessing the file for mortgage insurance if applicable. We give recourse to our customers on loans we underwrite for compliance. If we make a material error in underwriting a loan, we agree to provide a remedy of repurchasing or placing additional mortgage insurance coverage on the loan or indemnifying the customer against loss. For 2005, loans written via contract underwriting accounted for 11.7% of applications, 11.4% of commitments, and 10.1% of certificates issued by our mortgage insurance business, compared to 20.6%, 19.7% and 17.9%, respectively, for 2004 and 26.8%, 25.8% and 22.6%, respectively, for 2003. From time to time, we sell, on market terms, loans we have purchased under contract underwriting remedies to our affiliate, Credit-Based Asset Servicing and Securitization LLC (“C-BASS”). During 2005, we sold $1.6 million of loans sold to C-BASS compared to $4.3 million of loans to C-BASS during 2004.

 

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Financial Guaranty

We entered the financial guaranty business through our acquisition in 2001 of Enhance Financial Services Group Inc. (“EFSG”), a New York-based holding company that mainly provides financial guaranty insurance and reinsurance. Financial guaranty insurance generally provides an unconditional and irrevocable guaranty to the holder of a financial obligation of full and timely payment of principal and interest when due.

Our financial guaranty business offers the following products:

 

    insurance of municipal obligations, which include tax-exempt and taxable indebtedness of states, counties, cities, utility districts and other political subdivisions, bonds issued by sovereign and sub-sovereign entities and financings for enterprises such as airports, public and private higher education and health care facilities, where the issuers of such obligations are typically rated investment grade (BBB-/Baa3 or higher);

 

    insurance of structured finance transactions, consisting of funded and non-funded or “synthetic” asset-backed obligations that are payable from or tied to the performance of a specific pool of assets and that offer a defined cash flow. Examples include residential and commercial mortgages, a variety of consumer loans, corporate loans and bonds, equipment receivables, real and personal property leases and collateralized corporate debt obligations, including obligations of counterparties under derivative transactions and credit default swaps. The insured obligations in our financial guaranty business are generally rated investment-grade, without the benefit of our insurance;

 

    financial solutions products included in our structured direct business consisting of guaranties of securities exchanges, excess-Securities Investor Protection Corporation (“SIPC”) insurance for brokerage firms and excess-Federal Deposit Insurance Corporation (“FDIC”) insurance for banks; and

 

    reinsurance of public finance, structured finance, financial solutions and trade credit obligations in which we generally rely on the underwriting performed by the primary insurer.

In October 2005, we announced that we would be exiting the trade credit reinsurance line of business. Accordingly, this line of business has been placed into run-off and we have ceased initiating new trade credit reinsurance contracts going forward. We expect that our existing trade credit reinsurance business, including claims paid, will take several years to run off, although we expect that the bulk of the remaining premiums will be earned and losses incurred over the next two years. Management does not consider the trade credit line of business to be core to our financial guaranty business, and we do not expect that our move to exit the trade credit reinsurance line of business will materially impact the overall profitability or business position of our financial guaranty business. However, in the short-term, our decision to exit the trade credit reinsurance line of business will likely have a negative impact on certain financial measures for our financial guaranty business as this business line continues to run off. Trade credit insurance protects sellers of goods under certain circumstances against non-payment of their receivables, and covers receivables where the buyer and seller are in the same country, as well as cross-border receivables. In the latter instance, the coverage sometimes extends to certain political risks (foreign currency controls, expropriation, etc.) that potentially could interfere with the payment from the buyer. In 2005, trade credit reinsurance accounted for 15.7% of financial guaranty’s net premiums written, down from 27.4% of financial guaranty’s net premiums written in 2004.

In our financial guaranty business, the issuer of an insured obligation generally pays the premiums for our insurance either in full at the inception of the policy or, in the case of most structured finance transactions, in monthly, quarterly, semi-annual or annual installments from the cash flow of the related collateral. Premiums for synthetic credit protection are generally paid in monthly, quarterly, semi-annual or annual installments, but occasionally all or a portion of the premium is paid upfront at the inception of the protection. However, in synthetic credit protection transactions, payment is due directly from our counterparty and is generally not restricted to the cash flows from the underlying obligation or collateral supporting the obligation. Since we depend on the corporate creditworthiness of our counterparty rather than the cash flows from the insured collateral for payment, we generally have a right to terminate synthetic credit protection without penalty to us if our counterparty fails to pay amounts owed to us when due under the terms of the synthetic credit protection.

 

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For public finance transactions, premiums are typically paid upfront and premium rates typically are stated as a percentage of debt service, which includes total principal and interest. For structured finance transactions, premiums are paid in installments over time and premium rates typically are stated as a percentage of the total principal. Premiums are generally non-refundable. Premiums paid in full at inception are recorded as revenue “earned” over the life of the insured obligation (or the coverage period for such obligation if shorter). Premiums paid in installments are generally recorded as revenue in the accounting period in which coverage is provided. This long and relatively predictable premium earnings pattern from our public finance transactions provides us with a relatively predictable source of future revenues. The establishment of a premium rate for a transaction reflects some or all of the following factors:

 

    issuer-related factors, such as the issuer’s credit strength and sources of income;

 

    servicer-related factors, such as the ability of our counterparty or third-party servicer to manage the underlying collateral and the servicer’s credit strength and sources of income;

 

    obligation-related factors, such as the type of issue, the type and amount of collateral pledged, the revenue sources and amounts, the existence of structural features designed to provide additional credit enhancement should collateral performance not meet original expectations, the nature of any restrictive covenants and the length of time until the obligation’s stated maturity; and

 

    insurer- and market-related factors, such as rating agency capital charges, competition, if any, from other insurers and the credit spreads in the market available to pay premiums.

The majority of insured public finance and structured finance transactions are guaranteed by triple-A rated financial guaranty insurers. As a AA/Aa3-rated company, our financial guaranty business mainly targets distinct niches in the capital markets. There is generally a greater interest cost savings to an issuer by using triple-A rated credit enhancement as compared to our AA/Aa3 rated credit enhancement. However, financial guaranty insurance provided by a lower-rated provider also can provide significant value over uninsured executions in markets where the triple-A rated financial guaranty insurance is unavailable or uneconomical. In some markets, issuers and other counterparties receive no additional rating agency credit or regulatory relief from triple-A rated enhancement than they do with our AA/Aa3 enhancement, so our enhancement in these markets may be more economical.

On April 27, 2005, Fitch affirmed the “AA” insurance financial strength rating of Radian Asset Assurance Inc. (“Radian Asset Assurance”), our principal financial guaranty operating subsidiary, and Radian Asset Assurance Limited (“RAAL”), a subsidiary of Radian Asset Assurance that is authorized to conduct insurance business in the U.K., but revised its ratings outlook for the two entities to Negative from Stable. Fitch’s ratings for us and our other rated subsidiaries are unchanged. None of the primary insurance customers of our financial guaranty business have any recapture rights as a result of this ratings action by Fitch.

Effective June 1, 2004, EFSG’s two main operating subsidiaries, Radian Asset Assurance and Radian Reinsurance Inc. (“Radian Reinsurance”) were merged, with Radian Asset Assurance as the surviving company. Through this merger, the financial guaranty reinsurance business formerly conducted by Radian Reinsurance was combined with the direct financial guaranty business conducted by Radian Asset Assurance. The merger also combined the assets, liabilities and stockholders’ equity of the two companies. Prior to the merger, Moody’s Investor Service (“Moody’s”) downgraded the insurance financial strength rating of Radian Reinsurance from Aa2 to Aa3.

As a result of this downgrade, two of the primary insurer customers of our financial guaranty reinsurance business had the right to recapture previously written business ceded to our financial guaranty reinsurance business. Effective February 28, 2005, one of these customers recaptured approximately $7.4 billion of par in force that it had ceded to us, including $54.7 million of written premiums as of February 28, 2005, $4.5 million of which was recorded as an immediate reduction of premiums earned at the time of the recapture, which represents the difference between statutory accounting requirements (“STAT”) and accounting principles

 

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generally accepted in the United States of America (“GAAP”) unearned premiums. This return of unearned premiums resulted in an increase in policy acquisition costs of $1.7 million. The aggregate result was a reduction in pre-tax income of $6.2 million, or approximately $0.04 per share after tax on a GAAP basis. The amount of future lost premiums due to this recapture will be approximately $129.7 million, which consists of the unearned premium balance and the value of future installment premiums. Based on the February 28, 2005 recapture date the total approximate reduction in pre-tax income for 2005, including the immediate impact, was approximately $12.3 million or approximately $0.08 per share after tax.

The sum of the above adjustments related to this recapture is summarized as follows:

 

    

Cash Paid

(Received)

   

GAAP

Book

Basis

   

Initial

Gain

(Loss)

 
     (In thousands)  

Unearned Premiums

   $ 54,742     $ 50,204     $ (4,538 )

Acquisition Costs

     (17,097 )     (18,791 )     (1,694 )
                        

Total

   $ 37,645     $ 31,413     $ (6,232 )
                        

Despite the recapture, this primary insurer customer renewed its reinsurance treaty with us for 2005 and again recently for 2006 on substantially the same terms as in 2004 prior to the May 2004 downgrade. In March 2005, without cost to or concessions by us, this customer waived all of its remaining recapture rights with respect to the May 2004 downgrade by Moody’s. The other customer with recapture rights as a result of the May 2004 downgrade agreed, without cost to or concessions by us, to waive its recapture rights. There are no remaining recapture rights with respect to the May 2004 Moody’s downgrade of Radian Reinsurance. The combined company is now rated Aa3 (with a stable outlook) by Moody’s, AA (with a negative outlook) by Standard and Poor’s Insurance Rating Service (“S&P”) and AA (with a negative outlook) by Fitch Rating Service (“Fitch”).

In October 2002, S&P downgraded the insurer financial strength rating of Radian Reinsurance from AAA to AA. As a result of this downgrade, effective January 31, 2004, one of the primary insurer customers of our financial guaranty reinsurance business exercised its right to recapture approximately $16.4 billion of par in force ceded to our financial guaranty reinsurance business, including $96.4 million of net premiums written with a GAAP carrying value of approximately $71.5 million. The entire impact of this recapture was reflected as a reduction of net premiums written in the first quarter of 2004. Because, in accordance with GAAP, we already had reflected $24.9 million of these recaptured net premiums written as having been earned, we were required to record the entire $24.9 million reduction in net premiums earned in the first quarter of 2004. Also in connection with the recapture in the first quarter of 2004, we were reimbursed for policy acquisition costs of approximately $31.0 million for which the carrying value under GAAP was $21.3 million. In addition, the recapture included approximately $11.5 million that had been recorded as case reserves under GAAP. Finally, we took a charge of $0.8 million for mark-to-market adjustments related to certain insurance policies associated with the recapture. The sum of the above adjustments related to this recapture resulted in an immediate reduction of pre-tax income of $15.9 million. We estimate that the recapture of reinsurance business reduced 2004 pre-tax income by approximately $37.8 million or approximately $0.26 per share after tax, $0.11 per share of which was a result of the immediate impact of the recapture, and the balance was a result of recaptured net premiums written that would have been earned over time and estimated losses.

 

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The sum of the above adjustments related to this recapture is summarized as follows:

 

    

Cash Paid

(Received)

   

GAAP

Book

Basis

   

Initial

Gain

(Loss)

 
     (In thousands)  

Unearned Premium

   $ 96,417     $ 71,525     $ (24,892 )

Acquisition Costs

     (31,023 )     (21,257 )     9,766  

Case Reserves

     11,488       11,488       —    

Receivable from Unrealized Credit Derivatives Gain

     —         (791 )     (791 )
                        

Totals

   $ 76,882     $ 60,965     $ (15,917 )
                        

Without cost to or concessions by us, the remaining primary insurer customers with recapture rights agreed not to exercise those rights with respect to the October 2002 downgrade by S&P. None of the primary insurer customers of our financial guaranty reinsurance business have any remaining recapture rights as a result of prior downgrades of Radian Asset Assurance’s or Radian Reinsurance’s financial strength ratings from any of the three major ratings agencies.

Through RAAL, we have additional opportunities to write financial guaranty insurance in the U.K. and, subject to compliance with the European passporting rules, in other countries in the European Union. In particular, we expect that RAAL will continue to build its structured products business in the U.K. and throughout the European Union. RAAL accounted for $3.5 million of direct premiums written in 2005 (or 2.4% of financial guaranty’s 2005 direct premiums written), which is a $3.3 million increase from the $0.2 million of direct premiums written in 2004. In September 2004, the Financial Services Authority (the “FSA”) authorized Radian Financial Products Limited (“RFPL”), another subsidiary of Radian Asset Assurance, to transact as a Category A Securities and Futures Firm permitting it to act as a principal on credit default swap risk. Following receipt of this authorization, management decided that RFPL should focus its core business on arranging credit default swap risk for RAAL and Radian Asset Assurance. Accordingly, we expect to use RFPL solely for negotiating and arranging credit default swaps with counterparties located in the U.K. or other European countries with portions of the risk being assumed by RAAL and Radian Asset Assurance. As a result, we are in the process of lowering the category of authorization for RFPL commensurate with this more limited purpose.

Until September 30, 2004, our financial guaranty business also included our ownership interest in Primus Guaranty, Ltd. (“Primus”), a Bermuda holding company and parent to Primus Financial Products, LLC, a provider of credit risk protection to derivatives dealers and credit portfolio managers on individual investment-grade entities. In September 2004, Primus issued shares of its common stock in an initial public offering. We sold a portion of our shares in Primus as part of this offering. As a result of our reduced ownership and influence over Primus after the initial public offering, we reclassified our investment in Primus to our equity securities portfolio. Accordingly, beginning with the fourth quarter of 2004, we began recording changes in the fair value of the Primus securities as other comprehensive income rather than recording income or loss as equity in net income of affiliates. In 2005 and during the first quarter of 2006, we sold all of our remaining shares of Primus common stock, recording a pre-tax gain of $2.8 million in 2005 and a pre-tax gain of $21.4 million in the first quarter of 2006.

Financial Services

The financial services segment includes the credit-based businesses conducted through our affiliates, C-BASS and Sherman Financial Group LLC (“Sherman”). We own a 46% interest in C-BASS and a 34.58% interest in Sherman. C-BASS is a mortgage investment and servicing firm specializing in subprime, single-family residential mortgage assets and residential mortgage-backed securities. By using sophisticated analytics, C-BASS essentially seeks to take advantage of what it believes to be the mispricing of credit risk for certain of these assets in the marketplace. Sherman is a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets and charged-off high LTV mortgage receivables that it generally purchases at deep

 

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discounts from national financial institutions and major retail corporations and subsequently collects upon these receivables. In March 2005, Sherman acquired CreditOne, a credit card bank that provides Sherman with the ability to originate subprime credit card receivables.

On June 24, 2005, we entered into agreements to restructure our ownership interest in Sherman. Before the restructuring, Sherman was owned 41.5% by us, 41.5% by Mortgage Guaranty Insurance Corporation (“MGIC”) and 17% by an entity controlled by Sherman’s management team. As part of the restructuring, we and MGIC each agreed to sell a 6.92% interest in Sherman to a new entity controlled by Sherman’s management team, thereby reducing our ownership interest and MGIC’s ownership interest to 34.58% for each of us. In return, the new entity controlled by Sherman’s management team paid approximately $15.65 million (which resulted in a $3.3 million loss) to us and the same amount to MGIC. Regulatory approval for this transaction was received in August 2005, retroactive to May 1, 2005. Effective June 15, 2005, Sherman’s employees were transferred to the new entity controlled by Sherman’s management team, and this entity agreed to provide management services to Sherman. Sherman’s management team also agreed to reduce significantly its maximum incentive payout under its annual incentive plan for periods beginning on or after May 1, 2005. This has resulted in Sherman’s net income now being greater than it would have been without a reduction in the maximum incentive payout. Following the restructuring, we expect that our and MGIC’s share of Sherman’s net income will be similar to our respective shares before the restructuring because, although our percentage interest in Sherman is smaller than it was before the restructuring, Sherman’s net income is greater than it would have been if the restructuring had not occurred.

In connection with the restructuring, we and MGIC each also paid $1 million for each of us to have the right to purchase, on July 7, 2006, a 6.92% interest in Sherman from the new entity controlled by Sherman’s management team for a price intended to approximate current fair market value. If either we or MGIC exercise our purchase right but the other fails to exercise its purchase right, the exercising party also may exercise the purchase right of the non-exercising party. Our and MGIC’s representation on Sherman’s board of managers would not change regardless of which party or parties exercise the purchase right.

Prior to January 1, 2003, we owned a 45.5% interest in Sherman. Effective January 1, 2003, Sherman’s management exercised its rights to acquire additional ownership of Sherman, reducing our ownership interest in Sherman from 45.5% to 41.5%. We recorded a $1.3 million loss on this transaction.

The financial services segment formerly included the operations of RadianExpress.com Inc. (“RadianExpress”). In December 2003, we announced that we would cease operations of RadianExpress. Our decision followed our receipt in July 2003 of a decision by the California Commissioner of Insurance sustaining a California cease and desist order applicable to the offering of our Radian Lien Protection product. During the first quarter of 2004, RadianExpress, which was the entity through which Radian Lien Protection sales would have been processed, ceased processing new orders. RadianExpress completed the final processing of all remaining transactions in the first quarter of 2005 and was dissolved in the last quarter of 2005.

 

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Results of Operations – Consolidated

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

The following table summarizes our consolidated results of operations for 2005 and 2004 (in thousands):

 

    

Year Ended

December 31

   % Change  
     2005    2004    2005 vs. 2004  

Net income

   $ 522,854    $ 518,653    0.8 %

Net premiums written

     1,100,687      1,082,487    1.7  

Net premiums earned

     1,018,670      1,029,484    (1.1 )

Net investment income

     208,422      204,349    2.0  

Net gains on sales of investments

     36,638      50,799    (27.9 )

Change in fair value of derivative instruments

     9,170      47,135    (80.5 )

Other income

     25,251      32,286    (21.8 )

Provision for losses

     390,633      456,834    (14.5 )

Policy acquisition costs and other operating expenses

     341,828      327,517    4.4  

Interest expense

     43,043      34,660    24.2  

Equity in net income of affiliates

     217,692      180,550    20.6  

Provision for income taxes

     217,485      206,939    5.1  

Net Income.    Net income for 2005 was $522.9 million or $5.91 per share (diluted), compared to $518.7 million or $5.33 per share (diluted) for 2004. Diluted net income per share reflects the inclusion of 2.2 million and 3.8 million shares, respectively, for 2005 and 2004, underlying our contingently convertible debt, which was redeemed in its entirety on August 1, 2005. Including these shares in the calculation of diluted net income per share resulted in a reduction in diluted net income per share of $0.13 for 2005 and $0.18 for 2004. The results for 2005 reflect an immediate reduction in net income of $4.1 million or $0.04 per share (diluted) related to the first quarter of 2005 recapture of business previously ceded to us by one of the primary insurer customers of the financial guaranty segment. The results for 2004 reflect an immediate reduction in net income of $10.3 million or $0.11 per share (diluted) related to the first quarter of 2004 recapture of business previously ceded to us by another primary insurer customer of the financial guaranty segment. Also affecting net income for 2005 was a decrease in the provision for losses, partially offset by a decrease in earned premiums, an increase in operating expenses and a reduction in both net gains on sales of investments and the change in fair value of derivative instruments.

Net Premiums Written and Earned.    Consolidated net premiums written for 2005 were $1,100.7 million, an $18.2 million, or 1.7% increase from $1,082.5 million for 2004. Consolidated net premiums earned for 2005 were $1,018.7 million, a $10.8 million or 1.1% decrease from $1,029.5 million reported for 2004. The amount of net premiums written for 2005 reflects a reduction of $54.7 million related to the recapture of business by one primary insurer customer of our financial guaranty business in the first quarter of 2005, which also reduced 2005 net premiums earned by $4.5 million. The amount of net premiums written reported for 2004 reflects a reduction of $96.4 million related to the recapture of business by one primary insurer customer of our financial guaranty business in the first quarter of 2004, which also reduced 2004 net premiums earned by $24.9 million. Net premiums written and earned for both years also reflect changes in the mix of business written, substantial cancellations in the mortgage insurance business and a challenging new production environment for our structured business due to tight credit spreads.

Net Investment Income.    Net investment income for 2005 was $208.4 million, a $4.1 million or 2.0% increase from $204.3 million for 2004. This increase was mainly due to an increase in the yield on bonds in our investment portfolio as a result of a net increase in average investable funds and higher interest rates, partially offset by a liquidation of investments in the portfolio to fund the repurchase of approximately 10.8 million shares of our common stock at a purchase price of $533.9 million.

Net Gains on Sales of Investments and Change in Fair Value of Derivative Instruments.    Net gains on sales of investments for 2005 were $36.6 million (pre-tax), compared to $50.8 million (pre-tax) for 2004. The net

 

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gains on sales of investments in 2005 include a $3.3 million loss on the sale of a partial interest in Sherman and a $3.2 million loss from a complete write-down of our investment in SBF Participacoes Ltda., a Brazilian insurer that we acquired in connection with our acquisition of EFSG in 2001. The 2004 amount includes a significant amount of gains from changes in asset allocation and investment execution strategies. For 2005, the change in fair value of derivative instruments was a gain of $9.2 million (pre-tax), compared to a gain of $47.1 million (pre-tax) for the change in fair value of derivatives instruments for 2004. We account for derivatives under Statement of Financial Accounting Standards (“SFAS”) No. 133, which often results in volatility from period to period as reported on our consolidated statements of income. In the fourth quarter of 2005, we refined our mark-to-market of derivatives model to use active market spreads by individual name, when available, as compared to our previous version of the model which used the average spread on similarly rated names. While application of the new model resulted in minimal changes for most of our derivative transactions, one synthetic collateralized debt obligation showed a large difference due to greater spread volatility in the underlying high-yield corporate names included in this transaction. At December 31, 2005, our refined model indicated that a $50.8 million loss should be recognized on this transaction, which was included on our list of intensified surveillance credits at December 31, 2005. On March 2, 2006, Radian Asset Assurance and its counterparty to this transaction terminated this transaction and amended the one other derivative financial guaranty contract insured by Radian Asset Assurance with this same counterparty. See “Results of Operations—Financial Guaranty—Year Ended December 31, 2005 Compared to Year Ended December 31, 2004—Provision for Losses” below. In 2005, we sold convertible securities with embedded gains, which increased net gains on sales of investments and reduced the favorable change in the fair value of derivative instruments. In addition, the financial guaranty segment experienced favorable gains in the fair value of derivative instruments in 2005, in large part due to the general tightening of credit spreads on the synthetic collateralized corporate debt obligation business.

Other Income.    Other income decreased to $25.3 million for 2005 from $32.3 million for 2004, mainly due to lower income from contract underwriting.

Provision for Losses.    The provision for losses for 2005 was $390.6 million, a decrease of $66.2 million or 14.5% from $456.8 million reported for 2004. Our mortgage insurance business experienced a decrease in the provision for losses as claims paid declined. These decreases were partially offset by an increase in delinquencies. Our financial guaranty business experienced a decrease in the provision for losses in 2005 as a result of generally favorable loss development, including a reduction in the prior year’s reserves for trade credit reinsurance business and a lower volume of business in trade credit reinsurance, which generally carries a higher loss ratio.

Policy Acquisition Costs and Other Operating Expenses.    Policy acquisition costs were $115.8 million for 2005, a decrease of $6.0 million or 4.9% from $121.8 million reported for 2004. The amortization of policy acquisition costs in the mortgage insurance segment in 2005 was lower due to an $11.6 million acceleration of deferred policy acquisition cost amortization in 2004 coinciding with the cancellation of business in our mortgage insurance segment, which reduced the base asset that was subject to amortization. The amount reported for 2005 includes approximately $5.1 million of acceleration of deferred policy acquisition cost amortization in mortgage insurance. The amortization of policy acquisition costs reported for 2005 reflects an increase of $1.7 million related to the recapture of business by one of the primary insurer customers of our financial guaranty segment in the first quarter of 2005. The amortization of policy acquisition costs reported for 2004 reflects a reduction of $9.8 million related to the recapture of business by one of the primary insurer customers of our financial guaranty business in the first quarter of 2004. The business recaptured in the first quarter of 2004 included business originated before the acquisition of EFSG that carried a lower amount of deferred acquisition costs as a result of purchase accounting adjustments.

Other operating expenses increased to $226.0 million for 2005 from $205.7 million for 2004. Other operating expenses in 2005 include increases in employee costs and software expenses, as well as the write-off of debt insurance costs from the redemption of the $220 million of senior convertible debentures in 2005. Other operating expenses in 2005 compared to 2004 included higher information technology (“IT”) expenditures and the amortization of IT projects that were placed into service in 2004, as well as increased compliance costs, including Sarbanes-Oxley compliance.

 

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Interest Expense.    Interest expense of $43.0 million for 2005 increased $8.3 million or 24.2% from $34.7 million for 2004, in most part due to the issuance of $250 million of senior notes in June 2005 and a lower positive impact from interest-rate swaps that we entered into in the second quarter of 2004. These swaps effectively convert the interest rate on our 5.625% Senior Notes due 2013 to a variable rate based on a spread over the London Interbank Offered Rate (“LIBOR”). The increase in interest expense in 2005 was partially offset by the redemption of $220 million of senior convertible debentures in August 2005.

Equity in Net Income of Affiliates.    Equity in net income of affiliates increased to $217.7 million for 2005, up $37.1 million or 20.6% from $180.6 million for 2004. Equity in net income of affiliates includes the results of C-BASS, Sherman and, until September 30, 2004, Primus. This increase resulted from a continuation of very strong growth in earnings at both C-BASS and Sherman in 2005.

Provision for Income Taxes.    The consolidated effective tax rate was 29.4% for 2005, compared to 28.5% for 2004, reflecting a lower proportion of tax-exempt income to total income.

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

The following table summarizes our consolidated results of operations for 2004 and 2003 (in thousands):

 

    

Year Ended

December 31

   % Change  
     2004    2003    2004 vs. 2003  

Net income

   $ 518,653    $ 385,901    34.4 %

Net premiums written

     1,082,487      1,110,477    (2.5 )

Net premiums earned

     1,029,484      1,008,183    2.1  

Net investment income

     204,349      186,163    9.8  

Net gains on sales of investments

     50,799      17,387    n/m  

Change in fair value of derivative instruments

     47,135      4,139    n/m  

Other income

     32,286      63,322    (49.0 )

Provision for losses

     456,834      476,054    (4.0 )

Policy acquisition costs and other operating expenses

     327,517      339,595    (3.6 )

Interest expense

     34,660      37,542    (7.7 )

Equity in net income of affiliates

     180,550      105,476    71.2  

Provision for income taxes

     206,939      145,578    42.1  

n/m = not meaningful

Net Income.    Net income for 2004 was $518.7 million or $5.33 per share (diluted) compared to $385.9 million or $3.95 per share (diluted) for 2003. Net income per share for both periods reflects the inclusion of 3.8 million shares underlying our contingently convertible debt. The impact of including these shares in the calculation of diluted net income per share was a reduction of $0.18 in diluted net income per share for 2004 and $0.13 in diluted net income per share for 2003. The results for 2004 reflect an immediate reduction in net income of $10.3 million or $0.11 per share related to the first quarter of 2004 recapture of business previously ceded to us by one of the primary insurer customers of our financial guaranty segment. Net income for 2004 includes an increase of $76.4 million compared to 2003 due to net gains on sales of investments and the change in fair value of derivative instruments. Net income for 2004 also reflects a $19.3 million reduction in the provision for losses in 2004 compared to 2003, mostly due to the inclusion of a $111.0 million charge in 2003 for an insurance policy related to manufactured housing loans originated by Conseco Finance Corp. Also included in 2003 was a $13.0 million charge to other operating expenses in the fourth quarter of 2003 for the cessation of operations at RadianExpress.

Net Premiums Written and Earned.    Consolidated net premiums written for 2004 were $1,082.5 million, compared to $1,110.5 million for 2003. The amount of net premiums written in 2004 reflects a reduction of

 

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$96.4 million related to the recapture of business by one primary insurer customer of our financial guaranty business in the first quarter of 2004, which also reduced net premiums earned by $24.9 million. Net premiums earned for 2004 were $1,029.5 million, an increase of $21.3 million or 2.1% from $1,008.2 million recorded in 2003.

Net Investment Income.    Net investment income of $204.3 million for 2004 increased $18.1 million or 9.8% from $186.2 million in 2003, mainly due to growth in the investment portfolio funded by positive operating cash flows.

Net Gains on Sales of Investments and Change in Fair Value of Derivative Instruments.    Net gains on sales of investments for 2004 were $50.8 million (pre-tax), compared to $17.4 million (pre-tax) for 2003. The 2004 amount includes a significant amount of gains as a result of changes in asset allocation and investment execution strategies. The change in fair value of derivative instruments was $47.1 million (pre-tax) for 2004, compared to $4.1 million (pre-tax) for change in fair value of derivatives instruments for 2003.

Other Income.    Other income decreased to $32.3 million in 2004 from $63.3 million in 2003, mainly due to the cessation of operations at RadianExpress.

Provision for Losses.    The provision for losses was $456.8 million for 2004, a decrease of $19.3 million or 4.0% from $476.1 million in 2003. The decrease in the provision for losses in 2004 resulted mainly from the $111.0 million charge attributable to Conseco Finance Corp. in 2003, partially offset by a $91.7 million increase in the provision for losses in 2004 to support the $93.2 million increase in claims paid by our mortgage insurance segment in 2004.

Policy Acquisition Costs and Other Operating Expenses.    Policy acquisition costs for 2004 were $121.8 million, down $6.7 million or 5.2% from $128.5 million in 2003. The amortization of policy acquisition costs reported in 2004 reflects a reduction of $9.8 million related to the recapture of business by one of the primary insurer customers of our financial guaranty segment in the first quarter of 2004. The amount reported in 2004 also includes an $11.6 million acceleration of deferred policy acquisition cost amortization coinciding with the cancellation of business in our mortgage insurance segment, which reduced the base asset that was subject to amortization.

Other operating expenses of $205.7 million for 2004 decreased $5.4 million or 2.6% from $211.1 million in 2003. Other operating expenses in 2004 included higher IT expenditures and the amortization of IT projects that were placed into service in 2004, as well as increased compliance costs, including Sarbanes-Oxley compliance. Other operating expenses for 2003 included the $13.0 million charge for the cessation of operations at RadianExpress, as well as normal operating expenses of RadianExpress of $25.7 million. The $13.0 million charge includes the write-off of the carrying cost of the investment of $7.2 million and provisions for severance, leasehold commitments and other charges of $5.8 million.

Interest Expense.    Interest expense of $34.7 million for 2004 decreased $2.8 million from $37.5 million in 2003 due to the positive impact of the interest-rate swaps that we entered into in the second quarter of 2004.

Equity in Net Income of Affiliates.    Equity in net income of affiliates increased to $180.6 million in 2004 from $105.5 million in 2003. Equity in net income of affiliates includes the results of C-BASS, Sherman and, until September 30, 2004, Primus.

Provision for Income Taxes.    The consolidated effective tax rate was 28.5% and 27.4% for 2004 and 2003, respectively. The lower effective tax rate for 2003 reflects a higher proportion of tax-exempt income to total income resulting from the overall decline in 2003 earnings as a result of the charge for Conseco Finance Corp.

 

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Results of Operations – Mortgage Insurance

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

Although home purchase transactions have remained at strong levels, the mortgage insurance industry did not fully benefit from this in 2005 due to a loss of business to alternative mortgage executions that exclude mortgage insurance, particularly “80-10-10” arrangements or other variations of simultaneous second-lien mortgage loans. In addition, refinance activity, which often results in the elimination of the need for mortgage insurance on the refinanced loan, remained high during 2005, reducing the volume of loans requiring mortgage insurance in 2005. These items negatively impacted the flow business, but were somewhat offset by the continued increase in demand for structured transactions and non-traditional products. Primary new insurance written by our mortgage insurance business during 2005 was $42.6 billion, a $2.2 billion or 4.9% decrease from $44.8 billion written in 2004. In addition, we increased the prices of some of our products, particularly investor loans, effective in the first quarter of 2005, which led to a decrease in demand for our insurance on those specific products and, indirectly, on other products as well. For 2005, our mortgage insurance business wrote $25.6 billion in flow business and $17.0 billion in structured transactions, compared to $36.3 billion in flow business and $8.5 billion in structured transactions for 2004. Also in 2005, our mortgage insurance business wrote $569 million of pool risk compared to $304 million in 2004 and $9.0 billion of other risk in 2005 compared to $427 million in 2004.

An increase in the level of structured transactions, which sometimes take the form of pool insurance, was the primary cause of the increase in pool risk written. Other risk written included a higher level of second-lien mortgage insurance, insurance written internationally and an increase in other new products, such as credit default swaps, both domestically and internationally. Our participation in structured transactions is likely to vary significantly from period to period because we compete with other mortgage insurers, as well as capital market executions, for these transactions. However, the overall level is expected to rise over time. Included in the approximate $9.0 billion of other risk written in 2005 is $511 million of risk written related to a single transaction that is a AAA wrap on a large portfolio that was written in the first quarter of 2005. In addition, $7.3 billion of other risk written in 2005 was in the form of credit default swaps written as AAA tranches of mortgage-backed securities in Germany and Denmark, which were written late in the fourth quarter of 2005. Because of the remote nature of the risk associated with these transactions, premiums are low as a percentage of exposure.

The highest state concentration of risk in force at December 31, 2005, was Florida at 9.5%, compared to 9.1% at December 31, 2004. California had the highest state concentration of total direct primary and pool insurance in force at December 31, 2005. At December 31, 2005, California accounted for 10.4% of the mortgage insurance segment’s total direct primary insurance in force, compared to 12.4% at December 31, 2004, and 12.3% of the mortgage insurance segment’s total direct pool risk in force, compared to 14.7% for 2004. California also accounted for 13.8% of the mortgage insurance segment’s direct primary new insurance written for 2005 and 2004. The percentage of risk in force in California has been falling due to the high cancellation rate as compared to new business written.

Volume in 2005 continued to be impacted by lower interest rates that affected the entire mortgage insurance industry. The continued low interest-rate environment caused refinancing activity to remain high, which was similar to the comparable period of 2004. Refinancing activity as a percentage of our primary new insurance written was 41% for 2005, compared to 40% for 2004. The persistency rate, which is defined as the percentage of insurance in force that remains on our books after any 12-month period, was 58.2% for the twelve months ended December 31, 2005, compared to 58.8% for the twelve months ended December 31, 2004. This decrease in the persistency rate reflects a higher level of cancellations in the twelve months ended December 31, 2005. In the second quarter of 2005, $3.6 billion of primary insurance in force from one structured transaction was canceled, which reduced the persistency rate in 2005 by approximately three percentage points. We expect the persistency rates to slowly rise throughout 2006, influenced by relatively stable or slowly rising interest rates.

In addition to insuring prime mortgages, we also insure non-prime mortgages, including mainly Alt-A and A minus loans. Alt-A borrowers generally have a similar credit profile as the borrowers under the prime loans that

 

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we insure, with Fair Isaac and Company (“FICO”) credit scores of 620 and higher, but Alt-A loans are underwritten with reduced documentation and verification of information. We consider Alt-A business to be riskier than prime business because of the reduction or elimination of documentation supporting the loans. Alt-A loans also tend to have higher balances than other loans that we insure. We typically charge a higher premium rate for Alt-A business, particularly Alt-A loans to borrowers with FICO credit scores below 660, and we have measures in place to limit our exposure to these lower-FICO Alt-A loans. We previously had disclosed our intent to reduce our insurance in force for lower FICO Alt-A business and we have done so, but we continually re-evaluate this decision and will only increase our participation in this business if we believe we can do so at acceptable levels of risk and return. The A minus loans that we insure typically have non-traditional credit standards that are less stringent than standard credit guidelines and include loans to borrowers with FICO scores ranging from 575 to 619. We receive a significantly higher premium for insuring A minus loans.

During 2005, non-prime business accounted for $17.8 billion or 41.7% of new primary insurance written by our mortgage insurance business, compared to $16.4 billion or 36.6% for 2004. Of the $17.8 billion of non-prime business written for 2005, $11.2 billion or 63.3% was Alt-A. The relatively high amount of non-prime business is a result of the relatively high level of structured business written in 2005, which tends to be more concentrated in non-prime loans.

In 2004, we developed an approach for reinsuring our non-prime risk. The arrangement, which we refer to as “Smart Home,” effectively transfers risk from our portfolio to investors in the capital markets. Each transaction begins with the formation of an unaffiliated, offshore reinsurance company. We then enter into an agreement with the Smart Home reinsurer pursuant to which we agree to cede to the reinsurer a portion of the risk (and premium) associated with a portfolio of non-prime residential mortgage loans insured by us. The Smart Home reinsurer is funded in the capital markets through the issuance to investors of a series of separate classes of credit-linked notes. Each class 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 typically retain the risk associated with the first-loss coverage levels, and we may retain or sell, in a separate risk transfer agreement, the risk associated with the AAA-rated or most remote coverage level. Holders of the Smart Home credit-linked notes bear the risk of loss from losses paid to us under the reinsurance agreement. The Smart Home reinsurer invests the proceeds of the notes in high-quality short-term investments approved by the rating agencies. Income earned on those investments and a portion of the reinsurance premiums that we pay are applied to pay interest on the notes as well as certain of the Smart Home reinsurer’s expenses. The rate of principal amortization of the credit-linked notes approximates the rate of principal amortization of the underlying mortgages.

Since August of 2004, we have completed three “Smart Home” arrangements. Details of these transactions are as follows:

 

Date of Transaction

   Pool of Non-prime Mortgages
(Par Value)
  

Risk Ceded to

Reinsurer

(Par Value)

  

Notes Sold to
Investors

(Principal Amount)

December 2005 (1)

   $6.27 billion    $ 1.69 billion    $ 304.5 million

February 2005

   $1.68 billion    $ 495.6 million    $ 98.5 million

August 2004

   $ 882 million    $ 332.1 million    $ 86.1 million

(1) $172.9 million in principal amount of credit-linked notes was issued in December 2005. An additional $131.6 million in principal amount was issued in February 2006.

Smart Home allows us to continue to take on more non-prime risk and the higher premiums associated with insuring these types of products. As a result, we consider Smart Home arrangements to be important to our ability to effectively manage our risk profile and to remain competitive in the non-prime market. Approximately 13% of our non-prime risk in force is currently reinsured through Smart Home arrangements. We intend to increase this percentage substantially in 2006. Because the Smart Home arrangement ultimately depends on the willingness of investors to invest in Smart Home securities, we cannot be certain that Smart Home will always be

 

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available to us or will be available on terms that are acceptable to us. If we are unable to continue to use Smart Home arrangements, our ability to participate in the non-prime mortgage market could be limited, which could have a material adverse effect on our business, financial condition and operating results.

Premiums written (ceded) in 2005 and 2004 include $3.5 million and $1.0 million, respectively, related to the Smart Home transactions. There were no ceded losses in 2005 or 2004 as a result of the Smart Home transactions.

Direct primary insurance in force was $109.7 billion at December 31, 2005, compared to $115.3 billion at December 31, 2004. In the second quarter of 2005, $3.6 billion of primary insurance in force from one structured transaction was canceled. At December 31, 2005, non-prime insurance in force was $34.7 billion or 31.7% of total primary mortgage insurance in force, compared to $35.7 billion or 31.0% at December 31, 2004. Of the $34.7 billion of non-prime insurance in force at December 31, 2005, $21.2 billion or 61.1% was Alt-A. We anticipate that the proportion of non-prime mortgage insurance business and non-traditional products could continue to grow as a result of structural changes, competitive pricing differentials and competitive products in the mortgage lending and mortgage insurance businesses.

Pool risk in force was $2.7 billion at December 31, 2005, compared to $2.4 billion at December 31, 2004. In 2005, we wrote a significant amount of pool risk where we are in a second-loss position, and will therefore only pay claims if pool losses are greater than any applicable deductible or stop-loss.

Other risk in force was $9.7 billion at December 31, 2005, compared to $1.2 billion at December 31, 2004. The increase in other risk in force at December 31, 2005, was in large part due to the two large international mortgage securitizations comprising $7.3 billion of risk, in which we provided credit enhancement at a AAA level in credit default swap form. Also included in other risk in force at December 31, 2005, was a single structured transaction that is a AAA wrap that was done in credit default swap form in the first quarter of 2005. Because of the remote nature of the risk associated with these transactions, premiums are low as a percentage of exposure.

The default and claim cycle in the mortgage insurance business begins with our receipt of a default notice from the insured. Generally, our master policy of insurance requires the insured to notify us of a default within 15 days after the loan has become 60 days past due. The total number of loans in default increased from 48,940 at December 31, 2004, to 57,088 at December 31, 2005. The average loss reserve per default decreased from $11,435 at the end of 2004 to $10,444 at December 31, 2005. The loans in default at December 31, 2005, included approximately 6,700 defaults related to Hurricanes Katrina, Rita and Wilma. As discussed above, it is too early to tell how many claims we may ultimately have to pay on these defaults. Primary and pool defaults also included approximately 300 and 2,400 defaults, respectively, on loans with deductibles in excess of any required reserve. The loss reserve as a percentage of risk in force was 1.6% at December 31, 2005, compared to 1.8% at December 31, 2004. The decline in the reserve per default and reserve as a percentage of risk in force is partially due to the higher mix of defaults in the early stage of delinquency and loans with deductibles in excess of any required reserve and the significant increase in risk in force relating to business in a remote loss position. We also do not establish reserves on our derivative financial guaranty products.

Defaults in the non-prime mortgage insurance business, which has experienced a consistent increase in the number of defaults in the past few years, appear to have leveled off for Alt-A loans, but are still increasing for A minus and below loans. Although the default rate on this business is higher than on prime business, higher premium rates charged for non-prime business are expected to compensate for the increased level of expected losses associated with this business. However, we cannot be certain that the increased premiums charged on non-prime business will compensate for the ultimate losses on this business.

The number of non-prime loans in default at December 31, 2005, was 23,525, which represented 53% of the total primary loans in default, compared to 21,017 non-prime loans in default at December 31, 2004, which

 

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represented 52% of the total primary loans in default. The default rate on the Alt-A business was 6.4% at December 31, 2005, compared to 6.5% at December 31, 2004. The combined default rate on the A minus and below loans was 15.8% at December 31, 2005, compared to 12.1% at December 31, 2004. The default rate on the prime business was 3.6% at December 31, 2005, compared to 3.2% at December 31, 2004. The default rate on non-prime business increased to 10.7% at December 31, 2005 from 9.0% at December 31, 2004, as a result of that business seasoning.

Claim activity is not spread evenly throughout the coverage period of a book of business. 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. Historically, claim activity on prime loans has 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. Approximately 76.5% of the primary risk in force and approximately 38.6% of the pool risk in force at December 31, 2005, had not yet reached its highest claim frequency years. Because it is difficult to predict both the timing of originating new business and the run-off rate of existing business, it also is 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. The combined default rate for both primary and pool insurance, excluding second-lien mortgage insurance coverage, was 3.8% at December 31, 2005, compared to 3.3% at December 31, 2004, while the default rate on the primary business was 5.6% at December 31, 2005, compared to 4.8% at December 31, 2004.

Direct claims paid for 2005 were $320.3 million, compared to $364.4 million for 2004. The average claim paid has fluctuated over the past few years mostly due to deeper coverage amounts, larger loan balances and mitigation efforts. In addition, a change in real estate values may also affect the amount of the average claim paid. The average claim paid in 2005 included a larger than normal amount of recoveries and reflects increased loss mitigation efforts. Alt-A loans have a higher average claim payment due to higher loan balances. Claims paid on second-lien mortgages decreased in 2005 compared to 2004 as a result of an increase in recoveries, partially offset by the increase in the volume of business written over the past few years on which we have begun paying claims. During the third quarter of 2004, we announced our intent to limit the amount of second-lien mortgage business we would originate in the future, especially where we would be in a first-loss position. We continue to evaluate this decision and may increase our participation in second-lien mortgage business if we believe we can do so at acceptable levels of risk and return. For the majority of risk written on second-lien mortgage business in 2005, we are in a second- or shared-loss position, meaning that the insured must incur losses on the loan above a specified amount or deductible before any claim payments under the policy will be made. In reviewing our claims inventory, we expect that paid claims will be relatively flat in the first quarter of 2006 and will increase modestly after that.

A disproportionately higher incidence of claims in Georgia is directly related to what our risk management department believes to be questionable property value estimates performed by outside agencies in that state. Several years ago, our risk management department put into place 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. A higher level of claim incidence in Texas resulted, in part, from unemployment levels that were higher than the national average and from lower home price appreciation. We believe that claims in the Midwest and Southeast have been rising and will continue to rise due to the weak industrial sector of the economy. We also believe that increased claims in Michigan and North Carolina are a result of declining economic conditions in those areas, and that in Colorado, increased claims are a result of a significant decline in property values in that area.

 

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The following table summarizes our mortgage insurance segment’s results of operations for the years ended December 31, 2005 and 2004 (in thousands):

 

    

Year Ended

December 31

   % Change  
     2005    2004    2005 vs. 2004  

Net income

   $ 268,606    $ 271,882    (1.2 %)

Net premiums written

     877,632      866,051    1.3  

Net premiums earned

     806,897      814,553    (0.9 )

Net investment income

     118,325      118,694    (0.3 )

Net gains on sales of investments

     27,649      44,380    (37.7 )

Change in fair value of derivative instruments

     4,110      11,940    (65.6 )

Other income

     19,008      24,247    (21.6 )

Provision for losses

     359,116      400,936    (10.4 )

Policy acquisition costs and other operating expenses

     215,583      216,618    (0.5 )

Interest expense

     24,191      20,138    20.1  

Provision for income taxes

     108,493      104,240    4.1  

Net Income.    Our mortgage insurance segment’s net income for 2005 was $268.6 million, a decrease of $3.3 million or 1.2% from $271.9 million in 2004. This decrease was mainly due to a decrease in net gains on sales of investments, change in fair value of derivative instruments and other income, partially offset by decreases in the provision for losses and policy acquisition costs.

Net Premiums Written and Earned.    Net premiums written for 2005 were $877.6 million, an $11.5 million or 1.3% increase from $866.1 million for the comparable period of 2004. Net premiums earned for 2005 were $806.9 million, a $7.7 million or 0.9% decrease compared to $814.6 million for 2004. Net premiums earned reflect a decrease of $29.1 million in premiums earned from non-traditional products such as second-lien mortgages and NIMs business. Premiums earned from non-traditional products were $96.6 million in 2005, compared to $125.7 million in 2004 due to significant run-off in NIMs business and, until late in the year, a low volume of second-lien mortgage business written. Partially offsetting the 2005 decline in earned premiums was an increase of $21.4 million in premiums earned from the primary insurance business as a result of a change in the product mix to higher premium rate products and the acceleration of premiums earned in the third and fourth quarters resulting from the cancellation of policies contained within a large, single premium structured transaction. Premiums earned will fluctuate as the mix of premiums written changes. For 2005, the mix included a higher percentage of non-prime business, which has higher premium rates compared to the prime business because the level of expected loss associated with this type of insurance is higher than the expected loss associated with prime business. We intend to increase the percentage of non-prime risk that is reinsured through Smart Home arrangements in 2006. To the extent we are able to accomplish this, our earned premiums for 2006 would be affected commensurate with the amount of premiums ceded.

Net Investment Income.    Net investment income attributable to our mortgage insurance business for 2005 was $118.3 million, compared to $118.7 million for 2004. Investment income for 2005 reflects a higher level of investment expenses and a decrease in dividend income offset by an increase in interest income on bonds.

Net Gains on Sales of Investments and Change in Fair Value of Derivative Instruments.    Net gains on sales of investments 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 sales of investments recorded in 2004 as a result of changes in asset allocation and investment execution strategies. 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 due to market conditions. When convertible securities with embedded options carried at unrealized gains are sold, it has the effect of reclassifying the unrealized gain from the change in fair value of derivative instruments to realized gains on sales of investments.

 

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Other Income.    Other income for 2005 was $19.0 million, a $5.2 million or 21.6% decrease from $24.2 million in 2004. Other income mostly includes income related to contract underwriting services. Therefore, the decrease in 2005 mainly reflects a decrease in contract underwriting services. Included in the 2004 amount is a settlement received related to underwriting services and an allocation of other income from the parent company.

Provision for Losses.    The provision for losses for 2005 was $359.1 million, compared to $400.9 million for 2004. Our mortgage insurance business experienced a significant decrease in claims paid in 2005; however, there was an approximate 10% increase in delinquencies at December 31, 2005, compared to December 31, 2004, which is mainly related to the large number of hurricane–related delinquencies, as discussed above.

Policy Acquisition Costs and Other Operating Expenses.    Policy acquisition costs represent the amortization of expenses that relate directly to the acquisition of new business. The amortization of these expenses is related to the recognition of gross profits over the life of the policies and is influenced by such factors as persistency and estimated loss rates. Policy acquisition costs were $62.9 million for 2005, compared to $75.5 million for 2004. This change was mainly the result of a reduction in the acceleration of the amortization of policy acquisition costs for 2005 to $5.1 million compared to an $11.6 million acceleration of the amortization of policy acquisition costs in 2004. The accelerations related to prior years’ books of business that had canceled more quickly than anticipated due to repayments and pay-offs of the underlying mortgages and resulted in a reduction in the base asset that was subject to amortization.

Other operating expenses consist mostly of contract underwriting expenses, overhead and administrative costs, some of which are allocated to our various business segments. Other operating expenses were $152.7 million for 2005, an increase of $11.6 million or 8.2% compared to $141.1 million for 2004. For 2005, other operating expenses included increases in employee costs, depreciation expense, outside services and the write-off of debt issuance costs, partially offset by a decrease in the reserve for contract underwriting remedies. During 2005, we processed requests for remedies on less than 1% of loans underwritten. In 2004, as a result of increased underwriting in the previous two years, which significantly increased our exposure to underwriting errors, an increase in the contract underwriting reserve for remedies was necessary. Provisions for contract underwriting remedies were $8.0 million in 2005 compared to $11.9 million in 2004. Contract underwriting expenses for 2005 and 2004, including the impact of reserves for remedies included in other operating expenses, were $35.7 million and $46.8 million, respectively. During 2005, loans underwritten via contract underwriting accounted for 11.7% of applications, 11.4% of commitments for insurance and 10.1% of insurance certificates issued compared to 20.6%, 19.7% and 17.9%, respectively, in 2004.

Interest Expense.    Interest expense attributable to our mortgage insurance business for 2005 was $24.2 million compared to $20.1 million for 2004. Both periods include interest on our long-term debt that was allocated to the mortgage insurance segment as well as the impact of interest-rate swaps.

Provision for Income Taxes.    The effective tax rate for 2005 was 28.8% compared to 27.7% in 2004. The difference between the effective tax rate and the statutory rate of 35% reflects our significant investment in tax-advantaged securities.

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

Primary new insurance written during 2004 was $44.8 billion, a 34.5% decrease from $68.4 billion written in 2003. The decrease in primary new insurance written in 2004 was principally due to a smaller overall market, which led to a large decrease in insurance written both through flow business and structured transactions. During 2004, we wrote $8.5 billion in structured mortgage transactions compared to $18.9 billion in 2003. The amount originated in 2003 included a large structured transaction for one customer composed of prime mortgage loans originated throughout the United States. In 2004, we wrote $304 million of pool insurance risk compared to $933 million in 2003. The large transaction in 2003 referred to above also included a portion of risk written as pool insurance coverage.

 

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Our top 10 mortgage insurance customers, measured by primary risk in force were responsible for 42.2% of the direct primary risk in force at December 31, 2004 and for 46.7% of primary new insurance written in 2004. The largest single mortgage insurance customer (including branches and affiliates of such customer), measured by new insurance written, accounted for 9.6% of new insurance written during 2004, compared to 10.4% in 2003.

The highest state concentration of risk at December 31, 2004, was California at 13.0%. At December 31, 2004, California also accounted for 12.4% of our total direct primary insurance in force and 13.8% of our direct primary new insurance written for 2004.

Volume in 2004 was impacted by lower interest rates that affected the entire mortgage insurance industry. The low interest-rate environment caused refinancing activity to remain relatively high, although not as high as in 2003. Refinancing activity, as a percentage of primary new insurance written, was 40% for 2004 compared to 50% for 2003. The persistency rate was 58.8% for the 12 months ended December 31, 2004, compared to 46.7% for the 12 months ended December 31, 2003. This increase in the persistency rate reflects a decline in refinancing activity during 2004.

Direct primary insurance in force was $115.3 billion at December 31, 2004, compared to $119.9 billion at December 31, 2003. Total pool risk in force was $2.4 billion at December 31, 2004, and at December 31, 2003. Other risk in force was $1.2 billion at December 31, 2004, and $1.1 billion at December 31, 2003.

During 2004, non-prime business accounted for $16.4 billion or 36.6% of new primary mortgage insurance written compared to $27.4 billion or 40.1% for 2003. Of the $16.4 billion of non-prime business written in 2004, $10.2 billion or 61.9% was Alt-A. At December 31, 2004, non-prime insurance in force was $35.7 billion or 31.0% of total primary insurance in force, compared to $37.8 billion or 31.5% for 2003. Of the $35.7 billion of non-prime insurance in force at December 31, 2004, $22.1 billion or 61.9% was Alt-A.

Approximately 80.4% of the primary risk in force and approximately 30.4% of the pool risk in force at December 31, 2004, had not yet reached its highest claim frequency years. The combined default rate for both primary and pool insurance, excluding second-lien insurance coverage, was 3.3% at December 31, 2004, compared to 3.2% at December 31, 2003, while the default rate on the primary business alone was 4.8% at December 31, 2004, compared to 4.7% at December 31, 2003.

The total number of loans in default decreased from 50,080 at December 31, 2003, to 48,940 at December 31, 2004. The average loss reserve per default increased from $10,253 at the end of 2003 to $11,435 at December 31, 2004. The loss reserve as a percentage of risk in force was 1.8% at December 31, 2004, compared to 1.6% at December 31, 2003. The number of non-prime loans in default at December 31, 2004, was 21,017, which represented 52% of the total primary loans in default, compared to 19,840 non-prime loans in default at December 31, 2003, which represented 47% of the total primary loans in default. The default rate on the Alt-A business was 6.5% at December 31, 2004, compared to 5.3% at December 31, 2003. The default rate on the A minus and below loans was 12.1% at December 31, 2004, compared to 11.4% at December 31, 2003. The default rate on the prime business was 3.2% and 3.5% at December 31, 2004, and December 31, 2003, respectively. The default rate on non-prime business was 9.0% at December 31, 2004, compared to 8.0% at December 31, 2003, as a result of that business seasoning. The default rate on the prime business was 3.16% at December 31, 2004 compared to 3.53% at December 31, 2003.

Direct claims paid for 2004 were $364.4 million compared to $271.2 million for 2003. The average claim paid has increased in 2004 due mostly to deeper coverage amounts and larger loan balances. In addition, claims paid in 2004 were impacted by the rise in delinquencies in 2002 and 2003 that proceeded to foreclosure. Claims paid on second-lien mortgages increased year-over-year as a result of the increase in the volume of business written in 2003, for which we began paying claims in 2004.

 

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The following table summarizes our mortgage insurance segment’s results of operations for the years ended December 31, 2004 and 2003 (in thousands):

 

    

Year Ended

December 31

   % Change  
     2004    2003    2004 vs. 2003  

Net income

   $ 271,882    $ 279,813    (2.8 %)

Net premiums written

     866,051      741,840    16.7  

Net premiums earned

     814,553      759,620    7.2