Radian Asset Assurance Inc. Report of Independent Registered Public Accounting Firm

Transcription

1 Radian Asset Assurance Inc. Report of Independent Registered Public Accounting Firm Consolidated Financial Statements Years Ended December 31, 2007, 2006 and 2005

2 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2007, 2006 and 2005 Report of Independent Registered Public Accounting Firm 3 Page(s) Financial Statements Consolidated Balance Sheets 4 Consolidated Statements of Operations 5 Consolidated Statements of Shareholder s Equity 6 Consolidated Statements of Cash Flow 7 Notes to Consolidated Financial Statements 8-42

3 PricewaterhouseCoopers LLP PricewaterhouseCoopers Center 300 Madison Avenue New York NY Telephone (646) Facsimile (813) Report of Independent Auditors To the Board of Directors and Shareholder of Radian Asset Assurance Inc.: We have audited the accompanying consolidated balance sheet of Radian Asset Assurance Inc. and its subsidiaries (the "Company") as of December 31, 2007, and the related consolidated statements of operations, shareholder's equity and cash flows for the year then ended. These financial statements are the responsibility of the Company s management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of the Company as of December 31, 2006 and December 31, 2005 for the years then ended were audited by other auditors whose reports dated May 18, 2007 and March 15, 2006, respectively, expressed unqualified opinions on those statements. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the 2007 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Radian Asset Assurance Inc. and its subsidiaries at December 31, 2007, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. June 23,

4 CONSOLIDATED BALANCE SHEETS (In thousands) December 31, Assets Investments: Fixed maturities, available for sale, at fair value (amortized cost $2,066,052 and $2,111,479) $2,092,720 $2,171,578 Fixed maturities trading, at fair value (amortized cost $16,125 and $0) 16,132 - Hybrid securities, at fair value (amortized cost $140,325 and $0) 155,844 - Trading securities at fair value (cost $0 and $17,459) - 28,340 Common stock at fair value (cost $931 and $931) 1,143 1,152 Short-term investments 253,614 93,042 Total investments 2,519,453 2,294,112 Cash and cash equivalents 6,012 2,371 Deferred federal income taxes 233,996 - Premiums and other receivables 21,582 25,760 Accrued interest and dividends receivable 28,319 27,860 Deferred policy acquisition costs 172, ,094 Prepaid reinsurance premiums 1,138 1,184 Credit derivatives 43, ,721 Reinsurance recoverable on unpaid losses 169 2,259 Prepaid federal income taxes 14,995 14,995 Federal income taxes recoverable Other assets 13,259 7,752 Total Assets $3,054,628 $2,648,517 Liabilities and Shareholder s Equity Liabilities Losses and loss adjustment expenses $249,864 $ 173,990 Reinsurance payable on paid losses and loss adjustment expenses 1,410 1,853 Deferred premium revenue 713, ,877 Federal income taxes payable 4,348 - Deferred federal income taxes - 109,849 Payable to affiliates 6,298 5,141 Credit derivatives 801,284 59,143 Accrued expenses and other liabilities 24,721 32,388 Total Liabilities 1,801,651 1,042,241 Shareholder s Equity Common stock - $150 par value, Authorized, issued and outstanding -100,000 shares 15,000 15,000 Preferred stock - $1,000 par value, Authorized 4,000 shares - - Additional paid-in capital 704, ,654 Retained earnings 504, ,996 Accumulated other comprehensive income 29,136 45,626 Total Shareholder s Equity 1,252,977 1,606,276 Total Liabilities and Shareholder s Equity $3,054,628 $2,648,517 See notes to consolidated financial statements

5 CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands) Years Ended December 31, Revenues Net premiums written $228,761 $259,853 $219,581 Increase in deferred premium revenue (34,862) (60,280) (13,458) Premiums earned 193, , ,123 Net investment income 104,372 92,656 87,497 Gains on sales of investments 12,334 1,505 12,350 Change in fair value of derivative instruments (808,867) 12,384 6,053 Total Revenues (498,262) 306, ,023 Expenses Losses and loss adjustment expenses 107,232 21,849 31,445 Policy acquisition costs 45,163 46,263 52,354 Other operating expenses 48,821 59,543 65,919 Other expense 18,089 15,059 14,035 Total Expenses 219, , ,753 (Loss) income before income taxes (717,567) 163, ,270 Income tax (benefit) expense (273,648) 36,116 32,556 Net (Loss) Income $(443,919) $127,288 $115,714 See notes to consolidated financial statements

6 CONSOLIDATED STATEMENTS OF SHAREHOLDER S EQUITY (In thousands except share amounts) Accumulated Common Stock Additional Paid-in Retained Other Comprehensive Shares Amount Capital Earnings Income Total Balance, December 31, ,000 $15,000 $590,579 $801,994 $64,793 $1,472,366 Comprehensive Income: Net income , Unrealized foreign currency losses (net of tax of $5,167) (11,478) - Unrealized losses on investments (net of tax of $4,359) (8,095) - Reclassification adjustment for gains included in net income (net of tax of $4,322) (8,028) - Total comprehensive income ,113 Dividends paid (100,000) - (100,000) Balance, December 31, ,000 15, , ,708 37,192 1,460,479 Comprehensive Income: Net income , Unrealized foreign currency gains (net of tax of $2,216) ,152 - Unrealized gains on investments (net of tax of $2,175) ,260 - Reclassification adjustment for gains included in net income (net of tax of $527) (978) - Total comprehensive income ,722 Capital contribution , ,075 Balance, December 31, ,000 15, , ,996 45,626 1,606,276 Cumulative effect of accounting changes, net of tax 3,264 (3,188) 76 Comprehensive Income: Net loss (443,919) - - Unrealized foreign currency gains (net of tax of $2,804) ,246 - Unrealized losses on investments (net of tax of $5,480) (10,531) - Reclassification adjustment for gains included in net income (net of tax of $4,317) (8,017) - Total comprehensive loss (457,221) Capital contribution , ,846 Balance, December 31, ,000 $15,000 $704,500 $504,341 $29,136 $1,252,977 See notes to consolidated financial statements

7 CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Years ended December 31, CASH FLOWS FROM OPERATING ACTIVITIES: Net (loss) income $(443,919) $127,288 $115,714 Adjustments to reconcile net (loss) income to net cash provided by operating activities: Depreciation and amortization 6,043 6,609 10,050 Net realized investment gains (12,334) (1,505) (12,350) Unrealized loss (gain) on derivatives 805,550 (12,384) (6,053) Receipts (payments) on credit derivatives, net 31,189 (63,548) 7,618 Income taxes, net (332,579) 41,962 (9,060) Change in assets and liabilities: Premiums receivable 4,462 14,566 7,555 Accrued interest and dividends receivable (305) (1,367) 1,612 Accrued expenses and other liabilities 2,839 1,788 (109) Deferred policy acquisition costs (19,432) (12,233) 436 Deferred premium revenue, net 53,860 71,716 13,099 Deferred credit derivative revenue (19,023) (11,434) 359 Losses and loss adjustment expenses, net 76,767 (14,370) (26,753) Net balances to affiliates 1,232 (2,996) (1,518) Proceeds from sales of trading securities 589 9,678 13,054 Purchases of fixed maturity trading securities (16,145) - - Purchases of trading securities - (9,350) (7,803) Other assets (6,278) (3,922) 3,437 Net cash provided by operating activities 132, , ,288 CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sales and maturities of fixed maturity investments 208, , ,335 Purchases of fixed maturity investments (275,911) (551,234) (421,885) Proceeds from sales of common stocks 4,593 5,596 2,995 Purchases of common stocks (4,774) (5,492) (3,068) Proceeds from sales and maturities of hybrid securities 127, Purchases of hybrid securities (120,874) - - (Receivable) payable for securities (9,946) 13,328 (2,207) Purchases of fixed assets (1,788) (1,554) (960) Change in short-term investments, net (159,268) 11,289 9,666 Net cash used in investing activities (232,452) (152,983) (17,124) CASH FLOWS FROM FINANCING ACTIVITIES: Dividends paid - - (100,000) Capital contributions 103,845 10,075 - Net cash provided by (used in) financing activities 103,845 10,075 (100,000) Net change in cash and cash equivalents 3,909 (2,410) (7,836) Effect of exchange rate changes on cash and cash equivalents (268) (1,144) (256) Cash and cash equivalents, beginning of year 2,371 5,925 14,017 Cash and cash equivalents, end of year $ 6,012 $ 2,371 $ 5,925 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid (received) during the year for income taxes $ 58,931 $ (5,846) $ 41,616 See notes to consolidated financial statements

8 1. ORGANIZATION AND NATURE OF OPERATIONS Radian Asset Assurance Inc. ( Radian Asset ) and its consolidated subsidiaries (collectively known as the ( Company ) is a wholly-owned subsidiary of Enhance Financial Services Group Inc. ( Enhance Financial ). Enhance Financial is a wholly-owned subsidiary of its ultimate parent, Radian Group Inc. ( Radian ). The Company principally provides financial guaranty insurance by insuring and reinsuring public finance and structured finance obligations as well as credit default swap transactions ( CDS ). In addition, the Company provided trade credit reinsurance and surety lines of business that were placed in runoff in October Radian Asset Assurance Limited ( RAAL ) is a wholly-owned subsidiary of Radian Asset based in the United Kingdom and is regulated by the Financial Services Authority ( FSA ). RAAL is foreign insurance entity that provides trade credit and financial guaranty insurance in the United Kingdom as well as in several other countries in the European Union, subject to compliance with European passporting rules. Radian Financial Products Limited ( RFPL ) is a wholly owned subsidiary of Radian Asset. RFPL is currently authorized by the Financial Services Authority ( FSA ) under Part IV of the Financial Services and Markets Act 2000 as a Category D Securities and Futures Firm with permission to arrange and advise on investment transactions. The Company advises other Radian subsidiary companies in relation to arranging and executing credit default swaps, for which it receives a fee directly from those companies. Radian Asset also owns 100% of the common stock of Asset Recovery Solutions ( ARS ), a noninsurance entity that has no material operations. Radian Asset owns 100% of Van American Insurance Agency Inc. ( VAC ). VAC administrates policies which were originally insured by Van-American Company Inc. and its wholly-owned subsidiaries ( Van Am ). Van Am novated all its remaining insurance liabilities to Radian Asset, and was subsequently dissolved. 2. SIGNIFICANT ACCOUNTING POLICIES The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ( GAAP ), which for the Company differ in certain material respects from the accounting practices prescribed or permitted by regulatory authorities. The significant accounting policies of the Company are as follows: Consolidation The accompanying financial statements include the accounts of Radian Asset, RAAL, RFPL, Van Am and ARS. All significant intercompany accounts and transactions, and intercompany profits and losses have been eliminated. Use of Estimates The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results may differ from those estimates

9 Reclassifications Certain of the prior years amounts have been reclassified to conform to the current years presentation. Cash and Cash Equivalents The Company considers all highly liquid short-term investments with an original maturity of three months or less at the time of purchase to be cash equivalents. Investments In accordance with the Statement of Financial Accounting Standards ("SFAS") No. 115 "Accounting for Certain Investments in Debt and Equity Securities," management classifies all securities at the time of purchase as "held to maturity", "available for sale" or "trading". Fixed maturity securities available for sale, fixed maturity-trading securities, hybrid securities and trading securities are carried at fair value. Unrealized gains and losses, net of taxes, on the available for sale portfolio are charged or credited to accumulated other comprehensive income. Changes in the fair value on fixed maturity-trading securities, hybrid securities and the trading portfolio are included in the Consolidated Statements of Operations. Effective January 1, 2007, we began classifying as hybrid securities the securities which were previously classified as available for sale and the related derivative components which were previously classified as trading securities. Hybrid securities generally combine both debt and equity characteristics. Prior to 2007, the changes in fair value of the fixed-maturity component of these securities were recorded in our consolidated statements of changes in shareholders equity through accumulated other comprehensive income or loss (net of tax) and the changes in fair value of the derivative component of these securities were recorded as a gain or loss in our consolidated statements of operations. In accordance with SFAS No. 155, effective January 1, 2007, all changes in the fair value of the entire convertible securities are now recorded as net gains or losses on securities in our consolidated statements of operations. Our transition adjustment related to the adoption of SFAS No. 155 increased retained earnings at January 1, 2007 by $3.2 million, and reduced accumulated other comprehensive income by the same amount. The transition amount includes unrealized gains of $3.8 million (net of tax) and unrealized losses of $0.6 million (net of tax) related to convertible securities at December 31, Common stocks are carried at fair value. Short-term investments are carried at amortized cost, which approximates fair value. Unrealized gains and losses, net of taxes, on common stocks are charged or credited to accumulated other comprehensive income. For mortgage-backed and asset-backed securities, discounts and premiums are adjusted quarterly for the effects of actual and expected prepayments on a retrospective basis. For pre-refunded bonds, the remaining term is determined based on the contractual refunding date. Investment income is recognized as earned and includes the accretion of bond discount and amortization of bond premium. Realized gains or losses on sales of investments are determined on the basis of specific identification. The Company conducts a quarterly evaluation of declines in market value of the securities to determine whether the decline is other-than-temporary. If fair value of a security is below the cost basis, and it is judged to be other-than-temporary, the cost basis of the individual security is written down to fair value through earnings as a realized loss, and the fair value becomes the new basis. During 2007 and 2006 respectively, the Company recorded approximately $0.1 million and $1.2 million of charges related to declines in the fair value of securities (related to one corporate bond in 2007, and mainly convertible securities in 2006) considered to be other-than-temporary. There were no such charges in At December 31, 2007 and 2006, there were no other investments held in the portfolio that were determined to - 9 -

10 be other-than-temporarily impaired. Realized gains and losses are determined on a specific identification method and are included in income. Our evaluation of market declines for other-than-temporary impairment is based on management's case-bycase evaluation of the underlying reasons for the decline in fair value. We consider a wide range of factors about the security and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management's evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by us in the impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below cost or amortized cost; (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties; (iii) the potential for impairments in an entire industry sector or sub-sector; (iv) the potential for impairments in certain economically depressed geographic locations; (v) the potential for impairments of securities where the issuer, series of issuers or industry has suffered a catastrophic type of loss or has exhausted natural resources; (vi) the Company's ability and intent to hold the security for a period of time sufficient to allow for the full recovery of its value to an amount equal to or greater than cost or amortized cost; (vii) unfavorable changes in forecasted cash flows on asset-backed securities; and (viii) other subjective factors, including concentrations and information obtained from regulators and rating agencies. Premium Revenue Recognition and Premium Receivable Premiums are earned in proportion to the level of amortization of insured principal over the contract period or over the period that the insurance protection is provided. Deferred premium revenue represents that portion of premiums which will be earned over the remainder of the contract period, based upon information reported by primary insurers and management s estimates of amortization of insured principal. When insured issues are refunded or called, the remaining deferred premium revenue is recognized immediately. Credit enhancement fees on derivative financial guaranty contracts, primarily CDS, are included in premiums written and are earned over the period the credit protection is provided. Premiums receivable include amounts due from primary insurers, insured parties or broker agents. Deferred Policy Acquisition Costs Deferred policy acquisition costs are comprised of those expenses that vary with and are primarily related to the production of insurance premiums, including: commissions paid on reinsurance assumed, salaries and related costs of underwriting and marketing personnel, rating agency fees, premium taxes and certain other underwriting expenses. Ceding commission income received on premiums ceded reduces acquisition costs. Acquisition costs are deferred and amortized over the period in which the related premiums are earned. Deferred policy acquisition costs are reviewed periodically to determine recoverability, after considering investment income. Losses and Loss Adjustment Expenses ("LAE") Financial Guaranty Losses and LAE The following description of the Company s financial guaranty loss reserving policy relates only to nonderivative financial guaranty contracts provided through direct and assumed financial guaranty insurance business. The Company s financial guaranty insurance contracts provide an unconditional and irrevocable guaranty to the holder of a financial obligation that, upon payment default by the insured party, the Company will pay the full amount of principal and interest on an insured obligation when due. The Company s financial guaranty reinsurance contracts provide for reimbursement to the primary insurer under a reinsured financial guaranty contract when the primary insurer is obligated to pay principal and interest on an insured obligation

11 The Company establishes loss reserves on its financial guaranty contracts based on the estimated cost of settling claims and associated loss adjustment expenses ( LAE ), adjusted for estimated recoveries under salvage or subrogation rights. At December 31, 2007 and 2006, anticipated recoveries under salvage and subrogation rights were $2.5 million and $4.5 million, respectively. LAE consists of the estimated cost of the claims administration process, including legal fees and other associated fees and expenses. The Company s financial guaranty loss reserves are comprised of specific reserves (which the Company refers to as case reserves) and non-specific reserves. As discussed below, the reserving policies used by the financial guaranty industry are continuing to evolve and are subject to change. The Company records case reserves for losses and related LAE when a guaranteed obligation defaults in payment. In the case of direct financial guaranty contracts, the Company determines the existence of payment default and records case reserves when a default has occurred, based on a report from the insured party or based on the Company s surveillance efforts. In the case of financial guaranty reinsurance, the Company relies primarily on information provided by the primary insurer, as well as specific knowledge of the claim, in recording related case reserves. At December 31, 2007, the Company had financial guaranty case reserves of $31.7 million. Of this amount, $22.5 million is attributable to a single manufactured housing transaction originated and serviced by Conseco Finance Corp. The Company records non-specific reserves to reflect the deterioration of insured credits that have not yet defaulted. The Company determines this deterioration in two separate ways. First, the Company records non-specific reserves for losses when it identifies through its surveillance procedures or, in the case of reinsurance, after the Company confirms information provided by the primary insurer regarding specific significant deteriorating events that have occurred with respect to specific insured credits that have not yet defaulted. The Company refers to this category of its non-specific reserves as allocated non-specific reserves. At December 31, 2007, 16 credits were included in the Company s allocated non-specific reserves of $141.3 million. These credits have a par amount of $362.3 million. Second, because the Company believes that inherent deterioration begins immediately and continues over time on its remaining portfolio, the Company also records non-specific reserves for losses, on a portfolio basis, on the credits in its portfolio for which the Company does not have a case reserve or an allocated nonspecific reserve. The Company refers to this category of non-specific reserves as unallocated non-specific reserves. The Company s unallocated non-specific reserves are established over time by applying expected default factors to the premiums earned. The expected frequency and severity of losses for each credit is generated from three sources - two that are published by major rating agencies and one that is generated by a proprietary internal model - based on the product class, published rating and term to maturity for each credit. The Company sets the expected life-time losses for each credit at the approximate mid-point of the range between the highest and lowest expected life-time loss factors generated by the rating agency and internally generated models. Because of the low incidence of losses on financial guaranty obligations, it is also very difficult to estimate the timing of losses on our insured obligations for which we have not yet established a case reserve or allocated non-specific reserve. The default factors for the years ended December 31, 2007, 2006 and 2005 ranged from 10% to 20% of earned premiums. At December 31, 2007 the default factors were 10% of earned premiums on public finance credits and 15% of earned premiums on structured finance credits. As a result of favorable loss development, the Company was able to lower the default factor for structured finance credits in The Company s unallocated non-specific loss reserve at December 31, 2007 was $49.2 million. The range between the unallocated non-specific reserves that would have resulted from applying the highest and lowest default factors generated by any of the three models is approximately $25.0 million to $67.0 million, which the Company believes to provide a reasonably likely range of expected losses

12 At each balance sheet date, the Company also evaluates both the model-generated default factors and its unallocated non-specific reserves against management s subjective view of qualitative factors to ensure that the default factors and the unallocated non-specific reserves represent management s best estimate of expected losses on the Company s portfolio of credits for which it has not established a case reserve or an allocated non-specific reserve. These qualitative factors include existing economic and business conditions, overall credit quality trends resulting from industry, geographic, economic and political conditions, recent loss experience in particular segments of the portfolio, changes in underwriting policies and procedures and seasoning of the book of business. In addition, a significant change in size of the Company s portfolio underlying the unallocated non-specific reserves, such as through the expiration of policies or the refunding or recapture of insured exposures, could require an adjustment to default factors or the Company s level of unallocated non-specific reserves. Once a case reserve is established with respect to an insured credit, an offsetting adjustment typically is made to the non-specific reserve. This offsetting adjustment may or may not be on a dollar-for-dollar basis, depending on the size of the necessary case reserve and the sufficiency of the non-specific reserve with respect to the other credits in the Company s portfolio. In addition, the establishment of case reserves may require a provision beyond what is included in non-specific reserves. The establishment of reserves can reduce the Company s net income when unallocated non-specific reserves are increased, when allocated non-specific reserves are established in an amount that exceeds unallocated non-specific reserves, or when case reserves are established in an amount that exceeds non-specific reserves. Conversely, a reduction of reserves, due to improved economic conditions or a cure of a default with respect to a specific credit for which a case reserve has been established, or otherwise, can lead to an increase in the company s net income. The Company discounts financial guaranty case reserves arising from defaults that involve claim payments over an extended period of time. The discount rate corresponds to the Company s individual statutory investment yield of 4.40% in 2007, compared to 4.36% in Discounted liabilities at December 31, 2007 were $9.2 million, net of discounts of $3.2 million, compared to discounted liabilities of $9.7 million, net of discounts of $4.2 million at December 31, The Company does not discount its non-specific reserves. As an insurance enterprise, the Company relies principally on SFAS No. 60, Accounting and Reporting by Insurance Enterprises, in establishing loss reserves with respect to its financial guaranty business. With respect to its case reserves, the Company follows the guidance of SFAS No. 60 regarding the establishment of reserves upon the occurrence of an insured event. Although SFAS No. 60 provides guidance to insurance enterprises, it was adopted before the financial guaranty industry came into prominent existence and it does not comprehensively address the unique attributes of financial guaranty insurance. For example, SFAS No. 60 prescribes differing reserving treatment depending on whether a contract fits within SFAS No. 60 s definition of a short-duration contract or a long-duration contract. Financial guaranty contracts have elements of long-duration insurance contracts in that they are irrevocable and extend over a period that may extend 30 years or more, but are reported for regulatory purposes as property and liability insurance, normally considered short-duration contracts. Because of these ambiguities in the application of SFAS No. 60, the Company does not believe that SFAS No. 60 alone provides sufficient guidance for the Company s reserving policy, particularly with respect to the establishment of non-specific reserves before an insured event occurs. As a result, the Company and, to the Company s knowledge, other members of the financial guaranty industry, supplement the principles of SFAS No. 60 with those of SFAS No. 5, Accounting for Contingencies, which calls for the establishment of reserves when it is probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. The Company also relies by analogy on SFAS No. 114, Accounting by Creditors for Impairment of a Loan and EITF Issue No , Recognition of Fees for Guaranteeing a Loan, which state that a guarantor should perform an ongoing assessment of the probability of loss to determine if a liability (and a loss) should be recognized under SFAS No. 5. The establishment of non-specific reserves for credits that have not yet defaulted is a practice followed by the entire financial guaranty industry, although the Company

13 acknowledges that there may be differences in the specific methodologies used by other financial guarantors in establishing these reserves. The Company believes that its financial guaranty loss reserve policy is appropriate under the applicable accounting literature, and that it best reflects the fact that credit-based insurance involves a gradual deterioration of credit over time. However, because of the lack of specific accounting literature comprehensively addressing the unique attributes of financial guaranty contracts, the accounting principles applicable to the Company s loss reserving policy are subject to change. On June 8, 2005, the Financial Accounting Standards Board ( 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. On April 18, 2007, the FASB issued an exposure draft, Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60 ( Exposure Draft ). The Exposure Draft clarifies how SFAS No. 60 applies to financial guaranty insurance contracts and provides guidance with respect to the timing of claim liability recognition, premium recognition and the related amortization of deferred policy acquisition costs, specifically for financial guaranty contracts issued by insurance companies that are not accounted for as derivative contracts under SFAS No The goal of the proposed statement is to reduce diversity in accounting by financial guaranty insurers, thereby enabling users to better understand and more readily compare insurers financial statements. Final guidance from the FASB regarding accounting for financial guaranty insurance was issued in May The effect on the consolidated financial statements, particularly with respect to revenue recognition and claims liability, could be material. Trade Credit and Surety Losses and LAE Reserves for losses and LAE for the other lines of business, primarily trade credit reinsurance, are established solely under SFAS No. 60 because the Company believes that the nature of the trade credit business fits within the short-duration contract framework of SFAS No. 60. These reserves are based on reports and individual loss estimates received from ceding companies, net of anticipated estimated recoveries under salvage and subrogation rights. The Company uses historical loss information and makes inquiries to the cedants of known events as a means of validating its loss assumptions. Any differences in viewpoints are resolved expeditiously and have historically not resulted in material adjustments. In addition, a reserve is included for losses and LAE incurred but not reported ( IBNR ) on trade credit surety business. The Company periodically evaluates its estimates for losses and LAE and adjusts such reserves based on its actual loss experience, mix of business and economic conditions. Changes in total estimates for losses and LAE are reflected in current earnings. The Company believes that its total reserves for losses and LAE are adequate to cover the ultimate cost of all claims net of reinsurance recoveries. Setting the loss reserves involves significant reliance upon estimates with regard to the likelihood, magnitude and timing of a loss. The models and estimates the Company uses to establish loss reserves may not prove to be accurate, especially during an extended economic downturn. Ultimate losses and LAE may differ materially from amounts currently recorded. All changes in these estimates are recorded in the period in which such changes are identified

14 The following table shows the Company s case and non-specific reserves for losses and loss adjustment expenses for its financial guaranty business, and case reserves and IBNR related to the non-financial guaranty businesses (in thousands): Case Reserves Financial Guaranty Non- Specific Allocated Reserves Non- Specific Unallocated Reserves Trade Credit and Surety Case Reserves IBNR Total Loss Reserves at December 31, 2004 $91,905 $ 9,750 $56,748 $26,588 $31,211 $216,202 Less Reinsurance Recoverable 1, ,235 Net Loss Reserves at December 31, ,905 9,750 56,748 24,934 30, ,967 Total Incurred 14,307 17,393 (255) 31,445 Transfers (1,823) 18,000 (16,177) Total Paid 36,155 22,043 58,198 Foreign Exchange Adjustment (1,567) (1,921) (3,488) Net Loss Reserves at December 31, ,927 27,750 54,878 18,717 28, ,726 Plus Reinsurance Recoverable 1,517 1,182 2,699 Loss Reserves at December 31, ,927 27,750 54,878 20,234 29, ,425 Less Reinsurance Recoverable 1,517 1,182 2,699 Net Loss Reserves at December 31, ,927 27,750 54,878 18,717 28, ,726 Total Incurred 14,532 13,409 (6,092) 21,849 Transfers 10,544 (1,565) (8,979) Total Paid 22,012 14,207 36,219 Foreign Exchange Adjustment 1, ,375 Net Loss Reserves at December 31, ,459 26,185 60,431 19,416 23, ,731 Plus Reinsurance Recoverable 1, ,259 Loss Reserves at December 31, ,459 26,185 60,431 20,770 24, ,990 Less Reinsurance Recoverable 1, ,259 Net Loss Reserves at December 31, ,459 26,185 60,431 19,416 23, ,731 Total Incurred 114,900 3,147 (10,815) 107,232 Transfers 11, ,085 (126,136) Total Paid 21,825 8,699 30,524 Foreign Exchange Adjustment ,256 Net Loss Reserves at December 31, , ,270 49,195 14,800 12, ,695 Plus Reinsurance Recoverable Loss Reserves at December 31, 2007 $31,685 $141,270 $49,195 $14,800 $12,914 $249,

15 Federal Income Taxes The Company provides for income taxes in accordance with the provisions of SFAS No. 109, Accounting for Income Taxes ( SFAS No. 109 ). As required under SFAS No. 109, the Company s deferred tax assets and liabilities are recognized under the liability method which recognizes the future tax effect of temporary differences between the amounts recorded in the Consolidated Financial Statements and the tax bases of these amounts. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be realized or settled. The direct and indirect subsidiaries of Radian, including the Company, are included in a U.S. consolidated federal income tax return for the periods ending December 31, 2007 and Radian s tax sharing allocation agreement provides that any subsidiary having taxable income will pay a tax liability equivalent to what that subsidiary would have paid if it filed a separate income tax return for the year. If the separately calculated federal income tax return for any subsidiary results in a tax loss, the current benefit resulting from such loss, to the extent utilizable on a separate return basis, will be accrued and paid to that subsidiary. In June 2006, the FASB issued FASB Interpretation 48 ( FIN No. 48 ), Accounting for Uncertainty in Income Taxes an Interpretation of FASB Statement No FIN No. 48 is effective for fiscal years beginning after December 15, 2006, and clarifies the accounting for uncertainty in income taxes recognized in an enterprise s financial statements in accordance with SFAS No It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Radian s policy for the recognition of interest and penalties associated with uncertain tax positions is to record such items as a component of our income tax provision. The adoption of FIN 48 did not have a material effect on the Company s financial statements. As of December 31, 2007, the Company has not recognized a tax liability for uncertain tax positions. Derivative Instruments The Company accounts for derivatives under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted. SFAS No. 133 requires that all derivative instruments be recorded on the balance sheet at their respective fair values. All derivative instruments are recognized on the Consolidated Balance Sheets as either assets or liabilities, depending on the rights or obligations under the contracts. Transactions that the Company has entered into that are accounted for under SFAS No. 133 as amended, include investments in convertible fixed-maturity securities, selling credit protection in the form of CDS and certain financial guaranty contracts that are considered CDS. Over the term of the securities, changes in the fair value of debt securities available for sale are recorded in the Company s Consolidated Statement of Shareholder s Equity through accumulated other comprehensive income or loss. Concurrently, a deferred tax liability or benefit is recognized as the recorded value of the fixed-maturity security increases or decreases. A change in the fair value of the derivative is recorded as a gain or loss in the Company s Consolidated Statements of Operations. Certain financial guaranty contracts and CDS that are accounted for under SFAS No. 133 are part of the Company s overall business strategy of offering financial guaranty protection to its customers. The embedded equity derivatives contained within our investments in fixed-maturity securities and the sale of credit protection in the form of CDS do not qualify as hedges under SFAS No. 133, so changes in their fair value are included in current earnings in the periods presented in the Consolidated Statements of Operations. Net unrealized gains and losses on CDS and certain other financial guaranty contracts are included in credit derivatives on the Consolidated Balance Sheets

16 Settlements under derivative financial guaranty contracts are charged to assets or liabilities, as appropriate. From time to time, or as conditions warrant, we engage in derivative settlements to mitigate counterparty exposure and to provide additional capacity to our customers. During 2007, the Company recognized $31.1 million in termination receipts associated with agreements that the Company entered into with its counterparties to terminate certain of its structured finance policies. This resulted in the Company recognizing an additional loss of $3.3 million (pre-tax) which is reflected in the change in fair value of derivatives on the consolidated statement of operations. During 2007, the Company did not receive any recoveries related to previous default payments and did not make default payments on derivative financial guaranty contracts. During 2006, the Company received recoveries of $4.5 million related to previous default payments on derivative financial guaranty contracts and paid $68.1 million for default payments on derivative financial guaranty contracts. During 2005, the Company received recoveries of $7.7 million related to previous default payments on derivative financial guaranty contracts and paid $0.1 million for default payments on derivative financial guaranty contracts. Origination costs of these contracts are expensed as incurred. The gains and losses on direct derivative financial guaranty contracts are derived from internally generated models. Estimated fair value amounts are determined by using market information to the extent available, and in most cases, observable market information must be combined with unobservable market inputs in order to estimate fair value. These unobservable market inputs are required to consider differences that exist in the collateral underlying the Company s contracts and the collateral underlying market indices as well as the structural features of the Company s contracts. For corporate pooled CDOs, credit spreads on individual names in the Company s collateral pool are used to derive an equivalent risk tranche on an industry standard credit default swap index ( CDX ). When credit spreads on individual names are not available, the average credit spread of similar companies is used. For certain of the Company s non-corporate CDOs, dealer quotes on similar structured transactions are used. In determining the Company s December 31, 2007 valuations, generally market indices are used to estimate fair value on these deals. In determining gains and losses on RMBS and CMBS CDOs, the Company utilizes a generic spread from ABX and CMBX. The generic spread utilized is based on the nature of the underlying collateral in each deal. The gains and losses on Trust Preferred Securities deals are derived from internally generated models utilizing observable CDS spreads of a group of investment grade and high-yield financial institutions. Because the Company s collateral does not directly track market indices that are available, adjustments to account for differences in term, credit quality, and diversification of underlying collateral are made in the Company s internal models. In addition, the Company s internal models are adjusted to account for differences between the Company s financial guaranty contracts and similar derivative contracts executed by other primary market participants, the primary difference being the lack of a requirement to post collateral with the Company s counterparties when the Company s contracts are in a liability position. In instances where dealer quotes are not available and market indices are not appropriate, the Company considers the reinsurance market to be the principal market for purposes of determining fair value, therefore, the Company utilizes an internal model, similar to those used by reinsurers, to estimate fair value. Prior to 2007, many of the Company s non-corporate CDOs were valued using this methodology as the reinsurance market for these products was much more robust than the current environment. Significant differences may exist with respect to the available market information and assumptions used to determine gains and losses on derivative financial guaranty contracts. Considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates are not necessarily indicative of amounts the Company could realize in a current market exchange due to the lack of a liquid market. The use of different market assumptions and/or estimation methodologies may have a significant effect on the estimated fair value amounts. The application of SFAS No. 133, as amended, could result in volatility from period to period in gains and losses as reported on the Company s consolidated statements of operations. These gains and losses are mostly the result of changes in credit spreads, changes in the creditworthiness of underlying entities, and the equity performance of entities underlying convertible investments. Any incurred gains or losses on such

17 contracts would be recognized as a change in the fair value of derivatives. The Company is unable to predict the affect this volatility may have on the Company s financial condition or results of operations. Estimated net unrealized losses on credit derivatives were $777.6 million at December 31, Estimated net unrealized gains on credit derivatives were $94.4 million as of December 31, In the fourth quarter of 2005, the Company refined its internal model used to determine unrealized gains and losses on derivatives. The model uses actual credit spreads by individual name, when available, as compared to the previous version of the model, which used average spreads for similarly rated names. While application of the new model resulted in minimal changes for most of our derivative transactions, one high-yield deal showed a large difference due to greater spread volatility in the high-yield corporate names included in this transaction. At December 31, 2005, our refined model indicated that we had incurred a $50.8 million unrealized loss on this transaction, which was reflected in the change in the fair value of derivative instruments on the Consolidated Statement of Operations in 2005 and in the credit derivative reserve on the Consolidated Balance Sheet at December 31, On March 2, 2006, the Company paid $68.0 million to a counterparty to eliminate the uncertainty around this transaction with exposure of $247.5 million and amended one other derivative financial guaranty contract with the same counterparty. This settlement required the Company to recognize an additional loss of $17.2 million (pre-tax) that was reflected in the change in fair value of derivative instruments, on the Consolidated Statement of Operations in A summary of the Company s derivative information as of and for the periods indicated is as follows (in millions): Year Ended December 31 Balance Sheet Trading Securities Amortized cost $ - $ 17.5 Fair value Derivative Financial Guaranty Contracts Notional value $ 48,539.4 $ 43,728.0 Gross unrealized gains $ 7.9 $ Gross unrealized losses Net unrealized (losses) gains $ (777.6) $ 94.4 Put Options on Committed Preferred Securities Gross unrealized gains $ 35.2 $ - Gross unrealized losses - - Net unrealized gains $ 35.2 $ - The following table presents information related to net unrealized gains or losses on derivative financial guaranty contracts (included in assets or liabilities on the Consolidated Balance Sheets in millions) Balance at January 1 $ 94.4 $ 23.4 Net (losses) gains recorded (840.8) 7.4 Settlements of derivative contracts: Defaults Recoveries - (4.5) Payments Early termination receipts (31.2) - Balance at December 31 $(777.6) $

18 The components of the change in fair value of derivative instruments are as follows (in millions): Year Ended December Statement of Operations Trading Securities $ (0.3) $ 4.9 $ 0.4 Derivative Financial Guaranty Contracts (840.8) Put Options on Committed Preferred Securities Net (losses) gains $(808.9) $ 12.3 $ 6.1 The application of SFAS No. 133, as amended, could result in volatility from period to period in unrealized gains and losses as reported on the Company s Consolidated Statements of Operations. These unrealized gains and losses result primarily from changes in corporate credit spreads, changes in the creditworthiness of underlying corporate entities and the equity performance of the entities underlying the Company s convertible securities. The Company is unable to predict the effect this volatility may have on its financial position or results of operations. New Accounting Pronouncements Employees of the Company participate in a stock option plan sponsored by Radian. In December 2004, the FASB issued SFAS No. 123R ( SFAS No. 123R ) Share-Based Payment, which requires compensation cost related to share-based payment transactions to be recognized in the Company s financial statements. The compensation cost, with limited exceptions, is measured based on the grant-date fair value of the equity or liability instrument issued. In October 2005, the FASB issued Staff Position No. SFAS 123(R)-2 Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R), to provide guidance on the application of the term grant date in SFAS No. 123R. In accordance with this Staff Position, the grant date of an award shall be the date the award is approved by Radian s board of directors if, at such time, (i) the recipient of the award does not have the ability to negotiate the key terms and conditions of the award and (ii) the key terms of the award are expected to be communicated to the recipients within a relatively short time period after the date of approval. SFAS No. 123R replaces SFAS No. 123 Accounting for Stock-Based Compensation and supersedes Accounting Principles Board ( APB ) Opinion No. 25. Before the adoption of SFAS No. 123R, the Company applied APB 25 to account for our stock-based compensation. On January 1, 2006, the Company adopted SFAS No. 123R using a modified prospective application as permitted by SFAS No. 123R. Accordingly, prior period amounts have not been restated. Under this application, the Company is required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Compensation cost is recognized over the periods that an employee provides service in exchange for the award. The adoption of SFAS No. 123R did not have a material impact on the Company s financial statements. In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial instruments, an amendment of SFAS No. 133 and 140. SFAS No. 155 (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (ii) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, (iii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are a hybrid financial instruments that contain an embedded derivative requiring bifurcation, (iv) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives and, (v) amends SFAS No. 140 to eliminate the exemption from applying the