| **UNITED STATES**                       |
|-----------------------------------------|
| **SECURITIES  AND EXCHANGE COMMISSION** |
| **Washington,  D.C. 20549**             |
|                                         |
| **FORM 10-K**                      |

**ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

**Forthe fiscal year ended December 31, 2005**

**Commission File Number 1-12644**

**Financial SecurityAssurance Holdings Ltd.**

(Exact name of registrantas specified in its charter)

| **New York**                                                           |   | **13-3261323**                                |
|------------------------------------------------------------------------|--------|-----------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)       |   | (I.R.S. Employer  Identification No.)         |
| **31 West 52****nd**** Street,  New York, New York 10019**        |
| (Address of  principal executive offices, including zip code)          |
| **(212) 826-0100**                                                     |
| (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** |
| 67¤8% Quarterly Interest Bond Securities Due  2101                |   | New York Stock  Exchange, Inc.           |
| 6.25% Notes Due  November 1, 2102                                 |   | New York Stock  Exchange, Inc.           |
| 5.60% Notes Due  July 15, 2103                                    |   | New York Stock  Exchange, Inc.           |
| Securities  registered pursuant to Section 12(g) of the Act: |
| **None**                                                               |

 

Indicate by check if theregistrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities Act. Yes  o  No  x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes  o  No  x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes  x No  o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

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

Large acceleratedfiler o      Acceleratedfiler o      Non-acceleratedfiler x

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

The aggregate market valueof common equity, excluding treasury shares, held by non-affiliates of theregistrant at June 30, 2005 was $53,993,549. For purposes of theforegoing, directors are deemed to be affiliates of the registrant and thedollar amount shown is based on the price at which shares of the Company’s commonstock were valued under the Company’s director share purchase program on June 30,2005.

At March 27, 2006,there were outstanding 33,263,259 shares of common stock, par value $0.01 pershare, of the registrant (excludes 254,736 shares of treasury stock).

**Documents Incorporated By Reference**

None.

 

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**TABLE OF CONTENTS**

|               | ** ** | ** **                                                                                                         | ** ** | **Page** |
|---------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I   |       |                                                                                                               |       |     |
| Item 1.       |       | Business                                                                                                           |       | 3        |
| Item  1A.     |       | Risk  Factors                                                                                                      |       | 39       |
| Item 1B.      |       | Unresolved Staff Comments.                                                                                         |       | 42       |
| Item 2.       |       | Properties                                                                                                         |       | 42       |
| Item  3.      |       | Legal  Proceedings                                                                                                 |       | 42       |
| Item 4.       |       | Submission of Matters to a Vote of Security Holders                                                                |       | 42       |
| PART II  |       |                                                                                                               |       |     |
| Item 5.       |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 43       |
| Item 6.       |       | Selected Financial Data                                                                                            |       | 44       |
| Item 7.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |       | 45       |
| Item 7A.      |       | Quantitative and Qualitative Disclosures About Market  Risk                                                        |       | 68       |
| Item 8.       |       | Financial Statements and Supplementary Data                                                                        |       | 72       |
| Item  9.      |       | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                              |       | 116      |
| Item 9A.      |       | Controls and Procedures                                                                                            |       | 116      |
| Item 9B.      |       | Other Information                                                                                                  |       | 117      |
| PART III |       |                                                                                                               |       |     |
| Item 10.      |       | Directors and Executive Officers of the Registrant                                                                 |       | 118      |
| Item 11.      |       | Executive Compensation                                                                                             |       | 124      |
| Item 12.      |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |       | 131      |
| Item 13.      |       | Certain Relationships and Related Transactions                                                                     |       | 135      |
| Item 14.      |       | Principal Accounting Fees and Services                                                                             |       | 135      |
| PART IV  |       |                                                                                                               |       |     |
| Item 15.      |       | Exhibits, Financial Statement Schedules                                                                            |       | 136      |

 

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**PART I**

**Item 1.**                        Business.

Financial Security Assurance Holdings Ltd.,through its insurance company subsidiaries, is primarily engaged in thebusiness of providing financial guaranty insurance on municipal and asset-backedobligations in domestic and international markets. The financial strength ofthe Company’s insurance company subsidiaries is rated “Triple-A” by the majorsecurities rating agencies and obligations insured by them are generallyawarded “Triple-A” ratings by reason of such insurance. The Company’s principalinsurance company subsidiary is Financial Security Assurance Inc. (“FSA”),a wholly owned New York insurance company. FSA was the first insurance companyorganized to insure non-municipal obligations and has been a major insurer ofasset-backed and other non-municipal obligations since its inception in1985. FSA expanded the focus of its business in 1990 to include financialguaranty insurance of municipal obligations and has since become a majorinsurer of municipal obligations. In addition, the Company offers FSA-insuredguaranteed investment contracts and other investment agreements (“GICs”)through other consolidated entities. References to the “Company” are toFinancial Security Assurance Holdings Ltd. together with its subsidiaries.

Financial guaranty insurance written by FSA typicallyguarantees scheduled payments on financial obligations. Upon a payment defaulton an insured obligation, FSA is generally required to pay the principal,interest or other amounts due in accordance with the obligation’s originalpayment schedule or may, at its option, pay such amounts on an acceleratedbasis. FSA’s underwriting policy is to insure obligations that would otherwisebe investment grade without the benefit of FSA’s insurance.

For the year ended December 31, 2005, the Companyhad gross premiums written of $833.8 million, of which approximately 70%related to insurance of municipal obligations and approximately 30% related toinsurance of asset-backed and other non-municipal obligations. As of December 31,2005, the Company had net par outstanding of $337.5 billion, of which approximately67% represented insurance of municipal obligations and approximately 33%represented insurance of asset-backed and other non-municipal obligations.

The Company provides FSA-insuredGICs to municipalities and other market participants. As of December 31,2005, the Company had $12.7 billion principal amount of outstanding GICs.

**Organization**

FSA wholly owns FSA Insurance Company (“FSAIC”), whichin turn wholly owns Financial Security Assurance (U.K.) Limited (“FSA-UK”). FSAand FSAIC together own Financial Security Assurance International Ltd. (“FSAInternational”). FSAIC is an Oklahoma insurance company that primarily providesreinsurance to FSA. FSA-UK is a United Kingdom insurance company that primarilyprovides financial guaranty insurance for transactions in the United Kingdomand other European markets. FSA International is a Bermuda insurance companythat provides reinsurance to FSA and financial guaranty insurance fortransactions outside United States and European markets.

The Company conducts its GIC business through itsaffiliates FSA Capital Management Services LLC (“FSACM”), FSA Capital MarketsServices (Caymans) Ltd. and, prior to April 2003, FSA Capital MarketsServices LLC (collectively, the “GIC Affiliates”). The Company consolidates theresults of the GIC Affiliates. FSACM has conducted substantially all of theCompany’s GIC business since April 2003, following its receipt of anexemption from the requirements of the Investment Company Act of 1940. The GICAffiliates lend the proceeds from their sales of GICs to FSA Asset ManagementLLC (“FSAM”), which invests the funds, generally in obligations that qualifyfor FSA insurance.

The Company consolidates the results of certainvariable interest entities (“VIEs”), including FSA Global Funding Limited (“FSAGlobal”), Premier International Funding Co. (“Premier”), and Canadian 

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Global Funding Corporation(“Canadian Global”). FSA Global is a special purpose funding vehicle 29% ownedby the Company. FSA Global issues FSA-insured medium term notes and invests theproceeds from the sale of its notes in FSA-insured obligations with a viewtowards realizing the yield difference between the notes issued and theobligations purchased with the note proceeds. Premier is principally engaged indebt defeasance for lease transactions. The majority of Canadian Global’sassets were liquidated and its liabilities satisfied during the third quarterof 2004.

The Company refinances certain defaulted transactionsby employing special purpose vehicles to raise funds to refinance suchtransactions. These refinancing vehicles are also consolidated.

The Company’s management believes that the assets heldby FSA Global, Premier and the refinancing vehicles, including those that areeliminated in consolidation, are beyond the reach of the Company and itscreditors, even in bankruptcy or other receivership. See “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Resultsof Operations—Variable Interest Entities.”

FSA Portfolio Management Inc. (“FSA PortfolioManagement”), a wholly owned subsidiary of the Company, is engaged in thebusiness of managing a portion of the investment portfolios of the Company andcertain of its subsidiaries. FSA Portfolio Management also owns variousstrategic and other investments funded from time to time by the FSA group ofcompanies.

Transaction Services Corporation (“TSC”), a whollyowned subsidiary of the Company, is engaged in the business of managing workouttransactions, including, but not limited to, those referred to as refinancedtransactions, within the insured portfolios of FSA and its subsidiaries.

The Company is a subsidiary of Dexia Holdings, Inc.(“Dexia Holdings”), which, in turn, is owned 90% by Dexia Crédit Local S.A. (“DexiaCrédit Local”) and 10% by Dexia S.A. (“Dexia”). Dexia is a Belgian corporationwhose shares are traded on the Euronext Brussels and Euronext Paris markets aswell as on the Luxembourg Stock Exchange. Dexia is primarily engaged in thebusiness of public finance, banking and investment management in France,Belgium, Luxembourg and other European countries, as well as in the UnitedStates. Dexia Crédit Local is a wholly owned subsidiary of Dexia.

The Company’s ExecutiveManagement Committee manages the Company’s business. The Chief ExecutiveOfficer, President, General Counsel, Chief Risk Management Officer and ChiefFinancial Officer are members of the Executive Management Committee. The headsof Municipal Finance, Corporate Finance, the European Group, the Asia Group andFinancial Products serve as part-time members of this committee and, collectively,comprise the “Management Committee.”*** ***BrunoDeletre, a director of the Company and a member of the Executive Board of DexiaCrédit Local, is an *ex officio*member of the Management Committee.

**History**

When the Company commenced operations in 1985, it wasowned by a number of large insurance companies and other institutionalinvestors. In 1989, the Company was acquired by U S WEST Capital Corporation,which subsequently changed its name to MediaOne Capital Corporation (“MediaOne”).MediaOne was a subsidiary of MediaOne Group, Inc., with operations andinvestments in domestic cable and broadband communications and internationalbroadband and wireless communication. In 1990, the Company established astrategic relationship with The Tokio Marine and Nichido Fire InsuranceCo., Ltd. (“Tokio Marine”), which acquired a minority interest in theCompany. Tokio Marine is a major Japanese property and casualty insurancecompany.

In 1994, the Company completed an initial publicoffering of common shares, at which time White Mountains InsuranceGroup, Ltd. (“White Mountains”) (formerly known as Fund AmericanEnterprises Holdings, Inc.) made an investment in the Company, and thechairman of White Mountains became non-executive chairman of the Company. WhiteMountains is an insurance holding company.

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In 1998, the Company and XL Capital Ltd (“XL”), amajor Bermuda-based insurance holding company, entered into a jointventure, establishing two Bermuda domiciled financial guaranty insurancecompanies—FSA International and XL Financial Assurance Ltd (“XLFA”). Inconnection with the joint venture, XL acquired a minority interest in theCompany and FSA International, and the Company acquired a minority interest inXLFA.

On July 5, 2000, the Company completed a mergerin which the Company became a direct subsidiary of Dexia Holdings. At themerger date, each outstanding share of the Company’s common stock was convertedinto the right to receive $76.00 in cash. As of December 31, 2005,approximately 99% of the Company’s common stock was held by Dexia Holdings. Theother holders are a White Mountains affiliate and certain directors of theCompany who own shares of the Company’s common stock or economic intereststherein as described under “Item 11. Executive Compensation—Director SharePurchase Program.”  Dexia is required torepurchase the shares of the Company held by White Mountain’s affiliate in May 2006.

In October 2005, FSA purchased the interest inFSA International owned by XL for a cash purchase price of $39.1 million in anticipationof the repatriation of earnings and profits of FSA International. Giving effectto such purchase, FSA International became an indirect wholly owned subsidiaryof the Company.

Although the Company’s common stock is no longerlisted on the New York Stock Exchange (“NYSE”) as a consequence of the merger,the Company continues to file periodic reports under the Securities ExchangeAct of 1934, as amended (the “Exchange Act”), because the Company has debtsecurities listed on the NYSE.

The principal executiveoffices of the Company and FSA are located at 31 West 52nd Street, New York,New York, 10019. Subsidiaries of the Company maintain offices domestically inSan Francisco and Dallas and abroad in London, Madrid, Mexico City, Paris,Singapore, Sydney, Tokyo and Bermuda.

**Business Objectives**

***Financial Guaranty Business***

The Company’sobjective for its financial guaranty business is to remain a leading insurer ofmunicipal and asset-backed obligations while generating premium volume atattractive returns and minimizing the occurrence and severity of credit lossesin its insured portfolio. The Company believes that the demand for financialguaranty insurance will remain strong over the long term as a result of theanticipated continuation of the following trends:

·       growthof asset securitization;

·       growthof project finance in Europe and the United States through expansion of privatefinance for funding of infrastructure projects;

·       substantialvolume of new domestic municipal bonds that are insured, due, in part, to thecontinued use of municipal bonds to finance repairs and improvements to thenation’s infrastructure and continued demand for credit enhancement byindividuals who purchase municipal bonds; and

·       growinguse of financial guaranty insurance in non-U.S. markets.

The Companybelieves that short term trends for financial guaranty insurance remainuncertain due, among other things, to:

·       narrowinterest rate spreads between Triple-A rated obligations and lower ratedobligations;

·       potentialdecline in municipal financings and refundings should interest rates rise; and

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·       increasedcompetition among financial guarantors and other alternative providers ofcredit enhancement.

The Company expects tocontinue to originate a diversified insured portfolio characterized byinsurance of both municipal and asset-backed obligations, with a broadgeographic distribution and a variety of revenue sources and transactionstructures. In addition to its domestic business, the Company selectivelypursues international opportunities, primarily in Western European and AsiaPacific markets.

***Financial Products Business***

The Company’s objectivefor its financial products (“FP”) business is to generate net interest marginthrough borrowing funds at attractive rates in the municipal GIC and othermarkets and investing the proceeds in obligations satisfying the Company’sunderwriting criteria while minimizing the Company’s exposure to interest ratechanges. The Company anticipates continued demand over the long term for itsGIC business and other financial products programs that employ financialguaranty insurance provided by FSA. The Company’s ability to continue or growits financial products business, however, is subject to the conclusion of areview underway by Moody’s Investors Service, Inc. (“Moody’s”) of thenon-core business activities of financial guaranty insurers.

**Business of the Company**

The Company is engaged inthe financial guaranty business through its insurance company subsidiaries andin the FP business through its GIC Affiliates and FSAM (collectively, the “FPSegment”).

***Financial Guaranty Business***

FSA’s insurance is employed in both the new issue andsecondary markets. In the case of new issues, the insured obligations are soldwith FSA insurance at the time the obligations are issued. For both municipaland asset-backed obligations, FSA participates in negotiated offerings,where the investment banker and often the insurer have been selected by thesponsor or issuer. In addition, FSA participates in competitive offerings,where underwriting syndicates bid for securities and submit bids that mayinclude insurance.

FSA’s Custody Receipt Program provides insurance formunicipal obligations trading in the secondary market. Likewise, FSA’s Triple-AGuaranteed Secondary Securities (“TAGSS”®) Program provides insurance for asset-backedobligations trading in the secondary market. Investors and dealers generallyobtain secondary-market insurance to upgrade or stabilize the creditratings of securities they already hold or plan to acquire or to increase themarket liquidity of such securities. FSA’s underwriting guidelines require thesame underwriting standards on secondary market issues as on new issues,although FSA’s control rights in the event of default are generally morelimited.

In many insured transactions, the issuer of insuredsecurities is party to an interest rate, basis or currency swap that matchesthe issuer’s funding sources to the interest rate or currency of the insuredsecurities or otherwise hedges the issuer’s exposure. In such transactions, FSAtypically insures the issuer’s obligations under both the insured securitiesand the derivative contract.

FSA insures payment obligations of counterparties andissuers under GICs, GIC equivalents, credit-linked notes and obligationsunder interest rate, currency and credit default swaps (“CDS”), includingguaranties issued in connection with the Company’s FP Segment. FSA also issuessurety bonds under its Sure-Bid program, which provides an alternative totraditional types of good faith deposits for competitive municipal bondtransactions.

FSA insures obligations already carrying insurancefrom other monoline guarantors, with FSA generally obligated to pay claims on a“second-to-pay” basis, following a default by both the underlying 

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obligor and thefirst-to-pay financial guarantor. In recent years, FSA has reinsured a modestamount of business from other financial guaranty insurers.

The following tableindicates the Company’s percentages of par amount (net of reinsurance)outstanding as of December 31, 2005 and 2004 with respect to each type ofmunicipal and asset-backed program:

**NetPar Amount and Percentage Outstanding by Program Type**

| ** **       | ** ** | **As of December 31, 2005(1)** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | **Municipal Programs**                        | ** ** | **Asset-Backed Programs** | ** ** |
| ** **       | ** ** | **Net Par  Amount  Outstanding(1)**           | ** ** | **Percent of  Total Net Par  Amount  Outstanding** | ** ** | **Net Par  Amount  Outstanding** | ** ** | **Percent of  Total Net Par  Amount  Outstanding** | ** ** |
| ** **       | ** ** | **(in millions)**                             | ** ** |
| New Issue        |       |                                               | $          | 217,405 |   |   |   | 95.7 | % |   |   | $ | 102,464 |   |   |   | 92.8 | % |   |
| Secondary Market |       |                                               | 8,112      |   |   |   | 3.6 |   |   |   | 6,985 |   |   |   | 6.3 |   |   |
| Assumed          |       |                                               | 1,543      |   |   |   | 0.7 |   |   |   | 974 |   |   |   | 0.9 |   |   |
| Total            |       |                                               | $          | 227,060 |   |   |   | 100.0 | % |   |   | $ | 110,423 |   |   |   | 100.0 | % |   |

 

| ** **       | ** ** | **As of December 31, 2004(1)** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | **Municipal Programs**                        | ** ** | **Asset-Backed Programs** | ** ** |
| ** **       | ** ** | **Net Par  Amount  Outstanding(1)**           | ** ** | **Percent of  Total Net Par  Amount  Outstanding** | ** ** | **Net Par  Amount  Outstanding** | ** ** | **Percent of  Total Net Par  Amount  Outstanding** | ** ** |
| ** **       | ** ** | **(in millions)**                             | ** ** |
| New Issue        |       |                                               | $          | 186,090 |   |   |   | 95.3 | % |   |   | $ | 112,808 |   |   |   | 92.2 | % |   |
| Secondary Market |       |                                               | 8,240      |   |   |   | 4.2 |   |   |   | 8,496 |   |   |   | 6.9 |   |   |
| Assumed          |       |                                               | 1,062      |   |   |   | 0.5 |   |   |   | 1,046 |   |   |   | 0.9 |   |   |
| Total            |       |                                               | $          | 195,392 |   |   |   | 100.0 | % |   |   | $ | 122,350 |   |   |   | 100.0 | % |   |

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(1)          Excludesintercompany insurance of $13,463 million in 2005 and $7,143 million in2004 relating to FSA-insured GICs issued by the GIC Affiliates.

*Premiums*

In setting insurancepremium rates, FSA takes into account the risk it assumes and its projectedreturn. Critical factors in assessing risk include the credit quality of theissuer, type of issue, sources of repayment, transaction structure and term tomaturity. The premium rate is also a function of market factors and thecompetitive environment. Market factors include the value added by the use ofinsurance, such as the interest rate savings the issuer of an insuredobligation obtains. Competition arises from other insurers and alternative executionsthat do not involve insurance. For insurance on GIC and medium term notetransactions, transactions involving “repackaging” of outstanding securitiesand other transactions, FSA’s premium may be arbitrage-based, based uponthe difference between the effective borrowing cost at a Triple-A rate and theinterest rate on the underlying securities.

*MunicipalObligations*

FSA insures a rangeof municipal obligations, including:

·       generalobligation bonds supported by the issuers’ taxing power;

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·       revenuebonds and other obligations of state and local governments supported by theissuers’ ability to impose and collect fees and charges for public services orspecific projects such as utility revenues;

·       projectfinance obligations, consisting primarily of obligations of special purposeissuers backed by the cash flow from lease or other revenues from projectsserving a substantial public purpose, including government office buildings,toll roads, healthcare facilities and utilities;

·       paymentobligations of counterparties under CDS referencing municipal obligations; and

·       paymentobligations of municipal counterparties under interest rate swaps or otherderivatives.

Municipal obligations include bonds, notes and otherindebtedness issued by public and quasi-public entities, including statesand their political subdivisions (such as counties, cities or towns), utilitydistricts, public universities and hospitals, and public housing andtransportation authorities. Municipal obligations also include bonds, notes andother indebtedness issued by special purpose entities established to financeinvestments in infrastructure projects. An issuer’s obligation to pay issupported by the issuer’s taxing power in the case of general obligation bonds,and by the issuer’s ability to impose and collect fees and charges for publicservices or specific projects in the case of most revenue bonds and public-privateinfrastructure financings. Some municipal obligations, including most projectfinance obligations, include non-municipal credit risks (to swapcounterparties, insurance companies, construction companies or othernon-municipal credits) and operating risks (such as traffic volume or tuitionrevenues).

According to industrysources, the total and insured volume since 2001 of long-term U.S. municipalnew issues sold were as follows:

**U.S. Municipal Obligations(1)**

| **Year**   | ** ** | ** **             | ** ** | **New Total Volume** | ** ** | **New Insured Volume** | ** ** | **New Insured Volume as  Percent of New Total Volume** | ** ** |
|------------|------------|------------------------|------------|--------------------------------|------------|----------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** ** | ** ** | **(in billions)** | ** ** |
| 2001       |       |                   | $          | 288.2                          | ** ** |                             |       | $                                                                                         | 131.0      | ** ** |   |   | 45.5 | % |   |
| 2002       |       |                   | 358.8      | ** **                     |       |                             | 177.6      | ** **                                                                                |       |   | 49.5 |   |   |
| 2003       |       |                   | 383.7      | ** **                     |       |                             | 190.7      | ** **                                                                                |       |   | 49.7 |   |   |
| 2004       |       |                   | 360.1      | ** **                     |       |                             | 194.1      | ** **                                                                                |       |   | 53.9 |   |   |
| 2005       |       |                   | 408.4      | ** **                     |       |                             | 228.1      | ** **                                                                                |       |   | 55.9 |   |   |

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(1)          Source: *The Bond Buyer*, February 7, 2006.Volume is expressed in terms of principal issued and insured on a sale-datebasis. Subject to revision as additional information becomes available.

The municipal bond industry saw an increase in newissue volume in 2001, 2002 and 2003, as declining interest rates, diminishedtax revenues and continuing needs for infrastructure investment drovemunicipalities to borrow on an unprecedented scale. Insurance penetration hasrisen steadily since 2001, reaching its highest historical level in 2005. Newinsured par volume rose significantly in 2005 due to increased market volumeand higher penetration.

Outside the United States, guarantors have increasedtheir presence in public infrastructure finance from 2001 levels. Internationalmunicipal transactions include many public-private partnershipfinancings, such as those authorized by the U.K. Private Finance Initiative,and other highly structured transactions. Because such transactions tend tohave long development times and large par amounts, the timing of transactionsmay cause volatility in insured volume from year to year.

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Since 2001, the annualtotals of non-U.S. municipal par insured of financial guaranty insurancedirectly originated by monoline guarantors, according to industry sources, wereas follows:

**Non-U.S.Municipal Obligations Insured by MonolineInsurance Companies(1)**

| **Year**   | ** ** | **Amount**             | ** ** |
|------------|------------|------------------------|------------|
| ** ** | ** ** | **(in billions)** | ** ** |
| 2001       |       |                   | $          | 6.0 |   |   |
| 2002       |       |                   | 8.1        |   |   |
| 2003       |       |                   | 13.9       |   |   |
| 2004       |       |                   | 11.7       |   |   |
| 2005       |       |                   | N/A        | (2) |   |

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(1)          Source: Association ofFinancial Guaranty Insurers (“AFGI”) web page, July 2005. Data is subjectto revision as additional information becomes available.

(2)          Not available from the same source. Of the four largest monolineguarantors, three disclose the municipal component of their internationalbusiness in their statistical operating supplements. According to suchstatistical operating supplements, those three companies insured directly orassumed, in the aggregate, a principal amount of $15.7 billion of non-U.S.municipal obligations in 2005.

*Asset-BackedObligations*

Asset-backed obligations insured by FSA aregenerally issued in structured transactions backed by pools of assets such asresidential mortgage loans, consumer or trade receivables, securities or otherassets having an ascertainable cash flow or market value. Asset-backedobligations insured by FSA also include payment obligations of counterpartiesand issuers under synthetic obligations such as CDS and credit-linkednotes referencing asset-backed securities or pools of securities or otherobligations.

Asset-backed obligations are typically issued inconnection with structured financings or securitizations where the securitiesbeing issued are secured by or payable with funds from a specific pool ofassets. The assets are typically held by a special purpose entity that alsoacts as the issuer of the insured obligations. Most asset-backedobligations are secured by or represent interests in diverse pools of assets,such as residential mortgage loans, auto loans, credit card receivables, otherconsumer receivables, corporate loans or bonds, government debt and smallbusiness loans. Asset-backed obligations may also be secured by lessdiverse payment sources, such as multifamily real estate.

Asset-backed obligations include funded andsynthetic transactions. Funded asset-backed obligations are typicallypayable from cash flow generated by a pool of assets and take the form ofeither “pass-through” obligations, which represent interests in the relatedassets, or “pay-through” obligations, which generally are debt obligationscollateralized by the related assets. Both types of funded asset-backedobligations generally have the benefit of one or more forms of creditenhancement, such as overcollateralization or excess cash flow, to cover creditrisks associated with the related assets. Synthetic asset-backedobligations generally take the form of CDS obligations or credit-linkednotes that reference either an asset-backed security or pool ofsecurities or loans, with a defined deductible to cover credit risks associatedwith the referenced securities or loans.

Asset securitization often represents an efficient wayfor commercial banks to comply with capital requirements and for corporationsto access the capital markets at more attractive rates and, frequently, withdifferent accounting treatment. Banks have responded to increased capitalrequirements by selling certain of their assets, such as credit cardreceivables and automobile loans, in securitized structures to the financialmarkets. Some corporations have found securitization of their assets to be aless costly funding 

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alternative to traditionalforms of borrowing or otherwise important in diversifying funding sources. Manyfinance companies fund consumer finance and home equity lending throughsecuritization.

Since the late 1990s, a significant market hasdeveloped for funded and synthetic collateralized debt obligations (“CDOs”),which are securitizations of bonds, loans or other securities. CDOs are used byfinancial institutions to manage their risk profiles, optimize capitalutilization and improve returns on equity. CDOs are also used by dealers orportfolio managers to provide leveraged investments in bond and loan portfoliostailored to conform to differing risk appetites of investors.

Accordingto industry sources, the new par volumes since 2001 for each type of funded asset-backedsecurity presented, including securities distributed under Rule 144A underthe Securities Act of 1933 (as amended, the “Securities Act”), were as follows:

| **Year**   | ** ** | ** **             | ** ** | **New Issues of Funded U.S.  Public Asset-Backed  Securities(1)(2)** | ** ** | **U.S. Public Issues of  Private-Label  Mortgage-Backed  Securities(1)** | ** ** | **Non-U.S. Asset-  Backed Securities(1)(3)** | ** ** | **Worldwide Funded  Collateralized Debt  Obligations(1)** | ** ** |
|------------|------------|------------------------|------------|-----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** ** | ** ** | **(in billions)** | ** ** |
| 2001       |       |                   | $          | 324.6                                                                                         |       |                                                                                    |       | $                                                      | 143.1      |                                                                |       |   | $ | 115.2 |   |   |   | $ | 79.6 |   |   |
| 2002       |       |                   | 411.5      |                                                                                          |       |                                                                                    | 214.0      |                                                   |       |                                                                | 117.3      |   |   |   | 87.7 |   |   |
| 2003       |       |                   | 505.1      |                                                                                          |       |                                                                                    | 297.1      |                                                   |       |                                                                | 198.8      |   |   |   | 82.6 |   |   |
| 2004       |       |                   | 688.1      |                                                                                          |       |                                                                                    | 329.1      |                                                   |       |                                                                | 205.5      |   |   |   | 127.6 |   |   |
| 2005       |       |                   | 847.6      |                                                                                          |       |                                                                                    | 514.2      |                                                   |       |                                                                | 263.2      |   |   |   | 217.2 |   |   |

----

(1)          Source: *Asset-Backed Alert*, January 10,2003, January 9, 2004, January 7, 2005 and January 13, 2006.  Subject to revision as additional informationbecomes available.

(2)          Includes corporate andconsumer receivable-backed issues (including home equity loan issues) butexcludes private-label mortgage-backed securities, CDOs, commercialpaper and private placements not made under Rule 144A.

(3)          Includes asset-backedand mortgage-backed securities but excludes CDOs.

Thedata in the above table excludes synthetic transactions and therefore does notreflect the growth in the use of CDS during the years covered. According to theInternational Swaps and Derivatives Association, Inc. (“ISDA”), thenotional principal amount of CDS outstanding in world markets was as follows atthe dates indicated:

| ** **              | ** ** | **Outstanding  Credit Default Swaps(1)** | ** ** |
|-------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | **(in billions)**                             | ** ** |
| December 31,  2001 |       |                                               | $          | 918.9 |   |   |
| December 31,  2002 |       |                                               | 2,191.6    |   |   |
| December 31,  2003 |       |                                               | 3,779.4    |   |   |
| December 31,  2004 |       |                                               | 8,422.3    |   |   |
| June 30, 2005      |       |                                               | 12,429.9   |   |   |

----

(1)          Source: ISDA web page, February 22,2006.

According to industryinformation, the annual totals of funded and synthetic asset-backed parinsured of financial guaranty insurance directly originated by monolineguarantors during each year since 2001 were as follows:

10

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**Asset-BackedObligations Insured by Monoline Insurance Companies(1)**

| **Year Ended December 31,** | ** ** | ** **             | ** ** | **United States** | ** ** | **Non-U.S.** | ** ** |
|--------------------------------------------|------------|------------------------|------------|------------------------|------------|--------------|------------|
| ** **                                 | ** ** | **(in billions)** | ** ** |
| 2001                                       |       |                   | $          | 167.1                  |       |         |       | $ | 51.4 |   |   |
| 2002                                       |       |                   | 165.5      |                   |       |         | 63.2       |   |   |
| 2003                                       |       |                   | 120.4      |                   |       |         | 45.0       |   |   |
| 2004                                       |       |                   | 200.0      |                   |       |         | 46.8       |   |   |
| 2005                                       |       |                   | N/A        | (2)                    |       |         | N/A        | (2) |   |

----

(1)          Source: AFGI web page datedJuly 2005. Includes all funded and synthetic primary-market and secondary-marketU.S. insured transactions, excluding municipal obligations. Subject to revisionas additional information becomes available.

(2)          Notavailable from the same source. According to the statistical operatingsupplements published by the four largest monoline guarantors, those fourcompanies insured directly or assumed, in the aggregate, approximately$163.3 billion of U.S. asset-backed par volume. Three of thesecompanies disclose the non-U.S. component of their asset-backed business, whichin aggregate was $39.1 billion in 2005.

*ConsolidatedVariable Interest Entities*

FSA Global is a Cayman Islands domiciled issuer ofFSA-insured notes and other obligations sold in international markets that aregenerally referred to as “medium term notes.” FSA Global issues securities atthe request of interested purchasers in a process known as “reverse inquiry,”which generally results in lower interest rates and borrowing costs than wouldapply to direct borrowings. FSA Global also issues securities in traditionalprivate placements to institutional investors and to participants in leasefinancings in which Company affiliates may play a number of financing roles. Asof December 31, 2005, the VIEs, including FSA Global, had$2.3 billion principal amount of outstanding notes, after elimination ofintercompany transactions.

FSA Global ismanaged as a “matched funded vehicle,” in which the proceeds from the sale ofFSA Global notes are invested in obligations chosen to provide cash flowssubstantially matched to those of the notes (taking into account, in somecases, dedicated third party liquidity). This matched funding structure isdesigned to minimize the market risks borne by FSA Global and FSA. FSA Globalraises funds that are invested with a view towards realizing the yielddifference between the notes issued and the obligations purchased with the noteproceeds. FSA Global generally raises funds that are U.S. dollar-denominated orconverted into U.S. dollars at LIBOR-based floating borrowing rates, andinvests them in FSA-insured obligations that:

·       areU.S. dollar-denominated or converted into U.S. dollars at LIBOR-basedfloating rates,

·       matureprior to the maturity of the related FSA Global notes, and

·       pay a higher interest ratethan the interest rate on the related FSA Global notes.

***Financial Products Business***

The Company’s FP Segment provides GICs tomunicipalities and other market participants. FSA insures all GICs issued bythe GIC Affiliates. The majority of municipal GICs insured by FSA relate todebt service reserve funds or construction funds that support municipal bondtransactions.

Each GIC entitles its holder to receive the return ofthe holder’s initial principal plus interest at a specified rate, and towithdraw principal from the GIC as permitted. Generally, a municipal bondtrustee or issuer will acquire a municipal GIC in order to invest funds ondeposit in a debt service reserve fund or 

11

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construction fund until itneeds to use such funds to service debt or fund the payment of project expensesin accordance with the underlying bond documents. Non-municipal GICs insured byFSA include GICs acquired by issuers of credit linked notes and GICs acquiredby FSA Global.

The Company is exposed to risk associated withunexpected withdrawals on its FSA-insured GICs. Debt service reserve fund GICsmay be drawn unexpectedly upon a payment default by the municipal issuer.Construction fund GICs may be drawn more quickly or more slowly thananticipated to pay project expenses. Structured finance GICs for credit-linkednotes may be drawn unexpectedly upon certain credit events under the CDSrelated to such notes. In addition, most FSA-insured GICs allow for withdrawalof GIC funds in the event of a downgrade of FSA, typically below AA- byStandard & Poor’s Ratings Services (“S&P”) or Aa3 by Moody’s,unless the GIC provider posts collateral or otherwise enhances its credit. SomeFSA-insured GICs also allow for withdrawal of GIC funds in the event of adowngrade of FSA, typically below A3 by Moody’s or A- by S&P, with no rightof the GIC provider to avoid such withdrawal by posting collateral or otherwiseenhancing its credit. The Company manages this risk through the maintenance ofliquid collateral and liquidity agreements.

The GIC Affiliates issue GICs and, on the same terms,lend the funds raised to FSAM. The funds are generally raised at (or convertedby FSAM into) U.S. dollar LIBOR-based floating rate obligations. FSAMtypically invests the funds in, or converts them into, U.S. dollar LIBOR-basedfloating rate investments. The investments are generally obligations that wouldqualify for FSA insurance from a credit perspective. The GIC Affiliates andFSAM generate their gross profits or losses from the difference between therates at which the GIC Affiliates borrow the funds and the rates yielded byFSAM’s investments. These investments are owned, and all  related risk management functions areperformed, by FSAM.

**Insurance in Force**

Asummary of the Company’s par outstanding by type as of December 31, 2005is as follows:

| ** **      | ** ** | **Par Outstanding** | ** ** |
|-----------------|------------|--------------------------|------------|
| ** **      | ** ** | **Direct**               | ** ** | **Assumed** | ** ** | **Total Gross** | ** ** | **Ceded** | ** ** | **Net** | ** ** |
| ** **      | ** ** | **(in millions)**   | ** ** |
| Asset-backed(1) |       | $                        | 139,567    |   |   | $ | 999 |   |   |   | $ | 140,566 |   |   | $ | 30,143 |   | $ | 110,423 |   |
| Municipal       |       | 315,924                  |       |   | 1,600 |   |   |   | 317,524 |   |   | 90,464 |   | 227,060 |   |
| Total           |       | $                        | 455,491    |   |   | $ | 2,599 |   |   |   | $ | 458,090 |   |   | $ | 120,607 |   | $ | 337,483 |   |

----

(1)          Excludes direct paroutstanding on intercompany insurance of $13,463 million relating to FSA-insuredGICs issued by the GIC Affiliates.

As of December 31,2005, the weighted average life of the direct par insured on these policies wasapproximately four years for asset-backed and 13 years for municipalobligations.

***Municipal Obligations***

FSA’s insured portfolio ofmunicipal obligations is divided into eight major categories, which includefunded and synthetic obligations:

*Domestic GeneralObligation Bonds*

General obligation or fullfaith and credit bonds are issued by states, their political subdivisions andother municipal issuers, and are supported by the general obligation of theissuer to pay from available funds and by a pledge of the issuer to levy taxesaccording to value in an amount sufficient to provide for the full payment ofthe bonds.

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*Domestic HousingRevenue Bonds*

Housing revenue bondsinclude both multifamily and single family housing bonds, with multi-tieredsecurity structures based on the underlying mortgages, reserve funds, andvarious other features such as Federal Housing Administration or privatemortgage insurance, bank letters of credit, first loss guarantees and, in somecases, the general obligation of the issuing housing agency or a state’s “moralobligation” (that is, not a legally binding commitment) to make up deficiencies.

*Domestic MunicipalUtility Revenue Bonds*

Municipal utility revenuebonds include obligations of all forms of municipal utilities, includingelectric, water and sewer utilities. Insurable utilities may be organized asmunicipal enterprise systems, authorities or joint-action agencies.

*Domestic HealthCare Revenue Bonds*

Health care revenue bondsinclude bonds of state and local municipal authorities issued on a conduitbasis on behalf of not-for-profit hospitals and hospital systems forrefinancings and capital acquisitions and construction, payable from amountsderived under loan agreements and notes of such health care providers with suchauthorities.

*DomesticTax-Supported (Non-General Obligation) Bonds*

Tax-supported (non-generalobligation) bonds include a variety of bonds that, though not full faith andcredit general obligations, are supported by a specific or discrete source oftaxation of the issuer, and include tax-backed revenue bonds and general fundobligations of the issuer, such as lease revenue bonds. Tax-backed revenuebonds may be secured by a lien on pledged tax revenues, such as revenues fromspecial taxes, including retail sales and gasoline taxes, or from taxincrements (or tax allocations) generated by growth in property values within adistrict. FSA also insures bonds secured by special assessments levied againstproperty owners, which benefit from covenants by the issuer to levy, collectand enforce collections and to foreclose on delinquent properties. Leaserevenue bonds or certificates of participation (“COPs”) are usually generalfund obligations subject to annual appropriation or abatement. The projectsfinanced by lease revenue bonds or COPs are generally real property orequipment that, in the case of annual appropriation or abatement leases, FSAdeems to serve an essential public purpose (e.g., schools, prisons, courts).

*DomesticTransportation Revenue Bonds*

Transportation revenuebonds include a wide variety of revenue-supported bonds, such as bondsfor airports, ports, tunnels, municipal parking facilities, toll roads and tollbridges.

*Other DomesticMunicipal Bonds*

Other domestic municipalbonds insured by FSA include college and university (primarily public or state-supported)revenue bonds, moral obligation bonds, financings for stadiums, resourcerecovery bonds and debt issued, guaranteed or otherwise supported by domesticstate or local governmental entities.

*InternationalMunicipal Obligations*

International municipalobligations include obligations of sovereign and sub-sovereign non-domesticmunicipal issuers, project finance transactions involving projects leased to orsupported by payments from non-domestic governmental or quasi-governmentalentities, toll road transactions supported by toll revenues, obligationsarising under leases of equipment or facilities by non-domestic municipalobligors, 

13

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non-domesticmunicipal utility revenue bonds and other obligations having internationalaspects but otherwise within the municipal categories described above.

***Asset-Backed and Other Non-Municipal Obligations***

FSA’s insured portfolio ofasset-backed and other non-municipal obligations is divided into fivemajor categories, which are broadly based on the type of assets backing theinsured obligations and include funded and synthetic obligations:

*DomesticResidential Mortgage Loans*

Obligations primarilybacked by residential mortgage loans generally take the form of conventionalpass-through certificates or pay-through debt securities, but also includeother structured products. Residential mortgage loans backing these insuredobligations include closed- and open-end first and second mortgage loansor home equity loans on one-to-four family residential properties, includingcondominiums and cooperative apartments. Domestic residential mortgage loanobligations insured by FSA have tended to be concentrated in the “sub-prime”sector, characterized by lower quality borrowers and higher levels ofstructural credit protection through subordination and/or excess spread. FSAalso insures “net interest margin” (“NIM”) securities backed by the seniorportion of residual cash flows from securitizations of domestic residentialmortgage loans. FSA has generally declined participation in securitizations ofso-called “high cost mortgage loans,” characterized by very high interest ratesor “points and fees” and subject to restrictive federal and state regulations.

*Domestic ConsumerReceivables*

Obligations primarilybacked by consumer receivables include conventional pass-through andpay-through securities as well as more highly structured transactions. Consumerreceivables backing these insured obligations include automobile loans,manufactured housing loans and credit card receivables. Consumer receivabletransactions insured by FSA have tended to be concentrated in the sub-primeauto loan and credit card receivable sectors.

*Domestic PooledCorporate Obligations*

Obligations primarilybacked by pooled corporate obligations include funded and synthetic obligationscollateralized by corporate debt securities or corporate loans and obligationsbacked by cash flow or market value of non-consumer indebtedness, and includeCDOs, such as “collateralized bond obligations,” “collateralized loanobligations” and comparable risks under CDS obligations. Corporate obligationsinclude corporate bonds, bank loan participations, trade receivables, franchiseloans and equity securities. Some CDS obligations expose FSA to elements ofmarket value risk arising from obligations to pay the difference between parand market value upon the occurrence of a payment default or other defined “creditevents” specified in the CDS. FSA generally addresses these risks by requiringlarge deductibles as a condition to payment under pooled corporate CDS insuredby FSA.

*Other DomesticNon-Municipal Obligations*

Other domesticnon-municipal obligations include bonds or other securities backed bygovernment securities, letters of credit, guarantees by other monoline insurersor repurchase agreements collateralized by government securities, securitiesbacked by a combination of assets that include elements of more than one of thecategories set forth above and unsecured corporate obligations satisfying FSA’sunderwriting criteria. Other domestic non-municipal obligations insured by FSAalso include first mortgage bond obligations of for-profit electric or waterutilities providing retail, industrial and commercial service, sale-leasebackobligation bonds supported by such utilities and other obligations backed byinvestor-owned 

14

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utilities.These bonds are either secured by a mortgage on property owned by or leased toan investor-owned utility or have the benefit of a “negative pledge”ensuring that no other material creditors have priority claims to the utilityassets.

*International Asset-BackedObligations*

International asset-backedobligations include obligations of funded and synthetic CDOs, securitizationsof perpetual floating rate notes of non-domestic banks, obligations ofnon-domestic investor-owned utilities and other obligations havinginternational aspects but otherwise within the asset-backed categoriesdescribed above.

***Insured Portfolio***

A summary of FSA’s insuredportfolio as of December 31, 2005 is shown below. Exposure amounts areexpressed net of reinsurance but do not distinguish between quota share, firstloss or excess of loss reinsurance.

**Summaryof Insured PortfolioAs of December 31, 2005(1)**

| ** **                                    | ** ** | **Number of  Issuers**         | ** ** | **Net Par  Amount  Outstanding** | ** ** | **Net  Par and  Interest** | ** ** | **Percent  of Net  Par and  Interest** | ** ** |
|-----------------------------------------------|------------|-------------------------------------|------------|---------------------------------------|------------|---------------------------------|------------|--------------------------------------------------|------------|
| ** **                                    | ** ** | **(dollars in millions)** | ** ** |
| **Municipal  obligations**                    | ** ** |                                | ** ** | ** **                            |       |                            | ** ** | ** **                                       |       | ** ** | ** ** |   | ** ** | ** ** |   |
| General obligation bonds                      |       |                                | 6,104      | ** **                            |       |                            | $          | 88,922                                           | ** ** |   | $ | 132,020 |   |   | 28 | % |   |
| Housing revenue bonds                         |       |                                | 191        | ** **                            |       |                            | 7,585      | ** **                                       |       | 13,649 |   |   | 3 |   |   |
| Municipal utility revenue bonds               |       |                                | 1,079      | ** **                            |       |                            | 37,245     | ** **                                       |       | 60,350 |   |   | 13 |   |   |
| Health care revenue bonds                     |       |                                | 222        | ** **                            |       |                            | 11,789     | ** **                                       |       | 21,483 |   |   | 4 |   |   |
| Tax-supported (non-general obligation)  bonds |       |                                | 1,065      | ** **                            |       |                            | 40,622     | ** **                                       |       | 62,762 |   |   | 13 |   |   |
| Transportation revenue bonds                  |       |                                | 122        | ** **                            |       |                            | 14,695     | ** **                                       |       | 26,201 |   |   | 5 |   |   |
| Other domestic municipal bonds                |       |                                | 725        | ** **                            |       |                            | 13,955     | ** **                                       |       | 21,540 |   |   | 5 |   |   |
| International obligations                     |       |                                | 112        | ** **                            |       |                            | 12,247     | ** **                                       |       | 24,638 |   |   | 5 |   |   |
| Total municipal obligations                   |       |                                | 9,620      | ** **                            |       |                            | 227,060    | ** **                                       |       | 362,643 |   |   | 76 |   |   |
| **Asset-backed obligations**                  | ** ** |                                | ** ** | ** **                            |       |                            | ** ** | ** **                                       |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Residential mortgages                         |       |                                | 237        | ** **                            |       |                            | $          | 18,401                                           | ** ** |   | $ | 20,202 |   |   | 4 |   |   |
| Consumer receivables                          |       |                                | 50         | ** **                            |       |                            | 8,366      | ** **                                       |       | 8,862 |   |   | 2 |   |   |
| Pooled corporate obligations                  |       |                                | 309        | ** **                            |       |                            | 47,253     | ** **                                       |       | 49,613 |   |   | 10 |   |   |
| Other domestic asset-backed obligations       |       |                                | 130        | ** **                            |       |                            | 7,328      | ** **                                       |       | 8,714 |   |   | 2 |   |   |
| International obligations                     |       |                                | 108        | ** **                            |       |                            | 29,075     | ** **                                       |       | 30,151 |   |   | 6 |   |   |
| Total asset-backed obligations                |       |                                | 834        | ** **                            |       |                            | 110,423    | ** **                                       |       | 117,542 |   |   | 24 |   |   |
| Total                                         |       |                                | 10,454     | ** **                            |       |                            | $          | 337,483                                          | ** ** |   | $ | 480,185 |   |   | 100 | % |   |

----

(1)          Excludesintercompany insurance of $13,463 million in net par outstanding and$16,878 million in net par and interest outstanding relating to FSA-insuredGICs issued by the GIC Affiliates.

***Obligation Type***

The table below sets forththe relative percentages of net par amount insured by obligation type duringeach of the last five years:

15

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**AnnualNew Business Insured by Obligation Type**

| ** **                                            | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Municipal  obligations**                            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| General obligations bonds                             |       |                                       | 28         | % |   |   | 19 | % |   |   | 27 | % |   |   | 19 | % |   |   | 12 | % |   |
| Housing revenue bonds                                 |       |                                       | 1          |   |   |   | 6 |   |   |   | 3 |   |   |   | 2 |   |   |   | 1 |   |   |
| Municipal utility revenue bonds                       |       |                                       | 8          |   |   |   | 5 |   |   |   | 12 |   |   |   | 9 |   |   |   | 5 |   |   |
| Health care revenue bonds                             |       |                                       | 3          |   |   |   | 3 |   |   |   | 2 |   |   |   | 1 |   |   |   | 1 |   |   |
| Tax-supported (non-general obligation)  bonds         |       |                                       | 11         |   |   |   | 2 |   |   |   | 14 |   |   |   | 8 |   |   |   | 5 |   |   |
| Transportation revenue bonds                          |       |                                       | 3          |   |   |   | 2 |   |   |   | 5 |   |   |   | 4 |   |   |   | 1 |   |   |
| Other domestic municipal bonds                        |       |                                       | 5          |   |   |   | 2 |   |   |   | 4 |   |   |   | 3 |   |   |   | 1 |   |   |
| International obligations                             |       |                                       | 5          |   |   |   | 2 |   |   |   | 2 |   |   |   | 2 |   |   |   | 1 |   |   |
| Total municipal obligations                           |       |                                       | 64         |   |   |   | 41 |   |   |   | 69 |   |   |   | 48 |   |   |   | 27 |   |   |
| **Asset-backed  and other non-municipal obligations** |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential mortgages                                 |       |                                       | 9          |   |   |   | 28 |   |   |   | 7 |   |   |   | 9 |   |   |   | 16 |   |   |
| Consumer receivables                                  |       |                                       | 5          |   |   |   | 2 |   |   |   | 6 |   |   |   | 10 |   |   |   | 12 |   |   |
| Pooled corporate obligations                          |       |                                       | 13         |   |   |   | 13 |   |   |   | 5 |   |   |   | 15 |   |   |   | 25 |   |   |
| Other domestic non-municipal obligations(1)           |       |                                       | 1          |   |   |   | 8 |   |   |   | 2 |   |   |   | 1 |   |   |   | 1 |   |   |
| International obligations                             |       |                                       | 8          |   |   |   | 8 |   |   |   | 11 |   |   |   | 17 |   |   |   | 19 |   |   |
| Total asset-backed obligations                        |       |                                       | 36         |   |   |   | 59 |   |   |   | 31 |   |   |   | 52 |   |   |   | 73 |   |   |
| Total                                                 |       |                                       | 100        | % |   |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |

----

(1)          Excludesintercompany transactions of $6.3 billion in 2005, $2.7 billion in 2004,$3.6 billion in 2003, $2.0 billion in 2002 and $0.5 billion in2001, relating to FSA-insured GICs issued by the GIC Affiliates.

***Terms to Maturity***

The table below sets forththe contractual terms to maturity of the Company’s policies as of December 31,2005 and 2004:

**ContractualTerms to Maturity of Net Par of Insured Obligations(1)**

| ** **                     | ** ** | **As of December 31, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|--------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| **Term to Maturity** | ** ** | ** **                                      | ** ** | **Municipal**                                   | ** ** | **Asset-  Backed(2)** | ** ** | **Municipal** | ** ** | **Asset-  Backed(2)** | ** ** |
| ** **                     | ** ** | **(in millions)**                          | ** ** |
| 0 to 5 years                   |       | $                                               | 44,272     |                                            | $          | 41,997 |   | $ | 39,448 |   | $ | 46,800 |   |
| 5 to 10 years                  |       | 49,935                                          |       | 31,354                                          |       | 43,165 |   | 29,155 |   |
| 10 to 15 years                 |       | 44,392                                          |       | 12,180                                          |       | 37,174 |   | 10,772 |   |
| 15 to 20 years                 |       | 36,737                                          |       | 744                                             |       | 30,857 |   | 1,084 |   |
| 20 years and  above            |       | 51,724                                          |       | 24,148                                          |       | 44,748 |   | 34,539 |   |
| Total                          |       | $                                               | 227,060    |                                            | $          | 110,423 |   | $ | 195,392 |   | $ | 122,350 |   |
|                                |            |                                                 |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |

----

(1)          Actual maturities coulddiffer from contractual maturities because borrowers have the right to call orprepay certain obligations with or without call or prepayment penalties. Theaverage expected maturities for asset-backed obligations are expected tobe considerably shorter than the contractual maturities for such obligations.

(2)          Excludes intercompanyinsurance of $13,463 million in 2005 and $7,143 million in 2004relating to FSA-insured GICs issued by the GIC Affiliates.

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***Issue Size***

The tables below set forththe number of policies and net par outstanding as of December 31, 2005,based on the amount of original net par written:

**Municipal—PolicyCount and Net Par Amount Outstanding**

| **Original Net Par Amount** | ** ** | ** **                          | ** ** | **Number  of Policies** | ** ** | **Net Par Amount  Outstanding** | ** ** |
|--------------------------------------------|------------|-------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| ** **                                 | ** ** | **(dollars in millions)** | ** ** |
| Less than $10  million                     |       |                                | 15,579     |                         |       |                                      | $          | 34,276 |   |   |
| $10 to $50  million                        |       |                                | 5,475      |                         |       |                                      | 64,748     |   |   |
| $50 million to  $100 million               |       |                                | 979        |                         |       |                                      | 34,447     |   |   |
| $100 million or  greater                   |       |                                | 851        |                         |       |                                      | 93,589     |   |   |
| Total                                      |       |                                | 22,884     |                         |       |                                      | $          | 227,060 |   |   |

 

**Asset-Backed—PolicyCount and Net Par Amount Outstanding(1)**

| **Original Net Par Amount** | ** ** | ** **                          | ** ** | **Number   of Policies** | ** ** | **Net Par Amount  Outstanding** | ** ** |
|--------------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|-------------------------------------------|------------|
| ** **                                 | ** ** | **(dollars in millions)** | ** ** |
| Less than $10  million                     |       |                                | 731        |                               |       |                                      | $          | 302 |   |   |
| $10 to $50  million                        |       |                                | 641        |                               |       |                                      | 5,254      |   |   |
| $50 million to  $100 million               |       |                                | 477        |                               |       |                                      | 8,700      |   |   |
| $100 million or  greater                   |       |                                | 1,001      |                               |       |                                      | 96,167     |   |   |
| Total                                      |       |                                | 2,850      |                               |       |                                      | $          | 110,423 |   |   |

 

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(1)          Excludesintercompany insurance of $13,463 million relating to FSA-insured GICsissued by the GIC Affiliates.

17

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***Geographic Concentration***

The Company seeks tomaintain a diversified portfolio of insured municipal obligations designed tospread its risk across a number of geographic areas. The table below sets forththose jurisdictions in which municipalities issued an aggregate of 2% or moreof the total net par amount outstanding of FSA-insured municipal securities:

**MunicipalInsured Portfolio by Jurisdiction**

| ** **                    | ** ** | **As of December 31, 2005** | ** ** |
|-------------------------------|------------|-------------------------------------------------|------------|
| **Jurisdiction**              | ** ** | ** **                                      | ** ** | **Number  of Issuers** | ** ** | **Net Par  Amount  Outstanding** | ** ** | **Percent of Total  Municipal Net  Par Amount  Outstanding** | ** ** |
| ** **                    | ** ** | **(dollars in millions)**             | ** ** |
| California                    |       |                                            | 985        |   |   |   | $ | 30,159 |   |   |   | 13.3 | % |   |
| New York                      |       |                                            | 671        |   |   |   | 19,555 |   |   |   | 8.6 |   |   |
| Texas                         |       |                                            | 730        |   |   |   | 15,458 |   |   |   | 6.8 |   |   |
| Pennsylvania                  |       |                                            | 752        |   |   |   | 14,843 |   |   |   | 6.5 |   |   |
| Florida                       |       |                                            | 277        |   |   |   | 12,063 |   |   |   | 5.3 |   |   |
| Illinois                      |       |                                            | 653        |   |   |   | 11,255 |   |   |   | 5.0 |   |   |
| New Jersey                    |       |                                            | 584        |   |   |   | 10,459 |   |   |   | 4.6 |   |   |
| Washington                    |       |                                            | 328        |   |   |   | 8,289 |   |   |   | 3.6 |   |   |
| Michigan                      |       |                                            | 499        |   |   |   | 8,252 |   |   |   | 3.6 |   |   |
| Massachusetts                 |       |                                            | 206        |   |   |   | 6,309 |   |   |   | 2.8 |   |   |
| Ohio                          |       |                                            | 332        |   |   |   | 5,239 |   |   |   | 2.3 |   |   |
| Wisconsin                     |       |                                            | 437        |   |   |   | 4,938 |   |   |   | 2.2 |   |   |
| Georgia                       |       |                                            | 117        |   |   |   | 4,743 |   |   |   | 2.1 |   |   |
| All other U.S.  jurisdictions |       |                                            | 2,937      |   |   |   | 63,251 |   |   |   | 27.9 |   |   |
| International                 |       |                                            | 112        |   |   |   | 12,247 |   |   |   | 5.4 |   |   |
| Total                         |       |                                            | 9,620      |   |   |   | $ | 227,060 |   |   |   | 100.0 | % |   |
|                               |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In its asset-backed business, the Companyconsiders geographic concentration as a factor in underwriting insurance forsecuritizations of pools of assets, such as residential mortgage loans orconsumer receivables. However, the geographic concentration of the underlyingassets may change over the life of the policy. In addition, in writinginsurance for other types of asset-backed obligations, such as securitiesprimarily backed by government or corporate debt, geographic concentration isnot considered a significant credit factor given other more relevant measuresof diversification, such as issuer or industry diversification.

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The Company’s revenuesfrom external customers attributed to the United States and all foreigncountries during each of the last three fiscal years is shown below:

**TotalRevenues From External Customers**

| ** **     | ** ** | **Year Ended December 31,** | ** ** |
|----------------|------------|--------------------------------------------|------------|
| ** **     | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **     | ** ** | **(in thousands)**                    | ** ** |
| U.S.           |       | $                                          | 941,496    |   | $ | 1,095,914 |   | $ | 864,752 |   |
| International  |       | 39,739                                     |       | 52,355 |   | 32,926 |   |
| Total revenues |       | $                                          | 981,235    |   | $ | 1,148,269 |   | $ | 897,678 |   |

 

For a discussion of risks related to the Company’sforeign operations, see “Item 1A. Risk Factors—The Company’s internationaloperations expose it to less predictable credit and legal risks.”

See Note 23 to theConsolidated Financial Statements in Item 8 for revenues from externalcustomers, pre-tax earnings and total assets by segment.

***Issuer Concentration***

The Company has adoptedunderwriting and exposure management policies designed to limit the net parinsured or net retained credit gap for any one credit. Credit gap is a conceptemployed by S&P to estimate the at-risk amount (worst-case risk) on aninsured exposure. FSA has also established procedures to ensure compliance withregulatory single-risk limits applicable to bonds it has insured. In manycases, the Company uses reinsurance to limit net exposure to any one credit. Asof December 31, 2005, the ten largest net insured municipal creditsrepresented $9.6 billion, or 2.9%, of the total net par amount outstanding andthe ten largest net insured asset-backed transactions represented$16.1 billion, or 4.8%, of the total net par amount outstanding. Forpurposes of the foregoing, different issues of asset-backed securities bythe same sponsor have not been aggregated. However, the Company’s underwritingpolicies establish single risk guidelines applicable to asset-backedsecurities of the same sponsor. In addition, individual corporate names mayappear in more than one FSA-insured CDO transaction, but such exposures are notaggregated for purposes of identifying the largest exposures. Instead, FSAaddresses these risks by limiting its exposure to the CDO sector in theaggregate. In addition to the single risk limits established by itsunderwriting guidelines, the Company is subject to regulatory limits and ratingagency guidelines on exposures to single credits.

**CreditUnderwriting Guidelines, Standards and Procedures**

***Financial Guaranty Business***

Financial guaranty insurance written by FSA generallyrelies on an assessment of the adequacy of various payment sources to meet debtservice or other obligations in a specific transaction without regard topremiums paid or income from investment of premiums. FSA’s underwriting policyis to insure municipal and asset-backed obligations that it determinesare investment grade without the benefit of FSA’s insurance. To this end, eachpolicy FSA writes or reinsures is designed to satisfy the general underwritingguidelines and specific standards for particular types of obligations approvedby its Board of Directors. In addition, the Company’s Board of Directors hasestablished an Underwriting Committee that reviews completed transactions,generally on a quarterly basis, to ensure conformity with underwritingguidelines and standards. In addition, FSA’s underwriting policy allows for FSAto insure securities issued to refinance other securities insured by FSA as towhich the issuer is or may be in default.

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FSA’s underwriting guidelines for municipalobligations require that a transaction be rated investment grade by Moody’s orS&P or, in the alternative, that the credit quality of the obligor isconsidered by FSA to be the equivalent of investment grade. Where the municipalobligor is a governmental entity with taxing power or providing an essentialpublic service paid by taxes, assessments or other charges, supplementalprotections may be required if such taxes, assessments or other charges are notprojected to provide sufficient debt service coverage. Where appropriate, themunicipal obligor may be required to provide a rate covenant and a pledge ofadditional security (e.g., mortgages on real property, liens on equipment orrevenue pledges) to secure the insured obligation.

FSA’s underwriting guidelines for asset-backedobligations are premised on the concept of multiple layers of protection, andvary by obligation type in order to reflect different structures and types ofcredit support. FSA seeks to insure asset-backed obligations thatgenerally provide for one or more forms of overcollateralization (such asexcess collateral value, excess cash flow or “spread,” reserves or, in the caseof CDS, a deductible) or third-party protection (such as bank letters ofcredit, guarantees, net worth maintenance agreements, indemnity agreements, CDSor reinsurance agreements). Asset-backed obligations insured by FSA oftenbenefit from self-adjusting mechanisms, such as cash traps or acceleratedamortization that take effect upon a failure to satisfy performance basedtriggers. Overcollateralization or third-party protection does not needto protect FSA against all risk of loss, but is generally intended to assumethe primary risk of financial loss. Overcollateralization and third-partyprotection may not be required in transactions in which FSA is insuring theobligations of certain highly rated issuers that typically are regulated, haveimplied or explicit government support, or are short term, or in transactionsin which FSA is insuring securities issued to refinance other securitiesinsured by FSA as to which the issuer is or may be in default.

FSA’s general policy has been to insure 100% of theprincipal, interest and other amounts due in respect of funded asset-backedobligations rather than providing partial or first-loss coverage sufficient toconfer a Triple-A rating on the senior obligations. In the CDS sector, FSAoften insures risks, and in the funded sector FSA sometimes insures securities,on a “compressed” or “mezzanine” basis in which the obligations insured by FSAare subordinate, in whole or in part, to more senior uninsured obligations.

The rating agencies participate to varying degrees inthe underwriting process. Most asset-backed obligations insured by FSAare reviewed prior to issuance by both S&P and Moody’s to evaluate the riskproposed to be insured. In the case of municipal obligations, prior ratingagency review is a function of the type of insured obligation and the riskelements involved. The independent review of FSA’s underwriting practicesperformed by the rating agencies further strengthens the underwriting process.

The Company’s Risk Management Committee reviews theCompany’s insured portfolio on a periodic basis. The Risk Management Committeeincludes FSA’s Chief Risk Management Officer, Chief Domestic UnderwritingOfficer, Chief Municipal Underwriting Officer and Chief InternationalUnderwriting Officer, with FSA’s Chief Executive Officer, President, GeneralCounsel and Chief Financial Officer as *exofficio* members.

The underwriting process that implements the Company’sunderwriting guidelines and standards is supported by FSA’s professional staffof analysts, underwriting officers, credit officers and attorneys. Moreover,the approval of senior management and designated senior underwriting officersis required for all transactions.

Each underwriting group in the Financial GuarantyGroup is responsible for confirming that each transaction proposed by theFinancial Guaranty Group conforms to the underwriting guidelines and standards.This evaluation is reviewed by the chief underwriting officer for the particularsector. This review may take place while the transaction is in its formativestages, thus facilitating the introduction of further enhancements at a stagewhen the transaction is more receptive to change.

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Final transaction approval is obtained from FSA’sManagement Review Committee (the “MRC”) for asset-backed transactions andinternational transactions and from FSA’s Municipal Underwriting Committee (the“MUNC”) for domestic municipal transactions. Approval is usually based uponboth a written and an oral presentation by the underwriting group to therespective committee. Following approval, the Chair of the applicableunderwriting committee may approve minor transaction modifications. Majorchanges require the concurrence of the applicable underwriting committee.

The MRC is comprised of FSA’s Chief Executive Officer,President, Chief Risk Management Officer, Chief Domestic Underwriting Officer,Chief International Underwriting Officer, General Counsel and Associate GeneralCounsel for Asset-Backed Transactions. The Chief Executive Officer,President and General Counsel are not required to participate in MRC meetingsfor transactions meeting certain criteria. The MRC may delegate approvalauthority for certain highly rated asset-backed transactions that fall belowestablished monetary thresholds.

The MUNC iscomprised of FSA’s Chief Executive Officer, President, Chief MunicipalUnderwriting Officer, a Municipal Underwriting Officer, Managing Director ofPublic Finance and Associate General Counsel for Municipal Transactions. TheMUNC approval process generally requires approval by at least:

·       theChief Executive Officer or President,

·       theChief Municipal Underwriting Officer or Municipal Underwriting Officer, and

·       anAssociate General Counsel for Municipal Transactions.

Subject to applicablelimits, municipal transactions satisfying credit and return requirements may beapproved by a committee (the “Demi-MUNC”) comprised of at least two votingmembers, one of whom must be the Chief Municipal Underwriting Officer,Municipal Underwriting Officer or Managing Director for Municipal Operations,and any one of certain managing directors and directors designated by the MUNC.

***Financial Products Business***

The Company’s GIC Affiliates issue GICs and FSAM makesinvestments in accordance with the FP Segment’s underwriting guidelines. Theseunderwriting guidelines require that each GIC and investment meet the fundingstrategy of the FP business. The funding strategy, in turn, reflects theCompany’s short-term liquidity needs to meet withdrawals and purchase assets,the Company’s collateral posting obligations under collateralized GICs, theavailability of attractive investments, the risk that actual GIC withdrawalsmay vary from expected withdrawals and other factors.

FP’s underwriting guidelines also govern FSAM’sinvestment of funds raised from the issuance of GICs. In general, investmentsare obligations that would qualify for FSA insurance from a credit perspective,and must therefore be investment grade. The FP Segment manages its investmentportfolio to maintain sufficient liquidity to address expected and unexpectedGIC withdrawals and to maintain sufficient eligible collateral to supportcollateralized GICs.

Final transaction approval for a GIC depends on thetype and size of the GIC along with other criteria. FP’s underwritingguidelines require that the head of the FP Segment approve all GICs and specifywhether approval from FSA’s Chief Executive Officer, President, Chief RiskManagement Officer and/or other officers is also required.

Final transaction approvalfor an investment by FSAM depends on the investment sector, credit rating,amount and other factors. The FP Segment’s underwriting guidelines require thatthe head of the FP Segment approve all investments and specify whetherapprovals from FSA’s Chief Executive Officer, President, Chief Risk ManagementOfficer and/or other officers is also required.

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***Corporate Research***

FSA’s Corporate ResearchDepartment is comprised of a professional staff under the direction of theChief Risk Management Officer. The Corporate Research Department is responsiblefor evaluating the credit of entities participating in or providing recourse onobligations insured by FSA. It also provides analysis of industry segments.Members of the Corporate Research Department generally report their findingsdirectly to the appropriate underwriting committee in the context oftransaction review and approval.

***Transaction Oversight and Transaction Services***

FSA’s Transaction Oversight Groups and its workoutsubsidiary TSC are independent of the analysts and credit officers involved inthe underwriting process. The Municipal and Asset-Backed TransactionOversight Groups are responsible for monitoring the performance of outstandingtransactions. TSC, together with the Transaction Oversight Groups, isresponsible for taking remedial actions for underperforming transactions asappropriate. The managing directors responsible for the transaction oversightand transaction services functions report to the Chief Risk Management Officer.The Underwriting Committee of the Board of Directors receives quarterly reportsdescribing the changes in the overall insured portfolio during the quarter. TheTransaction Oversight Groups review insured transactions to confirm compliancewith transaction covenants, monitor credit and other developments affectingtransaction participants and collateral, and together with TSC and the RiskManagement Committee determine the steps, if any, required to protect theinterests of FSA and the holders of FSA-insured obligations. Reviews of asset-backedtransactions typically include an examination of reports provided by, and (ascircumstances warrant) discussions with, issuers, servicers, trustees and othertransaction participants. Reviews of asset-backed transactions ofteninclude servicer audits, site visits or evaluations by third-partyappraisers, engineers or other experts retained by FSA. The TransactionOversight Groups review transactions to determine the level of ongoing attentionrequired. These judgments relate to current credit quality and other factors,including compliance with reporting or other requirements, legal or regulatoryactions involving transaction participants and liquidity or other concerns thatmay not have a direct bearing on credit quality. Transactions with the highestrisk profile are generally subject to more intensive review and, ifappropriate, remedial action. The Transaction Oversight Groups and TSC worktogether with the Legal Department and Corporate Research in monitoring thesetransactions, negotiating restructurings and pursuing appropriate legalremedies.

The Company’s Transaction Oversight Groups categorizeall credits by risk of loss to facilitate appropriate allocation of resourcesto loss mitigation efforts and to efficiently communicate the relative creditcondition of any risk exposure, as well as the overall health of the insuredportfolio. Each risk in the insured portfolio is designated one of fivesurveillance rating categories.

Categories I and II represent fundamentally soundtransactions requiring routine monitoring. Category III representstransactions with a material deterioration in asset performance, financialhealth of the issuer, or other factors, but for which losses are deemed unlikely.Active monitoring and intervention is employed for Category IIItransactions.

Category IV reflects transactions demonstratingsufficient deterioration to indicate that material credit losses are possibleeven though not yet probable. Category IV is the equivalent of “watch list”by banking industry standards.

Category V reflects transactions where losses areprobable. This category includes (1) risks where claim payments have beenmade and where additional payments, net of recoveries, are expected, and (2) riskswhere claim payments are probable but none have yet been made. Category IVand Category V transactions are subject to intense monitoring andintervention.

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The table below presentsthe gross and net par outstanding and the gross and net reserves for risksclassified as described above, as of December 31, 2005 and 2004.

**Par Outstanding**

| ** **              | ** ** | **As of December 31,** | ** ** |
|-------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **              | ** ** | **Gross**                             | ** ** | **Net** | ** ** | **Gross** | ** ** | **Net** | ** ** |
| ** **              | ** ** | **(in millions)**                | ** ** |
| Categories I and  II    |       | $                                     | 450,967    |   | $ | 331,821 |   | $ | 426,142 |   | $ | 310,431 |   |
| Category III            |       | 6,244                                 |       | 4,900 |   | 7,213 |   | 6,384 |   |
| Category IV             |       | 266                                   |       | 242 |   | 283 |   | 245 |   |
| Category V no  claims   |       | 506                                   |       | 463 |   | 707 |   | 647 |   |
| Category V with  claims |       | 107                                   |       | 57 |   | 85 |   | 35 |   |
| Total                   |       | $                                     | 458,090    |   | $ | 337,483 |   | $ | 434,430 |   | $ | 317,742 |   |

 

**Case Basis Loss Reserves**

| ** **              | ** ** | **As of December 31,** | ** ** |
|-------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **              | ** ** | **Gross**                             | ** ** | **Net** | ** ** | **Gross** | ** ** | **Net** | ** ** |
| ** **              | ** ** | **(in millions)**                | ** ** |
| Category V no  claims   |       | $                                     | 49.1       |   | $ | 40.3 |   | $ | 36.4 |   | $ | 30.3 |   |
| Category V with  claims |       | 40.7                                  |       | 13.1 |   | 44.2 |   | 14.9 |   |
| Total                   |       | $                                     | 89.8       |   | $ | 53.4 |   | $ | 80.6 |   | $ | 45.2 |   |

 

The increase inCategory V reserves with no claims in 2005 compared to 2004 was dueprimarily to deterioration of certain CDO risks and the reassumption ofpreviously ceded business.

***Legal***

The Company’s LegalDepartment is comprised of a professional staff of attorneys and legalassistants under the direction of the General Counsel. The Company’s LegalDepartment is divided into five sectors: asset-backed transactions, municipal transactions, financialproducts, regulatory/reinsurance/corporate and compliance. The Legal Departmentplays a major role in establishing and implementing legal requirements andprocedures applicable to obligations insured by the Company. Members of theLegal Department serve on the MRC and MUNC, which provide final underwritingapproval for transactions. An attorney in the Legal Department works togetherwith his or her counterpart in the relevant financial guaranty group indetermining the legal and credit elements of each obligation proposed forinsurance and in overseeing the execution of approved transactions. Asset-backedobligations insured by the Company are ordinarily executed with the assistanceof outside counsel working closely with the Legal Department. Municipalobligations insured by the Company are ordinarily executed without employmentof outside counsel. The financial products attorneys in the Legal Departmentwork together with their counterparts in the FP group in developing andoverseeing the execution of approved financial products transactions. The LegalDepartment works closely with the Transaction Oversight Groups and TSC inaddressing legal issues, rights and remedies, as well as proposed amendments,waivers and consents, in connection with obligations insured by the Company.The Legal Department is also responsible for domestic and internationalregulatory compliance, reinsurance, secondary market transactions, litigationand other matters. The Chief Compliance Officer is a member of the LegalDepartment, and provides quarterly compliance activity reports to the Company’sManagement Committee and the Audit Committee of the Board of Directors of theCompany.

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**Competitionand Industry Concentration**

FSA faces competition from both other providers of andalternatives to third-party credit enhancement. Most securities are soldwithout third-party credit enhancement. Accordingly, each transaction FSAproposes to insure must generally compete against an alternative execution thatdoes not employ third-party credit enhancement. FSA faces competitionfrom other Triple-A rated monoline financial guaranty insurers, primarily AmbacAssurance Corp. (“Ambac”), Financial Guaranty Insurance Company (“FGIC”), MBIAInsurance Corp. (“MBIA”), XL Capital Assurance Inc. and CIFG Guaranty. Competitionis largely based on premium rates, capacity, underwriting requirements andtrading levels.

New entrants to the market provide increasingcompetition to more established market participants such as FSA as they attemptto grow their market share. Assured Guaranty Corp. and Radian AssetAssurance Inc., two market participants previously engaged primarily inreinsurance, either directly or through affiliates, recently increased theirfocus on the primary financial guaranty insurance market. The Companyunderstands that other parties are considering establishing new financialguaranty insurers that may compete with it. Entry requirements include:

·       assembling the group ofexperts required to operate a financial guaranty insurance business,

·       establishing claims-payingability ratings with the credit rating agencies,

·       complying with substantialcapital requirements,

·       developing name recognitionand market acceptance with issuers, investment bankers and investors, and

·       organizing a monolineinsurance company and obtaining insurance licenses to do business in theapplicable jurisdictions.

Traditionalcredit enhancers such as bank letter of credit providers and mortgage poolinsurers provide competition to FSA as providers of credit enhancement forasset-backed obligations. Actions by securities rating agencies in recentyears have significantly reduced the number of Triple-A rated financialinstitutions that can offer a product directly competitive with FSA’s Triple-Aguaranty, and risk-based capital guidelines applicable to banks have generallyincreased costs associated with letters of credit that compete directly withfinancial guaranty insurance. Nonetheless, bank sponsored commercial paperconduits, bank letter of credit providers and other credit enhancement, such ascash collateral accounts provided by banks, continue to provide significantcompetition to FSA. In addition, CDS, credit-linked notes and othersynthetic products provide coverage directly competitive with financialguaranty insurance, and expand the universe of participants in the financialrisk market. Bank affiliates may participate in the U.S. insurance business,including the financial guaranty insurance business.

Governmentsponsored entities, including Fannie Mae and Freddie Mac, compete with themonoline financial guaranty insurers, on a limited basis, in the mortgage-backedand multifamily sectors. Expansion of the business franchises by governmentsponsored entities, as well as potential new entrants into the financialguaranty sector such as Federal Home Loan Banks and state pension funds,present competitive challenges to private sector participants such as FSA.

Insurancelaw generally restricts multiline insurance companies, such as largeproperty/casualty insurers and life insurers, from engaging in the financialguaranty insurance business other than through separately capitalizedaffiliates.

Setforth below are FSA’s aggregate gross insurance in force, net insurance inforce, qualified statutory capital and capital ratio (represented by the ratioof its net insurance in force to qualified statutory capital) and the averageindustry capital ratio at the dates indicated. FSA’s net insurance in force isthe outstanding principal, interest and other amounts payable over theremaining life of all obligations insured by FSA, net of ceded reinsurance andrefunded bonds secured by U.S. government securities held in escrow or otherqualifying collateral. Qualified statutory capital, determined in accordancewith 

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statutory accounting practices, is the aggregate ofpolicyholders’ surplus and contingency reserves calculated in accordance withstatutory accounting practices. Net insurance data does not distinguish betweenquota share reinsurance and first-loss reinsurance. In light of FSA’s use offirst-loss reinsurance in the project finance and, to a lesser extent, asset-backedsectors, the data below tends to overstate FSA’s risk leverage in comparisonwith its industry counterparts. Conversely, FSA also insures mezzanine risksand obtains excess-of-loss credit protection in CDS transactions, which reducesFSA’s reported risk leverage. The statutory capital ratio does not reflect theunderlying credit quality of the insurance in force, which diminishes thecomparative value of the disclosure. Specifically, the credit quality of FSA’sinsured portfolio as measured by S&P and Moody’s is generally higher thanmost of FSA’s industry peers, although FSA’s ratio of net debt service tostatutory capital is also generally higher than most of FSA’s industry peers.
|                                                            | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                 | ** ** | **(dollars in millions)**   | ** ** |
| **Financial guaranty primary  insurers, excluding FSA(1)** | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Capital ratio                                              |       | 141:1                                 |       | 147:1 |   | 145:1 |   |
| **FSA(2)**                                                 |       |                                  |       |   |   |   |   |
| Gross insurance in force                                   |       | $                                     | 686,134    |   | $ | 633,037 |   | $ | 565,371 |   |
| Net insurance in force                                     |       | 497,624                               |       | 454,359 |   | 409,476 |   |
| Qualified statutory  capital                               |       | 2,418                                 |       | 2,281 |   | 2,104 |   |
| Capital ratio                                              |       | 206:1                                 |       | 199:1 |   | 195:1 |   |
|                                                            |            |                                       |            |  |  |  |  |  |  |  |

 

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(1)          Financialguaranty primary insurers for which data is included in this table are Ambac,FGIC and MBIA. Information relating to the financial guaranty primary insurersis derived from data from statutory accounting financial information publiclyavailable from each insurer as of December 31, 2005, 2004 and 2003.

(2)          Includesgross and net insurance in force relating to FSA-insured GICs issued by the GICAffiliates of $16,878 million for 2005, $8,753 million for 2004, and$5,708 million for 2003.

In December 2004, FSAobtained CDS protection on an excess of loss basis (exceeding very largedeductibles) on a number of FSA-insured synthetic CDO transactions shadow rated“super-Triple-A” at inception. As of December 31, 2005, the CDSprovided approximately $13.1 billion of credit protection. Given the highcredit quality of the risk transferred to the CDS provider, the main effect ofthis CDS was to improve FSA’s statutory capital ratios and increase FSA’smargin under regulatory risk limits on aggregate insured exposures.

**Reinsurance**

Reinsurance is the commitment by one insurancecompany, the “reinsurer,” to reimburse another insurance company, the “cedingcompany,” for a specified portion of the insurance risks underwritten by theceding company in consideration for a portion of the premiums received. Theceding company typically but not always receives a ceding commission to coverthe costs of business generation. Because the insured party contracts forcoverage solely with the ceding company, the failure of the reinsurer toperform does not relieve the ceding company of its obligation to the insuredparty under the terms of the insurance contract.

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As of December 31,2005, FSA reinsured approximately 26% of its principal amount outstanding. FSAobtains reinsurance to increase its policy writing capacity, both on anaggregate-risk and a single-risk basis, to:

·       meetinternal, rating agency and regulatory limits,

·       diversifyrisks,

·       reducethe need for additional capital, and

·       strengthenfinancial ratios.

FSA’s reinsurance may be on a quota share, first loss,or excess of loss basis. Quota share reinsurance generally provides protectionagainst a fixed specified percentage of all losses incurred by FSA. First lossreinsurance generally provides protection against a fixed specified percentageof losses incurred up to a specified limit. Excess of loss reinsurancegenerally provides protection against a fixed percentage of losses incurred tothe extent that losses incurred exceed a specified limit. Reinsurancearrangements typically require FSA to retain a minimum portion of the risksreinsured.

FSA arranges reinsurance on both a facultative(transaction-by-transaction) and treaty basis. In addition, FSA employs “automaticfacultative” reinsurance that permits FSA to apply reinsurance to transactionsit selects subject to certain limitations. Treaty reinsurance provides coveragefor a portion of the exposure from all qualifying policies issued during theterm of the treaty. The reinsurer’s participation in a treaty is eithercancelable annually upon 90 days’ prior notice by either FSA or thereinsurer or has a one-year term. Treaties generally provide coverage for thefull term of the policies reinsured during the annual treaty period, exceptthat, upon a financial deterioration of the reinsurer and the occurrence ofcertain other events, FSA generally has the right to reassume all or a portionof the business reinsured. Reinsurance agreements may be subject to othertermination conditions as required by applicable state law.

Primary insurers, such as FSA, are required to fulfilltheir obligations to policyholders if reinsurers fail to meet theirobligations. The financial condition of reinsurers is important to FSA, and FSAendeavors to place its reinsurance with financially strong reinsurers. FSA’streaty reinsurers as of December 31, 2005 were Assured Guaranty ReInternational Ltd. (formerly ACE Capital Re International Ltd.),BluePoint Re, Limited, Mitsui Sumitomo Insurance Company, Limited, Radian AssetReinsurance Inc. (successor to Radian Reinsurance Inc., formerlyEnhance Reinsurance Company), RAM Reinsurance Co. Ltd., Swiss ReinsuranceCompany, Tokio Marine and XLFA. FSA also has reciprocal surplus sharereinsurance treaties with Ambac and FGIC, which provide quota share reinsuranceon transactions exceeding specified par amounts insured.

Securities rating agencies allow FSA “credit” forreinsurance based on the reinsurer’s ratings. Generally, 95-100% creditis allowed for Triple-A reinsurance and 65-90% credit is allowed forDouble-A reinsurance. In recent years, a number of FSA’s reinsurers have beendowngraded from Triple-A to Double-A or lower by one or more rating agency.While ceding commissions or premium allocation adjustments may compensate inpart for such downgrades, the effect of such downgrades, in general, is todecrease the financial benefits of using reinsurance under rating agencycapital adequacy models.

In 2004, the insurance laws of the State of New York(the “New York Insurance Law”) were amended to allow financial guarantyinsurers such as FSA to treat qualifying CDS from highly rated financial institutionsas collateral for purposes of satisfying risk limits and certain reserverequirements. These amendments allow financial guaranty insurers to employ CDS ascollateral for statutory accounting purposes, with the collateral havingeffects similar to reinsurance in reducing single and aggregate risks forstatutory purposes. In December 2004, FSA obtained CDS protection on anexcess of loss basis (exceeding very large deductibles) on a number ofFSA-insured synthetic CDO transactions shadow rated 

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“super-Triple-A” atinception. As of December 31, 2005, the CDS provided approximately $13.1billion of credit protection. Given the high credit quality of the risktransferred to the CDS provider, the main effects of this CDS were to improveFSA’s statutory capital ratios and increase FSA’s margin under regulatory risklimits on aggregate insured exposures.

FSA, FSAIC and FSAInternational are party to a quota share reinsurance pooling agreement pursuantto which, after reinsurance cessions to other reinsurers, the FSA companiesshare in the net retained risk insured by each of these companies. Under thepooling agreement, FSA, FSAIC and FSA International share the net retained riskin proportion to their policyholders’ surplus and contingency reserves, or “statutorycapital,” at the end of the prior calendar quarter. FSA-UK and FSA are party toa quota share and stop loss reinsurance agreement pursuant to which:

·       FSA-UKreinsures with FSA its retention under its policies after third partyreinsurance based on an agreed-upon percentage that is substantially inproportion to the statutory capital of FSA-UK to the total statutory capital ofFSA and its subsidiary insurers (including FSA-UK); and

·       subjectto certain limits, FSA is required to make payments to FSA-UK when FSA-UK’sannual net incurred losses and expenses exceeds FSA-UK’s annual net earnedpremiums plus draws on FSA-UK’s equalization reserves to pay incurred losses.

Under this agreement,FSA-UK ceded to FSA approximately 97.9% of its retention after third partyreinsurance of its policies issued in 2005.

**Rating Agencies**

The value of FSA’s insurance product is generally afunction of the “rating” applied to the obligations it insures. The financialstrength of FSA and its insurance company subsidiaries is rated “Aaa” by Moody’sand “AAA” by S&P, Fitch Ratings and Rating and Investment Information, Inc.Such ratings reflect only the views of the respective rating agencies, are notrecommendations to buy, sell or hold securities and are subject to revision orwithdrawal at any time by such rating agencies.

These rating agencies periodically review FSA’sbusiness and financial condition, focusing on the insurer’s underwritingpolicies and procedures and the quality of the obligations insured, and publishtheir ratings and supporting analyses. Each rating agency performs periodicassessments of the credits insured by FSA, as well as the reinsurers and otherproviders of capital support to FSA, to confirm that FSA continues to satisfysuch rating agency’s capital adequacy criteria necessary to maintain FSA’sTriple-A rating. FSA’s ability to compete with other Triple-A rated financialguarantors, and its results of operations and financial condition, would bematerially adversely affected by any reduction in its ratings.

Moody’s, S&Pand Fitch apply their own capital adequacy models in assessing the financialstrength of FSA. Financial factors considered by the rating agencies inassessing capital adequacy include:

·       capitalcharges or other assessments of credit risks for FSA’s insured portfolio,including the degree of risk embedded in FSA-insured GICs;

·       thequality of FSA’s assets and other investments (the “Investment Portfolio”);

·       thecredit quality of FSA’s reinsurers and the type of reinsurance providedthereby;

·       creditlines and other capital support arrangements (“soft capital”);

·       premiumrevenues expected to be generated from outstanding policies; and

·       anticipatedfuture new business originations and anticipated future losses.

Given the importance ofits ratings to its on-going business, FSA’s underwriting process generallyincludes an analysis of the impact on rating agency capital adequacydeterminations in addition to other 

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measuresof creditworthiness. Reference is made to the published reports of Moody’s,S&P and Fitch Ratings regarding the Company, capital adequacy models, thebond insurance business in general and FSA’s standing relative to its industrypeers on the basis of capital adequacy and profitability.

**Insurance Regulatory Matters**

***General***

FSA is licensed to engage in insurance business in all50 states, the District of Columbia, Guam, Puerto Rico and the U.S. VirginIslands. FSA is subject to the New York Insurance Law and is also subject tothe insurance laws of the other states in which it is licensed to transactinsurance business. FSAIC is an Oklahoma domiciled insurance company alsolicensed in New York and subject to the New York Insurance Law. FSA and itsdomestic insurance company subsidiary are required to file quarterly and annualstatutory financial statements in each jurisdiction in which they are licensed,and are subject to statutory restrictions concerning the types and quality ofinvestments and the filing and use of policy forms and premium rates. FSA’saccounts and operations are subject to periodic examination by theSuperintendent of Insurance of the State of New York (the “New YorkSuperintendent”) and other state insurance regulatory authorities. The lastcompleted examination was conducted in 2004 for the three-year period ended December 31,2002.

FSA International is aBermuda domiciled insurance company subject to applicable requirements ofBermuda law. FSA International maintains its principal executive offices inHamilton, Bermuda. FSA International does not intend to transact business orestablish a permanent place of business in the United States or Europe. FSA-UKis a United Kingdom domiciled insurance company subject to applicablerequirements of English law. FSA-UK maintains its principal executive officesin London, England. Pursuant to European Union Directives, FSA-UK is generallyauthorized to write business out of its London office in other member countriesof the European Union subject to the satisfaction of perfunctory registrationrequirements. FSA has a Singapore branch authorized to transact insurancebusiness in Singapore and subject to regulation by Singapore authorities.

***Domestic Insurance Holding Company Laws***

The Company and its domestic insurance companysubsidiaries (FSA and FSAIC) are subject to regulation under insurance holdingcompany statutes of their jurisdiction of domicile (New York and Oklahoma,respectively), as well as other jurisdictions where these insurers are licensedto do insurance business. The requirements of holding company statutes varyfrom jurisdiction to jurisdiction but generally require insurance holdingcompanies and their insurance company subsidiaries to register and file certainreports describing, among other information, their capital structure, ownershipand financial condition. The holding company statutes also require priorapproval of changes in control, certain dividends and other intercorporatetransfers of assets and transactions between insurance companies and theiraffiliates. The holding company statutes generally require that alltransactions with affiliates be fair and reasonable and that those exceedingspecified limits require prior notice to or approval by insurance regulators.

Under the insuranceholding company laws in effect in New York and Oklahoma, any acquisition ofcontrol of the Company, and thereby indirect control of FSA and FSAIC, requiresthe prior approval of the New York Superintendent and the Oklahoma InsuranceCommissioner. “Control” is defined as the direct or indirect power to direct orcause the direction of the management and policies of a person, whether throughthe ownership of voting securities, by contract or otherwise. Any purchaser of10% or more of the outstanding voting securities of a corporation is presumedto have acquired control of that corporation and its subsidiaries, although theinsurance regulator may find that “control” in fact does or does not exist whena person owns or controls either a lesser or greater amount of votingsecurities.

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***New York Financial Guaranty Insurance Law***

Article 69 of the New York Insurance Law (“Article 69”),a comprehensive financial guaranty insurance statute, governs all financialguaranty insurers licensed to do business in New York, including FSA. Thisstatute limits the business of financial guaranty insurers to financialguaranty insurance and related lines (such as surety).

Article 69requires that financial guaranty insurers maintain a special statutoryaccounting reserve called the “contingency reserve” to protect policyholdersagainst the impact of excessive losses occurring during adverse economiccycles. Article 69 requires a financial guaranty insurer to provide acontingency reserve:

·       withrespect to policies written prior to July 1, 1989 in an amount equal to50% of earned premiums; and

·       withrespect to policies written on and after July 1, 1989, quarterly on a prorata basis over a period of 20 years for municipal bonds and 15 yearsfor all other obligations, in an amount equal to the greater of 50% of premiumswritten for the relevant category of insurance or a percentage of the principalguaranteed, varying from 0.55% to 2.50%, depending on the type of obligationguaranteed, until the contingency reserve amount for the category equals theapplicable percentage of net unpaid principal.

This reserve must be maintained for the periodsspecified above, except that reductions by the insurer may be permitted underspecified circumstances in the event that actual loss experience exceedscertain thresholds or if the reserve accumulated is deemed excessive inrelation to the insurer’s outstanding insured obligations. FSA has in the pastsought and obtained releases of excessive contingency reserves from the NewYork Insurance Department. Financial guaranty insurers are also required tomaintain reserves for losses and loss adjustment expenses on a case-by-casebasis and reserves against unearned premiums.

Article 69establishes single risk limits for financial guaranty insurers applicable toall obligations issued by a single entity and backed by a single revenuesource. For example, under the limit applicable to qualifying asset-backedsecurities, the lesser of:

·       theinsured average annual debt service for a single risk, net of qualifyingreinsurance and collateral, or

·       theinsured unpaid principal (reduced by the extent to which the unpaid principalof the supporting assets exceeds the insured unpaid principal) divided by nine,net of qualifying reinsurance and collateral

may not exceed 10% of the sum of the insurer’spolicyholders’ surplus and contingency reserves, subject to certain conditions.

Under the limit applicable to municipal obligations,the insured average annual debt service for a single risk, net of qualifyingreinsurance and collateral, may not exceed 10% of the sum of the insurer’spolicyholders’ surplus and contingency reserves. In addition, insured principalof municipal obligations attributable to any single risk, net of qualifyingreinsurance and collateral, is limited to 75% of the insurer’s policyholders’surplus and contingency reserves. Single risk limits are also specified forother categories of insured obligations, and generally are more restrictivethan those listed for asset-backed or municipal obligations.

Article 69 alsoestablishes aggregate risk limits on the basis of aggregate net liabilityinsured as compared to statutory capital. “Aggregate net liability” is definedas outstanding principal and interest of guaranteed obligations insured, net ofqualifying reinsurance and collateral. Under these limits, 

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policyholders’surplus and contingency reserves must not be less than a percentage ofaggregate net liability equal to the sum of various percentages of aggregatenet liability for various categories of specified obligations. The percentagevaries from 0.33% for certain municipal obligations to 4% for certainnon-investment grade obligations.

***Dividend Restrictions***

FSA’s ability topay dividends is dependent on FSA’s financial condition, results of operations,cash requirements, rating agency confirmation of non-impairment of FSA’sratings and other related factors, and is also subject to restrictionscontained in the New York Insurance Law and other states. Under New YorkInsurance Law, FSA may pay dividends out of statutory earned surplus, providedthat, together with all dividends declared or distributed by FSA during thepreceding 12 months, the dividends do not exceed the lesser of:

·       10%of policyholders’ surplus as of its last statement filed with the New YorkSuperintendent; or

·       adjustednet investment income during this period.

Based on FSA’s statutorystatements for 2005, the maximum amount available for payment of dividends byFSA without regulatory approval over the 12 months following December 31,2005 was approximately $153.8 million.

***Financial Guaranty Insurance Regulation in OtherJurisdictions***

FSA is subject to laws and regulations ofjurisdictions other than the State of New York concerning the transaction offinancial guaranty insurance. The laws and regulations of these otherjurisdictions are generally not more stringent in any material respect than theNew York Insurance Law.

The Bermuda Ministry ofFinance regulates FSA International. The United Kingdom Financial ServicesAuthority regulates FSA-UK. Pursuant to European Union Directives, FSA-UK hasbeen authorized to provide financial guaranty insurance for transactions innumerous European countries from its home office in the United Kingdom. FSA hasreceived a determination from the Australian Insurance and SuperannuationCommissioner that the financial guaranties issued by FSA with respect toAustralian transactions do not constitute insurance for which a license isrequired. The Monetary Authority of Singapore regulates activities of FSA’sSingapore branch. FSA is in the process of seeking a branch license in Japan.

**U.S. Bank Holding Company Act**

Dexia indirectlyowns approximately 99% of the Company’s common stock. Because Dexia has anon-U.S. bank subsidiary with a branch in the U.S., Dexia and all of itssubsidiaries, including the Company and its subsidiaries, are subject to theU.S. Bank Holding Company Act (the “BHC Act”). In general, the BHC Actrestricts the activities of banking organizations and their affiliates to theownership and operation of banks and to other activities that are “closelyrelated to banking” as determined by the Board of Governors of the FederalReserve System. Insurance activities such as those conducted by certain of theCompany’s subsidiaries are generally not permissible under this restriction.Under the BHC Act, however, an organization that qualifies as a “financialholding company” is permitted to engage in a broader range of permissible “financialactivities.” “Financial activities” include insurance underwriting and agencyactivities as well as merchant banking. For Dexia to qualify as a “financialholding company,” it and its non-U.S. bank subsidiary with a branch in the U.S.must be both:

·       “well-capitalized,”which requires a Tier I capital to risk-based assets ratio of at least 6% and atotal capital to risk-based assets ratio of at least 10%, as calculated underhome country standards (Tier I, or core, capital includes equity capital lesscertain intangibles), and

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·       “well-managed,”which requires a composite U.S. banking office examination rating by therelevant U.S. bank regulator of at least “satisfactory.”

Dexia holds its investmentin, and operates, the Company and its subsidiaries under the “financialactivities” authorization permitted to “financial holding companies.”  If Dexia does not continue to meet the requirements for qualifyingas a “financial holding company,” it may lose its ability to hold itsinvestment in, or operate, the Company and its subsidiaries.

**Investments**

In addition to itsinsurance company Investment Portfolio, the Company maintains investments fromproceeds of FSA-insured GICs (the “FP Investment Portfolio”), the portfolio ofsecurities owned by the VIEs (the “VIE Portfolio”) and assets acquired fromrefinancing transactions.

As of December 31,2005, the Company also had investments in strategic partners, including:

·       XLFA;and

·       TheDebtCenter,L.L.C., which operates TheMuniCenter, L.L.C., an online exchange for municipalbonds.

On October 4, 2005,the Company sold its investment in SPS Holding Corp. (“SPS”) (formerlyFairbanks Capital Holding Corp.), a residential mortgage loan servicer, to anunaffiliated third party. For its interest in SPS, the Company was paid $42.9million in cash and expects to receive additional amounts, from time to timethrough March 31, 2008, out of income earned by SPS through December 31,2007 from certain of its mortgage servicing activities. Under the saledocuments, the subsidiary of the Company which owned the SPS investment maderepresentations and warranties to, and undertook specified indemnificationobligations for the benefit of, the purchaser.

***Investments Insuredby the Company***

Both the InvestmentPortfolio and the FP Investment Portfolio include fixed income investments thatare insured by FSA (“FSA-Insured Investments”).  The staff of the Securities and ExchangeCommission (the “SEC”) is currently reviewing the accounting treatment offinancial guaranty industry participants’ investments in securities insured bythemselves or their affiliates, including the Company’s investments inFSA-Insured Investments. At December 31, 2005, the Investment Portfolioincluded $319.0 million of FSA-Insured Investments and the FP InvestmentPortfolio included $834.3 million of FSA-Insured Investments, measured atfair value, in each case representing approximately 7.0% of the relevantportfolio.

The Company, like itsindustry peers, records these investments as available-for-sale securities andcarries them at fair value, which includes the effect of the embedded FSAguaranty. The Company’s accounting treatment of the FSA-Insured Investments isbased on Statement of Financial Accounting Standards No. 115, “Accountingfor Certain Investments in Debt and Equity Securities,” which requires thatinvestment securities be carried at fair value, applying quoted prices whereavailable. Quoted prices reflect the value of the embedded FSA insurance policyand related Triple-A rating.

In 2005, the Company and otherfinancial guaranty industry participants received written comments from the SECstaff regarding the proper accounting treatment for investments held by suchcompanies that are also guaranteed by themselves or their affiliates, as is thecase with the FSA-Insured Investments. Recent discussions with the SEC staffsuggest that the staff’s tentative view of the appropriate accounting forFSA-Insured Investments is to extinguish a portion of the contingent guaranteeobligation related to the amount held in its investment portfolio.

The Company cannot predicthow the SEC staff will resolve this issue or the resulting effect on itsfinancial statements. The Company intends to continue to apply its currentmethodology until the issue is 

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resolved.There can be no certainty, however, that the SEC will not require the Companyto modify its methodology, either on a going-forward basis or for priorperiods.

***Investment Portfolio***

Management’s primary objective in managing theInvestment Portfolio is to generate an optimal level of after-tax investmentincome while preserving capital and maintaining adequate liquidity, subject torating agency capital adequacy criteria that reduce credit for investmentsbased on their ratings to the extent rated less than Triple-A. The InvestmentPortfolio is managed by unaffiliated professional investment managers and theCompany’s affiliate FSA Portfolio Management, which manages the majority of themunicipal portfolio. The investment management function is overseen by theInvestment Committee established by the Company’s Board of Directors.

To accomplish its objectives, the Company hasestablished guidelines for eligible fixed income investments by FSA, requiringthat at least 95% of such investments be rated at least Single-A at acquisitionand the overall portfolio be rated Double-A on average. Fixed income investmentsfalling below the minimum quality level are disposed of at such time asmanagement deems appropriate. For liquidity purposes, the Company’s policy isto invest primarily in readily marketable investments with no legal orcontractual restrictions on resale. Eligible fixed income investments includeU.S. Treasury and agency obligations, corporate bonds, tax-exempt bonds,asset-backed securities and mortgage-backed securities. In applying itsinvestment guidelines, the Company uses the published rating for FSA-InsuredInvestments, rather than the rating that such securities would have withoutgiving effect to the FSA guaranty, referred to as the “shadow rating.”  The Company’s current investment strategy isto invest in quality, readily marketable instruments of intermediate averageduration so as to generate stable investment earnings with minimal market valueor credit risk.

The weighted average maturity of the fixed incomesecurities in the Investment Portfolio as of December 31, 2005 wasapproximately 12 years.

The Company’s investment in XLFA is included in theInvestment Portfolio.

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The following tables setforth certain information concerning the Company’s Investment Portfolio:

**InvestmentPortfolio by RatingAs of December 31, 2005(1)(3)**

| **Rating** | ** ** | ** ** | ** ** | **Percent of  Investment  Portfolio** | ** ** |
|------------|------------|------------|------------|--------------------------------------------|------------|
| AAA(2)     |       |       | 78.6       | %                                          |       |
| AA         |       |       | 17.4       |                                       |       |
| A     |       |       | 4.0        |                                       |       |
| Total      |       |       | 100.0      | %                                          |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available as of December 31, 2005.

(2)          Includes U.S. Treasuryobligations, which comprised 4.1% of the portfolio as of December 31,2005.

(3)          6.8%of the Investment Portfolio was rated Triple-A by virtue of insurance providedby FSA. Over 95% of the FSA-Insured Investments were investment grade withoutgiving effect to the FSA insurance. The average shadow rating of the FSA-InsuredInvestments was in the Double-A range.

**Summary ofInvestments**

| ** **                     | ** ** | **As of December 31,** | ** ** |
|--------------------------------|------------|---------------------------------------|------------|
| ** **                     | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| **Investment Category**   | ** ** | ** **                            | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **                     | ** ** | **(dollars in thousands)**  | ** ** |
| Long term investments:         |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Taxable bonds                  |       | $                                     | 788,298    |   |   | 4.61 | % |   | $ | 804,942 |   |   | 4.77 | % |   |
| Tax-exempt bonds               |       | 3,431,046                             |       |   | 4.77 |   |   | 3,058,967 |   |   | 4.75 |   |   |
| Total long-term investments    |       | 4,219,344                             |       |   | 4.74 |   |   | 3,863,909 |   |   | 4.75 |   |   |
| Short-term  investments        |       | 182,645                               |       |   | 2.81 |   |   | 119,746 |   |   | 2.07 |   |   |
| Total fixed income investments |       | 4,401,989                             |       |   | 4.66 |   |   | 3,983,655 |   |   | 4.72 |   |   |
| Equity  investments            |       | 54,370                                |       |   |   |   |   | 54,300 |   |   |   |   |   |
| Total investments              |       | $                                     | 4,456,359  |   |   |   |   |   | $ | 4,037,955 |   |   |   |   |   |
|                                |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Yieldsare stated on a pre-tax basis.

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**InvestmentPortfolio by Security Type**

| ** **                             | ** ** | **As of December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| **Investment Category**           | ** ** | ** **                            | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**  | ** ** |
| U.S. government  and agency securities |       | $                                     | 195,495    |   |   | 4.49 | % |   | $ | 164,312 |   |   | 4.30 | % |   |
| Mortgage-backed  securities            |       | 250,001                               |       |   | 5.24 |   |   | 220,202 |   |   | 5.31 |   |   |
| Municipal bonds                        |       | 3,431,046                             |       |   | 4.77 |   |   | 3,058,967 |   |   | 4.75 |   |   |
| Asset-backed  securities               |       | 40,216                                |       |   | 3.84 |   |   | 56,843 |   |   | 3.23 |   |   |
| Corporate  securities                  |       | 186,369                               |       |   | 4.66 |   |   | 237,486 |   |   | 4.81 |   |   |
| Foreign  securities                    |       | 116,217                               |       |   | 3.62 |   |   | 126,099 |   |   | 5.06 |   |   |
| Total long-term  investments           |       | 4,219,344                             |       |   | 4.74 |   |   | 3,863,909 |   |   | 4.75 |   |   |
| Short-term  investments                |       | 182,645                               |       |   | 2.81 |   |   | 119,746 |   |   | 2.07 |   |   |
| Total fixed income investments         |       | 4,401,989                             |       |   | 4.66 |   |   | 3,983,655 |   |   | 4.72 |   |   |
| Equity  investments                    |       | 54,370                                |       |   |   |   |   | 54,300 |   |   |   |   |   |
| Total investments                      |       | $                                     | 4,456,359  |   |   |   |   |   | $ | 4,037,955 |   |   |   |   |   |
|                                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Yieldsare stated on a pre-tax basis.

**Distributionof Investments by Contractual Maturity**

| ** **                              | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                              | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| **Investment Category**            | ** ** | ** **                            | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| ** **                              | ** ** | **(in thousands)**               | ** ** |
| Due in one year  or less                |       | $                                     | 274,955    |   | $ | 275,017 |   | $ | 174,831 |   | $ | 174,872 |   |
| Due after one  year through five years  |       | 1,188,212                             |       | 1,248,314 |   | 552,672 |   | 558,554 |   |
| Due after five  years through ten years |       | 670,694                               |       | 701,085 |   | 521,256 |   | 559,119 |   |
| Due after ten  years                    |       | 1,977,911                             |       | 2,054,046 |   | 2,457,851 |   | 2,663,695 |   |
| Mortgage-backed  securities             |       | 250,001                               |       | 246,246 |   | 220,202 |   | 222,510 |   |
| Asset-backed  securities                |       | 40,216                                |       | 39,974 |   | 56,843 |   | 57,084 |   |
| Total fixed  income investments         |       | 4,401,989                             |       | 4,564,682 |   | 3,983,655 |   | 4,235,834 |   |
| Equity  investments                     |       | 54,370                                |       | 54,370 |   | 54,300 |   | 54,300 |   |
| Total investments                       |       | $                                     | 4,456,359  |   | $ | 4,619,052 |   | $ | 4,037,955 |   | $ | 4,290,134 |   |
|                                         |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Mortgage-BackedSecuritiesCost and Market Value by Investment Category**

| ** **                                      | ** ** | **As of December 31, 2005** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                      | ** ** | **Par Value**                              | ** ** | **Amortized  Cost** | ** ** | **Fair Value** | ** ** |
| ** **                                      | ** ** | **(in thousands)**                         | ** ** |
| Pass-through  securities U.S. Government agency |       | $                                               | 227,037    |   | $ | 228,781 |   | $ | 225,217 |   |
| CMOs—U.S.  Government agency               |       | 4,590                                           |       | 4,762 |   | 4,637 |   |
| CMOs—non-agency                            |       | 16,191                                          |       | 16,458 |   | 16,392 |   |
| Total mortgage-backed  securities               |       | $                                               | 247,818    |   | $ | 250,001 |   | $ | 246,246 |   |

 

The Company’s investments in mortgage-backedsecurities primarily consisted of pass-through certificates and collateralizedmortgage obligations (“CMOs”), which are backed by mortgage loans guaranteed orinsured by agencies of, or sponsored by, the federal government. Thesesecurities are highly 

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liquid with readilydeterminable market prices. The Company also held, as of December 31,2005, Triple-A rated CMOs which are not guaranteed by government agencies. Secondarymarket quotations are available for these securities, although they are not asliquid as government agency-backed securities.

The CMOs held as of December 31, 2005 have statedmaturities ranging from 1 to 30 years and expected average lives rangingfrom 1 to 15 years based on anticipated prepayments of principal.

Mortgage-backedsecurities differ from traditional fixed income bonds because they are subjectto prepayments at par value without penalty when the underlying mortgage loansare prepaid at the borrower’s option. Prepayment rates on mortgage-backedsecurities are influenced primarily by the general level of prevailing mortgageinterest rates, with prepayments increasing when prevailing loan interest ratesare lower than the rates on the underlying mortgage loans, and by the terms ofthe loans. When prepayments occur, the proceeds must be reinvested at thencurrent market rates, which may be below the yield on the prepaid securities.

***FP Investment Portfolio***

The following tables set forthcertain information concerning the FP Investment Portfolio:

**FPInvestment Portfolio by RatingAs of December 31, 2005(1)(2)**

| **Rating** | ** ** | ** ** | ** ** | **Percent of Investment  Portfolio** | ** ** |
|------------|------------|------------|------------|------------------------------------------------|------------|
| AAA        |       |       | 92.1       | %                                              |       |
| AA         |       |       | 6.5        |                                           |       |
| A     |       |       | 1.4        |                                           |       |
| Total      |       |       | 100.0      | %                                              |       |

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(1)          Ratings are based on thelower of Moody’s or S&P ratings available as of December 31, 2005.

(2)          7.0%of the FP Investment Portfolio was rated Triple-A by virtue of insuranceprovided by FSA. Over 90% of the FSA-Insured Investments were investment gradewithout giving effect to the FSA insurance. The average shadow rating of theFSA-Insured Investments was in the Single-A range.

**Summaryof FP Investment Portfolio**

| ** **               | ** ** | **December 31,**                | ** ** |
|--------------------------|------------|--------------------------------------|------------|
| ** **               | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **               | ** ** | **Amortized  Cost**                  | ** ** | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **               | ** ** | **(dollars in thousands)** | ** ** |
| FP Investment Portfolio: |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Taxable bonds            |       | $                                    | 11,754,330 |   |   | 3.54 | % |   | $ | 7,888,647 |   |   | 1.66 | % |   |
| Short-term investments   |       | 1,015,509                            |       |   | 3.31 |   |   | 268,125 |   |   | 1.43 |   |   |
| Total investments        |       | $                                    | 12,769,839 |   |   | 3.53 |   |   | $ | 8,156,772 |   |   | 1.64 |   |   |

----

(1)          Yields are stated on apre-tax basis. The weighted average yield presented is net of the effectsof derivative instruments used to economically convert interest rates fromfixed to floating rate.

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**FPInvestment Portfolio by Security Type**

| ** **                             | ** ** | **As of December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| **Investment Category**           | ** ** | ** **                            | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**  | ** ** |
| Mortgage-backed  securities            |       | $                                     | 2,821,562  |   |   | 3.31 | % |   | $ | 2,137,814 |   |   | 1.46 | % |   |
| Municipal bonds                        |       | 809,856                               |       |   | 3.93 |   |   | 442,169 |   |   | 1.57 |   |   |
| U.S. government  and agency securities |       | 175,703                               |       |   | 3.31 |   |   | 270,498 |   |   | 1.56 |   |   |
| Asset-backed  and other securities     |       | 7,947,209                             |       |   | 3.56 |   |   | 5,029,447 |   |   | 1.71 |   |   |
| Corporate  securities                  |       | —                                |       |   | 4.31 |   |   | 8,719 |   |   | 2.57 |   |   |
| Total fixed maturities                 |       | 11,754,330                            |       |   | 3.54 |   |   | 7,888,647 |   |   | 1.66 |   |   |
| Short-term  investments                |       | 1,015,509                             |       |   | 3.31 |   |   | 268,125 |   |   | 1.43 |   |   |
| Total investments                      |       | $                                     | 12,769,839 |   |   | 3.53 |   |   | $ | 8,156,772 |   |   | 1.64 |   |   |
|                                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Yields are stated on apre-tax basis. The weighted average yield presented is net of the effects ofderivative instruments used to economically convert interest rates from fixedto floating rates.

The weighted-average yieldincreased in 2005 due to rising interest rates, as the majority of the assetsin the FP Investment Portfolio were floating rate assets.

**Distributionof FP Investments by Contractual Maturity**

| ** **                              | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|
| **Investment Category**            | ** ** | ** **                                      | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| ** **                              | ** ** | **(in thousands)**                         | ** ** |
| Due in one year  or less                |       | $                                               | 1,037,032  |   | $ | 1,037,032 |   |
| Due after five  years through ten years |       | 19,802                                          |       | 19,720 |   |
| Due after ten  years                    |       | 944,234                                         |       | 999,227 |   |
| Mortgage-backed  securities             |       | 2,821,562                                       |       | 2,829,485 |   |
| Asset-backed  and other securities      |       | 7,947,209                                       |       | 7,957,869 |   |
| Total investments                       |       | $                                               | 12,769,839 |   | $ | 12,843,333 |   |
|                                         |            |                                                 |            |  |  |  |  |  |  |

 

***VIE Portfolio***

The Company’s management believes that the assets heldby the VIEs, including those that are eliminated in consolidation, are beyondthe reach of the Company and its creditors, even in bankruptcy or other receivership.

All bonds in the VIEPortfolio are insured by FSA. The credit quality of the VIE Portfolio, withoutthe benefit of FSA’s insurance, as of December 31, 2005 was as follows:

**VIE Portfolio byRating(1)**

| **Rating** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|------------|------------|------------|------------|--------------------------------|------------|
| AAA        |       |       | 2.3        | %                              |       |
| A          |       |       | 95.5       |                           |       |
| BB         |       |       | 2.2        |                           |       |
| Total      |       |       | 100.0      | %                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available as of December 31, 2005.

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Theamortized cost and estimated fair value of bonds in the VIE Portfolio were asfollows:

| ** **                                             | ** ** | **As of December 31, 2005** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                             | ** ** | **Amortized Cost**                         | ** ** | **Fair Value** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                         | ** ** |
| Obligations of  U.S. states and political subdivisions |       |                                            | $          | 15,879 |   |   | $ | 15,879 |   |
| Corporate  securities                                  |       |                                            | 20,013     |   |   | 19,327 |   |
| Foreign                                                |       |                                            | 8,995      |   |   | 9,841 |   |
| Asset-backed  securities(1)                            |       |                                            | 1,110,945  |   |   | 1,110,945 |   |
| Short term  investments                                |       |                                            | 2,674      |   |   | 2,674 |   |
| Total                                                  |       |                                            | $          | 1,158,506 |   |   | $ | 1,158,666 |   |

 

| ** **                                             | ** ** | **As of December 31, 2004** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                             | ** ** | **Amortized Cost**                         | ** ** | **Fair Value** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                         | ** ** |
| Obligations of  U.S. states and political subdivisions |       |                                            | $          | 16,007 |   |   | $ | 16,007 |   |
| Corporate  securities                                  |       |                                            | 156,030    |   |   | 157,990 |   |
| Foreign                                                |       |                                            | 56,077     |   |   | 57,983 |   |
| Asset-backed  securities(1)                            |       |                                            | 1,114,375  |   |   | 1,114,375 |   |
| Short term  investments                                |       |                                            | 1,194      |   |   | 1,194 |   |
| Total                                                  |       |                                            | $          | 1,343,683 |   |   | $ | 1,347,549 |   |

----

(1)          Asset-backedsecurities consist of floating rate assets, which are valued using readilyavailable quoted market prices or at amortized cost if there is no readilyavailable valuation. Management believes that amortized cost closelyapproximates fair value for these securities.

Theamortized cost and fair value of bonds in the VIE Portfolio as of December 31,2005, by contractual maturity, are shown below. Actual maturities could differfrom contractual maturities because borrowers have the right to call or prepaycertain obligations with or without call or prepayment penalties.

| ** **                                                    | ** ** | **As of December 31, 2005** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                    | ** ** | **Amortized Cost**                         | ** ** | **Fair Value** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                         | ** ** |
| Due in one year  or less                                      |       |                                            | $          | 2,674 |   |   | $ | 2,674 |   |
| Due after one  year through five years                        |       |                                            | 29,008     |   |   | 29,168 |   |
| Due after five  years through ten years                       |       |                                            | —     |   |   | — |   |
| Due after ten  years                                          |       |                                            | 15,879     |   |   | 15,879 |   |
| Asset-backed  securities (stated maturities of 4 to 17 years) |       |                                            | 1,110,945  |   |   | 1,110,945 |   |
| Total                                                         |       |                                            | $          | 1,158,506 |   |   | $ | 1,158,666 |   |

 

**Employees**

As of December 31,2005, the Company had 373 employees. None of its employees are covered bycollective bargaining agreements. The Company considers its employee relationsto be satisfactory.

**AvailableInformation**

The Company makesavailable, free of charge through its website, http://www.fsa.com, its annualreports on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K and amendments to those reports filed orfurnished pursuant to Section 13(a) and 15(d) of the ExchangeAct as soon as reasonably practicable after the Company electronically filessuch materials with, or furnishes them to, the Securities and ExchangeCommission.

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**Forward-LookingStatements**

The Company relies on thesafe harbor for forward-looking statements provided by the PrivateSecurities Litigation Reform Act of 1995. This safe harbor requires that theCompany specify important factors that could cause actual results to differmaterially from those contained in forward-looking statements made by oron behalf of the Company. Accordingly, forward-looking statements by theCompany and its affiliates are qualified by reference to the followingcautionary statements.

In itsfilings with the SEC, reports to shareholders, press releases and other writtenand oral communications, the Company from time to time makes forward-lookingstatements. Such forward-looking statements include, but are not limitedto:

·       projectionsof revenues, income (or loss), earnings (or loss) per share, dividends, marketshare or other financial forecasts;

·       statementsof plans, objectives or goals of the Company or its management, including thoserelated to growth in adjusted book value or return on equity; and

·       expectedlosses on, and adequacy of loss reserves for, insured transactions.

Words such as “believes,” “anticipates,”“expects,” “intends” and “plans” and similar expressions are intended toidentify forward looking statements but are not the exclusive means ofidentifying such statements.

TheCompany cautions that a number of important factors could cause actual resultsto differ materially from the plans, objectives, expectations, estimates andintentions expressed in forward-looking statements made by the Company.These factors include:

·       therisks discussed in Item 1A of this report;

·       changesin capital requirements or other criteria of securities rating agenciesapplicable to financial guaranty insurers in general or to FSA specifically;

·       competitiveforces, including the conduct of other financial guaranty insurers in general;

·       changesin domestic or foreign laws or regulations applicable to the Company, itscompetitors or its clients;

·       changesin accounting principles or practices that may result in a decline insecuritization transactions or impact the Company’s reported financial results;

·       aneconomic downturn or other economic conditions (such as a rising interest rateenvironment) adversely affecting transactions insured by FSA or its InvestmentPortfolio;

·       inadequacyof reserves established by the Company for losses and loss adjustment expenses;

·       temporaryor permanent disruptions in cash flow on FSA-insured structured transactionsattributable to legal challenges to such structures;

·       downgradeor default of one or more of FSA’s reinsurers;

·       marketconditions, including the credit quality and market pricing of securitiesissued;

·       capacitylimitations that may impair investor appetite for FSA-insured obligations;

·       marketspreads and pricing on insured CDS exposures, which may result in gain or lossdue to mark-to-market accounting requirements;

·       prepaymentspeeds on FSA-insured asset-backed securities and other factors that mayinfluence the amount of installment premiums paid to FSA; and

·       otherfactors, most of which are beyond the Company’s control.

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The Company cautions thatthe foregoing list of important factors is not exhaustive. In any event, suchforward-looking statements made by the Company speak only as of the dateon which they are made, and the Company does not undertake any obligation to updateor revise such statements as a result of new information, future events orotherwise.

**Item 1A.**                RiskFactors.

The information containedin this report may contain “forward-looking statements” within the meaning of Section 27Aof the Securities Act and Section 21E of the Exchange Act. See “Item 1.  Business—Forward-Looking Statements” forimportant factors that could cause actual results to differ materially from theplans, objectives, expectations, estimates and intentions expressed in forward-lookingstatements made by the Company. The Company’s actual future results may differmaterially depending on a variety of factors including, but not limited to, therisks and uncertainties expressed below.

**Lossof FSA’s “Triple-A” ratings would impair its ability to originate new business.**

FSA’s ability to originatenew insurance business is based upon the perceived financial strength of FSA’sinsurance, which in turn is based in large part upon the financial strengthratings assigned to FSA by the major securities rating agencies. The ratingagencies base their ratings upon a number of objective and subjective factors. Creditdeterioration in FSA’s insured portfolio or changes to rating agency capitaladequacy requirements could impair FSA’s ratings. For a discussion of otherfactors that might impair FSA’s ratings, see “Item 1. Business—Rating Agencies.”  Most of the risk factors mentioned belowwould be expected to be considered by the rating agencies in assessing FSA’sfinancial strength.

**TheCompany’s loss reserves may prove inadequate.**

The Company’s insurancepolicies guarantee financial performance of obligations over specified periodsof time, in some cases over 30 years, and are generally non-cancellable. TheCompany projects expected deterioration and ultimate loss amounts based onhistorical experience in order to estimate probable loss. If an individualpolicy risk has a probable loss as of the balance sheet date, the Companyestablishes a case reserve. For the remaining policy risks in the portfolio,the Company establishes a non-specific reserve to account for inherentcredit losses. The establishment of these reserves is a systematic process thatconsiders quantitative and statistical information together with qualitativefactors, resulting in management’s best estimate of inherent losses associatedwith providing credit protection at a given date. However, the process isinherently uncertain, and the Company cannot assure that its reserves willprove adequate. If losses in its insured portfolio materially exceed theCompany’s loss reserves, it could have a material adverse effect on thefinancial ratings, results of operations and financial condition of the Company. For additional discussion of the Company’sreserve methodologies, see “Item 7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Results of Operations—Losses andLoss Adjustment Expenses.”

**TheCompany is exposed to large risks.**

FSA seeks to manageexposure to large single risks and concentrations of risks that may becorrelated through credit and legal underwriting, reinsurance and other riskmitigation measures. In addition, the securities rating agencies and insuranceregulations establish limits applicable to FSA on the size of risks andconcentrations of risks that it may insure. Given FSA’s capital base and thequality of risks that it insures, FSA may and has insured individual municipaland asset-backed risks well in excess of $1 billion. Should FSA’s riskassessments prove inaccurate and should the limits applicable to FSA proveinadequate, FSA could be exposed to larger than anticipated losses. While FSA has to date experiencedcatastrophic events (such as the terrorist attacks of September 11, 2001and the 2005 hurricane season) without material loss, unexpected catastrophicevents may have a material adverse effect upon FSA’s insured portfolio and/orits Investment Portfolio.

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**Increasedcompetition could reduce the Company’s new business originations.**

The Company’s insurancecompany subsidiaries face competition from uninsured executions in the capitalmarkets, other Triple-A rated monoline financial guaranty insurers, banks andother credit providers, including government-sponsored entities in themortgage-backed and multifamily sectors. During recent years, competitiveforces have put considerable downward pressure on premium levels that FSA hasbeen able to obtain, and has led FSA to decline to participate in manytransactions. Competitive pressures may lead a bond insurer to sacrificeadequate pricing or adequate credit protection in order to maintain marketshare. See “Item 1.  Business—Competitionand Industry Concentration.”

**Declinein prevailing interest rates could reduce demand or premiums for financialguaranty insurance.**

Demand for financialguaranty insurance generally reflects prevailing interest-rate levels. Wheninterest rates are lower, the spread between insured and uninsured obligationstypically narrows and, as a result, financial guaranty insurance typically provideslower cost savings to issuers than it would during periods of relatively widerspreads. These lower cost savings may lead to a corresponding decrease indemand or premiums obtainable for financial guaranty insurance.

**Increasein prevailing interest rates would result in a decline in the market value ofthe Company’s Investment Portfolio.**

As of December 31,2005, the Company’s Investment Portfolio was approximately $4.5 billiondollars, almost entirely invested in bonds, primarily municipal bonds. TheCompany’s investment strategy is to invest in highly rated marketableinstruments of intermediate average duration so as to generate stableinvestment earnings with minimal market value or credit risk. Nonetheless, anyincrease in prevailing interest rates would reduce the market value ofsecurities in the Company’s Investment Portfolio, which would in turn reducethe Company’s capital adequacy.

**Markingto market the Company’s insured CDS portfolio may subject the Company’sreported earnings to extreme volatility.**

The Company is required to mark to market certainderivatives, including FSA-insured CDS considered derivatives, under UnitedStates generally accepted accounting principles (“GAAP”). As a result of suchtreatment, and given the large principal balance of FSA’s insured CDSportfolio, small changes in the market pricing for insurance of CDS willgenerally result in recognition by the Company of material gains or losses,with material market price increases generally resulting in large reportedlosses under GAAP. In addition, any previously reported mark to market gains inrespect of FSA’s insured portfolio would be expected to be reversed through therecognition of losses over the remaining terms of the insured risks. AtDecember 31, 2005, the inception-to-date net gain on the Company’s insuredCDS portfolio was $57.7 million. While management believes that reported mark to market gains orlosses on insured CDS generally do not represent true economic gains or losses,certain constituents, including capital market participants, may rely uponreported GAAP results. As a result, the Company's access to capital marketsmight be impaired if its reporting earnings were considered unusually volatile.See “Item 7. Management’s Discussion and Analysis of Financial Conditionand Results of Operations—Results of Operations—Operating Earnings and AdjustedBook Value.”

**Changein industry accounting practices could impair the Company’s reported financialresults and impede its ability to do business.**

The SEC staff and the Financial Accounting StandardsBoard (the “FASB”) are evaluating various accounting standards applicable tofinancial guaranty insurers under GAAP, including accounting for claimsliability recognition, premium recognition and amortization of deferred policyacquisition costs. The Company and its industry peers will be required toimplement any changes to GAAP reporting requirements adopted by the SEC or theFASB. Any such changes may have an adverse effect on the 

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Company’s reportedfinancial results. In addition, accounting changes may impact reportedprofitability of new business originations or their impact upon reportedearnings during the terms of outstanding risks (so-called “earnings volatility”)and, as such, may influence the types and/or volume of business that managementmay chose to pursue.

**Changein applicable law could impede the Company’s ability to do business.**

The Company’s businessesare subject to direct and indirect regulation under, among other things, stateinsurance laws, federal securities law, the U.S. Bank Holding Company Act, taxlaw and legal precedents affecting municipal and asset-backed obligations, aswell as applicable law in the other countries in which the Company operates. Futurelegislative, regulatory or judicial changes in the U.S. or abroad couldadversely affect the Company’s business by, among other things, placing limitson the Company’s ability to carry out its non-insurance business, loweringapplicable single or aggregate risk limits, increasing the level of supervisionor regulation to which its operations may be subject, or creating restrictionsthat make the Company’s products less attractive to potential buyers. Foradditional information regarding the regulations to which the Company issubject, see “Item 1. Business—Insurance Regulatory Matters” and “—U.S. BankHolding Company Act.”

**Changein management personnel or share ownership may have an adverse effect on theCompany’s business.**

The Company’s seniormanagement plays an active role in its underwriting and business decisions. Inaddition, FSA and Dexia have worked together on numerous new business opportunities,and such close cooperation may diminish were Dexia no longer an owner of theCompany. Accordingly, a change in management or share ownership may have anadverse effect upon the Company’s business.

**Ratingagency action may impede growth in the Company’s FP business.**

Moody’s is in the processof evaluating the conduct of non-core business activities by financial guarantyinsurers. The Company’s FP Segment represents a growing and profitable segmentof the Company’s operations. Any action by Moody’s or another securities ratingagency to impede such business would have an adverse effect upon the Company.

**Lossesmay result from the ineffectiveness of hedges or unanticipated timing ofwithdrawals of funds in the Company’s FP Segment.**

The Company hedges interest-raterisks in its FP Segment by investing in floating-rate instruments and issuingfloating-rate liabilities, or by employing derivative products to obtain thesame economic result. Judgments are made in this process regarding the expectedtiming of withdrawals of funds under GICs and other financial products. TheCompany may be exposed to unexpected losses if its hedging strategy provesineffective or its judgments prove inaccurate.

**TheCompany’s ability to make debt service payments on its outstanding debt issubject to its insurance company operations.**

Because it is a holdingcompany, the registrant does not conduct operations or generate material income.Instead, the Company’s financial condition and results of operations, and thusits long-term ability to service its debt, will largely depend on its receiptof dividends from, or payment on surplus notes by, FSA. FSA’s ability todeclare and pay dividends to the Company depends, among other factors, upon FSA’sfinancial condition, results of operations, cash requirements, and compliancewith rating agency requirements for maintaining its Triple-A ratings, and isalso subject to restrictions contained in the applicable insurance laws andregulations. Based on FSA’s statutory statements for 2005, the maximum amountavailable for payment of dividends by FSA without regulatory approval over the12 months following December 31, 2005 is approximately$153.8 million.

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**Downgradeor default of one or more of the Company’s reinsurers could reduce the Company’scapital adequacy and return on equity.**

As of December 31,2005, the Company had reinsured approximately 26% of its principal amount ofinsurance outstanding. In evaluating the credits insured by the Company,securities rating agencies allow “credit” for reinsurance, based on thereinsurers’ ratings. In recent years, a number of the Company’s reinsurers weredowngraded by one or more rating agencies, resulting in decreases in the creditallowed for reinsurance and in the financial benefits of using reinsuranceunder existing rating agency capital adequacy models. By itself, a downgrade ofall reinsurers to Double-A would not impair the Company’s Triple-Aratings. However, it would reduce the “margin of safety” by which the Companywould survive a theoretical catastrophic depression, and a more significantdowngrade of the reinsurers could impair the Company’s Triple-A ratings. TheCompany could be required to raise additional capital to replace the lostreinsurance credit in order to meet capital adequacy requirements. The ratingagencies’ reduction in credit for reinsurance could also ultimately reduce theCompany’s return on equity to the extent that ceding commissions paid to theCompany by the reinsurers were not increased to compensate for such reduction. Forfurther information regarding the Company’s use of reinsurance, see “Item 1. Business—Reinsurance.”

**TheCompany’s international operations expose it to less predictable credit andlegal risks.**

The Company pursuesopportunities in international markets and currently operates in variouscountries in Europe, the Pacific Rim and Latin America. The underwriting ofobligations of an issuer in a foreign country involves the same process as thatfor a domestic issuer, but additional risks must be addressed, such as theevaluation of foreign currency exchange rates, foreign business and legalissues, and the economic and political environment of the foreign country orcountries in which an issuer does business. Changes in such factors couldimpede the Company’s ability to insure, or increase the risk of loss frominsuring, obligations in the countries in which it currently does business andlimit its ability to pursue business opportunities in other countries.

**Item1B.**               Unresolved StaffComments.

Item 1B is not applicableto the Company, because the Company is not an accelerated filer or largeaccelerated filer, as defined in Rule 12b-2 of the Exchange Act, ora well-known seasoned issuer, as defined in Rule 405 of the SecuritiesAct. For a discussion of SEC staff comments, see “Item 1.Business—Investments—Investments Insured by the Company.”

**Item 2.**                        Properties.

The principal executiveoffices of the Company and FSA are located at 31 West 52nd Street, New York,New York, 10019, and consist of approximately 110,000 square feet of officespace.

FSA or its subsidiariesalso maintain leased office space in San Francisco, Dallas, Hamilton (Bermuda),London (England), Madrid (Spain), Mexico City (Mexico), Paris (France),Singapore, Sydney (Australia) and Tokyo (Japan). The Company and itssubsidiaries do not own any material real property.

The Company’s telephonenumber at its principal executive offices is (212) 826-0100.

**Item 3.**                        LegalProceedings.

In the ordinary course ofbusiness, the Company and certain subsidiaries are parties to litigation. TheCompany is not subject to any material pending legal proceedings.

**Item4.**                        Submissionof Matters to a Vote of Security Holders.

On February 16, 2006,the Company’s shareholders executed a Written Consent of Shareholders underwhich they unanimously approved amendments to the Company’s 2004 EquityParticipation Plan.

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchaser of Equity Securities.

On July 5, 2000, the Company completed a mergerin which the Company became an indirect wholly owned subsidiary of Dexia, aBelgian corporation whose shares are traded in the Euronext Brussels andEuronext Paris markets as well as on the Luxembourg Stock Exchange. See “Item1. Business—Organization.” As a consequence of the merger, there is no longeran established public trading market for the Company’s common stock, and bidquotations are not reported or otherwise available.

As of March 15, 2006, the only holders of theCompany’s common stock were Dexia Holdings, an affiliate of White Mountains (amajor shareholder of the Company prior to the merger), and seven directors ofthe Company who own shares of the Company’s common stock or economic intereststherein as described in “Item 11. Executive Compensation—Director SharePurchase Program.”  Dexia is required torepurchase the shares of the Company held by White Mountain’s affiliate in May 2006.

The Company paid a dividend on its common stock of$0.17625 per share for each of the first two quarters of 2002, totaling$11.7 million in aggregate for 2002. During the third quarter of 2002, theCompany determined that it would suspend payment of dividends. The Companyresumed payment of regular quarterly dividends in May 2004, paying$22.9 million in aggregate for 2004 and $71.1 million in aggregatefor 2005. In February 2006, the Board of Directors declared a regularquarterly dividend on the Company’s common stock of $0.97 per share, totaling$32.5 million in aggregate, to be paid on or before March 30, 2006. Informationconcerning restrictions on the payment of dividends is set forth in “Item 1.Business—Insurance Regulatory Matters—Dividend Restrictions.”

Information aboutsecurities authorized for issuance under the Company’s equity compensationplans is set forth in “Item 12. Security Ownership of Certain Beneficial Ownersand Management and Related Stockholder Matters—Securities Available UnderEquity Compensation Plans.”

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**Item 6.   Selected Financial Data.**

The following SelectedConsolidated Financial Data should be read in conjunction with the ConsolidatedFinancial Statements and accompanying notes included elsewhere herein.

| ** **                                     | ** ** | **As of and for the Year Ended December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2005**                                                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                     | ** ** | **(in millions)**                                                                | ** ** |
| **SUMMARY OF OPERATIONS(a)**                   |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Gross premiums  written                        |       | $                                                                                     | 833.8      |   | $ | 832.0 |   | $ | 895.8 |   | $ | 803.7 |   | $ | 485.6 |   |
| Net premiums  written                          |       | 577.7                                                                                 |       | 587.8 |   | 614.3 |   | 532.7 |   | 319.6 |   |
| Net premiums  earned                           |       | 404.1                                                                                 |       | 395.0 |   | 356.4 |   | 314.9 |   | 231.0 |   |
| Net investment  income                         |       | 200.8                                                                                 |       | 172.1 |   | 154.0 |   | 139.1 |   | 128.9 |   |
| Net income                                     |       | 326.1                                                                                 |       | 378.6 |   | 298.1 |   | 197.0 |   | 205.7 |   |
| **BALANCE SHEET DATA(a)**                      |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Investment  portfolio(b)                       |       | 18,621.1                                                                              |       | 13,836.8 |   | 9,493.2 |   | 5,037.4 |   | 3,214.1 |   |
| Total assets(b)                                |       | 22,001.6                                                                              |       | 17,081.0 |   | 12,407.6 |   | 7,045.8 |   | 4,309.9 |   |
| Deferred premium  revenue                      |       | 2,375.1                                                                               |       | 2,095.4 |   | 1,845.0 |   | 1,448.2 |   | 1,095.0 |   |
| Losses and loss  adjustment expense            |       | 205.7                                                                                 |       | 179.9 |   | 233.4 |   | 223.6 |   | 114.4 |   |
| Notes payable                                  |       | 430.0                                                                                 |       | 430.0 |   | 430.0 |   | 430.0 |   | 330.0 |   |
| GIC and VIE  debt(b)                           |       | 14,947.1                                                                              |       | 10,444.1 |   | 6,639.4 |   | 2,409.9 |   | 601.8 |   |
| Common  shareholders’ equity              |       | 2,822.9                                                                               |       | 2,611.3 |   | 2,219.2 |   | 1,919.4 |   | 1,633.8 |   |
| **ADDITIONAL DATA**                            |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Qualified  statutory capital(c)                |       | 2,417.5                                                                               |       | 2,280.9 |   | 2,104.3 |   | 1,876.1 |   | 1,593.6 |   |
| Total claims-paying  resources(d)              |       | 5,675.8                                                                               |       | 5,230.6 |   | 4,657.7 |   | 3,819.1 |   | 3,217.3 |   |
| Net par  outstanding                           |       | 337,483.0                                                                             |       | 317,742.6 |   | 289,200.2 |   | 263,010.5 |   | 217,110.8 |   |
| Net insurance in  force (principal + interest) |       | 480,184.5                                                                             |       | 444,511.5 |   | 403,019.4 |   | 364,908.5 |   | 300,637.1 |   |
| Total dividends                                |       | 71.1                                                                                  |       | 22.9 |   | — |   | 11.7 |   | 31.1 |   |
|                                                |            |                                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(a)           Preparedin accordance with accounting principles generally accepted in the UnitedStates of America.

(b)          VIEbalances are included beginning July 1, 2003 due to the adoption ofFinancial Accounting Standards Board Interpretation No. 46, “Consolidationof Variable Interest Entities, an interpretation of ARB No. 51.”

(c)           Amountsare statutory data for FSA and therefore differ from comparable GAAP amounts.

(d)          Totalclaims-paying resources refers to a term used by Moody’s to evaluateadequacy of claims-paying resources and credit ratings. Moody’s uses itsjudgment in making adjustments to some of the measures. The Company provides theadjusted balances. This term represents the sum of statutory capital, statutoryunearned premium reserve, present value of future net installment premiums,statutory loss reserve, credit available under standby line of credit facilityand money market committed preferred trust securities.

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**Item7.   Management’s Discussion and Analysis of Financial Condition andResults of Operations.**

**Overview**

Management’s principal business objective is to growthe intrinsic value of the Company over the long term. To this end, it seeks toaccumulate an insured portfolio of conservatively underwritten municipal andasset-backed obligations and attractively priced guaranteed investmentcontracts (“GICs”), in order to produce a reliable, predictable earningsstream. Strategically, the Company seeks to maintain balanced capabilitiesacross domestic and international municipal and asset-backed markets inorder to allow the flexibility to pursue the most attractive opportunitiesavailable at any point in the business cycle. References to the “Company” areto Financial Security Assurance Holdings Ltd. together with its subsidiaries.

To reflect accurately how management evaluates theCompany’s operations and progress toward long-term goals, this discussionemploys both measures promulgated in accordance with accounting principlesgenerally accepted in the United States of America (GAAP measures) and measuresnot so promulgated (non-GAAP measures). Although the measures identifiedas non-GAAP in this discussion should not be considered substitutes forGAAP measures, management considers them key performance indicators and employsthem in determining compensation. Non-GAAP measures therefore provideinvestors with important information about the way management analyzes itsbusiness and rewards performance.

Comparing 2005 GAAP results with those of 2004, theCompany’s total revenues decreased 14.5% to $981.2 million, and net incomedecreased 13.9% to $326.1 million. Gross premiums written increased 0.2% to$833.8 million. Shareholders’ equity increased 8.1% to $2.8 billion.

**Results ofOperations**

***Premiums***

**NetEarned and Written Premiums**

| ** **                                                | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                | ** ** | **(in millions)**                     | ** ** |
| Premiums written, net of reinsurance                      |       | $                                          | 577.7      |   | $ | 587.8 |   | $ | 614.3 |   |
| Premiums earned, net of reinsurance                       |       | 404.1                                      |       | 395.0 |   | 356.4 |   |
| Net premiums  earned excluding refundings and prepayments |       | 349.8                                      |       | 350.6 |   | 324.9 |   |
|                                                           |            |                                            |            |  |  |  |  |  |  |  |

 

Net premiums earnedincreased 2.3% in 2005 and 10.8% in 2004. Excluding the effects of refundingsand prepayments, net premiums earned decreased 0.2% in 2005 and increased 7.9%in 2004. Refundings and prepayments result from interest-rate movementsand other factors outside the Company’s control, and no assurance can be giventhat refundings and prepayments will continue at the recent level. The recentslower growth rate in earned premiums is a function of the relatively highercontribution from U.S. municipal originations, which generally have longermaturities and therefore  slowerearnings, and a decline in asset-backed earned premiums.

***New BusinessProduction***

For each accounting period,the Company estimates the present value of originations (“PV originations”).This non-GAAP measure consists of the total present value of premiumsoriginated (“PV 

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premiumsoriginated”) by Financial Security Assurance Inc. and its subsidiaries (“FSA”)and the present value of net interest margin (“PV NIM”) originated by theCompany’s financial products (“FP”) business (the “FP Segment”). The Companygenerated PV originations of $1,014.0 million in 2005, $927.2 million in 2004and $894.6 million in 2003. Management believes that by disclosing thecomponents of PV originations in addition to premiums written, the Companyprovides investors with a more comprehensive description of its new businessactivity in a given period.

*Present Value of Premiums Originated*

The GAAP measure “grosspremiums written” captures premiums collected in a given period, whethercollected for business originated in the period, or in installments forbusiness originated in prior periods. It is not a precise measure of current-periodoriginations because a significant portion of the Company’s premiums arecollected in installments. Therefore, to measure current-period premiumproduction, management calculates the gross present value of premiuminstallments originated in the accounting period and combines it with premiumsreceived upfront in the accounting period, which produces the non-GAAPmeasure PV premiums originated.

The Company’s insurancepolicies and insured credit derivative contracts are generally non-cancelableand remain outstanding for years from date of inception, in some cases 30 yearsor longer. Accordingly, current-period premium production, as distinctfrom earned premium, represents premiums to be earned in the future.

Viewed at a policy level,installment premiums are generally calculated as a fixed premium ratemultiplied by the insured debt outstanding as of dates established by the termsof the policy. Because the actual installment premiums received could vary fromthe amount estimated at the time of origination based on variances in theactual outstanding debt balances as of the pre-established dates, therealization of PV premiums originated could be greater or less than the amountreported.

Installment premiums arenot recorded in the financial statements until due, which is a function of theterms of each insurance policy. Future installment premiums are not captured inpremiums earned or premiums written, the most comparable GAAP measures.Management therefore uses PV premiums originated to evaluate current businessproduction.

PV premiums originatedreflects estimated future installment premiums discounted to their presentvalue, as well as upfront premiums, but only for business originated during theperiod. To calculate PV premiums originated, management discounts an estimateof all future installment premium receipts. The Company calculates the discountrate for PV premiums originated as the average pre-tax yield on itsinsurance investment portfolio for the previous three years. This rate servesas a proxy for the return that could be achieved if the premiums had beenreceived upfront. The estimated installment premium receipts are determinedbased on each installment policy’s projected par balances outstandingmultiplied by its premium rate. The Company’s Transaction Oversight Groupsestimate the relevant schedule of future par balances outstanding for eachinsurance policy with installment premiums. At the time of origination,projected debt schedules are generally based on good faith estimates developedand used by the parties negotiating the transaction.

Year-to-yearcomparisons of PV premiums originated are affected by the application of adifferent discount rate each year. The discount rate employed by the Companyfor this purpose was 5.30% for 2005 originations, 5.62% for 2004 originationsand 5.91% for 2003 originations. Management intends to revise the discount ratein future years according to the same methodology, in order to reflect specificreturn results realized by the Company.

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**Reconciliationof Gross Premiums Written to Non-GAAP PV Premiums Originated**

| ** **                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                   | ** ** | **(in millions)**                     | ** ** |
| Gross premiums written                       |       | $                                          | 833.8      |   | $ | 832.0 |   | $ | 895.8 |   |
| Gross installment premiums received          |       | (348.6                                     | )          | (332.4 | ) | (345.2 | ) |
| Gross upfront premiums originated            |       | 485.2                                      |       | 499.6 |   | 550.6 |   |
| PV estimated installment premiums originated |       | 436.2                                      |       | 353.9 |   | 299.9 |   |
| PV premiums  originated                      |       | $                                          | 921.4      |   | $ | 853.5 |   | $ | 850.5 |   |

 

*Financial Guaranty Insurance Originations*

Unless otherwise noted,percentage changes in this discussion and analysis compare the period namedwith the comparable period of the prior year.

The tables below show thePV premiums originated and gross par amount insured by FSA in its three majorbusiness sectors for transactions closed in the period.

**U.S.Municipal New Originations**

| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Gross par insured  (in billions)            |       | $                                          | 64.8       |   | $ | 49.0 |   | $ | 54.9 |   |
| Gross PV premiums  originated (in millions) |       | 484.5                                      |       | 433.5 |   | 483.1 |   |
|                                             |            |                                            |            |  |  |  |  |  |  |  |

 

Driven by steady new-money issuance and high levels ofrefundings, the U.S. municipal new-issue market reached approximately $408.4billion in 2005, on a sale-date basis, a 13.4% increase from $360.1 billion in2004 and a 6.4% increase from the record level of $383.7 billion in 2003.Insurance penetration was approximately 56%, compared with 54% in 2004 and 50%in 2003. In all three years, low interest rates, strong demand for refundingsand continuing needs for infrastructure investment drove high levels ofmunicipal borrowing. Of the insured par amount of municipal bonds sold eachyear, FSA guaranteed approximately 26% in 2005, 24% in 2004 and 27% in 2003.

Including both primary andsecondary U.S. municipal obligations with closing dates in 2005, FSA’s U.S.municipal par originated increased 32.3%, and the related PV premiumsoriginated increased 11.8%. In 2005, the mix of business shifted toward agreater volume of general obligations, including school bonds, and othertax-backed transactions that tend to have lower absolute premiums than revenuebonds because of their lower risk. In 2004, FSA’s U.S. municipal par originateddeclined 10.7%, and the related PV premiums originated declined 10.3%. FSAincreased its PV premiums originated in the health care revenue and generalobligation sectors during 2004, but those increases were offset by declines inthe non-general obligation tax-supported sector and various revenue-backedsectors.

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**U.S.Asset-Backed New Originations**

| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Gross par insured (in  billions)            |       | $                                          | 24.5       |   | $ | 48.6 |   | $ | 15.6 |   |
| Gross PV premiums  originated (in millions) |       | 195.4                                      |       | 234.2 |   | 177.6 |   |
|                                             |            |                                            |            |  |  |  |  |  |  |  |

 

The Company’s U.S. asset-backedgross par insured decreased 49.7% in 2005 and rose 211% in 2004. The Company’sassociated PV premiums originated decreased 16.6% in 2005 and rose 31.9% in2004. In 2005, PV premiums originated declined less than par originateddue to a shift toward longer duration transactions in the mix of business.Declines in PV premiums from high-premium net interest margin mortgage-backedtransactions, which are generally designed to securitize excess cash flowgenerated by an issuer’s residential mortgage loan securitizations, and otherresidential mortgage transactions represented most of the decrease in PVpremiums originated. Consumer finance and CDO PV premiums originated increased.In 2004, PV premiums originated did not grow as much as par insured becausemost of the growth in par volume came from pooled corporate and residentialmortgage transactions of Triple-A underlying credit quality. Such high-qualitytransactions tend to have relatively low premium rates but tend to achieve goodreturns on equity.

**InternationalNew Originations**

| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Gross par insured  (in billions)            |       | $                                          | 14.1       |   | $ | 10.2 |   | $ | 10.3 |   |
| Gross PV premiums  originated (in millions) |       | 241.5                                      |       | 185.8 |   | 189.8 |   |
|                                             |            |                                            |            |  |  |  |  |  |  |  |

 

Full-yearinternational par insured for 2005 increased 37.9% and international PV premiumoriginations increased 30.0%. In 2005, public infrastructure provided thegreatest share of PV premiums, as tight spreads constrained the internationalasset-backed business.****Full-yearinternational par insured for 2004 approximated that of the prior year, andinternational PV premium originations decreased 2.1%. PV premiums for internationaloriginations are translated into U.S. dollars using month-end currencyexchange rates. Actual premiums received could differ from this amount due toexchange-rate fluctuations.

*Financial ProductsOriginations*

The FP Segment, in which the Company conducts businessthrough affiliates (the “GIC Affiliates”), produces net interest margin (“FPNIM”) rather than insurance premiums. Like installment premiums, the PV NIMoriginated is expected to be earned and collected in future periods.

GICs are issued at or converted into LIBOR-basedfloating-rate obligations, with proceeds invested in or converted into LIBOR-basedfloating-rate investments intended to result in profits from a higherinvestment rate than borrowing rate. The difference between the current-yearinvestment revenue and borrowing cost is the FP NIM.

The non-GAAP measure PV NIM represents the differencebetween the present value of estimated interest to be received on theinvestments and the present value of estimated interest to be paid onliabilities issued in the form of GICs, net of the expected results ofderivatives used to hedge interest-rate risk. The Company’s future positiveinterest-rate spread can be reasonably estimated and generally relates tocontracts or security instruments that extend for multiple years.

Net interest income and net interest expense arereflected in the statements of operations and comprehensive income but arelimited to current-year earnings. As GIC contracts extend beyond thecurrent period, management considers the non-GAAP measure PV NIM to be auseful indicator of future 

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FP NIM to be earned andincludes it in the non-GAAP measure adjusted book value (“ABV”) as an elementof intrinsic value that is not found in GAAP book value.

The majority of municipal GICs issued by the GICAffiliates relate to debt service reserve funds and construction funds insupport of municipal bond transactions. These funds may be drawn unexpectedly,with the result that the actual timing and amount of repayments may differ fromthe original estimates, which in turn would affect the realization of theestimate of PV NIM originated in a given accounting period.

PV outstanding is the sumof cumulative years’ reported PV premiums originated and PV NIM originated,less what has been earned or adjusted due to changes in estimates as describedabove. Installment payment contracts, whether in the form of premiums or NIM,are generally non-cancelable by the Company and represent a claim to futurecash flows. Therefore, management includes these amounts in its estimate ofABV.

**FinancialProducts PV NIM Originated**

| ** **                                                    | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                    | ** ** | **(in millions)**                     | ** ** |
| Gross present  value of future net interest margin originated |       | $                                          | 92.6       |   | $ | 73.7 |   | $ | 44.1 |   |
|                                                               |            |                                            |            |  |  |  |  |  |  |  |

 

PV NIM originatedincreased 25.6% in 2005 as the book of business increased. Throughout 2005, theCompany generally took a cautious approach to asset acquisitions because of thenarrow spread environment, although it did find some long-dated purchasing opportunities.The growth in the book of business is largely a function of increased GICissuance activity in both municipal and structured GICs. In 2004, PV NIMoriginated increased 67.1%.

***Operating Earnings and Adjusted Book Value***

In addition to evaluating the Company’s GAAP financialinformation, management evaluates the Company’s business under certain non-GAAPperformance measures that management refers to as operating earnings and ABV.Management uses these two metrics to measure the Company’s performance and tocalculate long-term incentive compensation and the annual bonus pool.Management refers to this information in its presentations with rating agenciesand the Board of Directors. While these metrics are not substitutes forreported results under GAAP, management regards operating earnings and ABV asmeaningful indicators of operational performance that supplement theinformation available from GAAP measures. While GAAP provides a uniformcomprehensive basis of accounting, management believes that operating earningsare an important additional measure for providing a more complete understandingof the Company’s results of operations.

The Company definesoperating earnings as net income before the effects of fair-value adjustmentsfor two items:

1.                Interest-ratederivatives that are intended to hedge fixed-rate assets and liabilities but donot meet the criteria for hedge accounting treatment under Statement ofFinancial Accounting Standards No. 133, “Accounting for DerivativeInstruments and Hedging Activities” (“SFAS 133”) (“economic interest-ratehedges”); and

2.                FSA-insured creditdefault swaps (“CDS”) that have investment-grade underlying credit quality andthat must be marked to fair value under SFAS 133.

Periodic unrealized gains and losses related toeconomic interest-rate hedges arise in both the financial guaranty andfinancial products business segments, caused primarily by the one-sidedmark-to-

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market derivativevaluations prescribed by SFAS 133 for derivatives that do not qualify for “hedge-accountingtreatment” under GAAP. Under the Company’s definition of operating earnings,the economic effect of these hedges is recognized, which, for interest rateswaps, generally results in any cash paid or received being recognized ratablyas an expense or revenue over the hedged item’s life. Futures contracts used tohedge interest-rate risk include both the embedded current net interest paid orreceived, as well as the value of the future net interest cash flow. Therefore,to reflect the equivalent of any cash paid or received being recognized ratablyas an expense or revenue over the hedged item’s life, the current interestaccretion amount embedded in the mark-to-market value of open futures positionsis added back to operating earnings.

CDS contracts are generally non-cancelable prior tomaturity, and the Company views insured CDS risks as comparable to otherinsured risks. In a typical CDS transaction, the Company, in exchange for anupfront or periodic premium, indemnifies the insured party for economic losses(in excess of some agreed-upon deductible) related to debt obligations ofspecified obligors, structured such that the risk insured is investment gradewithout the benefit of the credit protection provided by the Company. In theevent a CDS were to migrate below investment grade, the fair-value impact wouldbe fully reflected in operating earnings.

Operating earnings are subject to certain general andspecific limitations that investors should carefully consider. For example, asstated above, unlike financial accounting, there is no comprehensive,authoritative guidance for management reporting. The Company’s operatingearnings are not defined terms within GAAP and may not be comparable tosimilarly titled measures reported by other companies. Unlike GAAP, the Company’soperating earnings presentation does not represent a comprehensive basis ofaccounting. Investors, therefore, should not compare the Company’s performancewith that of other financial guaranty companies based upon operating earnings. Operatingearnings results are only meant to supplement GAAP results by providingadditional information regarding the operational and performance indicatorsthat are most closely used by management, the Company’s Board of Directors andrating agencies to assess performance.

Other limitations arise from the specific adjustmentsthat management makes to GAAP results to derive operating earnings results. Forexample, in reversing the unrealized gains and losses that result fromapplication of SFAS 133 to derivatives that do not qualify for hedgeaccounting, management focuses on the long-term economic effectiveness of thoseinstruments relative to the underlying hedged item and isolates the effects ofinterest-rate volatility and changing credit spreads on the fair value of suchinstruments during the period. Under GAAP, the effects of these factors on thefair value of the derivative instruments (but not the underlying hedged item)tend to show more volatility in the short term. While the Company believes thatits presentation presents the economic substance of its FP Segment and thebusiness of FSA Global Funding Limited (“FSA Global”), a variable interestentity (“VIE”) whose results are consolidated with those of the Company, thepresentation understates GAAP earnings volatility.

Operating earnings also do not reflect earningsvariability related to CDS fair-value adjustments. A significant percentage ofthe Company’s CDS exposures subject to fair-value adjustments areconsidered Triple-A or Super Triple-A (defined as credit qualitybased on loss protection greater than 1.3 times the Triple-Astandard), and the Company does not intend to trade these highly rated, highlystructured contracts. Accordingly, management believes it is probable that thefinancial impact of the fair-value adjustments for the insured CDS willsum to zero over the finite terms of the exposures, which are typically five toten years at inception. For this reason, management believes that the marketvolatility of credit-spread pricing, the primary driver of the Company’schange in fair-value results, should not influence a measure of theCompany’s operating performance and therefore excludes CDS fair-valueadjustments from operating earnings.

Operating earnings increased 3.1% in 2005 and 22.8% in2004.

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The following tablereconciles net income to non-GAAP operating earnings for the years addressed:

**Reconciliationof Net Income to Non-GAAP Operating Earnings**

| ** **                                                                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                      | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                      | ** ** | **(in millions)**                     | ** ** |
| Net income                                                                      |       | $                                          | 326.1      |   | $ | 378.6 |   | $ | 298.1 |   |
| Less fair-value adjustments for economic  interest-rate hedges, net of taxes(1) |       | (15.0                                      | )          | 17.1 |   | 9.3 |   |
| Less fair-value adjustments for insured CDS,  net of taxes                      |       | 7.2                                        |       | 37.7 |   | 23.4 |   |
| Operating  earnings                                                             |       | $                                          | 333.9      |   | $ | 323.8 |   | $ | 265.4 |   |

 

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(1)          See following table fora more detailed presentation of fair-value adjustments for economicinterest-rate hedges.

**Fair-ValueAdjustments for Economic Interest-Rate Hedges**

| ** **                                                                     | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                     | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                     | ** ** | **(in millions)**                     | ** ** |
| Fair-value adjustment for economic interest-rate  hedges—FP Segment  |       | $                                          | (24.7      | ) | $ | (6.4 | ) | $ | 2.0 |   |
| Fair-value adjustment for economic interest-rate  hedges—VIEs             |       | 5.7                                        |       | 112.9 |   | 42.5 |   |
| VIE minority interest                                                          |       | (4.1                                       | )          | (80.2 | ) | (30.2 | ) |
| Tax effect                                                                     |       | 8.1                                        |       | (9.2 | ) | (5.0 | ) |
| Total fair-value  adjustments for economic interest-rate hedges                |       | $                                          | (15.0      | ) | $ | 17.1 |   | $ | 9.3 |   |

 

***Adjusted Book Value***

To calculate ABV, the following adjustments, on anafter-tax basis, are made to shareholders’ equity (GAAP “book value”):

1.                addition ofunearned premium revenues, net of amounts ceded to reinsurers;

2.                addition of thepresent value of future installment premiums, net of amounts ceded toreinsurers;

3.                addition of thepresent value of future net interest margin;

4.                subtraction of thedeferred costs of acquiring policies;

5.                elimination of theeffect of fair-value adjustments for insured CDS;

6.                elimination of thefair-value adjustments for economic interest-rate hedges; and

7.                elimination ofunrealized gains or losses on investments.

Management considers ABV an operating measure of theCompany’s intrinsic value. Book value reflects an estimate of loss for allinsured risks made at the time of contract origination. ABV adds back certainGAAP liabilities and deducts certain GAAP assets (adjustments 1, 4, 5, 6 and 7in the calculation above), and captures the estimated value of futurecontractual cash flows related to transactions in force as of the balance sheetdate (adjustments 2 and 3 in the calculation above) because installment paymentcontracts, whether in the form of premiums or NIM, are generally non-cancelableand represent a claim to future cash flows. An investor attempting to evaluatethe Company using GAAP measures alone would not have the benefit of thisinformation. In addition, investors may consider the growth of ABV to be aperformance measure indicating the degree to which management has succeeded inbuilding a reliable 

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source of future earnings.Certain of the Company’s compensation formulas are based, in part, on the ABVgrowth rate.

The limitations of the ABV metric are that it reflectsthe accelerated realization of certain assets and liabilities through equityand relies on an estimate of the amount and timing of the receipt ofinstallment premiums and future net interest margin. Actual installment premiumreceipts could vary from the amount estimated due to differences between actualand estimated insured debt balances outstanding. Actual net interest marginresults could vary from the amount estimated based on sales of investmentsprior to maturity and variances in the actual timing and amount of repaymentassociated with flexible-draw GICs that the Company issues. ABV excludesthe fair-value adjustments of investment-grade insured CDS and thefair-value adjustments of derivatives that hedge interest-rate risk but do notqualify for hedge accounting under SFAS 133.

Adjustments 1, 2 and 3 above represent the sum ofcumulative years’ reported PV premiums originated and PV NIM originated, lesswhat has been earned or adjusted due to changes in estimates as describedabove. Adjustments 1 and 2 in the calculation of ABV together representunearned premiums that have been collected and the Company’s best estimate ofthe present value of its future premium revenues (comprising current- andprior-period originations that have not yet been earned). Debt schedulesrelated to installment transactions change from time to time. Criticalassumptions underlying adjustment 2 are discussed above under “New BusinessProduction—Financial Guaranty Insurance Originations.”

As discussed above under “New Business Production—FinancialProducts Originations,” the Company calculates PV NIM originated (adjustment 3)because net interest income and net interest expense reflected in thestatements of operations and comprehensive income are limited to current-yearearnings. The Company’s future positive interest-rate spread from outstandingGIC business can be estimated and generally relates to contracts or securityinstruments that extend for multiple years. Management therefore includes it inABV as another element of intrinsic value not found in GAAP book value.

Adjustment 4 reflects the realization in equity ofdeferred costs associated with the origination of premiums.

Through adjustments 5 and 6, the effect of certainitems that are excluded from operating earnings are also excluded from ABV. Asexplained in the preceding discussion of operating earnings, management expectsthe financial impact of the CDS fair-value adjustments, reflected inadjustment 5, to sum to zero over the finite terms of the related exposures.Derivatives reflected in adjustment 6 reduce, on an economic basis, theinterest-rate risk of fixed-rate assets and liabilities held in the FP Segmentand FSA Global portfolios, although they do not meet SFAS 133 hedge-accountingrequirements. The Company uses such derivatives to hedge against interest-ratevolatility, rather than to speculate on the direction of interest rates. Theintent of management is to hold the derivatives to expected maturity along withthe related hedged fixed-rate assets or liabilities. In addition, throughadjustment 7, ABV excludes the effect of fair-value adjustments made toinvestments and reflected in other comprehensive income. As the objective is tooptimize long-term stable earnings, management generally seeks to minimizeturnover and therefore any unrealized investment gain or loss is subtractedfrom book value to exclude it from the ABV metric. In the event that aninvestment is liquidated prior to its maturity, any related gain or loss isreflected in both earnings and ABV without further adjustment.

Shareholders’ equity was $2.8 billion and non-GAAPABV was $3.9 billion at December 31, 2005. During 2005, ABV grew 14.0%.

The following tablereconciles book value to non-GAAP ABV for the years presented:

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**Reconciliationof Book Value to Non-GAAP Adjusted Book Value**

| ** **                                                        | ** ** | **As of December 31,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                        | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                                                        | ** ** | **(in millions)**                | ** ** |
| Shareholders’  equity (book value)                           |       | $                                     | 2,822.9    |   | $ | 2,611.3 |   |
| After-tax  adjustments:                                           |       |                                  |       |   |   |
| Plus net unearned premium revenues                                |       | 981.4                                 |       | 868.6 |   |
| Plus present value of net future installment  premiums and PV NIM |       | 556.0                                 |       | 497.3 |   |
| Less net deferred acquisition costs                               |       | 217.8                                 |       | 200.3 |   |
| Less fair-value adjustments for insured CDS                       |       | 37.4                                  |       | 31.4 |   |
| Less fair-value of economic interest-rate hedges                  |       | 20.8                                  |       | 36.1 |   |
| Less unrealized  gains on investments                             |       | 156.2                                 |       | 199.8 |   |
| Adjusted book  value                                              |       | $                                     | 3,928.1    |   | $ | 3,509.6 |   |

 

***Net Investment Income and Realized Gains***

Net investment incomeincreased 16.7% in 2005 and 11.7% in 2004, primarily due to higher investedbalances arising from new business writings and dividend income from theCompany’s equity investment in XL Financial Assurance Ltd (“XLFA”).

**Income fromInvestments**

| ** **                                                                                                              | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                              | ** ** | **(in millions)**                     | ** ** |
| Net investment  income                                                                                                  |       | $                                          | 200.8      |   | $ | 172.1 |   | $ | 154.0 |   |
| Net realized  gains (losses)                                                                                            |       | 8.3                                        |       | (0.5 | ) | 5.1 |   |
| Effective tax rate on  investment income excluding effects of realized gains and losses and variable  interest entities |       | 13.3                                       | %          | 9.2 | % | 9.2 | % |
|                                                                                                                         |            |                                            |            |  |  |  |  |  |  |  |

 

Realized gains and lossesare generally a by-product of the normal investment management processand may vary substantially from period to period.

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**Losses and Loss Adjustment Expenses**

Theprovision for losses and loss adjustment expenses was $25.4 million in 2005, $20.6 millionin 2004 and  $34.5 million in 2003.Activity in the liability for losses and loss adjustment expenses, whichconsists of case and non-specific reserves, is summarized as follows:

| ** **                            | ** ** | **Case Reserve Activity for the  Year Ended December 31,** | ** ** |
|---------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **2005**                                                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | **(in millions)**                                                              | ** ** |
| Gross balance at  January 1      |       | $                                                                                   | 80.6       |   | $ | 121.9 |   | $ | 134.0 |   |
| Less reinsurance recoverable          |       | 35.4                                                                                |       | 59.2 |   | 76.0 |   |
| Net balance at  January 1        |       | 45.2                                                                                |       | 62.7 |   | 58.0 |   |
| Transfer from non-specific  reserve   |       | 10.3                                                                                |       | 30.7 |   | 12.7 |   |
| Restructured transactions             |       | —                                                                              |       | (13.9 | ) | (2.2 | ) |
| Paid (net of  recoveries) related to: |       |                                                                                |       |   |   |   |   |
| Current year                          |       | —                                                                              |       | — |   | — |   |
| Prior year                            |       | (2.0                                                                                | )          | (34.3 | ) | (5.8 | ) |
| Total paid                            |       | (2.0                                                                                | )          | (34.3 | ) | (5.8 | ) |
| Net balance at  December 31      |       | 53.5                                                                                |       | 45.2 |   | 62.7 |   |
| Plus reinsurance recoverable          |       | 36.3                                                                                |       | 35.4 |   | 59.2 |   |
| Gross balance at  December 31    |       | $                                                                                   | 89.8       |   | $ | 80.6 |   | $ | 121.9 |   |

 

| ** **                            | ** ** | **Non-Specific Reserve  Activity for the  Year Ended December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **2005**                                                                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | **(in millions)**                                                                            | ** ** |
| Balance at  January 1            |       | $                                                                                                 | 99.3       |   | $ | 111.5 |   | $ | 89.7 |   |
| Provision for  losses                 |       |                                                                                              |       |   |   |   |   |
| Current year                          |       | 20.4                                                                                              |       | 20.4 |   | 22.4 |   |
| Prior year                            |       | 5.0                                                                                               |       | 0.2 |   | 12.1 |   |
| Transfers to case  reserves           |       | (10.3                                                                                             | )          | (30.7 | ) | (12.7 | ) |
| Restructured transactions             |       | 1.5                                                                                               |       | (2.1 | ) | — |   |
| Balance at  December 31          |       | 115.9                                                                                             |       | 99.3 |   | 111.5 |   |
| Total case and non-specific  reserves |       | $                                                                                                 | 205.7      |   | $ | 179.9 |   | $ | 233.4 |   |

 

The gross and net par amounts outstanding ontransactions with case reserves were $612.7 million and $519.5 million,respectively, at December 31, 2005. Net case reserves consisted primarilyof seven CDO transactions and one municipal transaction, which collectivelyaccounted for approximately 94% of the total net case reserve. The remaining 11exposures were in various sectors.

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Case and non-specificreserves for losses and loss adjustment expenses are discounted whenestablished using the risk-free rate appropriate for the term of theinsured obligation at the time the reserve is established.

During 2005, the Companycharged $25.4 million to loss expense, consisting of $20.4 million fororiginations of new business and $5.0 million related to accretion on thereserve for in-force business. Case reserves increased $8.3 million,primarily due to******deterioration of specificCDO risks. See Note 16 to the Consolidated Financial Statements inItem 8.

During 2004, the Companycharged $20.6 million to loss expense, consisting of $20.4 millionfor originations of new business, $4.6 million for accretion related toprior-year reserves and $3.2 million related to reassumptions ofpreviously ceded business, partially offset by reserve releases, which wereprimarily related to favorable experience in the CDO portfolio. The non-specificreserve decreased $12.2 million in 2004, primarily due to transfers fromthe non-specific reserve to case reserves of $30.7 million,partially offset by loss expense of $20.6 million. Case reserves decreased$17.5 million due to a large, voluntarily accelerated transactionthat had a $34.3 million payment and to reclassifications of $13.9 millionfrom reserves to asset valuation accounts for refinanced transactions,partially offset by transfers from the non-specific reserve of$30.7 million. See Note 22 to the Consolidated Financial Statementsin Item 8.

Since case and non-specificreserves are based on estimates, there can be no assurance that the ultimateliability will not differ from such estimates. The Company will continue, on anongoing basis, to monitor these reserves and may periodically adjust suchreserves, upward or downward, based on the Company’s revised estimate of loss,actual loss experience, its mix of business and economic conditions.

Thetable below presents the significant assumptions inherent in the calculationsof the case and non-specific reserves:

| ** **                          | ** ** | **As of December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Case reserve  discount rate         |       | 3.13%–5.90                       | %          | 3.13%–5.90 | % |
| Non-specific  reserve discount rate |       | 1.20%–7.95                       | %          | 1.20%–7.95 | % |
| Current experience  factor          |       | 1.8                                   |       | 2.0 |   |

 

The primary estimatesaffecting the statistical calculation are probability of default and severityof loss given default. The Company applies its experience factor to thestatistical calculation to reflect actual loss experience in terms of bothfrequency and severity. Historically, defaults on guaranteed obligations havebeen infrequent, but the size of resulting claims have varied widely due toboth the differing sizes of the obligations guaranteed and the significantvariability of the severity experienced. Severity represents the magnitude ofloss, which is calculated as claims paid minus total recoveries, expressed as apercentage of par guaranteed. Recoveries include salvage value of assets andamounts due from reinsurers. Actual claim frequency and severity experience mayevolve over time, affected by many factors, including changes in the insuredportfolio’s distribution across sectors and underlying ratings, as well aschanges in the economy and the political environment. The Company’s lossreserving methodology is designed to reflect these factors. Changes in thesectors and underlying credit quality of the transactions are captured in theformula directly, while changes in the economy and political environment arecaptured in the experience factor.

Given the broaddiversification of FSA’s insured portfolio, management believes that asignificant shift in overall portfolio quality is unlikely to occur except in acatastrophic economic environment. It is therefore necessary to look atparticular sectors when examining the sensitivity of the insured portfolio tochanges in underlying loss assumptions. Management believes that differentanalyses are required for the two broad sectors of the insured portfolio, asset-backedobligations and municipal credits.

Asset-backedobligations insured by FSA are secured by pools of assets. While the assets ina given transaction are generally of one type (such as automobile loans,residential mortgage loans, etc.), they are 

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diversifiedwithin that asset type. Due to characteristically low default frequency, losseson insured asset-backed transactions have been manageable, in management’sview, despite variability.

Management believesseverity is not the primary determinant of possible loss in a portfolio ofinsured asset-backed obligations. Since introducing a non-specificreserve in 1993, actual aggregate losses have been reasonably consistent with management’sexpectation in the majority of asset-backed categories, including insuredobligations collateralized by automobile loan or residential mortgage debt ofnon-prime borrowers. The one exception involved senior bonds issued in1998 and 1999 in connection with structured CDOs. In such a structure, thebonds insured by FSA are in second-loss positions, meaning that there areuninsured, subordinate bondholders or equity investors who must lose all oftheir investment outstanding at the time of default or earlier trigger eventbefore the FSA-insured bonds become subject to loss. These transactionswere structured to FSA’s requirement that the first-loss position provideFSA an investment-grade level of protection. The underlying assetssupporting the insured obligations were pools of corporate bonds individuallyrated below investment grade. In this structure, multiple credits must failbefore claims are triggered. In 2002, credit quality deteriorated across abroad spectrum of the corporate market, which led to projected claims on thesetransactions and charges to FSA’s statements of operations and comprehensiveincome, as well as an increase in the Company’s loss experience rate. Yet, evenunder this unprecedented stress scenario, the severity of the largest singleloss was relatively modest.

Accordingly, managementconsiders default frequency the relevant factor driving adverse loss experiencein the asset-backed sector and believes that a reasonably possibleadverse change in default frequencies would not result in a material adverseadjustment to the non-specific loss reserve.

Current asset-backedcase reserves could vary from the current estimate of loss. In particular, thedeterministic model used to determine case reserves for CDO transactions utilizesaverage cumulative default rates produced by a Monte Carlo simulation andapplies those defaults to a cash flow model. While CDO exposures are affectedby multiple variables, including default rates, collateral recovery rates,changes in interest rate movements and the prepayment speeds of the collateral,management believes default frequency is the key determinant of loss. Holdingall other variables constant and assuming only that the CDO’s underlyingcorporate debt instruments were to default at a higher rate than the MonteCarlo average default rate, actual losses would exceed the current estimate.Applying a higher frequency of default, observed at the 90% confidence level,would result in additional present-value loss of $15 million.

Management believes that amaterial adverse change to the loss estimate in its municipal risk sectors,excluding the health care category, would not occur under any reasonablypossible scenario. While the Company has not experienced a loss in the healthcare sector, the potential severity of health care losses is comparativelyhigh. Hospital facilities are single-purpose assets and a failing healthcare issuer is likely to be liquidated or acquired. If there is collateralassociated with a health care credit, it is generally in the form of a hospitalfacility, the value of which is primarily driven by the community’s need forthat facility. The more hospitals competing in a community, the more fragilethe value of the hospital collateral is likely to be in a stress scenario. FSAaddresses the severity risk in this sector through internal policies that limitexposure to any single credit.

In a Standard &Poor’s Ratings Services (“S&P”) scenario analysis, S&P assumed 75% lossseverity for health care credits, which means that a loss would equal 75% ofpar insured. If losses of this severity occurred in the lowest rated hospitalexposure in FSA’s insured portfolio, the loss would be as much as $35.5 millionon a pre-tax basis, net of reinsurance.

A material adverse changefrom management’s current estimate of loss for municipal transactions with casereserves is considered unlikely because the only such case reserve is set nearthe full policy amount.

FSA management believesthat the liability it carries for losses and loss expenses is adequate to coverthe net cost of claims. However, the loss liability is based on assumptionsregarding the insured portfolio’s 

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probabilityof default and its severity of loss and there can be no assurance that theliability for losses will not exceed such estimates.

The sensitivitiesdescribed above are hypothetical and should be used with caution. The effect ofvariation in a particular assumption is calculated without changing any otherassumption; in reality, changes in one factor may result in, or be accompaniedby, changes in another, which might magnify or counteract the sensitivities.

The Company is aware thatthere are differences regarding the method of measurement of the non-specificreserve among participants in the financial guaranty industry. Other financialguarantors may not establish a non-specific reserve in the manner describedabove, may call their non-specific reserve by a different name, such as,but not limited to “unallocated losses,” “active credit reserves” and “portfolioreserves,” or may use different statistical techniques from those the Companyuses to determine loss at a given point in time. Management and the industryexpect accounting literature specific to the financial guaranty industry toevolve; however, management cannot predict or estimate the scope of theguidance or potential impact on the Company’s financial statements at thistime. See Note 2 to the Consolidated Financial Statements in Item 8.

At December 31,2005, the reinsurance recoverable on unpaid losses from reinsurers and cededpar outstanding, by S&P rating levels, were as follows:

| **Reinsurer’s S&P Rating** | ** ** | ** **             | ** ** | **Reinsurance  Recoverable** | ** ** | **Ceded Par  Outstanding** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **(in millions)** | ** ** |
| AAA                                           |       |                   | $          | 1.2                          |       |                            | $          | 21,394.8 |   |
| AA                                            |       |                   | 34.8       |                         |       | 85,941.9                        |       |
| A** **                                   |       |                   | 0.3        |                         |       | 13,270.8                        |       |
| Total                                         |       |                   | $          | 36.3                         |       |                            | $          | 120,607.5 |   |

 

***Impact of Hurricane***s

The Company evaluated itsinsured portfolio to assess the potential impact of Hurricanes Katrina, Ritaand Wilma, which occurred in 2005. The Company records a non-specific reserveto reflect the credit risks inherent in its portfolio. Together, thenon-specific reserve and case reserves represent the Company’s estimate oftotal loss liability. The Company believes that its total loss liability isadequate given the current information. Generally, when an insured creditdeteriorates to a point where unreimbursed claims are expected, a case reserveis established.

As of March 24, 2006,FSA had not received notice of payment default on any exposures related toHurricanes Katrina, Rita or Wilma. To date, based on the Company’s review ofits exposure, 11 credits, with aggregate net par exposure of $215.8 million,have the most significant risk of loss. FSA-insured bonds are protected byvarious sources of support that would be invoked before FSA would incur losses.These sources include access to pledged taxes or revenues, reserve funds,property and casualty insurance and state and federal monies. In the case ofperpetual obligations, FSA may experience claims, but if the population returnsin adequate numbers, reimbursement is likely. Eight of the 11 obligations withsignificant risk of loss are perpetual.

The Company monitors itsexposure to Hurricanes Katrina and Rita in Louisiana and Mississippi and has determinedthat no case reserve is required. Of the 11 credits with significant risk ofloss, the Company has identified two high-priority risks. These risks areperpetual obligations, on which the Company may have to pay claims of up to$44.0 million in a worst-case scenario. However, in these two cases the Companyexpects that, so long as the population returns in adequate numbers, it wouldsuffer only the lost interest income on any claims paid until the issuer repaidthe Company at some point in the future.

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In order for a communityin Louisiana to restructure and potentially reduce its indebtedness, the BondCommission, which is headed by the State Treasurer, must authorize such action.The State Treasurer has publicly represented that the Bond Commission will notpermit any Louisiana municipality to declare bankruptcy.

Municipalities in Mississippiare not authorized to file for bankruptcy and therefore have no mechanism underlaw to adjust their payment obligations. Unlike the corporate market, themunicipal market has no private or equity source of capital and therefore lacksany means of starting fresh with a clean slate, with debts and liabilitiesrejected or adjusted in bankruptcy. To file for bankruptcy, or to leave ratedindebtedness unpaid in a bankruptcy proceeding, would serve to tarnish theissuer and the region and effectively deny the subject municipality and similarissuers of debt within the state access to capital. Historically, rather thanbankruptcy and adjustment of debt, financially distressed municipalities havebeen subjected to supervision and control by state-created authorities that actboth as issuers of debt, secured by a discrete, newly identified revenuestream, and as fiscal monitors.

Both the federalgovernment and the executive and legislative branches of the affected stateshave considered or are expected to consider proposals or legislation to assistthe municipalities and facilitate recovery. An example of such an enactment atthe federal level is the Community Disaster Loan Act of 2005, under which thefederal government has begun to make loans to affected municipalities.

In addition, FSA’sasset-backed transactions, which are generally backed by pools ofgeographically diverse assets, show no unusual concentrations in the affectedareas.

The loss estimationprocess involves the exercise of considerable judgment and therefore FSA’sultimate hurricane-related losses may be materially different from the currentestimate and may affect future operating results.

***Other OperatingExpenses***

Other operating expenses decreased5.5% in 2005 compared with an increase of 6.5% in 2004. Excluding compensationexpenses related to the Company’s deferred compensation and supplementalexecutive retirement plans, other operating expenses were $91.4 million in2005, $80.8 million in 2004 and $65.6 million in 2003. The increases in 2005and 2004 relate primarily to increased personnel costs and increases inpremises and equipment expense as a result of the move to the Company’s newheadquarters. The Company purchases assets selected by participants in thedeferred compensation and supplemental executive retirement plans toeconomically defease the Company’s liability under these plans. Deferredcompensation and supplemental executive retirement plan expenses are recordedin other operating expenses and the related income on the assets is recorded inother income. Such expenses and income therefore have no effect on net income.

***Financial ProductsNet Interest Margin***

FP operating NIM, anon-GAAP measure, is defined as the FP Segment net interest margin excludingfair-value adjustments for economic interest-rate hedges. Management uses FPoperating NIM as a key performance measure of the Company’s financial productsbusiness. FP operating NIM was $40.5 million in 2005, $23.5 millionin 2004 and $8.9 million in 2003. The increases in FP operating NIM wererelated primarily to the increase in the book of GIC business since the FPSegment commenced operations at the end of 2001. Prior-year balances havebeen reclassified to conform to the current-year presentation.

NIM shown in accordancewith classifications required under GAAP on the consolidated statements ofoperations and comprehensive income (“Total NIM”) is calculated as net interestincome from financial products and VIEs, plus financial products net realizedgains (losses), less net interest expense from financial products and VIEs.Total NIM was negative $11.2 million for 2005, negative $70.7 million for2004 and negative $37.1 million for 2003, and primarily representsfixed-rate liabilities (which are swapped to a floating-rate obligation)funding floating-rate assets. The differences between Total NIM and FP 

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operatingNIM relate primarily to the presentation of periodic interest income andexpense on derivatives, intersegment transactions and VIE NIM, as discussedfurther below.

The table below reconcilesTotal NIM with FP operating NIM.

**Reconciliationof Total NIM to Non-GAAP FP Operating NIM**

| ** **                                                                                                                                                       | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                                       | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                       | ** ** | **(in millions)**                     | ** ** |
| Total NIM                                                                                                                                                        |       | $                                          | (11.2      | ) | $ | (70.7 | ) | $ | (37.1 | ) |
| Realized net interest  income from hedges of fixed-rate assets and liabilities included in net  realized and unrealized gains (losses) on derivative instruments |       | 27.6                                       |       | 75.6 |   | 25.2 |   |
| Intersegment income  related to refinanced transactions                                                                                                          |       | 28.2                                       |       | 24.8 |   | 24.1 |   |
| VIE NIM(1)                                                                                                                                                       |       | (4.1                                       | )          | (4.8 | ) | (3.3 | ) |
| Intercompany adjustments                                                                                                                                         |       | —                                     |       | (1.4 | ) | — |   |
| FP operating NIM                                                                                                                                                 |       | $                                          | 40.5       |   | $ | 23.5 |   | $ |   8.9 |   |

 

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(1)          VIENIM represents the impact of consolidation of the VIEs on the Total NIM.

Realized interest incomeand expense associated with economic interest rate hedges is an element ofderivative gains and losses added back to calculate FP operating NIM. Derivatives that qualify for hedge accounting areclassified in the consolidated statements of operations and comprehensiveincome with the underlying item being hedged. Gains and losses on derivativesthat do not qualify for hedge accounting are shown under the caption netrealized and unrealized gains (losses) on derivative instruments. Unrealizedderivative gains and losses are excludedfrom FP operating NIM.

Intersegment incomerelates primarily to intercompany notes held in the FP bond portfolio. Inconnection with the Company’s refinancing transactions, FSA obtains funds fromthe FP operations to fund claim payments, as discussed further in Note 22to the Consolidated Financial Statements in Item 8, creating an interest-bearingintercompany note. This intercompany note is included in the assets of the FPSegment, with the related net interest income added to FP operating NIM,but is eliminated from the consolidated Total NIM.

VIE NIM and FP NIM arecombined on the consolidated statements of operations and comprehensive income.VIE NIM pertains to the net interest margin derived from transactions executedby FSA Global, Canadian Global Funding Corporation (“Canadian Global”) andPremier International Funding Co. (“Premier”). As the VIE NIM isconsidered part of the financial guaranty segment and not the FP Segment, thisNIM component is subtracted to calculate FP NIM. See Note 25 to theConsolidated Financial Statements in Item 8.

***Net Realized andUnrealized Gains (Losses) on Derivative Instruments***

Thecomponents of net realized and unrealized gains (losses) on derivativeinstruments are shown in the table below:

| ** **                                             | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                             | ** ** | **(in millions)**                     | ** ** |
| FP and VIE interest-rate derivatives                   |       | $                                          | 8.6        |   | $ | 181.1 |   | $ | 69.4 |   |
| FP and VIE foreign currency derivatives                |       | (189.8                                     | )          | 91.3 |   | 118.3 |   |
| Net CDS mark to fair value                             |       | 11.1                                       |       | 56.4 |   | 34.8 |   |
| Other                                                  |       | (2.4                                       | )          | 0.5 |   | 4.9 |   |
| Net realized and  unrealized derivative gains (losses) |       | $                                          | (172.5     | ) | $ | 329.3 |   | $ | 227.4 |   |

 

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*Credit DefaultSwaps*

FSA’s business includesinsurance of CDS referencing diversified pools of obligations. The net paroutstanding was $66.6 billion relating to these transactions at December 31,2005 and $66.0 billion at December 31, 2004. Many of these transactionsrequire periodic accounting adjustments to reflect an estimate of fair value(or the replacement cost of the Company’s financial guaranty contract) underSFAS 133. These transactions have generally been underwritten with Triple-Aor higher levels of credit protection provided by significant deductibles thatmust be exhausted prior to claims under FSA’s guaranty. Adjustments required bySFAS 133 resulted in pre-tax income of $11.1 million for 2005, $56.4million for 2004 and $34.8 million for 2003. The benefits during 2005, 2004 and2003 resulted primarily from tightening credit spreads in the CDS market. Noneof these adjustments indicate any material improvement or deterioration in theunderlying credit quality of FSA’s insured CDS portfolio. The gain or losscreated by estimated fair-value adjustments will rise or fall eachquarter based on estimated market pricing of highly rated swap guarantees andis not expected to be an indication of potential claims under FSA’s guaranty.Fair value is defined as the price at which an asset or a liability could bebought or sold in a current transaction between willing parties. The fair valueis determined based on quoted market prices, if available. If quoted marketprices are not available, as is the case primarily with CDS on pools of assets,then the determination of fair value is based on internally developedestimates. Management applies judgment when developing these estimates andconsiders factors such as current prices charged for similar agreements,performance of underlying assets, changes in internal shadow ratings, the levelat which the deductible has been set and FSA’s ability to obtain reinsurancefor its insured obligations. Due to changes in these factors, the gain or lossfrom derivative instruments may vary substantially from period to period.Absent any claims under FSA’s guaranty, any “losses” recorded in marking a guarantyto fair value will be reversed by an equivalent “gain” at or prior to theexpiration of the guaranty, and any “gain” recorded will be reversed by anequal “loss” over the remaining life of the transaction. The average remaininglife of these contracts is 3.2 years. The inception-to-datepre-tax gain on the CDS portfolio was $57.7 million at December 31, 2005and $46.6 million at December 31, 2004. Given the very high credit qualityof FSA’s insured CDS portfolio and the Company’s intent to hold to maturity,management believes that “losses” or “gains” attributable to marking theseexposures to fair value do not reflect on the profitability of the Company in ameaningful way.

*FP and VIEDerivatives*

The Company utilizes interest-rate derivatives to hedgeagainst fluctuations in interest rates and foreign currency derivatives tohedge against fluctuations in exchange rates. All gains and losses from changesin the fair-value of derivatives that do not qualify for hedge accounting underSFAS 133 are recognized immediately in the consolidated statements of operations and comprehensive incomeunder the caption net unrealized and realized gains (losses) on derivatives. Hedgeaccounting is applied to derivatives designated as hedging instruments in afair-value hedge, provided certain criteria are met.

***Income from Assets Acquired in RefinancingTransactions***

Income from assets acquired in refinancingtransactions, excluding realized gains or losses, was $35.2 million in 2005,$31.6 million in 2004 and $25.3 million in 2003. The 2004 increase was due torefinancings of several insured transactions whereby the Company acceleratedclaim payments on transactions that had experienced events of default andacquired the obligations or underlying collateral in order to mitigate futureclaims. The increase in 2005 reflects the impact of a full year of income fromtransactions that were refinanced at various times during 2004.

***Equity in Earningsof Unconsolidated Affiliates***

Total equity in earningsof unconsolidated affiliates was a pre-tax gain of $1.2 million in 2005, apre-tax loss of $3.3 million in 2004 and pre-tax income of $5.5 million in2003.

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As of December 31,2004, the Company owned 34.1% of the SPS Holding Corp. (“SPS”), formerlyFairbanks Capital Holding Corp., and the Company’s interest in SPS had a bookvalue of $49.6 million. As of December 31, 2003, the Company’s interest inSPS had a book value of $46.4 million, of which $7.6 million representedgoodwill. In the third quarter of 2004, the Company determined that its $7.6million of goodwill associated with its investment in SPS was impaired as aresult of challenges encountered by SPS in acquiring new business. The Company’sequity in earnings from SPS was a pre-tax gain of $1.2 million in 2005, apre-tax loss of $7.1 million in 2004 and a pre-tax loss of $13.5 million in2003.

In October 2005, theCompany sold its investment in SPS to an unaffiliated third party. For itsinterest in SPS, the Company was paid $42.9 million in cash at closing andexpects to receive additional amounts, from time to time through March 31,2008, out of income earned by SPS through December 31, 2007 from certainof its mortgage servicing activities. Under the sale documents, the Company’ssubsidiary that owned the SPS investment made customary representations andwarranties to, and undertook specified indemnification obligations for thebenefit of, the purchaser. Based on an estimate of the assets retained andliabilities assumed, the Company recorded a $0.4 million loss on the sale ofSPS. Under the terms of the agreement, the Company will receive cash paymentsthrough the first quarter of 2008 from a residual interest in mortgageservicing assets. The Company recorded an asset of $12.6 millionrepresenting this contingent payment asset. The Company and other priorshareholders indemnified the buyer for certain liabilities relating to SPS’soperations, including litigation and regulatory actions. The maximumindemnification obligation for SPS’s operations will not exceed approximately$34.0 million. The Company’s portion of this obligation is 37.4% or$12.7 million. As of December 31, 2005, the Company recorded a$5.1 million liability related to this indemnification representing theexpected liability. The Company will continue to evaluate the appropriatecarrying value of the liabilities assumed and whether the assets are impaired.

FSA’s 13% investment inpreferred shares of XLFA, a financial guaranty insurance subsidiary of XL, isredeemable by XLFA at a price equal to the fair market value of the preferredshares, subject to a cap defined as the internal rate of return of 19% perannum from the date of the investment through the date of redemption, plusaccrued dividends as if 100% of current-year earnings were distributed.Based on this formula, the Company carries this investment at the lesser of thecurrent calculated redemption value or the redemption value as of the next January first,which would exclude its share of accrued current-year earnings to the extentthe cap had been otherwise met. Consistent with this policy, in the thirdquarter of 2004, the Company charged a pre-tax amount of $11.7 million toequity in earnings of unconsolidated affiliates and reduced its carrying valuein this investment to $56.4 million.

For the first threequarters of 2004 and all prior years, equity in earnings of unconsolidatedaffiliates included the results of XLFA. In accordance with EITF 02-14, “Whetheran Investor Should Apply the Equity Method of Accounting for Investments OtherThan Common Stock,” the Company no longer accounts for its investment in XLFAunder the equity method of accounting. Effective October 1, 2004, theCompany’s  investment in XLFA has beenincluded in equity securities as an available-for-sale security.The fair value of the investment at December 31, 2005 and 2004 was $54.3million. In March 2006, the XLFA Board of Directors approved a by-lawamendment changing the coupon on XLFA’s preferred shares from the participatingdividend described above to an 8.25% per annum fixed dividend effective January 1,2006. Such by-law amendment remains subject to XLFA shareholder approval.Pending such approval, a dividend will be declared at this new rate on XLFA’spreferred shares for the first quarter of 2006.

***Variable InterestEntities***

Asset-backed and, toa lesser extent, municipal transactions insured by FSA may employ VIEs for avariety of purposes. A typical asset-backed transaction, for example,employs a VIE as the purchaser of the 

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securitizedassets and as the issuer of the insured obligations. FSA’s participation istypically requested by the sponsor of the VIE or the underwriter, either via abid process or on a sole-source basis. VIEs are typically owned by transactionsponsors or charitable trusts, although FSA may have an ownership interest insome cases. FSA maintains certain contractual rights and exercises varyingdegrees of influence over VIE issuers of FSA-insured obligations. FSAalso bears some of the “risks and rewards” associated with the performance ofVIEs’ assets. Specifically, as issuer of the financial guaranty insurancepolicy insuring a given VIE’s obligations, FSA bears the risk of assetperformance (typically, but not always, after a significant depletion ofovercollateralization, excess spread, a deductible or other credit protection).FSA’s underwriting policy is to insure only obligations that are otherwiseinvestment grade. In addition, the VIE typically pays a periodic premium to FSAin consideration of the issuance by FSA of its insurance policy, with the VIE’sassets typically serving as the source of such premium, thereby providing someof the “rewards” of the VIE’s assets to FSA. VIEs are also employed by FSA inconnection with “repackaging” of outstanding securities into new securitiesinsured by FSA and with refinancing underperforming, non-investment-gradetransactions insured by FSA.

The degree of influenceexercised by FSA over these VIEs varies from transaction to transaction, asdoes the degree to which “risks and rewards” associated with asset performanceare assumed by FSA. While all transactions insured by FSA are included in theCompany’s outstanding exposure, and losses under these obligations arereflected in the Notes to Consolidated Financial Statements, the assets andliabilities of these VIEs, except for refinanced transactions discussed belowand in Note 22 to the Consolidated Financial Statements in Item 8, have notbeen consolidated with those of the Company for financial reporting purposesbecause the Company is not the primary beneficiary.

In January 2003, theFinancial Accounting Standards Board (“FASB”) issued FASB InterpretationNo. 46, “Consolidation of Variable Interest Entities, an interpretation ofARB No. 51” (“FIN 46”). FIN 46 addresses consolidation of VIEs that haveone or both of the following characteristics: (a) the equity investment atrisk is not sufficient to permit the entity to finance its activities withoutadditional subordinated financial support from other parties, which is providedthrough other interests that will absorb some or all of the expected losses ofthe entity; and (b) the equity investors lack the direct or indirectability to make decisions about the entity’s activities through voting rightsor similar rights, the obligation to absorb the expected losses of the entityif they occur or the right to receive the expected residual returns of theentity if they occur. In December 2003, the FASB issued FASBInterpretation No. 46 (revised December 2003), “Consolidation ofVariable Interest Entities, an interpretation of ARB 51” (“FIN 46R”). FIN46R replaced FIN 46 and is effective for public companies for periods afterDecember 15, 2003.

The Company consolidatesFSA Global, Canadian Global and Premier. The Company’s adoption of FIN 46 onJuly 1, 2003 resulted in a $1.9 billion aggregate increase in totalassets and total liabilities. The differences upon consolidation were reflectedas a cumulative effect of a change in accounting principle. The cumulativeeffect of a change in accounting principle for Canadian Global resulted inadditional income of $4.8 million, net of income tax in 2003. During the thirdquarter of 2004, the majority of the assets of Canadian Global were liquidatedand its liabilities satisfied. There was no income statement effect fromconsolidating FSA Global and Premier. FSA Global is managed as a “matched fundedvehicle,” in which the proceeds from the issuance of FSA-guaranteed notesare invested in obligations having cash flows substantially matched to thoseof, and maturing prior to, such notes. In certain cases, investments of FSAGlobal consist of GICs issued by the GIC Affiliates. In each such case, theCompany’s GIC liability and GIC asset are eliminated in consolidation. AtDecember 31, 2005, $1,142.1 million was eliminated as a result of suchconsolidation.

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The Company’s managementbelieves that the assets held by the VIEs, including those that are eliminatedin consolidation, are beyond the reach of the Company and its creditors, evenin bankruptcy or other receivership. All intercompany insured amounts betweenFSA and FSA Global or Canadian Global are excluded from the Notes to theConsolidated Financial Statements. In addition, the Company refinances certaindefaulted transactions by employing refinancing vehicles to raise funds for therefinancings. These refinancing vehicles are also consolidated. See Note 22 tothe Consolidated Financial Statements in Item 8.

***Taxes***

The Company’s effective tax rates were 27.3% in 2005,19.0% in 2004 and 22.2% in 2003. The 2005 rate differs from the statutory rateof 35%, primarily due to tax-exempt interest income, minority interest, theCompany’s reorganization of Financial Security Assurance International Ltd. (“FSAInternational”) and its intention to repatriate FSA International’s futureearnings. In 2004 and 2003, the rates differed from the statutory rate of 35%primarily due to tax-exempt interest, income from FSA International, andminority interest, with the White Mountains indemnity payment (see below) andthe expected repatriation of earnings of FSA International in 2005 also havingan effect.

The American Jobs CreationAct of 2004 (the “Act”), enacted on October 22, 2004, added Section 965to the Internal Revenue Code. Section 965 provides for the repatriation ofdividends from a controlled foreign corporation to its U.S. shareholder at aneffective tax rate of 5.25%, provided that proceeds from the repatriation areutilized for qualified domestic investment activities. The U.S. TreasuryDepartment issued Notice 2005-10, which provides guidance on acceptableinvestment activities. The Company believes it qualifies for the beneficialtreatment under Section 965 and accordingly accrued a tax liability andexpense of $5.3 million at December 31, 2004. This amount approximated thetax effect on FSA International’s tax dividend distribution made in the fourthquarter of 2005.

In December 2005, theCompany repatriated earnings from FSA International to avail itself of thereduced effective tax rate of 5.25% (compared with the normal effective taxrate of 35%) applicable to certain earnings and profits of offshoresubsidiaries repatriated during the current tax year and invested in the UnitedStates pursuant to a qualifying reinvestment plan in accordance with the Act.In connection with such repatriation, the Company recapitalized FSAInternational in October of 2005 to become a wholly owned subsidiary anddeclared that it no longer intends to leave future earnings of that subsidiarypermanently offshore, with the effect that 2005 and future income from FSAInternational have become subject to an increased effective U.S. tax rate. Theimpact on earnings reflects (1) a tax liability of $15.1 million inrespect of earnings of FSA International that have previously been recognizedfor GAAP but not yet for tax and (2) $14.2 million related to 2005earnings.

Following a change in SPS’sinvestors in 2002, the Company determined that it would be appropriate to applythe 80% dividend-received deduction allowed by the Internal RevenueService when calculating the tax on its equity earnings from SPS, based onmanagement’s expectation that it would realize its gain on such investmentthrough dividend distributions rather than through sale of its investment.Accordingly, for 2004 and 2003, equity in earnings from SPS was taxed at aneffective rate of 7.0%. In the first quarter of 2005, the Company, due to thepending sale of its investment in SPS, eliminated the assumption thataccumulated earnings of SPS would be distributed in the form of dividendseligible for a dividend-received deduction. The net effect of this was to reservefor additional taxes of approximately $1.6 million.

In connection with Dexia’sacquisition of the Company in July 2000, the Company became the successor,for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH hadpreviously sold an insurance subsidiary to a third party that was indemnifiedby White Mountains for certain future adverse loss development up to $50.0million. In 2004, the Company made an indemnity payment of $47.0 million to thethird party with funds provided for such purpose by White Mountains InsuranceGroup. While the Company had no legal liability in connection with theindemnity payment, the payment should be treated 

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for taxpurposes as a $47.0 million loss deduction to the Company, as successor to WMH.The Company therefore recorded a deferred tax asset with a correspondingdeferred tax benefit of $16.5 million. There can be no assurance that thedeferred tax benefit will not be reversed in the future. In addition, theCompany has agreed to share 50% of the deferred tax benefit with WhiteMountains Insurance Group under certain circumstances, but did not satisfy thestandards for recording a liability for accounting purposes as of December 31,2005.

**CriticalAccounting Policies**

The Company’s criticalaccounting policies and estimates are described in Note 2 to the ConsolidatedFinancial Statements in Item 8. Note 2 to the Consolidated Financial Statementsincludes a discussion of the financial guaranty accounting project that theFASB staff has undertaken to provide accounting guidance to the financialguaranty industry.

Like other financialguarantors, the Company has received comments from the staff of the Securitiesand Exchange Commission (“SEC”) regarding its accounting for fixed incomeinvestments that are insured by FSA (“FSA-Insured Investments”). The Companycannot predict how the SEC staff will resolve this issue or the resultingeffect on the Company’s consolidated financial statements. See “Item 1. Business—InvestmentsInsured by the Company.”

**Liquidityand Capital Resources**

***Liquidity***

The Company’s consolidatedinvested assets at December 31, 2005, net of unsettled securitytransactions, were $17,372.2 million, compared with the December 31, 2004balance of $12,227.2 million. These balances include the change in the marketvalue of the Company’s various portfolios, which had an unrealized gainposition of $236.2 million at December 31, 2005, compared with anunrealized gain position of $294.5 million at December 31, 2004. Thesebalances exclude (1) the effect of any economic interest-rate derivatives’hedging and (2) assets in the VIE bond portfolio and assets acquired underrefinancing transactions that the Company’s management believes are beyond thereach of the Company and its creditors. Included in these balances areshort-term investments of $182.6 million at December 31, 2005 and $119.7million at December 31, 2004. Cash and cash equivalents were $20.1 millionat December 31, 2005 and $14.4 million at December 31, 2004.

The Company includesvariable-rate demand notes (“VRDN”) and auction-rate securities (“ARS”), which totalled$867.2 million at December 31,2005 and $613.7 million at December 31,2004, in its long-term bond portfolio. VRDNs are long-term bonds that bearfloating interest rates and provide investors with the option to tender or putthe bonds at par, generally on a daily, weekly or monthly basis. ARS arelong-term securities with interest-rate reset features and are traded in themarketplace through a bidding process. For management purposes, VRDN and ARSare managed as cash equivalents.

Cash flow from operationswas $653.0 million in 2005, $552.8 million in 2004 and $589.6 million in 2003.The increase in cash flow from operations in 2005 is attributable primarily tothe increase in net interest received from the FP Segment due to the growth inbook of business and premiums, partially offset by an increase in operatingexpenses and taxes paid. The increase in premium receipts was due primarily toincreased refunding activity. The increase in taxes paid was due primarily tothe repatriation of FSA International earnings.

At December 31, 2005,Financial Security Assurance Holdings Ltd. (as a separate holding company, “FSAHoldings”) had cash and investments of $60.2 million available to fund theliquidity needs of its non-insurance operations. Because the majority of theCompany’s operations are conducted through FSA, the long-term ability ofthe Company to service its debt will largely depend on its receipt of dividendsfrom, or payment on surplus notes by, FSA.

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In its financial guarantybusiness, premiums and investment income are the Company’s primary sources offunds to pay its operating expenses, insured losses and taxes. In its FP Segment,the Company relies on net interest income to fund its net interest expense andoperating expenses. Management believes that the Company’s operations providesufficient liquidity to pay its obligations. If additional liquidity is neededor cash flow from operations significantly decreases, the Company can liquidateor utilize its investment portfolio as a source of funds in addition to itsalternative liquidity arrangements, as discussed further below. The Company’scash flows from operations are heavily dependent on market conditions, thecompetitive environment and the mix of business originated. In addition,payments made in settlement of the Company’s obligations in its insuredportfolio may, and often do, vary significantly from year to year dependingprimarily on the frequency and severity of payment defaults and its decisionsregarding whether to exercise its right to accelerate troubled insuredtransactions in order to mitigate future losses. In each of the three yearsreported, the Company has not drawn on any alternative sources of liquidity tomeet its obligations, except that the Company has refinanced certaintransactions using funds raised through its GIC Affiliates.

The following is a summaryof the Company’s contractual obligations at December 31, 2005:

**ContractualObligations**

| ** **                     | ** ** | **Less than  1 Year** | ** ** | **1–3 Years** | ** ** | **3–5 Years** | ** ** | **Greater than  5 years** | ** ** | **Total** | ** ** |
|--------------------------------|------------|---------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------------------|------------|-----------|------------|
| ** **                     | ** ** | **(in millions)**          | ** ** |
| Loss reserves(1)               |       | $                               | (1.3       | )                       |       | $                       | 55.8       |                                |       |      | $          | 74.6 |   |   |   | $ | 195.2 |   |   | $ | 324.3 |   |
| Long-term debt  obligations(2) |       | 3,573.0                         |       |                    | 2,914.1    |                    |       |                                | 3,501.4    |      |       |   | 7,358.8 |   |   | 17,347.3 |   |
| Operating lease  obligations   |       | 7.1                             |       |                    | 16.5       |                    |       |                                | 16.3       |      |       |   | 119.9 |   |   | 159.8 |   |
| Total                          |       | $                               | 3,578.8    |                    |       | $                       | 2,986.4    |                                |       |      | $          | 3,592.3 |   |   |   | $ | 7,673.9 |   |   | $ | 17,831.4 |   |

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(1)          Amounts represent the undiscountedestimated claim payments.

(2)          Amounts include futureimplied interest accretion on zero-coupon obligations.

At December 31, 2003, FSA Holdings held $152.9million of surplus notes of FSA. During 2004, FSA repaid $44.0 million of thosesurplus notes. At December 31, 2005, FSA Holdings held $108.9 million ofFSA surplus notes. Payments of principal or interest on such notes may be madeonly with the approval of the Superintendent of Insurance of the State of NewYork (the “New York Superintendent”). FSA Holdings employs surplus notepurchases in lieu of capital contributions in order to allow it to withdrawfunds from FSA through surplus note payments without reducing earned surplus,thereby preserving dividend capacity of FSA.

FSA Holdings paid dividends of $71.1 million in 2005and $22.9 million in 2004. It did not pay dividends in 2003.

On July 31, 2003, FSA Holdings issued $100.0million principal amount of 5.60% Notes due July 15, 2103, which arecallable without premium or penalty in whole or in part at any time on or afterJuly 31, 2008. Debt issuance costs of $3.3 million are being amortizedover the life of the Notes. In September 2003, FSA Holdings called forredemption, on November 1, 2003, its 6.95% Senior Quarterly Income DebtSecurities (“Senior QUIDS”) due November 1, 2098 and delivered to thetrustee sufficient collateral to legally defease the 6.95% Senior QUIDS. Theunamortized debt issuance costs of $3.2 million for the 6.95% Senior QUIDS werecharged to interest expense in 2003. Subsequently, the trustee used thedefeasance collateral to redeem all of the 6.95% Senior QUIDS.

On November 26, 2002, FSA Holdings issued$230.0 million principal amount of 6.25% Notes due November 1, 2102,which are callable without premium or penalty in whole or in part at any timeon or after November 26, 2007. Debt issuance costs of $7.4 millionare being amortized over the life of the debt. 

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FSA Holdings used aportion of the proceeds of this issuance to redeem in whole FSA Holdings’$130.0 million principal amount of 7.375% Senior QUIDS due September 30,2097. Unamortized debt issuance costs of the retired debt of $4.1 millionwere charged to interest expense in 2002.

On December 19, 2001, FSA Holdings issued$100.0 million of 67¤8%Quarterly Income Bond Securities due December 15, 2101, which are callablewithout premium or penalty on or after December 19, 2006. Debt issuancecosts of $3.3 million are being amortized over the life of the debt.

FSA’s ability to pay dividends depends, among otherthings, upon FSA’s financial condition, results of operations, cashrequirements and compliance with rating agency requirements for maintaining itsTriple-A ratings, and is also subject to restrictions contained in theinsurance laws and related regulations of New York and other states. Under theinsurance laws of the State of New York (the “New York Insurance Law”), FSA maypay dividends out of earned surplus, provided that, together with all dividendsdeclared or distributed by FSA during the preceding 12 months, the dividends donot exceed the lesser of (a) 10% of policyholders’ surplus as of its laststatement filed with the New York Superintendent or (b) adjusted netinvestment income during this period. Based on FSA’s statutory statements for2004, and considering dividends that can be paid by its subsidiary, the maximumamount normally available for payment of dividends by FSA without regulatoryapproval over the 12 months following December 31, 2005 is approximately$153.8 million. FSA paid dividends of $87.0 million in 2005 and $30.0 millionin 2004 and paid none in 2003.

FSA International paidpreferred dividends to XL Capital Ltd, its minority interest owner, of $6.9million in 2005, $7.0 million in 2004 and $3.3 million in 2003.

***Additional Capital Resources***

FSA’s primary uses of funds are to pay operatingexpenses and to pay dividends to, or pay interest or principal on surplus notesheld by, its parent. FSA’s funds are also required to satisfy claims underinsurance policies in the event of default by an issuer of an insuredobligation and the unavailability or exhaustion of other payment sources in thetransaction, such as the cash flow or collateral underlying the obligations.FSA seeks to structure asset-backed transactions to address liquidityrisks by matching insured payments with available cash flow or other paymentsources. Insurance policies issued by FSA guaranteeing payments under bonds andother securities provide, in general, that payments of principal, interest andother amounts insured by FSA may not be accelerated by the holder of theobligation but are paid by FSA in accordance with the obligation’s originalpayment schedule or, at FSA’s option, on an accelerated basis. Insurancepolicies issued by FSA guaranteeing payments under CDS may provide foracceleration of amounts due upon the occurrence of certain credit eventssubject to single-risk limits specified in the New York insurance law. Thesepolicy provisions prohibiting or limiting acceleration of certain claims aremandatory under Article 69 of the New York Insurance Law and serve toreduce FSA’s liquidity requirements.

Management believes that the Company’s expectedoperating liquidity needs, on both a short- and long-term basis,can be funded from its operating cash flow. In addition, the Company has anumber of sources of liquidity available to pay claims on a short- and long-termbasis: cash flow from premiums written, FSA’s investment portfolio and earningsthereon, reinsurance arrangements with third-party reinsurers, newborrowings through its GIC Affiliates, liquidity lines of credit with banks andcapital market transactions.

FSA has a credit arrangement aggregating $150.0 million,provided by commercial banks and intended for general application totransactions insured by FSA. If FSA is downgraded below Aa3 and AA-, thelenders may terminate the commitment and the commitment commission becomes dueand payable. If FSA is downgraded below Baa3 and BBB-, any outstandingloans become due and payable. At 

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December 31, 2005,there were no borrowings under this arrangement, which expires on April 21,2006, if not extended.

FSA has a standby line of credit in the amount of$350.0 million with a group of international banks to provide loans to FSAafter it has incurred, during the term of the facility, cumulative municipallosses (net of any recoveries) in excess of the greater of $350.0 million orthe average annual debt service of the covered portfolio multiplied by 5.00%,which amounted to $1,220.0 million at December 31, 2005. The obligation torepay loans under this agreement is a limited recourse obligation payablesolely from, and collateralized by, a pledge of recoveries realized on defaultedinsured obligations in the covered portfolio, including certain installmentpremiums and other collateral. This commitment has a ten-year termexpiring on April 30, 2015 and contains an annual renewal provision,commencing April 30, 2008, subject to approval by the banks. A ratingsdowngrade of FSA would result in an increase in the commitment fee. No amountshave been utilized under this commitment as of December 31, 2005.

In June 2003, $200.0 million of money marketcommitted preferred trust securities (the “CPS Securities”) were issued bytrusts created for the primary purpose of issuing the CPS Securities, investingthe proceeds in high-quality commercial paper and providing FSA with putoptions for issuing to the trusts non-cumulative redeemable perpetualpreferred stock (the “Preferred Stock”) of FSA. If FSA were to exercise a putoption, the applicable trust would transfer the portion of the proceedsattributable to principal received upon maturity of its assets, net ofexpenses, to FSA in exchange for Preferred Stock of FSA. FSA pays a floatingput premium to the trusts. The cost of the structure was $1.3 million for 2005and $1.3 million for 2004 and was recorded as other operating expense in theCompany’s Consolidated Financial Statements. The trusts are vehicles forproviding FSA access to new capital at its sole discretion through the exerciseof the put options. The Company does not consider itself to be the primarybeneficiary of the trusts under FIN 46 because it does not retain the majorityof the residual benefits or expected losses.

FSA-insured GICs subject the Company to riskassociated with unexpected withdrawals of principal allowed by the terms of theGICs. The majority of municipal GICs insured by FSA relate to debt servicereserve funds and construction funds in support of municipal bond transactions.Debt service reserve fund GICs may be drawn unexpectedly upon a payment defaultby the municipal issuer. Construction fund GICs may be drawn unexpectedly whenconstruction of the underlying municipal project does not proceed as expected.In addition, most FSA-insured GICs allow for withdrawal of GIC funds inthe event of a downgrade of FSA, typically below Aa3 by Moody’s or AA- byS&P, unless the GIC provider posts collateral or otherwise enhances itscredit. Some FSA-insured GICs also allow for withdrawal of GIC funds inthe event of a downgrade of FSA, typically below A3 by Moody’s or A- byS&P, with no right of the GIC provider to avoid such withdrawal by postingcollateral or otherwise enhancing its credit. The Company manages this riskthrough the maintenance of liquid collateral and bank liquidity facilities.

FSA Asset Management LLC (“FSAM”)has a $100.0 million line of credit with UBS Loan Finance LLC, which expires December 8,2006, unless extended. This line of credit provides an additional source ofliquidity should there be unexpected draws on GICs issued by the GICAffiliates. There were no borrowings under this arrangement at December 31,2005. Borrowings under this agreement are conditioned on FSA having a Triple-Arating by either S&P or Moody’s, and on neither S&P nor Moody’s havingissued a rating to FSA below AA+ or Aa1, respectively.

***Capital Adequacy***

S&P, Moody’s and Fitch Ratings periodically assessthe credits insured by FSA, and the reinsurers and other providers of capitalsupport to FSA, to confirm that FSA continues to satisfy the rating agencies’capital adequacy criteria necessary to maintain FSA’s Triple-A ratings.Capital adequacy assessments by the rating agencies are generally based on FSA’squalified statutory capital, which is the aggregate of 

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policyholders’ surplus andcontingency reserves determined in accordance with statutory accountingprinciples.

In the case of S&P, assessments of the creditsinsured by FSA are reflected in defined “capital charges,” which are reduced byreinsurance and collateral to the extent “credit” is allowed for suchreinsurance and collateral. Credit provided for reinsurance under the S&Pcapital adequacy model is generally a function of the S&P rating of thereinsurer, as well as any collateral provided by the reinsurer. Capital chargeson outstanding insured transactions and reinsurer ratings are subject to changeby S&P at any time. In recent years, a number of Triple-A-ratedreinsurers employed by FSA have been downgraded by S&P. Downgrade of thesereinsurers by S&P to the Double-A category resulted in a decline inthe credit allowed for reinsurance by S&P from 100% to 70% or 65% underpresent criteria. While a downgrade by S&P of all reinsurers to the Double-Acategory would not impair FSA’s Triple-A ratings, it would reduce the “marginof safety” by which FSA would survive a theoretical catastrophic depressionmodeled by S&P. A reduction by S&P in credit for reinsurance used byFSA would also be expected ultimately to reduce the Company’s return on equityto the extent that ceding commissions paid to FSA by such reinsurers were notincreased to compensate for such reduction. FSA employs considerablereinsurance in its business to manage its single-risk exposures oninsured credits. Any material increase in capital charges by S&P on FSA’sinsured portfolio would likewise be expected to have an adverse effect on FSA’smargin of safety under the S&P capital adequacy model and, ultimately, theCompany’s return on equity. The Company may seek to raise additional capital toreplenish capital eliminated by any of the rating agencies and their assessmentof FSA’s capital adequacy.

Capital adequacy is one ofthe financial strength measures under Moody’s financial guarantor model. Themodel includes a penalty for risk concentration and recognizes a benefit fordiversification. The published results reflect four metrics of financialstrength relating to the insured portfolio’s credit quality, correlation risk,concentration of risk and capital adequacy. Moody’s assesses capital adequacyby comparing FSA’s claims-paying resources to a Moody’s-derivedprobability of potential credit losses. Moody’s loss distribution reflects FSA’scurrent distribution of risk by sector (municipal and asset-backed), thecredit quality of insured exposures, correlations that exist betweentransactions, the credit quality of FSA’s reinsurers and the term to maturityof FSA’s insured portfolio. The published results compare levels of theoreticalloss in the tail of this distribution to various measures of FSA’s claims-payingresources.

***Capital Expenditures***

The Company incurredapproximately $27.9 million in capital expenditures, net of leaseincentives, through 2005 for leasehold improvements, furniture and fixturesrelated to its new corporate headquarters. The Company has and expects tocontinue to fund these capital expenditures out of cash flows from operations. For additional information, see “Item 2. Properties.”

**Item 7A.**                Quantitativeand Qualitative Disclosures About Market Risk.

Market risk represents thepotential for loss due to adverse changes in the fair value of financialinstruments caused by interest rate, foreign exchange rate or equity pricemovements. The Company has exposure to market risk in (1)  the InvestmentPortfolio, (2) the FP Segment, which is driven by interest-rate spreads,and (3) its portfolio of insured CDS.

***Investment Portfolio***

Over 98% of the Company’s Investment Portfolio wasinvested in fixed-income securities at December 31, 2005. Changes ininterest rates affect the value of the Company’s fixed-income portfolio.As interest rates rise, the fair value of fixed-income securitiesdecreases.

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Management’s primary objective in managing the Company’sInvestment Portfolio is to generate an optimal level of after-taxinvestment income while preserving capital and maintaining adequate liquidity,subject to rating agency capital adequacy criteria that apply discount factorsto investments based on their ratings. The Company bases its investmentstrategies on many factors, including the Company’s tax position, anticipatedchanges in interest rates, regulatory and rating agency criteria and othermarket factors. One internal investment manager and two external investmentmanagers execute fixed-income investments on behalf of the Company.Management, with the approval of the Board of Directors, establishes guidelinesfor investment decisions.

Sensitivity of the Company’s Investment Portfolio tointerest-rate movements can be estimated by projecting a hypotheticalincrease in interest rates of 1.0%. Based on market values and interest ratesat year-end 2005, this hypothetical increase in interest rates of 1.0%across the entire yield curve would result in an estimated after-taxdecrease of $130.2 million in the fair value of the Company’s fixed-incomeportfolio, which would be recorded in other comprehensive income. Similarly, ahypothetical increase in interest rates of 1.0% would result in an estimatedafter-tax decrease of $11.3 million in the fair value of certain assetsacquired under refinancing transactions, offset by an after-tax gain of $11.9million on derivatives used to economically hedge the portfolio of assetsacquired under refinancing transactions.

The Company’s InvestmentPortfolio holdings are primarily U.S. dollar-denominated fixed-incomesecurities, including municipal bonds, U.S. government and agency bonds andmortgage-backed, asset-backed, corporate and foreign securities. Incalculating the sensitivity to interest rates for the taxable securities, U.S.Treasury rates are changed instantaneously by 1.0%. Tax-exempt securitiesare subjected to a change in the municipal Triple-A obligation curve thatwould be equivalent to a 1.0% taxable interest-rate change based on theaverage taxable/tax-exempt ratios for the prior 12 months. The simulationfor tax-exempts calculates duration by taking into account the applicablecall date if the bond is at a premium or the maturity date if the bond is at adiscount.

***Financial Products and Variable Interest Entities***

FSAM manages the investments in the FP InvestmentPortfolio. The primary objectives in managing the FP Investment Portfolio areto generate a stable net interest margin, to maintain liquidity and to optimizerisk-adjusted returns.

The assets and liabilities in the FP Segment arehedged using interest-rate swaps or futures. A hypothetical increase ininterest rates of 1% would result in an after-tax unrealized loss, whichwould be recorded in other comprehensive income, of $95.0 million to the assetportfolio, partially offset by a gain, which would be recorded in currentincome, of $80.3 million on derivatives used to economically hedge the assetportfolio. The same hypothetical increase in interest rates would result in aloss of $208.1 million on derivatives used to economically hedge the liabilityportfolio. This loss would be recorded in current income. The hypotheticalincrease in interest rates would result in a gain of $223.5 million in theliability portfolio. Changes in the fair value of the liability portfolio arenot recorded in the financial statements. Since such asset and liabilitypositions generally do not currently qualify for hedge accounting, a 1%increase in interest rates would result in lower reported net income of $127.8million due to the net derivatives loss that would result from such aninterest-rate decrease. Since the Company does not expect to trade theseinvestments prior to maturity absent an unusually large demand for funds, itdoes not expect to recognize any material adverse impact to cash flows underthe above scenario.

The FP Investment Portfolio consists primarily of U.S.dollar-denominated asset-backed securities, U.S. agency andgovernment securities and mortgage-backed securities. FSAM generallyconverts the interest rates of all fixed-rate assets and liabilities tofloating rates using hedging instruments. As interest rates change, andassuming an economically effective fair-value hedging arrangement, thechange in value of the fixed-income securities will be substantiallyoffset by a similar but opposite change in value of the 

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related hedginginstruments. To the extent the Company does not qualify for hedge accounting,such economic offsets cannot be presented in the financial statements,resulting in greater reported volatility arising from changes in interestrates.

FSA-insured GICs subject the Company to riskassociated with unexpected timing of withdrawal of principal allowed by theterms of the GICs. The majority of municipal GICs insured by FSA relate to debtservice reserve funds and construction funds in support of municipal bondtransactions. Debt service reserve fund GICs may be drawn unexpectedly when theunderlying bond issuance suffers a debt service shortfall. Construction fundGICs may experience withdrawal deviation when the underlying municipal projectdoes not proceed as expected. In addition, most FSA-insured GICs allowfor withdrawal of GIC funds in the event of a downgrade of FSA, typically belowAa3 by Moody’s or AA- by S&P unless the GIC provider posts collateralor otherwise enhances its credit. Most FSA-insured GICs further provide that inthe event of an additional downgrade, generally below A- by S&P or A3 byMoody’s, GIC funds may be withdrawn irrespective of whether the GIC providerposts collateral or otherwise enhances its credit.

FSAM also monitors theinvestments in the VIE Portfolio, which are generally held until maturity. TheVIE fixed-rate portfolio is economically hedged against changes in interestrates largely through the use of interest-rate swap contracts, which convertfixed rates to floating rates.

FSA Global is managed as a “matched funded vehicle,”in which the proceeds from the sale of FSA Global notes are invested inobligations chosen to provide cash flows substantially matched to those of thenotes (taking into account, in some cases, dedicated third-party liquidity).This matched funded structure is designed to minimize the market risks borne byFSA Global and FSA. FSA Global raises funds that are invested with a viewtowards realizing the yield difference between the notes issued and theobligations purchased with the note proceeds. FSA Global generally raises fundsthat are U.S. dollar-denominated or converted into U.S. dollars at LIBOR-basedfloating borrowing rates and invests them in FSA-insured obligations that:

·       areU.S. dollar denominated or converted into U.S. dollars at LIBOR-basedfloating rates,

·       matureprior to the maturity of the related FSA Global notes, and

·       pay a higher interest ratethan the interest rate on the related FSA Global notes.

The VIE fixed-rate investments and liabilities areeconomically hedged against changes in interest rates largely through the useof interest-rate swap contracts, which convert fixed rates to floating rates. Ahypothetical increase in interest rates of 1% would result in an approximateafter-tax loss of $24.8 million on the derivatives used to economicallyhedge the VIE asset and liability portfolios and would be recorded in currentincome.

***Credit Default Swaps***

Financial instruments that may be affected by changesin credit spreads include structured FSA-guaranteed CDS contracts. Suchcontracts are considered derivative instruments subject to fair-valueaccounting under SFAS 133. Because the Company generally provides creditprotection under such contracts, widening credit spreads will have an adversemark-to-fair-value effect on the Company’s consolidated statements ofoperations and comprehensive income while tightening credit spreads will have apositive effect. These contracts require the Company to make payments upon theoccurrence of certain defined credit events relating to underlying obligations(generally fixed-income obligations), which may be individual obligationsor a pool of obligations, subject to a deductible. These deductibles mitigatethe risk of loss. If credit spreads of the underlying obligations change,the fair value of the related structured CDS changes. Changes in credit spreadsare generally caused by changes in the market’s perception of the credit 

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quality of the underlyingreferenced obligations and by supply and demand factors that affect the levelof credit spreads generally.

The portfolio of CDS contracts consists primarily ofsynthetic structured credit derivatives guaranteed by the Company and isorganized into various categories, which are defined by the underlying assets,credit rating, maturity dates and other terms. Changes in fair value of CDScontracts are generally due to changes in credit spreads. Because the portfolioof FSA-insured CDS is not traded, the Company has developed a series ofasset credit-spread algorithms to estimate fair value. These algorithms derivefair value from several publicly available indices, depending on the types ofassets referenced by the CDS.

Management does not analyze the market sensitivity ofits insured CDS portfolio for purposes other than to quantify the potentialexposure to quarterly fair-value gain or loss. Management believes that each ofthe transactions for which it has provided CDS protection contains significantprotections against loss and quarterly changes in credit spreads generally donot imply any fundamental change in future loss potential. Any quantitativefair-value risk information generated by the application of statisticaltechniques is limited by the methods, assumptions and parameters established increating the model. The history of relevant asset credit-spread information isrelatively short, and the insight gained by using such information to forecastpotential future fair-value changes may therefore be limited.

The effect of any change in credit spreads isrecognized in current income. Generally, a sensitivity analysis is presented interms of the effect of a predetermined basis-point change in pricing or creditspreads. However, due to the wide range of pricing of the CDS portfolio,management believes that this type of sensitivity analysis is not the mostrelevant measure. For example, a hypothetical one basis-point change in fairvalue would have a significantly greater impact on a CDS contract priced atfive basis points than a CDS contract priced at 20 basis points.

The Company has evaluatedthe sensitivity of the CDS contracts by calculating the effect of percentagechanges in pricing. The following table summarizes the estimated after-taxeffect of hypothetical changes in fair value of the Company’s portfolio of CDScontracts defined as derivatives. In accordance with SFAS 133, any changes inpricing would be recorded in the statements of operations.

**Hypothetical increase in CDS prices:**

| ** ** | ** ** | **Estimated after-tax loss** | ** ** |
|------------|------------|----------------------------------------|------------|
| ** ** | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** ** | ** ** | **(in millions)**                 | ** ** |
| +25%       |       | $                                      | 56.4       |   | $ | 41.9 |   |
| +50%       |       | 112.7                                  |       | 84.4 |   |
| +75%       |       | 169.1                                  |       | 126.9 |   |
|            |            |                                        |            |  |  |  |  |

 

71

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**Item 8.**                        FinancialStatements and Supplementary Data.

**Financial Security Assurance Holdings Ltd. andSubsidiariesIndex to Consolidated Financial Statements and Schedule**

|                                                                                                         | ** ** | **Page** |
|---------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent Registered Public Accounting  Firm                                                |       | 73       |
| Consolidated  Balance Sheets as of December 31, 2005 and 2004                                      |       | 74       |
| Consolidated  Statements of Operations and Comprehensive Income for the Years Ended                     |       |     |
| December 31,  2005, 2004 and 2003                                                                  |       | 75       |
| Consolidated  Statements of Changes in Shareholders’ Equity for the Years Ended  December 31, |       |     |
| 2005, 2004 and  2003                                                                                    |       | 76       |
| Consolidated Statements of Cash Flows for the Years  Ended December 31, 2005, 2004 and 2003        |       | 77       |
| Notes to Consolidated Financial Statements                                                              |       | 79       |
| Schedule:                                                                                               |       |     |
| II Condensed  Financial Statements of Financial Security Assurance Holdings Ltd. as of                  |       |     |
| December 31,  2005 and 2004 and for the Years Ended December 31, 2005, 2004 and 2003          |       | 142      |

 

72

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**Report of Independent Registered Public AccountingFirm**

To Board of Directors and Shareholdersof Financial Security Assurance Holdings Ltd.:

In our opinion, the consolidated financial statementslisted in the accompanying index present fairly, in all material respects, thefinancial position of Financial Security Assurance Holdings Ltd. andSubsidiaries (the “Company”) at December 31, 2005 and December 31,2004, and the results of their operations and their cash flows for each of thethree years in the period ended December 31, 2005 in conformity withaccounting principles generally accepted in the United States of America. Inaddition, in our opinion, the financial statement schedule listed in theaccompanying index presents fairly, in all material respects, the informationset forth therein when read in conjunction with the related consolidatedfinancial statements. These financial statements and financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these financial statements and financial statementschedule based on our audits. We conducted our audits of these statements inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management,and evaluating the overall financial statement presentation. We believe thatour audits provide a reasonable basis for our opinion.

As discussed in Note 25 to the consolidated financialstatements, in 2003 the Company changed its method of accounting for itsinterest in certain variable interest entities.
| /s/ PricewaterhouseCoopers LLP |   |   |
|--------------------------------|--------|--------|
| New York, New York             |   |   |
| March 24, 2006            |   |   |

 

73

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**FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. ANDSUBSIDIARIESCONSOLIDATED BALANCE SHEETS(in thousands, except share data)**

| ** **                                                                                          | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                          | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                          |       |                                  |       |   |   |
| Bonds at fair value  (amortized cost of $4,219,344 and $3,863,909)                                  |       | $                                     | 4,382,037  |   | $ | 4,116,088 |   |
| Equity securities at fair  value (cost of $54,370 and $54,300)                                      |       | 54,370                                |       | 54,300 |   |
| Short-term  investments                                                                             |       | 182,645                               |       | 119,746 |   |
| Variable interest  entities’ bonds at fair value (amortized cost of $1,155,832 and $1,342,489) |       | 1,155,992                             |       | 1,346,355 |   |
| Variable interest  entities’ short-term investment portfolio                                   |       | 2,674                                 |       | 1,194 |   |
| Financial products bond  portfolio at fair value (amortized cost of $11,754,330 and $7,882,739)     |       | 11,827,824                            |       | 7,925,072 |   |
| Financial products bond  portfolio pledged as collateral at fair value (amortized cost of $5,908)   |       | —                                |       | 5,913 |   |
| Financial products short-term  investment portfolio                                                 |       | 1,015,509                             |       | 268,125 |   |
| Total investment  portfolio                                                                         |       | 18,621,051                            |       | 13,836,793 |   |
| Assets acquired in refinancing transactions:                                                        |       |                                  |       |   |   |
| Bonds at fair  value (amortized cost of $5,945 and $151,895)                                        |       | 9,145                                 |       | 157,036 |   |
| Securitized loans                                                                                   |       | 296,965                               |       | 369,749 |   |
| Other                                                                                               |       | 161,763                               |       | 222,423 |   |
| Total assets  acquired in refinancing transactions                                                  |       | 467,873                               |       | 749,208 |   |
| Total investments                                                                                   |       | 19,088,924                            |       | 14,586,001 |   |
| Cash                                                                                                |       | 20,117                                |       | 14,353 |   |
| Deferred acquisition  costs                                                                         |       | 335,129                               |       | 308,015 |   |
| Prepaid reinsurance  premiums                                                                       |       | 865,192                               |       | 759,191 |   |
| Investment in  unconsolidated affiliates                                                            |       | —                                |       | 49,645 |   |
| Reinsurance recoverable  on unpaid losses                                                           |       | 36,339                                |       | 35,419 |   |
| Other assets                                                                                        |       | 1,655,941                             |       | 1,328,384 |   |
| TOTAL ASSETS                                                                                        |       | $                                     | 22,001,642 |   | $ | 17,081,008 |   |
| **LIABILITIES AND MINORITY INTEREST AND  SHAREHOLDERS’ EQUITY**                                |       |                                  |       |   |   |
| Deferred premium revenue                                                                            |       | $                                     | 2,375,059  |   | $ | 2,095,423 |   |
| Losses and loss  adjustment expense                                                                 |       | 205,718                               |       | 179,941 |   |
| Guaranteed investment  contracts and variable interest entities’ debt                          |       | 14,947,118                            |       | 10,444,051 |   |
| Deferred federal income  taxes                                                                      |       | 231,265                               |       | 249,665 |   |
| Notes payable                                                                                       |       | 430,000                               |       | 430,000 |   |
| Minority interest                                                                                   |       | —                                |       | 48,550 |   |
| Minority interest in  variable interest entities                                                    |       | 180,406                               |       | 178,575 |   |
| Accrued expenses and  other liabilities                                                             |       | 809,174                               |       | 843,525 |   |
| TOTAL LIABILITIES  AND MINORITY INTEREST                                                            |       | $                                     | 19,178,740 |   | 14,469,730 |   |
| COMMITMENTS AND CONTINGENCIES                                                                       |       |                                  |       |   |   |
| Common stock (200,000,000  shares authorized; 33,517,995 issued; par value of $.01 per share)       |       | 335                                   |       | 335 |   |
| Additional paid-in  capital—common                                                             |       | 905,190                               |       | 905,080 |   |
| Accumulated other  comprehensive income (net of deferred income taxes of $84,123 and $103,755)      |       | 156,229                               |       | 199,764 |   |
| Accumulated earnings                                                                                |       | 1,761,148                             |       | 1,506,099 |   |
| Deferred equity  compensation                                                                       |       | 20,177                                |       | 23,528 |   |
| Less treasury stock at  cost (254,736 and 297,276 shares held)                                      |       | (20,177                               | )          | (23,528 | ) |
| TOTAL  SHAREHOLDERS’ EQUITY                                                                    |       | 2,822,902                             |       | 2,611,278 |   |
| TOTAL LIABILITIES AND MINORITY INTEREST AND  SHAREHOLDERS’ EQUITY                              |       | $                                     | 22,001,642 |   | $ | 17,081,008 |   |

 

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

74

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**FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. ANDSUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME**

**(inthousands)**

| ** **                                                                                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| **REVENUES:**                                                                                                                                     |       |                                       |       |   |   |   |   |
| Net premiums written                                                                                                                              |       | $                                          | 577,694    |   | $ | 587,769 |   | $ | 614,284 |   |
| Net premiums earned                                                                                                                               |       | $                                          | 404,059    |   | $ | 395,015 |   | $ | 356,373 |   |
| Net investment income                                                                                                                             |       | 200,827                                    |       | 172,051 |   | 154,048 |   |
| Net realized gains (losses)                                                                                                                       |       | 6,392                                      |       | (473 | ) | 5,126 |   |
| Net interest income from financial products and  variable interest entities                                                                       |       | 487,916                                    |       | 194,675 |   | 89,133 |   |
| Financial products net realized gains (losses)                                                                                                    |       | (7,473                                     | )          | 2,217 |   | 10,903 |   |
| Net realized and unrealized gains (losses) on  derivative instruments                                                                             |       | (172,475                                   | )          | 329,259 |   | 227,449 |   |
| Income from assets acquired in refinancing  transactions                                                                                          |       | 35,190                                     |       | 31,634 |   | 25,276 |   |
| Net realized gains from assets acquired in  refinancing transactions                                                                              |       | 6,508                                      |       | — |   | — |   |
| Other income                                                                                                                                      |       | 20,291                                     |       | 23,891 |   | 29,370 |   |
| TOTAL REVENUES                                                                                                                                    |       | 981,235                                    |       | 1,148,269 |   | 897,678 |   |
| **EXPENSES:**                                                                                                                                     |       |                                       |       |   |   |   |   |
| Losses and loss adjustment expenses                                                                                                               |       | 25,365                                     |       | 20,599 |   | 34,486 |   |
| Interest expense                                                                                                                                  |       | 26,990                                     |       | 26,993 |   | 33,026 |   |
| Policy acquisition costs                                                                                                                          |       | 68,340                                     |       | 62,201 |   | 58,391 |   |
| Financial products and variable interest entities’  foreign exchange (gain) loss                                                             |       | (189,785                                   | )          | 91,309 |   | 118,269 |   |
| Net interest expense from financial products and  variable interest entities                                                                      |       | 491,640                                    |       | 267,599 |   | 137,103 |   |
| Other operating expenses                                                                                                                          |       | 93,614                                     |       | 99,054 |   | 92,990 |   |
| TOTAL EXPENSES                                                                                                                                    |       | 516,164                                    |       | 567,755 |   | 474,265 |   |
| INCOME BEFORE  INCOME TAXES, MINORITY INTEREST, EQUITY IN EARNINGS OF UNCONSOLIDATED  AFFILIATES, AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE |       | 465,071                                    |       | 580,514 |   | 423,413 |   |
| Provision for income  taxes:                                                                                                                      |       |                                       |       |   |   |   |   |
| Current                                                                                                                                           |       | 127,479                                    |       | 53,472 |   | 74,619 |   |
| Deferred                                                                                                                                          |       | (606                                       | )          | 57,084 |   | 19,281 |   |
| Total provision                                                                                                                                   |       | 126,873                                    |       | 110,556 |   | 93,900 |   |
| NET INCOME BEFORE  MINORITY INTEREST, EQUITY IN EARNINGS OF UNCONSOLIDATED AFFILIATES, AND  CUMULATIVE EFFECT OF ACCOUNTING CHANGE                |       | 338,198                                    |       | 469,958 |   | 329,513 |   |
| Minority interest                                                                                                                                 |       | (11,224                                    | )          | (87,408 | ) | (39,817 | ) |
| Equity in earnings  (losses) of unconsolidated affiliates, net of income taxes of $(2,026),  $(604) and $1,884                               |       | (866                                       | )          | (3,943 | ) | 3,631 |   |
| Cumulative effect  of accounting change, net of income taxes of $2,598                                                                            |       | —                                     |       | — |   | 4,800 |   |
| NET INCOME                                                                                                                                        |       | 326,108                                    |       | 378,607 |   | 298,127 |   |
| **OTHER  COMPREHENSIVE INCOME (LOSS), NET OF TAX:**                                                                                               |       |                                       |       |   |   |   |   |
| Unrealized gains  (losses) arising during period (net of deferred income tax provision  (benefit) of $(25,837), $18,698 and $4,887)          |       | (32,012                                    | )          | 36,164 |   | 5,064 |   |
| Less:  reclassification adjustment for gains included in net income (net of deferred  income tax provision of $6,205, $237 and $1,278)            |       | 11,523                                     |       | 1,017 |   | 3,758 |   |
| Other  comprehensive income (loss)                                                                                                                |       | (43,535                                    | )          | 35,147 |   | 1,306 |   |
| COMPREHENSIVE INCOME                                                                                                                              |       | $                                          | 282,573    |   | $ | 413,754 |   | $ | 299,433 |   |

 

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

75

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**FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. ANDSUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

**(in thousands)**

| ** **                                                                                                 | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital-  Common** | ** ** | **Unrealized  Gain  on  Investments** | ** **    | **Accumulated  Earnings** | ** ** | **Deferred  Equity  Compensation** | ** ** | **Treasury  Stock** | ** ** | **Total** | ** **      |
|------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------------------------------|------------|---------------------------------------|---------------|---------------------------|------------|------------------------------------|------------|---------------------|------------|-----------|-----------------|
| BALANCE, December 31, 2002                                                                            |       |              | $          | 335                                       |       |                                  |          | $                         | 903,494    |                               |       |                | $          | 163,311   |            |   |   | $ | 852,241 |   |   |   | $ | 23,445 |   |   |   | $ | (23,445 | ) |   | $ | 1,919,381 |   |
| Net income for the year                                                                                    |       |              |       |                                      |       |                                  |          |                      |       |                               |       |                |       |      | 298,127         |   |   |   |   |   |   |   |   |   |   | 298,127 |   |
| Net change in  accumulated other comprehensive income (net of deferred income tax expense of  $3,609)      |       |              |       |                                      |       |                                  |          |                      |       |                               | 1,306      |                |       |      |            |   |   |   |   |   |   |   |   |   |   | 1,306 |   |
| Capital contribution                                                                                       |       |              |       |                                      |       |                                  | 335           |                      |       |                               |       |                |       |      |            |   |   |   |   |   |   |   |   |   |   | 335 |   |
| BALANCE, December 31, 2003                                                                            |       |              | 335        |                                      |       |                                  | 903,829       |                      |       |                               | 164,617    |                |       |      | 1,150,368       |   |   |   | 23,445 |   |   |   | (23,445 | ) |   | 2,219,149 |   |
| Net income for the year                                                                                    |       |              |       |                                      |       |                                  |          |                      |       |                               |       |                |       |      | 378,607         |   |   |   |   |   |   |   |   |   |   | 378,607 |   |
| Net change in  accumulated other comprehensive income (net of deferred income tax expense of  $18,461)     |       |              |       |                                      |       |                                  |          |                      |       |                               | 35,147     |                |       |      |            |   |   |   |   |   |   |   |   |   |   | 35,147 |   |
| Capital contribution                                                                                       |       |              |       |                                      |       |                                  | 1,251         |                      |       |                               |       |                |       |      |            |   |   |   |   |   |   |   |   |   |   | 1,251 |   |
| Dividends paid on  common stock                                                                       |       |              |       |                                      |       |                                  |          |                      |       |                               |       |                |       |      | (22,876         | ) |   |   |   |   |   |   |   |   |   | (22,876 | ) |
| Deferred equity payout                                                                                     |       |              |       |                                      |       |                                  |          |                      |       |                               |       |                |       |      |            |   |   |   | 83 |   |   |   | (83 | ) |   | — |   |
| BALANCE, December 31, 2004                                                                            |       |              |  335  |                                      |       |                                  |  905,080 |                      |       |                               | 199,764    |                |       |      |  1,506,099 |   |   |   | $ | 23,528 |   |   |   |  (23,528 | ) |   |  2,611,278 |   |
| Net income for the year                                                                                    |       |              |       |                                      |       |                                  |          |                      |       |                               |       |                |       |      | 326,108         |   |   |   |   |   |   |   |   |   |   | 326,108 |   |
| Net change in  accumulated other comprehensive income (net of deferred income tax (benefit)  of $(19,632)) |       |              |       |                                      |       |                                  |          |                      |       |                               | (43,535    | )                   |       |      |            |   |   |   |   |   |   |   |   |   |   | (43,535 | ) |
| Capital contribution                                                                                       |       |              |       |                                      |       |                                  | 110           |                      |       |                               |       |                |       |      |            |   |   |   |   |   |   |   |   |   |   | 110 |   |
| Dividends paid on  common stock                                                                       |       |              |       |                                      |       |                                  |          |                      |       |                               |       |                |       |      | (71,059         | ) |   |   |   |   |   |   |   |   |   | (71,059 | ) |
| Deferred equity payout                                                                                     |       |              |       |                                      |       |                                  |          |                      |       |                               |       |                |       |      |            |   |   |   | (3,351 | ) |   |   | 3,351 |   |   | — |   |
| BALANCE, December 31,  2005                                                                           |       |              | $          | 335                                       |       |                                  |          | $                         | 905,190    |                               |       |                | $          | 156,229   |            |   |   | $ | 1,761,148 |   |   |   | $ | 20,177 |   |   |   | $ | (20,177 | ) |   | $ | 2,822,902 |   |

 

The accompanying Notes to Consolidated Financial Statements are anintegral part of these statements.

76

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**FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. ANDSUBSIDIARIESCONSOLIDATED STATEMENTSOF CASH FLOWS(in thousands)**

| ** **                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash flows from  operating activities:                                              |       |                                        |       |   |   |   |   |
| Premiums received, net                                                              |       | $                                           | 594,390    |   | $ | 571,696 |   | $ | 591,030 |   |
| Policy acquisition and other operating expenses paid,  net                          |       | (167,947                                    | )          | (141,875 | ) | (105,870 | ) |
| Recoverable advances recovered (paid)                                               |       | (362                                        | )          | 7,327 |   | (959 | ) |
| Losses and loss adjustment expenses paid, net                                       |       | (1,124                                      | )          | (42,936 | ) | (5,972 | ) |
| Net investment income received                                                      |       | 204,460                                     |       | 171,915 |   | 145,221 |   |
| Federal income taxes paid                                                           |       | (122,754                                    | )          | (62,723 | ) | (83,972 | ) |
| Interest paid on notes                                                              |       | (26,957                                     | )          | (27,789 | ) | (28,687 | ) |
| Interest paid on guaranteed investment contracts                                    |       | (267,910                                    | )          | (71,392 | ) | (35,739 | ) |
| Interest received on guaranteed investment contracts  portfolio                     |       | 403,511                                     |       | 113,030 |   | 61,069 |   |
| Variable interest entities’ interest paid                                      |       | (6,739                                      | )          | (3,216 | ) | (3,513 | ) |
| Variable interest entities’ net interest income  received                      |       | 29,310                                      |       | 26,151 |   | 10,788 |   |
| Financial products and variable interest entities’  net derivative payments    |       | (21,016                                     | )          | (18,848 | ) | (12,564 | ) |
| Income received from refinanced assets                                              |       | 37,359                                      |       | 28,485 |   | 25,617 |   |
| Other                                                                               |       | (1,227                                      | )          | 2,989 |   | 33,170 |   |
| Net cash provided by operating activities                                           |       | 652,994                                     |       | 552,814 |   | 589,619 |   |
| Cash flows from investing  activities:                                              |       |                                        |       |   |   |   |   |
| Proceeds from sales and maturities of bonds                                         |       | 1,888,490                                   |       | 1,455,149 |   | 1,564,100 |   |
| Purchases of bonds                                                                  |       | (2,217,506                                  | )          | (1,918,477 | ) | (2,155,796 | ) |
| Net (increase) decrease in short-term  investments                                  |       | (62,899                                     | )          | (26,074 | ) | 93,653 |   |
| Proceeds from sales and maturities of financial  products bonds                     |       | 7,057,311                                   |       | 2,577,485 |   | 1,222,708 |   |
| Purchases of financial products bonds                                               |       | (11,107,956                                 | )          | (6,197,067 | ) | (3,385,041 | ) |
| Securities purchased under agreements to resell                                     |       | (350,000                                    | )          | 175,000 |   | (85,000 | ) |
| Net (increase) decrease in financial products short-term  investments               |       | (747,384                                    | )          | (39,310 | ) | (224,180 | ) |
| Purchases of variable interest entities’ bonds                                 |       | —                                      |       | — |   | (16,200 | ) |
| Maturities of variable interest entities’ bonds                                |       | 183,150                                     |       | 66,575 |   | — |   |
| Net (increase) decrease in variable interest entities’  short-term investments |       | (1,479                                      | )          | 9,925 |   | 13,048 |   |
| Purchases of property, plant and equipment                                          |       | (32,973                                     | )          | (5,427 | ) | (1,202 | ) |
| Assets acquired in refinancing transactions                                         |       | —                                      |       | (378,672 | ) | (53,625 | ) |
| Paydowns of assets acquired in refinancing  transactions                            |       | 92,514                                      |       | 102,534 |   | 51,395 |   |
| Proceeds from sales of assets acquired in refinancing  transactions                 |       | 182,701                                     |       | 60,953 |   | — |   |
| Other investments                                                                   |       | 46,877                                      |       | 247 |   | 30,367 |   |
| Net cash used for investing activities                                              |       | (5,069,154                                  | )          | (4,117,159 | ) | (2,945,773 | ) |
| Cash flows from financing  activities:                                              |       |                                        |       |   |   |   |   |
| Issuance of notes payable                                                           |       | —                                      |       | — |   | 96,673 |   |
| Repayment of notes payable                                                          |       | —                                      |       | — |   | (100,000 | ) |
| Distribution to minority shareholder                                                |       | (55,443                                     | )          | (6,980 | ) | (3,290 | ) |
| Dividends paid                                                                      |       | (71,059                                     | )          | (22,876 | ) | — |   |
| Securities sold under repurchase agreements                                         |       | (5,656                                      | )          | (58,309 | ) | 63,965 |   |
| Proceeds from issuance of guaranteed investment  contracts                          |       | 8,083,276                                   |       | 6,483,881 |   | 3,328,487 |   |
| Repayment of guaranteed investment contracts                                        |       | (3,545,405                                  | )          | (2,740,376 | ) | (1,139,173 | ) |
| Proceeds from issuance of variable interest entities’  debt                    |       | 206,674                                     |       | 102,139 |   | 101,189 |   |
| Repayment of variable interest entities’ debt                                  |       | (189,230                                    | )          | (190,681 | ) | — |   |
| Capital issuance costs                                                              |       | (1,343                                      | )          | (1,260 | ) | (3,605 | ) |
| Capital contribution                                                                |       | 110                                         |       | — |   | — |   |
| Repayment of variable interest entities’ preferred  stock                      |       | —                                      |       | (6,300 | ) | — |   |
| Net cash provided by financing activities                                           |       | 4,421,924                                   |       | 3,559,238 |   | 2,344,246 |   |
| Net (decrease) increase in cash                                                     |       | 5,764                                       |       | (5,107 | ) | (11,908 | ) |
| Cash at beginning of year                                                           |       | 14,353                                      |       | 19,460 |   | 31,368 |   |
| Cash at end of year                                                                 |       | $                                           | 20,117     |   | $ | 14,353 |   | $ | 19,460 |   |

 

The accompanying Notes to Consolidated Financial Statements are anintegral part of these statements.

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**FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. ANDSUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED(in thousands)**
|                                                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Reconciliation of  net income to net cash flows from operating activities:                              |       |                                       |       |   |   |   |   |
| Net income                                                                                              |       | $                                          | 326,108    |   | $ | 378,607 |   | $ | 298,127 |   |
| Increase in accrued investment income                                                                   |       | (14,126                                    | )          | (15,976 | ) | (5,535 | ) |
| Increase in deferred premium revenue, net of prepaid  reinsurance premiums                    |       | 173,635                                    |       | 169,670 |   | 274,010 |   |
| Increase in deferred acquisition costs                                                                  |       | (27,114                                    | )          | (34,369 | ) | (19,869 | ) |
| Increase (decrease) in current federal income taxes  payable                                            |       | 5,921                                      |       | 7,430 |   | 8,696 |   |
| Increase (decrease) in unpaid losses and loss  adjustment expenses, net of reinsurance recoverable |       | 24,856                                     |       | (29,651 | ) | 28,736 |   |
| Increase (decrease) in amounts withheld for others                                                      |       | —                                     |       | — |   | (18 | ) |
| Provision (benefit) for deferred income taxes                                                           |       | 1,330                                      |       | 57,689 |   | 23,767 |   |
| Net realized losses (gains) on investments                                                              |       | (5,427                                     | )          | (1,744 | ) | (16,029 | ) |
| Depreciation and accretion of discount                                                                  |       | 96,907                                     |       | 29,639 |   | 29,511 |   |
| Minority interest and equity in earnings of  unconsolidated affiliates                                  |       | 14,116                                     |       | 90,746 |   | 34,298 |   |
| Change in other assets and liabilities                                                                  |       | 56,788                                     |       | (99,227 | ) | (66,075 | ) |
| Cash provided by  operating activities                                                                  |       | $                                          | 652,994    |   | $ | 552,814 |   | $ | 589,619 |   |

 

On July 1, 2003, the Company consolidated $1.9billion in assets and $1.9 billion in liabilities relating to variable interestentities with no corresponding cash movement. The Company received tax benefitsof $1.2 million in 2004 and $0.3 million in 2003 from its parent company,which were recorded as capital contributions. There were no such benefitsrecorded in 2005. See Note 10 for disclosure of non-cashtransactions relating to restricted treasury stock transactions.

The accompanying Notes to Consolidated Financial Statements are anintegral part of these statements.

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**FINANCIALSECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIESNOTES TO CONSOLIDATEDFINANCIAL STATEMENTSFOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**

**1.**   ORGANIZATIONAND OWNERSHIP

Financial Security Assurance Holdings Ltd. (“FSAHoldings”, or together with its consolidated entities, the “Company”) is aholding company incorporated in the State of New York. The Company isprincipally engaged, through its insurance company subsidiaries, in providingfinancial guaranty insurance on municipal and asset-backed obligations. Itsprimary insurance company subsidiary is Financial Security Assurance Inc. (“FSA”).The Company’s underwriting policy is to insure municipal and asset-backedobligations that it determines would be investment-grade quality withoutthe benefit of the Company’s insurance. Municipal obligations insured by theCompany consist primarily of general obligation bonds that are supported by theissuers’ taxing powers and special revenue bonds and other special obligationsof states and local governments that are supported by the issuers’ abilities toimpose and collect fees and charges for public services or specific projects.Municipal obligations include obligations backed by the cash flow from leasesor other revenues from projects serving a substantial public purpose, includinggovernment office buildings, toll roads, healthcare facilities and utilities. Asset-backedobligations insured by the Company are generally issued in structuredtransactions and are backed by pools of assets, such as residential mortgageloans, consumer receivables, securities or other assets having an ascertainablecash flow or market value. The Company also insures synthetic asset-backedobligations that generally take the form of credit default swap (“CDS”) obligationsor credit-linked notes that reference pools of securities or loans, witha defined deductible to cover credit risks associated with the referencedsecurities or loans. Financial guaranty insurance written by the Companyguarantees scheduled payments on an issuer’s obligation. In the case of apayment default on an insured obligation, the Company is generally required topay the principal, interest or other amounts due in accordance with theobligation’s original payment schedule or, at its option, to pay such amountson an accelerated basis.

The Company expects to continue to emphasize adiversified insured portfolio characterized by insurance of both municipal andasset-backed obligations, with a broad geographic distribution and avariety of revenue sources and transaction structures. The Company’s insuredportfolio consists primarily of municipal and asset-backed obligationsoriginated in the United States of America, but the Company has also writtenand continues to pursue business in Europe and the Asia Pacific region.

The Company issues guaranteed investment contracts (“GICs”)through its consolidated affiliates: FSA Capital Management Services LLC (“FSACM”),FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSACapital Markets Services LLC (collectively, the “GIC Affiliates”). FSACM hasconducted substantially all of the Company’s GIC business since April 2003,following the receipt of an exemption from the requirements of the InvestmentCompany Act of 1940. The GIC Affiliates lend the proceeds from their sales ofGICs to FSA Asset Management LLC (“FSAM”), which invests the funds, generallyin obligations that qualify for FSA insurance. The GIC Affiliates and FSAM arecollectively referred to as the “FP Segment.”

The Company consolidates the results of certainvariable interest entities (“VIEs”), including FSA Global Funding Limited (“FSAGlobal”), Premier International Funding Co. (“Premier”) and Canadian GlobalFunding Corporation (“Canadian Global”). The Company consolidated FSA Globaland Canadian Global beginning in the third quarter of 2003 in accordance withFinancial Accounting Standards Board Interpretation No. 46, “Consolidationof Variable Interest Entities, an interpretation of ARB No. 51” (“FIN 46”).The Company also began to consolidate Premier in the third quarter of 2003 as aresult of 

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obtaining control rights.The Company refinanced certain defaulted transactions by employing refinancingvehicles to raise funds for the refinancings. These refinancing vehicles arealso consolidated.

FSA Global is a special purpose funding vehicle owned29% by a subsidiary of the Company. FSA Global issues FSA-insured mediumterm notes and invests the proceeds from the sale of its notes in FSA-insuredobligations with a view towards realizing the yield difference between thenotes issued and the obligations purchased with the note proceeds. The majorityof Canadian Global’s assets were liquidated and its liabilities satisfiedduring the third quarter of 2004. Premier is principally engaged in debtdefeasance for lease transactions.

The Company’s management believes that the assets heldby FSA Global, Premier and the refinancing vehicles, including those that areeliminated in consolidation, are beyond the reach of the Company and itscreditors, even in bankruptcy or other receivership. Substantially all of FSAGlobal’s assets are pledged as collateral to secure the repayment, on a prorata basis, of FSA Global’s debt.

On July 5, 2000, theCompany completed a merger in which Financial Security Assurance Holdings Ltd.(“FSA Holdings”) became a direct subsidiary of Dexia Holdings, Inc. (“DexiaHoldings”), which, in turn, is owned 90% by Dexia Crédit Local S.A. (“DexiaCrédit Local”) and 10% by Dexia S.A. (“Dexia”), a Belgian corporation whoseshares are traded on the Euronext Brussels and Euronext Paris markets, as wellas on the Luxembourg Stock Exchange. Dexia Crédit Local is a wholly ownedsubsidiary of Dexia. At December 31, 2005, Dexia Holdings ownedapproximately 99% of the Company’s outstanding shares; the only other holdersof the Company’s common stock were an affiliate of White Mountains InsuranceGroup, Ltd. (“White Mountains”) and certain directors of the Company who ownedshares of the Company’s common stock or economic interests therein under theDirector Share Purchase Program (see Note 10).

**2.**   SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES

The accompanyingConsolidated Financial Statements have been prepared in accordance withaccounting principles generally accepted in the United States of America (“GAAP”),which, for the insurance company subsidiaries, differ in certain materialrespects from the accounting practices prescribed or permitted by insuranceregulatory authorities (see Note 5). The preparation of financial statements inconformity with GAAP requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities in the Company’sconsolidated balance sheets at December 31, 2005 and 2004, the reportedamounts of revenues and expenses in the statements of operations andcomprehensive income during the years ended December 31, 2005, 2004 and2003 and disclosure of contingent assets and liabilities. Such estimates andassumptions include, but are not limited to, losses and loss adjustmentexpenses, fair value of financial instruments and the deferral and amortizationof policy acquisition costs. Actual results may differ from those estimates.Significant accounting policies under GAAP are as follows:

***Basis of Presentation***

The Consolidated FinancialStatements include the accounts of FSA Holdings and its direct and indirectsubsidiaries, principally including FSA, FSA Insurance Company, FinancialSecurity Assurance International Ltd. (“FSA International”), Financial SecurityAssurance (U.K.) Limited, the GIC Affiliates, FSAM, FSA Portfolio ManagementInc., Transaction Services Corporation, FSA Services (Australia) Pty Limitedand FSA Services (Japan) Inc. (collectively, the “Subsidiaries”). TheConsolidated Financial Statements also include the accounts of certain VIEs asdescribed in Note 1. All intercompany accounts and transactions have beeneliminated. Certain prior-year balances have been reclassified to conformto the current-year presentation.

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***Investments***

Investments in debt and equity securities designatedas available for sale are carried at fair value. The unrealized gain or loss oninvestments that are not hedged or are economically hedged but do not qualifyfor hedge accounting  is reflected as aseparate component of shareholders’ equity, net of applicable deferred incometaxes. The unrealized gain or loss attributable to the hedged risk oninvestments that qualify as fair-value hedges is recorded in incomecurrently.

Bond discounts and premiums are amortized on theeffective yield method over the remaining terms of the securities acquired. Formortgage-backed securities and any other holdings for which prepaymentrisk may be significant, assumptions regarding prepayments are evaluatedperiodically and revised as necessary. Any adjustments required due to theresulting change in effective yields are recognized in current income. Short-terminvestments, which are those investments with a maturity of less than one yearat time of purchase, are carried at cost, which approximates fair value.Amounts deposited in money market funds and investments with a maturity at timeof purchase of three months or less and are included in short-terminvestments.

Variable-rate demand notes (“VRDN”) and auction-ratesecurities (“ARS”) are included in bonds and financial products bond portfolioat fair value. VRDNs are long-term bonds that bear floating interest rates andprovide investors with the option to tender or put the bonds at par, generallyon a daily, weekly or monthly basis. ARS are long-term securities withinterest-rate reset features and are traded in the marketplace through abidding process. The cash flows related to these securities are presented on agross basis in the consolidated statements of cash flows. Mortgage loans arecarried at the lower of cost or market on an aggregate basis. Realized gains orlosses on sale of investments are determined on the basis of specificidentification. Investment income is recorded as earned. Other-than-temporaryimpairments are reflected in earnings as a realized loss.

Investments inunconsolidated affiliates are based on the equity method of accounting (seeNote 18). The Company records its share of unrealized gains or losses ofunconsolidated affiliates, net of applicable deferred taxes, in othercomprehensive income.

***Derivatives***

The Company enters into derivative contracts to manageinterest-rate and foreign currency exposure of the Company’s GIC and VIE debt,GIC bond portfolio and VIE bond portfolio. The derivatives are recorded at fairvalue. These derivatives generally include interest-rate futures andinterest rate and currency swap agreements, which are primarily utilized toconvert the Company’s fixed-rate obligations on its GIC and VIE debt, GICbond portfolio and VIE bond portfolio into U.S.-dollar floating-rateobligations. The gains and losses relating to the fair value of derivatives areincluded in net realized and unrealized gains (losses) on derivativeinstruments in the consolidated statements of operations and comprehensiveincome.

The gains and losses related to derivatives designatedas fair-value hedges are included in net interest income from financialproducts and variable interest entities and net interest expense from financialproducts and variable interest entities, as appropriate, along with theoffsetting change in the fair value of the risk being hedged.

The Company has alsoinsured a number of CDS agreements that it intends, in each case, to hold forthe full term of the agreement. It considers these agreements to be a normalextension of its financial guaranty insurance business, although they areconsidered derivatives for accounting purposes. These agreements are recordedat fair value. The Company believes that the most meaningful presentation ofthe financial statement impact of these derivatives is to reflect premiums asinstallments are received, to record losses and loss adjustment expenses asincurred and to record changes in fair value as incurred. 

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Changesin fair value are recorded in net realized and unrealized gains (losses) onderivative instruments and in other assets or other liabilities, asappropriate. The Company uses quoted market prices, when available, todetermine fair value. If quoted prices are not available, management uses internallydeveloped estimates of fair value. Due to a lack of a quoted market for the CDSobligations written by the Company, estimates generated from the Company’svaluation process may differ materially from values that may be realized inmarket transactions.

***Securities Purchased under Agreements to Resell andSecurities Sold under Agreements to Repurchase***

Securities purchased underagreements to resell and securities sold under agreements to repurchase areaccounted for as collateralized transactions and are recorded at contract valueplus accrued interest, subject to the provisions of Statement of FinancialAccounting Standards No. 140, “Accounting for Transfer and Servicing ofFinancial Assets and Extinguishment of Liabilities.” It is the Company’s policyto take possession of securities borrowed under agreements to resell.

***Premium Revenue Recognition***

Gross and ceded premiums received in upfront payoutsare earned in proportion to the expiration of the related risk. For upfrontpremium transactions, premium earnings are greater in the earlier periods whenthere is a higher amount of exposure outstanding. The amount of riskoutstanding is equal to the sum of the par amount of debt insured over theexpected period of coverage. Deferred premium revenue and prepaid reinsurancepremiums represent the portion of gross and ceded premium, respectively, thatis applicable to coverage of risk to be provided in the future on policies inforce. When an insured issue is retired or defeased prior to the end of the expectedperiod of coverage, the remaining deferred premium revenue and prepaidreinsurance premium, less any amount credited to a refunding issue insured bythe Company, are recognized.

For premiums received onan installment basis, the Company earns the premium over each installmentperiod, typically less than one year, throughout the period of coverage.Typically, installment premiums are applicable to insured transactions thatinvolve CDS or special purpose vehicles (“SPVs”) structured to finance pools ofassets such as auto loans or mortgage loans. Premiums on such transactions aretypically paid in installments because premium is paid from the interest spreadavailable to the SPV (i.e. the difference in interest rate between the yield onits assets and the yield on its liabilities). The nature of the assets financedcan have uncertain debt service schedules due to prepayments. When the Company,through its ongoing credit review process, identifies transactions wherepremiums are paid on an installment basis and certain default triggers havebeen breached, the Company ceases to earn premiums on such transactions.

***Losses and Loss Adjustment Expenses***

*Background*

Financial guaranty insurance generally provides anunconditional and irrevocable guaranty that protects the holder of a financialobligation against non-payment of principal and interest when due. Upon apayment default on an insured obligation, the Company is generally required topay the principal, interest or other amounts due in accordance with the obligation’soriginal payment schedule or, at its option, to pay such amounts on anaccelerated basis.

The financial guarantyindustry has emerged over the past thirty-four years. Management believes thatexisting insurance accounting under Statement of Financial Accounting StandardsNo. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”),does not specifically address financial guaranty insurance. Accordingly, theaccounting for loss and loss adjustment expenses within the financial guarantyinsurance industry has developed based on analogy to the most directlycomparable elements of existing 

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literature,including sections of SFAS 60, Statement of Financial Accounting Standards No. 5,“Accounting for Contingencies” (“SFAS 5”) and Emerging Issues Task Force Issue85-20, “Recognition of fees for guaranteeing a loan” (“EITF 85-20”).

*Company-specificpolicy*

The Company establishes loss liabilities based on itsestimate of specific and non-specific losses. The Company alsoestablishes liabilities for loss adjustment expenses (“LAE”), consisting of theestimated cost of settling claims, including legal and other fees and expensesassociated with administering the claims process.

The Company calculates a loss and LAE liability basedupon identified risks inherent in its insured portfolio. If an individualpolicy risk has a probable loss as of the balance sheet date, a case reserve isestablished. For the remaining policy risks in the portfolio, a non-specificreserve is established to account for the inherent credit losses that can bestatistically estimated.

Case reserves for financial guaranty insurancecompanies differ from those of traditional property and casualty insurancecompanies. The primary difference is that traditional property and casualty casereserves include only claims that have been incurred and reported to theinsurance company. In a traditional property and casualty company, claims areincurred when defined events occur such as an auto accident, home fire orstorm. Unlike traditional property and casualty claims, financial guarantylosses arise from the extension of credit protection and occur as the result ofthe credit deterioration of the issuer of the insured obligations over thelives of those insured obligations. Such deterioration and ultimate lossamounts can be projected based on historical experience in order to estimateprobable loss, if any. Accordingly, specific loss events that require casereserves include (1) policies under which claim payments have been madeand additional claim payments are expected and (2) policies under whichclaim payments are probable and reasonably estimable, but have not yet beenmade.

The Company establishes a case reserve for the presentvalue of the estimated loss, net of subrogation recoveries, when, in management’sopinion, the likelihood of a future loss on a particular insured obligation isprobable and reasonably estimable at the balance sheet date. When an insuredobligation has met the criteria for establishing a case reserve and that transactionpays a premium in installments, those premiums, if expected to be receivedprospectively, are considered a form of recovery and are no longer earned aspremium revenue. A case reserve is determined using cash flow or similar modelsthat represent the Company’s estimate of the net present value of theanticipated shortfall between (1) scheduled payments on the insuredobligation plus anticipated loss adjustment expenses and (2) anticipatedcash flow from and proceeds to be received on sales of any collateralsupporting the obligation and other anticipated recoveries. The estimated loss,net of recovery, on a transaction is discounted using the risk-free rateappropriate for the term of the insured obligation at the time the reserve isestablished and is not subsequently adjusted.

The Company records a non-specific reserve toreflect the credit risks inherent in its portfolio. The non-specific and casereserves together represent the Company’s estimate of total reserves.Generally, when an insured credit deteriorates to a point where claims areexpected, a case reserve is established. The establishment of a non-specificreserve for credits that have not yet defaulted is a common practice in thefinancial guaranty industry, although there are differences in the specificmethodologies applied by other financial guarantors in establishing andmeasuring these reserves.

The Company establishes a non-specific reserveon its portfolio of credits because management believes that a portfolio ofinsured obligations will deteriorate over its life and that the existence ofinherent loss can be proven statistically by data such as rating agencypublications. The establishment of the reserve is a systematic process thatconsiders this quantitative, statistical information obtained primarily fromMoody’s Investors Service, Inc. (“Moody’s”) and Standard & Poor’sRatings Services 

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(“S&P”), together withqualitative factors such as overall credit quality trends resulting fromeconomic and political conditions, recent loss experience in particularsegments of the portfolio and changes in underwriting policies and procedures.The factors used to establish reserves are evaluated periodically by comparingthe statistically computed loss amount with the incurred losses as representedby case reserve activity to develop an experience factor that is updated andapplied to current-year originations. The process results in management’s bestestimate of inherent losses associated with providing credit protection at eachbalance sheet date.

The non-specific reserve established considersall levels of protection (e.g., reinsurance and overcollateralization). Net paroutstanding for policies originated in the current period is multiplied by lossfrequency and severity factors, with the resulting amounts discounted at therisk-free rates using the treasury yield curve (the “statisticalcalculation”). The discount rate does not change and is used to accrete theloss for the life of each policy. The loss factors used for the calculation arethe product of default frequency rates obtained from Moody’s and severityfactors obtained from S&P. Moody’s is chosen for default frequency ratesdue to its credibility, large population, statistical format and reliability offuture update. The Moody’s default information is applied to all credit sectorsor asset classes as described below. In its publication of default rates from1970-2004, Moody’s tracks bonds over a twenty-year horizon bycredit rating at time of issuance. For the purpose of establishing appropriateseverity factors, the Company’s methodology segregates the portfolio into assetclasses, including health care transactions, all other municipal transactions,pooled corporate transactions, commercial real estate, and all other asset-backedtransactions. The severity factors are derived from capital charge assessmentsprovided by S&P. S&P capital charges project loss levels by asset classand are incorporated into their capital adequacy stress scenario analysis.

The product of the current-year statisticalcalculation multiplied by the current-year experience factor representsthe present value of loss amounts calculated for current-yearoriginations. The experience factor is based on the Company’s inception-to-datehistorical losses (starting from 1993, when the Company established thenon-specific reserve methodology). The experience factor is calculated bydividing cumulative inception-to-date actual losses incurred by the Company bythe cumulative inception-to-date losses determined by the statisticalcalculation. The experience factor that applies to the whole portfolio isreviewed and, where appropriate, updated periodically, but no less thanannually.

The present value of loss amounts calculated for thecurrent-year originations is established at inception of the policy, andthere is no subsequent change unless significant adverse or favorable lossexperience is observed. In the event that the experience factor is eitherincreased or decreased based on adverse or favorable loss experience, ananalysis is performed of the non-specific reserve balance with particularemphasis on the asset class, if any, driving the experience factor adjustment.The objective of such analysis is to quantify the appropriate adjustment to theoverall non-specific reserve balance for the change in experience. Theadjustment that increases or decreases the non-specific reserve is charged orcredited to loss expense.

The present value of loss amounts calculated for thecurrent-year originations plus an amount representing the accretion ofdiscount pertaining to prior-year originations are charged to lossexpense and increase the non-specific loss reserve after adjustments that maybe made to reflect observed favorable or adverse experience. The entirenon-specific reserve is available to absorb probable losses inherent in theportfolio. As there are no specific losses provided in the non-specificreserve, there is no identifiable reinsurance recoverable. At the time that acase reserve is identified, the gross loss liability is recognized along withthe reinsurance recoverable, if any. The amount of reinsurance recoverabledepends on the policy ceded and the reinsurance agreements covering suchpolicy. Management cannot predict the specific policies that will emerge as case-basislosses from the portfolio and is not entitled to recovery from the reinsurer inadvance of producing a case reserve.

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Since the non-specific reserve contains theinherent losses of the portfolio, when a case reserve adjustment is deemedappropriate, whether the result of adverse or positive credit developments,accretion or the addition of a new case reserve, a full transfer is madebetween the non-specific reserve and the case reserve balances with noeffect to income. The adequacy of the non-specific reserve balance is reviewedperiodically and at least annually based on a review of the Company’s inception-to-datecumulative losses divided by the total inception-to-date cumulativenet par underwritten. This inception-to-date result is compared withthe product of the non-specific reserves divided by the net par outstanding asof the balance sheet date. In the event that such ratios are not in line, thenfurther analysis is performed to quantify appropriate adjustments that may beeither charges or benefits on the consolidated statements of operations andcomprehensive income, as occurred in 2003, 2004 and 2005.

Thetable below presents the significant assumptions inherent in the calculationsof the case and non-specific reserves.

| ** **                          | ** ** | **As of December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Case reserve  discount rate         |       | 3.13%–5.90%                      |       | 3.13%–5.90% |   |
| Non-specific  reserve discount rate |       | 1.20%–7.95%                      |       | 1.20%–7.95% |   |
| Current experience  factor          |       | 1.8                                   |       | 2.0 |   |

 

*ReservingMethodology Industry Practice*

Management is aware that there are differencesregarding the method of defining and measuring both case reserves and non-specificreserves among participants in the financial guaranty industry. Other financialguarantors may establish case reserves only after a default and use differenttechniques to estimate probable loss. Other financial guarantors may establishthe equivalent of non-specific reserves, but refer to these reserves byvarious terms such as, but not limited to, “unallocated losses,” “active creditreserves” and “portfolio reserves,” or may use different statistical techniquesfrom those the Company uses to determine loss at a given point in time.

Management believes that existing accountingliterature does not address the unique attributes of financial guarantyinsurance. As an insurance enterprise, the Company initially refers to theaccounting and financial reporting guidance in SFAS 60. In establishing lossliabilities, the Company relies principally on SFAS 60, which prescribesdiffering treatment depending on whether a contract is a short-durationcontract or a long-duration contract. Financial guaranty insurance doesnot fall clearly within the definition of either short-duration or long-durationcontracts. Therefore, the Company does not believe that SFAS 60 aloneprovides sufficient guidance for financial guaranty claim liabilityrecognition.

As a result, the Company also analogizes to SFAS 5,which requires the establishment of liabilities when a loss is both probableand reasonably estimable. The Company also relies by analogy on EITF 85-20,which provides general guidance on the recognition of losses related toguaranteeing a loan. In the absence of a comprehensive accounting modelprovided by SFAS 60, industry participants, including the Company, have lookedto such other guidance referred to above to develop their accounting policiesfor the establishment and measurement of loss liabilities. The Company believesthat its financial guaranty loss reserve policy is appropriate under theapplicable accounting literature, and that it best reflects the fact that aportfolio of credit-based insurance, comprising irrevocable contracts thatcannot be unilaterally changed by the insurer and that match the maturity termsof the underlying insured obligation, contains probable and reasonablyestimable losses.

In January and February of 2005, theSecurities and Exchange Commission (“SEC”) staff discussed with financialguaranty industry participants, differences in loss recognition practices amongthose participants. Based on discussions with the SEC staff, the Companyunderstands that the Financial Accounting Standards Board (“FASB”) staff isconsidering additional guidance regarding financial 

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guaranty insurance. Whenand if the FASB or SEC reach a conclusion on this issue, the Company and therest of the financial guaranty industry may be required to change some aspectsof their loss reserving policies, and the potential changes could extend topremium and expense recognition. The Company cannot predict how the FASB or SECwill resolve this issue and the resulting impact on its financial statements.

Until additional guidanceis issued, the Company intends to continue applying its existing policyregarding the establishment of both case and non-specific loss reserves.

***Deferred Acquisition Costs***

Deferred acquisition costs are comprised of expensesrelated to the production of business, including commissions paid onreinsurance assumed, compensation and related costs of underwriting andmarketing personnel, certain rating agency fees, premium taxes and certainother underwriting expenses, reduced by ceding commission received on premiumsceded to reinsurers. Deferred acquisition costs are amortized over the periodin which the related premiums are earned. When an insured issue is retired or defeasedprior to the end of the expected period of coverage, the remaining deferredacquisition cost is recognized. A premium deficiency would be recognized if thepresent value of anticipated losses and loss adjustment expenses exceeded thesum of deferred premium revenue and estimated installment premiums.

The Company does not deferacquisition costs relating to GICs issued by the GIC Affiliates, except for GICcommissions paid to third parties, which are included in other assets. Theamortization of these commissions is recorded in net interest expense fromfinancial products and VIEs.

***GIC and VIE Debt***

GIC and VIE debt isrecorded at amortized cost. The Company may enter into associated transactionsin order to reduce the Company’s exposure to fluctuations in interest andforeign exchange rates and its related effect on the fair value of the debt.The change in the fair value of the hedged item in a qualifying accountinghedge attributable to the hedged risk adjusts the carrying amount of the hedgeditem and is recognized in income currently. VIE debt may include hybrid debtinstruments that contain embedded derivatives. Under certain conditions,embedded derivatives are required to be separated from the debt instrument andaccounted for at fair value, with all changes reflected through earnings.

***Foreign Currency Translation***

Monetary assets and liabilities denominated in foreigncurrencies are translated at the spot rate at the balance sheet date. Non-monetaryassets and liabilities are translated at historical rates. Revenues andexpenses denominated in foreign currencies are translated at average ratesprevailing during the year. Unrealized gains and losses on available-for-salesecurities, net of deferred taxes, resulting from translating investmentsdenominated in foreign currencies are recorded in shareholders’ equity. Gainsand losses from transactions in foreign currencies are recorded in income.

***Federal Income Taxes***

The provision for income taxes consists of an amountfor taxes currently payable and a provision for the deferred tax consequencesof temporary differences between the tax basis of assets and liabilities andthe financial statement basis.

Non-interest-bearingtax and loss bonds are purchased to prepay the tax benefit that results fromdeducting contingency reserves as provided under Internal Revenue CodeSection 832(e). The Company records the purchase of tax and loss bonds inother assets.

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***Assets Acquired in Refinancing Transactions***

Asset-backed senior notesrepresent the Company’s purchase of less than 50% of a refinanced transaction.Asset-backed senior notes are carried at cost, with any reduction in carryingvalue recognized as an adjustment to yield.

**3.**   INVESTMENTS

In addition to itsinsurance company and certain non-insurance subsidiaries’ investments(the “Investment Portfolio”), the Company maintains investments from proceedsof FSA-insured GICs (the “FP Investment Portfolio”) and investments inthe portfolio of securities owned by the VIEs (the “VIE Portfolio”) and assetsacquired in refinancing transactions (see Note 22).

***Investment Portfolio***

Bonds and short-term deposits at amortized cost of$9.9 million and $9.7 million at December 31, 2005 and 2004, respectively,were on deposit with state regulatory authorities as required by insuranceregulations.

Consolidatednet investment income attributable to the Investment Portfolio consisted of thefollowing (in thousands):

| ** **                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Bonds and  short-term investments |       | $                                          | 194,736    |   | $ | 174,551 |   | $ | 156,729 |   |
| Equity  investments               |       | 8,931                                      |       | — |   | — |   |
| Investment  expenses              |       | (2,840                                     | )          | (2,500 | ) | (2,681 | ) |
| Net investment income             |       | $                                          | 200,827    |   | $ | 172,051 |   | $ | 154,048 |   |

 

Thecredit quality of bonds in the Investment Portfolio at December 31, 2005was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|
| AAA           |       |       | 78.6       | %                              |       |
| AA            |       |       | 17.4       |                           |       |
| A        |       |       | 4.0        |                           |       |
|          |       |       | 100.0      | %                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2005.

Of the bonds included in the Investment Portfolio,6.8% were Triple-A by virtue of insurance provided by FSA (“FSA-InsuredInvestments”). Over 95% of the FSA-Insured Investments were investment gradewithout giving effect to the FSA insurance. The average shadow rating of theFSA-Insured Investments, which is the rating without giving effect to the FSA insurance,was in the Double-A range.

87

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Theamortized cost and fair value of the bonds in the Investment Portfolio were asfollows (in thousands):

| ** **                                                                             | ** ** | **As of December 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| U.S. Treasury securities and obligations of U.S.  government corporations and agencies |       | $                                               | 195,495    |   |   | $ | 3,881 |   |   |   | $ | (755 | ) |   | $ | 198,621 |   |
| Obligations of  states and political subdivisions                                      |       | 3,431,046                                       |       |   | 173,279 |   |   |   | (5,457 | ) |   | 3,598,868 |   |
| Mortgage-backed  securities                                                            |       | 250,001                                         |       |   | 809 |   |   |   | (4,564 | ) |   | 246,246 |   |
| Corporate  securities                                                                  |       | 186,369                                         |       |   | 1,797 |   |   |   | (2,124 | ) |   | 186,042 |   |
| Foreign  securities                                                                    |       | 116,217                                         |       |   | 1,260 |   |   |   | (5,191 | ) |   | 112,286 |   |
| Asset-backed  securities                                                               |       | 40,216                                          |       |   | 10 |   |   |   | (252 | ) |   | 39,974 |   |
| Subtotal                                                                               |       | 4,219,344                                       |       |   | 181,036 |   |   |   | (18,343 | ) |   | 4,382,037 |   |
| Short-term  investments                                                                |       | 182,645                                         |       |   | — |   |   |   | — |   |   | 182,645 |   |
| Total                                                                                  |       | $                                               | 4,401,989  |   |   | $ | 181,036 |   |   |   | $ | (18,343 | ) |   | $ | 4,564,682 |   |

 

| ** **                                                                             | ** ** | **As of December 31, 2004** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| U.S. Treasury securities and obligations of U.S.  government corporations and agencies |       | $                                               | 164,312    |   |   | $ | 5,347 |   |   |   | $ | (356 | ) |   | $ | 169,303 |   |
| Obligations of  states and political subdivisions                                      |       | 3,058,967                                       |       |   | 220,875 |   |   |   | (1,987 | ) |   | 3,277,855 |   |
| Mortgage-backed  securities                                                            |       | 220,202                                         |       |   | 3,630 |   |   |   | (1,322 | ) |   | 222,510 |   |
| Corporate  securities                                                                  |       | 237,486                                         |       |   | 7,075 |   |   |   | (505 | ) |   | 244,056 |   |
| Foreign  securities                                                                    |       | 126,099                                         |       |   | 19,895 |   |   |   | (714 | ) |   | 145,280 |   |
| Asset-backed  securities                                                               |       | 56,843                                          |       |   | 312 |   |   |   | (71 | ) |   | 57,084 |   |
| Subtotal                                                                               |       | 3,863,909                                       |       |   | 257,134 |   |   |   | (4,955 | ) |   | 4,116,088 |   |
| Short-term  investments                                                                |       | 119,746                                         |       |   | — |   |   |   | — |   |   | 119,746 |   |
| Total                                                                                  |       | $                                               | 3,983,655  |   |   | $ | 257,134 |   |   |   | $ | (4,955 | ) |   | $ | 4,235,834 |   |

 

The followingtable shows the gross unrealized losses and fair value, aggregated byinvestment category and length of time that individual securities have been ina continuous unrealized loss position (in thousands):

| ** **                                                                             | ** ** | **As of December 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                                             | ** ** | **Fair Value**                             | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| U.S. Treasury securities and obligations of U.S.  government corporations and agencies |       | $                                               | 65,922     |   |   | $ | (436 | ) |   | $ | 14,635 |   |   | $ | (319 | ) |   | $ | 80,557 |   |   | $ | (755 | ) |   |
| Obligations of states and political subdivisions                                       |       | 375,766                                         |       |   | (3,609 | ) |   | 108,031 |   |   | (1,848 | ) |   | 483,797 |   |   | (5,457 | ) |   |
| Mortgage-backed securities                                                             |       | 141,687                                         |       |   | (2,272 | ) |   | 48,060 |   |   | (2,292 | ) |   | 189,747 |   |   | (4,564 | ) |   |
| Corporate securities                                                                   |       | 103,144                                         |       |   | (1,492 | ) |   | 23,650 |   |   | (632 | ) |   | 126,794 |   |   | (2,124 | ) |   |
| Foreign securities                                                                     |       | 37,480                                          |       |   | (5,181 | ) |   | 1,508 |   |   | (10 | ) |   | 38,988 |   |   | (5,191 | ) |   |
| Asset-backed securities                                                                |       | 18,540                                          |       |   | (124 | ) |   | 14,813 |   |   | (128 | ) |   | 33,353 |   |   | (252 | ) |   |
| Total                                                                                  |       | $                                               | 742,539    |   |   | $ | (13,114 | ) |   | $ | 210,697 |   |   | $ | (5,229 | ) |   | $ | 953,236 |   |   | $ | (18,343 | ) |   |

 

 

88

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| ** **                                                                             | ** ** | **As of December 31, 2004** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                                             | ** ** | **Fair Value**                             | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| U.S. Treasury securities and obligations of U.S.  government corporations and agencies |       | $                                               | 60,259     |   |   | $ | (192 | ) |   | $ | 4,189 |   |   | $ | (164 | ) |   | $ | 64,448 |   |   | $ | (356 | ) |   |
| Obligations of states and political subdivisions                                       |       | 214,194                                         |       |   | (1,266 | ) |   | 67,095 |   |   | (721 | ) |   | 281,289 |   |   | (1,987 | ) |   |
| Mortgage-backed securities                                                             |       | 32,701                                          |       |   | (304 | ) |   | 38,784 |   |   | (1,018 | ) |   | 71,485 |   |   | (1,322 | ) |   |
| Corporate securities                                                                   |       | 29,146                                          |       |   | (162 | ) |   | 17,859 |   |   | (343 | ) |   | 47,005 |   |   | (505 | ) |   |
| Foreign securities                                                                     |       | 1,722                                           |       |   | (39 | ) |   | 40,136 |   |   | (675 | ) |   | 41,858 |   |   | (714 | ) |   |
| Asset-backed securities                                                                |       | 16,279                                          |       |   | (71 | ) |   | — |   |   | — |   |   | 16,279 |   |   | (71 | ) |   |
| Total                                                                                  |       | $                                               | 354,301    |   |   | $ | (2,034 | ) |   | $ | 168,063 |   |   | $ | (2,921 | ) |   | $ | 522,364 |   |   | $ | (4,955 | ) |   |

 

The Company periodically monitors its InvestmentPortfolio for individual investments in an unrealized loss position in order toassess whether any investment is considered other-than-temporarilyimpaired. In each case, the Company determines the nature and cause of thedecline and whether the Company maintains the ability and intent to hold thesecurity until the unrealized loss may reverse or until maturity. At December 31,2005, there were 96 securities that were in an unrealized loss position for acontinuous 12-month period or longer. None of the 96 securities had anunrealized loss that exceeded book value by 11% at December 31, 2005. At December 31,2005, the Company determined that no investments were considered other-than-temporarilyimpaired.

Theamortized cost and fair value of bonds in the Investment Portfolio at December 31,2005, by contractual maturity, are shown below (in thousands). Actual maturitiescould differ from contractual maturities because borrowers have the right tocall or prepay certain obligations with or without call or prepaymentpenalties.

| ** **                                                       | ** ** | **Amortized  Cost** | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| Due in one year  or less                                         |       | $                   | 274,955    |                | $          | 275,017 |   |
| Due after one  year through five years                           |       | 1,188,212           |       | 1,248,314           |       |
| Due after five  years through ten years                          |       | 670,694             |       | 701,085             |       |
| Due after ten  years                                             |       | 1,977,911           |       | 2,054,046           |       |
| Mortgage-backed  securities (stated maturities of 1 to 30 years) |       | 250,001             |       | 246,246             |       |
| Asset-backed  securities (stated maturities of 2 to 29 years)    |       | 40,216              |       | 39,974              |       |
| Total                                                            |       | $                   | 4,401,989  |                | $          | 4,564,682 |   |

 

Proceeds from sales of bonds for the InvestmentPortfolio during 2005, 2004 and 2003 were $1,757.6 million, $1,187.3million and $1,121.0 million, respectively. Proceeds from maturities of bondsfor the Investment Portfolio during 2005, 2004 and 2003 were $130.9 million, $267.8 million and $443.1 million. Gross gains of $10.9million, $5.2 million and $12.6 million and gross losses of $6.1 million, $5.7million and $7.5 million were realized on sales in 2005, 2004 and 2003,respectively.

 

89

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***FP Investment Portfolio***

Netinvestment income for the FP Investment Portfolio consisted of the following(in thousands):

| ** **              | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------|------------|--------------------------------------------|------------|
| ** **              | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Bonds                   |       | $                                          | 391,125    |   | $ | 137,548 |   | $ | 59,271 |   |
| Short-term  investments |       | 29,639                                     |       | 3,499 |   | 4,430 |   |
| Net investment income   |       | $                                          | 420,764    |   | $ | 141,047 |   | $ | 63,701 |   |

 

Thecredit quality of bonds held in the FP Investment Portfolio at December 31,2005 was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|
| AAA           |       |       | 92.1       | %                              |       |
| AA            |       |       | 6.5        |                           |       |
| A        |       |       | 1.4        |                           |       |
| Total         |       |       | 100.0      | %                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2005.

Of the bonds included in the FP Investment Portfolio,7.0% were Triple-A by virtue of insurance provided by FSA. Over 90% of the FSA-InsuredInvestments were investment grade without giving effect to the FSA insurance.The average shadow rating of the FSA-Insured Investments was in the Single-Arange.

Theamortized cost and fair value of bonds held in the FP Investment Portfolio wereas follows (in thousands):

| **December 31, 2005**                        | ** ** | ** ** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|--------------------------------------------------------|------------|------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------|------------|
| Obligations of  U.S. states and political subdivisions |       | $          | 985,559    |                |       | $                            | 55,595     |                          |       |                | $          | (684 | ) |   | $ | 1,040,470 |   |
| Mortgage-backed  securities                            |       | 2,821,562  |       |                | 8,994      |                         |       |                          | (1,071     | )                   |       | 2,829,485 |   |
| Corporate  securities                                  |       | —     |       |                | —     |                         |       |                          | —     |                |       | — |   |
| Asset-backed  and other securities                     |       | 7,947,209  |       |                | 13,387     |                         |       |                          | (2,727     | )                   |       | 7,957,869 |   |
| Subtotal                                               |       | 11,754,330 |       |                | 77,976     |                         |       |                          | (4,482     | )                   |       | 11,827,824 |   |
| Short-term  investments                                |       | 1,015,509  |       |                | —     |                         |       |                          | —     |                |       | 1,015,509 |   |
| Total                                                  |       | $          | 12,769,839 |                |       | $                            | 77,976     |                          |       |                | $          | (4,482 | ) |   | $ | 12,843,333 |   |

 

| **December 31, 2004**                        | ** ** | ** ** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|--------------------------------------------------------|------------|------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------|------------|
| Obligations of U.S. states and political  subdivisions |       | $          | 712,667    |                |       | $                            | 29,702     |                          |       |                | $          | (2,957 | ) |   | $ | 739,412 |   |
| Mortgage-backed securities                             |       | 2,137,814  |       |                | 12,377     |                         |       |                          | (678       | )                   |       | 2,149,513 |   |
| Corporate securities                                   |       | 8,719      |       |                | 36         |                         |       |                          | —     |                |       | 8,755 |   |
| Asset-backed and other securities                      |       | 5,029,447  |       |                | 5,770      |                         |       |                          | (1,912     | )                   |       | 5,033,305 |   |
| Subtotal                                               |       | 7,888,647  |       |                | 47,885     |                         |       |                          | (5,547     | )                   |       | 7,930,985 |   |
| Short-term investments                                 |       | 268,125    |       |                | —     |                         |       |                          | —     |                |       | 268,125 |   |
| Total                                                  |       | $          | 8,156,772  |                |       | $                            | 47,885     |                          |       |                | $          | (5,547 | ) |   | $ | 8,199,110 |   |

 

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Thefollowing table shows the gross unrealized losses and fair value for the FPInvestment Portfolio, aggregated by investment category and length of time thatindividual securities have been in a continuous unrealized loss position, at December 31,2005 (in thousands):

| ** **                                             | ** ** | **As of December 31, 2005** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                             | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                             | ** ** | **Fair Value**                             | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| Obligations of  U.S. states and political subdivisions |       | $                                               | 39,163     |   |   | $ | (207 | ) |   | $ | 35,523 |   |   | $ | (477 | ) |   | $ | 74,686 |   |   | $ | (684 | ) |   |
| Mortgage-backed  securities                            |       | 779,147                                         |       |   | (1,068 | ) |   | 5,993 |   |   | (3 | ) |   | 785,140 |   |   | (1,071 | ) |   |
| Corporate  securities                                  |       | —                                          |       |   | — |   |   | — |   |   | — |   |   | — |   |   | — |   |   |
| Asset-backed  securities                               |       | 912,314                                         |       |   | (2,375 | ) |   | 158,116 |   |   | (352 | ) |   | 1,070,430 |   |   | (2,727 | ) |   |
| Total                                                  |       | $                                               | 1,730,624  |   |   | $ | (3,650 | ) |   | $ | 199,632 |   |   | $ | (832 | ) |   | $ | 1,930,256 |   |   | $ | (4,482 | ) |   |

 
|                                                        | ** ** | **As of December 31, 2004** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                             | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                             | ** ** | **Fair Value**                             | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| Obligations of U.S. states and political  subdivisions |       | $                                               | 15,372     |   |   | $ | (306 | ) |   | $ | 63,661 |   |   | $ | (2,651 | ) |   | $ | 79,033 |   |   | $ | (2,957 | ) |   |
| Mortgage-backed securities                             |       | 453,067                                         |       |   | (665 | ) |   | 66,130 |   |   | (13 | ) |   | 519,197 |   |   | (678 | ) |   |
| Corporate securities                                   |       | —                                          |       |   | — |   |   | — |   |   | — |   |   | — |   |   | — |   |   |
| Asset-backed securities                                |       | 848,847                                         |       |   | (1,179 | ) |   | 236,573 |   |   | (733 | ) |   | 1,085,420 |   |   | (1,912 | ) |   |
| Total                                                  |       | $                                               | 1,317,286  |   |   | $ | (2,150 | ) |   | $ | 366,364 |   |   | $ | (3,397 | ) |   | $ | 1,683,650 |   |   | $ | (5,547 | ) |   |
|                                                        |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Company periodically monitors the FP InvestmentPortfolio for individual investments in an unrealized loss position in order toassess whether that investment is considered other-than-temporarilyimpaired. In each case, the Company determines the nature and cause of thedecline and whether the Company maintains the ability and intent to hold thesecurity until the unrealized loss may reverse or until maturity. At December 31,2005, there were 22 securities that were in an unrealized loss position for acontinuous 12-month period or longer. None of the 22 securities had anunrealized loss that exceeded book value by 3% at December 31, 2005. At December 31,2005, the Company determined that no investments were considered other-than-temporarilyimpaired.

Theamortized cost and fair value of the FP Investment Portfolio, at December 31,2005, by contractual maturity, are shown below (in thousands). Actualmaturities could differ from contractual maturities because borrowers have theright to call or prepay certain obligations with or without call or prepaymentpenalties.

| ** **                                                              | ** ** | **Amortized  Cost** | ** ** | **Fair Value** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| Due in one year  or less                                                |       | $                   | 1,037,032  |                | $          | 1,037,032 |   |
| Due after five  years through ten years                                 |       | 19,802              |       | 19,720              |       |
| Due after ten  years                                                    |       | 944,234             |       | 999,227             |       |
| Mortgage-backed  securities (stated maturities of 8 to 30 years)        |       | 2,821,562           |       | 2,829,485           |       |
| Asset-backed  and other securities (stated maturities of 1 to 45 years) |       | 7,947,209           |       | 7,957,869           |       |
| Total                                                                   |       | $                   | 12,769,839 |                | $          | 12,843,333 |   |

 

Proceeds from sales of bonds held in the FP InvestmentPortfolio during 2005, 2004 and 2003 were $293.0 million, $91.7 million and$190.7 million, respectively. Proceeds from maturities of bonds for the FPInvestment Portfolio during 2005, 2004 and 2003 were $6,764.3 million, $2,485.8 million and $1,032.0 million. Gross gains of $0.4million and gross losses of $7.9 million were realized on sales in 2005. Grossgains of $2.2 million were realized on sales in 2004. Gross gains of$10.9 million were realized on sales in 2003.

91

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**4.**   DEFERREDACQUISITION COSTS

Acquisitioncosts deferred for amortization against future income and the relatedamortization charged to expenses are as follows (in thousands):

| ** **                                | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Balance, beginning of period              |       | $                                          | 308,015    |   | $ | 273,646 |   | $ | 253,777 |   |
| Costs deferred  during the period:        |       |                                       |       |   |   |   |   |
| Ceding commission  income, net            |       | (63,174                                    | )          | (65,838 | ) | (73,943 | ) |
| Premium taxes                             |       | 20,894                                     |       | 16,551 |   | 16,773 |   |
| Compensation and other  acquisition costs |       | 137,734                                    |       | 145,857 |   | 135,430 |   |
| Total                                     |       | 95,454                                     |       | 96,570 |   | 78,260 |   |
| Costs amortized during the period         |       | (68,340                                    | )          | (62,201 | ) | (58,391 | ) |
| Balance, end of  period                   |       | $                                          | 335,129    |   | $ | 308,015 |   | $ | 273,646 |   |

 

**5.**   STATUTORYACCOUNTING PRACTICES

GAAP differs incertain significant respects from statutory accounting practices, applicable toinsurance companies, that are prescribed or permitted by insurance regulatoryauthorities. The principal differences result from the following statutoryaccounting practices:

·       upfrontpremiums are recognized as earned when related principal and interest haveexpired rather than over the expected coverage period;

·       acquisitioncosts are charged to operations as incurred rather than as related premiums areearned;

·       acontingency reserve (rather than a non-specific reserve) is computedbased on the following statutory requirements:

1)               for all policieswritten prior to July 1, 1989, an amount equal to 50% of cumulative earnedpremiums less permitted reductions, plus

2)               forall policies written on or after July 1, 1989, an amount equal to thegreater of 50% of premiums written for each category of insured obligation or adesignated percentage of principal guaranteed for that category. These amountsare provided each quarter as either 1/60th or 1/80th of the total required foreach category, less permitted reductions;

·       certainassets designated as “non-admitted assets” are charged directly tostatutory surplus but are reflected as assets under GAAP;

·       deferredtax assets are generally admitted to the extent reversals of existing temporarydifferences in the subsequent year can be recovered through carry back;

·       insuredCDS are considered to be insurance contracts, not derivative contracts recordedat fair value;

·       bondsare carried at amortized cost;

·       VIEsand refinancing vehicles are not consolidated under statutory accountingstandards;

·       surplusnotes are recognized as surplus rather than as a liability unless approved forrepayment; and

·       non-insurancecompany subsidiaries do not prepare accounts applying statutory accountingstandards.

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Reconciliationsof net income for the years ended 2005, 2004 and 2003 and shareholders’ equityat December 31, 2005 and 2004, reported by the Company on a GAAP basis, tothe amounts reported by the insurance company subsidiaries on a statutorybasis, are as follows (in thousands):

| ** **                                                    | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|
| **Net Income:**                                          | ** ** | ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| FSA Holdings consolidated GAAP net income                     |       | $                                          | 326,108    |   | $ | 378,607 |   | $ | 298,127 |   |
| Equity in earnings of FSA Holdings consolidated  subsidiaries |       | 25,870                                     |       | (11,319 | ) | 25,479 |   |
| FSA consolidated GAAP net income                              |       | 351,978                                    |       | 367,288 |   | 323,606 |   |
| Deferral of net acquisition costs                             |       | (95,454                                    | )          | (96,571 | ) | (78,259 | ) |
| Amortization of acquisition costs                             |       | 68,340                                     |       | 62,202 |   | 58,391 |   |
| Fair-value adjustment for derivatives                         |       | (9,836                                     | )          | (54,182 | ) | (35,091 | ) |
| Loss expense                                                  |       | 17,276                                     |       | 3,889 |   | 21,813 |   |
| Consolidation of assets acquired in refinancing  transactions |       | (10,207                                    | )          | (6,771 | ) | (335 | ) |
| Deferred income tax                                           |       | 17,335                                     |       | 63,465 |   | 11,364 |   |
| Current income tax                                            |       | (2,416                                     | )          | (18,706 | ) | (18,048 | ) |
| Earned premium                                                |       | (44,388                                    | )          | (74,707 | ) | (25,178 | ) |
| Other                                                         |       | 342                                        |       | (3,826 | ) | 4,681 |   |
| FSA consolidated  statutory net income                        |       | $                                          | 292,970    |   | $ | 242,081 |   | $ | 262,944 |   |
|                                                               |            |                                            |            |  |  |  |  |  |  |  |  |  |

 

| ** **                                                          | ** ** | **As of December 31,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------|------------|
| **Shareholders’ Equity:**                                 | ** ** | ** **                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| FSA Holdings consolidated GAAP Equity                               |       | $                                     | 2,822,902  |   | $ | 2,611,278 |   |
| Equity in earnings of FSA Holdings consolidated  subsidiaries       |       | 79,524                                |       | 85,957 |   |
| FSA consolidated GAAP Equity                                        |       | 2,902,426                             |       | 2,697,235 |   |
| Deferred acquisition costs                                          |       | (335,129                              | )          | (308,015 | ) |
| Fair-value of derivatives                                           |       | (56,811                               | )          | (47,343 | ) |
| Loss reserves                                                       |       | 115,162                               |       | 96,381 |   |
| Contingency reserves                                                |       | (906,841                              | )          | (1,099,462 | ) |
| Unrealized gain on investments                                      |       | (174,878                              | )          | (240,895 | ) |
| Consolidation of assets acquired in refinancing  transactions  |       | 248                                   |       | (1,960 | ) |
| Surplus notes                                                       |       | 93,850                                |       | 74,299 |   |
| Deferred income taxes                                               |       | 263,206                               |       | 275,323 |   |
| Deferred premium revenue                                            |       | (335,037                              | )          | (307,173 | ) |
| Other                                                               |       | (55,521                               | )          | 43,031 |   |
| FSA statutory surplus                                               |       | 1,510,675                             |       | 1,181,421 |   |
| Statutory surplus  plus contingency reserve                         |       | $                                     | 2,417,516  |   | $ | 2,280,883 |   |
|                                                                     |            |                                       |            |  |  |  |  |  |  |

 

**6.**   FEDERALINCOME TAXES

Dexia Holdings and the Company and its Subsidiaries,except FSA International, file a consolidated federal income tax return. A tax-sharingagreement between them provides that each member’s tax benefit or expense iscalculated on a separate-return basis and that any credits or losses availableto the Company are allocated among the members based on each member’s taxableincome. At December 31, 2004, the Company and its Subsidiaries receivedbenefits from utilizing Dexia Holdings’ credits and losses of $1.3 million.The Company and its Subsidiaries did not receive any such benefits in 2005. Theseamounts 

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have been recorded ascapital contributions and reductions in amounts payable to Dexia Holdings inthe financial statements.

Except as described below, federal income taxes werenot provided on all of the undistributed earnings of FSA International, sinceit was the Company’s practice and intent to reinvest such earnings in theoperations of this subsidiary. The cumulative amount of such untaxed earningswas $22.6 million and $86.7 million at December 31, 2004 and2003, respectively.

The American Jobs Creation Act of 2004 (the “Act”),enacted on October 22, 2004, added Section 965 to the InternalRevenue Code. Section 965 provides for the repatriation of dividends froma controlled foreign corporation to its U.S. shareholder at an effective taxrate of 5.25%, provided that proceeds from the repatriation are utilized forqualified domestic investment activities. The U.S. Treasury Department issuedNotice 2005-10, which provided guidance on acceptable investmentactivities. The Company believes it qualifies for the beneficial treatmentunder Section 965 and accordingly accrued a tax liability and expense of$5.3 million at December 31, 2004. This amount approximated the tax effecton FSA International’s tax dividend distribution made in the fourth quarter of2005.

In December 2005, the Company repatriatedearnings from FSA International to avail itself of the reduced effective taxrate of 5.25% (compared with the normal effective tax rate of 35%). Inconnection with such repatriation, the Company recapitalized FSA Internationalin October of 2005 to become a wholly owned subsidiary and declared thatit no longer intends to leave future earnings of that subsidiary permanentlyoffshore. As a result, FSA International is subject to an increased effectiveU.S. tax rate on its 2005 and future income. The impact on earnings reflects (1) atax liability of $15.1 million in respect of earnings of FSA International thathave previously been recognized for GAAP but not yet for tax purposes and (2) $14.2million related to 2005 earnings.

Following a change in SPS’s investors in 2002, theCompany determined that it would be appropriate to apply the 80% dividend-receiveddeduction allowed by the Internal Revenue Service when accounting for the taxon its equity earnings from SPS, based on management’s expectation that itwould realize its gain on such investment through dividend distributions ratherthan through sale of its investment. For 2004 and 2003, equity in earnings fromSPS was taxed at an effective rate of 7.0%. In the first quarter of 2005, dueto the pending sale of its investment in SPS Holding Corp. (“SPS”) (formerly,Fairbanks Capital Holding Corp.), the Company eliminated the assumption thataccumulated earnings of SPS would be distributed in the form of dividendseligible for a dividend-received deduction. The net effect of this was toprovide additional taxes on SPS’s accumulated earnings of approximately $1.6million.

In connection with Dexia’s acquisition of the Companyin July 2000, the Company became the successor, for tax purposes, to WhiteMountains Holdings, Inc. (“WMH”). WMH had previously sold an insurancesubsidiary to a third party that was indemnified by White Mountains for certainfuture adverse loss development up to $50.0 million. In 2004, the Company madean indemnity payment of $47.0 million to the third party with funds providedfor such purpose by White Mountains. While the Company had no legal liabilityin connection with the indemnity payment, the payment should be treated for taxpurposes as a $47.0 million loss deduction to the Company, as successor to WMH.The Company therefore recorded a deferred tax asset with a correspondingdeferred tax benefit of $16.5 million. There can be no assurance that thedeferred tax benefit will not be reversed in the future. In addition, theCompany has agreed to share 50% of the deferred tax benefit with WhiteMountains under certain circumstances, but did not satisfy the standards forrecording a liability for accounting purposes as of December 31, 2005.

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Thecumulative balance sheet effects of deferred federal tax consequences are asfollows (in thousands):

| ** **                                    | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Deferred  acquisition costs                   |       | $                                     | 104,335    |   | $ | 95,736 |   |
| Deferred premium  revenue adjustments         |       | 36,302                                |       | 37,826 |   |
| Unrealized  capital gains                     |       | 84,058                                |       | 104,604 |   |
| Contingency  reserves                         |       | 114,166                               |       | 113,507 |   |
| Undistributed  earnings                       |       | 16,613                                |       | 9,274 |   |
| Derivative fair-value  adjustments            |       | 29,946                                |       | 50,426 |   |
| Other                                         |       | 8,212                                 |       | 9,185 |   |
| Total deferred federal income tax liabilities |       | 393,632                               |       | 420,558 |   |
| Loss and loss  adjustment expense reserves    |       | (41,533                               | )          | (35,540 | ) |
| Deferred  compensation                        |       | (90,866                               | )          | (93,083 | ) |
| White Mountains  indemnity payment            |       | (16,450                               | )          | (16,450 | ) |
| Foreign currency  transaction loss            |       | (7,781                                | )          | (24,264 | ) |
| Other                                         |       | (5,737                                | )          | (1,556 | ) |
| Total deferred federal income tax assets      |       | (162,367                              | )          | (170,893 | ) |
| Net deferred federal  income tax liability    |       | $                                     | 231,265    |   | $ | 249,665 |   |

 

Management believes it is more likely than not thatthe tax benefit of the deferred tax assets will be realized. Accordingly, novaluation allowance was necessary at December 31, 2005 or 2004.

Areconciliation of the effective tax rate with the federal statutory ratefollows:

| ** **                                                   | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                   | ** ** | **  2005  **           | ** ** | **  2004  ** | ** ** | **  2003  ** | ** ** |
| Tax at statutory rate                                        |       |                                       | 35.0       | % |   |   | 35.0 | % |   |   | 35.0 | % |   |
| Tax-exempt investments                                       |       |                                       | (9.8       | ) |   |   | (7.1 | ) |   |   | (8.3 | ) |   |
| Income of foreign subsidiary                                 |       |                                       | 2.7        |   |   |   | (1.2 | ) |   |   | (1.7 | ) |   |
| White Mountain indemnity payment                             |       |                                       | —     |   |   |   | (2.8 | ) |   |   | — |   |   |
| Minority interest and equity in unconsolidated  subsidiaries |       |                                       | (0.8       | ) |   |   | (4.9 | ) |   |   | (2.9 | ) |   |
| Other                                                        |       |                                       | 0.2        |   |   |   | — |   |   |   | 0.1 |   |   |
| Provision for  income taxes                                  |       |                                       | 27.3       | % |   |   | 19.0 | % |   |   | 22.2 | % |   |

 

**7.**   DIVIDENDSAND CAPITAL REQUIREMENTS

FSA’s ability to paydividends depends on FSA’s financial condition, results of operations, cashrequirements, rating agency capital adequacy and other related factors, and isalso subject to restrictions contained in the insurance laws and relatedregulations of New York and other states. Under the insurance laws of the Stateof New York, FSA may pay dividends out of earned surplus, provided that,together with all dividends declared or distributed by FSA during the preceding12 months, the dividends do not exceed the lesser of (a) 10% ofpolicyholders’ surplus as of its last statement filed with the Superintendentof Insurance of the State of New York or (b) adjusted net investmentincome during this period. FSA paid $87.0 million of dividends in 2005 and$30.0 million in 2004. Based upon FSA’s statutory statements for December 31,2005, the maximum amount normally available for payment of dividends by FSAwithout regulatory approval over the following 12 months would beapproximately $153.8 million.

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**8.**   CREDITARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES

FSA has a credit arrangement aggregating $150.0million that is provided by commercial banks and intended for generalapplication to insured transactions. If FSA is downgraded below Aa3 and AA-,the lenders may terminate the commitment and the commitment commission becomesdue and payable. If FSA is downgraded below Baa3 and BBB-, anyoutstanding loans become due and payable. At December 31, 2005, there wereno borrowings under this arrangement, which expires on April 21, 2006, ifnot extended.

FSA has a standby line of credit commitment in theamount of $350.0 million with a group of international banks to provide loansto FSA after it has incurred, during the term of the facility, cumulative municipallosses (net of any recoveries) in excess of the greater of $350.0 million orthe average annual debt service of the covered portfolio multiplied by 5.00%,which amounted to $1,220.0 million at December 31, 2005. The obligation torepay loans made under this agreement is a limited recourse obligation payablesolely from, and collateralized by, a pledge of recoveries realized ondefaulted insured obligations in the covered portfolio, including certaininstallment premiums and other collateral. This commitment has a term expiringon April 30, 2015 and contains an annual renewal provision, commencing April 30,2008, subject to approval by the banks. No amounts have been utilized underthis commitment as of December 31, 2005.

FSAM has a $100.0 million line of credit with UBS LoanFinance LLC, which expires December 8, 2006, unless extended. This line ofcredit provides an additional source of liquidity should there be unexpecteddraws on GICs issued by the GIC Affiliates. There were no borrowings under thisagreement at December 31, 2005. Borrowings under this agreement areconditioned on FSA having a Triple-A rating by either S&P or Moody’s, andon neither S&P nor Moody’s having issued a rating to FSA below AA+ or Aa1,respectively.

In June 2003, $200.0million of money market committed preferred trust securities (the “CPSSecurities”) were issued by trusts created for the primary purpose of issuingthe CPS Securities, investing the proceeds in high-quality commercialpaper and providing FSA with put options for issuing to the trusts non-cumulativeredeemable perpetual preferred stock (the “Preferred Stock”) of FSA. If FSAwere to exercise a put option, the applicable trust would transfer the portionof the proceeds attributable to principal received upon maturity of its assets,net of expenses, to FSA in exchange for Preferred Stock of FSA. FSA pays afloating put premium to the trusts. The cost of the structure was $1.3 millionand $1.3 million for 2005 and 2004, respectively, and was recorded within otheroperating expenses. The trusts are vehicles for providing FSA access to newcapital at its sole discretion through the exercise of the put options. TheCompany does not consider itself to be the primary beneficiary of the trustsbecause it does not retain the majority of the residual benefits or expectedlosses.

**9.**   LONG-TERMDEBT

On July 31, 2003, the Company issued $100.0million principal amount of 5.60% Notes due July 15, 2103, which arecallable without premium or penalty in whole or in part at any time on or afterJuly 31, 2008. Debt issuance costs of $3.3 million are being amortizedover the life of the notes. In September 2003, the Company called forredemption, on November 1, 2003, $100.0 million of its 6.95% SeniorQuarterly Income Debt Securities (“Senior QUIDS”) due November 1, 2098 anddelivered to the trustee sufficient collateral to legally defease the 6.95%Senior QUIDS. Unamortized debt issuance costs of $3.2 million for the 6.95%Senior QUIDS were charged to interest expense in 2003. Subsequently, thetrustee used the defeasance collateral to redeem all of the 6.95% Senior QUIDS.

On November 26, 2002, the Company issued$230.0 million principal amount of 6.25% Notes due November 1, 2102,which are callable without premium or penalty in whole or in part at any timeon or after November 26, 2007. Debt issuance costs of $7.4 millionare being amortized over the life of the debt.

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On December 19, 2001,the Company issued $100.0 million of 67¤8% QuarterlyIncome Bond Securities due December 15, 2101, which are callable withoutpremium or penalty on or after December 19, 2006. Debt issuance costs of$3.3 million are being amortized over the life of the debt.

**10.**   EMPLOYEEBENEFIT PLANS

The Company maintains both qualified and non-qualified,non-contributory defined contribution pension plans for the benefit ofeligible employees. Contributions are based on a fixed percentage of employeecompensation. Pension expense, which is funded annually, amounted to$7.0 million, $5.8 million and $4.9 million for the years ended December 31,2005, 2004 and 2003, respectively.

The Company has an employee retirement savings planfor the benefit of eligible employees. The plan permits employees to contributea percentage of their salaries up to limits prescribed by Internal Revenue CodeSection 401(k). Contributions by the Company are discretionary, and nonehave been made.

Through 2004, performance shares were awarded underthe 1993 Equity Participation Plan (the “1993 Equity Plan”). The 1993 EquityPlan authorized the discretionary grant of performance shares by the Human ResourcesCommittee to key employees. The amount earned for each performance sharedepends on the attainment of certain growth rates of adjusted book value andbook value per outstanding share over a three-year period.

Performance shares issued prior to January 1,2005 permitted the participant to elect, at the time of award, growth ratesincluding or excluding realized and unrealized gains and losses on theInvestment Portfolio. Performance shares issued after January 1, 2005 donot offer the option to include the impact of unrealized gains and losses onthe Investment Portfolio. No payout occurs if the compound annual growth rateof adjusted book value and book value per outstanding share over specifiedthree-year performance cycles is less than 7%, and a 200% payout occurs if thecompound annual growth rate is 19% or greater. Payout percentages areinterpolated for compound annual growth rates between 7% and 19%.

In 2004, the Company adopted the 2004 EquityParticipation Plan (the “2004 Equity Plan”), which continues the incentivecompensation program formerly provided under the Company’s 1993 EquityParticipation Plan. The 2004 Equity Plan provides for performance share unitscomprised 90% of performance shares (which provide for payment based upon theCompany’s performance over specified three-year performance cycles as describedabove) and 10% of shares of Dexia restricted stock. The Dexia restricted stockcomponent is a fixed plan, where the Company purchases Dexia shares andestablishes a prepaid expense for the amount paid, which is amortized over 2.5-yearand 3.5-year vesting periods. In the first quarter of 2005, FSA purchasedshares to economically defease its liability for $4.4 million. This amountis being amortized to expense over the employees’ vesting periods.

Performanceshares granted under the 1993 Equity Plan and 2004 Equity Plan are as follows:

| ** ** | ** ** | **Outstanding  at  Beginning of  Year** | ** ** | **Granted  During  the Year** | ** ** | **Paid out  During  the Year** | ** ** | **Forfeited  During the  Year** | ** ** | **Outstanding  at  End of Year** | ** ** | **Price per  Share  at Grant  Date** | ** ** |
|------------|------------|----------------------------------------------|------------|------------------------------------|------------|------------------------------------------|------------|--------------------------------------|------------|--------------------------------------------|------------|------------------------------------------------|------------|
| 2003       |       |                                         | 1,415,826  |                               |       | 342,845                                  |       | 464,778                              |       |                                       | 13,261     |                                           |       |   | 1,280,632 |   |   | $ | 92.72 |   |
| 2004       |       |                                         | 1,280,632  |                               |       | 349,506                                  |       | 398,292                              |       |                                       | 20,038     |                                           |       |   | 1,211,808 |   |   | 109.71 |   |
| 2005       |       |                                         | 1,211,808  |                               |       | 330,957                                  |       | 313,987                              |       |                                       | 24,434     |                                           |       |   | 1,204,344 |   |   | 131.30 |   |
|            |            |                                              |            |                                    |            |                                          |            |                                      |            |                                            |            |                                                |            |  |  |  |  |  |  |  |

 

The estimated final cost of these performance sharesis accrued over the performance period. The expense for the performance shareswas $55.8 million, $73.3 million and $63.1 million for the yearsended December 31, 2005, 2004 and 2003, respectively.

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Awards of Dexia restrictedstock remain restricted for an additional six months after the end of thevesting periods. In 2005, the Company awarded 194,202 Dexia restricted sharesvalued at $22.69 on the award date. As of December 31, 2005, 5,150 shareshad been forfeited and 8,756 shares had vested.

**11.**   COMMITMENTSAND CONTINGENCIES

EffectiveJune 2004, the Company entered into a 21-year sublease agreementwith Deutsche Bank AG for office space at 31 West 52nd Street, New York, New York, to be used as theCompany’s new headquarters. The Company moved to this new space in June 2005.The lease contains scheduled rent increases every five years after a 19-monthrent-free period, as well as lease incentives for initial constructioncosts of up to $6.0 million, as defined in the sublease. The leasecontains provisions for rent increases related to increases in the building’soperating expenses. The lease also contains a renewal option for an additionalten-year period and an option to rent additional office space at variouspoints in the future, in each case at then-current market rents. Inaddition, the Company and its Subsidiaries lease additional office space undernon-cancelable operating leases, which expire at various dates through2013. Future minimum rental payments are as follows (in thousands):

| **Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|------------|------------|------------|------------|
| 2006                                       |       | $          | 7,141.6    |       |
| 2007                                       |       | 8,263.6    |       |
| 2008                                       |       | 8,217.3    |       |
| 2009                                       |       | 8,204.7    |       |
| 2010                                       |       | 8,141.2    |       |
| Thereafter                                 |       | 119,848.4  |       |
| Total                                      |       | $          | 159,816.8  |       |

 

Rent expense was $10.1 million in 2005,$7.8 million in 2004 and $7.3 million in 2003. Rent expense in 2005includes a $1.2 million lease termination fee related to the Company’s formerheadquarters.

During the ordinary courseof business, the Company and its Subsidiaries become parties to certainlitigation. The Company is not subject to any material pending legalproceedings.

**12.**   REINSURANCE

The Company obtains reinsurance to increase its policy-writingcapacity on both an aggregate-risk and a single-risk basis; to meetrating agency, internal and state insurance regulatory limits; to diversifyrisk; to reduce the need for additional capital; and to strengthen financialratios. The Company reinsures portions of its risks with affiliated (see Note14) and unaffiliated reinsurers under quota share, first-loss and excess-of-losstreaties and on a facultative basis.

In the event that any or all of the reinsuringcompanies are unable to meet their obligations, or contest such obligations,the Company would be unable to recover such defaulted amounts. Certain of thereinsuring companies have provided collateral to secure their reinsuranceobligations.

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Amountsof ceded and assumed business were as follows (in thousands):

| ** **                                           | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Written premiums ceded                               |       | $                                          | 256,087    |   | $ | 244,211 |   | $ | 281,542 |   |
| Written premiums assumed                             |       | 9,474                                      |       | 11,567 |   | 3,294 |   |
| Earned premiums ceded                                |       | 150,087                                    |       | 161,733 |   | 159,350 |   |
| Earned premiums assumed                              |       | 3,521                                      |       | 6,608 |   | 3,832 |   |
| Losses and loss adjustment expense payments ceded    |       | 1,465                                      |       | 52,372 |   | 16,993 |   |
| Losses and loss  adjustment expense payments assumed |       | 8                                          |       | 16 |   | — |   |
|                                                      |            |                                            |            |  |  |  |  |  |  |  |

 

| ** **                                           | ** ** | **As of December 31,** | ** **  |
|------------------------------------------------------|------------|---------------------------------------|-------------|
| ** **                                           | ** ** | **2005**                              | ** **  | **2004** | ** ** |
| Principal  outstanding ceded                         |       | $                                     | 120,607,468 |   | $ | 116,687,760 |   |
| Principal  outstanding assumed                       |       | 2,597,375                             |        | 2,134,427 |   |
| Deferred premium  revenue ceded                      |       | 865,192                               |        | 759,191 |   |
| Deferred premium  revenue assumed                    |       | 23,777                                |        | 17,823 |   |
| Losses and loss  adjustment expense reserves ceded   |       | 36,339                                |        | 35,419 |   |
| Losses and loss  adjustment expense reserves assumed |       | 643                                   |        | 553 |   |
|                                                      |            |                                       |             |  |  |  |  |

 

**13.**   OUTSTANDINGEXPOSURE AND COLLATERAL

The Company’s policies insure the scheduled paymentsof principal and interest on municipal and asset-backed (including FSA-insuredCDS) obligations. The gross amount of financial guarantees in force (principaland interest) was $668.2 billion at December 31, 2005 and $622.6 billionat December 31, 2004. The net amount of financial guarantees in force was$480.2 billion at December 31, 2005 and $444.5 billion at December 31,2004.

Thenet par outstanding as of December 31, 2005 and 2004 and the contractualterms to maturity are as follows (in millions):

| ** **                         | ** ** | **As of December 31, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| **Terms to Maturity(1)** | ** ** | ** **                                      | ** ** | **Municipal**                                   | ** ** | **Asset-Backed(2)** | ** ** | **Municipal** | ** ** | **Asset-Backed(2)** | ** ** |
| 0 to 5 years                       |       | $                                               | 44,272     |                                            |       | $ | 41,997 |   |   | $ | 39,448 |   |   | $ | 46,800 |   |   |
| 5 to 10 years                      |       | 49,935                                          |       |                                            | 31,354     |   |   | 43,165 |   |   | 29,155 |   |   |
| 10 to 15 years                     |       | 44,392                                          |       |                                            | 12,180     |   |   | 37,174 |   |   | 10,772 |   |   |
| 15 to 20 years                     |       | 36,737                                          |       |                                            | 744        |   |   | 30,857 |   |   | 1,084 |   |   |
| 20 years and  above                |       | 51,724                                          |       |                                            | 24,148     |   |   | 44,748 |   |   | 34,539 |   |   |
| Total                              |       | $                                               | 227,060    |                                            |       | $ | 110,423 |   |   | $ | 195,392 |   |   | $ | 122,350 |   |   |
|                                    |            |                                                 |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Actual maturities coulddiffer from contractual maturities because borrowers have the right to call orprepay certain obligations with or without call or prepayment penalties.

(2)          Excludes intercompanyinsurance of $13,463 million in 2005 and $7,143 million in 2004relating to FSA-insured GICs issued by the GIC Affiliates.

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Thepar amount ceded as of December 31, 2005 and 2004 and the terms tomaturity are as follows (in millions):

| ** **                         | ** ** | **As of December 31, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| **Terms to Maturity(1)** | ** ** | ** **                                      | ** ** | **Municipal**                                   | ** ** | **Asset-Backed(2)** | ** ** | **Municipal** | ** ** | **Asset-Backed(2)** | ** ** |
| 0 to 5 years                       |       |                                            | $          | 12,950                                          |       |   |   | $ | 16,180 |   |   |   | $ | 11,443 |   |   |   | $ | 21,662 |   |   |
| 5 to 10 years                      |       |                                            | 16,332     |                                            |       |   | 7,011 |   |   |   | 14,707 |   |   |   | 6,909 |   |   |
| 10 to 15 years                     |       |                                            | 16,954     |                                            |       |   | 1,477 |   |   |   | 14,630 |   |   |   | 2,228 |   |   |
| 15 to 20 years                     |       |                                            | 15,180     |                                            |       |   | 1,474 |   |   |   | 12,870 |   |   |   | 1,373 |   |   |
| 20 years and above                 |       |                                            | 29,048     |                                            |       |   | 4,001 |   |   |   | 26,004 |   |   |   | 4,862 |   |   |
| Total                              |       |                                            | $          | 90,464                                          |       |   |   | $ | 30,143 |   |   |   | $ | 79,654 |   |   |   | $ | 37,034 |   |   |
|                                    |            |                                                 |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thenet par outstanding of insured obligations in the municipal insured portfolioincludes the following amounts by type of issue (in millions):

| ** **                                  | ** ** | **Net Par Outstanding  as of December 31,** | ** ** | **Ceded  as of December 31,** | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------|------------|
| **Types of Issues**               | ** ** | ** **                                                           | ** ** | **2005**                                     | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| General  obligation bonds                   |       | $                                                                    | 91,338     |                                         | $          | 77,865 |   | $ | 26,295 |   | $ | 24,278 |   |
| Housing revenue  bonds                      |       | 7,585                                                                |       | 7,628                                        |       | 2,153 |   | 2,224 |   |
| Municipal utility  revenue bonds            |       | 36,794                                                               |       | 33,544                                       |       | 13,999 |   | 13,761 |   |
| Health care  revenue bonds                  |       | 11,789                                                               |       | 9,261                                        |       | 8,889 |   | 7,784 |   |
| Tax-supported  non-general obligation bonds |       | 40,622                                                               |       | 36,631                                       |       | 16,776 |   | 14,564 |   |
| Transportation  revenue bonds               |       | 14,695                                                               |       | 12,834                                       |       | 8,944 |   | 7,584 |   |
| Other municipal  bonds                      |       | 24,237                                                               |       | 17,629                                       |       | 13,408 |   | 9,459 |   |
| Total municipal  obligations                |       | $                                                                    | 227,060    |                                         | $          | 195,392 |   | $ | 90,464 |   | $ | 79,654 |   |
|                                             |            |                                                                      |            |                                              |            |  |  |  |  |  |  |  |  |  |  |

 

The Companylimits its exposure to losses from writing financial guarantees by underwritinginvestment-grade obligations, diversifying its portfolio and maintainingrigorous collateral requirements on asset-backed obligations, as well asthrough reinsurance. The net par outstanding of insured obligations in theasset-backed insured portfolio includes the following amounts by type ofcollateral (in millions):

| ** **                        | ** ** | **Net Par Outstanding(1)  as of December 31,** | ** ** | **Ceded  as of December 31,** | ** ** |
|-----------------------------------|------------|-------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| **Types of Collateral** | ** ** | ** **                                                              | ** ** | **2005**                                     | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Residential  mortgages            |       | $                                                                       | 24,718     |                                         | $          | 35,641 |   | $ | 3,841 |   | $ | 4,997 |   |
| Consumer  receivables             |       | 9,835                                                                   |       | 9,540                                        |       | 1,593 |   | 2,241 |   |
| Pooled corporate  obligations     |       | 66,873                                                                  |       | 68,340                                       |       | 20,688 |   | 26,223 |   |
| Other asset-backed  obligations   |       | 8,997                                                                   |       | 8,829                                        |       | 4,021 |   | 3,573 |   |
| Total asset-backed  obligations   |       | $                                                                       | 110,423    |                                         | $          | 122,350 |   | $ | 30,143 |   | $ | 37,034 |   |
|                                   |            |                                                                         |            |                                              |            |  |  |  |  |  |  |  |  |  |  |

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(1)          Excludes intercompanyinsurance of $13,463 million in 2005 and $7,143 million in 2004relating to FSA-insured GICs issued by the GIC Affiliates.

In its asset-backed business, the Companyconsiders geographic concentration as a factor in underwriting insurancecovering securitizations of pools of such assets as residential mortgages orconsumer receivables. However, after the initial issuance of an insurancepolicy relating to such securitizations, the geographic concentration of theunderlying assets may not remain fixed over the life of the policy. Inaddition, in writing insurance for other types of asset-backedobligations, such as securities primarily backed by government or corporatedebt, geographic concentration is not deemed by the Company to be significant,given other more relevant measures of diversification, such as issuer orindustry diversification.

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The Company seeks to maintain a diversified portfolioof insured municipal obligations designed to spread its risk across a number ofgeographic areas. The following table sets forth those states in whichmunicipalities located therein issued an aggregate of 2% or more of the Company’snet par amount outstanding (in millions) of insured municipal securities as of December 31,2005:

| **State**                     | ** ** | ** ** | ** ** | **Number of  Issuers** | ** ** | **Net Par Amount  Outstanding** | ** ** | **Percent of Total  Municipal Net  Par Amount  Outstanding** | ** ** | **Ceded Par  Amount  Outstanding** | ** ** |
|-------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------------------|------------|----------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| California                    |       |       | 985        |                        |       |                                      | $          | 30,159                                                                           |       |                                    |       | 13.3 | % |   |   | $ | 10,467 |   |   |
| New York                      |       |       | 671        |                        |       |                                      | 19,555     |                                                                             |       |                                    | 8.6        |   |   |   | 9,718 |   |   |
| Texas                         |       |       | 730        |                        |       |                                      | 15,458     |                                                                             |       |                                    | 6.8        |   |   |   | 5,301 |   |   |
| Pennsylvania                  |       |       | 752        |                        |       |                                      | 14,843     |                                                                             |       |                                    | 6.5        |   |   |   | 3,791 |   |   |
| Florida                       |       |       | 277        |                        |       |                                      | 12,063     |                                                                             |       |                                    | 5.3        |   |   |   | 4,004 |   |   |
| Illinois                      |       |       | 653        |                        |       |                                      | 11,255     |                                                                             |       |                                    | 5.0        |   |   |   | 5,411 |   |   |
| New Jersey                    |       |       | 584        |                        |       |                                      | 10,459     |                                                                             |       |                                    | 4.6        |   |   |   | 5,644 |   |   |
| Washington                    |       |       | 328        |                        |       |                                      | 8,289      |                                                                             |       |                                    | 3.6        |   |   |   | 3,192 |   |   |
| Michigan                      |       |       | 499        |                        |       |                                      | 8,252      |                                                                             |       |                                    | 3.6        |   |   |   | 2,219 |   |   |
| Massachusetts                 |       |       | 206        |                        |       |                                      | 6,309      |                                                                             |       |                                    | 2.8        |   |   |   | 3,325 |   |   |
| Ohio                          |       |       | 332        |                        |       |                                      | 5,239      |                                                                             |       |                                    | 2.3        |   |   |   | 2,194 |   |   |
| Wisconsin                     |       |       | 437        |                        |       |                                      | 4,938      |                                                                             |       |                                    | 2.2        |   |   |   | 1,297 |   |   |
| Georgia                       |       |       | 117        |                        |       |                                      | 4,743      |                                                                             |       |                                    | 2.1        |   |   |   | 1,457 |   |   |
| All other U.S.  jurisdictions |       |       | 2,937      |                        |       |                                      | 63,251     |                                                                             |       |                                    | 27.9       |   |   |   | 23,027 |   |   |
| International                 |       |       | 112        |                        |       |                                      | 12,247     |                                                                             |       |                                    | 5.4        |   |   |   | 9,417 |   |   |
| Total                         |       |       | 9,620      |                        |       |                                      | $          | 227,060                                                                          |       |                                    |       | 100.0 | % |   |   | $ | 90,464 |   |   |

 

**14.**   RELATEDPARTY TRANSACTIONS

For the years ended December 31, 2005, 2004 and2003, the Subsidiaries ceded premiums of $31.6 million, $35.2 millionand $48.8 million, respectively, to subsidiaries of XL Capital Ltd (“XL”), amajor Bermuda-based insurance holding company, which owned an interest inFSA International prior to October 2005, when it redeemed its interest inexchange for $39.1 million. During 2005, 2004 and 2003, the Company paiddividends to XL of $16.3 million, $7.0 million and $3.3 million,respectively. The amounts included in prepaid reinsurance premiums at December 31,2005 and 2004 for reinsurance ceded to subsidiaries of XL were$84.4 million and $70.3 million, respectively. The amounts of reinsurancerecoverable for unpaid losses at December 31, 2005 and 2004 forreinsurance ceded to subsidiaries of XL were $1.8 million and$8.2 million, respectively.

The Subsidiaries earned premiums of $2.5 millionin the first half of 2003 relating to the guarantees of debt issued or assetspurchased by FSA Global and Canadian Global. Intercompany premiums earnedrelating to VIEs have been eliminated in consolidation for periods subsequentto July 1, 2003.

The Subsidiaries earnedpremiums of $28.0 million, $28.0 million and $20.5 million for theyears ended December 31, 2005, 2004 and 2003, respectively, relating tobusiness with affiliates of Dexia. Deferred premium revenue relating to thosetransactions was $19.5 million and $17.0 million at December 31,2005 and 2004, respectively. Gross par outstanding relating to thosetransactions was $21.5 billion and $24.0 billion at December 31, 2005 and2004, respectively. The Company also paid Dexia a fee of $0.7 million in2003 relating to business in which both Dexia and the Company were involved. Nopayments were made in 2004 and 2005. For the year ended December 31, 2005,the Company recorded a pre-tax loss of $12.0 million, and for the yearsended December 31, 2004 and 2003, the Company recorded pre-tax income of$97.6 million and $52.9 million, respectively, relating to swaps whereDexia was the counterparty. The Company recorded other assets of $323.5 millionand other liabilities of $13.9 million in 2005 and recorded other assets of$353.1 million and other liabilities of $17.2 million in 2004, primarily 

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relatingto swaps where Dexia was the counterparty. In addition, at December 31,2005 and 2004, the Company had $172.0 million and $163.0 million inVIE debt, respectively, relating to debt issued by the Company and purchased byDexia. During 2005 and 2004, the Company recorded $9.3 million and$8.8 million, respectively, in VIE net interest expense relating to suchdebt.

**15.**   DISCLOSURESABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company determines fair value using availablemarket information and appropriate valuation methodologies. However,considerable judgment is necessary to interpret the data to develop theestimates of fair value. Accordingly, the estimates presented herein are notnecessarily indicative of the amount the Company could realize in a currentmarket exchange. The use of different market assumptions and/or estimationmethodologies may have a material effect on the estimated fair-valueamounts.

For bonds, equity securities, the FP InvestmentPortfolio, the FP Investment Portfolio pledged as collateral and the VIE bondportfolio, the carrying amount represents fair value. The fair value is basedon quoted market price or redemption value for the Company’s investment inXLFA.

For short-term investments, including the FPshort-term investment portfolio and the VIE short-term investments,the carrying amount is cost, which approximates fair market value due to theshort maturity of the instruments.

For cash, receivable for investments sold, and payablefor investments purchased, the carrying amount is cost, which approximates fairvalue because of the short maturity of these instruments.

For assets acquired under refinancing transactions,the fair value is either the present value of the expected cash flows or quotedmarket prices as of the reporting date.

For deferred premium revenue, net of prepaidreinsurance premiums, the carrying amount represents the Company’s futurepremium revenue, net of reinsurance, on policies where the premium was receivedat the inception of the insurance policy. The fair value of deferred premiumrevenue, net of prepaid reinsurance premiums, is an estimate of the statutorypremiums that would be paid under a reinsurance agreement with a third party totransfer the Company’s financial guaranty risk, net of that portion of thepremiums retained by the Company to compensate it for originating and servicingthe insurance contract.

For notes payable, the carrying amount of notespayable represents the principal amount due at maturity. The fair value isbased on the quoted market price.

For installment premiums, consistent with industrypractice, there is no carrying amount since the Company will receive premiumson an installment basis over the term of the insurance contract. Similar to thetreatment of deferred premium revenue, the fair value of installment premiumsis the estimated present value of the future contractual premium revenues thatwould be received under a reinsurance agreement with a third party to transferthe Company’s financial guaranty risk, net of that portion of the premiumretained by the Company to compensate it for originating and servicing theinsurance contract.

For GICs and VIE debt, the fair value is the presentvalue of the expected cash flows as of the reporting date.

For losses and loss adjustment expenses, net ofreinsurance recoverable on unpaid losses, the carrying amount is the net presentvalue of the expected cash flows for specifically identified claims andinherent losses in the Company’s insured portfolio, which management believesis a reasonable proxy for fair value.

For fair-value adjustments on derivatives, thecarrying amount represents fair value. The Company uses quoted market priceswhen available, but if quoted market prices are not available, management usesinternally developed estimates.

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Thetable below shows the carrying amount and fair value of the Company’s financialinstruments (in thousands):

| ** **                                                                            | ** ** | **As of December 31, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                            | ** ** | **Carrying  Amount**                            | ** ** | **Fair Value**                             | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
| Assets:                                                                               |       |                                            |       |                                            |       |   |   |   |   |
| Bonds                                                                                 |       | $                                               | 4,382,037  |                                            | $          | 4,382,037 |   | $ | 4,116,088 |   | $ | 4,116,088 |   |
| Equity securities                                                                     |       | 54,370                                          |       | 54,370                                          |       | 54,300 |   | 54,300 |   |
| Short-term  investments                                                               |       | 182,645                                         |       | 182,645                                         |       | 119,746 |   | 119,746 |   |
| FP bond portfolio                                                                     |       | 11,827,824                                      |       | 11,827,824                                      |       | 7,925,072 |   | 7,925,072 |   |
| FP short-term  investment portfolio                                                   |       | 1,015,509                                       |       | 1,015,509                                       |       | 268,125 |   | 268,125 |   |
| FP bond portfolio  pledged as collateral                                              |       | —                                          |       | —                                          |       | 5,913 |   | 5,913 |   |
| VIE bonds                                                                             |       | 1,155,992                                       |       | 1,155,992                                       |       | 1,346,355 |   | 1,346,355 |   |
| VIE short-term  investments                                                           |       | 2,674                                           |       | 2,674                                           |       | 1,194 |   | 1,194 |   |
| Cash                                                                                  |       | 20,117                                          |       | 20,117                                          |       | 14,353 |   | 14,353 |   |
| Assets acquired in  refinancing transactions                                          |       | 467,873                                         |       | 460,770                                         |       | 749,208 |   | 748,118 |   |
| Fair-value  adjustments for derivatives                                               |       | 494,490                                         |       | 494,490                                         |       | 642,045 |   | 642,045 |   |
| Receivable for  investments sold                                                      |       | 1,382                                           |       | 1,382                                           |       | 161 |   | 161 |   |
| Liabilities:                                                                          |       |                                            |       |                                            |       |   |   |   |   |
| Deferred premium  revenue, net of prepaid reinsurance premiums                        |       | 1,509,867                                       |       | 1,295,312                                       |       | 1,336,232 |   | 1,154,461 |   |
| Losses and loss  adjustment expenses, net of reinsurance recoverable on unpaid losses |       | 169,379                                         |       | 169,379                                         |       | 144,522 |   | 144,522 |   |
| GIC and VIE debt                                                                      |       | 14,947,118                                      |       | 15,185,891                                      |       | 10,444,051 |   | 10,751,688 |   |
| Notes payable                                                                         |       | 430,000                                         |       | 423,904                                         |       | 430,000 |   | 437,556 |   |
| Fair-value  adjustments for derivatives                                               |       | 61,924                                          |       | 61,924                                          |       | 25,582 |   | 25,582 |   |
| Payable for investments  purchased                                                    |       | 91,529                                          |       | 91,529                                          |       | 262,033 |   | 262,033 |   |
| Off-balance-sheet  instruments:                                                       |       |                                            |       |                                            |       |   |   |   |   |
| Installment premiums                                                                  |       | —                                          |       | 438,109                                         |       | — |   | 413,876 |   |
|                                                                                       |            |                                                 |            |                                                 |            |  |  |  |  |  |  |  |  |

 

**16.**   LIABILITYFOR LOSSES AND LOSS ADJUSTMENT EXPENSES

Activityin the liability for losses and loss adjustment expenses, which consists of thecase and non-specific reserves, is summarized as follows (in millions):

| ** **                           | ** ** | **Case Reserve Activity for the  Year Ended December 31,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **  2005  **                                                              | ** ** | **   2004   ** | ** ** | **    2003    ** | ** ** |
| Gross balance at  January 1     |       |                                                                                          | $          | 80.6 |   |   |   | $ | 121.9 |   |   |   | $ | 134.0 |   |   |
| Less reinsurance  recoverable        |       |                                                                                          | 35.4       |   |   |   | 59.2 |   |   |   | 76.0 |   |   |
| Net balance at  January 1       |       |                                                                                          | 45.2       |   |   |   | 62.7 |   |   |   | 58.0 |   |   |
| Transfer from non-specific  reserve  |       |                                                                                          | 10.3       |   |   |   | 30.7 |   |   |   | 12.7 |   |   |
| Restructured  transactions           |       |                                                                                          | —     |   |   |   | (13.9 | ) |   |   | (2.2 | ) |   |
| Paid (net of recoveries) related to: |       |                                                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Current year                         |       |                                                                                          | —     |   |   |   | — |   |   |   | — |   |   |
| Prior year                           |       |                                                                                          | (2.0       | ) |   |   | (34.3 | ) |   |   | (5.8 | ) |   |
| Total paid                           |       |                                                                                          | (2.0       | ) |   |   | (34.3 | ) |   |   | (5.8 | ) |   |
| Net balance at  December 31     |       |                                                                                          | 53.5       |   |   |   | 45.2 |   |   |   | 62.7 |   |   |
| Plus reinsurance  recoverable        |       |                                                                                          | 36.3       |   |   |   | 35.4 |   |   |   | 59.2 |   |   |
| Gross balance at December 31    |       |                                                                                          | $89.8      |   |   |   | $ | 80.6 |   |   |   | $ | 121.9 |   |   |

 

 

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| ** **                           | ** ** | **Non-Specific Reserve Activity  for the Year Ended December 31,** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **     2005     **                                  | ** ** | **     2004     ** | ** ** | **    2003    ** | ** ** |
| Balance at  January 1           |       |                                                                                                  | $          | 99.3 |   |   |   | $ | 111.5 |   |   |   | $ | 89.7 |   |   |
| Provision for losses                 |       |                                                                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Current year                         |       |                                                                                                  | 20.4       |   |   |   | 20.4 |   |   |   | 22.4 |   |   |
| Prior year                           |       |                                                                                                  | 5.0        |   |   |   | 0.2 |   |   |   | 12.1 |   |   |
| Transfers to case  reserves          |       |                                                                                                  | (10.3      | ) |   |   | (30.7 | ) |   |   | (12.7 | ) |   |
| Restructured  transactions           |       |                                                                                                  | 1.5        |   |   |   | (2.1 | ) |   |   | — |   |   |
| Balance at  December 31         |       |                                                                                                  | 115.9      |   |   |   | 99.3 |   |   |   | 111.5 |   |   |
| Total case and non-specific reserves |       |                                                                                                  | $          | 205.7 |   |   |   | $ | 179.9 |   |   |   | $ | 233.4 |   |   |

 

The gross and net par amounts outstanding ontransactions with case reserves were $612.7 million and $519.5 million,respectively, at December 31, 2005. The net case reserve consistedprimarily of seven CDO transactions and one municipal transaction, whichcollectively accounted for approximately 94% of the total net case reserve. Theremaining 11 exposures were in various sectors.

During 2005, the Company charged $25.4 million to lossexpense, consisting of $20.4 million for originations of new business and $5.0million related to accretion on in-force business. Case reservesincreased $8.3 million primarily due to******deteriorationof specific CDO risks.

During 2004, the Company charged $20.6 million toloss expense, consisting of $20.4 million for originations of newbusiness, $4.6 million for accretion related to prior years and$3.2 million related to reassumptions of previously ceded business, offsetby reserve releases primarily related to a large refinancing transaction in2004. The non-specific reserves decreased $12.2 million in 2004,primarily due to transfers from the non-specific reserve to the casereserves of $30.7 million, offset by loss expense of $20.6 million.Case reserves decreased $17.5 million due to (1) a large, voluntarilyaccelerated transaction that had a $34.3 million payment and (2) reclassificationsfrom reserves to asset valuation accounts for refinanced transactions of$13.9 million, partially offset by transfers from the non-specificreserve of $30.7 million (see Note 22).

In September 2004, FSA exercised its rights tohave the collateral of a defaulted collateralized bond obligation liquidated ata public sale, in which the Company offered the highest bid. The Companyacquired the collateral to gain control of the portfolio in order to mitigatefuture losses. The previously established case reserve was drawn down toreflect the excess of the purchase amount over the fair value of thecollateral. The remaining $9.5 million balance in the case reserve relatedto this transaction was returned to the non-specific reserve. Afterreevaluating its requirements for the CDO portion of the non-specificreserve, the Company then reduced the non-specific reserve by$9.5 million, which was partially offset by normal reserve additions. Thenet amount transferred from the case reserves to the non-specific reservewas $1.4 million, which also included a transfer from the non-specificto the case reserves for a municipal utility transaction. The CDO portfoliocontinues to perform within the expectations reflected in previously recordedprovisions for CDOs.

During 2003, the Company charged $34.5 million toloss expense, comprising $9.2 million related to the CDO portfoliodiscussed below, $22.4 million for origination of new business and$2.9 million for the accretion of the discount on prior years’ reserves.The non-specific reserve increased by $21.8 million in 2003,consisting of the loss expense, a transfer to the non-specific reserve of$1.4 million representing recoveries received on prior-yeartransactions and a transfer of $14.1 million from the non-specificreserve to case reserves. In addition, the Company reclassified$2.2 million of case reserves as an asset valuation account relating to arestructured transaction involving securitized loans (see Note 22).

Since case and non-specificreserves are based on estimates, there can be no assurance that the ultimateliability will not differ from such estimates. The Company will continue, on anongoing basis, to 

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monitorthese reserves and may periodically adjust such reserves, upward or downward,based on the Company’s actual loss experience, its future mix of business andfuture economic conditions.

***Impact of Hurricanes***

The Company evaluated its insured portfolio to assessthe potential impact of Hurricanes Katrina, Rita and Wilma, which occurred in2005. The Company records a non-specific reserve to reflect the credit risksinherent in its portfolio. Together, the non-specific reserve and case reservesrepresent the Company’s estimate of total loss liability. The Company believesthat its total loss liability is adequate given the current information.Generally, when an insured credit deteriorates to a point where unreimbursedclaims are expected, a case reserve is established.

As of March 24, 2006, FSA had not received noticeof payment default on any exposures related to Hurricanes Katrina, Rita orWilma. To date, based on the Company’s review of its exposure, 11 credits, withaggregate net par exposure of $215.8 million, have the most significant risk ofloss. FSA-insured bonds are protected by various sources of support that wouldbe invoked before FSA would incur losses. These sources include access topledged taxes or revenues, reserve funds, property and casualty insurance andstate and federal monies. In the case of perpetual obligations, FSA mayexperience claims, but if the population returns in adequate numbers,reimbursement is likely. Eight of the 11 obligations with significant risk ofloss are perpetual.

The Company monitors its exposure to HurricanesKatrina and Rita in Louisiana and Mississippi and has determined that no casereserve is required. Of the 11 credits with significant risk of loss, theCompany has identified two high-priority risks. These risks are perpetualobligations, on which the Company may have to pay claims of up to $44.0 millionin a worst-case scenario. However, in these two cases the Company expects that,so long as the population returns in adequate numbers, it would suffer only thelost interest income on any claims paid until the issuer repaid the Company atsome point in the future.

In order for a community in Louisiana to restructureand potentially reduce its indebtedness, the Bond Commission, which is headedby the State Treasurer, must authorize such action. The State Treasurer haspublicly represented that the Bond Commission will not permit any Louisianamunicipality to declare bankruptcy.

Municipalities in Mississippi are not authorized tofile for bankruptcy and therefore have no mechanism under law to adjust theirpayment obligations. Unlike the corporate market, the municipal market has noprivate or equity source of capital and therefore lacks any means of startingfresh with a clean slate with debts and liabilities rejected or adjusted inbankruptcy. To file for bankruptcy, or to leave rated indebtedness unpaid in abankruptcy proceeding, would serve to tarnish the issuer and the region andeffectively deny the subject municipality and similar issuers of debt withinthe state access to capital. Historically, rather than bankruptcy andadjustment of debt, financially distressed municipalities have been subjectedto supervision and control by state-created authorities that act both asissuers of debt, secured by a discrete, newly identified revenue stream, and asfiscal monitors.

Both the federal government and the executive andlegislative branches of the affected states have considered or are expected toconsider proposals or legislation to assist the municipalities and facilitaterecovery. An example of such an enactment at the federal level is the CommunityDisaster Loan Act of 2005, under which the federal government has begun to makeloans to affected municipalities.

In addition, FSA’s asset-backed transactions, whichare generally backed by pools of geographically diverse assets, show no unusualconcentrations in the affected areas.

The loss estimationprocess involves the exercise of considerable judgment and therefore theCompany’s ultimate hurricane-related losses may be materially different fromthe current estimate and may affect future operating results.

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**17.**   QUARTERLYFINANCIAL INFORMATION (UNAUDITED)
|                                                                                                                                                      | ** ** | **First**               | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Full Year** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------|------------|-----------|------------|------------|------------|--------------------|------------|
| ** **                                                                                                                                           | ** ** | **(in thousands)** | ** ** |
| 2005                                                                                                                                                 |       |                    |       |       |       |      |       |       |       |               |       |
| Gross premiums written                                                                                                                               |       | $                       | 164,049    |       | $          | 169,677   |       | $          | 236,751    |               | $          | 263,304 |   | $ | 833,781 |   |
| Net premiums written                                                                                                                                 |       | 109,502                 |       | 143,916    |       | 160,918   |       | 163,358    |       | 577,694            |       |
| Net premiums earned                                                                                                                                  |       | 94,881                  |       | 96,254     |       | 116,832   |       | 96,092     |       | 404,059            |       |
| Net investment income                                                                                                                                |       | 49,445                  |       | 50,404     |       | 50,696    |       | 50,282     |       | 200,827            |       |
| Losses and loss adjustment expenses                                                                                                                  |       | 3,984                   |       | 6,238      |       | 10,185    |       | 4,958      |       | 25,365             |       |
| Net realized and unrealized gains on derivative  instruments                                                                                         |       | (70,811                 | )          | 18,179     |       | (42,431   | )          | (77,412    | )          | (172,475           | )          |
| Income before income taxes, minority interest and  equity in earnings (losses) of unconsolidated affiliates                                     |       | 82,231                  |       | 235,832    |       | 97,136    |       | 49,872     |       | 465,071            |       |
| Net income                                                                                                                                           |       | $                       | 63,156     |       | $          | 129,307   |       | $          | 73,811     |               | $          | 59,834 |   | $ | 326,108 |   |
| 2004                                                                                                                                                 |       |                    |       |       |       |      |       |       |       |               |       |
| Gross premiums written                                                                                                                               |       | $                       | 189,521    |       | $          | 236,100   |       | $          | 198,171    |               | $          | 208,188 |   | $ | 831,980 |   |
| Net premiums written                                                                                                                                 |       | 116,494                 |       | 166,581    |       | 148,831   |       | 155,863    |       | 587,769            |       |
| Net premiums earned                                                                                                                                  |       | 92,210                  |       | 101,719    |       | 100,585   |       | 100,501    |       | 395,015            |       |
| Net investment income                                                                                                                                |       | 41,077                  |       | 41,555     |       | 43,684    |       | 45,735     |       | 172,051            |       |
| Losses and loss adjustment expenses                                                                                                                  |       | 7,700                   |       | 7,665      |       | (4,263    | )          | 9,497      |       | 20,599             |       |
| Net realized and unrealized gains (losses) on  derivative instruments                                                                                |       | 52,155                  |       | (65,247    | )          | 148,041   |       | 194,310    |       | 329,259            |       |
| Income before income taxes, minority interest,  equity in earnings (losses) of unconsolidated affiliates and cumulative  effect of accounting change |       | 160,279                 |       | 37,609     |       | 224,043   |       | 158,583    |       | 580,514            |       |
| Net income                                                                                                                                           |       | $                       | 101,611    |       | $          | 57,540    |       | $          | 114,190    |               | $          | 105,266 |   | $ | 378,607 |   |
|                                                                                                                                                      |            |                         |            |            |            |           |            |            |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**18.**   EQUITY INVESTMENTS

TheCompany made an additional equity investment in SPS of $10.3 million in 2004,and did not make any equity investments in SPS in 2005 or 2003. In 2005, theCompany sold its investment in SPS. At December 31, 2004, the Company hada 34.1% interest in SPS. The Company’s investment in SPS was accounted forusing the equity method of accounting. Amounts recorded by the Company inconnection with SPS at December 31, 2005, 2004 and 2003 were as follows(in thousands):

| ** **                                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Investment in SPS                               |       | —   |       | $        | 49,645     |     | $          | 46,423 |   |
| Equity in earnings  (losses) from SPS (pre-tax) |       | 1,160    |       | (7,100   | )          | (13,548  | )          |
|                                                 |            |          |            |          |            |          |            |  |  |

 

SPS’s business is subject to regulation, supervisionand licensing by various federal, state and local authorities. In October 2002,the Federal Trade Commission (the “FTC”) informed SPS that it was investigatingwhether SPS’s loan servicing or other practices violated the Fair DebtCollection Practices Act, the Fair Credit Reporting Act, Section 5 of theFederal Trade Commission Act or other laws enforced by the FTC.

On November 12, 2003, the FTC announced asettlement with SPS, resolving the FTC’s civil allegations against SPS.Pursuant to that settlement, SPS paid $40.0 million to the FTC to compensateconsumers who suffered harm. The settlement enjoins SPS from future lawviolations and imposes new restrictions on SPS’s business practices. A relatedsettlement of numerous class action lawsuits against SPS has been approved by afederal district court in Massachusetts. The $10.3 million additional equity 

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investment in SPS made bythe Company in 2004 funded a portion of the $40.0 million payment that wasrequired to be made to the FTC under the terms of the FTC’s settlementagreement with SPS.

In the third quarter of 2004, the Company determinedthat its $7.6 million of goodwill associated with its investment in SPS wasimpaired, and it charged that amount to income, as a result of challengesencountered by SPS in acquiring new business, despite servicer ratings of “Average.”

In October 2005, the Company sold its investmentin SPS to an unaffiliated third party. For its interest in SPS, the Company waspaid $42.9 million in cash at closing and expects to receive additionalamounts, from time to time through March 31, 2008, out of income earned bySPS through December 31, 2007 from certain of its mortgage servicingactivities. Under the sale documents, the Company’s subsidiary that owned theSPS investment made customary representations and warranties to, and undertookspecified indemnification obligations for the benefit of, the purchaser. Basedon an estimate of the assets retained and liabilities assumed, the Companyrecorded a $0.4 million loss on the sale of SPS. The Company will continue toevaluate the appropriate carrying value of the liabilities assumed and whetherthe assets are impaired.

FSA’s 13% investment in preferred shares of XLFinancial Assurance Ltd (“XLFA”), a financial guaranty insurancesubsidiary of XL, is redeemable by XLFA at a price equal to the fair marketvalue of the preferred shares, subject to a cap defined as the internal rate ofreturn of 19% per annum from the date of the investment through the date ofredemption, plus accrued dividends as if 100% of current-year earningswere distributed. Based on this formula, in 2004, the Company adopted a policyof carrying this investment at the lesser of the current calculated redemptionvalue or the redemption value as of the next January first, which wouldexclude its share of accrued current-year earnings to the extent the caphad been otherwise met. Consistent with this policy, in the third quarter of2004, the Company charged $11.7 million to equity in earnings of unconsolidatedaffiliates and reduced its carrying value in this investment to $56.4 million.

Untilthe fourth quarter of 2004 this investment was accounted for using the equitymethod of accounting because the Company has significant influence over XLFA’soperations. In the second quarter of 2004, the Emerging Issues Task Force (“EITF”)reached a consensus that under EITF Issue 02-14, “Whether an InvestorShould Apply the Equity of Method of Accounting to Investments Other ThanCommon Stock” (EITF 02-14), an investor should only apply the equitymethod of accounting when it has investments in either common stock or in-substancecommon stock of a corporation, provided that the investor has the ability toexercise significant influence over the operating and financial policies of theinvestee. The EITF 02-14 consensus is applicable to reporting periodsbeginning after September 15, 2004. In accordance with this consensus, theCompany no longer accrues undistributed earnings related to its investment inXLFA. Amounts recorded by the Company in connection with XLFA as of December 31,2005, 2004 and 2003 are as follows (in thousands):

| ** **                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Equity securities                       |       | $        | 54,300     |     | $          | 54,300   |       | — |   |
| Investment in  XLFA                     |       | —   |       | —   |       | $        | 64,440     |   |
| Equity in  earnings from XLFA (pre-tax) |       | —   |       | 3,761    |       | 19,077   |       |
| Dividends earned from  XLFA             |       | 8,926    |       | 14,103   |       | 6,640    |       |
|                                         |            |          |            |          |            |          |            |  |  |  |

 

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**19.**   MINORITY INTERESTIN SUBSIDIARY

In 1998, the Company andXL entered into a joint venture, establishing two Bermuda-domiciled financialguaranty insurance companies—FSA International and XLFA. At December 31,2004, XL owned a minority interest in FSA International and the Company owned aminority interest in XLFA. In October 2005, FSA purchased all thepreferred shares of FSA International owned by XL Insurance (Bermuda), Ltd. fora cash purchase price of $39.1 million in anticipation of the repatriation ofearnings and profits of FSA International. Giving effect to such purchase, FSAInternational became an indirect wholly owned subsidiary of the Company. Thepreferred shares were Cumulative Participating Voting Preferred Shares that, intotal, had a minimum fixed dividend of $1.5 million per annum. In 2005, 2004and 2003, FSA International paid preferred dividends of $16.3 million, $7.0million and $3.3 million, respectively, to XL. For the years endedDecember 31, 2005, 2004 and 2003, the Company recognized minority interestof $6.9 million, $7.0 million and $9.3 million, respectively.

**20.**   GIC AND VIE DEBT

The obligationsunder GICs issued by the GIC Affiliates may be called at various times prior tomaturity based on certain agreed-upon events. As of December 31,2005, interest rates were between 0.81% and 5.95% per annum on outstanding GICsand between 1.12% and 6.61% per annum on VIE debt. Payments due under GICs arebased on expected withdrawal dates and exclude hedge accounting adjustments andprepaid interest of $20.4 million, and include accretion of $868.0 million. VIEdebt includes $1,081.8 million of future interest accretion on zero-couponobligations. The following table presents (in millions) the combined principalamounts due under GICs and VIE debt for 2006 and each of the next four yearsending December 31, and thereafter:

| ** ** | ** ** | **Principal  Amount** | ** ** |
|------------|------------|-----------------------|------------|
| 2006       |       | $                     | 3,573.0    |   |
| 2007       |       | 2,112.2               |       |
| 2008       |       | 801.9                 |       |
| 2009       |       | 1,298.6               |       |
| 2010       |       | 2,202.8               |       |
| Thereafter |       | 6,928.8               |       |
| Total      |       | $                     | 16,917.3   |   |

 

**21.**   DERIVATIVEINSTRUMENTS

***Credit Default Swaps***

FSA has insured a number of CDS with the expectationthat these transactions will not be subject to a market value termination forwhich the Company would be liable. It considers these agreements to be a normalextension of its financial guaranty insurance business, although they areconsidered derivatives for accounting purposes. These agreements are recordedat fair value. The Company believes that the most meaningful presentation ofthe financial statement impact of these derivatives is to reflect premiums asinstallments are received, to record losses and loss adjustment expenses asincurred and to record changes in fair value as incurred. The Company recorded$89.2 million, $69.1 million and $57.7 million of net earned premium underthese agreements for the years ended 2005, 2004 and 2003, respectively.

Changes in the fair value of CDS, which were gains of$11.1 million, $56.4 million and $34.8 million for the years ended December 31,2005, 2004, and 2003, respectively, were recorded in net realized andunrealized gains on derivative instruments in the statements of operations andcomprehensive income. The Company included net par outstanding of $66.6 billionand $66.0 billion relating to these CDS transactions at December 31, 2005and December 31, 2004, respectively, in the asset-backed balances inNote 13. The gains or losses recognized by recording these contracts at fairvalue are determined each quarter based on 

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quoted market prices, ifavailable. If quoted market prices are not available, then the determination offair value is based on internally developed estimates. Management appliesjudgment when developing these estimates and considers factors such as currentprices charged for similar agreements, performance of underlying assets,changes in internal shadow ratings, the level at which the deductible has beenset and the Company’s ability to obtain reinsurance for its insuredobligations. The Company does not believe that the fair-value adjustments arean indication of potential claims under FSA’s guarantees. The average life ofthese contracts is 3.2 years. The inception-to-date gain on the CDSportfolio was $57.7 million at December 31, 2005 and $46.6 million atDecember 31, 2004, and was recorded in other assets.

***Interest Rate andForeign Exchange Rate Derivatives***

The Company utilizesinterest-rate derivatives to convert from fixed to floating the interest rateson assets and liabilities. All gains and losses from changes in the fair valueof derivatives that do not qualify for hedge accounting are recognizedimmediately in the statements of operationsand comprehensive income in net unrealized and realized gains (losses)on derivative instruments. Hedge accounting is applied to derivativesdesignated as hedging instruments in a fair-value hedge, provided certaincriteria are met.

TheCompany enters into derivative contracts to manage interest-rate andforeign currency exposure in its FP Investment Portfolio, GICs, VIE debt andVIE Portfolio. The derivative contracts are recorded at fair value. Thesederivatives generally include interest-rate futures and interest-rateand currency swap agreements, which are primarily utilized to convert fixed-ratedebt and investments into U.S. dollar floating-rate debt and investments.The gains and losses related to the fair value of derivatives are included innet realized and unrealized gains (losses) on derivative instruments. Theinception-to-date net unrealized loss on derivatives used to hedgeGIC liabilities and the financial products bond portfolio of $56.9 million and$2.2 million at December 31, 2005 and December 31, 2004,respectively, is recorded in other assets or accrued expenses and otherliabilities, as applicable. The inception-to-date net unrealizedgain on the outstanding derivatives used to economically hedge the VIE debt andVIE bond portfolio of $433.7 million and $570.8 million at December 31,2005 and December 31, 2004, respectively, are recorded in other assets andaccrued expenses and other liabilities, as applicable.

***Other Derivatives***

TheCompany enters into various other derivative contracts that do not qualify forhedge accounting treatment under Statement of Financial Accounting Standards No. 133,“Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”).These derivatives include swaptions, caps and other derivatives, which are usedprincipally as protection against large interest-rate movements. Gainsand losses on these derivatives are reflected in net realized and unrealizedgains (losses) on derivative instruments in the statements of operations andcomprehensive income.

**22.   REFINANCEDTRANSACTIONS**

The Company generally has rights under its financialguaranty insurance policies and indentures that allow it to accelerate theinsured notes and pay claims under its insurance policies upon the occurrenceof predefined events of default. To mitigate future losses, the Company mayelect to purchase the outstanding insured obligation or its underlyingcollateral. Generally, refinancing vehicles reimburse FSA in whole for itsclaims payments in exchange for assignments of certain of FSA’s rights againstthe trusts. The refinancing vehicles obtain their funds from the proceeds ofFSA-insured GICs issued in the ordinary course of business by the GICAffiliates. The refinancing vehicles are consolidated into the Company’sfinancial statements. The Company maintains its reinsurance on thesetransactions.

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The following tablepresents the components of the assets acquired in refinancing transactions (inthousands):

| ** **                                       | ** ** | **As of December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| **Assets acquired in refinancing  transactions** | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Securitized loans                                |       | $                                     | 296,965    |   | $ | 369,749 |   |
| Bonds                                            |       | 9,145                                 |       | 157,036 |   |
| Asset-backed  senior notes                       |       | 59,276                                |       | 90,516 |   |
| Equity securities                                |       | 3,488                                 |       | 15,659 |   |
| Mortgage loans                                   |       | 56,165                                |       | 77,462 |   |
| Short-term  investments                          |       | 37,512                                |       | 27,749 |   |
| Other assets                                     |       | 5,322                                 |       | 11,037 |   |
| Total                                            |       | $                                     | 467,873    |   | $ | 749,208 |   |

 

Securitized loans are carried at cost, net of lossesat the date of purchase. Income is recorded based on the effective yieldmethod. The accretable yield on the securitized loans at December 31,2005, 2004 and 2003 was $142.3 million, $145.7 million and $147.2 million,respectively. The cash flows on the securitized loans, net of reinsurance, aremonitored and the effective yield modified to reflect any change in the cashflow estimate on a prospective basis. Since the notes represent 100% of thedebt capitalization of the trusts and since FSA maintains all the risk offurther asset decline (except as provided by reinsurance) and maintains controlover key decisions regarding the trusts (such as removal of the servicer, saleof the assets and liquidation of the entity), the trusts were consolidated withthe Company for accounting purposes. The Company also consolidated therefinancing vehicles.

Bonds, equity securities and mortgage loans representliquidations of previously insured obligations and subsequent purchases of theunderlying collateral. Bonds and equity securities are available for sale andcarried at fair value. At December 31, 2005, there were no securities inthe refinanced asset portfolio in an unrealized loss position for a continuous12-month period or longer. At December 31, 2005, the Companydetermined that no investments were considered other-than-temporarily impaired.

The credit quality of bonds within the refinancedasset portfolio at December 31, 2005 was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|
| BBB           |       |       | 19.0       | %                              |       |
| CCC           |       |       | 67.6       |                           |       |
| D             |       |       | 5.4        |                           |       |
| NR            |       |       | 8.0        |                           |       |
|          |       |       | 100.0%     |                           |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2005.

The amortized cost andfair value of fixed-income assets within the refinanced asset portfolio were asfollows (in thousands):

| ** **               | ** ** | **As of December 31, 2005** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| Corporate securities     |       | $                                               | 5,946      |   |   | $ | 3,199 |   |   |   | — |   |   | $ | 9,145 |   |
| Asset-backed  securities |       | 59,920                                          |       |   | — |   |   |   | (644 | ) |   | 59,276 |   |
| Short-term  investments  |       | 37,512                                          |       |   | — |   |   |   | — |   |   | 37,512 |   |
| Total                    |       | $                                               | 103,378    |   |   | $ | 3,199 |   |   |   | $ | (644 | ) |   | $ | 105,933 |   |
|                          |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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| ** **               | ** ** | **As of December 31, 2004** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| Corporate securities     |       | $                                               | 151,895    |   |   | $ | 5,743 |   |   |   | $ | (602 | ) |   | $ | 157,036 |   |
| Asset-backed  securities |       | 89,500                                          |       |   | 1,016 |   |   |   | — |   |   | 90,516 |   |
| Short-term  investments  |       | 27,749                                          |       |   | — |   |   |   | — |   |   | 27,749 |   |
| Total                    |       | $                                               | 269,144    |   |   | $ | 6,759 |   |   |   | $ | (602 | ) |   | $ | 275,301 |   |

 

The amortized costand fair value of equities held within the refinanced asset portfolio were asfollows (in thousands):

| ** **        | ** ** | **As of December 31, 2005** | ** ** |
|-------------------|------------|-------------------------------------------------|------------|
| ** **        | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| Equity securities |       |                                            | $          | 2,206 |   |   |   | $ | 1,282 |   |   |   | — |   |   |   | $ | 3,488 |   |   |
|                   |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **        | ** ** | **As of December 31, 2004** | ** ** |
|-------------------|------------|-------------------------------------------------|------------|
| ** **        | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| Equity securities |       |                                            | $          | 13,919 |   |   |   | $ | 1,903 |   |   |   | (163 | ) |   |   | $ | 15,659 |   |   |
|                   |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theamortized cost and fair value of fixed-income assets within the refinancedasset portfolio at December 31, 2005, are shown below by contractualmaturity (in thousands). Actual maturities could differ from contractual maturitiesbecause borrowers have the right to call or prepay certain obligations with orwithout call or prepayment penalties.

| ** **                              | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|---------------------|------------|
| Due in one year  or less                |       |                    | $          | 37,967              |       |   | $ | 37,982 |   |
| Due after one  year through five years  |       |                    | 17,906     |                |       | 17,906 |   |
| Due after five  years through ten years |       |                    | 47,505     |                |       | 50,045 |   |
| Total                                   |       |                    | $          | 103,378             |       |   | $ | 105,933 |   |

 

At December 31, 2005,there were no securities in an unrealized loss position for a continuous 12-monthperiod or longer. The Company determined that there were six securitiesconsidered other-than-temporarily impaired. For 2005, a $4.5million impairment was recorded in the consolidated statements of operationsand comprehensive income.

**23.**   SEGMENTREPORTING

The Company operates in two business segments:financial guaranty and financial products. The financial guaranty segment isprimarily in the business of providing financial guaranty insurance onmunicipal and asset-backed obligations. It also includes the results ofthe VIEs that were consolidated for the first time in the third quarter of2003. The FP Segment includes the GIC operations of the Company, which issuesGICs to municipalities and other market participants. GICs provide for thereturn of principal and the payment of interest at pre-specified rates.The following tables summarize the financial 

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information(in thousands) by segment as of December 31, 2005 and 2004 and for theyears ended December 31, 2005, 2004 and 2003:

| ** **                                                           | ** ** | **For the Year Ended December 31, 2005** | ** ** |
|----------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **Financial  Guaranty**                                                | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| Revenues:                                                            |       |                                                                   |       |   |   |   |   |   |   |
| External                                                             |       | $                                                                      | 615,739    |   | $ | 365,496 |   | — |   | $ | 981,235 |   |
| Intersegment                                                         |       | 38,693                                                                 |       | 41,335 |   | (80,028 | ) | — |   |
| Expenses:                                                            |       |                                                                   |       |   |   |   |   |   |   |
| External                                                             |       | 141,837                                                                |       | 374,327 |   | — |   | 516,164 |   |
| Intersegment                                                         |       | 41,335                                                                 |       | 38,693 |   | (80,028 | ) | — |   |
| Pre-tax segment earnings                                             |       | $                                                                      | 448,422    |   | $ | 18,525 |   | — |   | 466,947 |   |
| Current and deferred taxes                                           |       |                                                                   |       |   |   |   |   | (128,900 | ) |
| SFAS133 CDS and economic interest-rate hedge  fair-value adjustments |       |                                                                   |       |   |   |   |   | (11,939 | ) |
| Net income                                                           |       |                                                                   |       |   |   |   |   | $ | 326,108 |   |
| Segment assets                                                       |       | $                                                                      | 9,841,539  |   | $ | 14,169,383 |   | $ | (2,009,280 | ) | $ | 22,001,642 |   |
|                                                                      |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                                           | ** ** | **For the Year Ended December 31, 2004** | ** ** |
|----------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **Financial  Guaranty**                                                | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| Revenues:                                                            |       |                                                                   |       |   |   |   |   |   |   |
| External                                                             |       | $                                                                      | 980,321    |   | $ | 167,948 |   | — |   | $ | 1,148,269 |   |
| Intersegment                                                         |       | 21,892                                                                 |       | 30,620 |   | (52,512 | ) | — |   |
| Expenses:                                                            |       |                                                                   |       |   |   |   |   |   |   |
| External                                                             |       | 391,138                                                                |       | 176,617 |   | — |   | 567,755 |   |
| Intersegment                                                         |       | 30,620                                                                 |       | 21,892 |   | (52,512 | ) | — |   |
| Pre-tax segment earnings                                             |       | $                                                                      | 400,881    |   | $ | 6,455 |   | — |   | $ | 407,336 |   |
| Current and deferred  taxes                                          |       |                                                                   |       |   |   |   |   | (111,160 | ) |
| SFAS133 CDS and economic interest-rate hedge  fair-value adjustments |       |                                                                   |       |   |   |   |   | 82,431 |   |
| Net income                                                           |       |                                                                   |       |   |   |   |   | $ | 378,607 |   |
| Segment assets                                                       |       | $                                                                      | 9,820,672  |   | $ | 9,379,900 |   | $ | (2,119,564 | ) | $ | 17,081,008 |   |
|                                                                      |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                                           | ** ** | **For the Year Ended December 31, 2003** | ** ** |
|----------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **Financial  Guaranty**                                                | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| Revenues:                                                            |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| External                                                             |       | $                                                                      | 827,360    |   |   | $ | 70,318 |   |   |   | — |   |   | $ | 897,678 |   |
| Intersegment                                                         |       | 7,436                                                                  |       |   | 25,875 |   |   |   | (33,311 | ) |   | — |   |
| Expenses:                                                            |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| External                                                             |       | 378,906                                                                |       |   | 95,359 |   |   |   | — |   |   | 474,265 |   |
| Intersegment                                                         |       | 25,875                                                                 |       |   | 7,436 |   |   |   | (33,311 | ) |   | — |   |
| Pre-tax segment earnings                                             |       | $                                                                      | 345,956    |   |   | $ | (8,649 | ) |   |   | — |   |   | $ | 337,307 |   |
| Current and deferred  taxes                                          |       |                                                                   |       |   |   |   |   |   |   |   |   | (95,784 | ) |
| Cumulative effect of  accounting change                              |       |                                                                   |       |   |   |   |   |   |   |   |   | 4,800 |   |
| SFAS133 CDS and economic  interest-rate hedge fair-value adjustments |       |                                                                   |       |   |   |   |   |   |   |   |   | 51,804 |   |
| Net income                                                           |       |                                                                   |       |   |   |   |   |   |   |   |   | $ | 298,127 |   |

 

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The intersegment assets consist of (1) intercompanynotes issued by FSA and held within the FP Investment Portfolio and (2) GICsissued by the GIC Affiliates and held within the VIE Portfolio. Theintersegment revenues and expenses relate to interest income and interestexpense on intercompany notes and GICs.

The SFAS 133 fair-value adjustments for CDS are areconciling item between pre-tax segment operating earnings and net income. Inaddition, management subtracts the impact of interest-rate derivatives whenanalyzing the segments, as it believes that, by removing the effect of theone-sided accounting caused by marking the derivatives, but not the hedgedassets or liabilities, to fair value, the measure will more closely reflect theunderlying performance of segment operations.

**24.   OTHERASSETS AND LIABILITIES**

The detailed balances thatcomprise other assets and accrued expenses and other liabilities at December 31,2005 and 2004 are as follows (in thousands):

| ** **                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Other assets:                                   |       |     |       |     |       |
| Fair value of VIE swaps                         |       | $        | 433,670    |     | $          | 570,764 |   |
| VIE other invested assets                       |       | 146,710  |       | 156,540  |       |
| Securities purchased under agreements to resell |       | 350,000  |       | —   |       |
| Deferred compensation trust                     |       | 107,140  |       | 112,941  |       |
| Tax and loss bonds                              |       | 105,324  |       | 102,193  |       |
| Accrued interest on VIE swaps                   |       | 108,421  |       | 99,794   |       |
| Accrued interest income                         |       | 76,295   |       | 63,614   |       |
| Fair-value adjustments on derivatives           |       | 60,820   |       | 71,281   |       |
| Other assets                                    |       | 267,561  |       | 151,257  |       |
| Total other assets                              |       | $        | 1,655,941  |     | $          | 1,328,384 |   |

 

| ** **                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Accrued expenses  and other liabilities:       |       |     |       |     |       |
| Payable for securities purchased               |       | $        | 91,529     |     | $          | 262,033 |   |
| Deferred compensation trust                    |       | 107,140  |       | 112,941  |       |
| Equity participation plan                      |       | 116,887  |       | 123,382  |       |
| Securities sold under agreements to repurchase |       | —   |       | 5,656    |       |
| Fair-value adjustments on derivatives          |       | 61,924   |       | 25,582   |       |
| Other liabilities                              |       | 431,694  |       | 313,931  |       |
| Total accrued expenses  and other liabilities  |       | $        | 809,174    |     | $          | 843,525 |   |

 

**25.   VARIABLEINTEREST ENTITIES**

In January 2003, theFASB issued FIN 46, which addresses consolidation of VIEs that have one or bothof the following characteristics: (a) the equity investment at risk is notsufficient to permit the entity to finance its activities without additionalsubordinated financial support from other parties, which is provided throughother interests that will absorb some or all of the expected losses of theentity; and (b) the equity investors lack the direct or indirect abilityto make decisions about the entity’s activities through voting rights orsimilar rights, the obligation to absorb the expected losses of the entity ifthey occur or the right to receive the expected residual returns of the entityif they occur. In December 2003, the FASB issued FASB Interpretation No. 46(revised December 2003), “Consolidation of Variable Interest Entities, aninterpretation of ARB 51” (“FIN 46R”). FIN 46R replaced FIN 46 and is effectivefor public companies for periods after December 15, 2003. The Company hasidentified three SPEs that satisfy the consolidation requirements.

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FSA Global is managed as a“matched funded vehicle,” in which the proceeds from the issuance of FSA-guaranteednotes are invested in obligations having cash flows substantially matched tothose of, and maturing prior to, such notes. In certain cases, investments ofFSA Global consist of GICs issued by the GIC Affiliates. Similarly, Premierholds GICs issued by the GIC Affiliates in their investment portfolios. In eachsuch case, the Company’s GIC liability and asset are eliminated inconsolidation. At December 31, 2005, $1,142.1 million was eliminated as aresult of such consolidation. All intercompany insured amounts between FSA andFSA Global and Canadian Global previously included in the Company’s outstandingexposure are excluded from the Notes to the Consolidated Financial Statementsfor December 31, 2005 and 2004.

FIN 46R requires that,upon consolidation, the Company initially measure the VIE’s assets, liabilitiesand minority interest at their carrying amounts under existing GAAP as if theentity had been consolidated from the time the Company was considered itsprimary beneficiary (or parent). The increase in total assets and totalliabilities related to the consolidation of these entities was $1.9 billion at July 1,2003, when they were first consolidated. The difference upon consolidation wasreflected as a cumulative effect of a change in accounting principle at July 1,2003. The cumulative effect of a change in accounting principle for CanadianGlobal resulted in additional income of $4.8 million, net of income tax. Therewere no cumulative income statement effects from consolidating FSA Global andPremier. The following table presents the impact of consolidation of the VIEs.

| ** **                                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|
| VIE net interest income                                    |       | $        | 67,152     |     | $          | 52,665 |   |
| FSA’s net premiums  earned on VIE bonds and debt      |       | (3,613   | )          | (5,351   | )          |
| Net realized and  unrealized gains (losses) on derivatives |       | (133,915 | )          | 249,752  |       |
| Total revenues                                             |       | $        | (70,376    | )        | $          | 297,066 |   |
| VIE net interest expense                                   |       | $        | 85,809     |     | $          | 105,173 |   |
| Other operating expenses                                   |       | 50       |       | (1,054   | )          |
| Foreign exchange loss                                      |       | (162,398 | )          | 79,270   |       |
| Total expenses                                             |       | $        | (76,539    | )        | $          | 183,389 |   |

 

***VIE Investments***

All bonds in the VIEPortfolio are insured by FSA. The credit quality of the VIE Portfolio, withoutthe benefit of FSA’s insurance, at December 31, 2005 was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|
| AAA           |       |       | 2.3        | %                              |       |
| A             |       |       | 95.5       |                           |       |
| BB            |       |       | 2.2        |                           |       |
|          |       |       | 100.0      | %                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2005.

Theamortized cost and fair value of bonds in the VIE Portfolio were as follows (inthousands):

| **December 31, 2005**                   | ** ** | ** ** | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|---------------------------------------------------|------------|------------|------------|-------------------------|------------|---------------------|------------|
| Obligations of states  and political subdivisions |       |       | $          | 15,879                  |       |                | $          | 15,879 |   |
| Corporate securities                              |       |       | 20,013     |                    |       | 19,327              |       |
| Foreign securities                                |       |       | 8,995      |                    |       | 9,841               |       |
| Asset-backed  securities(1)                       |       |       | 1,110,945  |                    |       | 1,110,945           |       |
| Short-term  investments                           |       |       | 2,674      |                    |       | 2,674               |       |
| Total                                             |       |       | $          | 1,158,506               |       |                | $          | 1,158,666 |   |

 

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| **December 31, 2004**                   | ** ** | ** ** | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|---------------------------------------------------|------------|------------|------------|-------------------------|------------|---------------------|------------|
| Obligations of states  and political subdivisions |       |       | $          | 16,007                  |       |                | $          | 16,007 |   |
| Corporate securities                              |       |       | 156,030    |                    |       | 157,990             |       |
| Foreign securities                                |       |       | 56,077     |                    |       | 57,983              |       |
| Asset-backed  securities(1)                       |       |       | 1,114,375  |                    |       | 1,114,375           |       |
| Short-term  investments                           |       |       | 1,194      |                    |       | 1,194               |       |
| Total                                             |       |       | $          | 1,343,683               |       |                | $          | 1,347,549 |   |

----

(1)          Asset-backedsecurities consist of floating-rate assets, which are valued using readilyavailable quoted market prices or at amortized cost if there is no readilyavailable valuation. Management believes that amortized cost closelyapproximates fair value for these securities.

The Company periodically monitors its investmentportfolio for individual investments in an unrealized loss position in order toassess whether that investment is considered other-than-temporarilyimpaired. In each case, the Company determines the nature and cause of thedecline and whether the Company maintains the ability and intent to hold thesecurity until the unrealized loss may reverse or until maturity. At December 31,2005, there were no securities in an unrealized loss position. The Companydetermined that no investments were considered other-than-temporarilyimpaired.

Theamortized cost and fair value of bonds in the VIE Portfolio at December 31,2005, by contractual maturity, are shown below (in thousands). Actualmaturities could differ from contractual maturities because borrowers have theright to call or prepay certain obligations with or without call or prepaymentpenalties.

| ** **                                                    | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|
| Due in one year  or less                                      |       |                    | $          | 2,674               |       |   | $ | 2,674 |   |
| Due after one  year through five years                        |       |                    | 29,008     |                |       | 29,168 |   |
| Due after five  years through ten years                       |       |                    | —     |                |       | — |   |
| Due after ten  years                                          |       |                    | 15,879     |                |       | 15,879 |   |
| Asset-backed  securities (stated maturities of 4 to 17 years) |       |                    | 1,110,945  |                |       | 1,110,945 |   |
| Total                                                         |       |                    | $          | 1,158,506           |       |   | $ | 1,158,666 |   |

 

**26.   RECENTLYISSUED ACCOUNTING STANDARDS**

In February 2006, theFASB issued Statement of Financial Accounting Standards No. 155, “Accountingfor Certain Hybrid Financial Instruments (“SFAS 155”). SFAS 155 providesguidance with respect to bifurcation of embedded credit risk in a specialpurpose entity. The adoption of SFAS 155 is not expected to have a materialimpact on the Company’s financial position or results of operations.

In November 2005, theFASB issued FASB Staff Position (“FSP”) 115-1, “The Meaning ofOther-Than-Temporary Impairment and its Application to Certain Investments,”which supersedes certain requirements of EITF 03-1, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments” andamends SFAS 115 and Accounting Principles Board Opinion (“APB”) 18, “The EquityMethod of Accounting for Investments in Common Stocks.” FSP 115-1outlines a three-step model to identify investment impairments in eachreporting period. First, for each reporting period, individual securities aredetermined to be impaired if the fair value of a security is less than itscost. Second, impaired securities are evaluated as to whether the impairment isother than temporary based on existing applicable guidance. Lastly, if theimpairment is other than temporary, an impairment loss is recognized inearnings equal to the difference between the investment’s cost and fair valueas of the reporting date. Under FSP 115-1, the disclosure requirementsrequired by EITF 03-1 issued in December 2003 remain in effect. EITF03-1 requires the Company to disclose certain information aboutunrealized losses on its investment 

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portfolio that have notbeen recognized as other-than-temporary impairments. The requirements under FSP115-1 are effective for reporting periods beginning after December 15,2005. The Company believes that the adoption of FSP 115-1 will not have amaterial effect on the Company’s financial position or results of operations.See Note 3 for disclosures required by EITF 03-1.

In December 2004, theFASB issued Statement of Financial Accounting Standards No. 123-R, “Share-BasedPayment” (“SFAS 123-R”). This Statement is a revision of SFAS 123, “Accountingfor Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees,” and its related implementation guidance. SFAS123-R requires entities to recognize compensation cost for all equity-classifiedawards after the effective date using the fair-value measurement method.SFAS 123-R is effective for annual periods beginning after June 15,2005. The adoption of SFAS 123-R is not expected to have a materialimpact on the Company’s financial position or results of operations.

**Item 9. Changes in and Disagreements with Accountantson Accounting and Financial Disclosure.**

There have been no changes in, or any disagreementswith, accountants on accounting and financial disclosure within the two yearsended December 31, 2005.

**Item9A.**                Controls andProcedures.

**Evaluationof Disclosure Controls and Procedures**

TheCompany’s management, with the participation of the Company’s Chief ExecutiveOfficer and Chief Financial Officer, hasevaluated the effectiveness of the Company’s disclosure controls and proceduresas of December 31, 2005. Based on that evaluation and because ofthe material weakness in internal control over financial reporting discussedbelow, the Chief Executive Officer and the Chief Financial Officer concludedthat as of such date the Company’s disclosure controls and procedures were noteffective in providing reasonable assurance that information required to bedisclosed in the reports the Company files or submits under the Exchange Act isrecorded, processed, summarized and reported as and when required and that suchinformation is accumulated and communicated to management, including the ChiefExecutive Officer and Chief Financial Officer, in a manner that allows timelydecisions regarding required disclosure. Notwithstanding the material weaknessdiscussed below, the Company’s management has concluded that the financial statementsincluded in this Form 10-K fairly present in all material respectsthe Company’s financial position, results of operations and cash flows for theperiods presented in conformity with generally accepted accounting principles.

**Changes in InternalControl over Financial Reporting**

Except as noted below,there were no changes in the internal control over financial reporting thatoccurred during the year ended December 31, 2005 that materially affected,or that are reasonably likely to materially affect, internal control overfinancial reporting.

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**Identificationof Material Weakness in Internal Control over Financial Reporting**

A material weakness is a control deficiency, orcombination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. Management has concluded that theCompany did not maintain effective controls to ensure that hedge accounting wascorrectly applied pursuant to generally accepted accounting principles. Specifically,the Company’s accounting documentation for certain hedging relationships didnot meet the requirements of Statement of Financial Accounting Standards No. 133,“Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”)and related interpretations and the Company incorrectly applied the short-cutmethod of hedge accounting to certain other hedge relationships. This controldeficiency resulted in the restatement of the Company’s Consolidated FinancialStatements for the years ended December 31, 2004, 2003 and 2002, theperiods ended March 30, June 30, September 30 and December 31,2003 and 2004 and opening retained earnings at January 1, 2002. Inaddition, this control deficiency could result in a misstatement of interestincome and expense from financial products and variable interest entities, netrealized and unrealized gains and losses on derivative instruments, income fromassets acquired in refinancing transactions and related accounts anddisclosures that would cause a material misstatement in the annual and interimfinancial statements. Accordingly, management determined that this controldeficiency constituted a material weakness in internal control over financialreporting as of December 31, 2005.

**Remediation**

In the Company’s amended annual report on Form 10-K/Afor the year ended December 31, 2004, filed December 19, 2005,management stated that it intended to remediate the material weakness ininternal control over financial reporting and that it would report on itsprogress in the present annual report. In particular, management stated that itintended to:

·       revise the Company’saccounting documentation of policies and procedures and review to meet thestandard of hedge documentation expected under SFAS 133; and

·       strengthen the Company’sinternal knowledge base regarding hedge accounting with improved training andexpertise.

Inaccordance with its stated intentions, management has revised the Company’saccounting documentation of policies and procedures and review to meet thestandard of hedge accounting under SFAS 133 and is applying such standard tocertain liabilities effective January 1, 2006. Management has also workedto strengthen the Company’s internal knowledge base regarding hedge accounting,through improved training designed to ensure that all relevant personnelunderstand and apply hedge accounting in compliance with SFAS 133.

Althoughit has implemented the remediation procedures as described above, managementcannot yet assert that the remediation is effective as it has not hadsufficient time to test the operating effectiveness of the newly implementedcontrols.

Managementexpects that the remediation of this material weakness in internal control overfinancial reporting will be complete before management and the Company’sindependent registered public accounting firm must first report on theeffectiveness of the internal control over financial reporting under Section 404of the Sarbanes-Oxley Act of 2002.

There are inherent limitations tothe effectiveness of any system of disclosure controls and procedures,including the possibility of human error and the circumvention or overriding ofthe controls and procedures. Accordingly, even effective disclosure controlsand procedures can only provide reasonable assurance of achieving their controlobjectives. The Company will continue to improve the design andeffectiveness of its disclosure controls and procedures and internal controlover financial reporting to the extent necessary in the future to providemanagement with timely access to such material information and to correct anydeficiencies that may be discovered in the future.

**Item 9B.**               OtherInformation.

None.

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**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant.

**Directors**

On May 19,2005, the Company’s shareholders appointed twelve directors to serve until thelater of the Company’s next annual meeting of shareholders or until theirsuccessors have been duly elected and qualified. Information about thedirectors as of December 31, 2005 is set forth below and in “Item 12.Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters—Directors and Executive Officers.”   
| Dirk Bruneel  Age 55      |   | Director of the Company since November 2001. Mr. Bruneel  has been a member of the Management Board of Dexia S.A. since July 2001,  and Chairman of the Management Board of Dexia Bank Nederland N.V. since November 2002.  He is currently the Chairman of the Board of Directors of Dexia Securities  France S.A., a member of the Supervisory Board of Dexia Municipal Agency S.A.  and Chairman of the Board of Directors of Artesia Mortgage Capital  Corporation. Mr. Bruneel served as Chairman of the Management Committee  of Artesia Banking Corporation (a Belgian-based bank acquired by Dexia  S.A. in July 2001) from November 1998 until August 2001 and of  BACOB Bank s.c. from January 1995 until August 2001, and was a  member of the Management Committee of Dexia Bank from July 2001 through January 2002.  He currently serves as a member of the Board of Directors of Dexia Insurance,  Dexia Capital Ireland, Dexia Financial Services Ireland, Dexia Investments  Ireland, Banque Artesia Nederland, Ehsal and VEV, and Treasurer of *Vlaams Omroeporkest en Kamerkoor**.* |
|---------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Robert P. Cochran  Age 56 |   | Chairman of the Board of  Directors of the Company since November 1997, and Chief Executive  Officer and a Director of the Company since August 1990. Mr. Cochran  served as President of the Company and FSA from August 1990 until November 1997.  He has been Chief Executive Officer of FSA since August 1990, Chairman  of FSA since July 1994, and a director of FSA since July 1988.  Prior to joining the Company in 1985, Mr. Cochran was Managing Partner  of the Washington, D.C. office of the Kutak Rock law firm. Mr. Cochran  is a Director of White Mountains Insurance Group, Ltd. and XL Financial  Assurance Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| Bruno Deletre  Age 44     |   | Director of the Company since September 2001. In  January 2006, Mr. Deletre became an Executive Vice President and  member of the Executive Committee of Dexia. Mr. Deletre was a member of  the Executive Board of Dexia Crédit Local from 2001 through January 2006  and Managing Director from December 2003. Prior to that time, he held  various positions in the French Ministry of Finance—Treasury, and served as  Advisor to the French Minister of Economy and Finance from 1995 to 1997.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |

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| Robert N. Downey  Age 70      |   | Director of the Company since August 1994. Mr. Downey  has been a Senior Director of Goldman Sachs & Co. since 1999, a  Limited Partner from 1991 to 1999, and a General Partner from 1976 until  1991. At Goldman, Sachs & Co., Mr. Downey served as head of the  Municipal Bond Department and Vice Chairman of the Fixed Income Division. Mr. Downey  was a Director of the Securities Industry Association from 1987 through 1991  and served as its Chairman in 1990 and Vice Chairman in 1988 and 1989. He was  also formerly Chairman of the Municipal Securities Division of the Public  Securities Association (known today as the Bond Market Association) and Vice  Chairman of the Municipal Securities Rulemaking Board.                |
|-------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Jacques Guerber  Age 56       |   | Director of the  Company since September 2002. In January 2006, Mr. Guerber  became Vice Chairman of the Management Board of Dexia and a Member of the  Management Board of Dexia Crédit Local. Mr. Guerber was Chairman  of the Executive Board of Dexia Crédit Local from 2000 through January 2006,  and a member of the Executive Committee of Dexia from December 1999 to January 2006.  Prior to then he was Senior Executive Vice President of Crédit Local de  France (subsequently known as Dexia Crédit Local) from 1996 and a member of  that company’s Management Board from 1988. Earlier, he held management  positions in the Local Development Division of *Caisse des  Dépôts et Consignations*.    |
| David O. Maxwell  Age 75      |   | Director of the  Company since August 1994. Mr. Maxwell was Chairman and Chief  Executive Officer of Fannie Mae from 1981 until his retirement in 1991. Mr. Maxwell  is a member of the advisory boards of Centre Partners II, L.P., Centre  Partners III, L.P. and Centre Partners IV, L.P.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| Séan W. McCarthy  Age 46 |   | Director of the Company  since February 1999. Mr. McCarthy has been President and Chief Operating  Officer of the Company since January 2002, and prior to that time served  as Executive Vice President of the Company since November 1997. He has  been President of FSA since November 2000, and served as Chief Operating  Officer of FSA from November 1997 until November 2000. Mr. McCarthy  was named a Managing Director of FSA in March 1989, head of its  Financial Guaranty Department in April 1993 and Executive Vice President  of FSA in October 1999. He has been a director of FSA since September 1993.  Prior to joining FSA in 1988, Mr. McCarthy was a Vice President of  PaineWebber Incorporated. |

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| James H. Ozanne  Age 62 |   | Director of the Company since September 2004. Mr. Ozanne  previously served on the Board of Directors of the Company from January 1990  through May 2003, when he became Chief Executive Officer of SPS Holding  Corp., a mortgage servicing holding company in which the Company owned a  minority interest, a position he held until September 2004. He served as  Vice Chairman of the Board of Directors of the Company from May 1998  until July 2000. Mr. Ozanne is Chairman of Greenrange Partners. He  was Chairman of Source One Mortgage Services Corporation, which was a  subsidiary of White Mountains (“Source One”), from March 1997 to May 1999,  Vice Chairman of Source One from August 1996 until March 1997, and  a director of Source One from August 1996 to May 1999. He was  Chairman and Director of Nations Financial Holdings Corporation from January 1994  to January 1996. He was President and Chief Executive Officer of U S  WEST Capital Corporation (“USWCC”) from September 1989 until December 1993.  Prior to joining USWCC, Mr. Ozanne was Executive Vice President of  General Electric Capital Corporation. Mr. Ozanne is currently a director  of Distributed Energy Services Corp. He has been Chairman of PECO Pallet, a  privately owned grocery pallet rental company, since 2000. |
|-------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Pierre Richard  Age 65  |   | Director and Vice  Chairman of the Company since July 2000. Mr. Richard has been  appointed Chairman of the Board of Directors of Dexia effective January 1,  2006. He was Group Chief Executive and Chairman of the Management Board of  Dexia from December 1999 to December 2005. He had been co-Chairman  of Dexia Group since its creation through the alliance between Crédit Local  de France and Crédit Communal de Belgique in December 1996. In October 1987,  when Crédit Local de France was incorporated, he became its Chief Executive  Officer and then, in December 1993, after the firm’s privatization, he  was named Chairman and Chief Executive Officer. He previously served as  Deputy General Manager of *Caisse des Dépôts et  Consignations*and, before that, as head of the Local Authorities  Department at the French Ministry of Interior, where he was closely involved  in drafting the new legislation for decentralization. He serves on the boards  of the European Investment Bank, Air France/KLM, Le Monde SA, Credit du Nord  and Generali France Holding. He has been decorated as an *Officier  of the Légion d*’*Honneur*and  the*Ordre National du Mérite* and as a*Commandeur of the Ordre of Leopold II*.                                                                                                              |

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| Roger K. Taylor  Age 54   |   | Director of the Company  since February 1995. Mr. Taylor was a part-time employee of the  Company and Vice Chairman of FSA from January 2002 until his retirement  in July 2004. Mr. Taylor served as Chief Operating Officer of the  Company from May 1993 through December 2001 and President of the  Company from November 1997 through December 2001. Mr. Taylor  joined FSA in January 1990, and served FSA as its President from November 1997  until November 2000, a director since January 1992 and a Managing  Director since January 1991. Prior to joining FSA, Mr. Taylor was  Executive Vice President of Financial Guaranty Insurance Company.                                                                                                                                                 |
|---------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Rembert von Lowis  Age 52 |   | Director of the  Company since July 2000. Mr. von Lowis is a member of the  Management Board of Dexia. He became Senior Executive Vice President of  Crédit Local de France in 1993. Mr. von Lowis joined Crédit Local de  France as Chief Financial Officer and member of its Executive Board in 1988.  Earlier, he held management positions in the Local Development Division in *Caisse des Dépôts et Consignations* and the Local  Authorities Department of the French Ministry of Interior. Mr. Von Lowis  is a director of Dexia CLF Finance Company.                                                                                                                                                                                                                                                                                         |
| George U. Wyper  Age 50   |   | Director of the  Company since September 2004. Mr. Wyper is the founder and managing  member of Wyper Capital Management, L.P., which he founded in 1998. He was  Senior Managing Director and a member of the Operating Committee of Warburg  Pincus Counsellors, Inc from 1994 to 1998. He served as Chief Investment  Officer of White River Corporation from 1991 to 1994 and as President and  Chief Executive Officer of Hanover Advisors from 1992 to 1994. Prior to 1991,  he was Chief Investment Officer of Fund American Enterprises from 1988 to  1990 and Director of Fixed Income Investments for Fireman’s Fund Insurance  Company from 1987 to 1988. Mr. Wyper is currently President of the  Darien Library and serves on the boards of the Yale School of Management, the  American Numismatic Society and the Museum of Rhode Island School of Design. |

 

On February 16, 2006, the Board of Directorsincreased the number of directors to 13 and elected Axel Miller to the Board ofDirectors. Information about Mr. Miller is set forth below and in “Item 12.Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters—Directors and Executive Officers.”

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| Axel Miller  Age 41 |   | Director of the Company  since February 2006. Mr. Miller obtained his law degree, a *Licence en droit*, from the *Université  Libre de Bruxelles*. After having worked for 14 years as a lawyer  specialized in finance law, mergers & acquisitions and international  commercial law, Mr. Miller joined the Dexia Group in 2001 as General  Counsel. He became a member of the Management Board of Dexia Bank in January 2002  and Chairman of the Management Board of Dexia Bank and Head of Personal  Financial Services at Group level in January 2003. On January 1,  2006, Mr. Miller became CEO and Chairman of the Management Board of  Dexia. On the same date, he also became a member of the Management Boards of  Dexia Crédit Local (France) and Dexia BIL (Luxembourg). He remains a member  of the Management Board of Dexia Bank (Belgium). He is also a Director of  several Dexia Group companies, Ethias, Crédit du Nord and LVI Holding (Groupe  Carmeuse).

  |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**Executive Officers of the Company**

Inaddition to Messrs. Cochran and McCarthy (who are described above underthe caption “Directors”), the Company’s other executive officers are describedbelow. The Company’s executive officers consist of the members of the ExecutiveManagement Committee.
| Name                  | ** ** | ** ** | ** ** | **Age**                                                                                       | ** ** | **Position** |
|-----------------------|------------|------------|------------|-----------------------------------------------------------------------------------------------|------------|--------------|
| Russell B. Brewer  II |       | 49         |       | Managing  Director of the Company and FSA; Chief Risk Management Officer and Director  of FSA |
| Joseph W. Simon       |       | 47         |       | Managing  Director and Chief Financial Officer of the Company and FSA; Director of FSA        |
| Bruce E. Stern        |       | 52         |       | Managing Director,  General Counsel and Secretary of the Company and FSA; Director of FSA     |

 

The present principal occupation and five-yearemployment history of each of the above-named executive officers of theCompany, as well as other directorships of corporations currently held by eachsuch person, are set forth below.

Mr. Brewer has been a Managing Director of FSAsince March 1989 and the Chief Risk Management Officer of FSA since September 2003.Mr. Brewer was the Chief Underwriting Officer of FSA from September 1990until September 2003. He has been a Managing Director of the Company sinceMay 1999 and a director of FSA since September 1993. From March 1989to August 1990, Mr. Brewer was Managing Director, Asset FinanceGroup, of FSA. Prior to joining FSA in 1986, Mr. Brewer was an AssociateDirector of Moody’s Investors Service, Inc.

Mr. Simon was elected a Managing Director and theChief Financial Officer of the Company and FSA in September 2002, havingserved in such capacity since April 2002. Prior to joining the Company, Mr. Simonwas Chief Financial Officer of Intralinks, a technology company serving thefinancial markets. Earlier, he worked for TENTV.com, a provider of business tobusiness video portals. From 1993 to 1999, he was a senior financial officer,last serving as the Chief Financial Officer, of Cantor Fitzgerald. Mr. Simon,a certified public accountant, began his professional career at PriceWaterhouse in 1983.

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Mr. Stern has been aManaging Director, the Secretary and the General Counsel of the Company since April 1993.Since April 1993, he has been the Secretary of FSA, and since March 1989,he has been a Managing Director of FSA. He has been a director of FSA since August 1990.Prior to joining FSA as General Counsel in 1987, Mr. Stern was an attorneywith Cravath, Swaine & Moore.

**Audit Committee**

The Company has a separately designated standing AuditCommittee established in accordance with Section 3(a)(58)(A) of theExchange Act. During 2005, the Audit Committee consisted of Messrs. Ozanne(Chairman), Maxwell and Wyper.  In February 2006,Mr. Taylor was elected to the Audit Committee and Mr. Maxwell ceasedto be a member of the Committee.

All members of the AuditCommittee are independent within the meaning of Rule 10A-3 of theExchange Act. Because the Company has only debt securities listed on the NewYork Stock Exchange, the additional independence standards for audit committeemembers imposed by the NYSE are not applicable to the Company.

**Audit Committee Financial Expert**

The Board of Directors ofthe Company has determined that Audit Committee members David O. Maxwell andJames H. Ozanne are audit committee financial experts as defined by Item 401(h) ofRegulation S-K of the Exchange Act.

**Code of Ethics**

The Company has adopted acode of ethics for directors, officers (including the Company’s principalexecutive officer, principal financial officer, and principal accountingofficer and controller) and employees, known as the Code of Conduct. TheCompany has posted its Code of Conduct on its Internet website, *www.fsa.com*. The Company intends to satisfy the disclosurerequirement under Item 5.05 of Form 8-K regarding amendments to, orwaivers from, provisions of its code of ethics that applies to its principalexecutive officer, principal financial officer and principal accounting officerand controller, or persons performing similar functions, and that relates toany element of the code of ethics definition enumerated in paragraph (b) ofItem 406 of Regulation S-K of the Exchange Act, by posting suchinformation on its website,*www.fsa.com*.

**Section 16(a) BeneficialOwnership Reporting Compliance**

Section 16 of the Exchange Act requires periodicreporting by beneficial owners of more than 10% of any equity securityregistered under Section 12 of the Exchange Act and directors andexecutive officers of issuers of such equity securities. Upon its merger with asubsidiary of Dexia in July 2000, the Company’s common stock ceased to beregistered under Section 12 of the Exchange Act or listed on the NYSE.Consequently, the Company no longer has equity securities registered under Section 12of the Exchange Act, and the reporting obligations of Section 16 of theExchange Act do not apply.

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**Item11.**                 ExecutiveCompensation.

**SummaryCompensation Table**

Thetable below sets forth a summary of all compensation paid to the chiefexecutive officer of the Company and the other four most highly compensatedexecutive officers of the Company and its subsidiaries, in each case forservices rendered in all capacities to the Company and its subsidiaries for theyears ended December 31, 2005, 2004 and 2003. 

| ** **                                     | ** ** | ** ** | ** ** | **Annual  Compensation** | ** ** | **Long-Term  Compensation(1)** | ** ** | ** **   | ** ** |
|------------------------------------------------|------------|------------|------------|--------------------------|------------|--------------------------------|------------|--------------|------------|
| **Name and Principal Position** | ** ** | ** ** | ** ** | **Year**                 | ** ** | **Salary**                     | ** ** | **Bonus(2)** | ** ** | **Dexia  Restricted  Stock  Awards(3)** | ** ** | **LTIP  Payouts(2)** | ** ** | **All Other  Compensation(4)** | ** ** |
| Robert P. Cochran                              |       | 2005       |       | $                        | 500,000    |                           | $          | 3,300,000    |       |   | $ | 480,029 |   |   | $ | 6,683,093 |   |   | $ | 90,000 |   |   |
| Chairman of the Board and                      |       | 2004       |       | 500,000                  |       | 3,400,000                      |       |         | 445,727    |   |   | 6,255,877 |   |   | 90,000 |   |   |
| Chief Executive Officer                        |       | 2003       |       | 500,000                  |       | 3,200,000                      |       |         | N/A        |   |   | 9,213,941 |   |   | 90,000 |   |   |
| Séan W. McCarthy                          |       | 2005       |       | 320,000                  |       | 3,000,000                      |       |         | 352,959    |   |   | 4,658,710 |   |   | 90,000 |   |   |
| President and                                  |       | 2004       |       | 310,000                  |       | 3,000,000                      |       |         | 327,741    |   |   | 4,705,296 |   |   | 90,000 |   |   |
| Chief Operating Officer                        |       | 2003       |       | 310,000                  |       | 2,800,000                      |       |         | N/A        |   |   | 6,858,901 |   |   | 90,000 |   |   |
| Bruce E. Stern                                 |       | 2005       |       | 250,000                  |       | 900,000                        |       |         | 127,070    |   |   | 1,867,355 |   |   | 90,000 |   |   |
| Managing Director,  General                    |       | 2004       |       | 240,000                  |       | 900,000                        |       |         | 117,986    |   |   | 2,003,907 |   |   | 90,000 |   |   |
| Counsel and Secretary                          |       | 2003       |       | 240,000                  |       | 800,000                        |       |         | N/A        |   |   | 2,269,286 |   |   | 80,100 |   |   |
| Russell B. Brewer II                           |       | 2005       |       | 250,000                  |       | 900,000                        |       |         | 127,070    |   |   | 1,864,458 |   |   | 90,000 |   |   |
| Managing Director and                          |       | 2004       |       | 240,000                  |       | 900,000                        |       |         | 117,986    |   |   | 1,956,545 |   |   | 90,000 |   |   |
| Chief Underwriting  Officer                    |       | 2003       |       | 240,000                  |       | 800,000                        |       |         | N/A        |   |   | 2,259,243 |   |   | 75,600 |   |   |
| Joseph W. Simon                                |       | 2005       |       | 250,000                  |       | 800,000                        |       |         | 127,070    |   |   | 916,036 |   |   | 90,000 |   |   |
| Managing Director and                          |       | 2004       |       | 240,000                  |       | 750,000                        |       |         | 104,889    |   |   | 297,899 |   |   | 66,600 |   |   |
| Chief Financial Officer                        |       | 2003       |       | 240,000                  |       | 500,000                        |       |         | N/A        |   |   | N/A |   |   | 33,300 |   |   |
|                                                |            |            |            |                          |            |                                |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Noawards of restricted stock of the Company or options/SARs were made to any ofthe executives named in the table during the period covered by the table.

(2)          Annualcompensation for each year includes bonus and LTIP payouts received or deferredby the named executive officer in January or February of thesubsequent year. LTIP payouts were made to or deferred by each named executivefor each year shown in the table above with respect to performance shares forthe three-year performance cycle ending December 31 of such year.For additional information regarding performance shares see “—Equity Plans—PerformanceShares.”

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(3)          DexiaRestricted Stock Awards represents the value of Dexia restricted stock awardedfor the years ended December 31, 2005 and 2004 (which awards were made in February 2006and 2005, respectively), based on the closing market price for ordinary sharesof Dexia on the date of grant. The Dexia restricted stock was awarded pursuantto the Company’s 2004 Equity Participation Plan, as amended (the “2004 EquityPlan”), and represents ordinary shares of Dexia subject to certain vestingrequirements and restrictions on transfer.   Holders of Dexia restricted stock areentitled to receive all dividends paid on such stock from the date of grant. Generally,one third of an award of Dexia restricted stock vests after 2.5 years and twothirds vests after 3.5 years, with transfer restrictions lapsing six monthsafter the vesting date. The awards reported in the Summary Compensation Tablefor Messrs. McCarthy, Stern, Brewer and Simon will accordingly vest asfollows:

| ** **            | ** ** | **Dexia Restricted Shares Vesting** | ** ** |
|-----------------------|------------|----------------------------------------------------|------------|
| **Name**              | ** ** | ** **                                         | ** ** | **Second Quarter 2007** | ** ** | **Second Quarter 2008** | ** ** | **Second Quarter 2009** | ** ** |
| Séan W. McCarthy |       |                                               | 4,821      |   |   |   | 14,445 |   |   |   | 9,603 |   |   |
| Bruce E. Stern        |       |                                               | 1,736      |   |   |   | 5,200 |   |   |   | 3,457 |   |   |
| Russell B. Brewer  II |       |                                               | 1,736      |   |   |   | 5,200 |   |   |   | 3,457 |   |   |
| Joseph W. Simon       |       |                                               | 1,543      |   |   |   | 4,815 |   |   |   | 3,457 |   |   |
|                       |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The 2004 Equity Plan providesthat, when a participant becomes eligible for retirement at age 55, shares ofDexia restricted stock vest thereafter to the extent the shares would havevested had the employee actually retired as of any particular date. Because Mr. Cochranbecame eligible for retirement during 2005, 6,368 of his shares vested during2005 and the remainder of his awarded shares will vest as follows, except asotherwise provided in his employment agreement: 3,178 shares per fiscalquarter during 2006 and through the first half of 2007, 2,523 per fiscalquarter from the second half of 2007 through the first half of 2008, and 933shares per fiscal quarter during the second half of 2008 and the first half of2009.

As of December 31,2005, based on the closing market price of ordinary shares of Dexia on thatdate, the aggregate holdings and market values of Dexia restricted stock byeach named executive officer are set forth below. These amounts exclude Dexiarestricted stock awarded in February 2006 and included in the summarycompensation table:

| **Name**              | ** ** | ** ** | ** ** | **Number of  Unvested  Dexia Shares** | ** ** | **Market Value** | ** ** |
|-----------------------|------------|------------|------------|-------------------------------------------------|------------|-----------------------|------------|
| Robert P. Cochran     |       |       | 13,301     |                                            |       |                  | $          | 307,020 |   |   |
| Séan W. McCarthy |       |       | 14,464     |                                            |       |                  | 333,856    |   |   |
| Bruce E. Stern        |       |       | 5,207      |                                            |       |                  | 120,187    |   |   |
| Russell B. Brewer  II |       |       | 5,207      |                                            |       |                  | 120,187    |   |   |
| Joseph W. Simon       |       |       | 4,629      |                                            |       |                  | 106,846    |   |   |

 

Prior to adopting the 2004Equity Plan, the Company did not have an equity plan that contemplated awardsof Dexia restricted stock. The Dexia restricted stock awards for the year endedDecember 31, 2004 (which awards were made in February 2005), were thefirst awards made under the 2004 Equity Plan. In its annual report on Form 10-Kfor the year 2004, the Company disclosed the awards to the named executiveofficers in its discussion of the 2004 Equity Plan under the caption “DexiaRestricted Stock,” but did not disclose the Dexia restricted stock awards inthe Summary Compensation Table. The Company has corrected its disclosure in theSummary Compensation Table above.

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(4)          AllOther Compensation includes contributions by the Company to its Supplemental ExecutiveRetirement Plan (“SERP”) and to its defined contribution pension plan (the “PensionPlan”), as follows:

| ** **            | ** ** | **2005**   | ** ** | **2004**              | ** ** | **2003** | ** ** |
|-----------------------|------------|------------|------------|-----------------------|------------|----------|------------|
| **Officer**           | ** ** | ** ** | ** ** | **Pension Plan** | ** ** | **SERP** | ** ** | **Pension Plan** | ** ** | **SERP** | ** ** | **Pension Plan** | ** ** | **SERP** | ** ** |
| Robert P. Cochran     |       |       | $          | 18,900                |       |     | $          | 71,100 |   |   | $ | 18,450 |   |   | $ | 71,550 |   |   | $ | 18,000 |   |   | $ | 72,000 |   |
| Séan W. McCarthy |       |       | 18,900     |                  |       | 71,100   |       |   | 18,450 |   |   | 71,550 |   |   | 18,000 |   |   | 72,000 |   |
| Bruce E. Stern        |       |       | 18,900     |                  |       | 71,100   |       |   | 18,450 |   |   | 71,550 |   |   | 18,000 |   |   | 62,100 |   |
| Russell B. Brewer  II |       |       | 18,900     |                  |       | 71,100   |       |   | 18,450 |   |   | 71,550 |   |   | 18,000 |   |   | 57,600 |   |
| Joseph W. Simon       |       |       | 18,900     |                  |       | 71,100   |       |   | 18,450 |   |   | 48,150 |   |   | 9,000 |   |   | 24,300 |   |
|                       |            |            |            |                       |            |          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Pension Plan and SERPamounts shown for each year were accrued during that year and paid in January orFebruary of the following year. The Pension Plan provides for a Companyfunded contribution equal to 9% of cash compensation (salary and bonus) up tothe compensation limit specified by the Internal Revenue Service. The SERPprovides for an unfunded Company contribution equal to 9% of cash compensationover and above the Pension Plan compensation limit but limited to $1 million ofcompensation. The Pension Plan and SERP provide for vesting of contributionsover a six-year employment period, after which all subsequentcontributions are 100% vested.

**EmploymentAgreements and Arrangements; Change in Control Provisions**

Each of Messrs. Cochranand McCarthy entered into employment agreements with the Company, effective July 5,2004. The employment agreements generally guarantee continuation ofcompensation and benefits through December 31, 2007, and provide forrenewals and extensions of this initial term for two-year terms, subjectto notice of termination from either party at least six months prior to the endof the extended term. At any point after the initial term has expired, Mr. Cochranmay elect to become Non-Executive Chairman of the Company for theremainder of the term and any extensions.

Underthe agreements, compensation consists of:

·       basesalary at the annual rate in effect immediately prior to the agreement, subjectto increase at the Board’s discretion;

·       annualbonus equal to a minimum percentage of a “bonus pool” determined pursuant toformulae from time to time determined by the Human Resources Committee of theBoard of Directors; and

·       annualawards of performance shares under the Company’s 1993 Equity ParticipationPlan, as amended (the “1993 Equity Plan”) and 2004 Equity Plan (together, the “EquityPlans”), having an estimated economic value at least equal to the employee’s2004 performance shares award. Each performance share represents the economicvalue of up to two shares of common stock of the Company, and not justappreciation in share value, as is the case with a stock option. For additionalinformation, see “—Equity Plans—Performance Shares.”

The 2005 bonus pool guidelinescontemplated a bonus pool equal to 11.25% of the growth in adjusted book valuefor the year, including a return on equity modifier. A similar guideline isexpected to apply in 2006. An additional reserve bonus pool made up ofpreviously earned but undistributed bonus pool allocations from prior years,equal to approximately $25.3 million after giving effect to 2005 bonuses (paidin the first quarter of 2006), could also be distributable. Messrs. Cochranand McCarthy are entitled to receive an annual cash bonus equal to at least5.0% and 4.0%, respectively, of the bonus pool. The employment agreementsprovide that an additional 2.0% of the bonus pool will be allocated among thosetwo executive officers as determined by the Human Resources Committee.

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The employment agreementsprovide that Messrs. Cochran and McCarthy may elect to retire atage 60, but that retirement is mandatory at age 65. Upon retirement, eachof Mr. Cochran and Mr. McCarthy will be entitled to his pro-rataannual base salary and annual bonus through the date of retirement and thevesting of his outstanding performance shares over time as if he remainedemployed. Messrs. Cochran and McCarthy are not entitled to any on-goingretirement compensation except as provided by the Company’s definedcontribution  Pension Plan and SERP.

Theemployment agreements provide for continued participation in the Company’sbenefit plans and severance benefits in lieu of the Company’s existingseverance policy. Specifically, if the Company terminates Mr. Cochran or Mr. McCarthywithout cause or either of such executive officers terminates his employmentfor “good reason,” he will be entitled to:

·       hispro-rata annual base salary and annual bonus through the date oftermination;

·       twicehis annual base salary at the rate then in effect and twice his average annualbonus for the two immediately prior years;

·       vestingof his outstanding performance shares; and

·       theminimum annual performance shares that he is entitled to receive through theend of the contract’s term.

“Good reason” includes,for Mr. McCarthy, not being named Mr. Cochran’s successor as ChiefExecutive Officer of the Company.

Both employment agreementsprovide that, if the employee is terminated for cause or terminates hisemployment without “good reason” during the term, he will be entitled only tobe paid his pro rata annual base salary through the date of termination. Ifsuch termination occurs after the term of the agreement, he will also beentitled to his pro-rata annual bonus through the date of termination andhis performance shares will vest pro rata in proportion to the percentage ofthe applicable performance cycle during which he was employed by the Company.Each employment agreement contains a non-compete provision extendingthrough the greater of two years and the term of the agreement.

If Mr. Cochranbecomes Non-Executive Chairman of the Company, he will be entitled to histhen-current salary and an annual performance share unit award with anestimated economic value at least equal to 50% of normal prior awards. If Mr. McCarthybecomes the Chief Executive Officer of the Company, he will be entitled tocompensation equal to 90% or more of Mr. Cochran’s latest compensation,including salary, bonus and performance share units.

The Company’s severancepolicy for senior management entitles Messrs. Brewer, Simon and Stern to12 months of compensation, in each case, if terminated without cause and basedon current salary and bonus (or, in certain events, prior compensation ifhigher). The severance policy provides reimbursement (on a grossed-upbasis) for any “golden parachute” excise taxes payable by employees upon theirtermination of employment.

The Equity Plans providefor accelerated vesting and payment of performance shares and restricted stockof Dexia awarded under the 2004 Equity Plan, if any, upon the occurrence ofcertain change in control transactions involving the Company. These provisionsare generally applicable to all participants in the Equity Plans. Each of thenamed executive officers holds performance shares and Dexia restricted stockawarded under the Equity Plans.

The 1993 Equity Planprovides that the Company’s Board of Directors may elect to continue the planand the 2004 Equity Plan provides that the plan shall automatically continue ifa change in control occurs. Following a “plan continuation,” performance sharesand Dexia restricted stock are not accelerated, but vest and are payable as ifno change in control had occurred, except in the case of any employee who is terminatedwithout cause or leaves for “good reason” following the change in control.

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**Compensation ofDirectors**

Each director of theCompany who is not an officer of the Company or Dexia received a fee of $50,000per annum for service as a director and an additional annual fee of $20,000 ifChairman of the Underwriting Committee or Audit Committee of the Board ofDirectors or $5,000 if Chairman of another Committee of the Board of Directors.Each director also received $2,000 for each Board meeting and regular Committeemeeting attended and reimbursement for expenses for each such meeting attended.Each director is entitled to defer fees under the Company’s DeferredCompensation Plan (the “DCP”) and to participate in the director share purchaseprogram.

**DirectorShare Purchase Program**

In thefourth quarter of 2000, the Company entered into an agreement with DexiaHoldings and Dexia Public Finance Bank, now Dexia Crédit Local, to establishthe Director Share Purchase Program, pursuant to which Company directors couldinvest in shares of the Company’s common stock. The Director Share PurchaseProgram entitles each director of the Company to purchase from Dexia (or anaffiliate thereof) up to 126,958 restricted shares of the Company’s commonstock (which represented a $10 million investment at the purchase price atinception of the program) at a price determined in accordance with the formuladescribed below, provided that:

·       restrictedshares must be held for the lesser of four years or the participant’s tenure asa director of the Company;

·       restrictedshares may be put to Dexia Crédit Local at any time or from time to timefollowing the required holding period for cash; and

·       purchasesof shares after inception of the program are at a price equal to the purchase pricefor shares put to Dexia Crédit Local described below.

Directors may purchasesuch shares either directly or through deemed investments under the DCP orSERP. Each deemed investment election with respect to these shares isirrevocable.

The Director SharePurchase Program enables the Company to purchase from Dexia Holdings, at thesame price, the same number of shares of common stock purchased by directorsthrough phantom investments under the DCP or SERP. Upon expiration of anyapplicable deferral period, the Company is obligated to pay out the phantominvestments in shares of common stock, which must be held by the participant asif acquired directly from Dexia Holdings for generally a minimum of six months.

The purchase price foreach restricted share acquired by a director or put to Dexia Crédit Local isequal to the product of 1.4676 and adjusted book value per share (“ABV pershare”), with ABV per share determined in accordance with the methodologyemployed for valuing performance share award payouts under the Equity Plans.The purchase price per share, determined pursuant to such formula, was $178.00as of December 31, 2005. ABV per share is measured at the close of thecalendar quarter in which a director submits a repurchase notice, provided thatABV per share for a terminated director freezes at the end of the calendarquarter including the first anniversary of the later of the termination ofdirectorship or, in the case of deferred shares, receipt of shares uponexpiration of the deferral period.

Sales under the programare not registered under the Securities Act in reliance upon an exemption fromregistration under Section 4(2) of that Act. None of the directorsmade any additional direct or phantom investments under the Director SharePurchase Program during 2003, or any direct investments after 2002, the year ofinception of the Program. During 2004, one director invested in 1,890 phantomshares and during 2005 one director purchased 6,199 shares outright. For moreinformation regarding the directors’ share ownership, see “Item 12. SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters—Directors and Executive Officers.”

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**Equity Plans**

In November 2004,the Company adopted the 2004 Equity Plan, to be used for equity compensationawards to Company executives and employees in lieu of the 1993 Equity Plan. The2004 Equity Plan provides for awards of:

·       performanceshares,

·       Dexiarestricted stock, and

·       performanceshare units comprised of performance shares and Dexia restricted stock.

Thefollowing table sets forth a summary of the performance share units awarded toeach of the named executive officers for the year ended December 31, 2005(which awards were made in February 2006), as well as the number ofperformance shares and Dexia restricted shares the awards were comprised of:

| **Name**              | ** ** | ** ** | ** ** | **Number of  Performance  Share Units** | ** ** | ** **      | ** ** | **Number of Performance Shares  (“PS”) and Dexia Restricted Shares** | ** ** |
|-----------------------|------------|------------|------------|---------------------------------------------------|------------|-----------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|
| Robert P. Cochran     |       |       | 34,000     | * *                                          |       | *Comprised of:* |       | 30,600 PS and 19,591  Dexia shares                                                                                |       |
| Séan W. McCarthy |       |       | 25,000     | * *                                          |       | *Comprised of:* |       | 22,500 PS and 14,405  Dexia shares                                                                                |       |
| Bruce E. Stern        |       |       | 9,000      | * *                                          |       | *Comprised of:* |       | 8,100 PS and 5,186 Dexia  shares                                                                                  |       |
| Russell B. Brewer  II |       |       | 9,000      | * *                                          |       | *Comprised of:* |       | 8,100 PS and 5,186 Dexia  shares                                                                                  |       |
| Joseph W. Simon       |       |       | 9,000      | * *                                          |       | *Comprised of:* |       | 8,100 PS and 5,186 Dexia shares                                                                                   |       |

 

***Performance Shares***

Each performance share represents the economic valueof up to two shares of common stock of the Company, and not just appreciation,as is the case with a stock option. The number of shares of common stockactually earned for each performance share depends upon the attainment by theCompany and its subsidiaries (on a consolidated basis) of “performanceobjectives” during the time period specified by the Committee at the time anaward of performance shares is made.

Both Equity Plans authorize the discretionary grant ofperformance shares by the committee administering the Equity Plan (the HumanResources Committee) to key employees of the Company and its subsidiaries. Solong as the Company’s common stock is not registered under the Exchange Act,the Company expects to pay its performance shares in cash rather than stock.

Since its inception, up to 3,300,000 shares of commonstock have been available for distribution under the 2004 Equity Plan inrespect of performance shares. Such shares may be newly issued shares, treasuryshares or shares purchased in the open market. If performance shares awardedunder the 2004 Equity Plan are forfeited, the shares allocated to such awardsare again available for distribution in connection with future awards under thePlan.

The following table setsforth (a) a summary of performance shares awarded to each of the namedexecutive officers for the year ended December 31, 2005 (which awards weremade in February 2006), (b) the applicable performance period untilpayout and (c) the related estimated future payouts at the stated assumedannual rates of adjusted book value per share and book value per share growth.

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**Long-TermIncentive Plans Awards in 2005(1)**

| ** **            | ** ** | **Performance**     | ** ** | **Performance**               | ** ** | **Estimated Future Payouts(3)** | ** ** |
|-----------------------|------------|---------------------|------------|-------------------------------|------------|-------------------------------------------|------------|
| **Name**              | ** ** | **Shares  Awarded** | ** ** | **Period Until  Payout** | ** ** | **Threshold  (no. of shares)**  | ** ** | **Target  (no. of shares)** | ** ** | **Maximum  (no. of shares)** | ** ** |
| Robert P. Cochran     |       |                | 30,600     |                          |       |                                      | (2         | ) |   |   | 0 |   |   |   | 30,600 |   |   |   | 61,200 |   |   |
| Séan W. McCarthy |       |                | 22,500     |                          |       |                                      | (2         | ) |   |   | 0 |   |   |   | 22,500 |   |   |   | 45,000 |   |   |
| Bruce E. Stern        |       |                | 8,100      |                          |       |                                      | (2         | ) |   |   | 0 |   |   |   | 8,100 |   |   |   | 16,200 |   |   |
| Russell B. Brewer  II |       |                | 8,100      |                          |       |                                      | (2         | ) |   |   | 0 |   |   |   | 8,100 |   |   |   | 16,200 |   |   |
| Joseph W. Simon       |       |                | 8,100      |                          |       |                                      | (2         | ) |   |   | 0 |   |   |   | 8,100 |   |   |   | 16,200 |   |   |

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(1)          These performance shareswere awarded under the 2004 Equity Plan in February 2006 for the yearended December 31, 2005. The table excludes performance shares awarded in February 2005for the year ended December 31, 2004, which are set forth in “Item 12.Security Ownership of Certain Beneficial Owners and Management—PerformanceShares” of the Company’s Annual Report on Form 10-K/A for the yearended December 31, 2004.

(2)          One-third of eachaward relates to the three-year performance cycle ending December 31,2008 and two-thirds of each award relates to the three-yearperformance cycle ending December 31, 2009. Awards are payable shortlyfollowing completion of the applicable performance cycle, subject to earlierpayment in certain circumstances or to deferral. Such performance shares vestat the completion of the applicable performance cycle, subject to rules pertainingto the recipient’s death, disability, retirement or termination of employment,or change-in-control transactions.

(3)          Theactual dollar value received by a holder of performance shares, in general,varies in accordance with the average of the annual rate of growth in “adjustedbook value” and “book value” per share (“ROE”) of common stock during anapplicable “performance cycle” and the value of common stock at the time ofpayout of such performance shares. For purposes of the foregoing, adjusted bookvalue per share and book value per share are adjusted to exclude the after-taxchange in accumulated other comprehensive income. Accumulated othercomprehensive income includes, for example, unrealized gains and losses in theCompany’s Investment Portfolio. With respect to the performance sharesdescribed in the table above, (a) if ROE is 7% or less per annum for anyperformance cycle, no shares of common stock will be earned for the performancecycle; (b) if ROE is 13% per annum for any performance cycle, a number ofshares of common stock equal to 100% of the number of performance shares willbe earned for that performance cycle; and (c) if ROE is 19% per annum orhigher for any performance cycle, a number of shares of common stock equal to200% of the number of performance shares will be earned for that performancecycle. If ROE is between 7% and 19%, the payout percentage will beinterpolated. So long as the Company’s common stock is not publicly traded, theCompany expects to pay its performance shares in cash rather than stock, withshares valued at the greater of (1) 0.85 times “adjusted book value” pershare and (2) the average of (a) 1.15 times “adjusted book value” pershare and (b) 14 times “operating earnings” per share (each such term asdefined in the Equity Plans). At December 31, 2005, the estimated presentvalue of one performance share at a one-times payout was $139.00 per share.

***Dexia Restricted Stock***

The 2004 Equity Plan authorizes the discretionarygrant of Dexia restricted stock by the Human Resources Committee, the committeeadministering the Equity Plan, to the employees of the Company and itssubsidiaries. Dexia restricted stock awarded under the 2004 Equity Planrepresents ordinary shares of Dexia subject to certain vesting requirements andrestrictions on transfer. Holders of Dexia restricted stock are entitled toreceive all dividends paid on such stock from the date of grant.

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The following table setsforth a summary of Dexia restricted stock awarded to each of the namedexecutive officers for the year ended December 31, 2005 (which awards weremade in February 2006) as a component of Performance Share Units.

**DexiaRestricted Stock Awarded For 2005**

| **Name**              | ** ** | ** ** | ** ** | **Dexia  Restricted  Shares  Awarded** | ** ** |
|-----------------------|------------|------------|------------|----------------------------------------|------------|
| Robert P. Cochran     |       |       | 19,591     |                                   |       |
| Séan W. McCarthy |       |       | 14,405     |                                   |       |
| Bruce E. Stern        |       |       | 5,186      |                                   |       |
| Russell B. Brewer  II |       |       | 5,186      |                                   |       |
| Joseph W. Simon       |       |       | 5,186      |                                   |       |

 

For additional informationregarding awards of Dexia restricted stock, see note (3) to the tableentitled “Summary Compensation Table,” above.

**CompensationCommittee Interlocks and Insider Participation**

The Human Resources Committeeconsisted of Messrs. Maxwell (Chairman), Cochran, Deletre, Downey, Richardand Taylor during 2005. In February 2006, Mr. Downey was namedChairman of the Committee, Axel Miller was elected to the Committee, and Messrs. Maxwelland Richard ceased to be members. Except for Messrs. Cochran and Taylor,none of such persons is currently or has ever been an officer or employee ofthe Company or any subsidiary of the Company. Mr. Richard is the Chairmanof the Board of Directors of Dexia, Mr. Miller is the Group ChiefExecutive Officer and Chairman of the Management Board of Dexia, and Mr. Deletreis a member of the Executive Board of Dexia Crédit Local.

As described in “DirectorShare Purchase Program,” above, members of the Human Resources Committee areentitled to participate in a share purchase program available to all directorsof the Company, either directly or through deemed investments under the Company’sDCP or SERP.

**Item12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.

**5% Shareholders**

The following table setsforth certain information regarding beneficial ownership of the Company’sequity at March 15, 2006 as to each person known by the Company tobeneficially own, within the meaning of the Exchange Act, 5% or more of theoutstanding shares of the common stock, par value $.01 per share, of theCompany.

| **Title of class** | ** ** | ** **                                           | ** ** | **Name and address of  beneficial owner** | ** ** | **Amount and nature of  beneficial ownership** | ** ** | **Percent of  class** | ** ** |
|------------------------------|------------|------------------------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|----------------------------|------------|
| Common stock, par  value     |       | Dexia  S.A.(1)                                       |       | 32,871,753 shares(1)(2)                                       |       |                                                               | 98.8       | %(2)                       |       |
| $.01 per share               |       | 7 à 11 quai André  Citröen BP-1002    |       |                                                          |       |                                                               |       |                       |       |
|                         |       | 75 901 Paris Cedex 15,  France                       |       |                                                          |       |                                                               |       |                       |       |
|                         |       | Boulevard Pachéco  44  B-1000 Brussels, Belgium |       |                                                          |       |                                                               |       |                       |       |

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(1)          Shares are heldindirectly through a subsidiary of Dexia.

(2)          Forpurposes of this table, Dexia is not deemed to be the beneficial owner of254,756 shares acquired by the Company in connection with the Director SharePurchase Program described in “Item 11. 

131

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ExecutiveCompensation—Director Share Purchase Program.” Ownership percentage iscalculated based on 33,263,259 shares of common stock outstanding at March 15,2006, which excludes such shares acquired by the Company.

**Directors and Executive Officers**

***Ownership of Company Common Stock***

The following table sets forth certain informationregarding beneficial and economic ownership of the Company’s common stock at March 15,2006 for (a) each director of the Company, (b) each executive officernamed under “Executive Compensation Summary Compensation Table” and (c) allexecutive officers and directors of the Company as a group.

Beneficialownership is less than 1% for each executive officer and director listed,individually and as a group.

| **Directors and Executive Officers**           | ** ** | ** ** | ** ** | **Amount and  Nature  of Beneficial  Ownership(1)** | ** ** | **Economic  Ownership(1)** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------------|------------|----------------------------|------------|
| Dirk Bruneel(2)                                               |       |       | —     |                                                          |       |                       | —     |   |   |
| Robert P. Cochran                                             |       |       | 41,744     |                                                          |       |                       | 253,491    |   |   |
| Bruno Deletre(2)                                              |       |       | —     |                                                          |       |                       | —     |   |   |
| Robert N. Downey                                              |       |       | 20,159     |                                                          |       |                       | 29,259     |   |   |
| Jacques  Guerber(2)                                           |       |       | —     |                                                          |       |                       | —     |   |   |
| Séan W. McCarthy                                         |       |       | —     |                                                          |       |                       | 116,719    |   |   |
| David O. Maxwell                                              |       |       | 6,009      |                                                          |       |                       | 19,299     |   |   |
| Axel Miller(2)                                                |       |       | —     |                                                          |       |                       | —     |   |   |
| James H. Ozanne                                               |       |       | —     |                                                          |       |                       | 24,591     |   |   |
| Pierre Richard(2)                                             |       |       | —     |                                                          |       |                       | —     |   |   |
| Roger K. Taylor                                               |       |       | —     |                                                          |       |                       | 96,489     |   |   |
| George U. Wyper                                               |       |       | 6,199      |                                                          |       |                       | 6,199      |   |   |
| Rembert von  Lowis(2)                                         |       |       | —     |                                                          |       |                       | —     |   |   |
| Bruce E. Stern                                                |       |       | —     |                                                          |       |                       | 32,867     |   |   |
| Russell B. Brewer  II                                         |       |       | —     |                                                          |       |                       | 32,867     |   |   |
| Joseph W. Simon                                               |       |       | —     |                                                          |       |                       | 25,633     |   |   |
| All executive officers  and directors as a group (15 persons) |       |       | 74,111     |                                                          |       |                       | 637,414    |   |   |

----

(1)          Sharesbeneficially owned were acquired under the Company’s Director Share PurchaseProgram described under “Item 11. Executive Compensation—Director SharePurchase Program.” To the extent shares economically owned exceed sharesbeneficially owned, such economic ownership is attributable to (a) deemedinvestments in the Company’s common stock under the Director Share PurchaseProgram, and  (b) performanceshares, with each performance share treated as one share of common stock, inthe amounts shown below (excluding fractional shares):

| **Officer**           | ** ** | ** ** | ** ** | **Performance Shares** | ** ** |
|-----------------------|------------|------------|------------|-----------------------------|------------|
| Robert P. Cochran     |       |       | 126,533    |                        |       |
| Séan W. McCarthy |       |       | 90,667     |                        |       |
| Bruce E. Stern        |       |       | 32,867     |                        |       |
| Russell B. Brewer  II |       |       | 32,867     |                        |       |
| Joseph W. Simon       |       |       | 25,633     |                        |       |

 

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In December 2000, the Company acquired 301,095shares of its common stock from Dexia Holdings to satisfy most of itsobligations under the Director Share Purchase Program in an amount equal to thenumber of shares deemed invested by directors at the Program’s inception dateunder the DCP and SERP. The Company held 254,736 of those shares as of December 31,2005.

(2)          Messrs. Bruneel,Deletre, Guerber, Miller, Richard and von Lowis are directors of the Companyand officers of Dexia or its subsidiaries. Dexia indirectly owns 98.8% of theCompany’s common stock.

The Company is not awareof any arrangements that may result in a change in control of the Company.

***Ownership of Dexia Common Stock***

Thefollowing table sets forth beneficial ownership of common shares of the Company’sparent, Dexia, at March 15, 2006, for (a) each director of theCompany, (b) each executive officer and (c) all executive officersand directors of the Company as a group. Beneficial ownership is less than 1%for each executive officer and director listed, individually and as a group.

| **Directors and Executive Officers(1)**        | ** ** | ** ** | ** ** | **Amount and Nature of  Beneficial Ownership** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------|------------|
| Dirk Bruneel                                                  |       |       | 42,429     |                                                               |       |
| Robert P.  Cochran(2)                                         |       |       | 743,679    |                                                               |       |
| Bruno Deletre                                                 |       |       | 1,189      |                                                               |       |
| Robert N. Downey                                              |       |       | —     |                                                               |       |
| Jacques Guerber                                               |       |       | 8,994      |                                                               |       |
| Séan W.  McCarthy(2)                                     |       |       | 613,599    |                                                               |       |
| David O. Maxwell                                              |       |       | —     |                                                               |       |
| Axel Miller                                                   |       |       | 200        |                                                               |       |
| James H. Ozanne                                               |       |       | —     |                                                               |       |
| Pierre Richard                                                |       |       | 40,210     |                                                               |       |
| Roger K. Taylor                                               |       |       | 247,750    |                                                               |       |
| George U. Wyper                                               |       |       | —     |                                                               |       |
| Rembert von Lowis                                             |       |       | 75,372     |                                                               |       |
| Bruce E. Stern(2)                                             |       |       | 225,115    |                                                               |       |
| Russell B. Brewer  II(2)                                      |       |       | 223,555    |                                                               |       |
| Joseph W. Simon(2)                                            |       |       | 42,005     |                                                               |       |
| All executive officers  and directors as a group (15 persons) |       |       | 2,264,097  |                                                               |       |

----

(1)          Dexia has provided the Company withinformation regarding shares owned by Messrs. Bruneel, Deletre, Guerber,Miller, Richard and von Lowis, and has advised the Company that:

(a)          shares presented for those directorsinclude only shares owned directly by such directors or shares for which thosedirectors can cast a vote and exclude warrants, and

(b)         as of December 31, 2005, the totalnumber of outstanding Dexia shares was 1,107,469,030, so that together theCompany’s executive officers and directors owned 0.20% of Dexia shares and themaximum amount owned by any of the Company’s executive officers and directorsrepresents 0.07% of Dexia shares.

Amajority of the shares set forth above were acquired under the Employee SharePlans sponsored by Dexia from 2000 to 2005. All employees of the Company wereallowed to participate in these plans. The number of shares an employee isentitled to purchase under these plans is a function of the employee’scompensation for the prior year of service. These plans allowed employees topurchase ordinary shares of Dexia stock at a 15% to 20% discount from marketvalue, but restricted the ability to dispose of such shares for a five-yearperiod following purchase, subject to limited exceptions. Shares purchasedunder these plans include shares acquired under “leveraged options.” Employeeswho purchased shares under the leveraged 

133

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optionsare entitled to the upside from ten shares for each share purchased with his orher own funds and benefit from a “floor” guarantying a return of invested fundsfollowing expiration of the five-year investment period. A third partyfinancial institution is entitled to (1) all dividends paid on theleveraged shares and (2) a specified percentage of any share appreciationduring the five-year investment period in the case of the “standard”leveraged option, and of the average monthly share appreciation during a 52-monthperiod commencing six months after inception of the five-year investmentperiod in the case of the “average” leveraged option. These percentages are asfollows:  38% (for 2001), 40% (for 2002),40% (for 2003 for the standard leveraged option), 20% (for 2003 for the averageleveraged option), 35% (for 2004 for the standard leveraged option), 15% (for 2004for the average leveraged option), 20% (for 2005 for the standard leveragedoption) and 0.5% (for 2005 for the average leveraged option).

| **Officer**           | ** ** | ** ** | ** ** | **Leveraged Shares** | ** ** |
|-----------------------|------------|------------|------------|---------------------------|------------|
| Robert P. Cochran     |       |       | 709,280    |                      |       |
| Séan W. McCarthy |       |       | 584,730    |                      |       |
| Bruce E. Stern        |       |       | 206,650    |                      |       |
| Russell B. Brewer  II |       |       | 209,050    |                      |       |
| Joseph W. Simon       |       |       | 32,190     |                      |       |

 

(2)          Includes shares granted under the 2004 Equity Plan, asdescribed in “Item 11. Executive Compensation—Equity Plans.” Generally, onethird of an award of Dexia restricted stock vests after 2.5 years and twothirds vests after 3.5 years, with transfer restrictions lapsing on one thirdof each award after three years and on two thirds of each award after fouryears.

**SecuritiesAvailable Under Equity Compensation Plans**

The following table setsforth information as of December 31, 2005 with respect to eachcompensation plan of the Company under which equity securities of the Companyare authorized for issuance.

**EquityCompensation Plan Information**

| **Plan Catebgory**                                             | ** ** | ** ** | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and  rights(a)** | ** ** | **Weighted average  exercise price of  outstanding options,  warrants and rights(b)** | ** **     | **Number of securities  remaining available  for future issuance under  equity compensation plans  (excluding securities  reflected in column (a))(c)** | ** ** |
|---------------------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|----------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity compensation plans  approved by security holders(1)          |       |       | 0          |                                                                                                                                            |       |                                                                                                                | Not applicable |                                                                                                                                                                                                                |       |   | 2,698,200 | (3) |   |
| Equity compensation  plans not approved by security holders(2) |       |       | —     |                                                                                                                                            |       |                                                                                                                | —         |                                                                                                                                                                                                                |       |   | — |   |   |
| Total                                                               |       |       | 0          |                                                                                                                                            |       |                                                                                                                | Not applicable |                                                                                                                                                                                                                |       |   | 2,698,200 |   |   |

----

(1)          The Company currently maintains one suchplan, the 2004 Equity Plan. A second plan, the Director Share Purchase Program,permits each director of the Company to purchase, directly from Dexia Holdingsor through “phantom” investments in the Company’s DCP or SERP, up to 126,958shares of common stock. However, such shares are already issued and outstanding.As of December 31, 2005, there were 1,194,649 shares available under theDirector Share Purchase Program, based on the number of directors as of December 31,2005 (12) and deducting shares that have already been purchased. See  “Item 11. Executive Compensation” for furtherdiscussion of these plans.

(2)          All of the Company’s equity compensationplans have been approved by the Company’s shareholders.

(3)          Shares available for future issuance underthe 2004 Equity Plan. Since its inception, up to 3,300,000 shares of commonstock have been available for distribution under the 2004 Equity Plan inrespect of performance shares. Such shares may be newly issued shares, treasuryshares or shares purchased in the open market.  If performance shares awarded under the 2004Equity Plan are forfeited, the shares allocated to such awards are againavailable for distribution in connection with future awards under the Plan. Solong as the Company’s common stock is not registered under the Exchange Act,the Company expects to pay its performance shares in cash rather than stock.

134

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**Item 13.**                 CertainRelationships and Related Transactions.

**Financial Guaranty Transactions**

Since the Company’s mergerwith a subsidiary of Dexia in July 2000, various affiliates of Dexia,including certain wholly owned bank subsidiaries and/or their U.S. branches,have participated in transactions in which subsidiaries of the Company have providedfinancial guaranty insurance. For example, Dexia affiliates have providedliquidity facilities and letters of credit in FSA-insured transactions,and been the beneficiary of financial guaranty insurance policies issued byinsurance company subsidiaries of the Company. In the opinion of management ofthe Company, the terms of these arrangements are no less favorable to theCompany than the terms that could be obtained from unaffiliated parties. SeeNote 14 to the Consolidated Financial Statements in Item 8.

**DirectorShare Purchase Program**

As of December 31,2005, directors were entitled to purchase up to 126,958 of actual or phantomshares of the Company’s common stock, as described in “Item 11. ExecutiveCompensation—Director Share Purchase Program.”

**Other Relationships**

Under a cost-sharingagreement, the Company reimburses Dexia Crédit Local for the portion ofdirector Bruno Deletre’s Dexia Crédit Local compensation that relates to hiswork as liaison with the Company on behalf of Dexia.

Additional informationrelating to certain relationships and related transactions is set forth in “Item 11.Executive Compensation—Compensation Committee Interlocks and InsiderParticipation.”

**Item14.**                 PrincipalAccounting Fees and Services.

Aggregatefees (in thousands) for professional services by PricewaterhouseCoopers LLPinvoiced in 2005 and 2004, were:

| ** **    | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------|------------|----------|------------|----------|------------|
| Audit         |       | $        | 2,033.9    |     | $          | 1,084.5 |   |
| Audit related |       | 392.1    |       | 367.7    |       |
| Tax           |       | 328.0    |       | 536.1    |       |
| Total         |       | $        | 2,754.0    |     | $          | 1,988.3 |   |

 

Audit fees for the yearsended December 31, 2005 and 2004 were for professional services renderedfor the audits of the Company’s Consolidated Financial Statements, audits ofthe Subsidiaries, and issuance of consents. Included in this amount is $0.2million and $0.2 million in fees relating to consents that are reimbursed tothe Company by the issuers of FSA-insured deals for the years ended December 31,2005 and 2004, respectively.

Audit related fees for theyears ended December 31, 2005 and 2004 were for assurance and relatedservices related to the Company’s retirement plans and consultations concerningfinancial accounting and reporting standards.

Tax fees for the yearsended December 31, 2005 and 2004 were for services related to taxcompliance, including the preparation of tax returns for expatriates,assistance with tax audits and appeals, and tax services for employee benefitplans.

**AuditCommittee Pre-Approval Policies and Procedures**

The Audit Committee of the Company’s Bond of Directorspre-approves all audit and non-audit related fees paid to theCompany’s auditors.

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**PART IV**

**Item15.   Exhibits, Financial Statement Schedules.**

**1.**   ConsolidatedFinancial Statements

**Item 8sets forth the following financial statements of Financial Security AssuranceHoldings Ltd. and Subsidiaries:**

| Report of Independent Registered Public Accounting  Firm                                                                   |   | 73 |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|----|--------|
| Consolidated  Balance Sheets at December 31, 2005 and 2004                                                            |   | 74 |   |
| Consolidated Statements of Operations and  Comprehensive Income for the Years Ended December 31, 2005, 2004 and  2003 |   | 75 |   |
| Consolidated Statements of Changes in Shareholders’  Equity for the Years Ended December 31, 2005, 2004 and 2003 |   | 76 |   |
| Consolidated Statements of Cash Flows for the Years  Ended December 31, 2005, 2004 and 2003                           |   | 77 |   |
| Notes to Consolidated Financial Statements                                                                                 |   | 79 |   |

 

**2.**   Financial StatementSchedules

Thefollowing financial statement schedule is filed as part of this Report.

| Schedule | ** ** | **Title**                                                                                                                                                                                      |
|----------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| II       |       | Parent Company Condensed  Financial Information at December 31, 2005 and 2004 and for the Years  Ended December 31, 2005, 2004 and 2003.                                             |
|     |       | The report of the  Independent Registered Public Accounting Firm with respect to the above  listed financial statement schedule is set forth under Item 8 of this Report.                      |
|     |       | All other  schedules are omitted because they are either inapplicable or the required  information is presented in the Consolidated Financial Statements of the  Company or the notes thereto. |

 

**3.**   Exhibits

Thefollowing are annexed as exhibits to this Report:

| Exhibit No. | ** ** | **Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1              |       | Agreement and  Plan of Merger dated as of March 14, 2000 by and among Dexia S.A.,  Dexia Crédit Local de France S.A., PAJY Inc. and the Company.  (Previously filed as Exhibit 2.1 to Current Report on Form 8-K  (Commission File No. 1-12644) dated March 14, 2000, and  incorporated herein by reference.)                                                                                               |
| 3.1              |       | Restated  Certificate of Incorporation of the Company. (Previously filed as  Exhibit 3.1 to the Company’s Registration Statement on Form S-3  (Reg. No. 333-74165) (the “Form S-3”), and incorporated  herein by reference.)                                                                                                                                                                                          |
| 3.1(A)           |       | Certificate of  Merger of PAJY Inc. into the Company under Section 904 of the Business  Corporation Law of the State of New York (effective July 5, 2000).  (Previously filed as Exhibit 3.1 to the Company’s Quarterly Report on  Form 10-Q (Commission File No. 1-12644) for the  quarterly period ended September 30, 2000 (the “September 30, 2000  10-Q”), and incorporated herein by reference.) |
| 3.1(B)           |       | Certificate of  Merger of White Mountains Holdings, Inc. and the Company into the  Company under Section 904 of the Business Corporation Law (effective  July 5, 2000). (Previously filed as Exhibit 3.2 to the  September 30, 2000 10-Q, and incorporated herein by reference.)                                                                                                                                                |

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| 3.2        |   | Amended and  Restated By-laws of the Company, as amended and restated on  July 5, 2000. (Previously filed as Exhibit 3.3 to the  September 30, 2000 10-Q, and incorporated herein by reference.)                                                                                                                                                                                                                                                                                                              |
|------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.1        |   | Amended and  Restated Trust Indenture dated as of February 24, 1999 (the “Amended and  Restated Senior Indenture”) between the Company and the Senior Debt Trustee.  (Previously filed as Exhibit 4.1 to the Company’s Registration Statement  on Form S-3 (Reg. No. 33-74165), and incorporated  herein by reference.)                                                                                                                                                                   |
| 4.1(A)     |   | Form of 67¤8%  Quarterly Interest Bond Securities due December 15, 2101. (Previously  filed as Exhibit 2 to the Company’s Current Report on Form 8-K  (Commission File No. 1-12644) dated December 12, 2001 (the  “December 2001 Form 8-K”), and incorporated herein by  reference.)                                                                                                                                                                             |
| 4.1(B)     |   | Officers’  Certificate pursuant to Sections 2.01 and 2.03 of the Amended and Restated  Senior Indenture. (Previously filed as Exhibit 3 to the  December 2001 Form 8-K, and incorporated herein by reference.)                                                                                                                                                                                                                                                                                           |
| 4.1(C)     |   | Form of  6.25% Notes due 2102. (Previously filed as Exhibit 3 to the Company’s  Current Report on Form 8-K (Commission File No. 1-12644)  dated November 6, 2002 and filed November 25, 2002 (the  “November 2002 Form 8-K”), and incorporated herein by  reference.)                                                                                                                                                                                                 |
| 4.1(D)     |   | Officers’  Certificate pursuant to Sections 2.01 and 2.03 of the Amended and  Restated Senior Indenture. (Previously filed as Exhibit 4 to the  November 2002 Form 8-K, and incorporated herein by  reference.)                                                                                                                                                                                                                                                                                |
| 4.1(E)     |   | Form of  5.60% Notes due 2103. (Previously filed as Exhibit 2 to the Company’s  Current Report on Form 8-K (Commission File No. 1-12644)  dated July 17, 2003 and filed July 30, 2003 (the “July 2003  Form 8-K”), and incorporated herein by reference.)                                                                                                                                                                                                             |
| 4.1(F)     |   | Officers’  Certificate pursuant to Sections 2.01 and 2.03 of the Amended and  Restated Senior Indenture. (Previously filed as Exhibit 3 to the  July 2003 Form 8-K, and incorporated herein by reference.)                                                                                                                                                                                                                                                                                          |
| 10.1       |   | Credit Agreement  dated as of August 31, 1998 among FSA, each of its insurance company  affiliates listed on Schedule I attached thereto, the Banks from time to  time party thereto and Deutsche Bank AG, New York Branch, as agent.  (Previously filed as Exhibit 10 to the Company’s Quarterly Report on  Form 10-Q (Commission File No. 1-12644) for the  quarterly period ended September 30, 1998, and incorporated herein by  reference.)                                     |
| 10.1(A)    |   | Amendment  No. 7 to the Credit Agreement, dated as of April 22, 2005, among  Financial Security Assurance Inc., the additional borrowers party thereto,  various banks, JPMorgan Chase Bank, N.A. and The Bank of New York, as agent. (Previously filed as Exhibit 10.1 to the  Company’s Quarterly Report on Form 10-Q (Commission File  No. 1-12644) for the quarterly period ended March 31, 2005  (the “March 31, 2005 10-Q”), and incorporated herein by  reference.) |
| 10.2       |   | Third Amended and  Restated Credit Agreement dated as of April 30, 2005, among Financial  Security Assurance Inc., FSA Insurance Company, the Banks party thereto from  time to time and Bayerische Landesbank, acting through its New York Branch,  as Agent. (Previously filed as  Exhibit 10.2 to the March 31, 2005 10-Q, and incorporated  herein by reference.)                                                                                                                                         |
| 10.3† |   | 1989 Supplemental Executive Retirement Plan (amended  and restated as of December 17, 2004). (Previously filed as  Exhibit 10.4 to the Company’s Current Report on Form 8-K  (Commission File No. 1-12644) dated December 17, 2004 and  filed on December 17, 2004 (the “December 2004 Form 8-K”),  and incorporated herein by reference.)                                                                                                                            |

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| 10.4†  |   | 2004 Supplemental  Executive Retirement Plan, dated as of December 17, 2004. (Previously  filed as Exhibit 10.3 to the December 2004 Form 8-K, and  incorporated herein by reference.                                                                                                                                                                                                                             |
|-------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5†  |   | Amended and  Restated 1993 Equity Participation Plan (amended and restated as of May 17,  2001). (Previously filed as Exhibit 10.1 to the Company’s Quarterly  Report on Form 10-Q (Commission File No. 1-12644) for  the quarterly period ended June 30, 2001 (the “June 30, 2001 10-Q”),  and incorporated herein by reference.)                                                       |
| 10.6†  |   | 2004 Equity Participation  Plan (Previously filed as Exhibit 10.1 to the Company’s current report  on Form 8-K (Commission File No. 1-12644) dated  November 18, 2004 and filed on November 23, 2004 (the  “November 2004 Form 8-K”) and incorporated herein by  reference.)                                                                                                        |
| 10.6A† |   | 2004 Equity  Participation Plan, as amended on September 15, 2005. (Previously filed  as Exhibit 10.1 to Current Report on Form 8-K (Commission  File No. 1-12644) dated September 16, 2005, and incorporated  herein by reference.)                                                                                                                                                                         |
| 10.6B† |   | 2004 Equity  Participation Plan, as amended on February 16, 2006. (Previously filed  as Exhibit 10.1 to Current Report on Form 8-K (Commission  File No. 1-12644) dated February 16, 2006 (the  “February 16, 2006 8-K”), and incorporated herein by reference.)                                                                                                                              |
| 10.6C† |   | Form of Financial  Security Assurance Holdings Ltd. Agreement Evidencing an Award of Dexia  Restricted Stock. (Previously filed as  Exhibit 10.4 to the March 31, 2005 10-Q, and incorporated  herein by reference.)                                                                                                                                                                                                   |
| 10.6D† |   | Form of  Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award of  Dexia Restricted Stock, as amended on February 16, 2006. (Previously filed as Exhibit 10.2 to the  February 16, 2006 8-K, and incorporated herein by reference.)                                                                                                                                                            |
| 10.6E† |   | Form of  Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award  of Performance Shares. (Previously filed as Exhibit 99.1 to the Current  Report on Form 8-K (Commission File No. 1-12644) dated  February 16, 2005, and incorporated herein by reference.)                                                                                                                           |
| 10.6F† |   | Form of  Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award  of Performance Shares, as amended on February 16, 2006. (Previously filed as Exhibit 10.3 to the  February 16, 2006 8-K, and incorporated herein by reference.)                                                                                                                                                           |
| 10.7†  |   | Financial  Security Assurance Inc. Overseas Pension Plan. (Previously filed as  Exhibit 10.3 to the February 16, 2006 8-K, and incorporated  herein by reference.)                                                                                                                                                                                                                                                          |
| 10.8†  |   | 1995 Deferred  Compensation Plan (amended and restated as of December 17, 2004).  (Previously filed as Exhibit 10.2 to the December 2004 8-K,  and incorporated herein by reference.)                                                                                                                                                                                                                                  |
| 10.9†  |   | 2004 Deferred  Compensation Plan, dated December 17, 2004. (Previously filed as  Exhibit 10.1 to the December 2004 8-K, and incorporated  herein by reference.)                                                                                                                                                                                                                                                        |
| 10.10† |   | Severance Policy  for Senior Management (amended and restated as of November 13, 2003).  (Previously filed as Exhibit 10.7 to the Company’s Annual Report on  Form 10-K (Commission File No. 1-12644) for the fiscal  year ended December 31, 2003, and incorporated herein by reference.)                                                                                                              |
| 10.11† |   | Share Purchase Program Agreement dated as of  December 15, 2000, among Dexia Public Finance Bank, Dexia  Holdings, Inc. and the Company. (Previously filed as  Exhibit 10.9(B) to the Company’s Annual Report on Form 10-K  (Commission File No. 1-12644) for the fiscal year ended  December 31, 2000 (the “December 31, 2000 10-K”), and  incorporated herein by reference.) |

138

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| 10.12† |   | Employment  Agreement dated as of July 5, 2004 by and between the Company and  Robert P. Cochran. (Previously filed as Exhibit 10.1 to the Company’s  Quarterly Report on Form 10-Q (Commission File No. 1-12644)  for the quarterly period ended September 30, 2004 (the  “September 30, 2004 10-Q”), and incorporated herein by reference.)                     |
|-------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13† |   | Employment  Agreement dated as of July 5, 2004 by and between the Company and Séan  W. McCarthy. (Previously filed as Exhibit 10.2 to the September 30,  2004 10-Q, and incorporated herein by reference.)                                                                                                                                                                                      |
| 10.14† |   | Financial  Security Assurance Holdings Ltd. Annual Bonus Pool Guideline.  (Previously filed as Exhibit 10.3 to the September 30, 2004 10-Q,  and incorporated herein by reference.)                                                                                                                                                                                                                  |
| 10.15       |   | Put Option  Agreement, dated as of June 23, 2003 by and between FSA and Sutton  Capital Trust I. (Previously filed as Exhibit 99.5 to the Company’s  Quarterly Report on Form 10-Q (Commission File No. 1-12644)  for the quarterly period ended June 30, 2003 (the “June 30, 2003 10-Q”),  and incorporated herein by reference.)                                |
| 10.16       |   | Put Option  Agreement, dated as of June 23, 2003 by and between FSA and Sutton  Capital Trust II. (Previously filed as Exhibit 99.6 to the  June 30, 2003 10-Q, and incorporated herein by reference.)                                                                                                                                                                                          |
| 10.17       |   | Put Option  Agreement, dated as of June 23, 2003 by and between FSA and Sutton  Capital Trust III. (Previously filed as Exhibit 99.7 to the  June 30, 2003 10-Q, and incorporated herein by reference.)                                                                                                                                                                                         |
| 10.18       |   | Put Option  Agreement, dated as of June 23, 2003 by and between FSA and Sutton  Capital Trust IV. (Previously filed as Exhibit 99.8 to the  June 30, 2003 10-Q, and incorporated herein by reference.)                                                                                                                                                                                          |
| 21*         |   | List of Subsidiaries.                                                                                                                                                                                                                                                                                                                                                                                               |
| 23*         |   | Consent of  PricewaterhouseCoopers LLP.                                                                                                                                                                                                                                                                                                                                                                             |
| 24.1        |   | Powers of  Attorney. (Previously filed as Exhibit 24 to the Company’s Annual Report  on Form 10-K (Commission File No. 1-12644) for the  fiscal year ended December 31, 2002 and as Exhibit 24.2 to the  Company’s Annual Report on Form 10-K (Commission File No. 1-12644)  for the fiscal year ended December 31, 2004, and incorporated herein by  reference.) |
| 24.2        |   | Power of  Attorney.*                                                                                                                                                                                                                                                                                                                                                                                                |
| 31.1*       |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                 |
| 31.2*       |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                 |
| 32.1**      |   | Certification  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                       |
| 32.2**      |   | Certification  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                       |
| 99.1*       |   | Financial  Security Assurance Inc. and Subsidiaries 2005 Consolidated Financial  Statements and Report of Independent Registered Public Accounting Firm.                                                                                                                                                                                                                                                       |

 

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*                    Filedherewith.

**             Furnishedherewith.

†                     Managementcontract of compensatory plan or arrangement.

139

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.

|   | FINANCIAL  SECURITY ASSURANCE HOLDINGS LTD. |
|--------|---------------------------------------------|
|   | By:                                         | /s/ ROBERT P. COCHRAN |
|   |                                        | Name: Robert P. Cochran |
|   |                                        | Title: Chairman and  Chief Executive Officer |
|   |                                        | Dated: March 28,  2006 |

 

Pursuant to the requirements of the Securities ExchangeAct of 1934, this report has been signed below by the following persons onbehalf of the Registrant and in the capacities and on the dates indicated.

| ** **                 | **Signature** | ** **                              | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|----------------------------|---------------|-----------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/ ROBERT P.  COCHRAN     |          | Chairman, Chief  Executive Officer and  |       | March 28, 2006  |
| Robert  P. Cochran         |          | Director (Principal Executive Officer)  |       |                 |
| /s/ SÉAN W.  MCCARTHY |          | President, Chief  Operating Officer and |       | March 28, 2006  |
| Séan  W. McCarthy     |          | Director                                |       |                 |
| /s/ JOSEPH W.  SIMON       |          | Managing Director and  Chief Financial  |       | March 28,  2006 |
| Joseph  W. Simon           |          | Officer (Principal Financial Officer)   |       |                 |
| /s/ LAURA A.  BIELING      |          | Managing Director and  Controller       |       | March 28,  2006 |
| Laura  A. Bieling          |          | (Principal Accounting Officer)          |       |                 |
| /s/ DIRK  BRUNEEL          |          | Director                                |       | March 28,  2006 |
| Dirk  Bruneel              |          |                                    |       |                 |
| /s/ BRUNO  DELETRE         |          | Director                                |       | March 28,  2006 |
| Bruno  Deletre             |          |                                    |       |                 |
| /s/ ROBERT N.  DOWNEY      |          | Director                                |       | March 28,  2006 |
| Robert  N. Downey          |          |                                    |       |                 |
| /s/ JACQUES  GUERBER       |          | Director                                |       | March 28,  2006 |
| Jacques  Guerber           |          |                                    |       |                 |

140

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| /s/ DAVID O.  MAXWELL  |   | Director                    |   | March 28,  2006 |
|------------------------|--------|-----------------------------|--------|----------------------|
| David  O. Maxwell      |   |                        |   |                 |
| /s/ AXEL  MILLER       |   | Director                    |   | March 28,  2006 |
| Axel  Miller           |   |                        |   |                 |
| /s/ JAMES H.  OZANNE   |   | Director                    |   | March 28,  2006 |
| James  H. Ozanne       |   |                        |   |                 |
| /s/ PIERRE  RICHARD    |   | Vice Chairman and  Director |   | March 28,  2006 |
| Pierre  Richard        |   |                        |   |                 |
| /s/ ROGER K.  TAYLOR   |   | Director                    |   | March 28,  2006 |
| Roger  K. Taylor       |   |                        |   |                 |
| /s/ REMBERT  VON LOWIS |   | Director                    |   | March 28,  2006 |
| Rembert  von Lowis     |   |                        |   |                 |
| /s/ GEORGE U.  WYPER   |   | Director                    |   | March 28,  2006 |
| George U. Wyper        |   |                        |   |                 |

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*                    RobertP. Cochran, by signing his name hereto, does hereby sign this Annual Report on Form 10-Kon behalf of himself and on behalf of each of the Directors and Officers of theRegistrant named above after whose typed names asterisks appear pursuant topowers of attorney duly executed by such Directors and Officers and filed withthe Securities and Exchange Commission as exhibits to this Report.

|        |     | By:      | /s/ ROBERT P. COCHRAN, |
|--------|----------|----------|------------------------|
|   |     |     | Robert P. Cochran      |
|   | * * | * * | *Attorney  in fact*    |

 

141

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**Schedule IIParent Company Condensed Financial Information**

**Condensed Balance Sheets(in thousands)**

| ** **                                                     | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Assets:                                                        |       |                  |       |   |   |
| Bonds at market  value (amortized cost of $10,923 and $25,301) |       | $                     | 11,158     |   | $ | 25,684 |   |
| Short-term  investments                                        |       | 47,140                |       | 220 |   |
| Cash                                                           |       | 1,895                 |       | 1,058 |   |
| Investment in  subsidiaries, at equity in net assets           |       | 3,052,478             |       | 2,868,797 |   |
| Notes receivable  from subsidiary                              |       | 108,850               |       | 108,850 |   |
| Deferred  compensation                                         |       | 107,140               |       | 112,941 |   |
| Deferred taxes                                                 |       | 34,011                |       | 40,843 |   |
| Due from subsidiaries                                          |       | 67                    |       | 2,519 |   |
| Other assets                                                   |       | 40,836                |       | 39,343 |   |
| Total Assets                                                   |       | $                     | 3,403,575  |   | $ | 3,200,255 |   |
| Liabilities and  Shareholders’ Equity:                    |       |                  |       |   |   |
| Notes Payable                                                  |       | $                     | 430,000    |   | $ | 430,000 |   |
| Other Liabilities                                              |       | 30,293                |       | 28,259 |   |
| Due to  subsidiaries                                           |       | 2,832                 |       | 5,317 |   |
| Deferred  compensation                                         |       | 107,140               |       | 112,941 |   |
| Taxes payable                                                  |       | 10,408                |       | 12,460 |   |
| Shareholders’  equity                                     |       | 2,822,902             |       | 2,611,278 |   |
| Total Liabilities and  Shareholders’ Equity               |       | $                     | 3,403,575  |   | $ | 3,200,255 |   |

 

**Condensed Statements of Income(in thousands)**

| ** **                                               | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Investment Income                                        |       | $                                          | 6,724      |   | $ | 7,379 |   | $ | 10,077 |   |
| Net realized  gains (losses)                             |       | (395                                       | )          | 497 |   | (909 | ) |
| Other income  (loss)                                     |       | 2,152                                      |       | 18,138 |   | 27,287 |   |
| Interest and  amortization expense                       |       | (26,993                                    | )          | (26,993 | ) | (33,026 | ) |
| Commissions                                              |       | —                                     |       | — |   | (703 | ) |
| Other expenses                                           |       | (6,539                                     | )          | (18,451 | ) | (29,023 | ) |
| Net unrealized  gains (losses) on derivative instruments |       | (304                                       | )          | 1,589 |   | 1,638 |   |
|                                                     |       | (25,355                                    | )          | (17,841 | ) | (24,659 | ) |
| Equity in  undistributed net income of subsidiaries      |       | 332,719                                    |       | 368,139 |   | 313,789 |   |
| Income before  taxes                                     |       | 307,364                                    |       | 350,298 |   | 289,130 |   |
| Income tax  benefit                                      |       | 18,744                                     |       | 28,309 |   | 8,997 |   |
| Net Income                                               |       | $                                          | 326,108    |   | $ | 378,607 |   | $ | 298,127 |   |

 

The Parent CompanyCondensed Financial Information should be read in conjunction with the ConsolidatedFinancial Statements and Notes to Consolidated Financial Statements included inItem 8.

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**CondensedStatements of Cash Flows(in thousands)**

| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash flows from  operating activities:             |       |                                       |       |   |   |   |   |
| Other operating expenses  recovered (paid), net    |       | $                                          | (1,678     | ) | $ | (1,271 | ) | $ | (4,672 | ) |
| Net investment income  received                    |       | 6,869                                      |       | 8,858 |   | 10,357 |   |
| Federal income taxes  received (paid)              |       | —                                     |       | — |   | (3,504 | ) |
| Interest paid                                      |       | (26,993                                    | )          | (26,850 | ) | (28,367 | ) |
| Other                                              |       | (2,689                                     | )          | 1,489 |   | 253 |   |
| Net cash used for  operating activities            |       | (24,491                                    | )          | (17,774 | ) | (25,933 | ) |
| Cash flows from  investing activities:             |       |                                       |       |   |   |   |   |
| Proceeds from sales of  bonds                      |       | 41,837                                     |       | 31,600 |   | 27,182 |   |
| Purchases of bonds                                 |       | (27,830                                    | )          | (36,103 | ) | (39,539 | ) |
| Dividend from subsidiary                           |       | 87,000                                     |       | 30,000 |   | 7,857 |   |
| Capital contribution                               |       | (5,700                                     | )          | (29,500 | ) | (37,500 | ) |
| Return of capital from  subsidiary                 |       | 48,000                                     |       | — |   | — |   |
| Net decrease (increase)  in short-term investments |       | (46,920                                    | )          | 465 |   | 9,754 |   |
| Other investments                                  |       | —                                     |       | — |   | 1,000 |   |
| Net cash used for investing  activities            |       | 96,387                                     |       | (3,538 | ) | (31,246 | ) |
| Cash flows from  financing activities:             |       |                                       |       |   |   |   |   |
| Issuance of notes  payable                         |       | —                                     |       | — |   | 96,673 |   |
| Repayment of notes  payable                        |       | —                                     |       | — |   | (100,000 | ) |
| Surplus notes redeemed  (purchased), net           |       | —                                     |       | 44,000 |   | 60,000 |   |
| Dividends paid                                     |       | (71,059                                    | )          | (22,876 | ) | — |   |
| Net cash provided by  financing activities         |       | (71,059                                    | )          | 21,124 |   | 56,673 |   |
| Net increase (decrease)  in cash                   |       | 837                                        |       | (188 | ) | (506 | ) |
| Cash at beginning of  year                         |       | 1,058                                      |       | 1,246 |   | 1,752 |   |
| Cash at end of year                                |       | $                                          | 1,895      |   | $ | 1,058 |   | $ | 1,246 |   |

 

In 2005, 2004 and 2003, the Company’s subsidiariesreceived a tax benefit of $4,624, $20,164 and $10,645, respectively, byutilizing the Company’s losses. These balances were recorded as capitalcontributions.

TheParent Company Condensed Financial Information should be read in conjunctionwith the Consolidated Financial Statements and Notes to Consolidated FinancialStatements included in Item 8.

| ** **                                                                                                               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Reconciliation of net income to net cash provided by operating  activities: |       |                                       |       |   |   |   |   |
| Net income                                                                                                               |       | $                                          | 326,108    |   | $ | 378,607 |   | $ | 298,127 |   |
| Equity in undistributed  net income of subsidiary                                                                        |       | (334,062                                   | )          | (368,139 | ) | (313,789 | ) |
| Decrease (increase) in  accrued investment income                                                                        |       | 154                                        |       | 1,373 |   | 11 |   |
| Increase (decrease) in  accrued income taxes                                                                             |       | (6,676                                     | )          | (10,821 | ) | (14,337 | ) |
| Provision (benefit) for  deferred income taxes                                                                           |       | (12,166                                    | )          | (10,932 | ) | 3,051 |   |
| Net realized losses  (gains) on investments                                                                              |       | 395                                        |       | (497 | ) | 909 |   |
| Accretion of bond  discount                                                                                              |       | (23                                        | )          | 96 |   | — |   |
| Change in other assets  and liabilities                                                                                  |       | 1,779                                      |       | (7,461 | ) | 95 |   |
| Cash used for operating activities                                                                                       |       | $                                          | (24,491    | ) | $ | (17,774 | ) | $ | (25,933 | ) |

 

The Parent Company Condensed Financial Informationshould be read in conjunction with the Consolidated Financial Statements andNotes to Consolidated Financial Statements included in Item 8.

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**SCHEDULE IIFinancial Security Assurance Holdings Ltd. (Parent Company)Notes to Condensed Financial Statements**

1.                 CondensedFinancial Statements

Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America have beencondensed or omitted. These condensed financial statements should be read inconjunction with the Company’s Consolidated Financial Statements and the notesthereto. Certain reclassifications have been made to conform to the currentyear presentation.

2.                 SignificantAccounting Policies

The Parent Company carries its investments insubsidiaries under the equity method.

3.                 Long-TermDebt

On July 31, 2003, the Company issued$100.0 million principal amount of 5.60% Notes due July 15, 2103,which are callable without premium or penalty in whole or in part at any timeon or after July 31, 2008. Debt issuance costs of $3.3 million arebeing amortized over the life of the Notes. In September 2003, the Companycalled for redemption, on November 1, 2003, $100.0 million of its6.95% Senior Quarterly Income Debt Securities (“Senior QUIDS”) due November 1,2098 and delivered to the trustee sufficient collateral to legally defease the6.95% Senior QUIDS. Unamortized debt issuance costs of $3.2 million for the6.95% Senior QUIDS were charged to interest expense in 2003. Subsequently, thetrustee used the defeasance collateral to redeem all of the 6.95% Senior QUIDS.

On November 26, 2002, the Company issued$230.0 million principal amount of 6.25% Notes due November 1, 2102,which are callable without premium or penalty in whole or in part at any timeon or after November 26, 2007. Debt issuance costs of $7.4 millionare being amortized over the life of the debt. The Company used a portion ofthe proceeds of this issuance to redeem in whole the Company’s$130.0 million principal amount of 7.375% Senior QUIDS due September 30,2097. Unamortized debt issuance costs of the retired debt of $4.1 millionwere charged to interest expense in 2002.

4.                 Taxes

In connection with the Dexia group’s acquisition ofthe Company in July 2000, the Company became the successor, for taxpurposes, to White Mountains Holdings, Inc. (“WMH”). WMH had previouslysold an insurance subsidiary to a third party that was indemnified by WhiteMountains Insurance Group for certain future adverse loss development up to$50.0 million. In 2004, the Company made an indemnity payment of $47.0 millionto the third party with funds provided for such purpose by White MountainsInsurance Group. While the Company had no legal liability in connection withthe indemnity payment, the payment should be treated for tax purposes as a$47.0 million loss deduction to the Company, as successor to WMH. The Companytherefore recorded a deferred tax asset with a corresponding deferred taxbenefit of $16.5 million. There can be no assurance that the deferred tax benefitwill not be reversed in the future. In addition, the Company has agreed toshare 50% of the deferred tax benefit with White Mountains Insurance Groupunder certain circumstances, but did not satisfy the standards for recording aliability for accounting purposes as of December 31, 2005.

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