**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

----

**FORM 10-K/A**

**(AmendmentNo. 1 to Form 10/K)**

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

**For the fiscal year ended December 31,2004**

**CommissionFile 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 organization)          |       | (I.R.S. Employer  Identification No.)         |
| **31 West 52nd 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 13 or Section 15(d) ofthe 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  o  No  x

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/A or any amendment tothis Form 10-K/A.  o

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act). Yes  o  No  x

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

The aggregate market valueof common equity, excluding treasury shares, held by non-affiliates of theregistrant at June 30, 2004 was $46,370,344. 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’scommon stock were valued under the Company’s director share purchase program onJune 30, 2004.

At March 23, 2005,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.

 

----

**Explanatory Note**

This Form 10-K/Afor the year ended December 31, 2004 is being filed for the purpose ofamending the annual report on Form 10-K of Financial SecurityAssurance Holdings Ltd. (together with its subsidiaries, the “Company”) toreflect the restatement of the Company’s financial results described herein. Therestatement affects Items 1, 6, 7, 7A, 8, 9A and 15 of this report. Except forthe foregoing amended disclosures, the information in this Form 10-K/Agenerally has not been updated to reflect events that occurred after March 30,2005, the filing date of the Company’s Annual Report on Form 10-Kwhich is being amended hereby, although Item 2, “Properties” and Item 4, “Submissionof Matters to a Vote of Security Holders,” have been updated.

***Restatement of Previously Issued Financial Statements***

The Company has restated its financial statements forthe years ended December 31, 2002, 2003 and 2004, and the periods ended March 31,June 30, September 30, and December 31, 2003 and 2004 andopening retained earnings at January 1, 2002. The Company’s previouslyissued financial statements for these and prior periods should no longer berelied upon. For a discussion of the restatement and a reconciliation ofpreviously reported amounts to the restated amounts, see Item 6, “SelectedFinancial Data,” Item 7, “Management’s Discussion and Analysis of FinancialCondition and Results of Operations,” and Note 3 of the Notes to ConsolidatedFinancial Statements in Item 8, “Financial Statements and Supplementary Data.”

----

**TABLE OF CONTENTS**
|               | ** ** | ** **                                                                                                          | ** ** | **Page** |
|---------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I   |       |                                                                                                                |       |     |
| Item 1.       |       | Business                                                                                                            |       | 2        |
| Item 2.       |       | Properties                                                                                                          |       | 35       |
| Item 3.       |       | Legal Proceedings                                                                                                   |       | 35       |
| Item 4.       |       | Submission of Matters to a  Vote of Security Holders                                                                |       | 35       |
| PART II  |       |                                                                                                                |       |     |
| Item 5.       |       | Market for Registrant’s  Common Equity, Related Stockholder Matters and Issuer Purchases of Equity  Securities |       | 37       |
| Item 6.       |       | Selected Financial Data                                                                                             |       | 38       |
| Item 7.       |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                         |       | 39       |
| Item 7A.      |       | Quantitative and Qualitative  Disclosures About Market Risk                                                         |       | 61       |
| Item 8.       |       | Financial Statements and  Supplementary Data                                                                        |       | 64       |
| 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                                                     |       | 131      |
| Item 13.      |       | Certain Relationships and  Related Transactions                                                                     |       | 135      |
| Item 14.      |       | Principal Accountant Fees  and Services                                                                             |       | 135      |
| PART IV  |       |                                                                                                                |       |     |
| Item 15.      |       | Exhibits, Financial  Statement Schedules                                                                            |       | 137      |

 

----

**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 asset-backed andmunicipal obligations in domestic and international markets. The financialstrength of the Company’s insurance company subsidiaries is rated “Triple-A” bythe major securities rating agencies and obligations insured by them aregenerally awarded “Triple-A” ratings by reason of such insurance. The Company’sprincipal insurance company subsidiary is Financial SecurityAssurance Inc. (“FSA”), a wholly owned New York insurance company. FSA wasthe first insurance company organized to insure non-municipal obligations andhas been a major insurer of asset-backed and other non-municipalobligations since its inception in 1985. FSA expanded the focus of its businessin 1990 to include financial guaranty insurance of municipal obligations andhas since become a major insurer of municipal obligations. FSA is licensed toengage in the financial guaranty insurance business in all 50 states, theDistrict of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands. Inaddition, the Company offers FSA-insured guaranteed investment contracts andother investment agreements (“GICs”) through other consolidated affiliates. Referencesto the “Company” are to Financial Security Assurance Holdings Ltd. togetherwith 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, 2004, the Companyhad gross premiums written of $832.0 million, of which 37% related toinsurance of asset-backed and other non-municipal obligations and 63%related to insurance of municipal obligations. At December 31, 2004, theCompany had net par outstanding of $317.7 billion, of which 39%represented insurance of asset-backed and other non-municipal obligationsand 61% represented insurance of municipal obligations. These amounts excludeintercompany transactions.

The Company provides FSA-insuredGICs to municipalities and other market participants. At December 31,2004, the Company had $8.0 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”) andowns a majority interest in Financial Security AssuranceInternational Ltd. (“FSA International”). FSAIC is an Oklahoma insurancecompany that primarily provides reinsurance to FSA. FSA International is aBermuda insurance company that provides reinsurance to FSA and financialguaranty insurance for transactions outside United States and European markets.FSA-UK is a United Kingdom insurance company that primarily provides financialguaranty insurance for transactions in the United Kingdom and other Europeanmarkets. At December 31, 2004, XL Capital Ltd (“XL”) owned a minorityinterest in FSA International, as discussed further below.

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 the 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.

2

----

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 refinances certaindefaulted transactions by employing refinancing vehicles to raise funds for therefinancings. These refinancing vehicles are also consolidated.

FSA Global is a special purpose funding vehicle 29%owned by the Company. FSA Global issues FSA-insured medium term notes andinvests the proceeds from the sale of its notes in FSA-insured obligations witha view towards realizing the yield difference between the notes issued and theobligations purchased with the note proceeds. At December 31, 2004, FSAGlobal had $2.4 billion principal amount of outstanding notes, afterelimination of intercompany transactions. The majority of Canadian Global’sassets were liquidated and its liabilities satisfied during the third quarterof 2004. Premier is principally engaged in debt defeasance for leasetransactions.

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—VariableInterest 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 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 SA (“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 ManagementCommittee manages the Company’s business. The Chief Executive Officer,President, General Counsel, Chief Risk Management Officer and Chief FinancialOfficer are full-time members of the Management Committee, and the heads of theMunicipal Finance, Corporate Finance, International Finance and FinancialProducts groups serve as part-time members. Bruno Deletre, a director of theCompany and a member of the Executive Board of Dexia Crédit Local, is an *ex officio* member of the ManagementCommittee.

**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 

3

----

Holdings, Inc.) madean investment in the Company, and the chairman of White Mountains becamenon-executive chairman of the Company. White Mountains is an insurance holdingcompany.

In 1998, the Company and XL 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. At December 31, 2004, XL owned a minority interest in FSAInternational and the Company owned a minority interest in XLFA. XL is a majorBermuda-based insurance holding company. In October 2005, FSApurchased all the preferred shares of FSA International owned by XL Insurance(Bermuda), Ltd. for a cash purchase price of $39.1 million in anticipation ofthe repatriation of earnings and profits of FSA International. Giving effect tosuch purchase, FSA International became an indirect wholly owned subsidiary ofthe Company.

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. At December 31, 2004,approximately 99% of the Company’s common stock was held by Dexia Holdings. Theother holders are an affiliate of White Mountains 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.” Although the Company’s common stock is no longer listed onthe New York Stock Exchange (“NYSE”) as a consequence of the merger, theCompany continues to file periodic reports under the Securities Exchange Act of1934, as amended (the “Exchange Act”), because debt securities issued by theCompany are listed on the NYSE.

At December 31, 2004,the principal executive offices of the Company and FSA were located at 350 ParkAvenue, New York, New York 10022. In June 2005, the Company moved itsprincipal executive offices to 31 West 52nd Street, New York, New York, 10019. Subsidiariesof the Company maintain offices domestically in San Francisco and Dallas andabroad in London, Madrid, Paris, Singapore, Sydney, Tokyo and Bermuda.

**Business Objectives**

The Company’sbusiness objective is to remain a leading insurer of asset-backed andmunicipal obligations while generating premium volume at attractive returns andminimizing the occurrence and severity of credit losses in its insuredportfolio. The Company believes that the demand for financial guarantyinsurance will remain strong over the long term as a result of the anticipatedcontinuation of the following trends:

·       growthof asset securitization;

·       growthof project finance in Europe through expansion of private finance for fundingof 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 Company also anticipates continued demand over thelong term for its GIC business and other financial products programs thatemploy financial guaranty insurance provided by FSA.

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;

4

----

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

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

The Company expects tocontinue to originate a diversified insured portfolio characterized byinsurance of both asset-backed and municipal 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.

**Business of the Company**

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

***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 asset-backedand municipal obligations, FSA participates in negotiated offerings, where theinvestment banker and often the insurer have been selected by the sponsor or issuer.In addition, FSA participates in competitive offerings, where underwritingsyndicates bid for securities and submit bids that may include insurance.

In the secondary market, FSA’s Triple-A GuaranteedSecondary Securities (“TAGSS”) Program provides insurance for asset-backedobligations trading in the secondary market. Likewise, FSA’s Custody ReceiptProgram provides insurance for municipal obligations trading in the secondarymarket. Investors and dealers generally obtain secondary-market insuranceto upgrade or stabilize the credit ratings of positions they already hold orplan to acquire or to increase the market liquidity of such positions. FSA’sunderwriting guidelines require the same underwriting standards on secondarymarket issues as on new issues, although FSA’s control rights in the event ofdefault are generally more limited.

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”), includingguarantees 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 obligor andthe first-to-pay financial guarantor. In recent years, FSA has reinsured amodest amount of business from other financial guaranty insurers.

5

----

The following tableindicates the Company’s percentages of par amount (net of reinsurance)outstanding at December 31, 2004 and 2003 with respect to each type ofasset-backed and municipal program:

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

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

 

| ** **       | ** ** | **As of December 31, 2003** | ** ** |
|------------------|------------|-------------------------------------------------|------------|
| ** **       | ** ** | **Asset-Backed Programs**                  | ** ** | **Municipal Programs** | ** ** |
| ** **       | ** ** | **Net Par  Amount  Outstanding(1)**        | ** ** | **Percent of  Total Net Par  Amount  Outstanding** | ** ** | **Net Par  Amount  Outstanding** | ** ** | **Percent of  Total Net Par  Amount  Outstanding** | ** ** |
| ** **       | ** ** | **(dollars in millions)**             | ** ** |
| New Issue        |       |                                            | $          | 110,163  |   |   |   | 93.2 | % |   |   | $ | 161,684  |   |   |   | 94.6 | % |   |
| Secondary Market |       |                                            | 6,941      |   |   |   | 5.8 |   |   |   | 8,553 |   |   |   | 5.0 |   |   |
| Assumed          |       |                                            | 1,158      |   |   |   | 1.0 |   |   |   | 701 |   |   |   | 0.4 |   |   |
| Total            |       |                                            | $          | 118,262  |   |   |   | 100.0 | % |   |   | $ | 170,938  |   |   |   | 100.0 | % |   |

----

(1)          Excludesintercompany insurance of $7,143 million in 2004 and $4,474 millionin 2003 relating to FSA-insured GICs issued by the GIC Affiliates.

*Premiums*

FSA takes into account therisk it assumes and its projected return in setting insurance premium rates.Critical factors in assessing risk include the credit quality of the issuer,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 uninsuredalternative executions. For insurance on GIC and medium term note transactions,transactions involving “repackaging” of outstanding securities and othertransactions, FSA’s premium may be arbitrage-based, based upon thedifference between the effective borrowing cost at a Triple-A rate and theinterest rate on the underlying securities.

*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 

6

----

of assets. The assets aretypically held by a special purpose entity that also acts as the issuer of theinsured obligations. Most asset-backed obligations are secured by orrepresent interests in diverse pools of assets, such as residential mortgageloans, auto loans, credit card receivables, other consumer receivables,corporate loans or bonds, government debt and small business loans. Asset-backed obligations may also be secured by less diverse payment sources, such asmultifamily 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 alternative to traditional forms of borrowing or otherwiseimportant in diversifying funding sources. Many finance companies fund consumerfinance and home equity lending through securitization.

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 2000 for each type of fundedasset-backed security presented, including securities distributed under Rule 144Aunder the Exchange 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)** | ** ** | **Worldwide Funded  Collateralized Debt  Obligations(1)** | ** ** |
|------------|------------|-------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** ** | ** ** | **(dollars in billions)** | ** ** |
| 2000       |       |                                | $          | 272.8                                                                                    |       |                                                                                    |       | $                                                   | 65.8  |                                                                |       |   | $ | 85.6  |   |   |   | $ | 78.5  |   |   |
| 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       |       |                                | 675.5      |                                                                                          |       |                                                                                    | 328.5      |                                                |       |                                                                | 192.8      |   |   |   | 97.0 |   |   |

----

(1)          Source: *Asset-Backed Alert*, January 11,2002, January 10, 2003, January 9, 2004 and January 7, 2005.Subject to revision as additional information becomes 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.

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 

7

----

Association, Inc. (“ISDA”), the notionalprincipal amount of CDS outstanding in world markets were as follows at thedates indicated:

| ** **              | ** ** | **Outstanding  Credit Default Swaps(1)** | ** ** |
|-------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | **(dollars in billions)**                | ** ** |
| December 31,  2001 |       |                                               | $          | 918.9  |   |   |
| December 31,  2002 |       |                                               | 2,191.6    |   |   |
| December 31,  2003 |       |                                               | 3,779.4    |   |   |
| June 30, 2004      |       |                                               | 5,441.9    |   |   |

----

(1)          Source: ISDA, February 15,2005.

According to industryinformation, the annual totals of funded and synthetic asset-backed parinsured of financial guaranty insurance directly originated by monolineguarantors since 2000 were as follows:

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

| ** ** | ** ** | **United States**              | ** ** | **Non-U.S.** | ** ** |
|------------|------------|-------------------------------------|------------|--------------|------------|
| ** ** | ** ** | **(dollars in billions)** | ** ** |
| 2000       |       |                                | $          | 116.1   |       |   |   | $ | 55.2  |   |   |
| 2001       |       |                                | 167.1      |         |       |   | 51.4 |   |   |
| 2002       |       |                                | 165.5      |         |       |   | 63.2 |   |   |
| 2003       |       |                                | 120.4      |         |       |   | 45.0 |   |   |
| 2004       |       |                                | 200.0      |         |       |   | 46.8 |   |   |

----

(1)          Source: Association ofFinancial Guaranty Insurers (“AFGI”) web page, July 2005. Includes allfunded and synthetic primary-market and secondary-market U.S.insured transactions, excluding municipal obligations. Subject to revision asadditional information becomes available.

Since 2000, the globalsecuritization market has significantly expanded year-over-year. The relativelymature U.S. asset-backed market is expected by management to continue togrow over the long term, although not necessarily at the pace of recent years.

*MunicipalObligations*

FSA insures a rangeof municipal obligations, including general obligation bonds supported by theissuers’ taxing power and special revenue bonds and other special obligationsof state and local governments supported by the issuers’ ability to impose andcollect fees and charges for public services or specific projects such asutility revenues. Additional municipal obligations insured by FSA include:

·       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; and

·       paymentobligations of counterparties under CDS referencing municipal obligations.

Municipal obligations include bonds, notes and otherevidences of indebtedness issued by public and quasi-public entities,including states and their political subdivisions (such as counties, cities ortowns), utility districts, public universities and hospitals, and public-housingand transportation authorities. An issuer’s obligation to pay is supported bythe issuer’s taxing power in the case of general obligation bonds, and by theissuer’s ability to impose and collect fees and charges for public services orspecific projects in the case of most special revenue bonds and public-privateinfrastructure financings. Certain municipal obligations, including mostproject finance obligations, include non-municipal credit risks (to swap 

8

----

counterparties, insurancecompanies, construction companies or other non-municipal credits) and operatingrisks (such as traffic volume or tuition revenues).

According to industrysources, the total and insured volume since 2000 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** | ** ** |
|------------|------------|-------------------------------------|------------|--------------------------------|------------|----------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** ** | ** ** | **(dollars in billions)** | ** ** |
| 2000       |       |                                | $          | 200.7                     |       |                             |       | $                                                                                         | 79.4  |   |   |   | 39.6 | % |   |
| 2001       |       |                                | 288.2      |                           |       |                             | 131.0      |                                                                                      |       |   | 45.5 |   |   |
| 2002       |       |                                | 358.8      |                           |       |                             | 177.6      |                                                                                      |       |   | 49.5 |   |   |
| 2003       |       |                                | 383.7      |                           |       |                             | 190.7      |                                                                                      |       |   | 49.7 |   |   |
| 2004       |       |                                | 360.2      |                           |       |                             | 192.7      |                                                                                      |       |   | 53.5 |   |   |

----

(1)          Source: *The Bond Buyer*, February 7, 2005.Volume is expressed in terms of principal issued and insured on a sale-datebasis. Subject to revision as additional information becomes available.

In 2000, the municipal bond industry saw a decline inboth total U.S. municipal bond issuance and the percentage of municipal parissued that benefited from bond insurance, attributable in part to budget surplusesreducing borrowing needs as well as the need to employ bond insurance. Newissue volume increased in 2001, 2002 and 2003, as declining interest rates,diminished tax revenues and continuing needs for infrastructure investmentdrove municipalities to borrow on an unprecedented scale. Insurance penetrationreached approximately 50% in 2002 and 2003, reaching its highest historicallevel in 2004. Insured par volume increased slightly in 2004 despite a declinein total market volume primarily due to generally higher interest rates.

Outside the United States, guarantors have increasedtheir presence in public infrastructure finance since 2000. These transactionsfrequently finance public-private partnerships, such as those authorizedby the U.K. Private Finance Initiative.

Since 2000, 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** | ** ** |
|------------|------------|-------------------------------------|------------|------------|------------|
| ** ** | ** ** | **(dollars in billions)** | ** ** |
| 2000       |       |                                | $          | 4.1   |       |   |
| 2001       |       |                                | 6.0        |       |       |
| 2002       |       |                                | 8.1        |       |       |
| 2003       |       |                                | 13.9       |       |       |
| 2004       |       |                                | 11.7       |       |       |

----

(1)          Source:AFGI web page, July 2005. Data is subject to revision as additionalinformation becomes available.

*Variable 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 (“MTNs”). FSA Global issues 

9

----

securities at the request ofinterested purchasers in a process known as “reverse inquiry,” which generallyresults in lower interest rates and borrowing costs than would apply to directborrowings. FSA Global also issues securities in traditional private placementsto institutional investors and to participants in lease financings in whichCompany affiliates may play a number of financing roles. At December 31,2004, the VIEs had $2.4 billion principal amount of outstanding notes,after elimination of intercompany transactions.

FSA Global ismanaged as a “matched funding 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 or equalinterest rate than the interest rate on the related FSA Global notes.

***Financial Product Business***

*GICs*

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 construction fund until it needs touse such funds to service debt or fund the payment of project expenses inaccordance 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. In addition, most FSA-insured GICs allowfor withdrawal of GIC funds in the event of a downgrade of FSA, typically belowAA- by Standard & Poor’s Ratings Services (“S&P”) or Aa3 by Moody’sInvestors Service, Inc. (“Moody’s”), unless the GIC provider postscollateral or otherwise enhances its credit. The Company manages this riskthrough the maintenance of liquid 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. FSAMgenerally 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 the related riskmanagement function is performed, by FSAM.

10

----

**Insurance in Force**

Asummary of the Company’s par outstanding by type at December 31, 2004 isas follows:

| ** **      | ** ** | **Par Outstanding**            | ** **    |
|-----------------|------------|-------------------------------------|---------------|
| ** **      | ** ** | **Direct**                          | ** **    | **Assumed** | ** ** | **Total Gross** | ** ** | **Ceded** | ** ** | **Net** | ** ** |
| ** **      | ** ** | **(dollars in millions)** | ** **    |
| Asset-backed(1) |       | $                                   | 158,338  |   |   | $ | 1,046  |   |   |   | $ | 159,384  |   |   | $ | 37,034  |   | $ | 122,350  |   |
| Municipal       |       | 273,984                             |          |   | 1,062 |   |   |   | 275,046 |   |   | 79,654 |   | 195,392 |   |
| Total           |       | $                                   | 432,322  |   |   | $ | 2,108  |   |   |   | $ | 434,430  |   |   | $ | 116,688  |   | $ | 317,742  |   |

----

(1)          Excludesdirect par outstanding on intercompany insurance of $7,143 millionrelating to FSA-insured GICs issued by the GIC Affiliates.

At December 31, 2004,the weighted average life of the direct par insured on these policies wasapproximately three years for asset-backed and 12 years formunicipal obligations.

***Asset-Backedand Other Non-Municipal Obligations***

FSA’sinsured portfolio of asset-backed and other non-municipal obligations isdivided into five major categories, which are broadly based on the type ofassets backing the insured obligations and include funded and syntheticobligations:

·       *Domestic Residential Mortgage Loans.  *Obligationsprimarily backed by residential mortgage loans generally take the form ofconventional pass-through certificates or pay-through debt securities, but alsoinclude other structured products. Residential mortgage loans backing theseinsured obligations include closed-end first mortgage loans and closed-and open-end second mortgage loans or home equity loans on one-to-four familyresidential properties, including condominiums and cooperative apartments.Domestic residential mortgage loan obligations insured by FSA have tended to beconcentrated in the “sub-prime” sector, characterized by lower qualityborrowers and higher levels of structural credit protection throughsubordination and/or excess spread. FSA also insures “net interest margin” (“NIM”)securities backed by the senior portion of residual cash flows fromsecuritizations of domestic residential mortgage loans. FSA has generallydeclined participation in securitizations of so-called “high cost mortgageloans,” characterized by very high interest rates or “points and fees” andsubject to restrictive federal and state regulations.

·       *Domestic Consumer Receivables*.   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 Pooled Corporate Obligations*.   Obligationsprimarily backed by pooled corporate obligations include funded and syntheticobligations collateralized by corporate debt securities or corporate loans andobligations backed by cash flow or market value of non-consumer indebtedness,and include CDOs, such as “collateralized bond obligations,” “collateralizedloan obligations” and comparable risks under CDS obligations. Corporateobligations include corporate bonds, bank loan participations, tradereceivables, franchise loans and equity securities. Some CDS obligations exposeFSA to elements of market value risk arising from obligations to pay thedifference between par and market value upon the occurrence of a paymentdefault or other defined “credit events” specified in the CDS. FSA generallyaddresses these risks by requiring large deductibles as a condition to paymentunder pooled corporate CDS insured by FSA.

·       *Other Domestic Non-Municipal Obligations*.   Otherdomestic non-municipal obligations include bonds or other securities backed bygovernment securities, letters of credit, guarantees by other 

11

----

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 utilities. These bonds are generally secured by a mortgageon property owned by or leased to an investor-owned utility.

·       *InternationalAsset-Backed Obligations*.   International asset-backedobligations include obligations of non-domestic portions of funded andsynthetic CDOs, securitizations of perpetual floating rate notes ofnon-domestic banks, obligations of non-domestic investor-owned utilitiesand other obligations having international aspects but otherwise within theasset-backed categories described above.

***MunicipalObligations***

FSA’sinsured portfolio of municipal obligations is divided into eight majorcategories, which include funded and synthetic obligations:

·       *Domestic General Obligation Bonds*.   General obligationor full faith and credit bonds are issued by states, their politicalsubdivisions and other municipal issuers, and are supported by the generalobligation of the issuer to pay from available funds and by a pledge of theissuer to levy taxes according to value in an amount sufficient to provide forthe full payment of the bonds.

·       *Domestic Housing Revenue 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 updeficiencies.

·       *Domestic Municipal Utility Revenue Bonds*.   Municipalutility revenue bonds include obligations of all forms of municipal utilities,including electric, water and sewer utilities. Insurable utilities may beorganized as municipal enterprise systems, authorities or joint-actionagencies.

·       *Domestic Health Care Revenue Bonds*.   Health carerevenue bonds include bonds of state and local municipal authorities issued ona conduit basis 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.

·       *Domestic Tax-Supported (Non-General Obligation) Bonds*.   Tax-supported(non-general obligation) bonds include a variety of bonds that, though not fullfaith and credit general obligations, are supported by a specific or discretesource of taxation of the issuer, and include tax-backed revenue bonds andgeneral fund obligations of the issuer, such as lease revenue bonds. Tax-backedrevenue bonds may be secured by a lien on pledged tax revenues, such asrevenues from special taxes, including retail sales and gasoline taxes, or fromtax increments (or tax allocations) generated by growth in property valueswithin a district. FSA also insures bonds secured by special assessments leviedagainst property owners, which benefit from covenants by the issuer to levy,collect and enforce collections and to foreclose on delinquent properties.Lease revenue bonds or certificates of participation (“COPs”) are usuallygeneral fund obligations subject to annual appropriation or abatement. Theprojects financed 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).

12

----

·       *Domestic Transportation Revenue Bonds*.   Transportationrevenue bonds include a wide variety of revenue-supported bonds, such asbonds for airports, ports, tunnels, municipal parking facilities, toll roadsand toll bridges.

·       *Other Domestic Municipal Bonds*.   Other domesticmunicipal bonds insured by FSA include college and university (primarily publicor state-supported) revenue bonds, moral obligation bonds, financings forstadiums, resource recovery bonds and debt issued, guaranteed or otherwisesupported by domestic state or local governmental entities.

·       *InternationalMunicipal Obligations*.   International municipal obligationsinclude obligations of sovereign and sub-sovereign non-domestic municipal issuers,project finance transactions involving projects leased to or supported bypayments from non-domestic governmental or quasi-governmental entities,toll road transactions supported by toll revenues, obligations arising underleases of equipment or facilities by non-domestic municipal obligors,non-domestic municipal utility revenue bonds and other obligations havinginternational aspects but otherwise within the municipal categories describedabove.

***Insured Portfolio***

Asummary of FSA’s insured portfolio at December 31, 2004 is shown below.Exposure amounts are expressed net of reinsurance but do not distinguishbetween quota share, first loss or excess of loss reinsurance.

**Summaryof Insured PortfolioAs of December 31, 2004(1)**

| ** **                                    | ** ** | **Number of  Issues In  Force** | ** ** | **Net Par  Amount  Outstanding** | ** ** | **Net  Par and  Interest** | ** ** | **Percent  of Net  Par  and  Interest** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|---------------------------------------|------------|---------------------------------|------------|----------------------------------------------|------------|
| ** **                                    | ** ** | **(dollars in millions)**       | ** ** |
| **Asset-backed obligations**                  | ** ** |                                      | ** ** | ** **                            |       |                            | ** ** | ** **                                   |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Residential mortgages                         |       |                                      | 302        | ** **                            |       |                            | $          | 27,042                                  | ** ** |   | $ | 29,172  |   |   | 7 | % |   |
| Consumer receivables                          |       |                                      | 50         | ** **                            |       |                            | 9,469      | ** **                                   |       | 10,024 |   |   | 2 |   |   |
| Pooled corporate obligations                  |       |                                      | 357        | ** **                            |       |                            | 46,390     | ** **                                   |       | 49,207 |   |   | 11 |   |   |
| Other domestic asset-backed obligations       |       |                                      | 116        | ** **                            |       |                            | 7,097      | ** **                                   |       | 8,807 |   |   | 2 |   |   |
| International obligations                     |       |                                      | 138        | ** **                            |       |                            | 32,352     | ** **                                   |       | 33,584 |   |   | 8 |   |   |
| Total asset-backed obligations                |       |                                      | 963        | ** **                            |       |                            | $          | 122,350                                 | ** ** |   | $ | 130,794  |   |   | 30 | % |   |
| **Municipal obligations**                     | ** ** |                                      | ** ** | ** **                            |       |                            | ** ** | ** **                                   |       | ** ** | ** ** |   | ** ** | ** ** |   |
| General obligation bonds                      |       |                                      | 5,596      | ** **                            |       |                            | $          | 76,081                                  | ** ** |   | $ | 113,733  |   |   | 25 | % |   |
| Housing revenue bonds                         |       |                                      | 193        | ** **                            |       |                            | 7,628      | ** **                                   |       | 13,941 |   |   | 3 |   |   |
| Municipal utility revenue bonds               |       |                                      | 1,025      | ** **                            |       |                            | 33,544     | ** **                                   |       | 54,403 |   |   | 12 |   |   |
| Health care revenue bonds                     |       |                                      | 202        | ** **                            |       |                            | 9,261      | ** **                                   |       | 16,959 |   |   | 4 |   |   |
| Tax-supported (non-general obligation)  bonds |       |                                      | 1,023      | ** **                            |       |                            | 36,631     | ** **                                   |       | 56,496 |   |   | 13 |   |   |
| Transportation revenue bonds                  |       |                                      | 121        | ** **                            |       |                            | 12,835     | ** **                                   |       | 23,106 |   |   | 5 |   |   |
| Other domestic municipal bonds                |       |                                      | 689        | ** **                            |       |                            | 10,962     | ** **                                   |       | 16,627 |   |   | 4 |   |   |
| International obligations                     |       |                                      | 85         | ** **                            |       |                            | 8,450      | ** **                                   |       | 18,453 |   |   | 4 |   |   |
| Total municipal obligations                   |       |                                      | 8,934      | ** **                            |       |                            | 195,392    | ** **                                   |       | 313,718 |   |   | 70 |   |   |
| Total                                         |       |                                      | 9,897      | ** **                            |       |                            | $          | 317,742                                 | ** ** |   | $ | 444,512  |   |   | 100 | % |   |

----

(1)          Excludesintercompany insurance of $7,143 million in net par outstanding and$8,753 million in net par and interest outstanding relating to FSA-insuredGICs issued by the GIC Affiliates.

13

----

***Obligation Type***

Thetable below sets forth the relative percentages of net par amount insured byobligation type during each of the last five years:

**AnnualNew Business Insured by Obligation Type**

| ** **                                            | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **Asset-backed and other non-municipal  obligations** |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential mortgages                                 |       |                                       | 28         | % |   |   | 7 | % |   |   | 9 | % |   |   | 16 | % |   |   | 10 | % |   |
| Consumer receivables                                  |       |                                       | 2          |   |   |   | 6 |   |   |   | 10 |   |   |   | 12 |   |   |   | 20 |   |   |
| Pooled corporate  obligations                         |       |                                       | 13         |   |   |   | 5 |   |   |   | 15 |   |   |   | 25 |   |   |   | 20 |   |   |
| Other domestic non-municipal  obligations(1)          |       |                                       | 8          |   |   |   | 2 |   |   |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| International  obligations                            |       |                                       | 8          |   |   |   | 11 |   |   |   | 17 |   |   |   | 19 |   |   |   | 21 |   |   |
| Total asset-backed  obligations                       |       |                                       | 59         |   |   |   | 31 |   |   |   | 52 |   |   |   | 73 |   |   |   | 72 |   |   |
| **Municipal obligations**                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| General obligations  bonds                            |       |                                       | 19         |   |   |   | 27 |   |   |   | 19 |   |   |   | 12 |   |   |   | 11 |   |   |
| Housing revenue bonds                                 |       |                                       | 6          |   |   |   | 3 |   |   |   | 2 |   |   |   | 1 |   |   |   | 3 |   |   |
| Municipal utility  revenue bonds                      |       |                                       | 5          |   |   |   | 12 |   |   |   | 9 |   |   |   | 5 |   |   |   | 3 |   |   |
| Health care revenue  bonds                            |       |                                       | 3          |   |   |   | 2 |   |   |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| Tax-supported (non-general  obligation) bonds         |       |                                       | 2          |   |   |   | 14 |   |   |   | 8 |   |   |   | 5 |   |   |   | 5 |   |   |
| Transportation revenue  bonds                         |       |                                       | 2          |   |   |   | 5 |   |   |   | 4 |   |   |   | 1 |   |   |   | 2 |   |   |
| Other domestic municipal  bonds                       |       |                                       | 2          |   |   |   | 4 |   |   |   | 3 |   |   |   | 1 |   |   |   | 2 |   |   |
| International  obligations                            |       |                                       | 2          |   |   |   | 2 |   |   |   | 2 |   |   |   | 1 |   |   |   | 1 |   |   |
| Total municipal  obligations                          |       |                                       | 41         |   |   |   | 69 |   |   |   | 48 |   |   |   | 27 |   |   |   | 28 |   |   |
| Total                                                 |       |                                       | 100        | % |   |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |

----

(1)          Excludesintercompany transactions of $2.7 billion in 2004, $3.6 billion in2003, $2.0 billion in 2002 and $0.5 billion in 2001, relating toFSA-insured GICs issued by the GIC Affiliates.

***Terms to Maturity***

The table below sets forththe contractual terms to maturity of the Company’s policies at December 31,2004 and 2003:

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

| ** **                                    | ** ** | **As of December 31, 2004** | ** **    | **As of December 31, 2003** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|---------------|-------------------------------------------------|------------|
| **Estimated Term to Maturity** | ** ** | ** **                                      | ** **    | **Asset-  Backed(2)**                           | ** ** | **Municipal** | ** ** | **Asset-  Backed(2)** | ** ** | **Municipal** | ** ** |
| ** **                                    | ** ** | **(dollars in millions)**             | ** **    |
| 0 to 5 years                                  |       | $                                               | 46,800   |                                            | $          | 39,448  |   | $ | 58,500  |   | $ | 34,274  |   |
| 5 to 10 years                                 |       | 29,155                                          |          | 43,165                                          |       | 32,998 |   | 38,401 |   |
| 10 to 15 years                                |       | 10,772                                          |          | 37,174                                          |       | 6,644 |   | 32,895 |   |
| 15 to 20 years                                |       | 1,084                                           |          | 30,857                                          |       | 1,450 |   | 27,133 |   |
| 20 years and above                            |       | 34,539                                          |          | 44,748                                          |       | 18,670 |   | 38,235 |   |
| Total                                         |       | $                                               | 122,350  |                                            | $          | 195,392  |   | $ | 118,262  |   | $ | 170,938  |   |
|                                               |            |                                                 |               |                                                 |            |  |  |  |  |  |  |  |  |  |  |

----

(1)          Actualmaturities could differ from contractual maturities because borrowers have theright to call or prepay certain obligations with or without call or prepaymentpenalties. The average expected maturities for asset-backed obligationsare expected to be considerably shorter than the contractual maturities forsuch obligations.

(2)          Excludesintercompany insurance of $7,143 million in 2004 and $4,474 millionin 2003 relating to FSA-insured GICs issued by the GIC Affiliates.

14

----

***Issue Size***

The tables below set forththe number of policies and net par outstanding as of December 31, 2004,based on the amount of original net par written:

**Asset-BackedPolicy Count and Net Par Amount Outstanding(1)**

| **Original Net Par Amount** | ** ** | ** **                          | ** ** | **Number of  Policies** | ** ** | **Net Par Amount  Outstanding** | ** ** |
|--------------------------------------------|------------|-------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| ** **                                 | ** ** | **(dollars in millions)** | ** ** |
| Less than $10  million                     |       |                                | 712        |                         |       |                                      | $          | 418  |   |   |
| $10 to $50  million                        |       |                                | 577        |                         |       |                                      | 5,337      |   |   |
| $50 million to  $100 million               |       |                                | 426        |                         |       |                                      | 8,519      |   |   |
| $100 million or  greater                   |       |                                | 942        |                         |       |                                      | 108,076    |   |   |
| Total                                      |       |                                | 2,657      |                         |       |                                      | $          | 122,350  |   |   |

----

(1)          Excludesintercompany insurance of $7,143 million relating to FSA-insuredGICs issued by the GIC Affiliates.

**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                     |       |                                | 14,158     |                         |       |                                  | $          | 32,394  |   |   |
| $10 to $50  million                        |       |                                | 4,737      |                         |       |                                  | 56,544     |   |   |
| $50 million to  $100 million               |       |                                | 801        |                         |       |                                  | 28,176     |   |   |
| $100 million or  greater                   |       |                                | 712        |                         |       |                                  | 78,278     |   |   |
| Total                                      |       |                                | 20,408     |                         |       |                                  | $          | 195,392  |   |   |

 

***Geographic Concentration***

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 underlying assetsmay change over the life of the policy. In addition, in writing insurance forother types of asset-backed obligations, such as securities primarilybacked by government or corporate debt, geographic concentration is notconsidered a significant credit factor given other more relevant measures ofdiversification, such as issuer or industry diversification.

15

----

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 insured municipal securities:

**MunicipalInsured Portfolio by Jurisdiction**

| ** **                    | ** ** | **As of December 31, 2004** | ** ** |
|-------------------------------|------------|-------------------------------------------------|------------|
| **Jurisdiction**              | ** ** | ** **                                      | ** ** | **Number  of Issues** | ** ** | **Net Par  Amount  Outstanding** | ** ** | **Percent of Total  Municipal Net  Par Amount  Outstanding** | ** ** |
| ** **                    | ** ** | **(dollars in millions)**             | ** ** |
| California                    |       |                                            | 934        |   |   |   | $ | 26,501  |   |   |   | 13.6 | % |   |
| New York                      |       |                                            | 622        |   |   |   | 17,917 |   |   |   | 9.2 |   |   |
| Texas                         |       |                                            | 701        |   |   |   | 13,297 |   |   |   | 6.8 |   |   |
| Pennsylvania                  |       |                                            | 704        |   |   |   | 12,276 |   |   |   | 6.3 |   |   |
| Florida                       |       |                                            | 274        |   |   |   | 10,881 |   |   |   | 5.6 |   |   |
| Illinois                      |       |                                            | 633        |   |   |   | 9,337 |   |   |   | 4.8 |   |   |
| New Jersey                    |       |                                            | 548        |   |   |   | 9,053 |   |   |   | 4.6 |   |   |
| Washington                    |       |                                            | 297        |   |   |   | 7,272 |   |   |   | 3.7 |   |   |
| Michigan                      |       |                                            | 399        |   |   |   | 5,896 |   |   |   | 3.0 |   |   |
| Massachusetts                 |       |                                            | 194        |   |   |   | 4,933 |   |   |   | 2.5 |   |   |
| Wisconsin                     |       |                                            | 425        |   |   |   | 4,713 |   |   |   | 2.4 |   |   |
| Ohio                          |       |                                            | 265        |   |   |   | 4,412 |   |   |   | 2.3 |   |   |
| Georgia                       |       |                                            | 106        |   |   |   | 4,288 |   |   |   | 2.2 |   |   |
| All other U.S.  jurisdictions |       |                                            | 2,747      |   |   |   | 56,283 |   |   |   | 28.7 |   |   |
| International                 |       |                                            | 85         |   |   |   | 8,333 |   |   |   | 4.3 |   |   |
| Total                         |       |                                            | 8,934      |   |   |   | $ | 195,392  |   |   |   | 100.0 | % |   |
|                               |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

| ** **     | ** ** | **Year Ended December 31,** | ** **      |
|----------------|------------|--------------------------------------------|-----------------|
| ** **     | ** ** | **2004**                                   | ** **      | **2003** | ** ** | **2002** | ** ** |
| ** **     | ** ** | **(restated)**                             | ** **      | **(restated)** | ** ** | **(restated)** | ** ** |
| ** **     | ** ** | **(dollars in thousands)**       | ** **      |
| U.S.           |       | $                                          | 1,077,735  |   | $ | 837,368  |   | $ | 401,970  |   |
| International  |       | 52,355                                     |            | 32,926 |   | 33,290 |   |
| Total revenues |       | $                                          | 1,130,090  |   | $ | 870,294  |   | $ | 435,260  |   |

 

See Note 24 to theConsolidated Financial Statements in Item 8 for revenues from externalcustomers, income before income taxes 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 insured. In many cases,the Company uses reinsurance to limit net exposure to any one credit. At December 31,2004, the ten largest net insured asset-backed transactions represented$18.9 billion, or 6.0%, of the total net par amount outstanding, and theten largest net insured municipal credits represented $9.6 billion, or3.1%, of the total 

16

----

net paramount outstanding. For purposes of the foregoing, different issues of asset-backedsecurities by the same sponsor have not been aggregated. However, the Company’sunderwriting policies 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 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 asset-backed and municipal 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.

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 orreinsurance agreements). This overcollateralization or third-partyprotection need not protect FSA against all risk of loss, but is generallyintended to assume the primary risk of financial loss.

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. Asset-backed obligations insured by FSA may benefit from thirdparty protection. Overcollateralization, excess spread or 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 generalpolicy has been to insure 100% of the principal, interest and other amounts duein respect of funded asset-backed obligations rather than providingpartial or first-loss coverage sufficient to confer a Triple-A rating on theinsured obligations. In the CDS sector, however, FSA has insured risks on a “compressed”or “mezzanine” basis in which the obligations insured by FSA are subordinate tomore senior uninsured obligations.

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, supplemental protectionsmay be required if such taxes, assessments or other charges are not projectedto provide sufficient debt service coverage. Where appropriate, the municipalobligor may be required to provide a rate covenant and a pledge of additionalsecurity (e.g., mortgages on real property, liens on equipment or revenuepledges) to secure the insured obligation.

17

----

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 Committeeis comprised of FSA’s Chief Risk Management Officer, Chief DomesticUnderwriting Officer, Chief Municipal Underwriting Officer and ChiefInternational Underwriting Officer, with FSA’s Chief Executive Officer,President, General Counsel and Chief Financial Officer as *ex officio* 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 is required for all transactions.

Each underwriting group in the Financial GuarantyDepartment is responsible for confirming that each transaction proposed by theFinancial Guaranty Department conforms to the underwriting guidelines andstandards. This evaluation is reviewed by the chief underwriting officer forthe particular sector. This review may take place while the transaction is inits formative stages, thus facilitating the introduction of furtherenhancements at a stage when the transaction is more receptive to change.

Final transaction approval is obtained from FSA’sManagement Review Committee (the “MRC”) for asset-backed transactions andmunicipal international transactions and from FSA’s Municipal UnderwritingCommittee (the “MUNC”) for domestic municipal transactions. Subject toapplicable limits, a subcommittee of the MRC or MUNC, as applicable, mayapprove guarantees of transactions in certain sectors. The MUNC and MRC jointlyreview certain international transactions with municipal credit elements. Approvalis usually based upon both a written and an oral presentation by theunderwriting group to the respective committee. Following approval, the Chairof the applicable underwriting committee may approve minor transactionmodifications. Major changes require the concurrence of the applicableunderwriting 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 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 the Chief MunicipalUnderwriting Officer, Municipal Underwriting Officer or Managing Director forMunicipal Operations, an Associate General Counsel for Municipal Transactions,and any one of certain managing directors and directors designated by the MUNC.The Demi-MUNC approval process generally requires approval by at least twovoting members, with approval by the Chief Municipal Underwriting Officer orMunicipal Underwriting Officer required for transactions exceeding a certainsize.

18

----

***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 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 Departments and itsworkout subsidiary TSC are independent of the analysts and credit officersinvolved in the underwriting process. The Asset-Backed and MunicipalTransaction Oversight Departments are responsible for monitoring theperformance of outstanding transactions. TSC, together with the TransactionOversight Departments, is responsible for taking remedial actions 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 Departments review insured transactions to confirmcompliance with transaction covenants, monitor credit and other developmentsaffecting transaction participants and collateral, and together with TSCdetermine the steps, if any, required to protect the interests of FSA and theholders of FSA-insured obligations. Reviews of asset-backed transactionstypically include an examination of reports provided by, and (as circumstanceswarrant) discussions with, issuers, servicers, trustees and other transactionparticipants. Reviews of asset-backed transactions often include serviceraudits, site visits or evaluations by third-party appraisers, engineersor other experts retained by FSA. The Transaction Oversight Departments reviewtransactions to determine the level of ongoing attention required. Thesejudgments relate to current credit quality and other factors, includingcompliance with reporting or other requirements, legal or regulatory actionsinvolving transaction participants and liquidity or other concerns that may nothave a direct bearing on credit quality. Transactions with the highest riskprofile are generally subject to more intensive review and, if appropriate,remedial action. The Transaction Oversight Departments and TSC work togetherwith the Legal Department and the Corporate Research Department in monitoringthese transactions, negotiating restructurings and pursuing appropriate legalremedies.

The Company’s Transaction Oversight Departmentscategorize all credits by risk of loss to facilitate appropriate allocation ofresources to loss mitigation efforts and to efficiently communicate therelative credit condition of any risk exposure, as well as the overall healthof the insured portfolio. Each risk in the insured portfolio is designated oneof five surveillance 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 deemedunlikely. 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 Vand Category IV transactions are subject to intense monitoring andintervention.

19

----

The table below presentsthe gross and net par outstanding and the gross and net reserves for risksclassified as Category IV and V, as described above, as of December 31,2004 and 2003.

**Par Outstanding**

| ** **                       | ** ** | **As of December 31,** | ** **    |
|----------------------------------|------------|---------------------------------------|---------------|
| ** **                       | ** ** | **2004**                              | ** **    | **2003** | ** ** |
| ** **                       | ** ** | **Gross**                             | ** **    | **Net** | ** ** | **Gross** | ** ** | **Net** | ** ** |
| ** **                       | ** ** | **(dollars in millions)**   | ** **    |
| Category I and II                |       | $                                     | 426,142  |   | $ | 310,431  |   | $ | 366,389  |   | $ | 274,305  |   |
| Category III                     |       | 7,213                                 |          | 6,384 |   | 17,080 |   | 12,920 |   |
| Category IV                      |       | 283                                   |          | 245 |   | 888 |   | 782 |   |
| Category V no claims             |       | 707                                   |          | 647 |   | 1,154 |   | 1,018 |   |
| Category V with previous  claims |       | 85                                    |          | 35 |   | 260 |   | 175 |   |
| Total                            |       | $                                     | 434,430  |   | $ | 317,742  |   | $ | 385,771  |   | $ | 289,200  |   |

 

**Case Basis LossReserves**

| ** **                       | ** ** | **As of December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|
| ** **                       | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| ** **                       | ** ** | **Gross**                             | ** ** | **Net** | ** ** | **Gross** | ** ** | **Net** | ** ** |
| ** **                       | ** ** | **(dollars in millions)**   | ** ** |
| Category V no claims             |       | $                                     | 36.4  |   | $ | 30.3  |   | $ | 93.8  |   | $ | 53.4  |   |
| Category V with previous  claims |       | 44.2                                  |       | 14.9 |   | 28.1 |   | 9.3 |   |
| Total                            |       | $                                     | 80.6  |   | $ | 45.2  |   | $ | 121.9  |   | $ | 62.7  |   |

 

The decrease in Category V reserves with noclaims in 2004 compared to 2003 was due primarily to the payment of a largeclaim for $34.3 million and a refinancing resulting in a reclassificationof $5.5 million from reserves to an asset valuation account applied to theunderlying collateral acquired in connection with the refinancing. Thesedecreases were partially offset by reassumption of previously ceded business.

The increase inCategory V reserves with previous claim payments in 2004 compared to 2003was primarily related to the deterioration of a municipal transaction.

***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 four sectors (asset-backed transactions,municipal transactions, regulatory/reinsurance/corporate and compliance). TheLegal Department plays a major role in establishing and implementing legalrequirements and procedures applicable to obligations insured by the Company.Members of the Legal Department serve on the MRC and MUNC, which provide finalunderwriting approval for transactions. An attorney in the Legal Departmentworks together with a counterpart in the financial guaranty department 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 Legal Department works closely with the transactionoversight and transaction services functions in addressing legal issues, rightsand remedies, as well as proposed amendments, waivers and consents, inconnection with obligations insured by the Company. The Legal Department isalso responsible for domestic and international regulatory compliance,reinsurance, secondary market transactions, litigation and other matters. TheChief Compliance Officer is a member of the Legal Department responsible forpreparing quarterly compliance activity reports provided to the Audit Committeeof the Board of Directors of the Company.

20

----

**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. (“XLCA”) and CDC-IXISFinancial Guaranty (“CIFG”). Although FGIC formerly limited its businessprimarily to underwriting certain categories of municipal risks, since itschange in control in December 2003 FGIC has competed more broadly in asset-backedand municipal sectors it had not previously serviced. Competition is largelybased on premium rates, capacity, underwriting requirements and trading 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 their focuson the primary financial guaranty insurance market. The Company understandsthat other parties are considering establishing new financial guaranty insurersthat may compete with it.

Traditional credit enhancers such as bank letter ofcredit providers and mortgage pool insurers provide competition to FSA asproviders of credit enhancement for asset-backed obligations. Actions bysecurities rating agencies in recent years have significantly reduced thenumber of Triple-A rated financial institutions that can offer a productdirectly competitive with FSA’s Triple-A guaranty and risk-based capitalguidelines applicable to banks have generally increased costs associated withletters of credit that compete directly with financial guaranty insurance.Nonetheless, bank sponsored commercial paper conduits, bank letter of creditproviders and other credit enhancement, such as cash collateral accountsprovided by banks, continue to provide significant competition to FSA. Inaddition, CDS, credit-linked notes and other synthetic products providecoverage directly competitive with financial guaranty insurance, and expand theuniverse of participants in the financial risk market. Bank affiliates mayparticipate in the U.S. insurance business, including the financial guaranty insurancebusiness.

Government sponsored entities, including Fannie Maeand Freddie Mac, compete with the monoline financial guaranty insurers, on alimited basis, in the mortgage-backed and multifamily sectors. Expansionof the business franchises by government sponsored entities, as well aspotential new entrants into the financial guaranty sector such as Federal HomeLoan Banks and state pension funds, present competitive challenges to privatesector participants such as FSA.

Insurance lawgenerally restricts multiline insurance companies, such as largeproperty/casualty insurers and life insurers, from engaging in the financialguaranty insurance business other than through separately capitalizedaffiliates. Entry requirements include:

·       assemblingthe group of experts required to operate a financial guaranty insurancebusiness,

·       establishingclaims-paying ability ratings with the credit rating agencies,

·       complyingwith substantial capital requirements,

·       developingname recognition and market acceptance with issuers, investment bankers andinvestors, and

·       organizinga monoline insurance company and obtaining insurance licenses to do business inthe applicable jurisdictions.

21

----

FSA’s net insurance in force is the outstandingprincipal, interest and other amounts payable over the remaining life of allobligations insured by FSA, net of ceded reinsurance and refunded bonds securedby U.S. government securities held in escrow or other qualifying collateral.Qualified statutory capital, determined in accordance with statutory accountingpractices, is the aggregate of policyholders’ surplus and contingency reservescalculated in accordance with statutory accounting practices.

In December 2004, FSA obtained CDS protection onan excess of loss basis (exceeding very large deductibles) providingapproximately $17 billion of credit protection on a number of FSA-insuredsynthetic CDO transactions shadow rated “super- triple A” at inception.Given the high credit quality of the risk transferred to the CDS provider, themain effects of this CDS were to improve FSA’s statutory capital ratios andincrease FSA’s margin under regulatory risk limits on aggregate insuredexposures.

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. Net insurance data does notdistinguish between quota share reinsurance and first-loss reinsurance. Inlight of FSA’s use of first-loss reinsurance in the asset-backed andproject finance sector, the data below tends to overstate FSA’s risk leveragein comparison with its industry counterparts. Conversely, FSA also insures mezzaninerisks and obtains excess-of-loss credit protection in CDS transactions, whichreduces FSA’s reported risk leverage. The statutory capital ratio does notreflect the underlying credit quality of the insurance in force, whichdiminishes the comparative value of the disclosure. Specifically, the creditquality of FSA’s insured portfolio as measured by S&P and Moody’s isgenerally higher than most of FSA’s industry peers, although FSA’s ratio of netdebt service to statutory capital is also generally higher than most of FSA’sindustry peers.

| ** **                                                 | ** ** | **As of December 31,** | ** **    |
|------------------------------------------------------------|------------|---------------------------------------|---------------|
| ** **                                                 | ** ** | **2004**                              | ** **    | **2003** | ** ** | **2002** | ** ** |
| ** **                                                 | ** ** | **(dollars in millions)**   | ** **    |
| **Financial guaranty primary  insurers, excluding FSA(1)** | ** ** | ** **                            | ** **    | ** ** | ** ** | ** ** | ** ** |
| Capital ratio                                              |       | 146:1                                 |          | 145:1 |   | 148:1 |   |
| **FSA(2)**                                                 |       |                                  |          |   |   |   |   |
| Gross insurance  in force                                  |       | $                                     | 633,037  |   | $ | 565,371  |   | $ | 512,233  |   |
| Net insurance in  force                                    |       | 454,359                               |          | 409,476 |   | 365,256 |   |
| Qualified  statutory capital                               |       | 2,281                                 |          | 2,104 |   | 1,876 |   |
| Capital ratio                                              |       | 199:1                                 |          | 195:1 |   | 195:1 |   |
|                                                            |            |                                       |               |  |  |  |  |  |  |  |

----

(1)          Financial guarantyprimary insurers for which data is included in this table are Ambac, FGIC andMBIA. Information relating to the financial guaranty primary insurers isderived from data from statutory accounting financial information publiclyavailable from each insurer at December 31, 2004, 2003 and 2002.

(2)          Includesgross and net insurance in force relating to FSA-insured GICs issued by the GICAffiliates of $8,753 for 2004, $5,708 million for 2003 and$3,199 million for 2002.

**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 

22

----

not relieve the cedingcompany of its obligation to the insured party under the terms of the insurancecontract.

At December 31,2004, FSA reinsured approximately 27% 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. Treaty reinsurance providescoverage for a portion of the exposure from all qualifying policies issuedduring the term of the treaty. In addition, FSA employs “automatic facultative”reinsurance that permits FSA to apply reinsurance to transactions it selectssubject to certain limitations. The reinsurer’s participation in a treaty iseither cancelable 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 at December 31, 2004 were Assured Guaranty ReInternational Ltd. (formerly ACE Capital Re International Ltd.),Assured Guaranty Corp. (formerly ACE Guaranty Corp.), Radian AssetReinsurance Inc. (successor to Radian Reinsurance Inc., formerlyEnhance Reinsurance Company), RAM Reinsurance Co. Ltd., Swiss ReinsuranceAmerica Corporation, Tokio Marine and XLFA.

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 agencies.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 New York Insurance Law was amended toallow financial guaranty insurers such as FSA to treat qualifying CDS fromhighly rated financial institutions as collateral for purposes of satisfyingrisk limits and certain reserve requirements. The effect of these amendments isto make credit defaults swaps an alternative to reinsurance. InDecember 2004, FSA entered into its first CDS permitted by the newlegislation, obtaining approximately $17 billion of credit protection onan excess of loss basis on certain insured synthetic CDOs.

23

----

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 the poolingagreement, FSA, FSAIC and FSA International share the net retained risk inproportion to their policyholders’ surplus and contingency reserves (“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 99% of its retention after third partyreinsurance of its policies issued in 2004.

**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’s businessand financial condition, focusing on the insurer’s underwriting policies andprocedures and the quality of the obligations insured, and publish theirratings 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 and S&Papply their own capital adequacy models in assessing the financial strength ofFSA. Financial factors considered by the rating agencies in assessing capitaladequacy 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 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 adequacy determinationsin addition to other measures of creditworthiness. Reference is made to thepublished reports of Moody’s, S&P and Fitch Ratings regarding the Company,capital adequacy models, the bond insurance business in general and FSA’sstanding relative to its industry peers on the basis of capital adequacy andprofitability.

24

----

**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 insurance laws of the State of New York (the “NewYork Insurance Law”), and is also subject to the insurance laws of the otherstates in which it is licensed to transact insurance business. FSAIC is anOklahoma domiciled insurance company also licensed in New York and subject tothe New York Insurance Law. FSA and its domestic insurance company subsidiaryare required to file quarterly and annual statutory financial statements ineach jurisdiction in which they are licensed, and are subject to statutoryrestrictions concerning the types and quality of investments and the filing anduse of policy forms and premium rates. FSA’s accounts and operations aresubject to periodic examination by the Superintendent of Insurance of the Stateof New York (the “New York Superintendent”) and other state insuranceregulatory authorities. The last completed examination was conducted in 2000for the three-year period ended December 31, 1999. FSA’s accounts arecurrently under examination for the three-year period ended December 31,2002; the examination is complete subject to receipt of the final examinationreport.

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 applicable requirementsof English law. FSA-UK maintains its principal executive offices in London,England. Pursuant to European Union Directives, FSA-UK is generally authorizedto write business out of its London office in other member countries of theEuropean 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.

25

----

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

Article 69 of the New York Insurance Law (asamended, “Article 69”), a comprehensive financial guaranty insurancestatute, governs all financial guaranty insurers licensed to do business in NewYork, including FSA. This statute limits the business of financial guarantyinsurers to financial guaranty 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 69 establishes single risk limits forfinancial guaranty insurers applicable to all obligations issued by a singleentity and backed by a single revenue source. For example, under the limitapplicable to qualifying asset-backed securities, the lesser of:

·  the insured average annual debt service for asingle risk, net of qualifying reinsurance 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 maynot exceed 10% of the sum of the insurer’s policyholders’ surplus andcontingency 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 also establishes aggregate risk limitson the basis of aggregate net liability insured as compared to statutorycapital. “Aggregate net liability” is defined as outstanding principal andinterest of guaranteed obligations insured, net of qualifying reinsurance andcollateral. Under these limits, policyholders’ surplus and contingency reservesmust not be less than a percentage of aggregate net liability equal to the sumof various percentages of aggregate net liability for various categories ofspecified 

26

----

obligations.The percentage varies from 0.33% for certain municipal obligations to 4% forcertain non-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 laststatement filed with the New York Superintendent; or

·  adjusted net investment income during thisperiod.

Based on FSA’s statutorystatements for 2004, the maximum amount available for payment of dividends byFSA without regulatory approval over the 12 months following December 31,2004 was approximately $84.5 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 branch licenses in Canada(and its respective provinces) and Japan.

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

Dexia indirectlyowns approximately 99% of the Company’s common stock, as described under “Item 1.Business—Organization.” Because Dexia has non-U.S. bank subsidiaries withbanking offices in the U.S., Dexia and all of its subsidiaries, including theCompany and its subsidiaries, are subject to the U.S. Bank Holding Company Act (the“BHC Act”). In general, the BHC Act restricts the activities of bankingorganizations and their affiliates to the ownership and operation of banks andto other activities that are “closely related to banking” as determined by theBoard of Governors of the Federal Reserve System (the “Federal Reserve”).Insurance activities such as those conducted by certain of the Company’ssubsidiaries are generally not permissible under this restriction. Under theBHC Act, however, an organization that qualifies as a “financial holdingcompany” is permitted to engage in a broader range of permissible “financialactivities.” “Financial activities” include insurance underwriting and agencyactivities as well as merchant banking. For a non-U.S. organization to qualifyas a “financial holding company,” it, if it has a U.S. banking office, and eachof its non-U.S. bank subsidiaries with a U.S. banking office, must be both:

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

27

----

·       “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.”

**Investments**

In addition to itsinsurance company assets and other investments (the “Investment Portfolio”),the Company maintains investments from proceeds of FSA-insured GICs (the “GICPortfolio”) , the portfolio of securities owned by the VIEs (the “VIE Portfolio”)and assets acquired from refinancing transactions.

***Investment Portfolio***

Management’s primary objective in managing theInvestment Portfolio is generation of 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 has establishedguidelines for eligible fixed income investments by FSA, requiring that atleast 95% of such investments be rated at least Single-A at acquisition and theoverall 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, assetbacked securities and mortgage-backed securities. The current investmentstrategy is to invest in quality, readily marketable instruments of intermediateaverage duration so as to generate stable investment earnings with minimalmarket value or credit risk.

At December 31,2004, the Company also had investments in various strategic partners,including:

·       XLFA;

·       creditex,Inc, which operates an exchange for credit-derivative products;

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

·       SPSHolding Corp. (“SPS”) (formerly Fairbanks Capital Holding Corp.), a residentialmortgage loan servicer.

On October 4,2005, the Company sold its investment in SPS to an unaffiliated third party. Forits interest in SPS, the Company was paid $43.4 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 subsidiaryof the Company which owned the SPS investment made customary representationsand warranties to, and undertook specified indemnification obligations for thebenefit of, the purchaser.

The weighted average maturity of the Company’sInvestment Portfolio at December 31, 2004 was approximately7.0 years.

28

----

The following tables setforth certain information concerning the investment portfolio of the Company:

**InvestmentPortfolio by RatingAs of December 31, 2004(1)(3)**

| **Rating** | ** ** | ** ** | ** ** | **Percent of  Investment  Portfolio** | ** ** |
|------------|------------|------------|------------|--------------------------------------------|------------|
| AAA(2)     |       |       | 77.8       | %                                          |       |
| AA         |       |       | 19.7       |                                       |       |
| A          |       |       | 2.5        |                                       |       |
| Total      |       |       | 100.0      | %                                          |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2004.Without giving effect to the FSA guaranty referred to in Note 3 below, theweighted-average rating of the FSA-insured investments was in the A+range, and all were investment grade.

(2)          Includes U.S. Treasuryobligations, which comprised 4.5% of the portfolio at December 31, 2004.

(3)          12.9%of the portfolio was rated AAA by virtue of insurance provided by FSA.

**Summary ofInvestments**

| ** **                   | ** ** | **As of December 31,** | ** **      |
|------------------------------|------------|---------------------------------------|-----------------|
| ** **                   | ** ** | **2004**                              | ** **      | **2003** | ** ** |
| **Investment Category** | ** ** | ** **                            | ** **      | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **                   | ** ** | **(dollars in thousands)**  | ** **      |
| Long term investments:       |       |                                  |            |   |   |   |   |   |   |   |   |   |   |
| Taxable bonds                |       | $                                     | 804,942    |   |   | 4.77 | % |   | $ | 768,930  |   |   | 4.71 | % |   |
| Tax-exempt bonds             |       | 2,857,642                             |            |   | 5.00 |   |   | 2,506,380 |   |   | 5.08 |   |   |
| Total long-term investments  |       | 3,662,584                             |            |   | 4.95 |   |   | 3,275,310 |   |   | 4.99 |   |   |
| Short-term  investments      |       | 321,071                               |            |   | 1.51 |   |   | 224,429 |   |   | 0.99 |   |   |
| Total  investments(2)        |       | $                                     | 3,983,655  |   |   | 4.72 | % |   | $ | 3,499,739  |   |   | 4.79 | % |   |
|                              |            |                                       |                 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Yields are stated on apre-tax basis.

(2)          2004total excludes the Company’s equity investment in XLFA, which has a fair valueof $54.3 million.

29

----

**InvestmentPortfolio by Security Type**

| ** **                             | ** ** | **As of December 31,** | ** **      |
|----------------------------------------|------------|---------------------------------------|-----------------|
| ** **                             | ** ** | **2004**                              | ** **      | **2003** | ** ** |
| **Investment Category**           | ** ** | ** **                            | ** **      | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**  | ** **      |
| U.S. government  and agency securities |       | $                                     | 164,312    |   |   | 4.30 | % |   | $ | 123,270  |   |   | 4.23 | % |   |
| Mortgage-backed  securities            |       | 220,202                               |            |   | 5.31 |   |   | 196,465 |   |   | 5.45 |   |   |
| Municipal bonds                        |       | 2,857,642                             |            |   | 5.00 |   |   | 2,506,380 |   |   | 5.08 |   |   |
| Asset-backed  securities               |       | 56,843                                |            |   | 3.23 |   |   | 81,844 |   |   | 3.66 |   |   |
| Corporate  securities                  |       | 237,486                               |            |   | 4.81 |   |   | 259,102 |   |   | 5.05 |   |   |
| Foreign  securities                    |       | 126,099                               |            |   | 5.06 |   |   | 108,249 |   |   | 3.91 |   |   |
| Total long-term  investments           |       | 3,662,584                             |            |   | 4.95 |   |   | 3,275,310 |   |   | 4.99 |   |   |
| Short-term  investments                |       | 321,071                               |            |   | 1.51 |   |   | 224,429 |   |   | 0.99 |   |   |
| Total  investments(2)                  |       | $                                     | 3,983,655  |   |   | 4.72 | % |   | $ | 3,499,739  |   |   | 4.79 | % |   |
|                                        |            |                                       |                 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)   Yields arestated on a pre-tax basis.

(2)   2004 total excludes the Company’s equity investment in XLFA, whichhas a fair value of $54.3 million.

**Distributionof Investments by Contractual Maturity**

| ** **                              | ** ** | **As of December 31,** | ** **      |
|-----------------------------------------|------------|---------------------------------------|-----------------|
| ** **                              | ** ** | **2004**                              | ** **      | **2003** | ** ** |
| **Investment Category**            | ** ** | ** **                            | ** **      | **Amortized  Cost** | ** ** | **Estimated  Market  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Market  Value** | ** ** |
| ** **                              | ** ** | **(dollars in thousands)**  | ** **      |
| Due in one year  or less                |       | $                                     | 376,156    |   | $ | 376,197  |   | $ | 243,251  |   | $ | 243,558  |   |
| Due after one  year through five years  |       | 542,572                               |            | 548,454 |   | 428,234 |   | 434,775 |   |
| Due after five  years through ten years |       | 517,956                               |            | 555,819 |   | 492,998 |   | 528,991 |   |
| Due after ten  years                    |       | 2,269,926                             |            | 2,475,770 |   | 2,056,949 |   | 2,243,307 |   |
| Mortgage-backed  securities             |       | 220,202                               |            | 222,510 |   | 196,464 |   | 198,909 |   |
| Asset-backed  securities                |       | 56,843                                |            | 57,084 |   | 81,843 |   | 83,538 |   |
| Total investments(1)                    |       | $                                     | 3,983,655  |   | $ | 4,235,834  |   | $ | 3,499,739  |   | $ | 3,733,078  |   |
|                                         |            |                                       |                 |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          2004total excludes the Company’s equity investment in XLFA, which has a fair valueof $54.3 million.

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

| ** **                                      | ** ** | **As of December 31, 2004** | ** **    |
|-------------------------------------------------|------------|-------------------------------------------------|---------------|
| ** **                                      | ** ** | **Par Value**                              | ** **    | **Amortized  Cost** | ** ** | **Estimated  Market Value** | ** ** |
| ** **                                      | ** ** | **(dollars in thousands)**            | ** **    |
| Pass-through  securities U.S. Government agency |       | $                                               | 202,429  |   | $ | 204,501  |   |   | $ | 206,494  |   |   |
| CMOs—U.S.  Government agency               |       | 13,016                                          |          | 12,978 |   |   | 13,355 |   |   |
| CMOs—non-agency                            |       | 2,624                                           |          | 2,723 |   |   | 2,661 |   |   |
| Total mortgage-backed  securities               |       | $                                               | 218,069  |   | $ | 220,202  |   |   | $ | 222,510  |   |   |

 

The Company’s investments in mortgage-backedsecurities consisted of pass-through certificates and collateralized mortgageobligations (“CMOs”), which are backed by mortgage loans guaranteed or insuredby agencies of, or sponsored by, the federal government. These securities arehighly liquid with readily 

30

----

determinable marketprices. The Company also held, at December 31, 2004, Triple-A rated CMOswhich are not guaranteed by government agencies. Secondary market quotationsare available for these securities, although they are not as liquid asgovernment agency-backed securities.

The CMOs held at December 31, 2004 have statedmaturities ranging from 1 to 40 years and expected average lives rangingfrom 1 to 14 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 at the borrower’s option.Prepayment rates on mortgage-backed securities are influenced primarilyby the general level of prevailing mortgage interest rates, with prepaymentsincreasing when prevailing interest rates are lower than the rates on theunderlying mortgages. When prepayments occur, the proceeds must be reinvestedat then current market rates, which may be below the yield on the prepaid securities.

***GIC Portfolio***

The following tables setforth certain information concerning the GIC Portfolio:

**GICPortfolio by RatingAs of December 31, 2004(1)(2)**

| **Rating** | ** ** | ** ** | ** ** | **Percent of Investment  Portfolio** | ** ** |
|------------|------------|------------|------------|------------------------------------------------|------------|
| AAA        |       |       | 81.5       | %                                              |       |
| AA         |       |       | 9.0        |                                           |       |
| A          |       |       | 4.8        |                                           |       |
| Other      |       |       | 4.7        |                                           |       |
| Total      |       |       | 100.0      | %                                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2004.

(2)          9.1%of the GIC Portfolio is rated AAA by virtue of insurance provided by FSA.Without giving effect to the FSA guaranty, the weighted-average rating ofthe FSA-insured investments was in the Double-A range, and all of theseinvestments were investment grade.

**Summary of GICPortfolio**

| ** **             | ** ** | **December 31,** | ** **      |
|------------------------|------------|-----------------------|-----------------|
| ** **             | ** ** | **2004**              | ** **      | **2003** | ** ** |
| ** **             | ** ** | **Amortized  Cost**   | ** **      | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **             | ** ** | **(restated)**        | ** **      | ** ** | ** ** | **(restated)** | ** ** | ** ** | ** ** |
| GIC Portfolio:         |       |                  |            |   |   |   |   |   |   |   |   |   |   |
| Taxable bonds          |       | $                     | 7,888,647  |   |   | 1.66 | % |   | $ | 4,092,963  |   |   | 1.76 | % |   |
| Short-term investments |       | 268,125               |            |   | 1.43 |   |   | 228,812 |   |   | 1.90 |   |   |
| Total investments      |       | $                     | 8,156,772  |   |   | 1.64 | % |   | $ | 4,321,775  |   |   | 1.77 | % |   |

----

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

31

----

**InvestmentPortfolio by Security Type**

| ** **                             | ** ** | **As of December 31,** | ** **      |
|----------------------------------------|------------|---------------------------------------|-----------------|
| ** **                             | ** ** | **2004**                              | ** **      | **2003** | ** ** |
| **Investment Category**           | ** ** | ** **                            | ** **      | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **                             | ** ** | **(restated)**                        | ** **      | ** ** | ** ** | **(restated)** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**  | ** **      |
| Mortgage-backed  securities            |       | $                                     | 2,137,814  |   |   | 1.46 | % |   | $ | 202,784  |   |   | 3.32 | % |   |
| Municipal bonds                        |       | 442,169                               |            |   | 1.57 |   |   | 184,560 |   |   | 2.66 |   |   |
| U.S. government and  agency securities |       | 270,498                               |            |   | 1.56 |   |   | 156,700 |   |   | 2.98 |   |   |
| Asset-backed and  other securities     |       | 5,029,447                             |            |   | 1.71 |   |   | 3,530,201 |   |   | 1.43 |   |   |
| Corporate securities                   |       | 8,719                                 |            |   | 2.57 |   |   | 18,718 |   |   | 2.20 |   |   |
| Total fixed maturities                 |       | 7,888,647                             |            |   | 1.66 |   |   | 4,092,963 |   |   | 1.76 |   |   |
| Short-term  investments                |       | 268,125                               |            |   | 1.43 |   |   | 228,812 |   |   | 1.90 |   |   |
| Total investments                      |       | $                                     | 8,156,772  |   |   | 1.64 | % |   | $ | 4,321,775  |   |   | 1.77 | % |   |
|                                        |            |                                       |                 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Yieldsare stated on a pre-tax basis. The weighted average yield presented is net ofthe effects of derivative instruments used to convert interest rates from fixedto floating rates.

**Distributionof Investments by Contractual Maturity**

| ** **                              | ** ** | **As of December 31, 2004** | ** **      |
|-----------------------------------------|------------|-------------------------------------------------|-----------------|
| **Investment Category**            | ** ** | ** **                                      | ** **      | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| ** **                              | ** ** | **(restated)**                                  | ** **      | ** ** | ** ** |
| ** **                              | ** ** | **(dollars in thousands)**            | ** **      |
| Due in one year  or less                |       | $                                               | 276,837    |   | $ | 276,882  |   |
| Due after one  year through five years  |       | —                                          |            | — |   |
| Due after five  years through ten years |       | 77,669                                          |            | 78,332 |   |
| Due after ten  years                    |       | 635,005                                         |            | 661,078 |   |
| Mortgage-backed  securities             |       | 2,137,814                                       |            | 2,149,513 |   |
| Asset-backed  and other securities      |       | 5,029,447                                       |            | 5,033,305 |   |
| Total investments                       |       | $                                               | 8,156,772  |   | $ | 8,199,110  |   |
|                                         |            |                                                 |                 |  |  |  |  |  |  |

 

***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 otherreceivership.

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, 2004 was as follows:

**VIE Portfolio by Rating(1)**

| **Rating** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|------------|------------|------------|------------|--------------------------------|------------|
| AAA        |       |       | 2.6        | %                              |       |
| AA         |       |       | 5.3        |                           |       |
| A          |       |       | 71.6       |                           |       |
| BBB        |       |       | 20.5       |                           |       |
| Total      |       |       | 100.0      | %                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2004.

32

----

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

| **As of December 31, 2004**        | ** ** | ** **                           | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                             | ** ** | **(restated)**                       | ** ** | ** **              | ** ** |
| ** **                                             | ** ** | **(dollars 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  |   |

 

| **As of December 31, 2003**        | ** ** | ** **                           | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                             | ** ** | **(restated)**                       | ** ** | ** **              | ** ** |
| ** **                                             | ** ** | **(dollars in thousands)** | ** ** |
| Obligations of U.S.  states and political subdivisions |       |                                 | $          | 16,200             |       |                | $          | 16,200  |   |
| Corporate securities                                   |       |                                 | 175,118    |                    |       | 180,380             |       |
| Foreign                                                |       |                                 | 56,451     |                    |       | 61,207              |       |
| Asset-backed  securities(1)                            |       |                                 | 1,164,751  |                    |       | 1,164,751           |       |
| Short term investments                                 |       |                                 | 11,102     |                    |       | 11,102              |       |
| Total                                                  |       |                                 | $          | 1,423,622          |       |                | $          | 1,433,640  |   |

 

----

(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 at December 31,2004, 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** | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                                    | ** ** | **(restated)**          | ** ** | ** **          | ** ** |
| Due in one year  or less                                      |       |                    | $          | 184,365        |       |   | $ | 186,182  |   |
| Due after one  year through five years                        |       |                    | 28,936     |                |       | 30,985 |   |
| Due after five  years through ten years                       |       |                    | —     |                |       | — |   |
| Due after ten  years                                          |       |                    | 16,007     |                |       | 16,007 |   |
| Asset-backed  securities (stated maturities of 1 to 18 years) |       |                    | 1,114,375  |                |       | 1,114,375 |   |
| Total                                                         |       |                    | $          | 1,343,683      |       |   | $ | 1,347,549  |   |

 

**Employees**

At December 31, 2004,the Company and its subsidiaries had 345 employees. None of its employees arecovered by collective bargaining agreements. The Company considers its employeerelations to be satisfactory.

**Available Information**

The Company makesavailable, free of charge on or through its website, http://www.fsa.com, itsannual reports 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.

33

----

**Forward-Looking Statements**

The Company relies on the safe harbor for forward-lookingstatements provided by the Private Securities Litigation Reform Act of 1995.This safe harbor requires that the Company specify important factors that couldcause actual results to differ materially from those contained in forward-lookingstatements made by or on behalf of the Company. Accordingly, forward-lookingstatements by the Company and its affiliates are qualified by reference to thefollowing cautionary statements.

In its filings with the SEC, reports to shareholders,press releases and other written and oral communications, the Company from timeto time makes forward-looking statements. Such forward-lookingstatements include, but are not limited to:

·       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 to identify forward lookingstatements but are not the exclusive means of identifying such statements.

The Company cautions that a number of importantfactors could cause actual results to differ materially from the plans,objectives, expectations, estimates and intentions expressed in forward-lookingstatements made by the Company. These factors include:

·       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;

·       theamount and nature of business opportunities that may be presented to theCompany;

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

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

·       marketspreads and pricing on insured credit default swap exposures, which may resultin gain or loss due to mark-to-market accounting requirements;

34

----

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

·       changes in the value orperformance of strategic investments made by the Company; and

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

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 toupdate or revise such statements as a result of new information, future eventsor otherwise.

**Item 2.**                        Properties.

At December 31, 2004, the principal executiveoffices of the Company and FSA were located at 350 Park Avenue, New York, NewYork 10022, and consisted of approximately 79,000 square feet of office space. InJune 2005, the Company moved its principal executive offices to 31 West52nd Street, New York, New York, 10019. These new headquarters consist ofapproximately 110,000 square feet of office space.

FSA or its subsidiaries also maintain leased officespace in San Francisco, Dallas, Hamilton (Bermuda), London (England), Madrid(Spain), Paris (France), Singapore, Sydney (Australia) and Tokyo (Japan). TheCompany and its subsidiaries 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 have become party to certainlitigation. The Company is not subject to any material pending legalproceedings.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders.

On October 29, 2004, the Company’s shareholdersexecuted a Written Consent of Shareholders in Lieu of Annual Meeting, underwhich they unanimously approved:

·       fixingthe number of directors constituting the Board of Directors at twelve;

·       theelection of the following persons to serve as members of the Board of Directorsof the Company until the later of (1) the next annual meeting ofshareholders or (2) their successors having been duly elected andqualified:

RobertP. Cochran

PierreRichard

DirkBruneel

BrunoDeletre

RobertN. Downey

JacquesGuerber

DavidO. Maxwell

SéanW. McCarthy

JamesH. Ozanne

RogerK. Taylor

Rembertvon Lowis

George U. Wyper; and

·       theBoard of Directors’ selection of PricewaterhouseCoopers LLP as the Company’sindependent registered public accountants to audit the Company’s accounts forthe year 2004.

35

----

On November 18, 2004, the Company’s shareholdersexecuted a Written Consent of Shareholders under which they unanimouslyapproved the Company’s 2004 Equity Participation Plan (the “EquityParticipation Plan”), in the form approved by the Board of Directors of theCompany.

On May 19, 2005, the Company’s shareholdersexecuted a Written Consent of Shareholders in Lieu of Annual Meeting, underwhich they unanimously approved (a) re-election of the members of theBoard of Directors of the Company until the later of (1) the next annualmeeting of shareholders or (2) their successors having been duly electedand qualified and (b) selection of PricewaterhouseCoopers LLP as theCompany’s independent registered public accountants to audit the Company’saccounts for the year 2005.

On September 15, 2005, the Company’s shareholdersexecuted a Written Consent of Shareholders in Lieu of Meeting, under which theyunanimously approved amendments to the Equity Participation Plan to allowemployees more flexibility in employing restricted stock for payment of withholdingtaxes associated with restricted stock awards.

36

----

**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity and 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, a Belgiancorporation whose shares are traded in the Euronext Brussels and Euronext Parismarkets as well as on the Luxembourg Stock Exchange. See “Item 1. Business—Organization.”As a consequence of these actions, there is no longer an established publictrading market for the Company’s common stock, and bid quotations are notreported or otherwise available.

As of March 2005, the only holders of the Company’scommon stock were Dexia Holdings, an affiliate of White Mountains (a majorshareholder of the Company prior to the merger); and seven directors of theCompany who own shares of the Company’s common stock or economic intereststherein as described under in “Item 11. Executive Compensation—Director SharePurchase Program.”

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 dividends in May 2004, paying a dividend on its commonstock of $0.2275 per share for each of the final three quarters of 2004,totaling $22.9 million in aggregate for 2004. The Company paid dividendsof $53.3 million in the nine month period ended September 30, 2005. 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—Securities Available Under Equity Compensation Plans.”

37

----

**Item6.**                     SelectedFinancial Data.

Thefollowing Selected Consolidated Financial Data should be read in conjunctionwith the Consolidated Financial Statements and accompanying notes includedelsewhere herein. The Company has restated its financial statements for 2004,2003, 2002 and 2001. The restated financial statements reflect the reversal ofhedge accounting treatment for certain hedging relationships and otherunrelated adjustments. See Note 3 to the Consolidated Financial Statements inItem 8.

| ** **                                     | ** ** | **As of and for the Year Ended December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2004**                                                                              | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                     | ** ** | **(restated)**                                                                        | ** ** | **(restated)** | ** ** | **(restated)** | ** ** | **(restated)** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **(dollars in millions)**                                                   | ** ** |
| **SUMMARY  OF OPERATIONS(a)**                  |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Gross premiums  written                        |       | $                                                                                     | 832.0      |   | $ | 895.8 |   | $ | 803.7 |   | $ | 485.6 |   | $ | 372.3 |   |
| Net premiums  written                          |       | 587.8                                                                                 |       | 614.3 |   | 532.7 |   | 319.6 |   | 218.1 |   |
| Net premiums  earned                           |       | 395.0                                                                                 |       | 356.4 |   | 314.9 |   | 231.0 |   | 192.1 |   |
| Net investment  income                         |       | 172.1                                                                                 |       | 154.0 |   | 139.1 |   | 128.9 |   | 121.1 |   |
| Net income                                     |       | 378.6                                                                                 |       | 298.1 |   | 197.0 |   | 205.7 |   | 63.3 | (e) |
| **BALANCE  SHEET DATA(a)**                     |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Investment  portfolio(b)                       |       | 13,836.8                                                                              |       | 9,493.2 |   | 5,037.4 |   | 3,214.1 |   | 2,234.9 |   |
| Total assets(b)                                |       | 17,081.0                                                                              |       | 12,407.6 |   | 7,045.8 |   | 4,309.9 |   | 3,148.7 |   |
| Deferred premium  revenue                      |       | 2,095.4                                                                               |       | 1,845.0 |   | 1,448.2 |   | 1,095.0 |   | 936.8 |   |
| Losses and loss  adjustment expense            |       | 179.9                                                                                 |       | 233.4 |   | 223.6 |   | 114.4 |   | 116.3 |   |
| Notes payable                                  |       | 430.0                                                                                 |       | 430.0 |   | 430.0 |   | 330.0 |   | 230.0 |   |
| GIC and VIE debt                               |       | 10,444.1                                                                              |       | 6,639.4 |   | 2,409.9 |   | 601.8 |   | — |   |
| Common  shareholders’ equity              |       | 2,611.3                                                                               |       | 2,219.2 |   | 1,919.4 |   | 1,633.8 |   | 1,465.7 |   |
| **ADDITIONAL  DATA**                           |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Qualified  statutory capital(c)                |       | 2,280.9                                                                               |       | 2,104.3 |   | 1,876.1 |   | 1,593.6 |   | 1,436.7 |   |
| Total claims-paying  resources(d)              |       | 5,230.6                                                                               |       | 4,657.7 |   | 3,819.1 |   | 3,217.3 |   | 2,805.1 |   |
| Net par  outstanding                           |       | 317,742.6                                                                             |       | 289,200.2 |   | 263,010.5 |   | 217,110.8 |   | 154,019.8 |   |
| Net insurance in  force (principal + interest) |       | 444,511.5                                                                             |       | 403,019.4 |   | 364,908.5 |   | 300,637.1 |   | 225,426.4 |   |
| Total dividends                                |       | 22.9                                                                                  |       | — |   | 11.7 |   | 31.1 |   | 7.9 |   |
|                                                |            |                                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(a)           Prepared in accordancewith accounting principles generally accepted in the United States of America.

(b)          VIE balances areincluded beginning July 1, 2003 due to the adoption of FinancialAccounting Standards Board Interpretation No. 46, “Consolidation ofVariable Interest Entities, an interpretation of ARB No. 51.”

(c)           Amounts are statutorydata for FSA and therefore differ from comparable GAAP amounts.

(d)          Total claims-payingresources refers to a term used by Moody’s to evaluate adequacy of claims-payingresources and credit ratings. Moody’s uses its judgment in making adjustmentsto some of the measures. The Company provides the adjusted balances. This termrepresents the sum of statutory capital, statutory unearned premium reserve,present value of future net installment premiums, statutory loss reserve,credit available under standby line of credit facility and money marketcommitted preferred trust securities.

(e)           $138.8 million ofnet income excluding merger-related costs.

38

----

**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results 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, in order to produce a reliable, predictable earnings stream.Strategically, the Company seeks to maintain balanced capabilities acrossdomestic and international asset-backed and municipal markets in order toallow the flexibility to pursue the most attractive opportunities available atany point in the business cycle. References to the “Company” are to FinancialSecurity 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 2004 GAAP resultswith those of 2003, the Company’s total revenues increased 29.9% to $1,130.1million, and net income increased 27.0% to $378.6 million. Gross premiumswritten declined 7.1% to $832.0 million due primarily to a decline in upfrontpremiums from municipal business. Shareholders’ equity increased 17.7% to $2.6billion.

**Results of Operations**

***Premiums***

**NetEarned and Written Premiums**

| ** **                                                | ** ** | **Year Ended December 31,** | ** **  |
|-----------------------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                                | ** ** | **2004**                                   | ** **  | **2003** | ** ** | **2002** | ** ** |
| ** **                                                | ** ** | **(dollars in millions)**        | ** **  |
| Premiums written,  net of reinsurance                     |       | $                                          | 587.8  |   | $ | 614.3  |   | $ | 532.7  |   |
| Premiums earned,  net of reinsurance                      |       | 395.0                                      |        | 356.4 |   | 314.9 |   |
| Net premiums earned  excluding refundings and prepayments |       | 350.6                                      |        | 324.9 |   | 286.9 |   |
|                                                           |            |                                            |             |  |  |  |  |  |  |  |

 

Net premiums earnedincreased 10.8% in 2004 and 13.2% in 2003. Excluding the effects of refundingsand prepayments, net premiums earned increased 7.9% in 2004 and 13.2% in 2003.Refundings and prepayments result from interest-rate movements and otherfactors outside the Company’s control, and no assurance can be given thatrefundings and prepayments will continue at the recent level. The recent slowergrowth rate in earned premiums is a function of the relatively highercontribution from U.S. municipal originations, which generally have longermaturities and therefore a slower earnings process.

***New Business Production***

As explained in detailbelow, for each accounting period, the Company estimates the present value oforiginations (“PV originations”). This non-GAAP measure consists of thetotal present value of premiums originated (“PV premiums originated”) byFinancial Security Assurance Inc. (“FSA”) and the present value of net interestmargin originated (“PV NIM originated”) by the FP Segment. The Companygenerated PV originations of $927.2 million in 2004, $894.6 million in 2003 and$881.8 million in 2002. Management believes that by disclosing the componentsof PV originations in addition to premiums 

39

----

written,the Company provides investors with a more comprehensive description of its newbusiness activity in a given period.

*PresentValue of Premiums Originated*

The GAAP measure “gross premiums written” capturespremiums collected in a given period, whether collected for business originatedin the period, or in installments for business originated in prior periods. Itis not a precise measure of current-period originations because asignificant portion of the Company’s premiums are collected in installments.Therefore, to measure current-period premium production, managementcalculates the gross present value of premium installments originated in theaccounting period and combines it with premiums received upfront in theaccounting period, which produces the non-GAAP measure PV premiumsoriginated.

The Company’s insurance policies and insured creditderivative contracts are generally non-cancelable and remain outstandingfor years from date of inception, in some cases as long as 30 years.Accordingly, current-period premium production, as distinct from earnedpremium, represents premiums to be earned in the future.

Viewed at a policy level, installment premiums aregenerally calculated as a fixed premium rate multiplied by the insured debtoutstanding as of dates established by the terms of the policy. Because theactual installment premiums received could vary from the amount estimated atthe time of origination based on variances in the actual outstanding debtbalances as of the pre-established dates, the realization of PV premiumsoriginated could be greater or less than the amount reported.

Installment premiums are not recorded in the financialstatements until due, which is a function of the terms of each insurancepolicy. Future non-cancelable 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 originated reflects estimated futureinstallment premiums discounted to their present value, as well as upfrontpremiums, but only for business originated during the period. To calculate PVpremiums originated, management discounts an estimate of all future installmentpremium receipts at a rate representing the Company’s three-year trailingaverage insurance investment portfolio return. The estimated installmentpremium receipts are determined based on each installment policy’s projectedpar balances outstanding multiplied by its premium rate. The Company’sTransaction Oversight Departments estimate the relevant schedule of future parbalances outstanding for each insurance policy with installment premiums. Atthe time of origination, projected debt schedules are generally based on goodfaith estimates developed and used by the parties negotiating the transaction.The Company calculates the discount rate for PV premiums originated as theaverage pre-tax yield on its investment portfolio for the previous threeyears. This serves as a proxy for the return that could be achieved if thepremiums had been received upfront.

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 5.62% for 2004 originations and 5.91% for 2003originations. Management intends to revise the discount rate in future yearsaccording to the same methodology, in order to reflect specific return resultsrealized by the Company.

40

----

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

| ** **                                    | ** ** | **Year Ended December 31,** | ** **  |
|-----------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                    | ** ** | **2004**                                   | ** **  | **2003** | ** ** | **2002** | ** ** |
| ** **                                    | ** ** | **(dollars in millions)**        | ** **  |
| Gross premiums  written                       |       | $                                          | 832.0  |   | $ | 895.8  |   | 803.7 |   |
| Gross installment  premiums received          |       | (332.4                                     | )           | (345.2 | ) | (321.6 | ) |
| Gross upfront  premiums originated            |       | 499.6                                      |        | 550.6 |   | 482.1 |   |
| PV estimated  installment premiums originated |       | 353.9                                      |        | 299.9 |   | 334.0 |   |
| PV premiums originated                        |       | $                                          | 853.5  |   | $ | 850.5  |   | $ | 816.1  |   |
|                                               |            |                                            |             |  |  |  |  |  |  |  |

 

*Financial GuarantyInsurance Originations*

Unless otherwise noted, percentage changes in thisdiscussion and analysis compare the period named with the comparable period ofthe prior year.

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

**U.S.Municipal New Originations**

| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Gross par insured  (in billions)            |       | $                                          | 49.0  |   | $ | 54.9  |   | $ | 51.6  |   |
| Gross PV premiums  originated (in millions) |       | 433.5                                      |       | 483.1 |   | 420.7 |   |
|                                             |            |                                            |            |  |  |  |  |  |  |  |

 

New-issue volume in the U.S. municipal bondmarket totaled approximately $360.2 billion, on a sale date basis, a 6.1%decline from the record level of $383.7 billion in 2003 and slightly more thanthe $358.8 billion in 2002. Insurance penetration was approximately 54%,compared with 50% in both 2003 and 2002. In all three years, low interestrates, strong demand for refundings and continuing needs for infrastructureinvestment drove high levels of municipal borrowing. FSA guaranteedapproximately 24% of the insured par amount of municipal bonds sold in 2004,and approximately 27% of the insured par amount of municipal bonds sold in 2003and 2002.

Including both primary andsecondary U.S. municipal obligations with closing dates in 2004, FSA’s U.S.municipal par originated declined 10.7%, and the related PV premiums originateddeclined 10.3%. FSA increased its PV premiums originated in the health carerevenue and general obligation sectors during the year, but those increaseswere offset by declines in the non-general obligation tax-supportedsector and various revenue-backed sectors. In 2003, the U.S. municipalpar amount insured by FSA increased 6.3%, and PV premiums originated increased14.8%. Municipal premium rates were strong throughout 2003 due to wider creditspreads than in prior periods.

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

| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Gross par insured  (in billions)            |       | $                                          | 48.6  |   | $ | 15.6  |   | $ | 35.6  |   |
| Gross PV premiums  originated (in millions) |       | 234.2                                      |       | 177.6 |   | 196.1 |   |
|                                             |            |                                            |            |  |  |  |  |  |  |  |

 

The Company’s U.S. asset-backedgross par insured rose 211% in 2004. The Company’s associated PV premiumsoriginated, which increased 31.9%, 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 

41

----

toachieve good returns on equity. In 2003, par originated in FSA’s U.S. asset-backedbusiness declined 56.2%, while PV premiums originated declined 9.4%. Comparedwith 2002 activity, the Company’s asset-backed business reflected a shiftaway from large Super Triple-A CDSs, Triple-A tranches ofresidential mortgage-backed securities and auto loan transactions towardhigher premium types of transactions, including Triple-A collateralizedloan obligations (“CLOs”) and certain residential mortgage and consumer financeissues.

**InternationalNew Originations**

| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Gross par insured  (in billions)            |       | $                                          | 10.2  |   | $ | 10.3  |   | $ | 19.8  |   |
| Gross PV premiums  originated (in millions) |       | 185.8                                      |       | 189.8 |   | 199.3 |   |
|                                             |            |                                            |            |  |  |  |  |  |  |  |

 

Full-yearinternational par insured for 2004 approximated that of the prior year, andinternational PV premium originations decreased 2.1%. FSA had expected toinsure a greater number of infrastructure transactions during the year, butsome significant transactions were postponed. In 2003, the 4.8% decline ininternational PV premiums originated was less than the 48.0% decline in grosspar insured, largely because of a shift from Super Triple-A pooledcorporate CDS to a broader range of transactions, including CLOs, syntheticresidential mortgage securitizations and other structured financings.Infrastructure financings contributed the largest share of internationalpremium production in 2003. PV premiums for international originations aretranslated into U.S. dollars using month-end currency exchange rates.Actual premiums received could differ from this amount due to exchange-ratefluctuations.

*Financial ProductsOriginations*

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

Guaranteed investment contracts (“GICs”) are issued ator converted into LIBOR-based floating rate obligations, with proceedsinvested in or converted into LIBOR-based floating-rate investmentsintended to result in profits from a higher investment rate than borrowingrate. The difference between the investment revenue and the borrowing cost isthe FP NIM.

The non-GAAP measure PV NIM represents the differencebetween present value of the 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 expected hedge derivativeresults. PV NIM is calculated after giving effect to swaps and other derivativesthat convert substantially all fixed-rate assets and liabilities to floatingrates. At the time of origination, all interest rate hedges are assumed to becompletely effective. The Company’s future positive interest rate spread can bereasonably estimated and generally relates to contracts or security instrumentsthat 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 FP NIM to be earned and includes it in adjusted bookvalue as an element of intrinsic value that is not found in GAAP book value. PVNIM represents the difference between the estimated interest to be received onthe investments and the estimated interest to be paid on liabilities issued inthe form of GICs, net of expected hedge derivative results. PV NIM iscalculated after giving effect to swaps and other derivatives that convertsubstantially all fixed-rate assets and liabilities to floating rates. Atthe time of origination, all interest-rate hedges are assumed to becompletely effective.

42

----

For each accountingperiod, the Company reports the non-GAAP measure PV NIM originated,reflecting its estimate of that period’s new business PV NIM generated by theFP Segment. The majority of municipal GICs issued by the GIC Affiliates relateto debt service reserve funds and construction funds in support of municipalbond transactions. These funds may be drawn unexpectedly, with the result thatthe actual timing and amount of repayments may differ from the originalestimates, which in turn would affect the realization of the estimate of PV NIMoriginated in a given accounting period. PV outstanding is 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. Installment payment contracts, whether in the form of premiums or FPNIM, are generally non-cancelable by the Company and represent a claim tofuture cash flows. Therefore, management includes these amounts in its estimateof ABV.

**FinancialProducts PV NIM Originated**

| ** **                                                    | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                    | ** ** | **(dollars in millions)**        | ** ** |
| Gross present  value of future net interest margin originated |       | $                                          | 73.7  |   | $ | 44.1  |   | $ | 65.7  |   |
|                                                               |            |                                            |            |  |  |  |  |  |  |  |

 

PV NIM originated rose67.1% in 2004. This growth reflects increased activity in both municipal andstructured GICs. PV NIM originated for 2003 was 32.9% below PV NIM originatedfor 2002. The Company constrained its GIC activity during the first four monthsof 2003 as it approached a regulatory limit of 100 non-qualified holders.This limit was lifted when the Company received an exemption from theInvestment Company Act in April 2003.

***Operating Earningsand Adjusted Book Value***

In addition to evaluatingthe Company’s GAAP-based financial information, management evaluates theCompany’s business under certain non-GAAP performance measures that managementrefers to as operating earnings and adjusted book value (“ABV”). Managementuses these two key metrics to measure company performance and to calculatelong-term incentive compensation and the annual bonus pool. Management refersto this information in its presentations with rating agencies and the Board ofDirectors. While these metrics are not substitutes for reported results underGAAP, management regards operating earnings and adjusted book value 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 tool for providing a more complete understanding ofthe Company’s results of operations.

TheCompany defines Operating Earnings as net income before the effects of fairvalue adjustments for two items:

1.                Interestrate derivatives that are intended to hedge fixed rate assets and liabilitiesbut do not 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-insuredcredit default swaps (CDS) that have investment grade underlying credit qualityand that must be marked to fair value under SFAS 133.

Periodic unrealized gainsand losses related to interest rate hedges arise in both the financial guarantyand financial products business segments, caused primarily by the one-sidedmark-to-market derivative valuations prescribed by SFAS 133 for derivativesthat do not qualify for “hedge treatment” under GAAP. Under the Company’sdefinition of operating earnings, the economic effect of these hedges isrecognized, which, for interest rate swaps, generally results in any cash paidor received being recognized ratably as an expense or revenue over the hedgeditem’s life. Futures contracts used to hedge interest rate risk include boththe embedded current net interest paid or received, as well as the value of thefuture net interest flow. 

43

----

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 aregenerally non-cancelable prior to maturity, and the Company views insured CDSrisks as comparable to other insured risks. In a typical CDS transaction, theCompany, in exchange for an upfront or periodic premium, indemnifies theinsured for economic losses (in excess of some agreed-upon deductible) relatedto specified reference obligations, primarily pools of corporate debtsecurities or bank loans, structured such that the risk insured is investmentgrade without the benefit of the credit protection provided by the Company. Inthe event a CDS were to migrate below investment grade, the fair-value impactwould be fully reflected in operating earnings.

Operating earnings aresubject to certain general and specific limitations that investors shouldcarefully consider. For example, as stated above, unlike financial accounting,there is no comprehensive, authoritative guidance for management reporting. TheCompany’s operating earnings are not defined terms within GAAP and may not becomparable to similarly titled measures reported by other companies. UnlikeGAAP, the Company’s operating earnings presentation does not represent acomprehensive basis of accounting. Investors, therefore, should not compare theCompany’s performance with that of other financial guaranty companies basedupon operating earnings. Operating earnings results are only meant to supplementGAAP results by providing additional information regarding the operational andperformance indicators that are most closely used by management, the Company’sboard of directors and rating agencies to assess performance.

Other limitations arise fromthe specific adjustments that management makes to GAAP results to deriveoperating earnings results. For example, in reversing the unrealized gains andlosses that result from SFAS 133, on 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 FSAGlobal business, the presentation understates earnings volatility.

Operating earnings resultsalso exclude earnings variability related to CDS fair value adjustments. Asignificant percentage of the Company’s CDS exposures subject to fair-valueadjustments are considered Triple-A or Super Triple-A (defined ascredit quality based on loss protection which is greater than 1.3 timesthe Triple-A standard), and the Company and its subsidiaries do notintend to trade these highly rated, highly structured contracts. Accordingly,management believes it is probable that the financial impact of the fair-valueadjustments for the insured CDS will sum to zero over the finite terms of theexposures, which are typically five to ten years at inception. For this reason,management believes that the market volatility of credit-spread pricing,the primary driver of the Company’s change in fair-value results, shouldnot influence a measure of the Company’s operating performance.

Operating earningsincreased 22.6% in 2004 and 21.4% in 2003.

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

| ** **                                                      | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                      | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                      | ** ** | **(restated)**                             | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| ** **                                                      | ** ** | **(dollars in millions)**        | ** ** |
| Net income                                                      |       |                                       | $          | 378.6  |   |   |   | $ | 298.1  |   |   |   | $ | 197.0  |   |   |
| Less fair-value adjustments for economic interest  rates hedges |       |                                       | 17.6       |   |   |   | 11.1 |   |   |   | 13.9 |   |   |
| Less fair-value adjustments for insured CDS,  net of taxes      |       |                                       | 37.7       |   |   |   | 23.4 |   |   |   | (34.1 | ) |   |
| Operating earnings                                              |       |                                       | $          | 323.3  |   |   |   | $263.6 |   |   |   | $ | 217.2  |   |   |

 

44

----

***Adjusted Book Value***

To calculate ABV, thefollowing adjustments, on an after-tax basis, are made to shareholders’equity (GAAP “book value”):

1.                additionof unearned premium revenues, net of amounts ceded to reinsurers;

2.                additionof the present value of future installment premiums, net of amounts ceded toreinsurers;

3.                additionof the present value of future net interest margin;

4.                subtractionof the deferred costs of acquiring policies;

5.                eliminationof the effect of fair-value adjustments for insured CDS;

6.                eliminationof the fair-value adjustments for economic interest rate hedges; and

7.                eliminationof unrealized gains or losses on investments.

Management considers ABV ameasure of the Company’s intrinsic value, exclusive of franchise value. Book valuereflects an estimate of loss for all insured risks made at the time of contractorigination. ABV adds back certain GAAP liabilities and deducts certain GAAPassets (adjustments 1, 4, 5, 6 and 7 in the calculation above), and capturesthe estimated value of future contractual cash flows related to transactions inforce as of the balance sheet date (adjustments 2 and 3 in the calculationabove) because installment payment contracts, whether in the form of premiumsor NIM, are generally non-cancelable and represent a claim to future cashflows. An investor attempting to evaluate the Company using GAAP measures alonewould not have the benefit of this information. In addition, investors mayconsider the growth of ABV to be a performance measure indicating the degree towhich management has succeeded in building a reliable source of futureearnings. Certain of the Company’s compensation formulas are based, in part, onthe ABV growth rate.

The limitation of the ABVmetric is that it reflects certain assets and liabilities and acceleratedrealization through equity, and relies on an estimate of the amount and timingof the receipt of installment premiums and future net interest margin. Actualinstallment premium receipts could vary from the amount estimated based on theactual insured outstanding debt balances as of the future dates used tocalculate those premiums due. Actual net interest margin results could varyfrom the amount estimated based on variances in the actual timing and amount ofrepayment associated with flexible-draw GICs that the Company issues. ABVexcludes the fair-value of investment-grade insured CDS and thefair value of derivatives that hedge interest rate risk but do not qualify forhedge accounting under SFAS 133.

Adjustments 1, 2 and 3 aboverepresent the sum of cumulative years’ reported PV premiums originated and PVNIM originated, less what has been earned or adjusted due to changes inestimates as described above. Adjustment 4 reflects the realization in equityof deferred costs associated with the origination of premiums.

Adjustments 1 and 2 abovein the calculation of ABV together represent the Company’s best estimate of theCompany’s present value of its future premium revenues (comprising current-and prior-period originations that have not yet been earned). Debtschedules related to installment transactions change from time to time.Critical assumptions underlying adjustment 2 are discussed above under “NewBusiness Production—Financial Guaranty Insurance Originations.”

As discussed above under “NewBusiness Production—Financial Products Originations,” the Company calculates PVNIM (adjustment 3 above) because net interest income and net interest expensereflected in the statement of operations 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 U.S. GAAP book value.

45

----

Through adjustments 5 and 6 above, ABV excludes theeffect of certain items that are also excluded from operating earnings. 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 Global Funding portfolio, although they do not meet SFAS 133 hedgeaccounting requirements. The Company uses such derivatives to hedge againstinterest rate volatility, rather than to speculate on the direction of interestrates. The intent of management is to hold the derivatives to expected maturityalong with the related hedged fixed rate assets or liabilities. Therefore, thefair value adjustments’ financial impact is expected to sum to zero over thederivatives’ holding term. In addition, ABV excludes the effect of fair valueadjustments made to investments and reflected in other comprehensive income(OCI) rather than net income. As the objective is to optimize long term stableearnings, management generally seeks to minimize turnover and therefore unrealizedinvestment gain or loss is subtracted from book value to exclude such componentfrom the ABV metric. In the event that an investment is liquidated prior to itsmaturity, any related gain or loss is reflected in both earnings and ABVwithout further adjustment.

Shareholders’ equity was$2.6 billion and non-GAAP ABV was $3.5 billion at December 31, 2004.During 2004, ABV grew 15.6%.

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

| ** **                                                        | ** ** | **As of December 31,** | ** **    |
|-------------------------------------------------------------------|------------|---------------------------------------|---------------|
| ** **                                                        | ** ** | **2004**                              | ** **    | **2003** | ** ** |
| ** **                                                        | ** ** | **(restated)**                        | ** **    | **(restated)** | ** ** |
| ** **                                                        | ** ** | **(dollars in millions)**   | ** **    |
| Shareholders’  equity (book value)                           |       | $                                     | 2,611.3  |   | $ | 2,219.1  |   |
| After-tax  adjustments:                                           |       |                                  |          |   |   |
| Plus net unearned premium revenues                                |       | 868.6                                 |          | 747.2 |   |
| Plus present value of net future installment  premiums and PV NIM |       | 497.3                                 |          | 424.1 |   |
| Less net deferred acquisition costs and goodwill                  |       | 200.3                                 |          | 185.3 |   |
| Less fair value adjustments for insured CDS                       |       | 31.4                                  |          | (6.3 | ) |
| Less fair-value adjustments for economic interest  rate hedges    |       | 63.8                                  |          | 35.8 |   |
| Less unrealized  gains on investments                             |       | 199.8                                 |          | 164.6 |   |
| Adjusted book  value                                              |       | $                                     | 3,481.9  |   | $ | 3,011.0  |   |

 

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

Net investment incomeincreased 11.7% in 2004, primarily due to higher invested balances arising fromnew business writings, partially offset by lower reinvestment rates stemmingfrom the low interest-rate environment during the year. Net investmentincome increased 10.7% in 2003 from that of the prior year, primarily due tohigher invested balances arising from new business writings. For furtherdiscussion, see “Liquidity and Capital Resources,” below.

**Income fromInvestments**

| ** **                                                                                                              | ** ** | **Year Ended December 31,** | ** **  |
|-------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                                                                                              | ** ** | **2004**                                   | ** **  | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                              | ** ** | **(dollars in millions)**        | ** **  |
| Net investment  income                                                                                                  |       | $                                          | 172.1  |   | $ | 154.0  |   | $ | 139.1  |   |
| Net realized  gains                                                                                                     |       | (0.5                                       | )           | 5.1 |   | 29.2 |   |
| Effective tax rate on  investment income excluding effects of realized gains and losses and variable  interest entities |       | 9.2                                        | %           | 9.2 | % | 10.4 | % |
|                                                                                                                         |            |                                            |             |  |  |  |  |  |  |  |

 

46

----

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

***Losses and Loss Adjustment Expenses***

Theprovision for losses and loss adjustment expenses was $20.6 million in2004, $34.5 million in 2003 and $65.6 million in 2002. Activity inthe liability for losses and loss adjustment expenses, which consists of case andnon-specific reserves, is summarized as follows:

| ** **                            | ** ** | **Case Reserve Activity for the  Year Ended December 31,** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **      2004      **              | ** ** | **      2003      ** | ** ** | **      2002      ** | ** ** |
| ** **                            | ** ** | **(dollars in millions)**                                                           | ** ** |
| Gross balance at  January 1      |       |                                                                                          | $          | 121.9  |   |   |   | $ | 134.0  |   |   |   | $ | 45.4  |   |   |
| Less reinsurance recoverable          |       |                                                                                          | 59.2       |   |   |   | 76.0 |   |   |   | 28.9 |   |   |
| Net balance at  January 1        |       |                                                                                          | 62.7       |   |   |   | 58.0 |   |   |   | 16.5 |   |   |
| Transfer from non-specific  reserve   |       |                                                                                          | 30.7       |   |   |   | 12.7 |   |   |   | 45.0 |   |   |
| Restructured  transactions            |       |                                                                                          | (13.9      | ) |   |   | (2.2 | ) |   |   | — |   |   |
| Paid (net of recoveries)  related to: |       |                                                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Current year                          |       |                                                                                          | —     |   |   |   | — |   |   |   | — |   |   |
| Prior year                            |       |                                                                                          | (34.3      | ) |   |   | (5.8 | ) |   |   | (3.5 | ) |   |
| Total paid                            |       |                                                                                          | (34.3      | ) |   |   | (5.8 | ) |   |   | (3.5 | ) |   |
| Net balance at  December 31      |       |                                                                                          | 45.2       |   |   |   | 62.7 |   |   |   | 58.0 |   |   |
| Plus reinsurance recoverable          |       |                                                                                          | 35.4       |   |   |   | 59.2 |   |   |   | 76.0 |   |   |
| Gross balance at  December 31    |       |                                                                                          | $          | 80.6  |   |   |   | $ | 121.9  |   |   |   | $ | 134.0  |   |   |

 

| ** **                            | ** ** | **Non-Specific Reserve Activity for the  Year Ended December 31,** | ** ** |
|---------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **      2004      **                      | ** ** | **      2003      ** | ** ** | **      2002      ** | ** ** |
| ** **                            | ** ** | **(dollars in millions)**                                                                   | ** ** |
| Balance at  January 1            |       |                                                                                                  | $          | 111.5  |   |   |   | $ | 89.7  |   |   |   | $ | 69.1  |   |   |
| Provision for losses                  |       |                                                                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Current year                          |       |                                                                                                  | 20.4       |   |   |   | 22.4 |   |   |   | 21.1 |   |   |
| Prior year                            |       |                                                                                                  | 0.2        |   |   |   | 12.1 |   |   |   | 44.5 |   |   |
| Transfers to case  reserves           |       |                                                                                                  | (30.7      | ) |   |   | (12.7 | ) |   |   | (45.0 | ) |   |
| Restructured transactions             |       |                                                                                                  | (2.1       | ) |   |   | — |   |   |   | — |   |   |
| Balance at  December 31          |       |                                                                                                  | 99.3       |   |   |   | 111.5 |   |   |   | 89.7 |   |   |
| Total case and non-specific  reserves |       |                                                                                                  | $          | 179.9  |   |   |   | $ | 233.4  |   |   |   | $ | 223.7  |   |   |

 

The gross and net par amounts outstanding ontransactions with case reserves were $791.4 million and$752.8 million, respectively, at December 31, 2004. The net case reserveconsisted primarily of six CDO transactions and one municipal transaction,which collectively accounted for approximately 95% of the total net casereserve. The remaining 11 exposures were in various sectors.

Reserves for losses and loss adjustment expenses arediscounted when established at the then current risk-free rates. Thecumulative amount of net discount taken was approximately $59.5 million atDecember 31, 2004, $65.9 million at December 31, 2003 and$44.7 million at December 31, 2002.

During 2004, the Company charged $20.6 million toloss expense, consisting of $25.0 million for originations of new businessand accretion on in-force business and $3.2 million related toreassumptions of previously ceded business, offset by reserve releases primarilyrelated 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 offset byloss expense of $20.6 million. Case 

47

----

reserves decreased$17.5 million due to (1) a large, voluntarily accelerated transactionthat had a $34.3 million payment and (2) reclassifications fromreserves to asset valuation accounts for refinanced transactions of$13.9 million offset by transfers from the non-specific reserve of$30.7 million. See Note 23 to the Consolidated Financial Statementsin Item 8.

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 relating to a restructured transaction to securitizedloans on the balance sheet. See Note 23 to the Consolidated FinancialStatements in Item 8.

In the second quarter of 2002, as part of the Company’songoing credit review process, management identified certain transactions notperforming as expected in its portfolio of insured CDOs. As a result,management undertook a quantitative analysis of all CDO transactions in itsinsured portfolio that breached senior overcollateralization triggers, whichwere included in such transactions as one measure of adverse performance. Apresent value “deterministic” approach was utilized to estimate the lossinherent in this portfolio. The deterministic model takes the averagecumulative default rate produced by a Monte Carlo simulation and applies thosedefaults to a cash flow model using (i) a timing sequence dependent on theportfolio’s rating and maturity composition, (ii) an estimate ofcollateral recovery values for severity and (iii) the LIBOR forward curveas a predictor of interest rates. Management assumed that current default rateson CDO collateral would improve in a manner consistent with an economicrecovery following a period of significant credit deterioration similar to thatexperienced in 1991/1992 and, as a result, management utilized the Moody’s idealizeddefault curve, adjusted by a factor consistent with the relationship betweenthe 1992 cohort experience and the Moody’s 30-year average default rate.The per-period default rate was calculated based on the Moody’s weighted-averagerating factor for each piece of surviving collateral. Recovery rates werejudgmentally established by the Company. In considering the recovery rates tobe utilized, management adjusted Moody’s average recovery rates (observed since1982) downward to reflect more recent adverse observations.

At June 30, 2002, this analysis produced apresent value of expected losses of $51.5 million, net of reinsurancerecoveries and net of unearned premiums and future ceding commissions.Management addressed this net present value of expected loss($51.5 million) through (i) an increase in the Company’s non-specificreserve ($31.0 million) and (ii) amounts already existing in its non-specificreserve ($20.5 million), including non-specific reserve amountsreallocated to case reserves ($11.3 million). The $31.0 millionincrease in the Company’s non-specific reserve resulted in acorresponding increase to losses and loss adjustment expenses in the Statementsof Operations and Comprehensive Income of $31.0 million. An additionaladjustment of $10.1 million was made in the fourth quarter of 2002 as aresult of further deterioration of the CDO portfolio, resulting in an increaseto loss expense and a corresponding increase to the non-specific reserve.Management established a methodology of recording case reserves on CDOtransactions based on the extent to which the overcollateralization ratio (non-defaultedcollateral at par value divided by the debt insured) has fallen below 100%,since management believes that claims on such transactions are probable andthat the amount of the undercollateralization is a reasonable estimate of suchclaims. Such transactions may benefit from excess cash flow attributable inpart to higher interest rates on the underlying collateral than on the insuredsecurities. In addition, such transactions generally require insured paymentsof principal only at the ultimate maturity of such transactions. As a result,the Company does not expect to be required to pay claims on these transactionsfor several years, but may elect to do so at earlier dates at its discretion.In some cases since 2002, the Company has elected to pay claims earlier thanrequired. Application of this methodology resulted in recording $68.8 millionin gross 

48

----

case reserves and$29.8 million in reinsurance recoverable on unpaid losses, resulting in a$39.0 million increase in net case reserves in 2002. Management, beginningin the second quarter of 2002, has refined the loss factor it applies to itsnet par underwritten when calculating the non-specific reserve in orderto reflect its recent adverse experience. As a result, the non-specificreserve accrual for the year ended December 31, 2002 was$65.6 million, rather than the approximately $14.9 million that would havebeen accrued using the prior assumptions.

During 2002, the Company increased its non-specificreserve by $65.6 million, of which $41.1 million related to the CDOportfolio discussed above, $21.1 million was for origination of newbusiness and $3.4 million was for accretion of the discount on prior years’reserves. Also during 2002, the Company transferred to the non-specificreserve $0.8 million representing recoveries received on prior-yeartransactions and transferred $45.8 million from the non-specificreserve to case reserves.

Since case and non-specific reserves are basedon estimates, there can be no assurance that the ultimate liability will notdiffer from such estimates. The Company will continue, on an ongoing basis, tomonitor these reserves and may periodically adjust such reserves, upward ordownward, based on the Company’s actual loss experience, its future mix ofbusiness and future economic conditions.

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

| ** **                          | ** ** | **As of December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Case reserve  discount rate         |       | 3.13%–5.90%                      |       | 4.94%–6.10% |   |
| Non-specific  reserve discount rate |       | 1.20%–7.95%                      |       | 1.2%–7.95% |   |
| Current experience  factor          |       | 2.0                                   |       | 2.4 |   |

 

The primary estimates affecting the statisticalcalculation are (a) probability of default and (b) severity of lossgiven default. The Company applies its experience factor to the statisticalcalculation to reflect actual loss experience in terms of both frequency andseverity. Historically, defaults on guaranteed obligations have beeninfrequent, but the size of resulting claims have varied widely due to both thediffering sizes of the obligations guaranteed and the significant variabilityof the severity experienced. Severity represents the magnitude of loss, whichis calculated as par guaranteed 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 broad diversification of FSA’s insuredportfolio, management believes that a systemic shift in overall portfolioquality is unlikely to occur except in a catastrophic economic environment. Itis therefore necessary to look at particular sectors when examining thesensitivity of the insured portfolio to changes in underlying loss assumptions.Management believes that different analyses are required for the two broadsectors of the insured portfolio, asset-backed obligations and municipalcredits.

Asset-backed obligations insured by FSA aresecured by pools of assets. While the assets in a given transaction aregenerally of one type (such as automobile loans, residential mortgage loans,etc.), they are diversified within that asset type. Due to characteristicallylow default frequency, losses on insured asset-backed transactions havebeen manageable in management’s view, despite variability.

49

----

Management believes severity is not the primarydeterminant of possible loss in a portfolio of insured asset-backedobligations. Since introducing a non-specific reserve in 1993, actualaggregate losses have been reasonably consistent with management’s expectationin the majority of asset-backed categories, including insured obligationscollateralized by automobile loan or residential mortgage debt of non-primeborrowers. The one exception involved senior bonds issued in 1998 and 1999 inconnection with structured CDOs. In such a structure, the bonds insured by FSAare in second-loss positions, meaning that there are uninsured,subordinate bondholders or equity investors who must lose all of theirinvestment outstanding at the time of default or earlier trigger event beforethe FSA-insured bonds become subject to loss. These transactions werestructured to FSA’s requirement that the first-loss position provide FSAan investment-grade level of protection. The underlying assets supportingthe insured obligations were pools of corporate bonds individually rated belowinvestment grade. In this structure, multiple credits must fail before claimsare triggered. In 2002, credit quality deteriorated across a broad spectrum ofthe corporate market, which led to projected claims on these transactions andcharges to FSA’s income statement, as well as an increase in the Company’s lossexperience rate. Yet even under this unprecedented stress scenario, theseverity of the largest single loss was relatively modest.

Accordingly, management considers default frequencythe relevant factor driving adverse loss experience in the asset-backedsector and believes that a reasonably possible adverse change in defaultfrequencies would not result in a material adverse adjustment to the non-specificloss reserve.

Current asset-backed case reserves could varyfrom the current estimate of loss. In particular, the deterministic model usedto determine case reserves for CDO transactions utilizes average cumulativedefault rates produced by a Monte Carlo simulation and applies those defaultsto a cash flow model. While CDO exposures are affected by multiple variables,including default rates, collateral recovery rates, changes in interest ratemovements and the prepayment speeds of the collateral, management believesdefault frequency is the key determinant of loss. Holding all other variablesconstant and assuming only that the CDO’s underlying corporate debt instrumentswere to default at a higher rate than the Monte Carlo average default rate,actual losses would exceed the current estimate. Applying a higher frequency ofdefault, observed at the 90% confidence level, would result in additionalpresent value loss of $30 million.

To assess sensitivity to changes in loss assumptionsin the municipal insured portfolio, management believes that categories ofmunicipal risk other than the health care sector should not result in amaterial adverse change to the estimate of loss under a reasonably possiblescenario. Management believes that a material adverse change in loss isreasonably possible to occur in the health care sector. While the Company hasnot experienced a loss in this sector, the potential severity of health carelosses is comparatively high. Hospital facilities are single-purposeassets and a failing health care issuer is likely to be liquidated or acquired.If there is collateral associated with a health care credit, it is generally inthe form of a hospital facility, the value of which is primarily driven by thecommunity’s need for that facility. The more hospitals competing in acommunity, the more fragile the value of the hospital collateral is likely tobe in a stress scenario. FSA addresses the severity risk in this sector throughinternal policies that limit exposure to any single credit.

In a recently issued S&P scenario analysis,S&P assumed 75% loss severity for health care credits, which means that aloss would equal 75% of par insured. If losses of this severity occurred inboth the lowest rated single-site hospital exposure and the lowest-ratedhospital system exposure in FSA’s insured portfolio, the loss would be as muchas $48 million on a pre-tax basis, net of reinsurance.

A material adverse change from management’s currentestimate of loss for municipal transactions with case reserves is consideredunlikely because the only such case reserve is set near the full policy amount.

FSA management believes that the liability it carriesfor losses and loss expenses are adequate to cover the net cost of claims.However, the loss liability is based on assumptions regarding the Company’s 

50

----

probability of default andits severity of loss and there can be no assurance that the liability forlosses will not exceed such estimates.

The sensitivities described above are hypothetical andshould be used with caution. The effect of variation in a particular assumptionis calculated without changing any other assumption; in reality, changes in onefactor may result in changes in another, which might magnify or counteract thesensitivities.

The Company is aware that there are differencesregarding the method of measurement of the non-specific reserve amongparticipants in the financial guaranty industry. Other financial guarantors maynot establish a non-specific reserve in the manner described above, may calltheir non-specific reserve by a different name, such as, but not limitedto “unallocated losses,” “active credit reserves” and “portfolio reserves,” ormay use different statistical techniques than the Company uses to determineloss at a given point in time. Management and the industry expect accountingliterature specific to the financial guaranty industry to evolve; however,management cannot predict or estimate the scope of the guidance or potentialimpact on the financial statements at this time. See Note 2 to theConsolidated Financial Statements in Item 8.

At December 31,2004, the reinsurance recoverable on unpaid losses from reinsurers and cededpar outstanding, by Standard & Poor’s Ratings Services (“S&P”)rating levels, are as follows:

| **Reinsurer’s S&P Rating** | ** ** | ** **                          | ** ** | **Reinsurance  Recoverable** | ** ** | **Ceded Par  Outstanding** | ** ** |
|-----------------------------------------------|------------|-------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **(dollars in millions)** | ** ** |
| AAA                                           |       |                                | $          | 11.9                    |       |                            | $          | 34,193.8  |   |
| AA                                            |       |                                | 23.5       |                         |       | 65,147.0                        |       |
| A                                             |       |                                | —     |                         |       | 17,552.7                        |       |
| Not currently  rated                          |       |                                | —     |                         |       | 26.9                            |       |
| Total                                         |       |                                | $          | 35.4                    |       |                            | $          | 116,920.4  |   |

 

***Interest Expense***

Interest expense was$27.0 million in 2004, $33.0 million in 2003 and $28.1 million in2002. For further discussion, see “Liquidity and Capital Resources” below.

***Other Operating Expenses***

Other operating expensesfor 2004 increased 23.3% from that of the previous year. The increase relatesprimarily to increased personnel costs. The corresponding 27.4% increase inother operating expenses for 2003 is related primarily to higher personnelcosts. For additional discussion, see Note 11 to the ConsolidatedFinancial Statements in Item 8.

***Financial Products Net Interest Margin***

For the FP Segment, FP NIM was $27.6 millionin 2004, $8.9 million in 2003 and $3.5 million in 2002. The increases inFP NIM are related primarily to an increasing book of GIC business sincecommencing operations at the end of 2001. Prior-year balances have beenreclassified to conform to the current-year presentation.

NIM shown in accordance with classifications requiredunder GAAP on the statements of operations and comprehensive income (“Total NIM”)is calculated as net interest income on financial products and variableinterest entities, plus net realized gains (losses) on financial products, lessnet interest expense on financial products and variable interest entities.Total NIM was negative $70.7 million for 2004, negative $37.1 millionfor 2003 and negative $2.6 million for 2002, and primarily representsfixed rate liabilities (which are swapped to a floating rate obligation)funding floating rate assets. The differences between 

51

----

Total NIM and FP NIMrelate primarily to the presentation of periodic interest income and expense onderivatives, intersegment transactions and variable interest entities (“VIEs”)NIM, as discussed further below.

Thetable below reconciles Total NIM with FP NIM, which management uses as a keyperformance measure of the financial products business.

| ** **                                                                                                                                            | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                            | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                                                            | ** ** | **(restated)**                             | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| ** **                                                                                                                                            | ** ** | **(dollars in millions)**        | ** ** |
| Total NIM                                                                                                                                             |       |                                       | $          | (70.7  | ) |   |   | $ | (37.1  | ) |   |   | $ | (2.6  | ) |   |
| Realized net  interest from hedges of fixed rate assets and liabilities included in  realized and unrealized gains (losses) on derivative instruments |       |                                       | 79.7       |   |   |   | 25.2 |   |   |   | 0.5 |   |   |
| Intersegment  income related to refinanced transactions                                                                                               |       |                                       | 24.8       |   |   |   | 24.1 |   |   |   | 5.6 |   |   |
| VIE NIM(1)                                                                                                                                            |       |                                       | (4.8       | ) |   |   | (3.3 | ) |   |   | — |   |   |
| Inter-company  adjustments                                                                                                                            |       |                                       | (1.4       | ) |   |   | — |   |   |   | — |   |   |
| FP NIM                                                                                                                                                |       |                                       | $          | 27.6  |   |   |   | $ | 8.9  |   |   |   | $ | 3.5  |   |   |

----

(1)          VIE NIM represents theimpact of consolidation of the VIEs on the Total NIM.

Realized interest income and expense associated witheconomic interest rate hedges is an element of derivative gains and lossesadded back to calculate FP NIM. Derivativesdesignated as hedges are classified in the statements of operations andcomprehensive income with the underlying item being hedged. Gains and losses onderivatives that do not qualify for hedge accounting are shown under thecaption net realized and unrealized gains (losses) on derivative instruments. Unrealizedderivative gains and losses are excludedfrom FP NIM.

Intersegment income relates primarily to intercompanynotes held in the FP bond portfolio. In connection with the Company’srefinancing transactions, the Company obtains funds from the FP operations tofund claim payments, as discussed further in Note 23 to the ConsolidatedFinancial Statements in Item 8, creating an interest-bearingintercompany note. This intercompany note is included in the assets of the FPSegment. The net interest income on intercompany notes is added to FP NIM,but is not included in the consolidated Total NIM.

VIE NIM and FP NIM arecombined on the statements of operations and comprehensive income. VIE NIMpertains to the net interest margin derived from transactions executed by FSAGlobal Funding Limited (“FSA Global”), Canadian Global Funding Corporation (“CanadianGlobal”) and Premier International Funding Co. (“Premier”). As the VIE NIMis considered part of the financial guaranty segment and not the FP businessline, this NIM component is subtracted to calculate FP’s NIM. See Note 26to the Consolidated Financial Statements in Item 8.

***Net Realized and Unrealized Gains (Losses) onDerivatives***

FSA’s business includes insurance of CDS referencingdiversified pools of obligations. The net par outstanding was $66.0 billionrelating to these transactions at December 31, 2004 and $63.8 billion at December 31,2003. Many of these transactions require periodic accounting adjustments toreflect an estimate of fair value (or the replacement cost of the Company’sfinancial guarantee contract) under SFAS 133. These transactions havegenerally been underwritten with Triple-A or higher levels of creditprotection provided by significant deductibles that must be exhausted prior toclaims under FSA’s guaranty. Adjustments required by SFAS 133 resulted inpre-tax income of $56.4 million for 2004 and $34.8 million for 2003 andlosses of $50.2 million for 2002. The benefits during 2004 and 2003 resulted 

52

----

primarily from tightening creditspreads in the CDS market, while the charge for 2002 resulted primarily fromwidening credit spreads in that market. Neither of these adjustments indicateany material improvement or deterioration in the underlying credit quality ofFSA’s insured CDS portfolio. The gain or loss created by estimated fair-valueadjustments will rise or fall each quarter based on estimated market pricing ofhighly rated swap guarantees and is not expected to be an indication ofpotential claims under FSA’s guarantee. Fair value is defined as the price atwhich an asset or a liability could be bought or sold in a current transactionbetween willing parties. The fair value is determined based on quoted marketprices, if available. If quoted market prices are not available, as is the caseprimarily with CDS on pools of assets, then the determination of fair value isbased on internally developed estimates. Management applies judgment whendeveloping these estimates and considers factors such as current prices chargedfor similar agreements, performance of underlying assets, changes in internalshadow ratings, the level at which the deductible has been set and FSA’sability to obtain reinsurance for its insured obligations. Due to changes inthese factors, the gain or loss from derivative instruments may varysubstantially from period to period. Absent any claims under FSA’s guaranty,any “losses” recorded in marking a guaranty to fair value will be reversed byan equivalent “gain” at or prior to the expiration of the guaranty and any “gain”recorded would be reversed by an equal “loss” over the remaining life of thetransaction. The average life of these contracts is 2.9 years. Theinception-to-date gain (loss) on the CDS portfolio was $46.6million at December 31, 2004 and $(9.8) million at December 31,2003. Given the very high credit quality of FSA’s insured CDS portfolio and theCompany’s intent to hold to maturity, management believes that “losses” or “gains”attributable to marking these exposures to fair value do not reflect on theprofitability of the Company in a meaningful way.

During the first half of 2002, FSA’s insured portfoliocontained a portfolio of CDS on 100 corporate names (each rated investmentgrade at inception of the swap), with $10 million of exposure per name, forwhich the Company had first-loss exposure. This “single- name CDSprogram” was the only transaction of its kind in the insured portfolio. In thethird quarter of 2002, the Company terminated its exposure under this programin exchange for paying termination costs of $43.0 million. The charge wasincluded in net realized and unrealized gains (losses) on derivativeinstruments in the statements of operations and comprehensive income during2002.

The Company utilizes interest rate derivatives to convertassets and liabilities with fixed interest rates to floating rates. All gainsand losses from changes in the fair value of any derivatives that do notqualify for hedge accounting under SFAS 133 are recognized immediately inthe statements of operations andcomprehensive income under the caption net unrealized and realized gainsand losses on derivatives. Hedge accounting is applied to derivativesdesignated as hedging instruments in a fair value hedge provided certaincriteria are met.

Thefollowing table details the income statement activity within the “Net Realizedand Unrealized Gains (Losses) on Derivative Instruments.” It should be notedthat VIEs were only consolidated beginning in the third quarter of 2003.

| ** **                                                     | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                     | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                     | ** ** | **(restated)**                             | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| ** **                                                     | ** ** | **(dollars in millions)**        | ** ** |
| VIE and FP  derivatives                                        |       |                                       | $          | 181.1  |   |   |   | $ | 69.4  |   |   |   | $ | (4.6  | ) |   |
| CDS mark to fair  value (net)                                  |       |                                       | 56.4       |   |   |   | 34.8 |   |   |   | (50.2 | ) |   |
| Single-name  termination fee                                   |       |                                       | —     |   |   |   | — |   |   |   | (43.0 | ) |   |
| Foreign currency  exchange gain                                |       |                                       | 91.3       |   |   |   | 118.3 |   |   |   | — |   |   |
| Other (net)                                                    |       |                                       | 0.5        |   |   |   | 4.9 |   |   |   | 0.4 |   |   |
| Total realized and  unrealized derivative gains (losses) (net) |       |                                       | $          | 329.3  |   |   |   | $ | 227.4  |   |   |   | $ | (97.4  | ) |   |

 

53

----

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

Income from assetsacquired in refinancing transactions was $31.6 million in 2004, $25.3 millionin 2003 and $6.3 million in 2002. The significantly higher amounts in 2004 and2003 than in 2002 were due to the refinancings of several insured transactionswhereby the Company accelerated claims payment on transactions that hadexperienced events of default and acquired the obligations or underlyingcollateral in order to mitigate future claims.

***Equity in Earnings of Unconsolidated Affiliates***

Total equity in earnings of unconsolidated affiliateswas a pre-tax loss of $3.3 million in 2004 and pre-tax income of $5.5 millionin 2003 and $54.4 million in 2002. As of December 31, 2004, the Companyhad an investment in SPS Holding Corp. (“SPS”), formerly Fairbanks CapitalHolding Corp. SPS was owned 64.92% by The PMI Group Inc. and 34.06% by theCompany, with the remainder owned by individuals. At December 31, 2004,the Company’s interest in SPS had a book value of $49.6 million. At December 31,2003, the Company’s interest in SPS was $46.4 million, of which $7.6 millionrepresented goodwill. The Company’s equity in earnings from SPS was a pre-taxloss of $7.1 million in 2004, a pre-tax loss of $13.5 million in 2003, andpre-tax income of $13.8 million in 2002.

SPS’s business is subject to regulation, supervisionand licensing by various federal, state and local authorities that haveincreased their focus on lending and servicing practices in the sub-primelending industry. In October 2002, the Federal Trade Commission (“FTC”)informed SPS that it was investigating whether SPS’s loan servicing or otherpractices violated the Fair Debt Collection Practices Act, the Fair CreditReporting Act, Section 5 of the Federal Trade Commission Act or other lawsenforced by the FTC. Certain of SPS’s shareholders, including the Company,received civil investigative demands from the FTC relating to their investmentsin SPS and their knowledge of SPS’s servicing operations.

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 restrictions on SPS’s business practices. A relatedsettlement of numerous class action lawsuits against SPS has been approved by afederal district court in Massachusetts. In the second quarter of 2004, theCompany made a $10.3 million additional equity investment in SPS to fund aportion of the $40.0 million payment that was required to be made to the FTCunder the terms of the FTC’s settlement agreement with SPS.

In the third quarter of 2004, the Company determinedthat its $7.6 million of goodwill associated with its investment in SPS wasimpaired as a result of challenges encountered by SPS in acquiring newbusiness, despite servicer ratings of “Average.” While management believes bookvalue approximates fair value, the Company continued to monitor the value ofits investment in SPS. The Company and the other owners of SPS have enteredinto a binding Summary of Terms relating to the potential sale to anunaffiliated third party of their respective interests in SPS pursuant to anoption, exercisable on or before July 31, 2005. The sale is subject toseveral conditions, including, among other things, execution of definitiveagreements.

FSA’s 13% investment in preferred shares of XLFA, afinancial guaranty insurance subsidiary of XL, is redeemable by XLFA at a priceequal to the fair market value of the preferred shares, subject to a capdefined as the internal rate of return of 19% per annum from the date of theinvestment through the date of redemption, plus accrued dividends as if 100% ofcurrent-year earnings were distributed. Based on this formula, the Companyrecently adopted a policy of carrying this investment at the lesser of thecurrent calculated redemption value or the redemption value as of the nextJanuary first, which would exclude its share of accrued current yearearnings to the extent the cap had been otherwise met. Consistent with thispolicy, in the third quarter of 2004, the Company charged pre-tax $11.7 millionto equity in earnings of unconsolidated affiliates and reduced its carryingvalue in this investment to $56.4 million.

54

----

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 15% investment in XLFA is included in equity securities as anavailable-for-sale security. The fair value of the investment at December 31,2004 was $54.3 million.

***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 securitized assets and as the issuer ofthe insured obligations. FSA’s participation is typically requested by thesponsor of the VIE or the underwriter, either via a bid process or on a solesource basis. VIEs are typically owned by transaction sponsors or charitabletrusts, although FSA may have an ownership interest in some cases. FSAmaintains certain contractual rights and exercises varying degrees of influenceover VIE issuers of FSA-insured obligations. FSA also bears some of the “risksand rewards” associated with the performance of the VIE’s assets. Specifically,as issuer of a financial guaranty insurance policy insuring the VIE’sobligations, FSA bears the risk of asset performance (typically, but not always,after a significant depletion of overcollateralization, excess spread, adeductible or other credit protection). FSA’s underwriting policy is to insureonly obligations that are otherwise investment grade. In addition, the VIEtypically pays a periodic premium to FSA in consideration of the issuance byFSA of its insurance policy, with the VIE’s assets typically serving as thesource of such premium, thus providing some of the “rewards” of the VIE’sassets to FSA. VIEs are also employed by FSA in connection with “repackaging”of outstanding securities into new securities insured by FSA and withrefinancing underperforming, non-investment-grade transactionsinsured by FSA. The degree of influence exercised by FSA over these VIEs variesfrom transaction to transaction, as does the degree to which “risks and rewards”associated with asset performance are assumed by FSA. While all transactionsinsured by FSA are included in the Company’s outstanding exposure, and lossesunder these obligations are reflected in the Notes to Consolidated FinancialStatements for the year ended December 31, 2004, the assets andliabilities of these VIEs, except for refinanced transactions discussed belowand in Note 23 to the Consolidated Financial Statements in Item 8, have not beenconsolidated with those of the Company for financial reporting purposes becausethe Company is not the primary beneficiary.

In January 2003, theFinancial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46,“Consolidation of Variable Interest Entities, an interpretation of ARB No. 51”(“FIN 46”). FIN 46 addresses consolidation of VIEs that have one or both of thefollowing 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 iseffective for public companies for periods after December 15, 2003.

The Company consolidatesFSA Global, Canadian Global and Premier. The adoption of FIN 46 on July 1,2003 resulted in a $1.9 billion aggregate increase in total assets andtotal liabilities. The differences upon consolidation were reflected as acumulative effect of a change in accounting principle. The cumulative effect ofa change in accounting principle for Canadian Global resulted in additionalincome of $4.8 million, net of income tax in 2003. During the third quarter of2004 the majority of the assets of Canadian Global were liquidated and itsliabilities satisfied. There was no income statement effect from 

55

----

consolidatingFSA Global and Premier. FSA Global is managed as a “matched funding vehicle,”in which the proceeds from the issuance of FSA-guaranteed notes areinvested in obligations having cash flows substantially matched to those of,and maturing prior to, such notes. In certain cases, investments of FSA Globalconsist of GICs issued by the GIC Affiliates. In each such case, the Company’sGIC liability and GIC asset are eliminated in consolidation. At December 31,2004, $961.9 million was eliminated as a result of such consolidation. TheCompany’s management believes that the assets held by the VIEs, including thosethat are eliminated in consolidation, are beyond the reach of the Company andits creditors, even in bankruptcy or other receivership. All intercompanyinsured amounts between FSA and FSA Global or Canadian Global are excluded fromthe Notes to the Consolidated Financial Statements for the years ended December 31,2004 and 2003. In addition, the Company refinances certain defaultedtransactions by employing refinancing vehicles to raise funds for therefinancings. These refinancing vehicles are also consolidated. See Note 23 tothe Consolidated Financial Statements in Item 8.

***Taxes***

The effective tax rateswere 19.0% in 2004, 22.2% in 2003 and 16.3% in 2002, which differ from thestatutory rate of 35% due primarily to tax-exempt interest income, incomefrom Financial Security Assurance International Ltd. (“FSA International”), andminority interest, with the White Mountains indemnity payment (see below) beingan additional difference in 2004. In addition, the effective tax rate wasaffected by the expected repatriation of earnings of FSA International in 2005.

The American Job CreationAct of 2004 was enacted on October 22, 2004, which added new 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 has accordingly accrued a deferred taxliability and expense of $5.3 million at December 31, 2004. This amountrepresents the tax effect on FSA International’s tax dividend distributioncapability at December 31, 2004. To the extent FSA International generatesadditional tax earnings and profits in 2005, it is probable that the Companywill incur taxes whether or not such earnings are distributed.

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 Insurance Group for certain future adverse loss developmentup to $50.0 million. In 2004, the Company made an indemnity payment of $47.0million to the third party with funds provided for such purpose by WhiteMountains Insurance Group. While the Company had no legal liability inconnection 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, undercertain circumstances, which are not probable as of December 31, 2004, theCompany expects to agree to share 50% of the deferred tax benefit with WhiteMountains Insurance Group.

In the third quarter of2002, the Company changed its method of taxing its equity in earnings from SPS,an unconsolidated affiliate of the Company. Prior to 2002, the Company taxed100% of its equity in earnings from SPS at the statutory rate of 35%. Followinga change in SPS’s investors, the Company determined that it would beappropriate to apply the 80% dividend-received deduction allowed by theInternal Revenue Service when calculating the tax on its equity in earningsfrom SPS, based on management’s expectation that it would realize its gain onsuch investment through dividend distributions rather than through sale of itsinvestment. In 2002, the Company recorded a cumulative-to-datebenefit of $4.0 million.

56

----

**CriticalAccounting Policies**

The Company’s criticalaccounting policies are described in Note 2 to the Consolidated FinancialStatements in Item 8.

**Liquidityand Capital Resources**

***Liquidity***

The Company’s consolidatedinvested assets at December 31, 2004, net of unsettled securitytransactions, were $12,227.2 million, compared with the December 31, 2003balance of $7,942.7 million. These balances include the change in the marketvalue of the Investment Portfolio, which had an unrealized gain position of$294.5 million at December 31, 2004, compared with an unrealized gainposition of $233.4 million at December 31, 2003. These balances exclude (1) theeffect of any economic interest rate derivatives’ hedging impacts and (2) assetsin the VIE bond portfolio that the Company’s management believes are beyond thereach of the Company and its creditors and the assets acquired underrefinancing transactions.

At December 31, 2004,the Company had, at the holding company level, an investment portfolio of $25.9million available to fund the liquidity needs of its activities outside of itsinsurance operations. Because the majority of the Company’s operations areconducted through FSA, the long-term ability of the Company to serviceits debt will largely depend on its receipt of dividends from, or payment onsurplus notes by, FSA.

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 financialproducts business, the Company relies on net interest income to fund its netinterest expense and operating expenses. Management believes that the Company’soperations provide sufficient liquidity to pay its obligations. If additionalliquidity is needed or cash flow from operations significantly decreases, theCompany can liquidate or utilize its investment portfolio as a source of fundsin addition to its alternative liquidity arrangements, as discussed furtherbelow. The Company’s cash flows from operations are heavily dependent on marketconditions, the competitive environment and the mix of business originated. Inaddition, payments made in settlement of the Company’s obligations in itsinsured portfolio may, and often do, vary significantly from year to yeardepending primarily on the frequency and severity of payment defaults and itsdecisions regarding whether to exercise its right to accelerate troubledinsured transactions in order to mitigate future losses. In each of the threeyears reported, the Company has not drawn on any alternative sources ofliquidity to meet its obligations, except that the Company has refinancedcertain transactions using funds raised through its GIC Affiliates.

The following is a summaryof the Company’s long-term obligations at December 31, 2004:

**Long-TermObligations**

| ** **                     | ** ** | **Less than 1  Year**     | ** ** | **1–3 Years** | ** ** | **3–5 Years** | ** ** | **Greater than  5 years** | ** ** | **Total**      | ** **    |
|--------------------------------|------------|-------------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------------------|------------|----------------|---------------|
| ** **                     | ** ** | **(restated)**                      | ** ** | **(restated)**          | ** ** | **(restated)**          | ** ** | **(restated)**                      | ** ** | **(restated)** | ** **    |
| ** **                     | ** ** | **(dollars in millions)** | ** ** |
| Loss reserves(1)               |       |                                | $          | 3.3                |       |                    | $          | 4.2                            |       | $              | 3.6      |   |   | $ | 248.6  |   |   | $ | 259.7  |   |
| Long-term  debt obligations(2) |       |                                | 2,881.7    |                    |       | 2,664.9                 |       | 1,402.4                             |       |           | 6,019.9       |   |   | 12,968.9 |   |
| Operating lease  obligations   |       |                                | 5.5        |                    |       | 16.6                    |       | 16.3                                |       |           | 114.3         |   |   | 152.7 |   |
| Total                          |       |                                | $          | 2,890.5            |       |                    | $          | 2,685.7                        |       | $              | 1,422.3  |   |   | $ | 6,382.8  |   |   | $ | 13,381.3  |   |

----

(1)          Amounts represent theundiscounted estimated claim payments.

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

57

----

At December 31, 2003, Financial SecurityAssurance Holdings Inc. (as a separate holding company, “FSA Holdings”) held$152.9 million of surplus notes of FSA. During 2004, FSA repaid $44.0 millionof those surplus notes. At December 31, 2004, FSA Holdings held $108.9million of FSA surplus notes. Payments of principal or interest on such notesmay be made only with the approval of the Superintendent of Insurance of theState of New York (the “New York Superintendent”). FSA Holdings employs surplusnote purchases in lieu of capital contributions in order to allow it towithdraw funds from FSA through surplus note payments without reducing earnedsurplus, thereby preserving dividend capacity of FSA.

FSA Holdings paid dividends of $22.9 million in 2004and $11.7 million in 2002. 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 6.950% Senior Quarterly Income DebtSecurities (“Senior QUIDS”) due November 1, 2098 and delivered to thetrustee sufficient collateral to legally defease the 6.950% Senior QUIDS. Theunamortized debt issuance costs of $3.2 million for the 6.950% Senior QUIDSwere charged to interest expense in 2003. Subsequently, the trustee used thedefeasance collateral to redeem all of the 6.950% 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. FSA Holdings used a portion ofthe 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 on FSA’sfinancial condition, results of operations, cash requirements, determinationthat FSA’s ratings will not be adversely affected and other related factors,and is also 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 New YorkSuperintendent or (b) adjusted net investment income during this period.Based on FSA’s statutory statements for 2004, and considering dividends thatcan be paid by its subsidiary, the maximum amount normally available forpayment of dividends by FSA without regulatory approval over the 12 monthsfollowing December 31, 2004 was approximately $84.5 million. FSA paiddividends of $30.0 million in 2004, and none in 2003 and 2002.

In 2004 and 2003, FSAInternational paid preferred dividends of $4.9 million and $3.3 million,respectively, to XL Capital Ltd, its minority interest owner.

***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 

58

----

payments with availablecash flow or other payment sources. The insurance policies issued by FSAprovide, in general, that payments of principal, interest and other amountsinsured by FSA may not be accelerated by the holder of the obligation but arepaid by FSA in accordance with the obligation’s original payment schedule or,at FSA’s option, on an accelerated basis. These policy provisions prohibitingacceleration of certain claims are mandatory under Article 69 of the NewYork Insurance Law and serve to reduce 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 that are available to pay claims on a short andlong-term basis: cash flow from premiums written, FSA’s investmentportfolio and earnings thereon, reinsurance arrangements with third-partyreinsurers, new borrowings through its GIC Affiliates, liquidity lines ofcredit with banks, and capital market transactions.

FSA has a credit arrangement aggregating $150.0million, which is provided by commercial banks and intended for generalapplication to transactions insured by FSA. If FSA is downgraded below Aa3 andAA-, the lenders may terminate the commitment and the commitmentcommission becomes due and payable. If FSA is downgraded below Baa3 and BBB-,any outstanding loans become due and payable. At December 31, 2004, therewere no borrowings under this arrangement, which expires on April 22,2005, if not extended.

FSA has a standby line of credit in the amount of$325.0 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 $325.0 million orthe average annual debt service of the covered portfolio multiplied by 5.00%,which amounted to $1,067.0 million at December 31, 2004. 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 seven-yearterm that will expire on April 30, 2011 and contains an annual renewalprovision subject to approval by the banks. A ratings downgrade of FSA wouldresult in an increase in the commitment fee. No amounts have been utilizedunder this commitment as of December 31, 2004.

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 a put option were to beexercised by FSA, the applicable trust would use the portion of the proceedsattributable to principal received upon maturity of its assets, net ofexpenses, and transfer such proceeds to FSA in exchange for Preferred Stock ofFSA. FSA pays a floating put premium to the trusts. The cost of the structurewas $1.3 million for 2004 and $3.6 million for 2003 and was recorded as expensein equity. The trusts are vehicles for providing FSA access to new capital atits sole discretion through the exercise of the put options. The Company doesnot consider itself to be the primary beneficiary of the trusts under FIN 46because it does not retain the majority of the residual benefits or expectedlosses.

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 

59

----

in the event of adowngrade of FSA below A3 by Moody’s or A- by S&P with no right ofthe GIC provider to avoid such withdrawal by posting collateral or otherwiseenhancing its credit. The Company manages this risk through the maintenance ofliquid 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 9,2005, unless extended. This line of credit provides an additional source ofliquidity should there be unexpected draws on GICs issued by the GIC Affiliates.There were no borrowings under this arrangement at December 31, 2004.

***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 policyholders’ surplusand contingency 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 providing the reinsurance, as well as any collateral provided by thereinsurer. Capital charges on outstanding insured transactions and reinsurerratings are subject to change by S&P at any time. In recent years, a numberof Triple-A-rated reinsurers employed by FSA have been downgradedby S&P. Downgrade of these reinsurers by S&P to the Double-Acategory resulted in a decline in the credit allowed for reinsurance by S&Pfrom 100% to 70% or 65% under present criteria. While a downgrade by S&P ofall reinsurers to the Double-A category would not impair FSA’s Triple-Aratings, it would reduce the “margin of safety” by which FSA would survive atheoretical catastrophic depression modeled by S&P. A reduction by S&Pin credit for reinsurance used by FSA would also be expected ultimately toreduce the Company’s return on equity to the extent that ceding commissionspaid to FSA by such reinsurers were not increased to compensate for suchreduction. FSA employs considerable reinsurance in its business to manage itssingle-risk exposures on insured credits. Any material increase incapital charges by S&P on FSA’s insured portfolio would likewise beexpected to have an adverse effect on FSA’s margin of safety under the S&Pcapital adequacy model and, ultimately, the Company’s return on equity. TheCompany may seek to raise additional capital to replenish capital eliminated byany of the rating agencies and their assessment of 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 (asset-backed and municipal), 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 plans to incurapproximately $30 million, net of lease incentives, in capital expendituresthrough the second quarter of 2005 for leasehold improvements, furniture andfixtures related to its new 

60

----

corporateheadquarters. The Company expects to fund these capital expenditures out ofcash flows from operations. For additionalinformation, 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) its insurance companyassets and other investments (the “Investment Portfolio”), (2) thefinancial products business, which is driven by interest spreads, and (3) itsportfolio of insured CDS.

***Investment Portfolio***

Over 95% of the Company’s Investment Portfolio wasinvested in fixed-income securities at December 31, 2004. Changes ininterest rates affect the value of the Company’s fixed-income portfolio.As interest rates rise, the fair value of fixed-income securitiesdecreases.

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 theguidelines for 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 2004, this hypothetical increase in interest rates of 1.0%across the entire yield curve would result in an estimated after-taxdecrease of $134.8 million in the net fair value of the Company’s fixed-incomeportfolio. Similarly, a hypothetical increase in interest rates of 1.0% wouldresult in an estimated after-tax decrease of $14.8 million in the netfair value of the Company’s portfolio of assets acquired under refinancingtransactions, offset by an after-tax gain of $14.4 million on derivatives usedto economically hedge the portfolio of assets acquired under refinancingtransactions.

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***

FSAM manages the investments in the GIC Portfolio. Theprimary objectives in managing the GIC Portfolio are to generate a stable netinterest margin, to maintain liquidity and to optimize risk-adjustedreturns.

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 a pre-tax loss of $144.3 million tothe asset portfolio, offset by a gain of $130.9 million on derivatives used toeconomically hedge the asset portfolio. 

61

----

The same hypotheticalincrease in interest rates would result in a pre-tax gain of $261.7million in the liability portfolio, offset by a loss of $250.0 million onderivatives used to economically hedge the liability portfolio. Since theCompany does not expect to trade these investments prior to maturity absent anunusually large demand for funds, it does not expect to recognize any materialadverse impact to cash flows under the above scenario. Since such asset andliability positions do not currently qualify for hedge accounting, an increasein interest rates would result in lower reported net income of $77.4 milliondue to the net derivatives loss that would result from such an interest rate decrease.

The GIC Portfolio consists primarily of U.S. dollar-denominatedasset-backed securities, U.S. agency and government securities andmortgage-backed securities. FSAM generally converts all fixed-rateassets and liabilities to floating rates using hedging instruments. As interestrates change, and assuming an economically effective fair-value hedgingarrangement, the change in value of the fixed-income securities will besubstantially offset by a similar but opposite change in value of the relatedhedging instruments. To the extent the Company did not qualify for hedgeaccounting, such economic offsets cannot be presented in the financialstatements, resulting in greater reported volatility arising from changes ininterest rates. See Note 3 to the Consolidated Financial Statements in Item 8for discussion of the Company’s hedge accounting.

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 fundsmay experience withdrawal deviation when the underlying municipal project doesnot proceed as expected. In addition, most FSA-insured GICs allow forwithdrawal of GIC funds in the event of a downgrade of FSA, typically below Aa3by Moody’s or AA-by S&P unless the GIC provider posts collateral orotherwise enhances its credit.

FSAM also manages theinvestments in the VIE Portfolio, which are generally held until maturity. TheVIE fixed interest rate portfolio is economically hedged against change ininterest rates largely through the use of interest rate swap contracts, whichconvert fixed rates to floating rates.

***Credit Default Swaps***

Financial instruments that may be affected by changesin credit spreads include structured CDS contracts where the Company acts as aguarantor. Such contracts are considered derivative instruments subject to fairvalue accounting under SFAS 133. Because the Company generally providescredit protection under such contracts, widening credit spreads will have an adversemark to fair value effect on the Company’s Statements of Operations andComprehensive Income while tightening credit spreads will have a positiveeffect. 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 obligation(s) 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 creditquality of the underlying referenced obligations and by supply and demandfactors that affect the level of credit spreads generally.

Because the portfolio of FSA-insured CDS is nottraded, the Company has developed a series of asset credit spread algorithms toestimate fair value. These algorithms derive fair value from several publiclyavailable indices, depending on the types of assets referenced by the CDS.

To estimate the income statement sensitivity tochanges in CDS market premium rates, the Company has analyzed the historicalcredit spread data for each of the principal indices used to determine fairvalue 

62

----

of the CDS portfolio(applicable to most but not all net CDS par outstanding) and, throughstatistical techniques, measured the historical volatility as a means toestimate future performance.

Measuring potential losses in fair value can beperformed through the application of various statistical techniques. One suchtechnique is Value at Risk (“VaR”), which is a summary statistical measurethat, in the Company’s application, uses historical credit spread informationby asset type to estimate the volatility and correlation of credit spreadmovements in order to calculate a maximum loss that could occur over a definedperiod of time (three months) given a certain probability (95%).

Statistical models alone do not provide a reliablemethod of monitoring and controlling market risk. Furthermore, the Company doesnot analyze the market sensitivity of its insured CDS portfolio for purposesother than to quantify the potential exposure to quarterly accounting fair-valuegain or loss. Management believes that each of the transactions for which ithas provided CDS protection contain significant protections against loss, andquarterly changes in credit spreads generally do not imply any fundamentalchange in future loss potential. The quantitative fair-value riskinformation generated by a VaR model is limited by the methods, assumptions andparameters established in creating the model. In particular, the history of therelevant asset credit spread information is relatively short and the insightgained by using such information to forecast potential future fair-valuechanges may therefore be limited.

The application of the VaR model as of year-end2004 resulted in a three-month maximum change in fair value of $57million at a 95% confidence level. Management does not believe that thisrepresents potential claim payments as the related CDS contracts are presumedto maintain their current high credit ratings. To the extent credit spreadswidened at the same time underlying CDS asset pools measurably deteriorated,the mark to fair value could be significantly more adverse than estimated.

The net par outstanding that was not part of the abovestatistical analysis has a weighted average market premium rate of 10.4 basispoints and an average life of 3.7 years. A one-basis-point wideningin credit spreads to an average of 11.4 basis points would produce a mark-to-marketloss of $3.2 million. Historically, the quarterly change in credit spreads ofthis part of the portfolio has not been greater than one basis point.

63

----

**Item8.**                        FinancialStatements and Supplementary Data.

**FinancialSecurity Assurance Holdings Ltd. and SubsidiariesIndex to Restated Consolidated Financial Statements and Schedule**
|                                                                                                                                                                                        | ** ** | Page   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------|
| Report of Independent  Registered Public Accounting Firm                                                                                                                               |       | 65     |
| Consolidated Balance Sheets as of  December 31, 2004 and 2003                                                                                                                     |       | 66     |
| Consolidated Statements of  Operations and Comprehensive Income for the Years Ended December 31,  2004, 2003 and 2002                                                             |       | 67     |
| Consolidated Statements of  Changes in Shareholders’ Equity for the Years Ended December 31, 2004,  2003 and 2002                                                            |       | 68     |
| Consolidated Statements of Cash Flows for the Years  Ended December 31, 2004, 2003 and 2002                                                                                       |       | 69     |
| Notes to Consolidated  Financial Statements                                                                                                                                            |       | 71     |
| Schedule:                                                                                                                                                                              |       |   |
| II  Condensed Financial Statements of Financial Security Assurance Holdings Ltd.  as of December 31, 2004 and 2003 and for the Years Ended  December 31, 2004, 2003 and 2002 |       | 144    |

 

64

----

**Reportof Independent Registered Public Accounting Firm**

To Board of Directors andShareholdersof 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, 2004 and December 31,2003, and the results of their operations and their cash flows for each of thethree years in the period ended December 31, 2004 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 26 to the consolidated financialstatements, in 2003 the Company changed its method of accounting for itsinterest in certain variable interest entities.

As discussed in Note 3,the consolidated financial statements as of December 31, 2004 and 2003 andfor each of the three years in the period ended December 31, 2004 havebeen restated.
| /s/ PRICEWATERHOUSECOOPERS  LLP                 |   |
|-------------------------------------------------|--------|
| New York, New York                              |
| March 23, 2005 (except for Notes 3 and 23, |
| which are as of December 16, 2005)         |

 

65

----

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

| ** **                                                                                                     | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                     | ** ** | **(restated)**              | ** ** | **(restated)**              | ** ** |
| **ASSETS**                                                                                                     |       |                        |       |                        |       |   |   |   |   |
| Bonds at fair  value (amortized cost of $3,662,584 and $3,275,310)                                             |       |                        | $          | 3,914,763                   |       |   |   | $ | 3,508,649 |   |   |
| Equity securities  at fair value (cost of $54,300)                                                             |       |                        | 54,300     |                        |       |   | — |   |   |
| Short-term  investments                                                                                        |       |                        | 321,071    |                        |       |   | 224,429 |   |   |
| Variable interest  entities’ bonds at fair value (amortized cost of $1,342,489 and $1,412,520)            |       |                        | 1,346,355  |                        |       |   | 1,422,538 |   |   |
| Variable interest  entities’ short-term investment portfolio                                              |       |                        | 1,194      |                        |       |   | 11,102 |   |   |
| Financial products  bond portfolio at fair value (amortized cost of $7,882,739 and $4,022,605)                 |       |                        | 7,925,072  |                        |       |   | 4,031,263 |   |   |
| Financial products  bond portfolio pledged as collateral at fair value (amortized cost of $5,908  and $70,358) |       |                        | 5,913      |                        |       |   | 66,423 |   |   |
| Financial products  short-term investment portfolio                                                            |       |                        | 268,125    |                        |       |   | 228,812 |   |   |
| Total investment portfolio                                                                                     |       |                        | 13,836,793 |                        |       |   | 9,493,216 |   |   |
| Assets acquired in  refinancing transactions:                                                                  |       |                        |       |                        |       |   |   |   |   |
| Bonds at fair  value (amortized cost of $151,895)                                                              |       |                        | 157,036    |                        |       |   | — |   |   |
| Securitized loans                                                                                              |       |                        | 369,749    |                        |       |   | 433,949 |   |   |
| Other                                                                                                          |       |                        | 222,423    |                        |       |   | 73,002 |   |   |
| Total assets  acquired in refinancing transactions                                                             |       |                        | 749,208    |                        |       |   | 506,951 |   |   |
| Total investments                                                                                              |       |                        | 14,586,001 |                        |       |   | 10,000,167 |   |   |
| Cash                                                                                                           |       |                        | 14,353     |                        |       |   | 19,460 |   |   |
| Deferred  acquisition costs                                                                                    |       |                        | 308,015    |                        |       |   | 273,646 |   |   |
| Prepaid  reinsurance premiums                                                                                  |       |                        | 759,191    |                        |       |   | 695,398 |   |   |
| Investment in  unconsolidated affiliates                                                                       |       |                        | 49,645     |                        |       |   | 110,863 |   |   |
| Reinsurance  recoverable on unpaid losses                                                                      |       |                        | 35,419     |                        |       |   | 59,235 |   |   |
| Other assets                                                                                                   |       |                        | 1,328,384  |                        |       |   | 1,248,794 |   |   |
| TOTAL ASSETS                                                                                                   |       |                        | $          | 17,081,008                  |       |   |   | $ | 12,407,563 |   |   |
| **LIABILITIES  AND MINORITY INTEREST AND SHAREHOLDERS’ EQUITY**                                           |       |                        |       |                        |       |   |   |   |   |
| Deferred premium  revenue                                                                                      |       |                        | $          | 2,095,423                   |       |   |   | $ | 1,844,991 |   |   |
| Losses and loss  adjustment expenses                                                                           |       |                        | 179,941    |                        |       |   | 233,408 |   |   |
| Guaranteed  investment contracts and variable interest entities’ debt                                     |       |                        | 10,444,051 |                        |       |   | 6,639,381 |   |   |
| Deferred federal  income taxes                                                                                 |       |                        | 249,665    |                        |       |   | 173,515 |   |   |
| Notes payable                                                                                                  |       |                        | 430,000    |                        |       |   | 430,000 |   |   |
| Minority interest                                                                                              |       |                        | 48,550     |                        |       |   | 60,525 |   |   |
| Minority interest  in variable interest entities                                                               |       |                        | 178,575    |                        |       |   | 102,451 |   |   |
| Accrued expenses  and other liabilities                                                                        |       |                        | 843,525    |                        |       |   | 704,143 |   |   |
| TOTAL LIABILITIES  AND MINORITY INTEREST                                                                       |       |                        | 14,469,730 |                        |       |   | 10,188,414 |   |   |
| 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                                                                        |       |                        | 905,080    |                        |       |   | 903,829 |   |   |
| Accumulated other  comprehensive income (net of deferred income taxes of $103,755 and $85,294)                 |       |                        | 199,764    |                        |       |   | 164,617 |   |   |
| Accumulated  earnings                                                                                          |       |                        | 1,506,099  |                        |       |   | 1,150,368 |   |   |
| Deferred equity  compensation                                                                                  |       |                        | 23,528     |                        |       |   | 23,445 |   |   |
| Less treasury  stock at cost (297,276 and 297,658 shares held)                                                 |       |                        | (23,528    | )                           |       |   | (23,445 | ) |   |
| TOTAL  SHAREHOLDERS’ EQUITY                                                                               |       |                        | 2,611,278  |                        |       |   | 2,219,149 |   |   |
| TOTAL LIABILITIES  AND MINORITY INTEREST AND SHAREHOLDERS’ EQUITY                                         |       |                        | $          | 17,081,008                  |       |   |   | $ | 12,407,563 |   |   |

 

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

66

----

**FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. ANDSUBSIDIARIESCONSOLIDATED STATEMENTSOF OPERATIONS AND COMPREHENSIVE INCOME(in thousands)**

| ** **                                                                                                                                                 | ** ** | **Year Ended December 31,** | ** **    |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|---------------|
| ** **                                                                                                                                                 | ** ** | **2004**                                   | ** **    | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                                                                 | ** ** | **(restated)**                             | ** **    | **(restated)** | ** ** | **(restated)** | ** ** |
| **REVENUES:**                                                                                                                                              |       |                                       |          |   |   |   |   |   |   |   |   |
| Net premiums written                                                                                                                                       |       | $                                          | 587,769  |   |   | $ | 614,284  |   |   |   | $ | 532,747  |   |   |
| Net premiums earned                                                                                                                                        |       | $                                          | 395,015  |   |   | $ | 356,373  |   |   |   | $ | 314,880  |   |   |
| Net investment income                                                                                                                                      |       | 172,051                                    |          |   | 154,048 |   |   |   | 139,120 |   |   |
| Net realized gains (losses)                                                                                                                                |       | (473                                       | )             |   | 5,126 |   |   |   | 29,204 |   |   |
| Net interest income from financial products and  variable interest entities                                                                                |       | 194,675                                    |          |   | 89,133 |   |   |   | 41,011 |   |   |
| Financial products net realized gains (losses)                                                                                                             |       | 2,217                                      |          |   | 10,903 |   |   |   | (154 | ) |   |
| Net realized and unrealized gains (losses) on  derivative instruments                                                                                      |       | 329,259                                    |          |   | 227,449 |   |   |   | (97,432 | ) |   |
| Income from assets acquired in refinancing  transactions                                                                                                   |       | 31,634                                     |          |   | 25,276 |   |   |   | 6,349 |   |   |
| Other income                                                                                                                                               |       | 5,712                                      |          |   | 1,986 |   |   |   | 2,282 |   |   |
| TOTAL REVENUES                                                                                                                                             |       | 1,130,090                                  |          |   | 870,294 |   |   |   | 435,260 |   |   |
| **EXPENSES:**                                                                                                                                              |       |                                       |          |   |   |   |   |   |   |   |   |
| Losses and loss adjustment expenses                                                                                                                        |       | 20,599                                     |          |   | 34,486 |   |   |   | 65,613 |   |   |
| Interest expense                                                                                                                                           |       | 26,993                                     |          |   | 33,026 |   |   |   | 28,098 |   |   |
| Policy acquisition costs                                                                                                                                   |       | 62,201                                     |          |   | 58,391 |   |   |   | 54,093 |   |   |
| Financial products and variable interest entities’  foreign exchange loss                                                                             |       | 91,309                                     |          |   | 118,269 |   |   |   | — |   |   |
| Net interest expense from financial products and  variable interest entities                                                                               |       | 267,599                                    |          |   | 137,103 |   |   |   | 43,445 |   |   |
| Other operating expenses                                                                                                                                   |       | 80,875                                     |          |   | 65,606 |   |   |   | 51,505 |   |   |
| TOTAL EXPENSES                                                                                                                                             |       | 549,576                                    |          |   | 446,881 |   |   |   | 242,754 |   |   |
| INCOME BEFORE INCOME TAXES, MINORITY INTEREST, EQUITY IN  EARNINGS (LOSSES) OF UNCONSOLIDATED AFFILIATES, AND CUMULATIVE EFFECT OF  ACCOUNTING CHANGE |       | 580,514                                    |          |   | 423,413 |   |   |   | 192,506 |   |   |
| Provision (benefit) for  income taxes:                                                                                                                     |       |                                       |          |   |   |   |   |   |   |   |   |
| Current                                                                                                                                                    |       | 53,472                                     |          |   | 74,619 |   |   |   | 51,485 |   |   |
| Deferred                                                                                                                                                   |       | 57,084                                     |          |   | 19,281 |   |   |   | (20,196 | ) |   |
| Total provision                                                                                                                                            |       | 110,556                                    |          |   | 93,900 |   |   |   | 31,289 |   |   |
| NET INCOME BEFORE MINORITY INTEREST, EQUITY IN  EARNINGS (LOSSES) OF UNCONSOLIDATED AFFILIATES, AND CUMULATIVE EFFECT OF  ACCOUNTING CHANGE                |       | 469,958                                    |          |   | 329,513 |   |   |   | 161,217 |   |   |
| Minority interest                                                                                                                                          |       | (6,948                                     | )             |   | (9,292 | ) |   |   | (6,684 | ) |   |
| Minority interest in variable interest entities                                                                                                            |       | (80,460                                    | )             |   | (30,525 | ) |   |   | — |   |   |
| Equity in earnings (losses) of unconsolidated  affiliates, net of income taxes of $604, $1,884 and $12,008                                            |       | (3,943                                     | )             |   | 3,631 |   |   |   | 42,432 |   |   |
| Cumulative effect of accounting change, net of income  taxes of $2,598                                                                                     |       | —                                     |          |   | 4,800 |   |   |   | — |   |   |
| NET INCOME                                                                                                                                                 |       | 378,607                                    |          |   | 298,127 |   |   |   | 196,965 |   |   |
| **OTHER  COMPREHENSIVE INCOME, NET OF TAX:**                                                                                                               |       |                                       |          |   |   |   |   |   |   |   |   |
| Unrealized gains arising during period (net of  deferred income tax provision of $18,698, $4,887 and $60,165)                                         |       | 36,164                                     |          |   | 5,064 |   |   |   | 121,533 |   |   |
| Less: reclassification adjustment for gains included  in net income (net of deferred income tax provision of $237, $1,278 and  $7,874)                     |       | 1,017                                      |          |   | 3,758 |   |   |   | 21,188 |   |   |
| Other comprehensive income                                                                                                                                 |       | 35,147                                     |          |   | 1,306 |   |   |   | 100,345 |   |   |
| COMPREHENSIVE INCOME                                                                                                                                       |       | $                                          | 413,754  |   |   | $ | 299,433  |   |   |   | $ | 297,310  |   |   |

 

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

67

----

**FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. ANDSUBSIDIARIESCONSOLIDATED STATEMENTSOF 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**      | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------------------------------|------------|---------------------------------------|------------|---------------------------|------------|------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                                                                                            | ** ** | ** **        | ** ** | **(restated)**                            | ** ** | **(restated)**                        | ** ** | **(restated)**            | ** ** | ** **                         | ** ** | ** **          | ** ** | **(restated)** | ** ** |
| BALANCE, December 31, 2001                                                                       |       |              | $          | 335                                       |       |                                  |       | $                         | 903,494    |                               |       |                | $          | 62,966         |       |   |   | $ | 666,985 |   |   |   | $ | 23,716 |   |   |   | $ | (23,716 | ) |   | $ | 1,633,780 |   |
| Net income for the year                                                                               |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |           | 196,965    |   |   |   |   |   |   |   |   |   |   | 196,965 |   |
| Net change in accumulated other comprehensive income  (net of deferred income tax expense of $52,291) |       |              |       |                                      |       |                                  |       |                      |       |                               | 100,345    |                |       |           |       |   |   |   |   |   |   |   |   |   |   | 100,345 |   |
| Dividends paid on common stock                                                                        |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |           | (11,709    | ) |   |   |   |   |   |   |   |   |   | (11,709 | ) |
| Deferred equity payout                                                                                |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |           |       |   |   |   | (271 | ) |   |   | 271 |   |   |   |   |
| 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 |   |

 

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

68

----

**FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)**

| ** **                                                                        | ** ** | **Years Ended December 31,** | ** **    |
|-----------------------------------------------------------------------------------|------------|---------------------------------------------|---------------|
| ** **                                                                        | ** ** | **2004**                                    | ** **    | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                        | ** ** | **(restated)**                              | ** **    | **(restated)** | ** ** | **(restated)** | ** ** |
| Cash flows from operating activities:                                             |       |                                        |          |   |   |   |   |
| Premiums received,  net                                                           |       | $                                           | 571,696  |   | $ | 591,030  |   | $ | 575,889  |   |
| Policy acquisition  and other operating expenses paid, net                        |       | (141,875                                    | )             | (105,870 | ) | (101,954 | ) |
| Termination fee on  derivatives                                                   |       | —                                      |          | — |   | (43,000 | ) |
| Recoverable  advances recovered (paid)                                            |       | 7,327                                       |          | (959 | ) | 5,010 |   |
| Losses and loss  adjustment expenses paid, net                                    |       | (42,936                                     | )             | (5,972 | ) | (2,403 | ) |
| Net investment  income received                                                   |       | 171,915                                     |          | 145,221 |   | 129,641 |   |
| Federal income  taxes paid                                                        |       | (62,723                                     | )             | (83,972 | ) | (81,349 | ) |
| Interest paid on  notes                                                           |       | (27,789                                     | )             | (28,687 | ) | (22,710 | ) |
| Interest paid on  guaranteed investment contracts                                 |       | (71,392                                     | )             | (35,739 | ) | (24,411 | ) |
| Interest received  on guaranteed investment contracts portfolio                   |       | 113,030                                     |          | 61,069 |   | 41,837 |   |
| Variable interest  entities’ interest paid                                   |       | (3,216                                      | )             | (3,513 | ) | — |   |
| Variable interest  entities’ net interest income received                    |       | 26,151                                      |          | 10,788 |   | — |   |
| Financial products  and variable interest entities’ net derivative payments  |       | (18,848                                     | )             | (12,564 | ) | 245 |   |
| Income received  from refinanced assets                                           |       | 28,485                                      |          | 25,617 |   | 5,422 |   |
| Other                                                                             |       | 2,989                                       |          | 33,170 |   | (14,593 | ) |
| Net cash provided  by operating activities                                        |       | 552,814                                     |          | 589,619 |   | 467,624 |   |
| Cash flows from investing activities:                                             |       |                                        |          |   |   |   |   |
| Proceeds from  sales and maturities of bonds                                      |       | 784,244                                     |          | 948,365 |   | 785,929 |   |
| Purchases of bonds                                                                |       | (1,176,997                                  | )             | (1,598,396 | ) | (1,188,115 | ) |
| Net (increase)  decrease in short-term investments                                |       | (96,649                                     | )             | 151,988 |   | (155,871 | ) |
| Proceeds from  sales and maturities of guaranteed investment contract bonds       |       | 2,577,485                                   |          | 1,222,708 |   | 850,399 |   |
| Purchases of  guaranteed investment contract bonds                                |       | (6,197,067                                  | )             | (3,385,041 | ) | (2,313,412 | ) |
| Securities  purchased under agreements to resell                                  |       | 175,000                                     |          | (85,000 | ) | (90,000 | ) |
| Net (increase)  decrease in guaranteed investment contract short-term investments |       | (39,310                                     | )             | (224,180 | ) | 313,404 |   |
| Purchases of  variable interest entities’ bonds                              |       | —                                      |          | (16,200 | ) | — |   |
| Maturities of  variable interest entities’ bonds                             |       | 66,575                                      |          | — |   | — |   |
| Net decrease in  variable interest entities’ short-term investments          |       | 9,925                                       |          | 13,048 |   | — |   |
| Purchases of  property, plant and equipment                                       |       | (5,427                                      | )             | (1,202 | ) | (6,126 | ) |
| Assets acquired  through refinancing transactions                                 |       | (215,185                                    | )             | (2,230 | ) | (522,225 | ) |
| Other investments                                                                 |       | 247                                         |          | 30,367 |   | (12,217 | ) |
| Net cash used for  investing activities                                           |       | (4,117,159                                  | )             | (2,945,773 | ) | (2,338,234 | ) |
| Cash flows from financing activities:                                             |       |                                        |          |   |   |   |   |
| Issuance of notes  payable                                                        |       | —                                      |          | 96,673 |   | 222,605 |   |
| Repayment of notes  payable                                                       |       | —                                      |          | (100,000 | ) | (130,000 | ) |
| Distribution to  minority shareholder                                             |       | (6,980                                      | )             | (3,290 | ) | — |   |
| Dividends paid                                                                    |       | (22,876                                     | )             | — |   | (11,700 | ) |
| Securities sold  under repurchase agreements                                      |       | (58,309                                     | )             | 63,965 |   | — |   |
| Proceeds from  issuance of guaranteed investment contracts                        |       | 6,483,881                                   |          | 3,328,487 |   | 2,304,362 |   |
| Repayment of  guaranteed investment contracts                                     |       | (2,740,376                                  | )             | (1,139,173 | ) | (491,073 | ) |
| Proceeds from  issuance of variable interest entities’ debt                  |       | 102,139                                     |          | 101,189 |   | — |   |
| Repayment of  variable interest entities’ debt                               |       | (190,681                                    | )             | — |   | — |   |
| Capital issuance  costs                                                           |       | (1,260                                      | )             | (3,605 | ) | — |   |
| Repayment of  variable interest entities’ preferred stock                    |       | (6,300                                      | )             | — |   | — |   |
| Net cash provided  by financing activities                                        |       | 3,559,238                                   |          | 2,344,246 |   | 1,894,194 |   |
| Net (decrease)  increase in cash                                                  |       | (5,107                                      | )             | (11,908 | ) | 23,584 |   |
| Cash at beginning  of year                                                        |       | 19,460                                      |          | 31,368 |   | 7,784 |   |
| Cash at end of  year                                                              |       | $                                           | 14,353   |   | $ | 19,460  |   | $ | 31,368  |   |

 

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

69

----

**FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED (in thousands)**

 

| ** **                                                                                              | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                              | ** ** | **(restated)**                             | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| Reconciliation of net  income to net cash flows from operating activities:                              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                                              |       |                                       | $          | 378,607  |   |   |   | $ | 298,127  |   |   |   | $ | 196,965  |   |   |
| Increase in accrued investment income                                                                   |       |                                       | (15,976    | ) |   |   | (5,535 | ) |   |   | (6,891 | ) |   |
| Increase in deferred premium revenue and related  foreign exchange adjustment                           |       |                                       | 169,670    |   |   |   | 274,010 |   |   |   | 223,018 |   |   |
| Increase in deferred acquisition costs                                                                  |       |                                       | (34,369    | ) |   |   | (19,869 | ) |   |   | (13,285 | ) |   |
| Increase (decrease) in current federal income taxes  payable                                            |       |                                       | 7,430      |   |   |   | 8,696 |   |   |   | (21,700 | ) |   |
| Increase (decrease) in unpaid losses and loss  adjustment expenses, net of reinsurance recoverable |       |                                       | (29,651    | ) |   |   | 28,736 |   |   |   | 62,120 |   |   |
| Increase (decrease) in amounts withheld for others                                                      |       |                                       | —     |   |   |   | (18 | ) |   |   | — |   |   |
| Provision (benefit) for deferred income taxes                                                           |       |                                       | 57,689     |   |   |   | 23,767 |   |   |   | (16,983 | ) |   |
| Net realized losses (gains) on investments                                                              |       |                                       | (844       | ) |   |   | (5,126 | ) |   |   | (30,879 | ) |   |
| Depreciation and accretion of discount                                                                  |       |                                       | 29,639     |   |   |   | 29,511 |   |   |   | 38,023 |   |   |
| Minority interest and equity in earnings of  unconsolidated affiliates                                  |       |                                       | 90,746     |   |   |   | 34,298 |   |   |   | (38,962 | ) |   |
| Change in other assets and liabilities                                                                  |       |                                       | (100,127   | ) |   |   | (76,978 | ) |   |   | 76,198 |   |   |
| Cash provided by  operating activities                                                                  |       |                                       | $          | 552,814  |   |   |   | $ | 589,619  |   |   |   | $ | 467,624  |   |   |

 

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. See Note 11 for disclosureof non-cash transactions relating to restricted treasury stocktransactions.

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

70

----

**FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. ANDSUBSIDIARIESNOTES TO CONSOLIDATEDFINANCIAL STATEMENTSFOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002**

**1.   ORGANIZATION AND OWNERSHIP**

Financial Security Assurance Holdings Ltd. (togetherwith its consolidated entities, the “Company”) is a holding companyincorporated in the State of New York. The Company is principally engaged,through its insurance company subsidiaries, in providing financial guarantyinsurance on asset-backed and municipal obligations. Its primaryinsurance company subsidiary is Financial Security Assurance Inc. (“FSA”). TheCompany’s underwriting policy is to insure asset-backed and municipalobligations that it determines would be of investment-grade qualitywithout the benefit of the Company’s insurance. The 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”)obligations or credit-linked notes that reference pools of securities orloans, with a defined deductible to cover credit risks associated with thereferenced securities or loans. The municipal obligations insured by theCompany consist primarily of general obligation bonds that are supported by theissuers’ taxing power and of special revenue bonds and other specialobligations of states and local governments that are supported by the issuers’ability to impose and collect fees and charges for public services or specificprojects. Municipal obligations include obligations backed by the cash flowfrom leases or other revenues from projects serving a substantial publicpurpose, including government office buildings, toll roads, healthcarefacilities and utilities. 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 asset-backedand municipal obligations, with a broad geographic distribution and a varietyof revenue sources and transaction structures. The Company’s insured portfolioconsists primarily of asset-backed and municipal obligations originatedin the United States of America, but the Company has also written and continuesto 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 obtaining control rights. The Company refinanced certain defaultedtransactions by employing refinancing vehicles to raise funds for therefinancings. These refinancing vehicles are also consolidated.

71

----

FSA Global is a special purpose funding vehicle owned29% by an affiliate 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 debt defeasancefor 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.

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.,which, in turn, is owned 90% by Dexia Crédit Local and 10% by Dexia S.A. (“Dexia”),a Belgian corporation whose shares are traded on the Euronext Brussels andEuronext Paris markets, as well as on the Luxembourg Stock Exchange. DexiaCrédit Local is a wholly owned subsidiary of Dexia. At the merger date, eachoutstanding share of the Company’s common stock was converted into the right toreceive $76.00 in cash. At December 31, 2004, Dexia Holdings, Inc.owned approximately 99% of the Company’s outstanding shares; the only otherholders of the Company’s common stock were an affiliate of White MountainsInsurance Group, Ltd. and certain current and former directors of the Companywho owned shares of the Company’s common stock or economic interests thereinunder the Director Share Purchase Program (see Note 11).

**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 6). The preparation of financial statements inconformity with GAAP requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities in the Company’s consolidated balance sheetsat December 31, 2004 and 2003 and the reported amounts of revenues andexpenses in the statements of operations and comprehensive income during theyears ended December 31, 2004, 2003 and 2002. 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 Management Inc.,Transaction Services Corporation, FSA Services (Australia) Pty Limited and FSAServices (Japan) Inc. (collectively, the “Subsidiaries”). The consolidatedfinancial statements also include the accounts of certain VIEs as described inNote 1. All intercompany accounts and transactions have been eliminated.Certain prior-year balances have been reclassified to conform to the 2004presentation.

***Investments***

Investments in debt and equity securities designatedas available for sale are carried at fair value. The unrealized gain or loss onthe investments that are not hedged is reflected as a separate component of 

72

----

shareholders’ equity, netof applicable deferred income taxes. The unrealized gain or loss attributableto the hedged risk on the investments that qualify as fair-value hedgesis recorded in income currently.

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. Cashequivalents are amounts deposited in money market funds and investments with amaturity at time of purchase of three months or less and are included in short-terminvestments. Mortgage loans are carried at the lower of cost or market on anaggregate basis. Realized gains or losses on sale of investments are determinedon the basis of specific identification. Investment income is recorded asearned. Other-than-temporary impairments are reflected in earningsas a realized loss.

Investments inunconsolidated affiliates are based on the equity method of accounting (seeNote 19). The Company records its share of unrealized gains or losses, net ofapplicable deferred taxes, in other comprehensive income.

***Derivatives***

Derivative instruments are entered into toeconomically manage the interest-rate and currency exchange-rateexposure of the Company’s GIC and VIE debt, GIC bond portfolio, and VIE bondportfolio and are recorded at fair value. These derivatives generally includeinterest-rate futures and interest-rate and currency swapagreements, which are primarily utilized to convert the Company’s fixed-rateobligations on its GIC and VIE debt, GIC bond portfolio and VIE bond portfoliointo U.S.-dollar floating-rate obligations. The gains and lossesrelating to the fair value of derivatives are included in net realized andunrealized gains (losses) on derivative instruments in the Statements ofOperations and Comprehensive Income.

The gains and losses related to derivatives designatedas fair value hedges are included in financial products and variable interestentities net interest income and financial products and variable interest entitiesnet interest expense, as appropriate, along with the offsetting change in thefair value of the hedged item attributable to the risk being hedged.

The Company has also insured a number of CDSagreements that it intends, in each case, to hold for the full term of theagreement. It considers these agreements to be a normal extension of itsfinancial guaranty insurance business, although they are considered derivativesfor accounting purposes. These agreements are recorded at fair value. TheCompany believes that the most meaningful presentation of the financialstatement impact of these derivatives is to reflect premiums as installmentsare received, to record losses and loss adjustment expenses as incurred and torecord changes in fair value as incurred. Changes in fair value are recorded innet realized and unrealized gains (losses) on derivative instruments and inother assets or other liabilities, as appropriate. The Company uses quotedmarket prices, when available, to determine fair value. If quoted prices arenot available, management uses internally developed estimates of fair value.Due to a lack of a quoted market for the CDS obligations written by theCompany, estimates generated from the Company’s valuation process may differmaterially from values that may be realized in market transactions.

In addition to insuringCDS agreements, the Company may, from time to time, enter into derivativeinstruments that have not been designated as hedges. The Company records theseinstruments at fair value with a corresponding adjustment to net realized andunrealized gains (losses) on derivative instruments in the Statements ofOperations and Comprehensive Income.

73

----

***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 premiumsreceived in upfront payouts are earned in proportion to the amount of riskoutstanding over the expected period of coverage. 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 premium that is applicable to coverage ofrisk to be provided in the future on policies in force. When an insured issueis retired or defeased prior to the end of the expected period of coverage, theremaining deferred premium revenue and prepaid reinsurance premium, less anyamount credited to a refunding issue insured by the Company, are recognized.For premiums received on an installment basis, the Company earns the premiumover each installment period, typically less than one year, throughout theperiod of coverage. Typically, installment premiums are applicable to insuredtransactions that involve special purpose vehicles (SPVs) structured to financepools of assets such as auto loans or mortgage loans. Premiums on suchtransactions are typically paid in installments because premium is paid fromthe interest spread available to the SPV (i.e. the difference in interest ratebetween the yield on its assets and the yield in its liabilities). The natureof the assets financed can have uncertain debt service schedules due toprepayments. When the Company, through its ongoing credit review process,identifies transactions where premiums are paid on an installment basis andcertain default triggers have been breached, the Company ceases to earnpremiums 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 theobligation’s original payment schedule or, at its option, to pay such amountson an accelerated basis.

Financial guaranty as anindustry has emerged over the past thirty 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 literature including sections of SFAS 60,Statement of Financial Accounting Standards No. 5, “Accounting forContingencies” (“SFAS 5”) and Emerging Issues Task Force Issue 85-20, “Recognitionof 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.

74

----

The Company calculates a loss and LAE liability basedupon identified risks inherent in its entire insured portfolio. If anindividual policy risk has a probable loss as of the balance sheet date, a casereserve is established. 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 casualtycase reserves 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 thattransaction pays a premium in installments, those premiums, if expected to bereceived prospectively, are considered a form of recovery and are no longerearned as premium revenue. A case reserve is determined using cash flow orsimilar models that represent the Company’s estimate of the net present valueof the anticipated shortfall between (i) scheduled payments on the insuredobligation plus anticipated loss adjustment expenses and (ii) 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. Non-specific reservesin addition to case reserves represent the Company’s estimate of totalreserves. Generally, when an insured credit deteriorates to a point whereclaims are expected, a case reserve is established. The establishment of non-specificreserves for credits that have not yet defaulted is a common practice in thefinancial guaranty industry, although the Company acknowledges that there maybe differences in the specific methodologies applied by other financialguarantors in establishing and measuring these reserves.

The Company establishes non-specific reserves onits entire 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 these reserves is a systematic process thatconsiders this quantitative, statistical information obtained primarily fromMoody’s Investors Service, Inc. (“Moody’s”) and Standard & Poor’sRatings Services (“S&P”), together with qualitative factors such as overallcredit quality trends resulting from economic and political conditions, recentloss experience in particular segments of the portfolio and changes inunderwriting policies and procedures. The factors used to establish reservesare evaluated periodically by comparing the statistically computed loss amountto the incurred losses as represented by case reserve activity to develop anexperience factor, which is updated and applied to future originations. Theprocess results in management’s best estimate of inherent losses associatedwith providing credit protection at each balance sheet date.

75

----

The non-specific reserve amount establishedconsiders all levels of protection (e.g. reinsurance andovercollateralization). Net par outstanding for policies originated in thecurrent period is multiplied by loss frequency and severity factors, with theresulting amounts discounted at the risk-free rates using the treasuryyield curve (the “statistical calculation”). The discount rate does not changeand is used to accrete the loss for the life of each policy. The loss factorsused for the calculation are the product of default frequency rates obtainedfrom Moody’s and severity factors obtained from S&P. Moody’s is chosen dueto 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 from1970-2003, 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-specific reservethere is no identifiable reinsurance recoverable. At the time that a casereserve is identified, the gross loss liability is recognized along with thereinsurance recoverable, if any. The amount of reinsurance recoverable dependson the policy ceded and the reinsurance agreements covering such policy.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.

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 case basis losses divided by the total inception-to-datecumulative net par underwritten. This inception-to-date result iscompared with the product of the non specific reserves divided by the net paroutstanding as of the balance sheet date. In the event that such ratios are notin line, then further analysis is performed to 

76

----

quantify appropriateadjustments that may be either income statement charges or benefits, asoccurred in 2002, 2003 and 2004 as described in Note 17.

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

| ** **                          | ** ** | **As of December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Case reserve  discount rate         |       | 3.13%–5.90%                      |       | 4.94%–6.10% |   |
| Non-specific  reserve discount rate |       | 1.20%–7.95%                      |       | 1.2%–7.95% |   |
| Current experience  factor          |       | 2.0                                   |       | 2.4 |   |

 

*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 different techniquesto estimate probable loss. Other financial guarantors may establish theequivalent 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 estimable. The Company also relies by analogy on EITF 85-20, whichprovides general guidance on the recognition of losses related to guaranteeinga loan. In the absence of a comprehensive accounting model provided by SFAS 60,industry participants, including the Company, have looked to such other guidancereferred to above to develop their accounting policies for the establishmentand measurement of loss liabilities. The Company believes that its financialguaranty loss reserve policy is appropriate under the applicable accountingliterature, and that it best reflects the fact that a portfolio of credit basedinsurance, comprising irrevocable contracts that cannot be unilaterally changedby the insurer and that match the maturity terms of the underlying insuredobligation, contains probable and reasonably estimable 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 whether additional guidance regarding financial guaranty insuranceshould be provided. When and if the FASB or SEC reach a conclusion on thisissue, the Company and the rest of the financial guaranty industry may berequired to change some aspects of their loss reserving policies, and thepotential changes could extend to premium and expense recognition. The Companycannot predict how the FASB or SEC will resolve this issue and the resultingimpact on its financial statements.

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

77

----

***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 income on premiumsceded to reinsurers. Deferred acquisition costs are amortized over the periodin which the related premiums are earned. When an insured issue is retired ordefeased prior to the end of the expected period of coverage, the remainingdeferred acquisition cost is recognized. Recoverability of deferred acquisitioncosts is determined by considering deferred premium revenue and estimated installmentpremiums and the present value of anticipated losses and loss adjustmentexpenses.

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 currency 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 hedge,attributable to the hedged risk, adjusts the carrying amount of the hedged itemand is recognized in income currently. VIE debt may include hybrid debtinstruments that contain embedded derivatives. Under certain conditions,embedded derivatives are required to be accounted for separately, at fair valuethrough earnings.

***Foreign Currency Translation***

Monetary assets andliabilities denominated in foreign currencies are translated at the spot rate.Non-monetary assets and liabilities are translated at historical rates.Revenues and expenses denominated in foreign currencies are translated ataverage rates prevailing during the year. Unrealized gains and losses onavailable-for-sale securities, net of deferred taxes, resultingfrom translating investments denominated in foreign currencies are recorded inshareholders’ equity. Gains and losses from transactions in foreign currenciesare 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 for the tax benefit that results fromdeducting contingency reserves as provided under Internal Revenue Code Section 832(e).The Company records the purchase of tax and loss bonds as prepayments offederal income taxes and includes them in other assets.

**3.   RESTATEMENTOF PREVIOUSLY ISSUED FINANCIAL STATEMENTS**

The Company has restatedits financial statements for the years ended December 31, 2004, 2003 and2002, and the periods ended March 31, June 30, September 30 and December 31,2003 and 2004, and opening retained earnings at January 1, 2002. Therestatement arises from the Company’s incorrect application of hedge accountingto certain transactions conducted through FSA Global and the FP Segment.

78

----

***Background***

FSA Global conducts its business on a matched fundingbasis, such that (1) fixed interest rate assets are matched with fixedinterest rate liabilities and (2) floating interest rate assets arematched with floating interest rate liabilities using the same interest ratemeasure (e.g. LIBOR). The purpose of matching interest rates on assets withinterest rates on liabilities is to “hedge” any risk associated with interestrate fluctuations. In the event that assets and liabilities do not match, FSAGlobal may enter into an interest rate swap to make such a match. FSA Global fundscertain assets with foreign denominated debt and accordingly it may also enterinto foreign currency swaps to hedge the currency risk associated with foreigndenominated debt.

The FP Segment issues U.S. dollar and foreign denominatedGICs and invests the proceeds with the primary objectives of producing a stablenet interest margin, maintaining liquidity and optimizing risk-adjustedreturns. The assets and liabilities are hedged using interest rate swaps, crosscurrency swaps and futures in order to convert all fixed rate assets andliabilities into U.S. dollar denominated floating rate assets and liabilities.

The Company follows SFAS 133 in accounting forderivative transactions. SFAS 133 requires that a company carry its derivativeson its balance sheet at fair value, reflecting periodic changes in fair valuein earnings.

In accordance with SFAS 133, a hedging relationshipthat has appropriate contemporaneous documentation and meets certain specifiedcriteria is eligible for “fair value” hedge accounting, and the offsettingchanges in fair value of the hedged items attributable to the risk being hedgedmay be recorded in earnings. To the extent that these changes in value do notcompletely offset the changes in value of the related derivatives, there is anet impact on the statements of operations and comprehensive income. Theapplication of hedge accounting generally requires a company to evaluate theeffectiveness of the hedging relationships on an ongoing basis and to calculatethe changes in fair value of the derivatives and related hedged itemsindependently. This is known as the “long-haul” method of hedge accounting.Hedging relationships that meet more stringent criteria under SFAS 133 mayqualify for the “short-cut” method of hedge accounting, in which a company canmake the assumption that the change in fair value of a hedged item attributableto changes in interest rate exactly offsets the change in fair value of therelated derivative, rather than periodically evaluating the actual change infair value of the hedged item independently.

79

----

Theimpact of the restatement on the balance sheet is shown in the tables below. See“Restatement” section for discussion of the adjustments made in columns 1through 3.

| ** **                                                                 | ** ** | **As of December 31, 2004** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As  previously  filed**                       | ** ** | **(1)  Hedge  Accounting** | ** ** | **(2)  Other  Adjustments** | ** ** | **(3)  Reclasses** | ** ** | **Restated** | ** ** |
| ** **                                                                 | ** ** | **(in thousands)**                         | ** ** |
| **ASSETS:**                                                                |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Bonds at fair value                                                        |       | $                                               | 3,914,763  |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 3,914,763 |   |
| Equity securities at fair  value                                           |       | 54,300                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | 54,300 |   |
| Short-term investments                                                     |       | 321,071                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 321,071 |   |
| Variable interest  entities’ bonds at fair value                      |       | 1,346,355                                       |       |   | — |   |   |   | — |   |   |   | — |   |   | 1,346,355 |   |
| Variable interest  entities’ short-term  investment portfolio         |       | 1,194                                           |       |   | — |   |   |   | — |   |   |   | — |   |   | 1,194 |   |
| Financial products bond  portfolio                                         |       | 7,925,072                                       |       |   | — |   |   |   | — |   |   |   | — |   |   | 7,925,072 |   |
| Financial products bond  portfolio pledged as collateral                   |       | 5,913                                           |       |   | — |   |   |   | — |   |   |   | — |   |   | 5,913 |   |
| Financial products short-term  investment portfolio                        |       | 268,125                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 268,125 |   |
| Total investment  portfolio                                                |       | 13,836,793                                      |       |   | — |   |   |   | — |   |   |   | — |   |   | 13,836,793 |   |
| Assets acquired in refinancing transactions:                               |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Bonds                                                                      |       | 157,036                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 157,036 |   |
| Securitized loans                                                          |       | 371,092                                         |       |   | (1,343 | ) |   |   | — |   |   |   | — |   |   | 369,749 |   |
| Other                                                                      |       | 224,908                                         |       |   | 2,215 |   |   |   | — |   |   |   | (4,700 | ) |   | 222,423 |   |
| Total assets acquired in  refinancing transactions                         |       | 753,036                                         |       |   | 872 |   |   |   | — |   |   |   | (4,700 | ) |   | 749,208 |   |
| Total investments                                                     |       | 14,589,829                                      |       |   | 872 |   |   |   | — |   |   |   | (4,700 | ) |   | 14,586,001 |   |
| Cash                                                                       |       | 14,353                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | 14,353 |   |
| Deferred acquisition  costs                                                |       | 308,015                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 308,015 |   |
| Prepaid reinsurance premiums                                               |       | 759,191                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 759,191 |   |
| Investment in  unconsolidated affiliate                                    |       | 49,645                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | 49,645 |   |
| Reinsurance recoverable  on unpaid losses                                  |       | 35,419                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | 35,419 |   |
| Other assets                                                               |       | 1,324,355                                       |       |   | — |   |   |   | (20,028 | ) |   |   | 24,057 |   |   | 1,328,384 |   |
| TOTAL ASSETS                                                          |       | $                                               | 17,080,807 |   |   | $ | 872 |   |   |   | $ | (20,028 | ) |   |   | $ | 19,357 |   |   | $ | 17,081,008 |   |
| **LIABILITIES AND MINORITY INTEREST AND  SHAREHOLDERS’ EQUITY:**      |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deferred premium revenue                                                   |       | $                                               | 2,095,423  |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 2,095,423 |   |
| Losses and loss  adjustment expenses                                       |       | 179,941                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 179,941 |   |
| Guaranteed investment  contracts and variable interest entities’ debt |       | 10,734,357                                      |       |   | (270,278 | ) |   |   | (20,028 | ) |   |   | — |   |   | 10,444,051 |   |
| Deferred federal income  taxes                                             |       | 216,619                                         |       |   | 32,994 |   |   |   | 52 |   |   |   | — |   |   | 249,665 |   |
| Notes payable                                                              |       | 430,000                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 430,000 |   |
| Minority interest                                                          |       | —                                          |       |   | — |   |   |   | — |   |   |   | 48,550 |   |   | 48,550 |   |
| Minority interest in  variable interest entities                           |       | —                                          |       |   | 176,881 |   |   |   | — |   |   |   | 1,694 |   |   | 178,575 |   |
| Accrued expenses and  other liabilities                                    |       | 874,510                                         |       |   | — |   |   |   | (98 | ) |   |   | (30,887 | ) |   | 843,525 |   |
| TOTAL LIABILITIES AND MINORITY INTEREST                          |       | 14,530,850                                      |       |   | (60,403 | ) |   |   | (20,074 | ) |   |   | 19,357 |   |   | 14,469,730 |   |
| COMMITMENTS AND CONTINGENCIES:                                             |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Common stock                                                               |       | 335                                             |       |   | — |   |   |   | — |   |   |   | — |   |   | 335 |   |
| Additional paid-in  capital—common                                    |       | 900,215                                         |       |   | — |   |   |   | 4,865 |   |   |   | — |   |   | 905,080 |   |
| Accumulated other  comprehensive income                                    |       | 177,796                                         |       |   | 21,968 |   |   |   | — |   |   |   | — |   |   | 199,764 |   |
| Accumulated earnings                                                       |       | 1,471,611                                       |       |   | 39,307 |   |   |   | (4,819 | ) |   |   | — |   |   | 1,506,099 |   |
| Deferred equity  compensation                                              |       | 23,528                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | 23,528 |   |
| Less treasury stock at cost                                                |       | (23,528                                         | )          |   | — |   |   |   | — |   |   |   | — |   |   | (23,528 | ) |
| TOTAL SHAREHOLDERS’  EQUITY                                           |       | 2,549,957                                       |       |   | 61,275 |   |   |   | 46 |   |   |   | — |   |   | 2,611,278 |   |
| TOTAL LIABILITIES AND MINORITY INTEREST AND  SHAREHOLDERS’ EQUITY     |       | $                                               | 17,080,807 |   |   | $ | 872 |   |   |   | $ | (20,028 | ) |   |   | $ | 19,357 |   |   | $ | 17,081,008 |   |

 

80

----

 

| ** **                                                                 | ** ** | **AS of December 31, 2003** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As  previously   filed**                 | ** ** | **(1)  Hedge  Accounting** | ** ** | **(2)  Other  Adjustments** | ** ** | **(3)  Reclasses** | ** ** | **Restated** | ** ** |
| ** **                                                                 | ** ** | **(in thousands)**                         | ** ** |
| **ASSETS:**                                                                |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Bonds at fair  value                                                       |       | $                                               | 3,508,649  |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 3,508,649 |   |
| Equity securities  at fair value                                           |       | —                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | — |   |
| Short-term  investments                                                    |       | 224,429                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 224,429 |   |
| Variable interest  entities’ bonds at fair value                      |       | 1,422,538                                       |       |   | — |   |   |   | — |   |   |   | — |   |   | 1,422,538 |   |
| Variable interest  entities’ short-term  investment portfolio         |       | 11,102                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | 11,102 |   |
| Financial products  bond portfolio                                         |       | 4,031,263                                       |       |   | — |   |   |   | — |   |   |   | — |   |   | 4,031,263 |   |
| Financial products  bond portfolio pledged as collateral                   |       | 66,423                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | 66,423 |   |
| Financial products  short-term investment portfolio                        |       | 228,812                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 228,812 |   |
| Total investment  portfolio                                                |       | 9,493,216                                       |       |   | — |   |   |   | — |   |   |   | — |   |   | 9,493,216 |   |
| Assets acquired in refinancing transactions:                               |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Bonds                                                                      |       | —                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | — |   |
| Securitized loans                                                          |       | 440,611                                         |       |   | (6,662 | ) |   |   | — |   |   |   | — |   |   | 433,949 |   |
| Other                                                                      |       | 70,592                                          |       |   | 992 |   |   |   | — |   |   |   | 1,418 |   |   | 73,002 |   |
| Total assets  acquired in refinancing transactions                         |       | 511,203                                         |       |   | (5,670 | ) |   |   | — |   |   |   | 1,418 |   |   | 506,951 |   |
| Total investments                                                     |       | 10,004,419                                      |       |   | (5,670 | ) |   |   | — |   |   |   | 1,418 |   |   | 10,000,167 |   |
| Cash                                                                       |       | 19,460                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | 19,460 |   |
| Deferred  acquisition costs                                                |       | 273,646                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 273,646 |   |
| Prepaid  reinsurance premiums                                              |       | 695,398                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 695,398 |   |
| Investment in  unconsolidated affiliate                                    |       | 110,863                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 110,863 |   |
| Reinsurance  recoverable on unpaid losses                                  |       | 59,235                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | 59,235 |   |
| Other assets                                                               |       | 1,246,739                                       |       |   | — |   |   |   | (18,297 | ) |   |   | 20,352 |   |   | 1,248,794 |   |
| TOTAL ASSETS                                                          |       | $                                               | 12,409,760 |   |   | $ | (5,670 | ) |   |   | $ | (18,297 | ) |   |   | $ | 21,770 |   |   | $ | 12,407,563 |   |
| **LIABILITIES AND MINORITY INTEREST AND  SHAREHOLDERS’ EQUITY:**      |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deferred premium  revenue                                                  |       | $                                               | 1,861,960  |   |   | $ | — |   |   |   | $ | (16,969 | ) |   |   | $ | — |   |   | $ | 1,844,991 |   |
| Losses and loss  adjustment expenses                                       |       | 233,408                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 233,408 |   |
| Guaranteed  investment contracts and variable interest entities’ debt |       | 6,809,771                                       |       |   | (152,093 | ) |   |   | (18,297 | ) |   |   | — |   |   | 6,639,381 |   |
| Deferred federal income  taxes                                             |       | 152,646                                         |       |   | 15,523 |   |   |   | 5,346 |   |   |   | — |   |   | 173,515 |   |
| Notes payable                                                              |       | 430,000                                         |       |   | — |   |   |   | — |   |   |   | — |   |   | 430,000 |   |
| Minority interest                                                          |       | —                                          |       |   | — |   |   |   | — |   |   |   | 60,525 |   |   | 60,525 |   |
| Minority interest  in variable interest entities                           |       | —                                          |       |   | 102,070 |   |   |   | — |   |   |   | 381 |   |   | 102,451 |   |
| Accrued expenses  and other liabilities                                    |       | 753,539                                         |       |   | — |   |   |   | (10,260 | ) |   |   | (39,136 | ) |   | 704,143 |   |
| TOTAL LIABILITIES AND MINORITY INTEREST                          |       | 10,241,324                                      |       |   | (34,500 | ) |   |   | (40,180 | ) |   |   | 21,770 |   |   | 10,188,414 |   |
| COMMITMENTS AND CONTINGENCIES:                                             |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Common stock                                                               |       | 335                                             |       |   | — |   |   |   | — |   |   |   | — |   |   | 335 |   |
| Additional paid-in  capital—common                                    |       | 900,224                                         |       |   | — |   |   |   | 3,605 |   |   |   | — |   |   | 903,829 |   |
| Accumulated other  comprehensive income                                    |       | 147,433                                         |       |   | 10,685 |   |   |   | 6,499 |   |   |   | — |   |   | 164,617 |   |
| Accumulated  earnings                                                      |       | 1,120,444                                       |       |   | 18,145 |   |   |   | 11,779 |   |   |   | — |   |   | 1,150,368 |   |
| Deferred equity  compensation                                              |       | 23,445                                          |       |   | — |   |   |   | — |   |   |   | — |   |   | 23,445 |   |
| Less treasury  stock at cost                                               |       | (23,445                                         | )          |   | — |   |   |   | — |   |   |   | — |   |   | (23,445 | ) |
| TOTAL  SHAREHOLDERS’ EQUITY                                           |       | 2,168,436                                       |       |   | 28,830 |   |   |   | 21,883 |   |   |   | — |   |   | 2,219,149 |   |
| TOTAL LIABILITIES  AND MINORITY INTEREST AND SHAREHOLDERS’ EQUITY     |       | $                                               | 12,409,760 |   |   | $ | (5,670 | ) |   |   | $ | (18,297 | ) |   |   | $ | 21,770 |   |   | $ | 12,407,563 |   |

 

The impact of the restatement on opening retainedearnings at January 1, 2002 was a decrease of $2.2 million.

81

----

Theimpact of the restatement on the consolidated statements of operations andcomprehensive income is shown in the tables below. See “Restatement” sectionfor discussion of the adjustments made in columns 1 through 3.

| ** **                                                                                                                                            | ** ** | **Year Ended December 31, 2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                                            | ** ** | **As  previously  filed**                            | ** ** | **(1)  Hedge  Accounting** | ** ** | **(2)  Other  Adjustments** | ** ** | **(3)  Reclasses** | ** ** | **Restated** | ** ** |
| ** **                                                                                                                                            | ** ** | **(in thousands)**                              | ** ** |
| **REVENUES:**                                                                                                                                         |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net premiums  written                                                                                                                                 |       |                                                 | $          | 587,769 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 587,769 |   |
| Net premiums  earned                                                                                                                                  |       |                                                 | $          | 395,015 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 395,015 |   |
| Net investment  income                                                                                                                                |       |                                                 | 172,051    |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 172,051 |   |
| Net realized gains  (losses)                                                                                                                          |       |                                                 | (473       | ) |   |   | — |   |   |   | — |   |   |   | — |   |   | (473 | ) |
| Net interest  income from financial products and variable interest entities                                                                           |       |                                                 | 152,641    |   |   |   | 42,034 |   |   |   | — |   |   |   | — |   |   | 194,675 |   |
| Financial products  net realized gains (losses)                                                                                                       |       |                                                 | 2,217      |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 2,217 |   |
| Net realized and  unrealized gains (losses) on derivative instruments                                                                                 |       |                                                 | 54,576     |   |   |   | 274,683 |   |   |   | — |   |   |   | — |   |   | 329,259 |   |
| Income from assets  acquired in refinancing transactions                                                                                              |       |                                                 | 14,765     |   |   |   | 16,869 |   |   |   | — |   |   |   | — |   |   | 31,634 |   |
| Other income                                                                                                                                          |       |                                                 | 5,712      |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 5,712 |   |
| Total Revenues                                                                                                                                        |       |                                                 | 796,504    |   |   |   | 333,586 |   |   |   | — |   |   |   | — |   |   | 1,130,090 |   |
| **EXPENSES:**                                                                                                                                         |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Losses and loss  adjustment expenses                                                                                                                  |       |                                                 | 20,599     |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 20,599 |   |
| Interest expense                                                                                                                                      |       |                                                 | 26,993     |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 26,993 |   |
| Policy acquisition  costs                                                                                                                             |       |                                                 | 62,201     |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 62,201 |   |
| Financial products  and variable interest entities’ foreign exchange loss                                                                        |       |                                                 | —     |   |   |   | 91,309 |   |   |   | — |   |   |   | — |   |   | 91,309 |   |
| Net interest  expense from financial products and variable interest entities                                                                          |       |                                                 | 138,075    |   |   |   | 129,524 |   |   |   | — |   |   |   | — |   |   | 267,599 |   |
| Other operating  expenses                                                                                                                             |       |                                                 | 72,645     |   |   |   | — |   |   |   | 8,230 |   |   |   | — |   |   | 80,875 |   |
| Total Expenses                                                                                                                                        |       |                                                 | 320,513    |   |   |   | 220,833 |   |   |   | 8,230 |   |   |   | — |   |   | 549,576 |   |
| Minority interest                                                                                                                                     |       |                                                 | (7,210     | ) |   |   | — |   |   |   | — |   |   |   | 7,210 |   |   | — |   |
| Equity in earnings  (losses) of unconsolidated affiliates                                                                                             |       |                                                 | (3,339     | ) |   |   | — |   |   |   | — |   |   |   | 3,339 |   |   | — |   |
| Income before  income taxes, minority interest, equity in earnings (losses) of  unconsolidated affiliates, and cumulative effect of accounting change |       |                                                 | 465,442    |   |   |   | 112,753 |   |   |   | (8,230 | ) |   |   | 10,549 |   |   | 580,514 |   |
| Current federal  taxes                                                                                                                                |       |                                                 | 53,570     |   |   |   | — |   |   |   | (98 | ) |   |   | — |   |   | 53,472 |   |
| Deferred federal  taxes                                                                                                                               |       |                                                 | 48,088     |   |   |   | 11,395 |   |   |   | (1,794 | ) |   |   | (605 | ) |   | 57,084 |   |
| Total provision                                                                                                                                       |       |                                                 | 101,658    |   |   |   | 11,395 |   |   |   | (1,892 | ) |   |   | (605 | ) |   | 110,556 |   |
| Net income before  minority interest, equity in earnings (losses) of unconsolidated affiliates,  and cumulative effect of accounting change           |       |                                                 | 363,784    |   |   |   | 101,358 |   |   |   | (6,338 | ) |   |   | 11,154 |   |   | 469,958 |   |
| Minority interest                                                                                                                                     |       |                                                 | —     |   |   |   | — |   |   |   | — |   |   |   | (6,948 | ) |   | (6,948 | ) |
| Minority interest  in variable interest entities                                                                                                      |       |                                                 | —     |   |   |   | (80,197 | ) |   |   | — |   |   |   | (263 | ) |   | (80,460 | ) |
| Equity in earnings  (losses) of unconsolidated affiliates                                                                                             |       |                                                 | —     |   |   |   | — |   |   |   | — |   |   |   | (3,943 | ) |   | (3,943 | ) |
| Cumulative effect  of accounting change                                                                                                               |       |                                                 | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   | — |   |
| Net Income                                                                                                                                            |       |                                                 | 363,784    |   |   |   | 21,161 |   |   |   | (6,338 | ) |   |   | — |   |   | 378,607 |   |
| **OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX:**                                                                                                    |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized Gains  arising during period                                                                                                               |       |                                                 | 31,380     |   |   |   | 11,282 |   |   |   | (6,498 | ) |   |   | — |   |   | 36,164 |   |
| Less:  reclassification adjustment for gains included in net income                                                                                   |       |                                                 | 1,017      |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 1,017 |   |
| Other  comprehensive income (loss)                                                                                                                    |       |                                                 | 30,363     |   |   |   | 11,282 |   |   |   | (6,498 | ) |   |   | — |   |   | 35,147 |   |
| COMPREHENSIVE  INCOME (LOSS)                                                                                                                          |       |                                                 | $          | 394,147 |   |   |   | $ | 32,443 |   |   |   | $ | (12,836 | ) |   |   | $ | — |   |   | $ | 413,754 |   |

 

82

----

| ** **                                                                                                                                            | ** ** | **Year Ended December 31, 2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                                            | ** ** | **As  previously  filed**                            | ** ** | **(1)  Hedge  Accounting** | ** ** | **(2)  Other  Adjustments** | ** ** | **(3)  Reclasses** | ** ** | **Restated** | ** ** |
| ** **                                                                                                                                            | ** ** | **(in thousands)**                              | ** ** |
| **REVENUES:**                                                                                                                                         |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net premiums  written                                                                                                                                 |       |                                                 | $          | 614,284 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 614,284 |   |
| Net premiums  earned                                                                                                                                  |       |                                                 | $          | 356,373 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 356,373 |   |
| Net investment  income                                                                                                                                |       |                                                 | 154,048    |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 154,048 |   |
| Net realized gains  (losses)                                                                                                                          |       |                                                 | 5,126      |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 5,126 |   |
| Net interest  income from financial products and variable interest entities                                                                           |       |                                                 | 56,851     |   |   |   | 32,282 |   |   |   | — |   |   |   | — |   |   | 89,133 |   |
| Financial products  net realized gains (losses)                                                                                                       |       |                                                 | (950       | ) |   |   | 11,853 |   |   |   | — |   |   |   | — |   |   | 10,903 |   |
| Net realized and  unrealized gains (losses) on derivative instruments                                                                                 |       |                                                 | 39,442     |   |   |   | 188,007 |   |   |   | — |   |   |   | — |   |   | 227,449 |   |
| Income from assets  acquired in refinancing transactions                                                                                         |       |                                                 | 19,460     |   |   |   | 5,816 |   |   |   | — |   |   |   | — |   |   | 25,276 |   |
| Other income                                                                                                                                          |       |                                                 | 1,986      |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 1,986 |   |
| Total Revenues                                                                                                                                        |       |                                                 | 632,336    |   |   |   | 237,958 |   |   |   | — |   |   |   | — |   |   | 870,294 |   |
| **EXPENSES:**                                                                                                                                         |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Losses and loss  adjustment expenses                                                                                                                  |       |                                                 | 34,486     |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 34,486 |   |
| Interest expense                                                                                                                                      |       |                                                 | 33,026     |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 33,026 |   |
| Policy acquisition  costs                                                                                                                             |       |                                                 | 58,391     |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 58,391 |   |
| Financial products  and variable interest entities’ foreign exchange loss                                                                        |       |                                                 | —     |   |   |   | 118,269 |   |   |   | — |   |   |   | — |   |   | 118,269 |   |
| Net interest  expense from financial products and variable interest entities                                                                          |       |                                                 | 59,037     |   |   |   | 78,066 |   |   |   | — |   |   |   | — |   |   | 137,103 |   |
| Other operating  expenses                                                                                                                             |       |                                                 | 66,940     |   |   |   | — |   |   |   | (1,334 | ) |   |   | — |   |   | 65,606 |   |
| Total Expenses                                                                                                                                        |       |                                                 | 251,880    |   |   |   | 196,335 |   |   |   | (1,334 | ) |   |   | — |   |   | 446,881 |   |
| Minority interest                                                                                                                                     |       |                                                 | (9,612     | ) |   |   | — |   |   |   | — |   |   |   | 9,612 |   |   | — |   |
| Equity in earnings  (losses) of unconsolidated affiliates                                                                                             |       |                                                 | 5,529      |   |   |   | — |   |   |   | — |   |   |   | (5,529 | ) |   | — |   |
| Income before  income taxes, minority interest, equity in earnings (losses) of  unconsolidated affiliates, and cumulative effect of accounting change |       |                                                 | 376,373    |   |   |   | 41,623 |   |   |   | 1,334 |   |   |   | 4,083 |   |   | 423,413 |   |
| Current federal  taxes                                                                                                                                |       |                                                 | 74,619     |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 74,619 |   |
| Deferred federal  taxes                                                                                                                               |       |                                                 | 15,968     |   |   |   | 4,005 |   |   |   | 1,206 |   |   |   | (1,898 | ) |   | 19,281 |   |
| Total provision                                                                                                                                       |       |                                                 | 90,587     |   |   |   | 4,005 |   |   |   | 1,206 |   |   |   | (1,898 | ) |   | 93,900 |   |
| Net income before  minority interest, equity in earnings (losses) of unconsolidated affiliates,  and cumulative effect of accounting change           |       |                                                 | 285,786    |   |   |   | 37,618 |   |   |   | 128 |   |   |   | 5,981 |   |   | 329,513 |   |
| Minority interest                                                                                                                                     |       |                                                 | —     |   |   |   | — |   |   |   | — |   |   |   | (9,292 | ) |   | (9,292 | ) |
| Minority interest  in variable interest entities                                                                                                      |       |                                                 | —     |   |   |   | (30,205 | ) |   |   | — |   |   |   | (320 | ) |   | (30,525 | ) |
| Equity in earnings  (losses) of unconsolidated affiliates                                                                                             |       |                                                 | —     |   |   |   | — |   |   |   | — |   |   |   | 3,631 |   |   | 3,631 |   |
| Cumulative effect  of accounting change                                                                                                               |       |                                                 | 4,800      |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 4,800 |   |
| Net Income                                                                                                                                            |       |                                                 | 290,586    |   |   |   | 7,413 |   |   |   | 128 |   |   |   | — |   |   | 298,127 |   |
| **OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX:**                                                                                                    |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized Gains  arising during period                                                                                                               |       |                                                 | 16,508     |   |   |   | (17,942 | ) |   |   | 6,498 |   |   |   | — |   |   | 5,064 |   |
| Less:  reclassification adjustment for gains included in net income                                                                                   |       |                                                 | 3,758      |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 3,758 |   |
| Other  comprehensive income (loss)                                                                                                                    |       |                                                 | 12,750     |   |   |   | (17,942 | ) |   |   | 6,498 |   |   |   | — |   |   | 1,306 |   |
| COMPREHENSIVE  INCOME (LOSS)                                                                                                                          |       |                                                 | $          | 303,336 |   |   |   | $ | (10,529 | ) |   |   | $ | 6,626 |   |   |   | $ | — |   |   | $ | 299,433 |   |

 

83

----

| ** **                                                                                                                                                      | ** ** | **Year Ended December 31, 2002** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                                                      | ** ** | **As  previously  filed**                            | ** ** | **(1)  Hedge  Accounting** | ** ** | **(2)  Other  Adjustments** | ** ** | **(3)  Reclasses** | ** ** | **Restated** | ** ** |
| ** **                                                                                                                                                      | ** ** | **(in thousands)**                              | ** ** |
| **REVENUES:**                                                                                                                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net premiums  written                                                                                                                                           |       | $                                                    | 532,747    |   |   | $ | — |   |   |   | $ | — |   |   | $ | — |   | $ | 532,747 |   |
| Net premiums  earned                                                                                                                                            |       | $                                                    | 314,880    |   |   | $ | — |   |   |   | $ | — |   |   | $ | — |   | $ | 314,880 |   |
| Net investment  income                                                                                                                                          |       | 139,120                                              |       |   | — |   |   |   | — |   |   | — |   | 139,120 |   |
| Net realized gains  (losses)                                                                                                                                    |       | 29,204                                               |       |   | — |   |   |   | — |   |   | — |   | 29,204 |   |
| Net interest  income from financial products and variable interest entities                                                                                |       | 27,261                                               |       |   | 13,750 |   |   |   | — |   |   | — |   | 41,011 |   |
| Financial products  net realized gains (losses)                                                                                                                 |       | (154                                                 | )          |   | — |   |   |   | — |   |   | — |   | (154 | ) |
| Net realized and  unrealized gains (losses) on derivative instruments                                                                                           |       | (94,377                                              | )          |   | (3,055 | ) |   |   | — |   |   | — |   | (97,432 | ) |
| Income from assets  acquired in refinancing transactions                                                                                                        |       | 1,882                                                |       |   | 4,467 |   |   |   | — |   |   | — |   | 6,349 |   |
| Other income                                                                                                                                                    |       | 2,282                                                |       |   | — |   |   |   | — |   |   | — |   | 2,282 |   |
| Total Revenues                                                                                                                                                  |       | 420,098                                              |       |   | 15,162 |   |   |   | — |   |   | — |   | 435,260 |   |
| **EXPENSES:**                                                                                                                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Losses and loss  adjustment expenses                                                                                                                            |       | 65,613                                               |       |   | — |   |   |   | — |   |   | — |   | 65,613 |   |
| Interest expense                                                                                                                                                |       | 28,098                                               |       |   | — |   |   |   | — |   |   | — |   | 28,098 |   |
| Policy acquisition  costs                                                                                                                                       |       | 54,093                                               |       |   | — |   |   |   | — |   |   | — |   | 54,093 |   |
| Financial products  and variable interest entities’ foreign exchange loss                                                                             |       | —                                               |       |   | — |   |   |   | — |   |   | — |   | — |   |
| Net interest expense  from financial products and variable interest entities                                                                               |       | 20,481                                               |       |   | 22,964 |   |   |   | — |   |   | — |   | 43,445 |   |
| Other operating  expenses                                                                                                                                       |       | 58,265                                               |       |   | — |   |   |   | (6,760 | ) |   | — |   | 51,505 |   |
| Total Expenses                                                                                                                                                  |       | 226,550                                              |       |   | 22,964 |   |   |   | (6,760 | ) |   | — |   | 242,754 |   |
| Minority interest                                                                                                                                               |       | (6,684                                               | )          |   | — |   |   |   | — |   |   | 6,684 |   | — |   |
| Equity in earnings  (losses) of unconsolidated affiliates                                                                                                       |       | 29,315                                               |       |   | — |   |   |   | — |   |   | (29,315 | ) | — |   |
| Income before  income taxes, minority interest, equity in earnings (losses) of  unconsolidated affiliates, and cumulative effect of accounting change |       | 216,179                                              |       |   | (7,802 | ) |   |   | 6,760 |   |   | (22,631 | ) | 192,506 |   |
| Current federal taxes                                                                                                                                           |       | 51,485                                               |       |   | — |   |   |   | — |   |   | — |   | 51,485 |   |
| Deferred federal  taxes                                                                                                                                         |       | (16,381                                              | )          |   | (2,730 | ) |   |   | 2,129 |   |   | (3,214 | ) | (20,196 | ) |
| Total provision                                                                                                                                                 |       | 35,104                                               |       |   | (2,730 | ) |   |   | 2,129 |   |   | (3,214 | ) | 31,289 |   |
| Net income before  minority interest, equity in earnings (losses) of unconsolidated affiliates, and  cumulative effect of accounting change           |       | 181,075                                              |       |   | (5,072 | ) |   |   | 4,631 |   |   | (19,417 | ) | 161,217 |   |
| Minority interest                                                                                                                                               |       | —                                               |       |   | — |   |   |   | — |   |   | (6,684 | ) | (6,684 | ) |
| Minority interest  in variable interest entities                                                                                                                |       | —                                               |       |   | — |   |   |   | — |   |   | — |   | — |   |
| Equity in earnings  (losses) of unconsolidated affiliates                                                                                                  |       | —                                               |       |   | 16,331 |   |   |   | — |   |   | 26,101 |   | 42,432 |   |
| Cumulative effect  of accounting change                                                                                                                         |       | —                                               |       |   | — |   |   |   | — |   |   | — |   | — |   |
| Net Income                                                                                                                                                      |       | 181,075                                              |       |   | 11,259 |   |   |   | 4,631 |   |   | — |   | 196,965 |   |
| **OTHER COMPREHENSIVE INCOME:**                                                                                                                                 |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized Gains  arising during period                                                                                                                         |       | 92,905                                               |       |   | 28,628 |   |   |   | — |   |   | — |   | 121,533 |   |
| Less:  reclassification adjustment for gains included in net income                                                                                             |       | 21,188                                               |       |   | — |   |   |   | — |   |   | — |   | 21,188 |   |
| Other  comprehensive income                                                                                                                                     |       | 71,717                                               |       |   | 28,628 |   |   |   | — |   |   | — |   | 100,345 |   |
| COMPREHENSIVE  INCOME                                                                                                                                           |       | $                                                    | 252,792    |   |   | $ | 39,887 |   |   |   | $ | 4,631 |   |   | $ | — |   | $ | 297,310 |   |

 

84

----

***Restatement***

*(1)   HedgeAccounting*

In the course of preparing its quarterly report for September 30,2005, the Company determined that its accounting documentation for certain “short-cut”hedging relationships did not meet the requirements of SFAS 133. In addition,the Company determined that it had incorrectly applied the short-cut method ofhedge accounting to certain other hedging relationships, includingrelationships for which the maturity dates and reset dates of the hedged itemdid not match the derivative. Since the Company had incorrectly designatedthese hedges as qualifying for short-cut hedge accounting at the time of theirinception, the Company did not periodically test the hedging relationships foreffectiveness, as it would have done had they been designated as qualifying forlong-haul hedge accounting. Although the hedging relationships would havequalified for long-haul hedge accounting treatment if they had been documented assuch at their inception, the provisions of SFAS 133 do not allow theCompany to apply the long-haul method retroactively.

Upon performance of an analysis of its long-haul hedgeaccounting documentation and methods, the Company determined that its hedgeaccounting documentation did not meet the requirements of SFAS 133. Inparticular, (a) prospective hedge effectiveness policies and proceduresand (b) policies and procedures for de-designation and redesignation ofhedging relationships were not documented sufficiently and, as a result, theapplication of long-haul hedge accounting was deemed to be inappropriate forall long-haul hedging relationships.

To correct theseerrors, the Company has reversed the periodic changes in fair value of thehedged items discussed above, which it previously recognized in earnings, andhas reclassified the statements of operations and comprehensive income impactof the derivatives from net interest incomefrom financial products and variable interest entities, net interest expensefrom financial products and variable interest entities, and income fromassets acquired in refinancing transactions to net realized and unrealized gains (losses) on derivativeinstruments. In addition, simultaneous with the reversal of hedge accounting onforeign denominated debt, foreign exchange gains (losses) on the translation offinancial products and variable interestentities’ debt have been reclassified from net interest expense from financial products and variable interestentities to financial products and variable interest entities’ foreignexchange (gain) loss.

FSAGlobal is partially owned by third parties, therefore minority interest invariable interest entities in the financial statements reflects the impact ofthe corrections discussed above for the ownership held by these third parties.

*(2)   OtherAdjustments*

The Company incorrectly treated as derivatives underSFAS 133 four financing agreements, which included commitments to providefuture financing. The Company had previously accounted for these agreements asderivatives and applied the short-cut method of hedge accounting, whereby themark to market of both the hedged and hedging items were included in netinterest expense from financial products and variable interest entities, withno net effect on the line item or net income. To reverse the incorrectaccounting for these agreements, the mark-to-market adjustments on both theagreements and the hedged items have been reversed in all applicable periods,resulting in a reduction of assets and liabilities on the balance sheet. Therewas no change to the consolidated statements of operations and comprehensiveincome arising from this correction.

The Company corrected an immaterial error in 2004,2003, and 2002 relating to a contract that permits FSA at its sole option toissue certain equity securities to a funded trust. The costs relating to thiscontract were incorrectly charged against equity. The restated financialstatements correctly reflect these costs as other operating expenses in theapplicable periods.

85

----

The Company also correctedimmaterial errors in 2003 and 2002 relating to minority interest and foreigncurrency movements on deferred premium revenue and certain investments. Adjustmentfor the cumulative impact of the errors was made in the periods in which theerrors were identified. The restated financial statements reflect thecorrection of the errors in the applicable periods.

*(3)   Reclasses*

In the previously filedstatements of operations and comprehensive income minority interest and equityin earnings (losses) of unconsolidated affiliates were reflected before thefederal tax line items. The restated figures properly display these balancesafter the federal tax line items. The balance sheet presentation of minorityinterest has been reclassified from accrued expenses and other liabilities totwo line items: (a) minority interest, relating to FSAI, and (b) minorityinterest in variable interest entities, relating to FSA Global.

***Footnote Disclosures***

Relevant disclosures have been restated in footnotesaffected by the restatement discussed above. In addition, as part of therestatement, the Company has provided additional disclosures pertaining toassets acquired in refinancing transactions (Note 23) and the schedule ofpayments due under GIC and VIE debt (Note 21) was adjusted to correct theexclusion of the mark to market of embedded derivative features of certain debtinstruments for which the embedded derivatives had been bifurcated andaccounted for separately at fair value.

The restatementadjustments do not result in any significant changes to the Company’s liquidityor its overall financial condition.

**4.   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 “GIC Portfolio”) and the portfolio of securitiesowned by the VIEs (the “VIE Portfolio”), and assets acquired in refinancingtransactions (see Note 23).

***Investment Portfolio***

Bonds at amortized cost of $9.7 million and $8.9million at December 31, 2004 and 2003, respectively, were on deposit withstate regulatory authorities as required by insurance regulations.

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

| ** **              | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------|------------|--------------------------------------------|------------|
| ** **              | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Bonds                   |       | $                                          | 171,736    |   | $ | 153,544 |   | $ | 138,095 |   |
| Equity investments      |       | —                                     |       | — |   | 336 |   |
| Short-term  investments |       | 2,815                                      |       | 3,185 |   | 3,092 |   |
| Investment expenses     |       | (2,500                                     | )          | (2,681 | ) | (2,403 | ) |
| Net investment income   |       | $                                          | 172,051    |   | $ | 154,048 |   | $ | 139,120 |   |

 

86

----

Thecredit quality of bonds in the Investment Portfolio at December 31, 2004was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|
| AAA           |       |       | 77.8       | %                              |       |
| AA            |       |       | 19.7       |                           |       |
| A             |       |       | 2.5        |                           |       |
|          |       |       | 100.0      | %                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2004.

Of the bonds included in the Investment Portfolio,12.9% were AAA by virtue of insurance provided by FSA. Without giving effect tothe FSA guaranty, the weighted-average rating of the FSA-insuredinvestments was in the A+ range, and all of these investments were investmentgrade.

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

| ** **                                                                             | ** ** | **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                                      |       | 2,857,642                                       |       |   | 220,875 |   |   |   | (1,987 | ) |   | 3,076,530 |   |
| 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 |   |
| Short-term  investments                                                                |       | 321,071                                         |       |   | — |   |   |   | — |   |   | 321,071 |   |
| Total                                                                                  |       | $                                               | 3,983,655  |   |   | $ | 257,134 |   |   |   | $ | (4,955 | ) |   | $ | 4,235,834 |   |

 

| ** **                                                                             | ** ** | **As of December 31, 2003** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| U.S. Treasury securities  and obligations of U.S. government corporations and agencies |       | $                                               | 123,270    |   |   | $ | 4,136 |   |   |   | $ | (355 | ) |   | $ | 127,051 |   |
| Obligations of states  and political subdivisions                                      |       | 2,506,380                                       |       |   | 218,930 |   |   |   | (1,287 | ) |   | 2,724,023 |   |
| Mortgage-backed  securities                                                            |       | 196,465                                         |       |   | 3,834 |   |   |   | (1,389 | ) |   | 198,910 |   |
| Corporate securities                                                                   |       | 259,102                                         |       |   | 10,668 |   |   |   | (593 | ) |   | 269,177 |   |
| Foreign securities                                                                     |       | 108,249                                         |       |   | 69 |   |   |   | (2,368 | ) |   | 105,950 |   |
| Asset-backed  securities                                                               |       | 81,844                                          |       |   | 1,720 |   |   |   | (26 | ) |   | 83,538 |   |
| Short-term  investments                                                                |       | 224,429                                         |       |   | — |   |   |   | — |   |   | 224,429 |   |
| Total                                                                                  |       | $                                               | 3,499,739  |   |   | $ | 239,357 |   |   |   | $ | (6,018 | ) |   | $ | 3,733,078 |   |

 

87

----

Thefollowing table 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, at December 31, 2004 (inthousands):

| ** **                                                                             | ** ** | **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. AtDecember 31, 2004, there were 113 securities that were in an unrealizedloss position for a continuous 12-month period or longer. None of the 113securities had an unrealized loss that exceeded book value by 7% atDecember 31, 2004. At December 31, 2004, the Company determined thatno investments were considered other-than-temporarily impaired.

Theamortized cost and fair value of bonds in the Investment Portfolio at December 31,2004, 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                                          |       | $                   | 376,156    |                | $          | 376,197 |   |
| Due after one year  through five years                           |       | 542,572             |       | 548,454             |       |
| Due after five years  through ten years                          |       | 517,956             |       | 555,819             |       |
| Due after ten years                                              |       | 2,269,926           |       | 2,475,770           |       |
| Mortgage-backed  securities (stated maturities of 1 to 40 years) |       | 220,202             |       | 222,510             |       |
| Asset-backed  securities (stated maturities of 1 to 35 years)    |       | 56,843              |       | 57,084              |       |
| Total                                                            |       | $                   | 3,983,655  |                | $          | 4,235,834 |   |

 

Proceeds from sales of bonds for the investmentportfolio during 2004, 2003 and 2002 were $770.5 million, $948.3 millionand $772.0 million, respectively. Gross gains of $5.2 million, $12.6 millionand $30.5 million and gross losses of $5.7 million, $7.5 million and $1.3million were realized on sales in 2004, 2003 and 2002, respectively.

In 2002, the Companypurchased foreign currency call options. These calls were marked to marketthrough earnings and, for the years ended December 31, 2004, 2003 and2002, resulted in net unrealized gains of $0.9 million, $0.3 million and $0.2million, respectively.

88

----

***GIC Portfolio***

Netinvestment income for the GIC Portfolio consisted of the following (inthousands):

| ** **              | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------|------------|--------------------------------------------|------------|
| ** **              | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **              | ** ** | **(restated)**                             | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| Bonds                   |       | 137,548                                    |       |   | 59,271 |   |   |   | 39,517 |   |   |
| Short-term  investments |       | 3,499                                      |       |   | 4,430 |   |   |   | 1,494 |   |   |
| Net interest income     |       | $                                          | 141,047    |   |   | $ | 63,701 |   |   |   | $ | 41,011 |   |   |
|                         |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |

 

The credit quality ofbonds held in the GIC Portfolio at December 31, 2004 was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|
| AAA           |       |       | 81.5       | %                              |       |
| AA            |       |       | 9.0        |                           |       |
| A             |       |       | 4.8        |                           |       |
| Other         |       |       | 4.7        |                           |       |
| Total         |       |       | 100.0      | %                              |       |

----

(1)    Ratingsare based on the lower of Moody’s or S&P ratings available atDecember 31, 2004.

Of the bondsincluded in the GIC Portfolio, 9.1% were AAA by virtue of insurance provided byFSA. Without giving effect to the FSA guaranty, the weighted-averagerating of the FSA-insured investments was in the Double-A range,and all of these investments were investment grade.

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

| **December 31, 2004**                        | ** ** | ** **     | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|--------------------------------------------------------|------------|----------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------|------------|
| ** **                                             | ** ** | **(restated)** | ** ** | **(restated)**      | ** ** | **(restated)**               | ** ** | ** **                    | ** ** |
| 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 |   |
| Short-term  investments                                |       | 268,125        |       |                | —     |                         |       |                          | —     |                |       | 268,125 |   |
| Total                                                  |       | $              | 8,156,772  |                |       | $                            | 47,885     |                          |       |                | $          | (5,547 | ) |   | $ | 8,199,110 |   |

 

| **December 31, 2003**                        | ** ** | ** **     | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|--------------------------------------------------------|------------|----------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------|------------|
| ** **                                             | ** ** | **(restated)** | ** ** | **(restated)**      | ** ** | **(restated)**               | ** ** | ** **                    | ** ** |
| Obligations of  U.S. states and political subdivisions |       | $              | 341,260    |                |       | $                            | 8,493      |                          |       |                | $          | (9,068 | ) |   | $ | 340,685 |   |
| Mortgage-backed  securities                            |       | 202,784        |       |                | 3,467      |                         |       |                          | (143       | )                   |       | 206,108 |   |
| Corporate  securities                                  |       | 18,718         |       |                | 221        |                         |       |                          | (3         | )                   |       | 18,936 |   |
| Asset-backed  and other securities                     |       | 3,530,201      |       |                | 4,635      |                         |       |                          | (2,879     | )                   |       | 3,531,957 |   |
| Short-term  investments                                |       | 228,812        |       |                | —     |                         |       |                          | —     |                |       | 228,812 |   |
| Total                                                  |       | $4,321,775     |       |                | $          | 16,816                       |       |                          |       | $                   | (12,093    | ) |   | $ | 4,326,498 |   |
|                                                        |            |                |            |                     |            |                              |            |                               |            |                     |            |  |  |  |  |  |  |  |  |

 

89

----

Thefollowing table shows the gross unrealized losses and fair value for the GICPortfolio, aggregated by investment category and length of time that individualsecurities have been in a continuous unrealized loss position, at December 31,2004 (in thousands):

| ** **                                             | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**           | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|---------------------|------------|
| ** **                                             | ** ** | **Fair Value**                    | ** ** | **Unrealized  Losses**               | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| ** **                                             | ** ** | ** **                             | ** ** | **(restated)**                       | ** ** | ** **          | ** ** | **(restated)** | ** ** | ** ** | ** ** | **(restated)** | ** ** |
| Obligations of  U.S. states and political subdivisions |       | $                                      | 15,372     |                                 |       | $                   | (306       | ) |   | $ | 63,661 |   |   | $ | (2,651 | ) |   | $ | 79,033 |   |   | $ | (2,957 | ) |   |
| Mortgage-backed  securities                            |       | 466,739                                |       |                                 | (379       | )                   |       | 8,886 |   |   | (2 | ) |   | 475,625 |   |   | (381 | ) |   |
| Corporate  securities                                  |       | —                                 |       |                                 | —     |                |       | 29,026 |   |   | (17 | ) |   | 29,026 |   |   | (17 | ) |   |
| Asset-backed  securities                               |       | 898,459                                |       |                                 | (1,461     | )                   |       | 274,596 |   |   | (731 | ) |   | 1,173,055 |   |   | (2,192 | ) |   |
| Total                                                  |       | $                                      | 1,380,570  |                                 |       | $                   | (2,146     | ) |   | $ | 376,169 |   |   | $ | (3,401 | ) |   | $ | 1,756,739 |   |   | $ | (5,547 | ) |   |

 

The Company periodically monitors the GIC Portfoliofor individual investments in an unrealized loss position in order to assesswhether 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 31,2004, there were 29 securities that were in an unrealized loss position for acontinuous 12-month period or longer. None of the 29 securities had anunrealized loss that exceeded book value by 7% at December 31, 2004. At December 31,2004, the Company determined that no investments were considered other-than-temporarilyimpaired.

Theamortized cost and fair value of the GIC Portfolio, at December 31, 2004,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** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                                              | ** ** | **(restated)**      | ** ** | ** **          | ** ** |
| Due in one year  or less                                                |       | $                   | 276,837    |                | $          | 276,882 |   |
| Due after one  year through five years                                  |       | —              |       | —              |       |
| Due after five  years through ten years                                 |       | 77,669              |       | 78,332              |       |
| Due after ten  years                                                    |       | 635,005             |       | 661,078             |       |
| Mortgage-backed  securities (stated maturities of 1 to 30 years)        |       | 2,137,814           |       | 2,149,513           |       |
| Asset-backed  and other securities (stated maturities of 3 to 40 years) |       | 5,029,447           |       | 5,033,305           |       |
| Total                                                                   |       | $                   | 8,156,772  |                | $          | 8,199,110 |   |

 

Proceeds from sales ofbonds held in the GIC Portfolio during 2004, 2003 and 2002 were $91.7 million,$190.7 million and $274.1 million, respectively. Gross gains of $2.2 millionwere realized on sales in 2004. Gross gains of $10.9 million were realizedon sales in 2003. Gross losses of $0.2 million were realized on sales in2002.

90

----

**5.**   DEFERREDACQUISITION COSTS

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

| ** **                               | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|
| ** **                               | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Balance,  beginning of period            |       | $                                          | 273,646    |   | $ | 253,777 |   | $ | 240,492 |   |
| Costs deferred  during the period:       |       |                                       |       |   |   |   |   |
| Ceding commission income, net            |       | (65,838                                    | )          | (73,943 | ) | (68,464 | ) |
| Premium taxes                            |       | 16,551                                     |       | 16,773 |   | 13,401 |   |
| Compensation and other acquisition costs |       | 145,857                                    |       | 135,430 |   | 122,441 |   |
| Total                                    |       | 96,570                                     |       | 78,260 |   | 67,378 |   |
| Costs amortized  during the period       |       | (62,201                                    | )          | (58,391 | ) | (54,093 | ) |
| Balance, end of  period                  |       | $                                          | 308,015    |   | $ | 273,646 |   | $ | 253,777 |   |

 

**6.**   STATUTORYACCOUNTING PRACTICES

GAAP differs incertain significant respects from accounting practices prescribed or permittedby insurance regulatory authorities, which are applicable to the Company’sinsurance company subsidiaries. The principal differences result from thefollowing statutory accounting 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 carryback;

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

·       bondsare carried at amortized cost;

·       VIEsare not consolidated under statutory accounting standards;

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

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

91

----

Reconciliationsof net income for the years ended 2004, 2003 and 2002 and shareholders’ equityat December 31, 2004 and 2003, 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:**                          | ** ** | ** **                                 | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                    | ** ** | **(restated)**                             | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| GAAP BASIS                                    |       | $                                          | 378,607    |   | $ | 298,127 |   | $ | 196,965 |   |
| Non-insurance  companies net loss             |       | 6,435                                      |       | 29,939 |   | 2,746 |   |
| Premium revenue  recognition                  |       | (80,169                                    | )          | (27,867 | ) | (19,624 | ) |
| Losses and loss  adjustment expenses incurred |       | 3,889                                      |       | 21,813 |   | 20,585 |   |
| Deferred  acquisition costs                   |       | (34,370                                    | )          | (19,868 | ) | (13,285 | ) |
| Deferred income  tax provision (benefit)      |       | 73,066                                     |       | 22,505 |   | (24,490 | ) |
| Current income  tax                           |       | (18,804                                    | )          | (18,049 | ) | (8,162 | ) |
| Change in fair  value of derivatives          |       | (56,927                                    | )          | (34,796 | ) | 48,788 |   |
| VIE consolidation                             |       | (117,762                                   | )          | (135,717 | ) | (16,330 | ) |
| Foreign exchange  transaction loss            |       | 91,309                                     |       | 118,269 |   | — |   |
| Other                                         |       | (3,193                                     | )          | 8,588 |   | 7,895 |   |
| STATUTORY BASIS                               |       | $                                          | 242,081    |   | $ | 262,944 |   | $ | 195,088 |   |
|                                               |            |                                            |            |  |  |  |  |  |  |  |  |  |

 

| ** **                                 | ** ** | **As of December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------|------------|
| **Shareholders’ Equity:**        | ** ** | ** **                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                 | ** ** | **(restated)**                        | ** ** | **(restated)** | ** ** |
| GAAP BASIS                                 |       | $                                     | 2,611,278  |   | $ | 2,219,149 |   |
| Non-insurance  companies liabilities, net  |       | 127,707                               |       | 109,314 |   |
| Premium revenue  recognition               |       | (290,204                              | )          | (189,823 | ) |
| Loss and loss  adjustment expense reserves |       | 96,380                                |       | 109,237 |   |
| Deferred  acquisition costs                |       | (308,015                              | )          | (273,646 | ) |
| Contingency  reserve                       |       | (1,099,462                            | )          | (936,761 | ) |
| Unrealized gain  on investments            |       | (258,677                              | )          | (232,877 | ) |
| Deferred income  taxes                     |       | 310,875                               |       | 220,215 |   |
| Surplus notes                              |       | 74,756                                |       | 154,761 |   |
| Other                                      |       | (83,217                               | )          | (12,072 | ) |
| STATUTORY BASIS  SURPLUS                   |       | 1,181,421                             |       | 1,167,497 |   |
| SURPLUS PLUS CONTINGENCY  RESERVE          |       | $                                     | 2,280,883  |   | $ | 2,104,258 |   |
|                                            |            |                                       |            |  |  |  |  |  |  |

 

**7.**   FEDERAL INCOMETAXES

Dexia Holdings, Inc. (“Dexia Holdings”) and theCompany and its Subsidiaries, except FSA International, file a consolidatedfederal income tax return.

The tax-sharing agreement provides that eachmember’s tax benefit or expense is calculated on a separate return basis andthat any credit or losses available to the Company be allocated among themembers based on each member’s taxable income. At December 31, 2004 and2003, the Company and its Subsidiaries received benefits from utilizing DexiaHolding’s credits and losses of $1.3 million and $0.3 million,respectively. These amounts have been recorded as capital contributions andreductions in amounts payable to Dexia Holdings in the financial statements.

Except as described below, federal income taxes havenot been provided on all of the undistributed earnings of FSA International,since it has been the Company’s practice and intent to reinvest such earningsin the operations of this subsidiary. The cumulative amount of such untaxedearnings was $86.7 million and $57.1 million at December 31,2003 and 2002, respectively.

92

----

The American Job Creation Act of 2004 (the “Act”) wasenacted on October 22, 2004, which 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 has accordingly accrued a deferred tax liability andexpense of $5.3 million at December 31, 2004. This amount represents thetax effect on FSA International’s tax dividend distribution capability at December 31,2004. To the extent FSA International generates additional tax earnings andprofits in 2005, it is probable that the Company will distribute such amountsand, accordingly, provide taxes on such earnings as they accrue during 2005.

The Act provides special tax treatment only for taxdividends. Tax dividends can be made only to the extent of earnings and profitsthat have a different basis of calculation from that of GAAP earnings. At December 31,2004, GAAP earnings exceeded tax earnings and profits by approximately$22.6 million. It is the Company’s intention to repatriate only earningsthat qualify for the special tax treatment under the Act.

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 InsuranceGroup for certain future adverse loss development up to $50.0 million. In 2004,the Company made an indemnity payment of $47.0 million to the third party withfunds provided for such purpose by White Mountains Insurance Group. While theCompany had no legal liability in connection with the indemnity payment, thepayment should be treated for tax purposes as a $47.0 million loss deduction tothe Company, as successor to WMH. The Company therefore recorded a deferred taxasset with a corresponding deferred tax benefit of $16.5 million. There can beno assurance that the deferred tax benefit will not be reversed in the future.In addition, under certain circumstances, which are not probable, the Companyexpects to agree to share 50% of the deferred tax benefit with White MountainsInsurance Group.

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

| ** **                                    | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| ** **                                    | ** ** | **(restated)**                        | ** ** | **(restated)** | ** ** |
| Deferred  acquisition costs                   |       | $                                     | 95,736     |   | $ | 85,441 |   |
| Deferred premium  revenue adjustments         |       | 37,826                                |       | 21,865 |   |
| Unrealized  capital gains                     |       | 104,604                               |       | 82,644 |   |
| Contingency  reserves                         |       | 113,507                               |       | 96,481 |   |
| Undistributed  earnings                       |       | 9,274                                 |       | 4,513 |   |
| Derivative fair-value  adjustments            |       | 50,426                                |       | 6,921 |   |
| Other                                         |       | 9,185                                 |       | 11,140 |   |
| Total deferred federal income tax liabilities |       | 420,558                               |       | 309,005 |   |
| Loss and loss  adjustment expense reserves    |       | (35,540                               | )          | (34,304 | ) |
| Deferred  compensation                        |       | (93,083                               | )          | (89,182 | ) |
| White Mountains  indemnity payment            |       | (16,450                               | )          | — |   |
| Foreign currency  transaction loss            |       | (24,264                               | )          | (12,004 | ) |
| Other                                         |       | (1,556                                | )          | — |   |
| Total deferred federal income tax assets      |       | (170,893                              | )          | (135,490 | ) |
| Net deferred federal  income tax liability    |       | $                                     | 249,665    |   | $ | 173,515 |   |

 

93

----

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, 2004 or 2003.

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

| ** **                                                 | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                 | ** ** | **(restated)**                             | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| Tax at statutory  rate                                     |       |                                       | 35.0       | % |   |   | 35.0 | % |   |   | 35.0 | % |   |
| Tax-exempt  investments                                    |       |                                       | (7.1       | ) |   |   | (8.3 | ) |   |   | (15.7 | ) |   |
| Income of foreign  subsidiary                              |       |                                       | (1.2       | ) |   |   | (1.7 | ) |   |   | (3.2 | ) |   |
| White Mountain  indemnity payment                          |       |                                       | (2.8       | ) |   |   | — |   |   |   | — |   |   |
| Minority Interest  and Equity in Unconsolidated Subs  |       |                                       | (4.9       | ) |   |   | (2.9 | ) |   |   | — |   |   |
| Other                                                      |       |                                       | —     |   |   |   | 0.1 |   |   |   | 0.2 |   |   |
| Provision for income  taxes                                |       |                                       | 19.0       | % |   |   | 22.2 | % |   |   | 16.3 | % |   |

 

In 2002, the Companychanged its method of accounting for taxes in respect of its equity in earningsof SPS Capital Holding Corp. (“SPS”), an unconsolidated affiliate of theCompany (see Note 19). Prior to 2002, the Company accounted for its equityearnings from SPS net of income tax at the statutory rate of 35%. Following achange in SPS’s investors, the Company determined that it would be appropriateto apply the 80% dividend-received deduction allowed by the InternalRevenue Service when accounting for the tax on its equity earnings from SPS,based on management’s expectation that it would realize its gain on suchinvestment through dividend distributions rather than through sale of itsinvestment. In 2002, the Company recorded a cumulative-to-datebenefit of $4.0 million, included in tax-exempt investments in the abovereconciliation, relating to this change.

**8.   DIVIDENDSAND CAPITAL REQUIREMENTS**

Under the insurance lawsof the State of New York, FSA may pay a dividend to the Company without theprior approval of the Superintendent of Insurance of the State of New York (the“New York Superintendent”) only from earned surplus subject to the maintenanceof a minimum capital requirement. In addition, the dividend, together with alldividends declared or distributed by FSA during the preceding 12 months, maynot exceed the lesser of 10% of its policyholders’ surplus shown on FSA’s lastfiled statement, or adjusted net investment income, as defined, for such 12-monthperiod. In 2004 FSA paid $30.0 million in dividends and had an additional $84.5million available for the payment of dividends over the next 12 months. Nodividends were paid in 2003 or 2002.

**9.   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, 2004, there wereno borrowings under this arrangement, which expires on April 22, 2005, ifnot extended.

FSA has a standby line of credit commitment in theamount of $325.0 million with a group of international banks to provide loansto FSA after it has incurred, during the term of the facility, cumulativemunicipal losses (net of any recoveries) in excess of the greater of $325.0million or the average annual debt service of the covered portfolio multipliedby 5.00%, which amounted to $1,067.0 million at December 31, 2004. Theobligation to repay loans made under this agreement is a limited recourse 

94

----

obligation payable solelyfrom, 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 term expiring on April 30,2011 and contains an annual renewal provision subject to approval by the banks.No amounts have been utilized under this commitment as of December 31,2004.

FSAM has a $100.0 million line of credit with UBS LoanFinance LLC, which expires December 9, 2005, 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, 2004.

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 a putoption were to be exercised by FSA, the applicable trust would use the portionof the proceeds attributable to principal received upon maturity of its assets,net of expenses, and transfer such proceeds to FSA in exchange for PreferredStock of FSA. FSA pays a floating put premium to the trusts. The cost of thestructure was $1.3 million and $3.6 million for 2004 and 2003, respectively,and was recorded within other operating expenses. 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.

**10.   LONG-TERM DEBT**

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 6.950% SeniorQuarterly Income Debt Securities (“Senior QUIDS”) due November 1, 2098 anddelivered to the trustee sufficient collateral to legally defease the 6.950%Senior QUIDS. Unamortized debt issuance costs of $3.2 million for the 6.950%Senior QUIDS were charged to interest expense in 2003. Subsequently, thetrustee used the defeasance collateral to redeem all of the 6.950% SeniorQUIDS.

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.

On December 19, 2001,the Company issued $100.0 million of 6 7¤8% Quarterly Income Bond Securities due December 15,2101, which are callable without premium or penalty on or after December 19,2006. Debt issuance costs of $3.3 million are being amortized over thelife of the debt.

**11.   EMPLOYEE BENEFIT PLANS**

The Company maintains both qualified and non-qualifiednon-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$5.8 million, $4.9 million and $5.1 million for the years ended December 31,2004, 2003 and 2002, respectively.

95

----

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.

Performance shares are awarded under the 1993 EquityParticipation Plan. The 1993 Equity Participation Plan authorizes thediscretionary grant of performance shares by the Human Resources Committee tokey employees. The amount earned for each performance share depends on theattainment of certain growth rates of adjusted book value (or, in the case ofperformance shares issued after January 1, 2001, growth rates of adjustedbook value and book value) per outstanding share over a three-yearperiod. At the election of the participant at the time of award, growth ratesmay be determined including or excluding realized and unrealized gains andlosses on the Investment Portfolio. No payout occurs if the compound annualgrowth rate of adjusted book value (or in the case of performance shares issuedafter January 1, 2001, growth rates of adjusted book value and book value)per outstanding share is less than 7%, and a 200% payout occurs if the compoundannual growth rate is 19% or greater. Payout percentages are interpolated forcompound annual growth rates between 7% and 19%.

Performanceshares granted under the 1993 Equity Participation Plan were as follows:

| ** ** | ** ** | **Outstanding  at  Beginning of  Year** | ** ** | **Granted  During  the Year** | ** ** | **Earned  During  the Year** | ** ** | **Forfeited  During the  Year** | ** ** | **Outstanding  at  End of Year** | ** ** | **Price per  Share  at Grant  Date** | ** ** |
|------------|------------|----------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|--------------------------------------|------------|--------------------------------------------|------------|------------------------------------------------|------------|
| 2002       |       |                                         | 1,437,231  |                               |       | 372,775                           |       | 380,279                              |       |                                       | 13,901     |                                           |       |   | 1,415,826 |   |   | $ | 85.63  |   |
| 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 |   |
|            |            |                                              |            |                                    |            |                                   |            |                                      |            |                                            |            |                                                |            |  |  |  |  |  |  |  |

 

The Company applies APB Opinion 25 and relatedInterpretations in accounting for its performance shares. The estimated finalcost of these performance shares is accrued over the performance period. Theexpense for the performance shares was $73.3 million, $63.1 millionand $58.9 million for the years ended December 31, 2004, 2003 and2002, respectively.

For obligations under the Company’s DeferredCompensation Plan (“DCP”) and Supplemental Executive Retirement Plan (“SERP”),the Company generally purchases investments expected to perform similarly tothe tracking investments chosen by the participants under the plans.

In the fourth quarter of2000, the Company purchased 304,757 shares of its common stock from DexiaHoldings, Inc. for $24.0 million. In 2004, an additional 1,890shares were purchased for $0.3 million. This purchase was intended to fundobligations relating to the Company’s Director Share Purchase Program (“DSPP”),which enables its participants to make deemed investments in the Company’scommon stock under the DCP and SERP. Under the DSPP, the deemed investments inthe Company’s stock are irrevocable, settlement of the deemed investments mustbe in stock and, after receipt, the participants must generally hold the stockfor at least six months. In 2004 and 2002, $0.2 million and $0.3 million,respectively, of restricted treasury stock was distributed to a director as aDSPP payout. No distribution was made in 2003.

**12.   COMMITMENTS AND CONTINGENCIES**

EffectiveJune 2004, the Company entered into a 20-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 anticipates moving from its currentlocation at 350 Park Avenue, New York, New York, to its new space in mid-2005.The lease contains scheduled rent increases every five years after a 19-monthrent-free period, as well as lease incentives for initial construction costsof up to $6.0 million, as defined in the sublease. The lease containsprovisions for rent increases related to increases in the building’s operatingexpenses. The lease also contains a renewal option for an additional ten-yearperiod 

96

----

and an option to rent additional office space atvarious points in the future, in each case at then-current market rents.In addition, the Company and its Subsidiaries lease additional office spaceunder non-cancelable operating leases, which expire at various datesthrough 2013. Future minimum rental payments are as follows (in thousands):

| **Year Ended December 31,** | ** ** | ** ** | ** **      | ** ** | ** ** |
|--------------------------------------------|------------|------------|-----------------|------------|------------|
| 2005                                       |       | $          | 5,462.3    |       |
| 2006                                       |       | 7,579.7    |            |
| 2007                                       |       | 8,913.4    |            |
| 2008                                       |       | 8,156.1    |            |
| 2009                                       |       | 8,171.1    |            |
| Thereafter                                 |       | 114,367.5  |            |
| Total                                      |       | $          | 152,650.1  |       |

 

Rent expense was $7.8 million in 2004,$7.3 million in 2003 and $6.2 million in 2002.

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

**13.   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 Note15) 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 liable for such defaulted amounts. Certain of thereinsuring companies have provided collateral to secure their reinsuranceobligations.

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

| ** **                                               | ** ** | **Year Ended December 31,** | ** **    |
|----------------------------------------------------------|------------|--------------------------------------------|---------------|
| ** **                                               | ** ** | **2004**                                   | ** **    | **2003** | ** ** | **2002** | ** ** |
| Written premiums  ceded                                  |       | $                                          | 244,211  |   | $ | 281,542  |   | $ | 270,954  |   |
| Written premiums  assumed                                |       | 11,567                                     |          | 3,294 |   | 2,443 |   |
| Earned premiums  ceded                                   |       | 161,733                                    |          | 159,350 |   | 134,093 |   |
| Earned premiums  assumed                                 |       | 6,608                                      |          | 3,832 |   | 4,079 |   |
| Losses and loss  adjustment expense payments ceded  |       | 52,372                                     |          | 16,993 |   | (2,513 | ) |
| Losses and loss  adjustment expense payments assumed     |       | 16                                         |          | — |   | — |   |
|                                                          |            |                                            |               |  |  |  |  |  |  |  |

 

| ** **                                           | ** ** | **As of December 31,** | ** **        |
|------------------------------------------------------|------------|---------------------------------------|-------------------|
| ** **                                           | ** ** | **2004**                              | ** **        | **2003** | ** ** |
| Principal  outstanding ceded                         |       | $                                     | 116,687,760  |   | $ | 96,571,216  |   |
| Principal  outstanding assumed                       |       | 2,134,427                             |              | 1,935,306 |   |
| Deferred premium  revenue ceded                      |       | 759,191                               |              | 695,398 |   |
| Deferred premium  revenue assumed                    |       | 17,823                                |              | 13,060 |   |
| Losses and loss  adjustment expense reserves ceded   |       | 35,419                                |              | 59,235 |   |
| Losses and loss  adjustment expense reserves assumed |       | 553                                   |              | 592 |   |
|                                                      |            |                                       |                   |  |  |  |  |

 

97

----

**14.   OUTSTANDINGEXPOSURE AND COLLATERAL**

TheCompany’s policies insure the scheduled payments of principal and interest onasset-backed (including FSA-insured CDS) and municipal obligations.The gross amount of financial guarantees in force (principal and interest) was$622.6 billion at December 31, 2004 and $558.2 billion atDecember 31, 2003. The net amount of financial guarantees in force was$444.5 billion at December 31, 2004 and $403.1 billion atDecember 31, 2003.

Thematurities below are based on estimates made by the issuers of the insuredobligations. The net par outstanding as of December 31, 2004 and 2003 andthe contractual terms to maturity are as follows (in millions):

| ** **                         | ** ** | **As of December 31, 2004** | ** ** | **As of December 31, 2003** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| **Terms to Maturity(1)** | ** ** | ** **                                      | ** ** | **Asset-Backed(2)**                             | ** ** | **Municipal** | ** ** | **Asset-Backed(2)** | ** ** | **Municipal** | ** ** |
| 0 to 5 years                       |       |                                            | $          | 46,800                                     |       |   | $ | 39,448  |   |   | $ | 58,500  |   |   | $ | 34,274  |   |
| 5 to 10 years                      |       |                                            | 29,155     |                                            |       | 43,165 |   |   | 32,998 |   |   | 38,401 |   |
| 10 to 15 years                     |       |                                            | 10,772     |                                            |       | 37,174 |   |   | 6,644 |   |   | 32,895 |   |
| 15 to 20 years                     |       |                                            | 1,084      |                                            |       | 30,857 |   |   | 1,450 |   |   | 27,133 |   |
| 20 years and above                 |       |                                            | 34,539     |                                            |       | 44,748 |   |   | 18,670 |   |   | 38,235 |   |
| Total                              |       |                                            | $          | 122,350                                    |       |   | $ | 195,392  |   |   | $ | 118,262  |   |   | $ | 170,938  |   |
|                                    |            |                                                 |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Actualmaturities could differ from contractual maturities because borrowers have theright to call or prepay certain obligations with or without call or prepaymentpenalties.

(2)          Excludesintercompany insurance of $7,143 million in 2004 and $4,474 millionin 2003 relating to FSA-insured GICs issued by the GIC Affiliates.

Thepar amount ceded as of December 31, 2004 and 2003 and the terms tomaturity are as follows (in millions):

| ** **                      | ** ** | **As of December 31, 2004** | ** ** | **As of December 31, 2003** | ** ** |
|---------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| **Terms to Maturity** | ** ** | ** **                                      | ** ** | **Asset-Backed**                                | ** ** | **Municipal** | ** ** | **Asset-Backed** | ** ** | **Municipal** | ** ** |
| 0 to 5 years                    |       |                                            | $          | 21,662                                     |       |   |   | $ | 11,443  |   |   |   | $ | 9,372  |   |   |   | $ | 9,952  |   |   |
| 5 to 10 years                   |       |                                            | 6,909      |                                            |       |   | 14,707 |   |   |   | 7,567 |   |   |   | 13,355 |   |   |
| 10 to 15 years                  |       |                                            | 2,228      |                                            |       |   | 14,630 |   |   |   | 2,454 |   |   |   | 12,662 |   |   |
| 15 to 20 years                  |       |                                            | 1,373      |                                            |       |   | 12,870 |   |   |   | 1,971 |   |   |   | 12,223 |   |   |
| 20 years and above              |       |                                            | 4,862      |                                            |       |   | 26,004 |   |   |   | 3,583 |   |   |   | 23,432 |   |   |
| Total                           |       |                                            | $          | 37,034                                     |       |   |   | $ | 79,654  |   |   |   | $ | 24,947  |   |   |   | $ | 71,624  |   |   |
|                                 |            |                                                 |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

TheCompany limits its exposure to losses from writing financial guarantees byunderwriting investment-grade obligations, diversifying its portfolio andmaintaining rigorous collateral requirements on asset-backed obligations,as well as through reinsurance. The net par outstanding of insured obligationsin the asset-backed insured portfolio includes the following amounts bytype of collateral (in millions):

| ** **                        | ** ** | **Net of Amounts  Ceded(1) as of  December 31,** | ** **    | **Amounts  Ceded as of  December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------------------|---------------|-------------------------------------------------------|------------|
| **Types of Collateral** | ** ** | ** **                                                                | ** **    | **2004**                                              | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Residential mortgages             |       | $                                                                         | 35,641   |                                                  | $          | 20,643  |   | $ | 4,997  |   | $ | 4,024  |   |
| Consumer receivables              |       | 9,540                                                                     |          | 14,039                                                |       | 2,241 |   | 5,033 |   |
| Pooled corporate  obligations     |       | 68,340                                                                    |          | 77,921                                                |       | 26,223 |   | 11,690 |   |
| Other asset-backed  obligations   |       | 8,829                                                                     |          | 5,659                                                 |       | 3,573 |   | 4,200 |   |
| Total asset-backed obligations    |       | $                                                                         | 122,350  |                                                  | $          | 118,262  |   | $ | 37,034  |   | $ | 24,947  |   |
|                                   |            |                                                                           |               |                                                       |            |  |  |  |  |  |  |  |  |  |  |

----

(1)          Excludesintercompany insurance of $7,143 million in 2004 and $4,474 millionin 2003 relating to FSA-insured GICs issued by the GIC Affiliates.

98

----

The netpar 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**               | ** ** | ** **                                                           | ** **    | **2004**                                     | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
| General obligation bonds                    |       | $                                                                    | 77,865   |                                         | $          | 67,212  |   | $ | 24,278  |   | $ | 20,184  |   |
| Housing revenue bonds                       |       | 7,628                                                                |          | 7,597                                        |       | 2,224 |   | 2,074 |   |
| Municipal utility  revenue bonds            |       | 33,544                                                               |          | 30,024                                       |       | 13,761 |   | 14,270 |   |
| Health care revenue  bonds                  |       | 9,261                                                                |          | 7,051                                        |       | 7,784 |   | 6,971 |   |
| Tax-supported non-general  obligation bonds |       | 36,631                                                               |          | 33,835                                       |       | 14,564 |   | 13,526 |   |
| Transportation revenue  bonds               |       | 12,834                                                               |          | 10,744                                       |       | 7,584 |   | 7,376 |   |
| Other municipal bonds                       |       | 17,629                                                               |          | 14,475                                       |       | 9,459 |   | 7,223 |   |
| Total municipal obligations                 |       | $                                                                    | 195,392  |                                         | $          | 170,938  |   | $ | 79,654  |   | $ | 71,624  |   |
|                                             |            |                                                                      |               |                                              |            |  |  |  |  |  |  |  |  |  |  |

 

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.

TheCompany seeks to maintain a diversified portfolio of insured municipalobligations designed to spread its risk across a number of geographic areas.The following table sets forth those states in which municipalities locatedtherein issued an aggregate of 2% or more of the Company’s net par amountoutstanding (in millions) of insured municipal securities as of December 31,2004:

| **State**                     | ** ** | ** ** | ** ** | **Number of  Issues** | ** ** | **Net Par Amount  Outstanding** | ** ** | **Percent of Total  Municipal Net  Par Amount  Outstanding** | ** ** | **Ceded Par  Amount  Outstanding** | ** ** |
|-------------------------------|------------|------------|------------|----------------------------|------------|-------------------------------------------|------------|----------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| California                    |       |       | 934        |                       |       |                                      | $          | 26,501                                                                      |       |                                    |       | 13.6 | % |   |   | $ | 8,897  |   |   |
| New York                      |       |       | 622        |                       |       |                                      | 17,917     |                                                                             |       |                                    | 9.2        |   |   |   | 9,362 |   |   |
| Texas                         |       |       | 701        |                       |       |                                      | 13,297     |                                                                             |       |                                    | 6.8        |   |   |   | 4,815 |   |   |
| Pennsylvania                  |       |       | 704        |                       |       |                                      | 12,276     |                                                                             |       |                                    | 6.3        |   |   |   | 3,418 |   |   |
| Florida                       |       |       | 274        |                       |       |                                      | 10,881     |                                                                             |       |                                    | 5.6        |   |   |   | 3,820 |   |   |
| Illinois                      |       |       | 633        |                       |       |                                      | 9,337      |                                                                             |       |                                    | 4.8        |   |   |   | 3,699 |   |   |
| New Jersey                    |       |       | 548        |                       |       |                                      | 9,053      |                                                                             |       |                                    | 4.6        |   |   |   | 4,176 |   |   |
| Washington                    |       |       | 297        |                       |       |                                      | 7,272      |                                                                             |       |                                    | 3.7        |   |   |   | 2,867 |   |   |
| Michigan                      |       |       | 399        |                       |       |                                      | 5,896      |                                                                             |       |                                    | 3.0        |   |   |   | 2,096 |   |   |
| Massachusetts                 |       |       | 194        |                       |       |                                      | 4,933      |                                                                             |       |                                    | 2.5        |   |   |   | 2,639 |   |   |
| Wisconsin                     |       |       | 425        |                       |       |                                      | 4,713      |                                                                             |       |                                    | 2.4        |   |   |   | 1,299 |   |   |
| Ohio                          |       |       | 265        |                       |       |                                      | 4,412      |                                                                             |       |                                    | 2.3        |   |   |   | 2,199 |   |   |
| Georgia                       |       |       | 106        |                       |       |                                      | 4,288      |                                                                             |       |                                    | 2.2        |   |   |   | 1,417 |   |   |
| All other U.S.  jurisdictions |       |       | 2,747      |                       |       |                                      | 56,283     |                                                                             |       |                                    | 28.7       |   |   |   | 21,740 |   |   |
| International                 |       |       | 85         |                       |       |                                      | 8,333      |                                                                             |       |                                    | 4.3        |   |   |   | 7,210 |   |   |
| Total                         |       |       | 8,934      |                       |       |                                      | $          | 195,392                                                                     |       |                                    |       | 100.0 | % |   |   | $ | 79,654  |   |   |

 

**15.**   RELATEDPARTY TRANSACTIONS

The Subsidiaries ceded premiums of $35.2 million,$48.8 million and $23.4 million to subsidiaries of XL Capital Ltd (“XL”),which owned an interest in FSA International as of December 31, 2004, forthe 

99

----

years ended December 31,2004, 2003 and 2002, respectively. The amounts included in prepaid reinsurancepremiums at December 31, 2004 and 2003 for reinsurance ceded tosubsidiaries of XL were $84.6 million and $60.8 million,respectively. The reinsurance recoverable for unpaid losses at December 31,2004 and 2003 for reinsurance ceded to subsidiaries of XL were$8.2 million and $10.9 million, respectively.

The Subsidiaries earned premiums of $2.5 millionand $5.0 million in the first half of 2003 and full year 2002,respectively, relating to the guarantees of debt issued or assets purchased byFSA Global and Canadian Global. Inter-company premiums earned relating toVIEs have been eliminated in consolidation for periods subsequent to July 1,2003.

The Subsidiaries earnedpremiums of $28.0 million, $20.5 million and $17.3 million for theyears ended December 31, 2004, 2003 and 2002, respectively, relating tobusiness with affiliates of Dexia. Deferred premium revenue relating to thosetransactions was $17.0 million and $6.9 million at December 31,2004 and 2003, respectively. Gross par outstanding relating to thosetransactions was $24.0 billion and $16.8 billion at December 31, 2004 and2003, respectively. The Company also paid Dexia a fee of $0.7 million in2003 and $3.3 million in 2002 relating to business in which both Dexia andthe Company were involved. For the years ended December 31, 2004, 2003 and2002 the Company recorded pre-tax income (loss) of $97.6 million,$52.9 million and $(3.7) million, respectively, relating to swaps whereDexia was the counterparty. The Company recorded other assets of $353.1 millionand other liabilities of $17.2 million in 2004 and recorded other assets of $223.6million and other liabilities of $8.6 million in 2003, primarily relating to swapswhere Dexia was the counterparty. In addition, at December 31, 2004 and2003, the Company had $163.0 million and $154.3 million in VIE debt,respectively, relating to debt issued by the Company and purchased by Dexia.During 2004 and 2003, the Company recorded $8.8 million and$3.3 million, respectively, in VIE net interest expense relating to suchdebt.

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

The Company determines fair values 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 current marketexchange. The use of different market assumptions and/or estimationmethodologies may have a material effect on the estimated fair-valueamounts.

For bonds, equity securities, GIC bond portfolio, GICbond portfolio pledged as collateral and VIE bond portfolio, the carryingamount represents fair value. The fair value is based on quoted market price orredemption value for the Company’s investment in XLFA.

For short-term investments, including the GICshort-term investment portfolio and VIE short-term investments, thecarrying amount is cost, which approximates fair market value due to the shortmaturity 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 premiumsthat would be paid under a reinsurance agreement with a third party to transferthe Company’s financial guaranty risk, net of that portion of the premiumsretained by the Company to compensate it for originating and servicing theinsurance contract.

100

----

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 premiums isthe 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 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.

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

| ** **                                                                            | ** ** | **As of December 31, 2004** | ** **      | **As of December 31, 2003** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------------|-----------------|-------------------------------------------------|------------|
| ** **                                                                            | ** ** | **Carrying  Amount**                            | ** **      | **Fair Value**                             | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
| ** **                                                                            | ** ** | **(restated)**                                  | ** **      | **(restated)**                                  | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| Assets:                                                                               |       |                                            |            |                                            |       |   |   |   |   |
| Bonds                                                                                 |       | $                                               | 3,914,763  |                                            | $          | 3,914,763  |   | $ | 3,508,649  |   | $ | 3,508,649  |   |
| Equity securities                                                                     |       | 54,300                                          |            | 54,300                                          |       |   |   |   |   |
| Short-term investments                                                                |       | 321,071                                         |            | 321,071                                         |       | 224,429 |   | 224,429 |   |
| FP bond portfolio                                                                     |       | 7,925,072                                       |            | 7,925,072                                       |       | 4,031,263 |   | 4,031,263 |   |
| FP short-term investment portfolio                                                    |       | 268,125                                         |            | 268,125                                         |       | 228,812 |   | 228,812 |   |
| FP bond portfolio pledged as collateral                                               |       | 5,913                                           |            | 5,913                                           |       | 66,423 |   | 66,423 |   |
| VIE bonds                                                                             |       | 1,346,355                                       |            | 1,346,355                                       |       | 1,422,538 |   | 1,422,538 |   |
| VIE short-term investments                                                            |       | 1,194                                           |            | 1,194                                           |       | 11,102 |   | 11,102 |   |
| Cash                                                                                  |       | 14,353                                          |            | 14,353                                          |       | 19,460 |   | 19,460 |   |
| Assets acquired in refinancing transactions                                           |       | 749,208                                         |            | 748,118                                         |       | 506,951 |   | 503,255 |   |
| Fair-value adjustments on derivatives                                                 |       | 642,045                                         |            | 642,045                                         |       | 409,798 |   | 409,798 |   |
| Receivable for investments sold                                                       |       | 161                                             |            | 161                                             |       | 389 |   | 389 |   |
| Liabilities:                                                                          |       |                                            |            |                                            |       |   |   |   |   |
| Deferred premium revenue, net of prepaid reinsurance  premiums                        |       | 1,336,232                                       |            | 1,154,461                                       |       | 1,149,593 |   | 949,469 |   |
| Losses and loss adjustment expenses, net of  reinsurance recoverable on unpaid losses |       | 144,522                                         |            | 144,522                                         |       | 174,173 |   | 174,173 |   |
| GIC and VIE debt                                                                      |       | 10,444,051                                      |            | 10,751,688                                      |       | 6,639,381 |   | 6,834,321 |   |
| Notes payable                                                                         |       | 430,000                                         |            | 437,556                                         |       | 430,000 |   | 439,264 |   |
| Fair-value adjustments on derivatives                                                 |       | 25,582                                          |            | 25,582                                          |       | 45,760 |   | 45,760 |   |
| Payable for investments purchased                                                     |       | 262,033                                         |            | 262,033                                         |       | 116,878 |   | 116,878 |   |
| Off-balance-sheet  instruments:                                                       |       |                                            |            |                                            |       |   |   |   |   |
| Installment  premiums                                                                 |       | —                                          |            | 413,876                                         |       | — |   | 381,686 |   |
|                                                                                       |            |                                                 |                 |                                                 |            |  |  |  |  |  |  |  |  |

 

101

----

**17.   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**             | ** ** |
|--------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **      2004       ** | ** ** | **      2003      ** | ** ** | **      2002      ** | ** ** |
| ** **                           | ** ** | **(dollars in millions)**                                                    | ** ** |
| Gross balance at  January 1     |       |                                                                                   | $          | 121.9 |   |   |   | $ | 134.0 |   |   |   | $ | 45.4 |   |   |
| Less reinsurance  recoverable        |       |                                                                                   | 59.2       |   |   |   | 76.0 |   |   |   | 28.9 |   |   |
| Net balance at  January 1       |       |                                                                                   | 62.7       |   |   |   | 58.0 |   |   |   | 16.5 |   |   |
| Transfer from non-specific  reserve  |       |                                                                                   | 30.7       |   |   |   | 12.7 |   |   |   | 45.0 |   |   |
| Restructured  transactions           |       |                                                                                   | (13.9      | ) |   |   | (2.2 | ) |   |   | — |   |   |
| Paid (net of recoveries) related to: |       |                                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| Current year                         |       |                                                                                   | —     |   |   |   | — |   |   |   | — |   |   |
| Prior year                           |       |                                                                                   | (34.3      | ) |   |   | (5.8 | ) |   |   | (3.5 | ) |   |
| Total paid                           |       |                                                                                   | (34.3      | ) |   |   | (5.8 | ) |   |   | (3.5 | ) |   |
| Net balance at  December 31     |       |                                                                                   | 45.2       |   |   |   | 62.7 |   |   |   | 58.0 |   |   |
| Plus reinsurance  recoverable        |       |                                                                                   | 35.4       |   |   |   | 59.2 |   |   |   | 76.0 |   |   |
| Gross balance at December 31    |       |                                                                                   | $          | 80.6 |   |   |   | $ | 121.9 |   |   |   | $ | 134.0 |   |   |

 

| ** **                           | ** ** | **Non-Specific Reserve Activity for the Year Ended**                       | ** ** |
|--------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **        2004        ** | ** ** | **        2003        ** | ** ** | **        2002        ** | ** ** |
| ** **                           | ** ** | **(dollars in millions)**                                                                      | ** ** |
| Balance at  January 1           |       |                                                                                                     | $          | 111.5 |   |   |   | $ | 89.7 |   |   |   | $ | 69.1 |   |   |
| Provision for losses                 |       |                                                                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Current year                         |       |                                                                                                     | 20.4       |   |   |   | 22.4 |   |   |   | 21.1 |   |   |
| Prior year                           |       |                                                                                                     | 0.2        |   |   |   | 12.1 |   |   |   | 44.5 |   |   |
| Transfers to case  reserves          |       |                                                                                                     | (30.7      | ) |   |   | (12.7 | ) |   |   | (45.0 | ) |   |
| Restructured  transactions           |       |                                                                                                     | (2.1       | ) |   |   | — |   |   |   | — |   |   |
| Balance at  December 31         |       |                                                                                                     | 99.3       |   |   |   | 111.5 |   |   |   | 89.7 |   |   |
| Total case and non-specific reserves |       |                                                                                                     | $          | 179.9 |   |   |   | $ | 233.4 |   |   |   | $ | 223.7 |   |   |

 

The gross and net par amounts outstanding ontransactions with case reserves were $791.4 million and$682.6 million, respectively, at December 31, 2004. The net casereserve consisted primarily of six CDO transactions and one municipaltransaction, which collectively accounted for approximately 95% of the totalnet case reserve. The remaining 11 exposures were in various sectors.

During 2004, the Company charged $20.6 million toloss expense, consisting of $25.0 million for originations of new businessand $3.2 million related to reassumptions of previously ceded business,offset by reserve releases primarily related to a large refinancing transactionin 2004. 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 offset by transfers from the non-specific reserve of$30.7 million. (See Note 23.)

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 

102

----

returned to the non-specificreserve. After reevaluating 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 relating to a restructured transaction tosecuritized loans on the balance sheet (see Note 23).

In the second quarter of 2002, as part of the Company’songoing credit review process, management identified certain transactions notperforming as expected in its portfolio of insured CDOs. As a result,management undertook a quantitative analysis of all CDO transactions in itsinsured portfolio that breached senior overcollateralization triggers, which wereincluded in such transactions as one measure of adverse performance. A presentvalue “deterministic” approach was utilized to estimate the loss inherent inthis portfolio. The deterministic model takes the average cumulative defaultrate produced by a Monte Carlo simulation and applies those defaults to a cashflow model using (1) a timing sequence dependent on the portfolio’s ratingand maturity composition, (2) an estimate of collateral recovery valuesfor severity and (3) the LIBOR forward curve as a predictor of interestrates. Management assumed that current default rates on CDO collateral wouldimprove in a manner consistent with an economic recovery following a period ofsignificant credit deterioration similar to that experienced in 1991 and 1992 and,as a result, management utilized the Moody’s idealized default curve, adjustedby a factor consistent with the relationship between the 1992 cohort experienceand the Moody’s 30-year average default rate. The per-perioddefault rate was calculated based on the Moody’s weighted-average ratingfactor for each piece of surviving collateral. Recovery rates were judgmentallyestablished by the Company. In considering the recovery rates to be utilized,management adjusted Moody’s average recovery rates (observed since 1982)downward to reflect more recent adverse observations.

At June 30, 2002, this analysis produced apresent value of expected losses of $51.5 million, net of reinsurancerecoveries and net of unearned premiums and future ceding commissions. Managementaddressed this net present value of expected loss ($51.5 million) through (1) anincrease in the Company’s non-specific reserve ($31.0 million) and (2) amountsalready existing in its non-specific reserve ($20.5 million), includingnon-specific reserve amounts reallocated to case reserves($11.3 million). The $31.0 million increase in the Company’s non-specificreserve resulted in a corresponding increase to losses and loss adjustmentexpenses in the statement of operations of $31.0 million. An additionaladjustment of $10.1 million was made in the fourth quarter of 2002 as aresult of further deterioration of the CDO portfolio. Management established amethodology of recording case reserves on CDO transactions based on the extentto which the overcollateralization ratio (non-defaulted collateral at parvalue divided by the debt insured) has fallen below 100%, since managementbelieves that claims on such transactions are probable and that the amount ofthe undercollateralization is a reasonable estimate of such claims. Suchtransactions may benefit from excess cash flow attributable in part to higherinterest rates on the underlying collateral than on the insured securities. Inaddition, such transactions generally require insured payments of principalonly at the ultimate maturity of such transactions. Application of thismethodology resulted in recording $68.8 million in gross case reserves and$29.8 million in reinsurance recoverable on unpaid losses, resulting in a$39.0 million increase in net case reserves in 2002. Management, beginningin the second quarter of 2002, has refined the loss factor it applies to itsnet par underwritten when 

103

----

calculating the non-specificreserve in order to reflect its recent adverse experience. As a result, the non-specificreserve accrual for the year ended December 31, 2002 was$65.6 million, rather than approximately $14.9 million that wouldhave been accrued using the prior assumptions.

During 2002, the Company increased its non-specificreserve by $65.6 million, of which $41.1 million related to the CDOportfolio discussed above, $21.1 million was for origination of newbusiness and $3.4 million was for accretion of the discount on prior years’reserves. Also during 2002, the Company transferred to the non-specificreserve $0.8 million representing recoveries received on prior-yeartransactions and transferred $45.8 million from the non-specificreserve to case reserves.

The cumulative amount of net discount taken wasapproximately $59.5 million, $65.9 million and $44.7 million at December 31,2004, 2003 and 2002, respectively.

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 actual loss experience,its future mix of business and future economic conditions.

**18.   QUARTERLYFINANCIAL INFORMATION (UNAUDITED)**

| ** **                                                                                                                                           | ** ** | **First**                            | ** ** | **Second**     | ** ** | **Third**      | ** ** | **Fourth**     | ** ** | **Full Year** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|--------------------|------------|
| ** **                                                                                                                                           | ** ** | **(restated)**                       | ** ** | **(restated)** | ** ** | **(restated)** | ** ** | **(restated)** | ** ** | **(restated)**     | ** ** |
| ** **                                                                                                                                           | ** ** | **(dollars in thousands)** | ** ** |
| 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 on derivative  instruments                                                                                         |       | 52,155                               |       | (65,247        | )          | 148,041        |       | 194,310        |       | 329,259            |       |
| Income before income taxes, minority interest and  equity in earnings (losses)  of unconsolidated affiliates                                         |       | 160,279                              |       | 37,609         |       | 224,043        |       | 158,583        |       | 580,514            |       |
| Net income                                                                                                                                           |       | $                                    | 101,611    |           | $          | 57,540         |       | $              | 114,190    |               | $          | 105,266 |   | $ | 378,607 |   |
| 2003                                                                                                                                                 |       |                                 |       |           |       |           |       |           |       |               |       |
| Gross premiums written                                                                                                                               |       | $                                    | 129,554    |           | $          | 294,832        |       | $              | 262,127    |               | $          | 209,313 |   | $ | 895,826 |   |
| Net premiums written                                                                                                                                 |       | 92,185                               |       | 187,884        |       | 182,946        |       | 151,269        |       | 614,284            |       |
| Net premiums earned                                                                                                                                  |       | 80,090                               |       | 88,158         |       | 95,460         |       | 92,665         |       | 356,373            |       |
| Net investment income                                                                                                                                |       | 36,533                               |       | 37,776         |       | 38,991         |       | 40,748         |       | 154,048            |       |
| Losses and loss adjustment expenses                                                                                                                  |       | 6,300                                |       | 6,595          |       | 14,638         |       | 6,953          |       | 34,486             |       |
| Net realized and unrealized gains (losses) on  derivative instruments                                                                                |       | (225                                 | )          | (9,552         | )          | 111,314        |       | 125,912        |       | 227,449            |       |
| Income before income taxes, minority interest,  equity in earnings (losses) of unconsolidated affiliates and cumulative  effect of accounting change |       | 78,507                               |       | 103,747        |       | 157,116        |       | 84,043         |       | 423,413            |       |
| Cumulative effect of accounting change, net of  taxes                                                                                           |       | —                               |       | —         |       | 4,800          |       | —         |       | 4,800              |       |
| Net income                                                                                                                                           |       | $                                    | 67,018     |           | $          | 74,441         |       | $              | 80,313     |               | $          | 76,355 |   | $ | 298,127 |   |

 

Certain prior-quarterbalances have been reclassified to conform to the year-end presentation.

104

----

**19.   EQUITY INVESTMENTS**

TheCompany made equity investments in SPS Holding Corp. (“SPS”) (formerly,Fairbanks Capital Holding Corp.) of $10.3 million and $13.4 million in 2004 and2002, respectively, and did not make any equity investments in 2003. At December 31,2004, the Company had a 34.1% interest in SPS. The Company’s investment in SPSis accounted for using the equity method of accounting. Amounts recorded by theCompany in connection with SPS at December 31, 2004, 2003 and 2002 were asfollows (in thousands):

| ** **                                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Investment in SPS                               |       | $49,645  |       | $46,423  |       | $59,971  |       |
| Equity in earnings  (losses) from SPS (pre-tax) |       | (7,100   | )          | (13,548  | )          | 13,795   |       |

 

At December 31, 2004 and 2003, the Company’sretained earnings included $4.0 million and $3.5 million, respectively, ofaccumulated undistributed earnings of SPS.

SPS’s business is subject to regulation, supervisionand licensing by various federal, state and local authorities that haveincreased their focus on lending and servicing practices in the sub-primelending industry. In October 2002, the Federal Trade Commission (the “FTC”)informed SPS that it was investigating whether SPS’s loan servicing or otherpractices violated the Fair Debt Collection Practices Act, the Fair CreditReporting Act, Section 5 of the Federal Trade Commission Act or other lawsenforced by the FTC. Certain of SPS’s shareholders, including the Company,received civil investigative demands from the FTC relating to their investmentsin SPS and their knowledge of SPS’s servicing operations.

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 equityinvestment in SPS 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.”While management believes book value approximates fair value, the Company willcontinue to monitor the value of its investment in SPS. The Company and theother owners of SPS have entered into a binding Summary of Terms relating tothe potential sale to an unaffiliated third party of their respective interestsin SPS pursuant to an option, exercisable on or before July 31, 2005. Thesale is subject to several conditions, including, among other things, executionof definitive agreements.

FSA’s 13% investment in preferred shares of XLFA, afinancial guaranty insurance subsidiary of XL, is redeemable by XLFA at a priceequal to the fair market value of the preferred shares, subject to a capdefined as the internal rate of return of 19% per annum from the date of theinvestment through the date of redemption, plus accrued dividends as if 100% ofcurrent-year earnings were distributed. Based on this formula, theCompany recently adopted a policy of carrying this investment at the lesser ofthe current calculated redemption value or the redemption value as of the next January first,which would exclude its share of accrued current-year earnings to theextent the cap had been otherwise met. Consistent with this policy, in thethird quarter of 2004, the Company charged $11.7 million to equity in earningsof unconsolidated affiliates and reduced its carrying value in this investmentto $56.4 million. In the fourth quarter of 2004, the Company recorded a returnof capital of $2.1 million.

105

----

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 will no longer accrue undistributed earnings related to its investmentin XLFA. Amounts recorded by the Company in connection with XLFA as of December 31,2004, 2003 and 2002 are as follows (in thousands):

| ** **                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Equity securities                       |       | $54,300  |       | —   |       | —   |       |
| Investment in  XLFA                     |       | —   |       | 64,440   |       | 52,206   |       |
| Equity in  earnings from XLFA (pre tax) |       | 3,761    |       | 19,077   |       | 9,145    |       |
| Dividends received from  XLFA           |       | 12,003   |       | 6,640    |       | 6,665    |       |

 

At December 31, 2003,the Company’s retained earnings included $25.7 million of accumulatedundistributed earnings of XLFA.

**20.   MINORITYINTEREST IN SUBSIDIARY**

In November 1998, FSAInternational sold to XL $20.0 million of preferred shares representing aminority interest in FSA International, which is a Bermuda-basedfinancial guaranty subsidiary of FSA. In December 1999, FSA Internationalsold to XL an additional $10.0 million of preferred shares to enable XL tomaintain its minority ownership percentage. The preferred shares are CumulativeParticipating Voting Preferred Shares that, in total, have a minimum fixeddividend of $1.5 million per annum. In 2004 and 2003, FSA International paidpreferred dividends of $4.9 million and $3.3 million, respectively, to XL. Forthe years ended December 31, 2004, 2003 and 2002, the Company recognizedminority interest of $6.9 million, $9.3 million and $6.7 million, respectively.

**21.   GICAND VIE DEBT**

The obligations under GICsissued by the GIC Affiliates may be called at various times prior to maturitybased on certain agreed-upon events. As of December 31, 2004, theinterest rates on outstanding GICs were between 0.85% and 5.95% per annum andbetween 1.12% and 7.75% per annum on VIE debt. Payments due under GICs arebased on expected withdrawal dates and exclude hedge accounting adjustments andprepaid interest of $20.3 million and include accretion of $743.5 million. VIEdebt includes $1,331.0 million of future interest accretion on zero couponobligations. The following table presents (in millions) the combined principalamounts due under GICs and VIE debt for 2005 and each of the next four yearsending December 31, and thereafter:

| ** ** | ** ** | **Principal  Amount** | ** ** |
|------------|------------|-----------------------|------------|
| ** ** | ** ** | **(restated)**        | ** ** |
| 2005       |       | $                     | 2,881.7    |   |
| 2006       |       | 1,508.4               |       |
| 2007       |       | 1,156.5               |       |
| 2008       |       | 462.3                 |       |
| 2009       |       | 940.1                 |       |
| Thereafter |       | 5,589.9               |       |
| Total      |       | $                     | 12,538.9   |   |

 

106

----

**22.   DERIVATIVE INSTRUMENTS**

***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$69.1 million, $57.7 million and $35.0 million of net earned premium underthese agreements for the years ended 2004, 2003 and 2002, respectively.

Changes in the fair value of CDS, which were gains of$56.4 million and $34.8 million for the years ended December 31, 2004 and2003, respectively, and losses of $50.2 million in 2002, were recorded in netrealized and unrealized gains (losses) on derivative instruments in thestatements of operations and comprehensive income. The Company included net paroutstanding of $66.0 billion and $63.8 billion relating to these CDStransactions at December 31, 2004 and December 31, 2003,respectively, in the asset-backed balances in Note 14. The gains orlosses recognized by recording these contracts at fair value are determinedeach quarter based on quoted market prices, if available. If quoted marketprices are not available then the determination of fair value is based oninternally developed estimates. Management applies judgment when developingthese estimates and considers factors such as current prices charged for similaragreements, performance of underlying assets, changes in internal shadowratings, the level at which the deductible has been set and the Company’sability to obtain reinsurance for its insured obligations. The Company does notbelieve that the fair value adjustments are an indication of potential claimsunder FSA’s guarantees. The average life of these contracts is 2.9 years.The inception to date gain (loss) on the CDS portfolio was $46.6 million at December 31,2004 and $(9.8) million at December 31, 2003, and was recorded inother assets or accrued expenses and other liabilities, as applicable.

In August 2002, theCompany terminated its exposure under its single-corporate-name CDSprogram in exchange for paying termination costs of $43.0 million, of which$38.0 million was related to FSA’s exposure. The charge was included in netrealized and unrealized gains (losses) on derivative instruments in thestatements of operations and comprehensive income.

***Interest Rate and Foreign Exchange Rate Derivatives***

The Company utilizes interest rate derivatives toconvert assets and liabilities with fixed interest rates to floating rates. Allgains and losses from changes in the fair value of derivatives that do notqualify for hedge accounting are recognized immediately in the statements of operations and comprehensive incomeunder the caption of net unrealized and realized gains (losses) on derivativeinstruments. Hedge accounting is applied to derivatives designated as hedginginstruments in a fair value hedge provided certain criteria are met. 

The Company enters intoderivative contracts to manage interest-rate and foreign currencyexposure in its GIC bond portfolio, GICs, VIE debt and VIE Portfolio. Thederivative contracts are recorded at fair value. These derivatives generallyinclude interest-rate futures and interest-rate and currency swapagreements, which are primarily utilized to convert fixed-rate debt andinvestments into U.S. dollar floating-rate debt and investments. Thegains and losses related to the fair value of derivatives are included in netrealized and unrealized gains (losses) on derivative instruments. The inception-to-datenet unrealized loss on derivatives used to hedge GIC liabilities and thefinancial products bond portfolio of $6.2 million and $14.2 million at December 31,2004 and December 31, 2003, respectively, is recorded in other assets andaccrued expenses and other liabilities, as applicable. The inception-to-datenet unrealized gain on the outstanding derivatives used to economically hedgethe VIE debt and VIE bond portfolio of 

107

----

$570.8million and $389.1 million at December 31, 2004 and December 31,2003, respectively, are recorded in other assets and accrued expenses and otherliabilities, as applicable.

***Other Derivatives***

The Company enters intovarious other derivative contracts that do not qualify for hedge accountingtreatment under SFAS 133. These derivatives include swaptions, caps and otherderivatives, which are used principally as protection against large interest-ratemovements. Gains and losses on these derivatives are reflected in net realizedand unrealized gains (losses) on derivative instruments in the statements of operationsand comprehensive income.

**23.   REFINANCED TRANSACTIONS**

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.

At December 31, 2004, the Company has includedall of the assets acquired in refinancing transactions under one balance sheetcaption, “Assets acquired in refinancing transactions,” and the relatedrevenues from those assets into one revenue caption, “Income from assetsacquired in refinancing transactions.”

Thefollowing table presents the components of the assets acquired in refinancingtransactions:

| ** **                                       | ** ** | **As of December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| ** **                                       | ** ** | **(restated)**                        | ** ** | **(restated)** | ** ** |
| **Assets  acquired in refinancing transactions** | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Securitized loans                                |       | $                                     | 369,749    |   | $ | 433,949 |   |
| Bonds                                            |       | 157,036                               |       | — |   |
| Asset-backed senior notes                        |       | 90,516                                |       | 72,089 |   |
| Equity securities                                |       | 15,659                                |       | — |   |
| Mortgage loans                                   |       | 77,462                                |       | — |   |
| Short-term investments                           |       | 27,749                                |       | — |   |
| Other assets                                     |       | 11,037                                |       | 913 |   |
| Total                                            |       | $                                     | 749,208    |   | $ | 506,951 |   |

 

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 31,2004, 2003 and 2002 was $443.3 million, $513.5 million and $565.7 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 (see Note 27). Since the notes represent100% of the debt capitalization of the trusts and since FSA maintains all therisk of further asset decline (except as provided by reinsurance) and maintainscontrol over key decisions regarding the trusts (such as removal of theservicer, sale of the assets and liquidation of the entity), the trusts wereconsolidated with FSA for accounting purposes. FSA also consolidated therefinancing vehicles.

108

----

Thecredit quality of fixed income assets within the refinanced asset portfolio at December 31,2004 was as follows:

| **Rating(1)** | ** ** | ** **     | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|----------------|------------|--------------------------------|------------|
| ** **    | ** ** | **(restated)** | ** ** |
| BBB           |       |           | 9.8        | %                              |       |
| BB            |       |           | 1.8        |                           |       |
| B             |       |           | 16.6       |                           |       |
| CCC           |       |           | 57.1       |                           |       |
| CC            |       |           | 5.8        |                           |       |
| NR            |       |           | 8.9        |                           |       |
|          |       |           | 100.0      | %                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2004.

Theamortized cost and fair value of fixed income assets within the refinancedasset portfolio were as follows (in thousands):

| ** **               | ** ** | **As of December 31, 2004** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **               | ** ** | **(restated)**                                  | ** ** | **(restated)** | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| 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 |   |

 

| ** **               | ** ** | **As of December 31, 2003** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **               | ** ** | **(restated)**                                  | ** ** | **(restated)** | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| Asset-backed  securities |       |                                            | $          | 70,272 |   |   |   | $ | 1,817 |   |   |   | — |   |   |   | $ | 72,089 |   |   |
| Total                    |       |                                            | $          | 70,272 |   |   |   | $ | 1,817 |   |   |   | — |   |   |   | $ | 72,089 |   |   |

 

Theamortized cost and fair value of equities held within the refinanced assetportfolio were as follows (in thousands):

| ** **        | ** ** | **As of December 31, 2004** | ** ** |
|-------------------|------------|-------------------------------------------------|------------|
| ** **        | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **        | ** ** | **(restated)**                                  | ** ** | **(restated)** | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| Equity securities |       |                                            | $          | 13,919 |   |   |   | $ | 1,903 |   |   |   | $ | (163 | ) |   |   | $ | 15,659 |   |   |
|                   |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

109

----

Theamortized cost and fair value of fixed income assets within the refinancedasset portfolio at December 31, 2004, are shown below by contractualmaturity (in thousands). Actual maturities could differ from contractualmaturities because borrowers have the right to call or prepay certain obligationswith or without call or prepayment penalties.

| ** **                              | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                              | ** ** | **(restated)**          | ** ** | ** **          | ** ** |
| Due in one year  or less                |       |                    | $          | 34,934              |       |   | $ | 34,908 |   |
| Due after one  year through five years  |       |                    | 126,153    |                |       | 129,827 |   |
| Due after five  years through ten years |       |                    | 108,057    |                |       | 110,566 |   |
| Total                                   |       |                    | $          | 269,144             |       |   | $ | 275,301 |   |

 

At December 31, 2004,there were no securities in an unrealized loss position for a continuous 12-monthperiod or longer. The Company determined that no investments were consideredother-than-temporarily impaired.

**24.   SEGMENT REPORTING**

TheCompany operates in two business segments: financial guaranty and financialproducts. The financial guaranty segment is primarily in the business ofproviding financial guaranty insurance on asset-backed and municipalobligations. It also includes the results of the VIEs that were consolidatedfor the first time in the third quarter of 2003. The FP Segment includes theGIC operations of the Company, which issues GICs to municipalities and othermarket participants. The GICs provide for the return of principal and thepayment of interest at a pre-specified rate. The following tablessummarize the financial information (in thousands) by segment as of December 31,2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002:

| ** **                                                           | ** ** | **For the Year Ended December 31, 2004** | ** ** |
|----------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **Financial  Guaranty**                                                | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| ** **                                                           | ** ** | **(restated)**                                                         | ** ** | **(restated)** | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| Revenues:                                                            |       |                                                                   |       |   |   |   |   |   |   |
| External                                                             |       | $                                                                      | 962,142    |   | $ | 167,948 |   | — |   | $ | 1,130,090 |   |
| Intersegment                                                         |       | 21,892                                                                 |       | 30,620 |   | (52,512 | ) | — |   |
| Expenses:                                                            |       |                                                                   |       |   |   |   |   |   |   |
| External                                                             |       | 372,959                                                                |       | 176,617 |   | — |   | 549,576 |   |
| Intersegment                                                         |       | 30,620                                                                 |       | 21,892 |   | (52,512 | ) | — |   |
| Pre-tax segment earnings                                             |       | $                                                                      | 395,667    |   | $ | 10,643 |   | — |   | $ | 406,310 |   |
| Current and deferred taxes                                           |       |                                                                   |       |   |   |   |   | (111,160 | ) |
| SFAS133 CDS and economic interest rate hedge fair  value adjustments |       |                                                                   |       |   |   |   |   | 83,457 |   |
| Net Income                                                           |       |                                                                   |       |   |   |   |   | $ | 378,607 |   |
| Segment assets                                                       |       | $                                                                      | 9,820,672  |   | $ | 9,379,900 |   | $ | (2,119,564 | ) | $ | 17,081,008 |   |
|                                                                      |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |

 

110

----

 

| ** **                                                           | ** ** | **For the Year Ended December 31, 2003** | ** ** |
|----------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **Financial  Guaranty**                                                | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| ** **                                                           | ** ** | **(restated)**                                                         | ** ** | **(restated)** | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| Revenues:                                                            |       |                                                                   |       |   |   |   |   |   |   |
| External                                                             |       | $                                                                      | 799,976    |   | $ | 70,318 |   | — |   | $ | 870,294 |   |
| Intersegment                                                         |       | 7,436                                                                  |       | 25,875 |   | (33,311 | ) | — |   |
| Expenses:                                                            |       |                                                                   |       |   |   |   |   |   |   |
| External                                                             |       | 351,522                                                                |       | 95,359 |   | — |   | 446,881 |   |
| 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 |   |
| Segment assets                                                       |       | $                                                                      | 8,845,016  |   | $ | 5,424,864 |   | $ | (1,862,317 | ) | $ | 12,407,563 |   |
|                                                                      |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                                           | ** ** | **For the Year Ended December 31, 2002** | ** ** |
|----------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **Financial  Guaranty**                                                | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| ** **                                                           | ** ** | **(restated)**                                                         | ** ** | **(restated)** | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| Revenues:                                                            |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| External                                                             |       | $                                                                      | 399,034    |   |   | $ | 36,226 |   |   |   | — |   |   | $ | 435,260 |   |
| Intersegment                                                         |       | —                                                                 |       |   | 5,619 |   |   |   | (5,619 | ) |   | — |   |
| Expenses:                                                            |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| External                                                             |       | 187,284                                                                |       |   | 55,470 |   |   |   | — |   |   | 242,754 |   |
| Intersegment                                                         |       | 5,619                                                                  |       |   | — |   |   |   | (5,619 | ) |   | — |   |
| Pre-tax segment earnings                                             |       | $                                                                      | 277,575    |   |   | $ | (8,536 | ) |   |   | — |   |   | $ | 269,039 |   |
| Current and deferred taxes                                           |       |                                                                   |       |   |   |   |   |   |   |   |   | (43,297 | ) |
| SFAS133 CDS and economic  interest rate hedge fair value adjustments |       |                                                                   |       |   |   |   |   |   |   |   |   | (28,777 | ) |
| Net Income                                                           |       |                                                                   |       |   |   |   |   |   |   |   |   | $ | 196,965 |   |

 

The intersegment assets consist of (1) intercompanynotes issued by FSA and held within the GIC Portfolio and (2) GICs issuedby the GIC Affiliates and held within the VIE Portfolio. The intersegmentrevenues and expenses relate to interest income and interest expense onintercompany notes and GICs.

The SFAS 133 CDS andeconomic interest rate hedge fair value adjustments are used to reconcile thepre-tax segment earnings to net income. Management subtracts the impact of these derivatives when analyzing thesegments, as it believes that, by removing the effect of the one-sidedaccounting caused by marking the derivatives, but not the hedged assets orliabilities, to fair value, the measure will more closely reflect theunderlying performance of segment operations.

111

----

**25.   OTHER ASSETS AND LIABILITIES**

Thedetailed balances that comprise other assets and accrued expenses and otherliabilities at December 31, 2004 and 2003 are as follows (in thousands):

| ** **                                      | ** ** | **2004**       | ** ** | **2003**       | ** ** |
|-------------------------------------------------|------------|----------------|------------|----------------|------------|
| ** **                                      | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| Other Assets:                                   |       |           |       |           |       |
| Fair value of VIE swaps                         |       | $              | 570,764    |           | $          | 398,803 |   |
| VIE other invested assets                       |       | 156,540        |       | 150,410        |       |
| Securities purchased under agreements to resell |       | —         |       | 175,000        |       |
| Deferred compensation trust                     |       | 112,941        |       | 97,514         |       |
| Tax and loss bonds                              |       | 102,193        |       | 85,512         |       |
| Accrued interest on VIE swaps                   |       | 99,794         |       | 76,295         |       |
| Accrued interest income                         |       | 63,614         |       | 56,076         |       |
| Fair-value adjustments on derivatives           |       | 71,281         |       | 10,995         |       |
| Other assets                                    |       | 151,257        |       | 198,189        |       |
| Total Other Assets                              |       | $              | 1,328,384  |           | $          | 1,248,794 |   |

 

| ** **                                     | ** ** | **2004**       | ** ** | **2003**       | ** ** |
|------------------------------------------------|------------|----------------|------------|----------------|------------|
| ** **                                     | ** ** | **(restated)** | ** ** | **(restated)** | ** ** |
| Accrued Expenses  and Other Liabilities:       |       |           |       |           |       |
| Payable for securities purchased               |       | $              | 262,033    |           | $          | 116,878 |   |
| Deferred compensation trust                    |       | 112,941        |       | 97,262         |       |
| Equity participation plan                      |       | 123,382        |       | 114,165        |       |
| Securities sold under agreements to repurchase |       | 5,656          |       | 63,965         |       |
| Fair-value adjustments on derivatives          |       | 25,582         |       | 45,760         |       |
| Other liabilities                              |       | 313,931        |       | 266,113        |       |
| Total Accrued Expenses  and Other Liabilities  |       | $              | 843,525    |           | $          | 704,143 |   |

 

**26.   VARIABLE INTEREST ENTITIES**

In January 2003, the FASB issued FIN 46, whichaddresses consolidation of VIEs that have one or both of the followingcharacteristics: (a) the equity investment at risk is not sufficient topermit the entity to finance its activities without additional subordinatedfinancial support from other parties, which is provided through other intereststhat will absorb some or all of the expected losses of the entity; and (b) theequity investors lack the direct or indirect ability to make decisions aboutthe entity’s activities through voting rights or similar rights, the obligationto absorb the expected losses of the entity if they occur or the right toreceive the expected residual returns of the entity if they occur. In December 2003,the FASB issued FASB Interpretation No. 46 (revised December 2003), “Consolidationof Variable Interest Entities, an interpretation of ARB 51” (“FIN 46R”). FIN46R replaced FIN 46 and is effective for public companies for periods after December 15,2003.

FSA Global is managed as a “matched funding vehicle,”in which the proceeds from the issuance of FSA-guaranteed notes areinvested in obligations having cash flows substantially matched to those of,and maturing prior to, such notes. In certain cases, investments of FSA Globalconsist of GICs issued by the GIC Affiliates. Similarly, Premier has GICsissued by the GIC Affiliates in their investment portfolios. In each such case,the Company’s GIC liability and asset are eliminated in consolidation. At December 31,2004, $961.9 million was eliminated as a result of such consolidation. Allintercompany insured amounts between FSA and FSA Global and Canadian Globalpreviously included in the Company’s outstanding exposure are excluded from theNotes to the Consolidated Financial Statements for December 31, 2004 and2003.

112

----

FIN46R requires that, upon consolidation, the Company initially measure the VIE’sassets, liabilities and minority interest at their carrying amounts underexisting GAAP as if the entity had been consolidated from the time the Companywas considered its primary beneficiary (or parent). The increase in totalassets and total liabilities, at July 1, 2003, related to theconsolidation of these entities was $1.9 billion. The difference upon consolidationwas reflected 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.

| ** **                                                 | ** ** | **Twelve Months Ended  December 31, 2004** | ** ** | **Six Months Ended  December 31, 2003** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **(restated)**                                                 | ** ** | **(restated)**                                              | ** ** |
| VIE net interest  income                                   |       |                                                           | $          | 52,665                                                      |       |   |   | $ | 25,432 |   |   |
| FSA’s net  premiums earned on VIE bonds and debt      |       |                                                           | (5,351     | )                                                           |       |   | (2,690 | ) |   |
| Net realized and  unrealized gains (losses) on derivatives |       |                                                           | 249,752    |                                                        |       |   | 192,040 |   |   |
| Total revenues                                             |       |                                                           | $          | 297,066                                                     |       |   |   | $ | 214,782 |   |   |
| VIE net interest  expense                                  |       |                                                           | $          | 105,173                                                     |       |   |   | $ | 53,271 |   |   |
| Other operating  expenses                                  |       |                                                           | (1,054     | )                                                           |       |   | 383 |   |   |
| Foreign Exchange  Loss                                     |       |                                                           | 79,270     |                                                        |       |   | 118,269 |   |   |
| Total expenses                                             |       |                                                           | $          | 183,389                                                     |       |   |   | $ | 171,923 |   |   |

 

***VIE Investments***

Allbonds in the VIE Portfolio are insured by FSA. The credit quality of the VIEPortfolio, without the benefit of FSA’s insurance, at December 31, 2004was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|
| AAA           |       |       | 2.6        | %                              |       |
| AA            |       |       | 5.3        |                           |       |
| A             |       |       | 71.6       |                           |       |
| BBB           |       |       | 20.5       |                           |       |
|          |       |       | 100.0      | %                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2004.

113

----

Theamortized cost and fair value of bonds in the VIE Portfolio were as follows (inthousands):

| **December 31, 2004**                   | ** ** | ** **     | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|---------------------------------------------------|------------|----------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                        | ** ** | **(restated)** | ** ** | ** **              | ** ** |
| 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 |   |

 

| **December 31, 2003**                   | ** ** | ** **     | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|---------------------------------------------------|------------|----------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                        | ** ** | **(restated)** | ** ** | ** **              | ** ** |
| Obligations of  states and political subdivisions |       |           | $          | 16,200                  |       |                | $          | 16,200 |   |
| Corporate  securities                             |       |           | 175,118    |                    |       | 180,380             |       |
| Foreign  securities                               |       |           | 56,451     |                    |       | 61,207              |       |
| Asset-backed  securities(1)                       |       |           | 1,164,751  |                    |       | 1,164,751           |       |
| Short-term  investments                           |       |           | 11,102     |                    |       | 11,102              |       |
| Total                                             |       |           | $          | 1,423,622               |       |                | $          | 1,433,640 |   |

----

(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 31,2004, 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 31,2004, 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** | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                                    | ** ** | **(restated)**          | ** ** | ** **          | ** ** |
| Due in one year  or less                                      |       |                    | $          | 184,365             |       |   | $ | 186,182 |   |
| Due after one  year through five years                        |       |                    | 28,936     |                |       | 30,985 |   |
| Due after five  years through ten years                       |       |                    | —     |                |       | — |   |
| Due after ten  years                                          |       |                    | 16,007     |                |       | 16,007 |   |
| Asset-backed  securities (stated maturities of 1 to 18 years) |       |                    | 1,114,375  |                |       | 1,114,375 |   |
| Total                                                         |       |                    | $          | 1,343,683           |       |   | $ | 1,347,549 |   |

 

**27.   RECENTLYISSUED ACCOUNTING STANDARDS**

In December 2003, the Accounting StandardsExecutive Committee of the American Institute of Certified Public Accountantsissued Statement of Position 03-3: “Accounting for Certain Loans or DebtSecurities Acquired in a Transfer” (“SOP 03-3”). SOP 03-3addresses accounting for differences between contractual cash flows and cashflows expected to be collected from an investor’s initial investment in loansor debt securities (loans) acquired in a transfer if those differences areattributable, at least in part, to 

114

----

credit quality. SOP 03-3supersedes Practice Bulletin 6 for transactions entered into after the initialapplication of SOP 03-3. For loans acquired in fiscal years prior to theeffective date of SOP 03-3 and within the scope of Practice Bulletin 6(such as certain assets acquired via refinancing transactions, see Note 22),SOP 03-3 amends the application of Practice Bulletin 6 with regard toaccounting for decreases in cash flows expected to be collected.

SOP 03-3 requires that the investor recognizethe excess of all cash flows expected at acquisition over the investor’sinitial investment in the loan as interest income on a level-yield basisover the life of the loan. SOP 03-3 prohibits investors from displayingdifferences from expected cash flows in the balance sheet. Subsequent increasesin cash flows expected to be collected generally should be recognizedprospectively through adjustment of the loan’s yield over its remaining life.Decreases in cash flows expected to be collected should be recognized as animpairment.

SOP 03-3 is effective for loans acquired infiscal years beginning after December 15, 2004. For loans acquired infiscal years beginning on or before December 15, 2004 and that fall withinthe scope of Practice Bulletin 6 as it applies to decreases in cash flowsexpected to be collected, SOP 03-3 should be applied prospectively forfiscal years beginning after December 15, 2004. Management believes thatthe implementation of SOP 03-3 will not have a material effect on theCompany’s financial position, results of operations or cash flows.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123-R, “Share-Based Payment”(“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 interim or 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.

115

----

**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure.

There have been no changesin, or any disagreements with, accountants on accounting and financialdisclosure within the two years ended December 31, 2004.

**Item 9A.**                Controlsand Procedures.

***Evaluation of 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, 2004. 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 the Company’s disclosure controls and procedures were not effective inproviding reasonable assurance that information required to be disclosed in thereports the Company files or submits under the Exchange Act is recorded,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 financialstatements included in this Form 10-K/A fairly present in allmaterial respects the Company’s financial position, results of operations andcash flows for the periods presented in conformity with generally acceptedaccounting principles.

***Changes in Internal Control 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, 2004 that materially affected,or that are reasonably likely to materially affect, internal control overfinancial reporting.

***Identification of Material Weakness in InternalControl over Financial Reporting***

A material weakness is acontrol deficiency, or combination of control deficiencies, that results inmore than a remote likelihood that a material misstatement of the annual orinterim financial statements will not be prevented or detected.  Management has concluded that the Company didnot maintain effective controls to ensure that hedge accounting was correctlyapplied pursuant to generally accepted accounting principles. Specifically, theCompany’s accounting documentation for certain hedging relationships did not meet the requirements of SFAS 133and 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.  In addition, this control deficiency couldresult in a misstatement of interest income and expense from financial productsand variable interest entities, net realized and unrealized gains and losses onderivative instruments, income from assets acquired in refinancing transactionsand related accounts and disclosures that would cause a material misstatementin the annual and interim financial statements. Accordingly, managementdetermined that this control deficiency constituted a material weakness ininternal control over financial reporting as of December 31, 2004.

116

----

***Plans for Remediation***

Management intendsto remediate the material weakness in internal control over financial reportingand will report on its status when it files its Form 10-K for theyear ending December 31, 2005. In particular, management intends to:

·       revisethe Company’s accounting documentation of policies and procedures and review tomeet the standard of hedge documentation expected under SFAS 133; and

·       strengthenthe Company’s internal knowledge base regarding hedge accounting with improvedtraining and expertise.

By implementing these internal control improvements,management expects to remediate this material weakness in internal control overfinancial reporting before the Company’s management and independent registeredpublic accounting firm must first report on the effectiveness of the internalcontrol over financial reporting under Section 404 of the Sarbanes-OxleyAct of 2002.

Thereare inherent limitations to the effectiveness of any system of disclosurecontrols and procedures, including the possibility of human error and thecircumvention or overriding of the controls and procedures. Accordingly, eveneffective disclosure controls and procedures can only provide reasonableassurance of achieving their control objectives. The Company willcontinue to improve the design and effectiveness of its disclosure controls andprocedures and internal control over financial reporting to the extentnecessary in the future to provide senior management with timely access to suchmaterial information and to correct any deficiencies that may be discovered inthe future.

**Item 9B.**               OtherInformation.

None.

117

----

**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant.

**Directors**

On October 29,2004, 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, 2004 is set forth below and in “Item 12.Security Ownership of Certain Beneficial Owners and Management—Directors andExecutive Officers.”
| Dirk Bruneel  Age 54      |   | 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 and DVV Verzekeringen NV, Ehsal and VEV, and  Treasurer of *Vlaams Omroeporkest en  Kamerkoor**.* |
|---------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Robert P. Cochran  Age 55 |   | 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 XL  Financial Assurance Ltd and White Mountains Insurance Group, Ltd.                                                                                                                                                                                                                                                                                                                                                                                 |
| Bruno Deletre  Age 43     |   | Director of the Company  since September 2001. Mr. Deletre has been a member of the Executive Board  and Managing Director of Dexia Crédit Local since May 2001. 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |

118

----

 
| Robert N. Downey  Age 69      |   | 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 55       |   | Director of the  Company since September 2002. Mr. Guerber has been Chairman of the Executive  Board of Dexia Crédit Local, a subsidiary of Dexia S.A. formerly known as  Crédit Local de France, since January 2000 and a member of the Executive  Committee of Dexia S.A. since December 1999. He was previously Senior  Executive Vice President of Crédit Local de France since 1996 and a member of  that company's Management Board since 1988. Earlier, he held management  positions in the Local Development Division of Caisse des Dépôts et Consignations.                                                                                                                                                |
| David O. Maxwell  Age 74      |   | 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. and Centre  Partners III, 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.                      |

119

----

 
| James H. Ozanne  Age 61 |   | 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 owns  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. Prior to May 2003, Mr. Ozanne was 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 non executive chairman of  SPS and 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 64  |   | Director and Vice  Chairman of the Company since July 2000. Mr. Richard was appointed Group  Chief Executive and Chairman of the Executive Committee of Dexia S.A. in  December 1999 after its reorganization. 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,  Compagnie Nationale Air France, 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*.                                                                                                                                                                              |

120

----

 
| Roger K. Taylor  Age 53   |   | Director of the  Company since February 1995. Effective January 2002, Mr. Taylor became a  part  time employee of the Company and  Vice Chairman of FSA. He formally retired 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, a financial  guaranty insurer. Mr. Taylor is a director of SPS Capital Holding Corp.                                                                                                        |
|---------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Rembert von Lowis  Age 51 |   | Director of the  Company since July 2000. Mr. von Lowis is a member of the Executive Committee  and Chief Financial Officer of Dexia S.A. 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 49   |   | 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. |

 

**ExecutiveOfficers 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 full-time membersof the Management Committee.
| Name                  | ** ** | ** ** | ** ** | **Age**                                                                                      | ** ** | **Position** | ** ** |
|-----------------------|------------|------------|------------|----------------------------------------------------------------------------------------------|------------|--------------|------------|
| Russell B. Brewer  II |       | 48         |       | Managing Director  of the Company and FSA; Chief Risk Management Officer and Director of FSA |       |
| Joseph W. Simon       |       | 46         |       | Managing  Director and Chief Financial Officer of the Company and FSA; Director of FSA       |       |
| Bruce E. Stern        |       | 51         |       | Managing  Director, General Counsel and Secretary of the Company and FSA; Director of  FSA   |       |

 

121

----

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 FSA since March 1989and the Chief Risk Management Officer of FSA since September 2003. Mr. Brewerwas the Chief Underwriting Officer of FSA from September 1990 until September 2003.He has been a Managing Director of the Company since May 1999 and adirector of FSA since September 1993. From March 1989 to August 1990,Mr. Brewer was Managing Director, Asset Finance Group, of FSA. Prior tojoining FSA in 1986, Mr. Brewer was an Associate Director of Moody’sInvestors Service, Inc.

Mr. Simon was elected a Managing Director and theChief Financial Officer of the Company and FSA in September 2002, having servedin 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.

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. From January to September 2004 the Audit Committeeconsisted of Messrs. von Lowis (who served as Chairman), Deletre andMaxwell. On September 9, 2004, Messrs. von Lowis and Deletre steppeddown from the Committee, and Messrs. Ozanne and Wyper joined theCommittee.

Mr. Ozanne serves asChairman of the Audit Committee. All members of the Audit Committee areindependent within the meaning of Rule 10A-3 of the Exchange Act.Because the Company has only debt securities listed on the New York StockExchange, the additional independence standards for audit committee membersimposed 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 a code of ethics fordirectors, officers (including the Company’s principal executive officer,principal financial officer, principal accounting officer and controller) andemployees, known as the Code of Conduct. The Company will provide to any personwithout charge, upon request, a copy of the Code of Conduct. Any such requestshould be made to the Company in writing or by telephone, to:

Financial SecurityAssurance Holdings Ltd.

31 West 52ndStreet

New York, NY 10019

Attn: General Counsel.

122

----

The Company intends tosatisfy the disclosure requirement under Item 10 of Form 8-Kregarding an amendment to, or a waiver from, a provision of its code of ethicsthat applies to its principal executive officer, principal financial officer,principal accounting officer or controller, or persons performing similarfunctions, and that relates to any element of the code of ethics definitionenumerated in paragraph (b) of Item 406 of Regulation S-K of theExchange Act, by posting such information 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 the Merger in July 2000,the Company’s common stock ceased to be registered under Section 12 of theExchange Act or listed on the NYSE. Consequently, the Company no longer hasequity securities registered under Section 12 of the Exchange Act, and thereporting obligations of Section 16 of the Exchange Act no longer apply.

123

----

**Item 11.**                 ExecutiveCompensation.

**Summary Compensation 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, 2004, 2003 and 2002.

| ** **                                     | ** ** | ** ** | ** ** | **Annual Compensation** | ** **    | **Long-Term  Compensation(1)** | ** ** | ** **         | ** ** |
|------------------------------------------------|------------|------------|------------|------------------------------|---------------|--------------------------------|------------|--------------------|------------|
| ** **                                     | ** ** | ** ** | ** ** | ** **                   | ** **    | **LTIP**                       | ** ** | **All Other** | ** ** |
| **Name and Principal Position** | ** ** | ** ** | ** ** | **Year**                     | ** **    | **Salary**                     | ** ** | **Bonus(2)**       | ** ** | **Payouts(2)** | ** ** | **Compensation(3)** | ** ** |
| Robert P. Cochran                              |       | 2004       |       | $                            | 500,000  |                           | $          | 3,400,000     |       |   | $ | 6,255,877  |   |   |   | $ | 90,000  |   |   |
| Chairman of the  Board and                     |       | 2003       |       | 500,000                      |          | 3,200,000                      |       |               | 9,213,941  |   |   |   | 90,000 |   |   |
| Chief Executive  Officer                       |       | 2002       |       | 490,000                      |          | 2,600,000                      |       |               | 3,078,527  |   |   |   | 90,000 |   |   |
| Séan W. McCarthy                          |       | 2004       |       | 310,000                      |          | 3,000,000                      |       |               | 4,705,296  |   |   |   | 90,000 |   |   |
| President and                                  |       | 2003       |       | 310,000                      |          | 2,800,000                      |       |               | 6,858,901  |   |   |   | 90,000 |   |   |
| Chief Operating  Officer                       |       | 2002       |       | 300,000                      |          | 2,400,000                      |       |               | 3,609,374  |   |   |   | 90,000 |   |   |
| Bruce E. Stern                                 |       | 2004       |       | 240,000                      |          | 900,000                        |       |               | 2,003,907  |   |   |   | 90,000 |   |   |
| Managing  Director, General                    |       | 2003       |       | 240,000                      |          | 800,000                        |       |               | 2,269,286  |   |   |   | 80,100 |   |   |
| Counsel and  Secretary                         |       | 2002       |       | 230,000                      |          | 650,000                        |       |               | 1,304,909  |   |   |   | 90,000 |   |   |
| Russell B. Brewer II                           |       | 2004       |       | 240,000                      |          | 900,000                        |       |               | 1,956,545  |   |   |   | 90,000 |   |   |
| Managing Director  and                         |       | 2003       |       | 240,000                      |          | 800,000                        |       |               | 2,259,243  |   |   |   | 75,600 |   |   |
| Chief  Underwriting Officer                    |       | 2002       |       | 230,000                      |          | 600,000                        |       |               | 1,289,911  |   |   |   | 90,000 |   |   |
| Joseph W. Simon(4)                             |       | 2004       |       | 240,000                      |          | 750,000                        |       |               | 297,899    |   |   |   | 66,600 |   |   |
| Managing Director  and                         |       | 2003       |       | 240,000                      |          | 500,000                        |       |               | N/A        |   |   |   | 33,300 |   |   |
| Chief Financial  Officer                       |       | 2002       |       | 172,500                      |          | 400,000                        |       |               | N/A        |   |   |   | N/A |   |   |
|                                                |            |            |            |                              |               |                                |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          No awards of restrictedstock or options/SARs were made to any of the executives named in the tableduring the period covered by the table.

(2)          Annual compensation foreach year includes bonus and LTIP payouts received or deferred by the namedexecutive officer in January or February of the subsequent year. LTIPpayouts were made to or deferred by each named executive for each year shown inthe table above with respect to performance shares for the three-yearperformance cycle ending December 31 of such year. For additionalinformation regarding performance shares see “—Equity Plans—Performance Shares.”

(3)          AllOther Compensation includes contributions by the Company to its SupplementalExecutive Retirement Plan (“SERP”) and to its defined contribution pension plan(the “Pension Plan”), as follows:

| ** **            | ** ** | **2004**   | ** ** | **2003**              | ** ** | **2002** | ** ** |
|-----------------------|------------|------------|------------|-----------------------|------------|----------|------------|
| **Officer**           | ** ** | ** ** | ** ** | **Pension Plan** | ** ** | **SERP** | ** ** | **Pension Plan** | ** ** | **SERP** | ** ** | **Pension Plan** | ** ** | **SERP** | ** ** |
| Robert P. Cochran     |       |       | $          | 18,450           |       |     | $          | 71,550  |   |   | $ | 18,000  |   |   | $ | 72,000  |   |   | $ | 18,000  |   |   | $ | 72,000  |   |
| Séan W. McCarthy |       |       | 18,450     |                  |       | 71,550   |       |   | 18,000 |   |   | 72,000 |   |   | 18,000 |   |   | 72,000 |   |
| Bruce E. Stern        |       |       | 18,450     |                  |       | 71,550   |       |   | 18,000 |   |   | 62,100 |   |   | 18,000 |   |   | 72,000 |   |
| Russell B. Brewer  II |       |       | 18,450     |                  |       | 71,550   |       |   | 18,000 |   |   | 57,600 |   |   | 18,000 |   |   | 72,000 |   |
| Joseph W. Simon       |       |       | 18,450     |                  |       | 48,150   |       |   | 9,000 |   |   | 24,300 |   |   | N/A |   |   | N/A |   |
|                       |            |            |            |                       |            |          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Pension Plan andSERP amounts 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 

124

----

contribution equalto 9% of cash compensation (salary and bonus) up to the compensation limitspecified by the Internal Revenue Service. The SERP provides for an unfundedCompany contribution equal to 9% of cash compensation over and above thePension Plan compensation limit but limited to $1 million of compensation. ThePension Plan and SERP provide for vesting of contributions over a six-yearemployment period, after which all subsequent contributions are 100% vested.

(4)          Mr. Simonjoined the Company as Chief Financial Officer in April 2002.

**EmploymentAgreements and Arrangements; Change in Control Provisions**

Each of Messrs. Cochran and McCarthy entered intoemployment agreements with the Company, effective July 5, 2004. Theemployment agreements generally guarantee continuation of compensation andbenefits through December 31, 2007, and provide for renewals andextensions of this initial term for two-year terms, subject to notice oftermination from either party at least six months prior to the end of theextended 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.

Under theagreements, 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 Participation Plan(the “2004 Equity Plan” and together with the 1993 Equity Plan, 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 2004 bonus pool guidelines contemplate a bonuspool equal to 11.25% of the after-tax growth in adjusted book value forthe year, excluding unrealized gains/losses on investments and SFAS 133mark-to-market adjustments, but including a return on equitymodifier. An additional reserve bonus pool made up of previously earned butundistributed bonus pool allocations from prior years, equal to approximately$25 million after giving effect to 2004 bonuses (paid in the first quarter of2005), may also be distributable. Messrs. Cochran and McCarthy areentitled to receive an annual cash bonus equal to at least 5.0% and 4.0%,respectively, of the bonus pool. The employment agreements provide that anadditional 2.0% of the bonus pool will be allocated among those two executiveofficers as determined by the Human Resources Committee.

The employment agreements provide that Messrs. Cochranand McCarthy may elect to retire at age 60, but that retirement ismandatory at age 65. Upon retirement, each of Mr. Cochran and Mr. McCarthywill be entitled to his pro-rata annual base salary and annual bonusthrough the date of retirement and the vesting of his outstanding performanceshares over time as if he remained employed. Messrs. Cochran and McCarthyare not entitled to any on-going retirement compensation except asprovided by the Company’s defined contribution Pension Plan and SERP.

The employment agreements provide for continuedparticipation in the Company’s benefit plans and severance benefits in lieu ofthe Company’s existing severance policy. Specifically, if the Company 

125

----

terminates Mr. Cochranor Mr. McCarthy without cause or either of such executive officersterminates his employment for “good reason,” he will be entitled to:

·       hispro-rata annual base salary and annual bonus through the date oftermination;

·       twicehis annual base salary and twice his average annual bonus for the twoimmediately 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 beingnamed Mr. Cochran’s successor as Chief Executive Officer of the Company.

Both employment agreements provide that, if theemployee is terminated for cause or terminates his employment without “goodreason” during the term, he will be entitled only to be paid his pro rataannual base salary through the date of termination. If such termination occursafter the term of the agreement, he will also be entitled to his pro-rataannual bonus through the date of termination and his performance shares willvest pro rata in proportion to the percentage of the applicable performancecycle during which he was employed by the Company. Each employment agreementcontains a non-compete provision extending through the greater of twoyears and the term of the agreement.

If Mr. Cochran becomes Non-ExecutiveChairman of the Company, he will be entitled to his then-current salaryand an annual performance share unit award with an estimated economic value atleast equal to 50% of normal prior awards. If Mr. McCarthy becomes the ChiefExecutive Officer of the Company, he will be entitled to compensation equal to90% or more of Mr. Cochran’s latest compensation, including salary, bonusand performance share units.

The Company’s severance policy for senior managemententitles Messrs. Brewer, Simon and Stern to 12 months of compensation, ineach case if terminated without cause and based on current compensation (or, incertain events, prior compensation if higher). The severance policy was amendedin connection with the Merger to provide reimbursement (on a grossed-upbasis) for any “golden parachute” excise taxes payable by employees upon theirtermination of employment following the Merger, and to restrict adverseamendments to the policy through December 31, 2004.

The Equity Plans provide for accelerated vesting andpayment of performance shares and Dexia Restricted Stock awarded thereunder, ifany, upon the occurrence of certain change in control transactions involvingthe Company. These provisions are generally applicable to all participants inthe Equity Plans. Each of the named executive officers holds performance sharesand Dexia Restricted Stock awarded under the Equity Plans.

The Equity Plans providethat the Company’s Board of Directors may elect to continue the plan if a changein control occurs. Following a “plan continuation,” performance shares andDexia Restricted Stock are not accelerated, but vest and are payable as if nochange in control had occurred, except in the case of any employee who isterminated without cause or leaves for “good reason” following the change incontrol. The Board elected a plan continuation in connection with the Merger.

**Compensation of Directors**

Each director of theCompany who is not an officer of the Company or Dexia received a fee of $40,000per annum for service as a director (increased to $50,000 per annum effective May 2004),and an additional annual fee of $5,000 if chairperson of a Committee of theBoard of Directors (increased to $20,000 in the case of the UnderwritingCommittee and Audit Committee effective May 2004). Such directors alsoreceived $2,000 for each Board meeting and regular Committee meeting attendedand 

126

----

reimbursementfor expenses for each such meeting attended. Each director is entitled to deferfees under the Company’s Deferred Compensation Plan (the “DCP”) and toparticipate in the director share purchase program. 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.

**Director Share Purchase Program**

In the fourthquarter of 2000, the Company entered into an agreement with Dexia Holdings andDexia Public Finance Bank, now Dexia Crédit Local, to establish the DirectorShare Purchase Program, pursuant to which Company directors could invest inshares of the Company’s common stock. The Director Share Purchase Programentitles each director of the Company to purchase from Dexia (or an affiliatethereof) up to 126,958 restricted shares of the Company’s common stock (whichrepresented a $10 million investment at the purchase price at inception of theprogram) at a price determined in accordance with the formula described 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 purchaseprice for shares put to Dexia Crédit Local described below.

Directors may purchase such shares either directly orthrough deemed investments under the DCP or SERP. Each deemed investment electionwith respect to these shares is irrevocable.

The Director Share Purchase Program enables theCompany to purchase from Dexia Holdings, at the same price, the same number ofshares of common stock purchased by directors through phantom investments underthe DCP or SERP. Upon expiration of any applicable deferral period, the Companyis obligated to pay out the phantom investments in shares of common stock,which must be held by the participant as if acquired directly from DexiaHoldings for generally a minimum of six months.

The purchase price for each restricted share acquiredby a director or put to Dexia Crédit Local is equal to the product of 1.4676and adjusted book value per share (“ABV per share”), with ABV per sharedetermined in accordance with the methodology employed for valuing performanceshare award payouts under the Equity Plans. The purchase price per share,determined pursuant to such formula, was $162.78 at December 31, 2004. ABVper share is measured at the close of the calendar quarter in which a directorsubmits a repurchase notice, provided that ABV per share freezes on the firstanniversary of the later of the termination of directorship or, in the case ofdeferred shares, receipt of shares upon expiration of the deferral period.

Sales under the programare not registered under the Securities Act of 1933 in reliance upon anexemption from registration under Section 4(2) of that Act. None ofthe directors made any additional direct or phantom investments under theDirector Share Purchase Program during 2003, or any direct investments after2002, the year of inception of the Program. During 2004, one director investedin 1,890 phantom shares and during the first quarter of 2005, one directorpurchased 6,199 shares outright. For more information regarding the directors’share ownership, see “Item 12. Security Ownership of Certain Beneficial Ownersand Management—Directors and Executive Officers.”

127

----

**Equity Plans**

In November 2004the Company adopted the 2004 Equity Plan, to be used for future equitycompensation awards to Company executives and employees in lieu of the 1993Equity Plan. The 2004 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 (“PSU”)awarded to each of the named executive officers for the year ended December 31,2004 (which awards were made in February 2005), as well as the number of performanceshares (“PS”) 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 19,671 Dexia shares                                                                                |       |
| Séan W. McCarthy |       |       | 25,000     | * *                                          |       | *Comprised of:* |       | 22,500  PS and 14,464 Dexia shares                                                                                |       |
| Bruce E. Stern        |       |       | 9,000      | * *                                          |       | *Comprised of:* |       | 8,100  PS and 5,207 Dexia shares                                                                                  |       |
| Russell B. Brewer  II |       |       | 9,000      | * *                                          |       | *Comprised of:* |       | 8,100  PS and 5,207 Dexia shares                                                                                  |       |
| Joseph W. Simon       |       |       | 8,000      | * *                                          |       | *Comprised of:* |       | 7,200 PS and 4,629 Dexia  shares                                                                                  |       |

 

Unlike the 1993 EquityPlan, the 2004 Equity Plan does not provide for stock options, Companyrestricted stock or equity bonus awards.

***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 sets forth(a) a summary of performance shares awarded to each of the named executiveofficers for the year ended December 31, 2004 (which awards were made in February 2005),(b) the applicable performance period until payout and (c) therelated estimated future payouts at the stated assumed annual rates of adjustedbook value per share and book value per share growth.

128

----

**Long-TermIncentive Plans Awards in 2004(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 |   |   |   | 71,200 |   |   |
| 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       |       |            | 7,200      |                |       |                                      | (2         | ) |   |   | 0 |   |   |   | 7,200 |   |   |   | 14,400 |   |   |
|                       |            |                 |            |                     |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          These performance shareswere awarded under the 2004 Equity Plan in February 2005 for the yearended December 31, 2004. The table excludes performance shares awarded in February 2004for the year ended December 31, 2003, 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 for the yearended December 31, 2003.

(2)          One-third of eachaward relates to the three-year performance cycle ending December 31,2007 and two-thirds of each award relates to the three-yearperformance cycle ending December 31, 2008. 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 registered under theExchange Act, the Company expects to pay its performance shares in cash ratherthan stock, with shares valued at the greater of (1) 0.85 times “adjustedbook value” per share and (2) the average of (a) 1.15 times “adjustedbook value” per share and (b) 14 times “operating earnings” per share(each such term as defined in the Equity Plans).

***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 its subsidiaries.Dexia restricted stock awarded under the 2004 Equity Plan represents ordinaryshares of Dexia subject to certain vesting requirements and restrictions ontransfer. Holders of Dexia restricted stock are entitled to receive alldividends paid on such stock from the date of grant.

129

----

The following table setsforth a summary of Dexia restricted stock awarded to each of the namedexecutive officers for the year ended December 31, 2004 (which awards weremade in February 2005) as a component of Performance Share Units.

**DexiaRestricted Stock Awarded In 2004(1)**

| **Name**              | ** ** | ** ** | ** ** | **Dexia Shares  Awarded** | ** ** | **Performance  Period Until  Payout** | ** ** |
|-----------------------|------------|------------|------------|--------------------------------|------------|--------------------------------------------|------------|
| Robert P. Cochran     |       |       | 19,671     |                           |       |                                       | (2         | ) |   |
| Séan W. McCarthy |       |       | 14,464     |                           |       |                                       | (2         | ) |   |
| Bruce E. Stern        |       |       | 5,207      |                           |       |                                       | (2         | ) |   |
| Russell B. Brewer  II |       |       | 5,207      |                           |       |                                       | (2         | ) |   |
| Joseph W. Simon       |       |       | 4,629      |                           |       |                                       | (2         | ) |   |

----

(1)          The Dexia restrictedstock awarded was valued at the average actual purchase price paid by theCompany for such shares when purchased on the open market, which equaledapproximately $22.69 per share.

(2)          Generally,one third of an award of Dexia restricted stock vests after 2.5 years and twothird vests after 3.5 years, with transfer restrictions lapsing on one third ofeach award after three years and on two thirds of each award after four years.

**CompensationCommittee Interlocks and Insider Participation**

The Human Resources Committee consisted of Messrs. Maxwell(Chairperson), Cochran, Deletre, Downey and Richard during 2004. Mr. Taylorjoined the Committee in September 2004. Except for Messrs. Cochranand Taylor, none of such persons is currently or has ever been an officer oremployee of the Company or any subsidiary of the Company. Mr. Richard isthe Group Chief Executive and Chairman of the Executive Committee 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.

130

----

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management.

**5% Shareholders**

The following table setsforth certain information regarding beneficial ownership of the Company’sequity at March 15, 2005 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  $.01 per share |       | Dexia S.A.(1)  7 à 11 quai André Citröen BP-1002  75 901 Paris Cedex 15, France |       | 32,871,757 shares(1)(2)                                       |       |                                                               | 98.8       | %(2)                       |       |
|                                    |       | Boulevard Pachéco  44  B-1000 Brussels, Belgium                                           |       |                                                          |       |                                                               |       |                       |       |

----

(1)          Shares are heldindirectly through a subsidiary of Dexia.

(2)          For purposes of thistable, Dexia is not deemed to be the beneficial owner of 254,756 sharesacquired by the Company in connection with the Director Share Purchase Programdescribed in “Item 11. Executive Compensation—Director Share Purchase Program.”Ownership percentage is calculated based on 33,263,259 shares of common stockoutstanding at March 15, 2005, which excludes such shares acquired by theCompany.

 

131

----

**Directors and Executive Officers**

Thefollowing table sets forth certain information regarding beneficial andeconomic ownership of the Company’s Common Stock at March 15, 2005 for (a) eachdirector of the Company, (b) each executive officer named under “ExecutiveCompensation Summary Compensation Table” 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**           | ** ** | ** ** | ** ** | **Amount and  Nature  of Beneficial  Ownership(1)** | ** ** | **Economic  Ownership(1)** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------------|------------|----------------------------|------------|
| Dirk Bruneel(2)                                               |       |       | —     |                                                          |       |                       | —     |   |   |
| Robert P. Cochran                                             |       |       | 41,744     |                                                          |       |                       | 258,891    |   |   |
| Bruno Deletre(2)                                              |       |       | —     |                                                          |       |                       | —     |   |   |
| Robert N. Downey                                              |       |       | 20,159     |                                                          |       |                       | 29,259     |   |   |
| Jacques  Guerber(2)                                           |       |       | —     |                                                          |       |                       | —     |   |   |
| Séan W. McCarthy                                         |       |       | —     |                                                          |       |                       | 119,219    |   |   |
| David O. Maxwell                                              |       |       | 6,009      |                                                          |       |                       | 19,299     |   |   |
| 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                                                |       |       | —     |                                                          |       |                       | 34,767     |   |   |
| Russell B. Brewer  II                                         |       |       | —     |                                                          |       |                       | 34,767     |   |   |
| Joseph W. Simon                                               |       |       | —     |                                                          |       |                       | 22,533     |   |   |
| All executive officers  and directors as a group (15 persons) |       |       | 74,111     |                                                          |       |                       | 646,014    |   |   |

----

(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) performanceshares, with each performance share treated as one share of common stock, inthe amounts shown below (excluding fractional shares), and (b) deemedinvestments in the Company’s common stock under the Director Share PurchaseProgram:

| **Officer**           | ** ** | ** ** | ** ** | **Performance Shares** | ** ** |
|-----------------------|------------|------------|------------|-----------------------------|------------|
| Robert P. Cochran     |       |       | 131,933    |                        |       |
| Séan W. McCarthy |       |       | 93,167     |                        |       |
| Bruce E. Stern        |       |       | 34,767     |                        |       |
| Russell B. Brewer  II |       |       | 34,767     |                        |       |
| Joseph W. Simon       |       |       | 22,533     |                        |       |

 

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 at December 31,2004.

(2)          Messrs. Bruneel,Deletre, Guerber, Richard and von Lowis are directors of the Company andofficers of Dexia or its subsidiaries. Dexia indirectly owns 98.82% of theCompany’s Common Stock.

The Company is not aware of any arrangements that mayresult in a change in control of the Company.

132

----

The following table sets forth beneficial ownership ofcommon shares of the Company’s parent, Dexia, at March 15, 2005, for (a) eachdirector of the Company, (b) each executive officer 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(1)(2)**     | ** ** | ** ** | ** ** | **Amount and Nature of  Beneficial Ownership** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------|------------|
| Dirk Bruneel                                                  |       |       | 38,102     |                                                               |       |
| Robert P. Cochran                                             |       |       | 546,341    |                                                               |       |
| Bruno Deletre                                                 |       |       | 1,155      |                                                               |       |
| Robert N. Downey                                              |       |       | —     |                                                               |       |
| Jacques Guerber                                               |       |       | 8,427      |                                                               |       |
| Séan W. McCarthy                                         |       |       | 457,304    |                                                               |       |
| David O. Maxwell                                              |       |       | —     |                                                               |       |
| James H. Ozanne                                               |       |       | —     |                                                               |       |
| Pierre Richard                                                |       |       | 30,210     |                                                               |       |
| Roger K. Taylor                                               |       |       | 249,250    |                                                               |       |
| George U. Wyper                                               |       |       | —     |                                                               |       |
| Rembert von Lowis                                             |       |       | 24,802     |                                                               |       |
| Bruce E. Stern                                                |       |       | 173,916    |                                                               |       |
| Russell B. Brewer  II                                         |       |       | 172,706    |                                                               |       |
| Joseph W. Simon                                               |       |       | 26,189     |                                                               |       |
| All executive officers  and directors as a group (15 persons) |       |       | 1,728,402  |                                                               |       |

----

(1)          Dexia has provided theCompany with information regarding shares owned by Messrs. Bruneel,Deletre, Guerber, Richard and von Lowis, and has advised the Company that:

(a)          shares presented forthose directors include only shares owned directly by such directors or sharesfor which those directors can cast a vote and exclude warrants, and

(b)         on December 31,2004, the total number of outstanding Dexia shares was 1,145,261,366, so thattogether the Company’s executive officers and directors owned 0.15% of Dexiashares and the maximum amount owned by any of the Company’s executive officersand directors represents 0.05% of Dexia shares.

133

----

A majority of the sharesset forth above were acquired under the Employee Share Plans sponsored by Dexiabetween 2000 and 2004. All employees of the Company were allowed to participatein these plans. These plans allowed employees to purchase ordinary shares ofDexia stock at a 15% to 20% discount from market value, but restricted theability to dispose of such shares for a five-year period followingpurchase, subject to limited exceptions. Shares purchased under these plansinclude shares acquired under “leveraged options.” Employees who purchasedshares under the leveraged options are entitled to the upside from ten sharesfor each share purchased with his or her own funds and benefit from a “floor”guarantying a return of invested funds following expiration of the five-yearinvestment period. A third party financial institution is entitled to (1) alldividends paid on the leveraged shares and (2) a specified percentage ofany share appreciation during the five-year investment period in the caseof the “standard” leveraged option, and of the average monthly shareappreciation during a 52-month period commencing six months afterinception of the five-year investment period in the case of the “average”leveraged option. These percentages are as follows: 38% (for 2001), 40% (for2002), 40% (for 2003 for the standard leveraged option), 20% (for 2003 for theaverage leveraged option), 35% (for 2004 for the standard leveraged option) and15% (for 2004 for the average leveraged option).

| **Officer**           | ** ** | ** ** | ** ** | **Leveraged Shares** | ** ** |
|-----------------------|------------|------------|------------|---------------------------|------------|
| Robert P. Cochran     |       |       | 525,170    |                      |       |
| Séan W. McCarthy |       |       | 441,340    |                      |       |
| Bruce E. Stern        |       |       | 160,280    |                      |       |
| Russell B. Brewer  II |       |       | 163,030    |                      |       |
| Joseph W. Simon       |       |       | 21,560     |                      |       |

 

(2)          Includesshares granted under the 2004 Equity Plan, as described in “Item 11. ExecutiveCompensation—Equity Plans.” Generally, one third of an award of Dexiarestricted stock vests after 2.5 years and two third vests after 3.5 years,with transfer restrictions lapsing on one third of each award after three yearsand on two thirds of each award after four years.

**SecuritiesAvailable Under Equity Compensation Plans**

Thefollowing table sets forth information as of December 31, 2004 withrespect to each compensation plan of the Company under which equity securitiesof the Company are authorized for issuance.

| **Plan Category**                                              | ** ** | ** ** | ** ** | **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 |                                                                                                                                                                                                                |       | 2004  Equity Plan(3): 2,964,400 |   |
|                                                                |       |       |       |                                                                                                                                            |       |                                                                                                                |           |                                                                                                                                                                                                                |       | Director Share Purchase Program(4):  1,196,528 |   |
| Equity  compensation plans not approved by security holders(2) |       |       | —     |                                                                                                                                            |       |                                                                                                                | —         |                                                                                                                                                                                                                |       | — |   |
| Total                                                               |       |       | 0          |                                                                                                                                            |       |                                                                                                                | Not applicable |                                                                                                                                                                                                                |       | 4,160,928 |   |

----

(1)          The Company currently maintains two such plans: the2004 Equity Plan and the Director Share Purchase Program.

134

----

(2)          All of the Company’s equity compensation plans havebeen approved by the Company’s shareholders.

(3)          Excludes shares awarded in January and February 2004for the year ended December 31, 2003. Since its inception, up to 3,300,000shares of common stock have been available for distribution under the 2004Equity Plan in respect of performance shares. Such shares may be newly issuedshares, treasury shares or shares purchased in the open market. If performanceshares awarded under the 2004 Equity Plan are forfeited, the shares allocatedto such awards are again available for distribution in connection with futureawards under the Plan. So long as the Company’s common stock is not registeredunder the Exchange Act, the Company expects to pay its performance shares incash rather than stock.

(4)          Under the Director Share Purchase Program,each director of the Company can purchase, directly from Dexia Holdings orthrough “phantom” investments in the Company’s DCP or SERP, up to 126,958shares of common stock. Shares acquired under the Program may generally be putto a Dexia affiliate after a four-year minimum holding period for a priceequal to the product of (a) 1.4676 and (b) adjusted book value pershare. The number set forth above assumes the current number of directors (12)and deducts shares that they already purchased. These programs are furtherdescribed in “Item 11. Executive Compensation.”

**Item 13.**                 CertainRelationships and Related Transactions.

**Financial Guaranty Transactions**

Since the Merger in July 2000,various affiliates of Dexia S.A., including certain wholly owned banksubsidiaries and/or their U.S. branches, have participated in transactions inwhich subsidiaries of the Company have provided financial guaranty insurance.For example, Dexia affiliates have provided liquidity facilities and letters ofcredit in FSA-insured transactions, and been the beneficiary of financialguaranty insurance policies issued by insurance company subsidiaries of theCompany. In the opinion of management of the Company, the terms of thesearrangements are no less favorable to the Company than the terms that could beobtained from unaffiliated parties.

**Director Share Purchase Program**

As of December 31,2004, 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**

Additional informationrelating to certain relationships and related transactions is set forth in “Item 11.Executive Compensation—Compensation Committee Interlocks and InsiderParticipation.”

**Item 14.      PrincipalAccountant Fees and Services.**

Aggregatefees (in thousands) for professional services by PricewaterhouseCoopers LLPinvoiced in 2004 and 2003, were:

| ** **    | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------|------------|----------|------------|----------|------------|
| Audit         |       | $        | 1,084.5    |     | $          | 1,088.9 |   |
| Audit related |       | 367.7    |       | 276.8    |       |
| Tax           |       | 536.1    |       | 446.4    |       |
| Total         |       | $        | 1,988.3    |     | $          | 1,812.1 |   |

 

Audit fees for the years ended December 31, 2004and 2003 were for professional services rendered for the audits of theconsolidated financial statements of the Company and statutory and subsidiaryaudits 

135

----

(including value addedtax), issuance of comfort letters and consents. Included in this amount is $0.2million and $0.2 million in fees relating to consents that are reimbursed tothe Company by the issuer of FSA-insured deals for the years ended December 31,2004 and 2003, respectively.

Audit related fees for the years ended December 31,2004 and 2003 were for assurance and related services related to the Company’sretirement plans and consultations concerning financial accounting andreporting standards.

Tax fees for the yearsended December 31, 2004 and 2003 were for services related to tax compliance,including the preparation of tax returns for expatriates, assistance with taxaudits and appeals, and tax services for employee benefit plans.

**AuditCommittee Pre-Approval Policies and Procedures**

The Audit Committee pre-approves all non-auditrelated fees and approves all audit fees paid to the Company’s auditors.

136

----

**Part IV**

**Item 15.**                 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                                                                    |   | 65 |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|----|--------|
| Consolidated Balance  Sheets at December 31, 2004 and 2003                                                             |   | 66 |   |
| Consolidated  Statements of Operations and Comprehensive Income for the Years Ended  December 31, 2004, 2003 and 2002  |   | 67 |   |
| Consolidated  Statements of Changes in Shareholders’ Equity for the Years Ended  December 31, 2004, 2003 and 2002 |   | 68 |   |
| Consolidated  Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and  2002                           |   | 69 |   |
| Notes to  Consolidated Financial Statements                                                                                 |   | 71 |   |

 

**2.   FinancialStatement Schedules**

Thefollowing financial statement schedule is filed as part of this Report.

| Schedule | ** ** | ** **                                                                                                                                                                                     | ** ** | Title |
|----------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------|
| II       |       | Condensed  Financial Statements of Independent Registrant for the Years Ended  December 31, 2004, 2003 and 2002.                                                                          |
|     |       | 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**

The following are annexedas 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.)                                                                                             |

137

----

 

| 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.)                                                                                                                                                                               |
| 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.) |

138

----

 

| 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        |   | Facility Agreement dated as of August 30, 1994,  among FSA, Canadian Global Funding Corporation and Hambros Bank Limited.  (Previously filed as Exhibit 2 to the Company’s Quarterly Report on  Form 10-Q (Commission File No. 1-12644) for the  quarterly period ended September 30, 1994, and incorporated herein by  reference.)                                                                                                                                                            |
| 10.3        |   | 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.)                                                                                                                                           |
| 10.4†  |   | 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.)                                                                                                                            |
| 10.5†  |   | 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.                                                                                                                                                                                                                                                                                                                     |
| 10.6†  |   | 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.)                                                                                                                                              |
| 10.7†  |   | 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.)                                                                                                                                                                                                |
| 10.8†  |   | 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.)                                                                                                                                                                                                                                                                 |
| 10.9†  |   | 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.)                                                                                                                                                                                                                                                                                            |
| 10.10† |   | 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.)                                                                                                                                                                                                                  |
| 10.11† |   | 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.)                                                                                                                                                                                                                                                                                                                         |
| 10.12† |   | 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.)                                                                                                                                                                                                                                                                                                                                                |

139

----

 

| 10.13† |   | 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.)                                                                                                              |
|-------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.14† |   | 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.) |
| 10.15† |   | 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.)                                       |
| 10.16† |   | 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.)                                                                                                                                                                                                        |
| 10.17† |   | 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.)                                                                                                                                                                                                                                     |
| 10.18       |   | 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.)                                                  |
| 10.19       |   | 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.)                                                                                                                                                                                                            |
| 10.20       |   | 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.)                                                                                                                                                                                                           |
| 10.21       |   | 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. (Previously filed as  Exhibit 21 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.)                                                                                                                                                                                        |
| 23*         |   | Consent of PricewaterhouseCoopers LLP.                                                                                                                                                                                                                                                                                                                                                                                                |
| 24          |   | 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.)                    |
| 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.                                                                                                                                                                                                                                                                                         |

140

----

 

| 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 2004 Consolidated Financial Statements and Report of Independent  Registered Public Accounting Firm. (Previously filed as Exhibit 99.1 to  the Current Report on Form 8-K (Commission File No. 1-12644)  dated November 21, 2005, and incorporated herein by reference.) |

----

*                    Filedherewith.

**             Furnished herewith.

†                    Managementcontract of compensatory plan or arrangement.

141

----

**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: December 19, 2005 |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.

|                            | **Signature** | ** **                              | ** ** | ** **              | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|----------------------------|---------------|-----------------------------------------|------------|-------------------------|-----------|------------|------------|------------|----------|------------|
| /s/  ROBERT P. COCHRAN     |          | Chairman, Chief  Executive Officer and  |       | December 19,  2005 |
| Robert P. Cochran          |          | Director                                |       |                    |
|                       |          | (Principal  Executive Officer)          |       |                    |
| /s/  SÉAN W. MCCARTHY |          | President, Chief  Operating Officer and |       | December 19,  2005 |
| Séan W. McCarthy      |          | Director                                |       |                    |
| /s/  JOSEPH W. SIMON       |          | Managing Director and  Chief Financial  |       | December 19,  2005 |
| Joseph W. Simon            |          | Officer  (Principal Financial Officer)  |       |                    |
| /s/  LAURA A. BIELING      |          | Managing Director and Controller        |       | December 19,  2005 |
| Laura A. Bieling           |          | (Principal  Accounting Officer)         |       |                    |
| /s/  DIRK BRUNEEL          |          | Director                                |       | December 19,  2005 |
| Dirk Bruneel               |          |                                    |       |                    |
| /s/  BRUNO DELETRE         |          | Director                                |       | December 19,  2005 |
| Bruno Deletre              |          |                                    |       |                    |
| /s/  ROBERT N. DOWNEY      |          | Director                                |       | December 19,  2005 |
| Robert N. Downey           |          |                                    |       |                    |
| /s/  JACQUES GUERBER       |          | Director                                |       | December 19,  2005 |
| Jacques Guerber            |          |                                    |       |                    |
| /s/  DAVID O. MAXWELL      |          | Director                                |       | December 19,  2005 |
| David O. Maxwell           |          |                                    |       |                    |
| /s/  JAMES H. OZANNE       |          | Director                                |       | December 19,  2005 |
| James H. Ozanne            |          |                                    |       |                    |
| /s/ PIERRE  RICHARD        |          | Vice Chairman and  Director             |       | December  19, 2005      |
| Pierre Richard             |          |                                    |       |                    |

142

----

 

| /s/ ROGER  K. TAYLOR   |   | Director |   | December  19, 2005 |
|------------------------|--------|----------|--------|--------------------|
| Roger  K. Taylor       |   |     |   |               |
| /s/ REMBERT VON  LOWIS |   | Director |   | December  19, 2005 |
| Rembert  von Lowis     |   |     |   |               |
| /s/ GEORGE U.  WYPER   |   | Director |   | December  19, 2005 |
| George U. Wyper        |   |     |   |               |

----

*       Robert P. Cochran, by signing his namehereto, does hereby sign this Annual Report on Form 10 K/A on behalf of himselfand on behalf of each of the Directors and Officers of the Registrant namedabove after whose typed names asterisks appear pursuant to powers of attorneyduly executed by such Directors and Officers and filed with the Securities andExchange Commission as exhibits to this Report.
|        | By:    | /s/ ROBERT P. COCHRAN |
|--------|--------|-----------------------|
|   |   | Robert P. Cochran,    |
|   |   | *Attorney in fact*    |

 

143

----

**Schedule IIParent Company Condensed Financial Information**

**Condensed Balance Sheets(in thousands)**

| ** **                                                     | ** ** | **December 31,** | ** **      |
|----------------------------------------------------------------|------------|-----------------------|-----------------|
| ** **                                                     | ** ** | **2004**              | ** **      | **2003** | ** ** |
| ** **                                                     | ** ** | **(restated)**        | ** **      | **(restated)** | ** ** |
| Assets:                                                        |       |                  |            |   |   |
| Bonds at market  value (amortized cost of $25,301 and $20,397) |       | $                     | 25,684     |   | $ | 20,858  |   |
| Short-term  investments                                        |       | 220                   |            | 685 |   |
| Cash                                                           |       | 1,058                 |            | 1,246 |   |
| Investment in  subsidiaries, at equity in net assets           |       | 2,868,797             |            | 2,438,504 |   |
| Notes receivable  from subsidiary                              |       | 108,850               |            | 152,850 |   |
| Deferred  compensation                                         |       | 112,941               |            | 97,571 |   |
| Deferred taxes                                                 |       | 40,843                |            | 29,911 |   |
| Due from  subsidiaries                                         |       | 2,519                 |            | 5,104 |   |
| Other assets                                                   |       | 39,343                |            | 34,904 |   |
| Total Assets                                                   |       | $                     | 3,200,255  |   | $ | 2,781,633  |   |
| Liabilities and  Shareholders’ Equity:                    |       |                  |            |   |   |
| Notes Payable                                                  |       | $                     | 430,000    |   | $ | 430,000  |   |
| Other Liabilities                                              |       | 28,259                |            | 28,529 |   |
| Due to subsidiaries                                            |       | 5,317                 |            | 4,441 |   |
| Deferred  compensation                                         |       | 112,941               |            | 96,397 |   |
| Taxes payable                                                  |       | 12,460                |            | 3,117 |   |
| Shareholders’  equity                                     |       | 2,611,278             |            | 2,219,149 |   |
| Total Liabilities and  Shareholders’ Equity               |       | $                     | 3,200,255  |   | $ | 2,781,633  |   |

 

**CondensedStatement of Income(in thousands)**

| ** **                                               | ** ** | **Year Ended December 31,** | ** **    |
|----------------------------------------------------------|------------|--------------------------------------------|---------------|
| ** **                                               | ** ** | **2004**                                   | ** **    | **2003** | ** ** | **2002** | ** ** |
| ** **                                               | ** ** | **(restated)**                             | ** **    | **(restated)** | ** ** | **(restated)** | ** ** |
| Investment Income                                        |       | $                                          | 7,379    |   | $ | 10,077  |   | $ | 8,161  |   |
| Net realized  gains (losses)                             |       | 497                                        |          | (909 | ) | 805 |   |
| Other income  (loss)                                     |       | (21                                        | )             | (97 | ) | 38 |   |
| Interest and  amortization expense                       |       | (26,993                                    | )             | (33,026 | ) | (28,098 | ) |
| Commissions                                              |       | —                                     |          | (703 | ) | (3,300 | ) |
| Other expenses                                           |       | (292                                       | )             | (1,639 | ) | (1,681 | ) |
| Net unrealized  gains (losses) on derivative instruments |       | 1,589                                      |          | 1,638 |   | (2,013 | ) |
|                                                     |       | (17,841                                    | )             | (24,659 | ) | (26,088 | ) |
| Equity in  undistributed net income of subsidiaries      |       | 368,139                                    |          | 313,789 |   | 209,394 |   |
| Income before  taxes                                     |       | 350,298                                    |          | 289,130 |   | 183,306 |   |
| Income tax  benefit                                      |       | 28,309                                     |          | 8,997 |   | 13,659 |   |
| Net Income                                               |       | $                                          | 378,607  |   | $ | 298,127  |   | $ | 196,965  |   |

 

The Parent Company Condensed Financial Informationshould be read in conjunction with the Consolidated Financial Statements andNotes to Consolidated Financial Statements included in Item 8.

144

----

**CondensedStatements of Cash Flows(in thousands)**

| ** **                                         | ** ** | **Year Ended December 31,** | ** **   |
|----------------------------------------------------|------------|--------------------------------------------|--------------|
| ** **                                         | ** ** | **2004**                                   | ** **   | **2003** | ** ** | **2002** | ** ** |
| Cash flows from operating activities:              |       |                                       |         |   |   |   |   |
| Other operating expenses  recovered (paid), net    |       | $                                          | (1,271  | ) | $ | (4,672  | ) | $ | 27  |   |
| Net investment income  received                    |       | 8,858                                      |         | 10,357 |   | 9,007 |   |
| Federal income taxes  received (paid)              |       | —                                     |         | (3,504 | ) | 2,696 |   |
| Interest paid                                      |       | (26,850                                    | )            | (28,367 | ) | (22,710 | ) |
| Other                                              |       | 1,489                                      |         | 253 |   | 1,194 |   |
| Net cash used for  operating activities            |       | (17,774                                    | )            | (25,933 | ) | (9,786 | ) |
| Cash flows from investing activities:              |       |                                       |         |   |   |   |   |
| Proceeds from sales of  bonds                      |       | 31,600                                     |         | 27,182 |   | 24,703 |   |
| Purchases of bonds                                 |       | (36,103                                    | )            | (39,539 | ) | (7,669 | ) |
| Dividend from subsidiary                           |       | 30,000                                     |         | 7,857 |   | — |   |
| Capital contribution                               |       | (29,500                                    | )            | (37,500 | ) | — |   |
| Net decrease (increase)  in short-term investments |       | 465                                        |         | 9,754 |   | (9,128 | ) |
| Other investments                                  |       | —                                     |         | 1,000 |   | (8,835 | ) |
| Net cash used for  investing activities            |       | (3,538                                     | )            | (31,246 | ) | (929 | ) |
| Cash flows from financing activities:              |       |                                       |         |   |   |   |   |
| Issuance of notes  payable                         |       | —                                     |         | 96,673 |   | 222,605 |   |
| Repayment of notes  payable                        |       | —                                     |         | (100,000 | ) | (130,000 | ) |
| Surplus notes redeemed  (purchased), net           |       | 44,000                                     |         | 60,000 |   | (68,850 | ) |
| Dividends paid                                     |       | (22,876                                    | )            | — |   | (11,709 | ) |
| Net cash provided by  financing activities         |       | 21,124                                     |         | 56,673 |   | 12,046 |   |
| Net increase (decrease)  in cash                   |       | (188                                       | )            | (506 | ) | 1,331 |   |
| Cash at beginning of  year                         |       | 1,246                                      |         | 1,752 |   | 421 |   |
| Cash at end of year                                |       | $                                          | 1,058   |   | $ | 1,246  |   | $ | 1,752  |   |

 

In 2004, 2003 and 2002, the Company’s subsidiariesreceived a tax benefit of $20,164, $10,645 and $18,812, 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,** | ** **    |
|--------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|---------------|
| ** **                                                                                                               | ** ** | **2004**                                   | ** **    | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                               | ** ** | **(restated)**                             | ** **    | **(restated)** | ** ** | **(restated)** | ** ** |
| Reconciliation of net income to net cash provided by operating  activities: |       |                                       |          |   |   |   |   |
| Net income                                                                                                               |       | $                                          | 378,607  |   | $ | 298,127  |   | $ | 196,965  |   |
| Equity in undistributed  net income of subsidiary                                                                        |       | (368,139                                   | )             | (313,789 | ) | (209,394 | ) |
| Decrease (increase) in  accrued investment income                                                                        |       | 1,373                                      |          | 11 |   | 891 |   |
| Increase (decrease) in  accrued income taxes                                                                             |       | (10,821                                    | )             | (14,337 | ) | 7,747 |   |
| Provision (benefit) for  deferred income taxes                                                                           |       | (10,932                                    | )             | 3,051 |   | (517 | ) |
| Net realized losses  (gains) on investments                                                                              |       | (497                                       | )             | 909 |   | (805 | ) |
| Accretion of bond  discount                                                                                              |       | 96                                         |          | — |   | — |   |
| Change in other assets  and liabilities                                                                                  |       | (7,461                                     | )             | 95 |   | (4,673 | ) |
| Cash used for operating activities                                                                                       |       | $                                          | (17,774  | ) | $ | (25,933  | ) | $ | (9,786  | ) |

 

The Parent Company Condensed Financial Informationshould be read in conjunction with the Consolidated Financial Statements andNotes to Consolidated Financial Statements included in Item 8.

145

----

**SCHEDULEIIFinancial Security Assurance Holdings Ltd. (Parent Company)Notes to Condensed Financial Statements**

1.                 CondensedFinancial Statements

Certain informationand footnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted. These condensed financial statementsshould be read in conjunction with the Company’s consolidated financialstatements and the notes thereto. Certain reclassifications have been made toconform to the 2004 presentation.

2.                 SignificantAccounting Policies

The Parent Companycarries its investments in subsidiaries under the equity method.

3.                 Restatement ofpreviously issued financial statements

The Company hasrestated its financial statements for the years ended December 31, 2004,2003 and 2002. The restatement arises from certain of the Company’ssubsidiaries’ incorrect application of hedge accounting. See Note 3 to theConsolidated Financial Statements in Item 8.

4.                 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 its6.950% Senior Quarterly Income Debt Securities (“Senior QUIDS”) due November 1,2098 and delivered to the trustee sufficient collateral to legally defease the6.950% Senior QUIDS. Unamortized debt issuance costs of $3.2 million for the6.950% Senior QUIDS were charged to interest expense in 2003. Subsequently, thetrustee used the defeasance collateral to redeem all of the 6.950% SeniorQUIDS.

On November 26,2002, the Company issued $230.0 million principal amount of 6.25% Notesdue November 1, 2102, which are callable without premium or penalty inwhole or in part at any time on or after November 26, 2007. Debt issuancecosts of $7.4 million are being amortized over the life of the debt. TheCompany used a portion of the proceeds of this issuance to redeem in whole theCompany’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.

5.                 Taxes

In connection with the Dexia group’s acquisition ofthe Company in July 2000, the Company became the successor, for tax purposes,to White Mountains Holdings, Inc. (“WMH”). WMH had previously sold aninsurance subsidiary to a third party that was indemnified by White MountainsInsurance Group 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 for tax purposes as a $47.0million 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 taxbenefit will not be reversed in the future. In addition, under certaincircumstances, which are not probable, the Company expects to agree to share50% of the deferred tax benefit with White Mountains Insurance Group.

146

----