**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

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

**For the fiscal year ended December 31,2006**

**Commission File Number 1-12644**

**Financial Security Assurance Holdings Ltd.**

(Exact name of registrantas specified in its charter)

| **New York**                                                     |   | **13-3261323**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**31 West 52**nd Street, NewYork, New York 10019

(Address of principal executive offices, including zipcode)

**(212) 826-0100**

(Registrant’s telephonenumber, 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 toSection 12(g) of the Act:

**None**

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

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

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

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

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

Large accelerated filer  o      Acceleratedfiler  o      Non-acceleratedfiler  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, 2006 was $1,102,411. For purposes of the foregoing,directors are deemed to be affiliates of the registrant and the dollar amountshown is based on the price at which shares of the Company’s common stock werevalued under the Company’s director share purchase program on June 30,2006.

At March 26, 2007,there were outstanding 33,276,017 shares of common stock, par value $0.01 pershare, of the registrant (excludes 241,978 shares of treasury stock).

**Documents Incorporated By Reference**

None.

 

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**TABLEOF CONTENTS**
|               | ** ** | ** **                                                                                                                      | ** ** | **Page** |
|---------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I   |       |                                                                                                                            |       |     |   |   |
| Item 1.       |       | Business                                                                                                                        |       |     | 1 |   |
| Item  1A.     |       | Risk Factors                                                                                                                    |       |     | 38 |   |
| Item 1B.      |       | Unresolved Staff Comments                                                                                                       |       |     | 42 |   |
| Item 2.       |       | Properties                                                                                                                      |       |     | 42 |   |
| Item  3.      |       | Legal  Proceedings                                                                                                              |       |     | 42 |   |
| Item 4.       |       | Submission of Matters to a Vote of Security Holders                                                                             |       |     | 42 |   |
| PART II  |       |                                                                                                                            |       |     |   |   |
| Item 5.       |       | Market for Registrant’s Common Equity, Related Stockholder  Matters and Issuer Purchases of Equity Securities              |       |     | 43 |   |
| Item 6.       |       | Selected Financial Data                                                                                                         |       |     | 44 |   |
| Item 7.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations       |       |     | 45 |   |
| Item 7A.      |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                     |       |     | 67 |   |
| Item 8.       |       | Financial Statements and Supplementary Data                                                                                     |       |     | 71 |   |
| Item 9.       |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                  |       |     | 119 |   |
| Item 9A.      |       | Controls and Procedures                                                                                                         |       |     | 119 |   |
| Item  9B.     |       | Other  Information                                                                                                              |       |     | 120 |   |
| PART III |       |                                                                                                                            |       |     |   |   |
| Item 10.      |       | Directors and Executive Officers of the Registrant                                                                              |       |     | 121 |   |
| Item 11.      |       | Executive Compensation                                                                                                          |       |     | 126 |   |
| Item 12.      |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                  |       |     | 151 |   |
| Item 13.      |       | Certain Relationships and Related Transactions                                                                                  |       |     | 154 |   |
| Item 14.      |       | Principal Accounting Fees and Services                                                                                          |       |     | 156 |   |
| PART IV  |       |                                                                                                                            |       |     |   |   |
| Item 15.      |       | Exhibits, Financial Statement Schedules                                                                                         |       |     | 157 |   |

 

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**PART I**

**Item1.**                        Business.

Financial SecurityAssurance Holdings Ltd., through its insurance company subsidiaries, isprimarily engaged in the business of providing financial guaranty insurance onpublic finance and asset-backed obligations in domestic and internationalmarkets. The financial strength of the Company’s insurance company subsidiariesis rated “Triple-A” by the major securities rating agencies and obligationsinsured by them are generally awarded “Triple-A” ratings by reason of suchinsurance. The Company’s principal insurance company subsidiary is FinancialSecurity Assurance Inc. (“FSA”), a wholly owned New York insurancecompany. FSA was the first insurance company organized to insure non-municipalobligations and has been a major insurer of asset-backed and othernon-municipal obligations since its inception in 1985. FSA expanded the focusof its business in 1990 to include financial guaranty insurance of municipalobligations and has since become a major insurer of municipal and other public financeobligations. In addition, the Company offers FSA-insured guaranteed investmentcontracts and other investment agreements (“GICs”) through other consolidatedentities. References to the “Company” are to Financial Security AssuranceHoldings Ltd. together with its subsidiaries.

Financial guarantyinsurance written by FSA typically guarantees scheduled payments on financialobligations. Upon a payment default on an insured obligation, FSA is generallyrequired to pay the principal, interest or other amounts due in accordance withthe obligation’s original payment schedule or may, at its option, pay suchamounts on an accelerated basis. FSA’s underwriting policy is to insureobligations that would otherwise be investment grade without the benefit of FSA’sinsurance.

For the year ended December 31,2006, the Company had gross premiums written of $816.0 million, of whichapproximately 72.6% related to insurance of public finance obligations andapproximately 27.4% related to insurance of asset-backed and othernon-public finance obligations. As of December 31, 2006, the Company hadnet par outstanding of $359.6 billion, of which approximately 69.9%represented insurance of public finance obligations and approximately 30.1%represented insurance of asset-backed and other non-public financeobligations.

The Company provides FSA-insuredGICs to municipalities and other market participants. As of December 31,2006, the Company had $15.8 billion principal amount of outstanding GICs.

**Organization**

FSA wholly owns FSAInsurance Company (“FSAIC”), which in turn wholly owns Financial SecurityAssurance (U.K.) Limited (“FSA-UK”) and FSA Mexico Holdings Inc. (“FSA MexicoHoldings”). FSA and FSAIC together own Financial Security AssuranceInternational Ltd. (“FSA International”). FSAIC is an Oklahoma insurancecompany that primarily provides reinsurance to FSA. FSA-UK is a United Kingdominsurance company that primarily provides financial guaranty insurance fortransactions in the United Kingdom and other European markets. FSAInternational is a Bermuda insurance company that provides reinsurance to FSAand financial guaranty insurance for transactions outside United States andEuropean markets. FSA Mexico Holdings is the New York holding company that,together with FSAIC, owns FSA’s Mexican subsidiary, FSA Seguros México, S.A. deC.V. (“FSA Mexico”). FSA Mexico has an application pending to be licensed totransact financial guaranty insurance in Mexico.

The Company conducts itsGIC business through its affiliates FSA Capital Management Services LLC (“FSACM”),FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003,FSA Capital Markets Services LLC (collectively, the “GIC Affiliates”). TheCompany consolidates the results of the GIC Affiliates. FSACM has conductedsubstantially all of the Company’s GIC business since April 2003,following its 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. FSAM wholly owns FSA PortfolioAsset Limited (“FSA-PAL”), a U.K. company that invests in non-U.S. securities.

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The Company consolidatesthe results of certain variable interest entities (“VIEs”), including FSAGlobal Funding Limited (“FSA Global”) and Premier International Funding Co. (“Premier”).FSA Global is a special purpose funding vehicle partially owned by the Company.FSA Global issues FSA-insured medium term notes and generally invests theproceeds from the sale of its notes in FSA-insured GICs or other FSA-insuredobligations with a view to realizing the yield difference between the notesissued and the obligations purchased with the note proceeds. Premier isprincipally engaged in debt defeasance for lease transactions.

The Company divides itsoperations into two business segments: financial guaranty and financial products (“FP”). Prior to the periodended December 31, 2006, the VIEs were included in the financial guarantysegment. However, beginning December 31, 2006, the VIEs are included inthe Company’s FP Segment, reflecting the Company’s management of the VIEs’operations. The Company has reclassified the corresponding information forearlier periods to conform to the current year presentation. Together, the GICAffiliates, FSAM, FSA-PAL and the VIEs make up the “FP Segment.”

The Company refinancescertain underperforming transactions by employing special purpose vehicles toraise funds to refinance such transactions. These refinancing vehicles are alsoconsolidated.

The Company’s managementbelieves that the assets held by FSA Global, Premier and the refinancingvehicles, including those that are eliminated in consolidation, are beyond thereach of the Company and its creditors, even in bankruptcy or otherreceivership. See “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Results of Operations—Variable InterestEntities.”

FSA PortfolioManagement Inc. (“FSA Portfolio Management”), a wholly owned subsidiary ofthe Company, is engaged in the business of managing a portion of the investmentportfolios of the Company and certain of its subsidiaries. FSA PortfolioManagement also owns various strategic and other investments funded from timeto time by the FSA group of companies.

Transaction ServicesCorporation (“TSC”), a wholly owned subsidiary of the Company, is engaged inthe business of managing troubled transactions, including, but not limited to,those referred to as refinanced transactions, within the insured portfolios ofFSA and its subsidiaries.

The Company is asubsidiary of Dexia Holdings, Inc. (“Dexia Holdings”), which, in turn, isowned 90% by Dexia Crédit Local S.A. (“Dexia Crédit Local”) and 10% by DexiaS.A. (“Dexia”). Dexia is a Belgian corporation whose shares are traded on theEuronext Brussels and Euronext Paris markets as well as on the Luxembourg StockExchange. Dexia is primarily engaged in the business of public finance, bankingand investment management in France, Belgium, Luxembourg and other Europeancountries, as well as in the United States. Dexia Crédit Local is a whollyowned subsidiary of Dexia.

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

**History**

When the Company commencedoperations in 1985, it was owned by a number of large insurance companies andother institutional investors. In 1989, the Company was acquired by U S WESTCapital Corporation, which subsequently changed its name to MediaOne CapitalCorporation (“MediaOne”). MediaOne was a subsidiary of MediaOne Group, Inc.,with operations and investments in domestic cable and broadband communicationsand international broadband and wireless communication. In 1990, the Companyestablished a strategic relationship with The Tokio Marine and Nichido FireInsurance Co., Ltd. 

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(“TokioMarine”), which acquired a minority interest in the Company. Tokio Marine is amajor Japanese property and casualty insurance company.

In 1994, the Companycompleted an initial public offering of common shares, at which time WhiteMountains Insurance Group, Ltd. (“White Mountains”) (formerly known asFund American Enterprises Holdings, Inc.) made an investment in theCompany, and the chairman of White Mountains became non-executive chairman ofthe Company. White Mountains is an insurance holding company.

In 1998, the Company andXL Capital Ltd (“XL”), a major Bermuda-based insurance holding company,entered into a joint venture, establishing two Bermuda-domiciled financialguaranty insurance companies—FSA International and XL FinancialAssurance Ltd (“XLFA”). In connection with the joint venture, XL acquireda minority interest in the Company and FSA International, and the Companyacquired a minority interest in XLFA.

On July 5, 2000, theCompany completed a merger in which the Company became a direct subsidiary ofDexia Holdings. At the merger date, each outstanding share of the Company’scommon stock was converted into the right to receive $76.00 in cash. As of December 31,2006, 99.7% of the Company’s common stock was held by Dexia Holdings. The otherholders are certain current and former directors of the Company who own sharesof the Company’s common stock or economic interests therein as described under “Item11. Executive Compensation—Compensation of Directors—Director Share PurchaseProgram” and “Item 12. Security Ownership of Certain Beneficial Owners andManagement and Related Stockholder Matters—Directors and Executive Officers.”  Dexia repurchased the last shares of theCompany held by a White Mountains affiliate in May 2006.

In October 2005, FSApurchased the interest in FSA International owned by XL for a cash purchaseprice of $39.1 million in anticipation of the repatriation of earnings andprofits of FSA International. Giving effect to such purchase, FSA Internationalbecame an indirect, wholly owned subsidiary of the Company.

Although the Company’scommon stock is no longer listed on the New York Stock Exchange (“NYSE”) as aconsequence of the merger, the Company continues to file periodic reports underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”), becausethe Company has debt securities listed on the NYSE.

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

**Business Objectives**

***Financial Guaranty Business***

TheCompany’s objective for its financial guaranty business is to remain a leadinginsurer of public finance and asset-backed obligations while generatingpremium volume at attractive returns and minimizing the occurrence and severityof credit losses in its insured portfolio. The Company believes that the demandfor financial guaranty insurance will remain strong over the long term as aresult of the anticipated continuation of the following trends:

·       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;

·       expansionof private finance for funding of infrastructure projects throughout the world;

·       growthof asset securitization; and

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

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TheCompany believes that short-term trends for financial guaranty insurance remainuncertain due, among other things, to:

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

·       potentialdecline in public finance issues, including refundings, should interest ratesrise; 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 public finance and asset-backed obligations, with abroad geographic distribution and a variety of revenue sources and transactionstructures. In addition to its domestic business, the Company pursuesinternational opportunities in Western European and Asia Pacific markets and,selectively, in Eastern European and Latin American markets.

***Financial ProductsBusiness***

The Company’s objectivefor its FP business is to generate net interest margin through borrowing fundsat attractive rates in the municipal GIC and other markets and investing theproceeds in obligations satisfying the Company’s underwriting criteria whileminimizing the Company’s exposure to interest rate changes. The Companyanticipates continued demand over the long term for its GIC business and otherfinancial products programs that employ financial guaranty insurance providedby FSA. A review by Moody’s Investors Service, Inc. (“Moody’s”) of thenon-core business activities of financial guaranty insurers, completed in December 2006,proposed benchmark limits on the growth of insurers’ financial productsbusinesses. The Company does not expect that such limits will affect its FPbusiness in 2007.

**Business of the Company**

The Company is engaged inthe financial guaranty business through FSA and its other insurance companysubsidiaries and in the FP business through its GIC Affiliates, FSAM, FSA-PALand the VIEs.

***Financial GuarantyBusiness***

FSA’s insurance isemployed in both the new-issue and secondary markets. In the case of newissues, the insured obligations are sold with FSA insurance at the time the obligationsare issued. For both public finance and asset-backed obligations, FSAparticipates in negotiated offerings, where the investment banker and often theinsurer have been selected by the sponsor or issuer. In addition, FSAparticipates in competitive offerings, where underwriting syndicates bid forsecurities and submit bids that may include insurance.

FSA has several programsthat provide insurance for obligations trading in the secondary markets,including its Custody Receipt Program, which provides insurance primarily fordomestic municipal obligations trading in the secondary market, and itsTriple-A Guaranteed Secondary Securities (“TAGSS”®) Program, which providesinsurance primarily for asset-backed and public infrastructureobligations trading in the secondary market. Investors and dealers generallyobtain secondary-market insurance to upgrade or stabilize the creditratings of securities they already hold or plan to acquire or to increase themarket liquidity of such securities. FSA’s underwriting guidelines require thesame underwriting standards on secondary-market issues as on new issues,although FSA’s control rights in the event of default are generally morelimited.

In many insuredtransactions, the issuer of insured securities is party to an interest rate,basis or currency swap that matches the issuer’s funding sources to theinterest rate or currency of the insured securities or otherwise hedges theissuer’s exposure. In such transactions, FSA typically insures the issuer’sobligations under both the insured securities and the derivative contract.

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FSA insures paymentobligations of counterparties and issuers under GICs, GIC equivalents, credit-linkednotes and obligations under interest rate, currency and credit default swaps (“CDS”),including guarantees issued in connection with the Company’s FP business. FSAalso issues surety bonds under its Sure-Bid program, which provides analternative to traditional types of good faith deposits for competitivemunicipal bond transactions.

FSA insures obligationsalready carrying insurance from other monoline guarantors, with FSA generallyobligated to pay claims on a “second-to-pay” basis, following a default by boththe underlying obligor and the first-to-pay financial guarantor. In recentyears, FSA has also reinsured a modest amount of business from other financialguaranty insurers.

The following tableindicates the Company’s percentages of par amount (net of reinsurance)outstanding as of December 31, 2006 and 2005 with respect to each type ofpublic finance and asset-backed program:

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

| ** **       | ** ** | **As of December 31, 2006** | ** ** |
|------------------|------------|-------------------------------------------------|------------|
| ** **       | ** ** | **Public Finance Programs**           | ** ** | **Asset-Backed Programs(1)** | ** ** |
| ** **       | ** ** | **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        |       |                                            | $          | 239,705 |   |   |   | 95.4 | % |   |   | $ | 101,727 |   |   |   | 94.0 | % |   |
| Secondary Market |       |                                            | 9,187      |   |   |   | 3.6 |   |   |   | 5,267 |   |   |   | 4.9 |   |   |
| Assumed          |       |                                            | 2,401      |   |   |   | 1.0 |   |   |   | 1,273 |   |   |   | 1.1 |   |   |
| Total            |       |                                            | $          | 251,293 |   |   |   | 100.0 | % |   |   | $ | 108,267 |   |   |   | 100.0 | % |   |

 

| ** **       | ** ** | **As of December 31, 2006** | ** ** |
|------------------|------------|-------------------------------------------------|------------|
| ** **       | ** ** | **Public Finance Programs**           | ** ** | **Asset-Backed Programs(1)** | ** ** |
| ** **       | ** ** | **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        |       |                                            | $          | 217,405 |   |   |   | 95.7 | % |   |   | $ | 102,464 |   |   |   | 92.8 | % |   |
| Secondary Market |       |                                            | 8,112      |   |   |   | 3.6 |   |   |   | 6,985 |   |   |   | 6.3 |   |   |
| Assumed          |       |                                            | 1,543      |   |   |   | 0.7 |   |   |   | 974 |   |   |   | 0.9 |   |   |
| Total            |       |                                            | $          | 227,060 |   |   |   | 100.0 | % |   |   | $ | 110,423 |   |   |   | 100.0 | % |   |

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(1)          Excludesintercompany insurance of $16,558 million in 2006 and $13,463 million in2005 relating to FSA-insured GICs issued by the GIC Affiliates.

*Premiums*

In setting insurancepremium rates, FSA takes into account the risk it assumes and its projectedreturn. Critical factors in assessing risk include the credit quality of therisk, type of issue, sources of repayment, transaction structure and term tomaturity. The premium rate is also a function of market factors, capitalcharges assessed by securities rating agencies and the competitive environment.Market factors include the value added by the use of insurance, such as theinterest rate savings obtained by the issuer of an insured obligation. Standard &Poor’s Ratings Services (“S&P”) assigns a “capital charge” for mostobligations insured by FSA. The capital charge for a transaction is animportant factor in determining the “return on equity” from a specifiedtransaction premium rate under the Company’s proprietary model. Competitionarises from other insurers and alternative executions that do not involveinsurance. For insurance on GIC and medium term note transactions, transactionsinvolving “repackaging” of outstanding 

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securitiesand other transactions, FSA’s premium may be arbitrage-based, based uponthe difference between the effective borrowing cost at a Triple-A rate and theinterest rate on the underlying securities.

*Public Finance Obligations*

FSAinsures a range of public finance obligations, including:

·       generalobligation bonds supported by the issuers’ taxing power;

·       tax-supportedbonds supported by leases, a specific or discrete source of taxation or “moralobligation” (that is, not a legally binding commitment);

·       revenuebonds and other obligations of state and local governments supported by theissuers’ ability to impose and collect fees and charges for public services orspecific projects, such as utility, health care and transportation revenuebonds, as well as housing bonds secured by portfolios of single-familymortgages or secured by mortgages for government-supported multifamilyresidences; and

·       internationalpublic finance obligations, including obligations of sovereign andsub-sovereign issuers and project finance transactions.

Public finance obligationsinclude municipal bonds, notes and other indebtedness issued by public andquasi-public entities, including states and their political subdivisions(such as counties, cities or towns), utility districts, universities andhospitals, and public housing and transportation authorities. Public financeobligations also include bonds, notes and other indebtedness issued by specialpurpose entities established to finance investments in infrastructure projects.An issuer’s obligation to pay is supported by the issuer’s taxing power in thecase of general obligation bonds, and by the issuer’s or obligor’s ability toimpose and collect fees and charges for public services or specific projects inthe case of most revenue bonds and public-private infrastructurefinancings. Some public finance obligations, including most project financeobligations, include non-governmental credit risks (to swap counterparties,insurance companies, construction companies or other non-governmental credits)and operating risks (such as traffic volume or student enrollment).

According to industrysources, the total and insured volume since 2002 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)** | ** ** |
| 2002       |       |                                | $          | 358.6                          |       |                             |       | $                                                                                         | 178.9      |   |   |   | 49.9 | % |   |
| 2003       |       |                                | 383.6      |                           |       |                             | 190.5      |                                                                                      |       |   | 49.7 |   |   |
| 2004       |       |                                | 359.7      |                           |       |                             | 194.9      |                                                                                      |       |   | 54.2 |   |   |
| 2005       |       |                                | 408.3      |                           |       |                             | 233.0      |                                                                                      |       |   | 57.1 |   |   |
| 2006       |       |                                | 387.7      |                           |       |                             | 190.6      |                                                                                      |       |   | 49.2 |   |   |

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(1)          Source:*The Bond Buyer*, February 7,2007. Volume is expressed in terms of principal issued and insured on asale-date basis. Subject to revision as additional information becomesavailable.

The U.S. municipal bondmarket is a mature market in which the volume of new issues has exceeded $358billion in each of the five years from 2002 through 2006. Volume generally hasbeen higher throughout this five-year period than in earlier periods, primarilydue to low interest rates. Following a record year in 2005, market volumedeclined 5% in 2006. Bond insurers generally insure about 50% of the U.S.municipal bond market, although insurance penetration rose as high as 57% in2005.

Outside the United States,guarantors have increased their presence in public infrastructure finance from2002 levels. International public finance transactions include many public-privatepartnership 

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financings,such as those authorized under the U.K. Private Finance Initiative, and otherhighly structured transactions. Because such transactions tend to have longdevelopment times and large par amounts, the timing of transactions may causevolatility in insured volume from year to year.

Since 2002, the annualtotals of non-U.S. public finance par insured of financial guaranty insurancedirectly originated by monoline guarantors, according to industry sources, wereas follows:

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

| **Year**   | ** ** | ** **             | ** ** | **Amount** | ** ** |
|------------|------------|------------------------|------------|------------|------------|
| ** ** | ** ** | **(in billions)** | ** ** |
| 2002       |       |                   | $          | 8.1        |       |   |
| 2003       |       |                   | 13.9       |       |       |
| 2004       |       |                   | 11.7       |       |       |
| 2005       |       |                   | 14.9       |       |       |
| 2006       |       |                   | N/A        | (2)        |       |

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(1)          Source:Association of Financial Guaranty Insurers (“AFGI”) news release dated May 16, 2006.Data is subject to revision as additional information becomes available.

(2)          Not available from the same source. Of thefour largest monoline guarantors, three disclose the public finance componentof their international business in their statistical operating supplements.According to such statistical operating supplements, those three companiesinsured directly or assumed, in the aggregate, a principal amount of $23.3billion of non-U.S. public finance obligations in 2006.

*Asset-Backed Obligations*

Asset-backedobligations insured by FSA are generally issued in structured transactionsbacked by pools of assets such as residential mortgage loans, consumer or tradereceivables, securities or other assets having an ascertainable cash flow ormarket value. Asset-backed obligations insured by FSA also includepayment obligations of counterparties and issuers under synthetic obligationssuch as CDS and credit-linked notes referencing asset-backed securitiesor pools of securities or other obligations.

Asset-backedobligations are typically issued in connection with structured financings orsecuritizations where the securities being issued are secured by or payablewith funds from a specific pool of assets. The assets are typically held by aspecial purpose entity that also acts as the issuer of the insured obligations.Most asset-backed obligations are secured by or represent interests indiverse pools of assets, such as residential mortgage loans, auto loans, creditcard receivables, other consumer receivables, corporate loans or bonds,government debt and small business loans. Asset-backed obligations mayalso be secured by less diverse payment sources, such as multifamily realestate.

Asset-backedobligations include funded and synthetic transactions. Funded asset-backedobligations are typically payable from cash flow generated by a pool of assetsand take the form of either “pass-through” obligations, which representinterests in the related assets, or “pay-through” obligations, which generallyare debt obligations collateralized by the related assets. Both types of fundedasset-backed obligations generally have the benefit of one or more formsof credit enhancement, such as overcollateralization or excess cash flow, tocover credit risks 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.

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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. Banks have responded toincreased capital requirements by selling certain of their assets, such ascredit card receivables and automobile loans, in securitized structures to thefinancial markets. Some corporations have found securitization of their assetsto be a less costly funding alternative to traditional forms of borrowing orotherwise important in diversifying funding sources. Many finance companiesfund consumer finance 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 or portfoliomanagers to provide leveraged investments in bond and loan portfolios tailoredto conform to differing risk appetites of investors.

Accordingto industry sources, the new par volumes since 2002 for each type of fundedasset-backed security presented, including securities distributed underRule 144A under the Securities Act of 1933 (as amended, the “SecuritiesAct”), were as follows:
| Year       | ** ** | ** **             | ** ** | **New Issues of Funded   U.S. Asset-Backed  Securities(1)(2)** | ** ** | **U.S. Public Issues of  Private-Label  Mortgage-Backed  Securities(1)** | ** ** | **Non-U.S. Asset-  Backed Securities(1)(3)** | ** ** | **Worldwide Funded  Collateralized Debt  Obligations(1)** | ** ** |
|------------|------------|------------------------|------------|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** ** | ** ** | **(in billions)** | ** ** |
| 2002       |       |                   | $          | 413.2                                                                                   |       |                                                                                    |       | $                                                      | 214.0      |                                                                |       |   | $ | 117.3 |   |   |   | $ | 87.7 |   |   |
| 2003       |       |                   | 505.6      |                                                                                    |       |                                                                                    | 297.1      |                                                   |       |                                                                | 198.8      |   |   |   | 82.6 |   |   |
| 2004       |       |                   | 691.6      |                                                                                    |       |                                                                                    | 329.1      |                                                   |       |                                                                | 205.5      |   |   |   | 127.6 |   |   |
| 2005       |       |                   | 875.2      |                                                                                    |       |                                                                                    | 540.5      |                                                   |       |                                                                | 278.9      |   |   |   | 241.3 |   |   |
| 2006       |       |                   | 907.7      |                                                                                    |       |                                                                                    | 566.3      |                                                   |       |                                                                | 419.1      |   |   |   | 445.3 |   |   |

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(1)          Source: *Asset-Backed Alert*, January 9,2004, January 7, 2005, January 13, 2006 and January 12, 2007.Subject to revision as additional information becomes available.

(2)          Includes public andprivately placed corporate and consumer receivable-backed issues(including home equity loan issues) but excludes private-label mortgage-backedsecurities, CDOs, commercial paper and those private placements for whichinformation is not available.

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

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

|                         | ** ** | **Outstanding  Credit Default Swaps(1)** | ** ** |
|-------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | **(in billions)**                             | ** ** |
| December 31,  2002 |       |                                               | $          | 2,191.6 |   |   |
| December 31,  2003 |       |                                               | 3,779.4    |   |   |
| December 31,  2004 |       |                                               | 8,422.3    |   |   |
| December 31,  2005 |       |                                               | 17,096.1   |   |   |
| June 30, 2006      |       |                                               | 26,005.7   |   |   |

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(1)          Source: ISDA web page,February 22, 2007.

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Accordingto industry information, the annual totals of funded and synthetic asset-backedpar insured of financial guaranty insurance directly originated by monolineguarantors during each year since 2002 were as follows:

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

| **Year Ended December 31,** | ** ** | ** **             | ** ** | **United States** | ** ** | **Non-U.S.** | ** ** |
|--------------------------------------------|------------|------------------------|------------|------------------------|------------|--------------|------------|
| ** **                                 | ** ** | **(in billions)** | ** ** |
| 2002                                       |       |                   | $          | 165.5                  |       |         |       | $ | 63.2 |   |   |
| 2003                                       |       |                   | 120.4      |                   |       |         | 45.0       |   |   |
| 2004                                       |       |                   | 200.0      |                   |       |         | 46.8       |   |   |
| 2005                                       |       |                   | 216.3      |                   |       |         | 61.5       |   |   |
| 2006                                       |       |                   | N/A        | (2)                    |       |         | N/A        | (2) |   |

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(1)          Source: AFGI newsrelease dated May 16, 2006. Includes all funded and synthetic primary-marketand secondary-market U.S. insured transactions, excluding public financeobligations. Subject to revision as additional information becomes available.

(2)          Notavailable from the same source. According to the statistical operatingsupplements published by the four largest monoline guarantors, those fourcompanies insured directly or assumed, in the aggregate, approximately$177.7 billion of U.S. asset-backed par volume. Three of thesecompanies disclose the non-U.S. component of their asset-backed business, whichin aggregate was $43.5 billion in 2006.

***Financial Products Business***

The Company’s FP business 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 include GICsacquired by issuers of credit-linked notes and GICs acquired by 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 than anticipatedto pay project expenses. Structured finance GICs for credit-linked notes may bedrawn unexpectedly upon certain credit events under the CDS related to suchnotes. In addition, most FSA-insured GICs allow for withdrawal of GIC funds inthe event of a downgrade of FSA, typically below AA- by S&P or Aa3 byMoody’s, unless the GIC provider posts collateral or otherwise enhances itscredit. Some FSA-insured GICs also allow for withdrawal of GIC funds in theevent of a downgrade of FSA, typically below A3 by Moody’s or A- by S&P,with no right of the GIC provider to avoid such withdrawal by postingcollateral or otherwise enhancing its credit. The Company manages this riskthrough the maintenance of liquid collateral and liquidity agreements.

The GIC Affiliates issue GICs and, on the same terms,lend the funds raised to FSAM. The payment obligations relating to the GICsgenerally are (or are converted by FSAM into) U.S. dollar LIBOR-basedfloating rate obligations. FSAM typically invests the funds in U.S. dollarLIBOR-based floating rate 

9

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investments. To the extentthat such investments do not meet such criteria, FSAM utilizes swaps, futuresand other hedge transactions to convert them into U.S. dollar LIBOR-basedfloating rate investments.

FSA-PAL, which was formed in 2006, invests in non-U.S.securities. FSAM’s and FSA-PAL’s investments are generally obligations thatwould qualify for FSA insurance from a credit perspective. The GIC Affiliates,FSAM and FSA-PAL generate their gross profits or losses from the differencebetween the rates at which the GIC Affiliates borrow the funds and the ratesyielded by FSAM’s and FSA-PAL’s investments. All related risk managementfunctions are performed by FSAM.

Thefollowing table indicates the Company’s carrying amount of debt outstanding asof December 31, 2006 and 2005 with respect to municipal and non-municipalGICs:
|                  | ** ** | **As of December 31** | ** ** |
|------------------|------------|--------------------------------------|------------|
| ** **       | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **       | ** ** | **(in thousands)**              | ** ** |
| Municipal        |       | $                                    | 6,725,578  |   | $ | 7,311,530 |   |
| Non-municipal(1) |       | 8,950,656                            |       | 5,318,152 |   |
| Total            |       | $                                    | 15,676,234 |   | $ | 12,629,682 |   |

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(1)          ExcludesGICs acquired by FSA Global.

*ConsolidatedVariable Interest Entities*

FSA Global is a Cayman Islands-domiciled issuer ofFSA-insured notes and other obligations sold in international markets that aregenerally referred to as “medium term notes.” The Company owns 49% of the voting ordinary shares and 100% of thenonvoting preference shares of FSA Global.

FSA Global issues 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. As ofDecember 31, 2006, the VIEs, including FSA Global, had $2.7 billionprincipal amount of outstanding notes, after elimination of intercompanytransactions.

FSA Global is managed as a “match funded vehicle,” inwhich the proceeds from the sale of FSA Global notes are invested inobligations chosen to provide cash flows substantially matched to those of thenotes (taking into account, in some cases, dedicated third party liquidity). Thismatch funded structure is designed to minimize the market risks borne by FSAGlobal and FSA.

FSA Global generally raises funds that are denominatedin U.S. dollars or converted into U.S. dollars at LIBOR-based floatingborrowing rates. In recent years, the funds FSA Global raises have generallybeen invested in FSA-insured GICs, but it may invest, and has in the pastinvested, in other FSA-insured obligations. FSA Global invests with a view torealizing the yield difference between the notes issued and the obligationspurchased with the note proceeds. While the majority of FSA Global’sinvestments are either denominated in U.S. dollars or converted into U.S.dollars at LIBOR-based floating rates, it also holds investments in othercurrencies.

FSA Global’s investments:

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

·       paya higher interest rate than the interest rate on the related FSA Global notes.

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**Insurance in Force**

Setforth below is a summary of the Company’s par outstanding by type as ofDecember 31, 2006:

| ** **      | ** ** | **Par Outstanding** | ** ** |
|-----------------|------------|--------------------------|------------|
| ** **      | ** ** | **Direct**               | ** ** | **Assumed** | ** ** | **Total Gross** | ** ** | **Ceded** | ** ** | **Net** | ** ** |
| ** **      | ** ** | **(in millions)**   | ** ** |
| Public finance  |       | $                        | 347,685    |   |   | $ | 2,461 |   |   |   | $ | 350,146 |   |   | $ | 98,853 |   | $ | 251,293 |   |
| Asset-backed(1) |       | 129,947                  |       |   | 1,297 |   |   |   | 131,244 |   |   | 22,977 |   | 108,267 |   |
| Total           |       | $                        | 477,632    |   |   | $ | 3,758 |   |   |   | $ | 481,390 |   |   | $ | 121,830 |   | $ | 359,560 |   |

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(1)          Excludes direct paroutstanding on intercompany insurance of $16,558 million relating to FSA-insuredGICs issued by the GIC Affiliates.

As of December 31,2006, the weighted average life of the direct par insured on these policies wasapproximately five years for asset-backed and 15 years for publicfinance obligations.

***Public Finance Obligations***

FSA’s insured portfolio ofpublic finance obligations is divided into nine major categories, which includefunded and synthetic obligations:

*Domestic GeneralObligation Bonds*

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

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

Tax-supported (non-generalobligation) bonds include a variety of bonds that, though not full faith andcredit general obligations, are generally supported by leases, a specific ordiscrete source of taxation or moral obligation. Lease revenue bonds orcertificates of participation (“COPs”) are usually general fund obligationsthat finance real property or equipment that, in the case of leases subject toannual appropriation or abatement, FSA deems to serve an essential publicpurpose (e.g., schools, public safety facilities, courts and correctional facilities).Tax-backed revenue bonds are secured by a lien on pledged tax revenues,including retail sales, excise and gasoline taxes, or from tax increments (ortax allocations) generated by growth in property values within a district. FSAalso insures bonds secured by special assessments levied against propertyowners, which benefit from covenants by the issuer to levy, collect and enforcecollections and to foreclose on delinquent properties.

*Domestic MunicipalUtility Revenue Bonds*

Municipal utility revenuebonds include obligations of all forms of municipal utilities, includingelectric, gas, water and sewer and solid waste. Insurable utilities may beorganized as municipal enterprise systems, authorities or joint-actionagencies.

*Domestic HealthCare Revenue Bonds*

Health care revenue bondsinclude bonds of state and local municipal authorities issued on a conduitbasis on behalf of not-for-profit health care providers and health careprovider systems, including health maintenance organizations, payable fromamounts derived under loan agreements and notes of such health care providerswith such authorities.

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*Domestic HousingRevenue Bonds*

Housing revenue bondsinclude both multifamily and single family housing bonds, with multi-tieredsecurity structures based on the underlying mortgages, reserve funds, andvarious other features such as Federal Housing Administration or privatemortgage insurance, bank letters of credit, first-loss guarantees and, in somecases, the general obligation of the issuing housing agency or a state’s moralobligation to make up deficiencies.

*DomesticTransportation Revenue Bonds*

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

*Domestic EducationBonds*

Education bonds includeobligations of colleges and universities, primarily public or state-supported,and independent primary and secondary schools.

*Other DomesticPublic Finance Obligations*

Other domestic publicfinance obligations insured by FSA include previously insured bonds, bondssecured by revenues and guarantees from the federal government, financingssupported by specific state or local government entity revenues, and stadiumfinancings.

*InternationalPublic Finance Obligations*

International publicfinance obligations have non-U.S. obligors and include obligations of sovereignand sub-sovereign issuers, project finance transactions involving projectsleased to or supported by payments from governmental or quasi-governmentalentities, toll road transactions supported by toll revenues, obligationsarising under leases of equipment or facilities by municipal obligors, utilityfinancings, securitizations of government-supported receivables or sovereign ormunicipal debt, corporate debt guaranteed by government-owned financialinstitutions and other obligations having international aspects but otherwisewithin the public finance categories described above.

***Asset-Backed and Other Non-Public Finance Obligations***

FSA’s insured portfolio ofasset-backed and other non-public finance obligations is divided intofive major categories, which are broadly based on the type of assets backingthe insured obligations and include funded and synthetic obligations:

*DomesticResidential Mortgage Loans*

Obligations primarilybacked by residential mortgage loans generally take the form of conventionalpass-through certificates or pay-through debt securities, but also includeother structured products. Residential mortgage loans backing these insuredobligations include closed- and open-end first and second mortgage loansor home equity loans on one-to-four family residential properties, includingcondominiums and cooperative apartments and non-owner occupied residentialhousing. More than half of the domestic residential mortgage loan obligationscurrently insured by FSA are in the “sub-prime” sector, characterized by lowerquality borrowers 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,” 

12

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characterizedby very high interest rates or “points and fees” and subject to restrictivefederal and state regulations.

*Domestic ConsumerReceivables*

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

*Domestic PooledCorporate Obligations*

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

*Other DomesticNon-Public Finance Obligations*

Other domestic non-publicfinance obligations include bonds or other securities backed by governmentsecurities, letters of credit, guarantees by other monoline insurers orrepurchase 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-public finance obligations insured byFSA also include first mortgage bond obligations of for-profit electric orwater utilities providing retail, industrial and commercial service,sale-leaseback obligation bonds supported by such utilities and otherobligations backed by investor-owned utilities. These bonds are generallyeither secured by a mortgage on property owned by or leased to an investor-ownedutility or have the benefit of a “negative pledge” ensuring that no othermaterial creditors have priority claims to the utility assets. Other domesticnon-public finance obligations include securitization of life insurance risks(including so-called “triple-X transactions”) and airplane leases, includingtransactions benefiting from third-party financial guaranty insurance.

*International Asset-BackedObligations*

International asset-backedobligations include (1) funded and synthetic CDOs,(2) securitizations of perpetual floating rate notes of non-domesticbanks, diversified payment rights, future flows, health care receivables andresidential housing construction loans, (3) obligations of non-domesticinvestor-owned utilities and (4) other obligations having internationalaspects but otherwise within the asset-backed categories described above.

***Insured Portfolio***

A summary of FSA’s insuredportfolio as of December 31, 2006 is shown below. Exposure amounts areexpressed net of reinsurance but do not distinguish between quota share,first-loss or excess-of-loss reinsurance.

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**Summaryof Insured PortfolioAs of December 31, 2006(1)**
|                                  | ** ** | **Number of  Risks**           | ** ** | **Net Par  Amount  Outstanding** | ** ** | **Net  Par and  Interest** | ** ** | **Percent  of Net  Par and  Interest** | ** ** |
|----------------------------------|------------|-------------------------------------|------------|---------------------------------------|------------|---------------------------------|------------|--------------------------------------------------|------------|
| ** **                       | ** ** | **(dollars in millions)** | ** ** |
| **Public finance obligations**   | ** ** |                                | ** ** | ** **                            |       |                            | ** ** | ** **                                       |       | ** ** | ** ** |   | ** ** | ** ** |   |
| General obligation               |       |                                | 6,912      | ** **                            |       |                            | $          | 103,112                                          | ** ** |   | $ | 153,500 |   |   | 29 | % |   |
| Tax-supported                    |       |                                | 1,128      | ** **                            |       |                            | 46,479     | ** **                                       |       | 72,160 |   |   | 14 |   |   |
| Municipal utility revenue        |       |                                | 1,115      | ** **                            |       |                            | 40,495     | ** **                                       |       | 65,709 |   |   | 12 |   |   |
| Health care revenue              |       |                                | 242        | ** **                            |       |                            | 13,155     | ** **                                       |       | 24,140 |   |   | 5 |   |   |
| Housing revenue                  |       |                                | 183        | ** **                            |       |                            | 7,576      | ** **                                       |       | 13,390 |   |   | 3 |   |   |
| Transportation revenue           |       |                                | 119        | ** **                            |       |                            | 16,164     | ** **                                       |       | 28,618 |   |   | 5 |   |   |
| Education                        |       |                                | 109        | ** **                            |       |                            | 4,378      | ** **                                       |       | 6,989 |   |   | 1 |   |   |
| Other domestic public finance    |       |                                | 85         | ** **                            |       |                            | 1,628      | ** **                                       |       | 2,480 |   |   | — |   |   |
| International                    |       |                                | 143        | ** **                            |       |                            | 18,306     | ** **                                       |       | 47,659 |   |   | 9 |   |   |
| Total public finance obligations |       |                                | 10,036     | ** **                            |       |                            | 251,293    | ** **                                       |       | 414,645 |   |   | 78 |   |   |
| **Asset-backed  obligations**    | ** ** |                                | ** ** | ** **                            |       |                            | ** ** | ** **                                       |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Residential mortgages            |       |                                | 202        | ** **                            |       |                            | $          | 15,666                                           | ** ** |   | $ | 17,441 |   |   | 3 |   |   |
| Consumer receivables             |       |                                | 42         | ** **                            |       |                            | 10,599     | ** **                                       |       | 11,214 |   |   | 2 |   |   |
| Pooled corporate                 |       |                                | 260        | ** **                            |       |                            | 45,914     | ** **                                       |       | 48,745 |   |   | 9 |   |   |
| Other domestic asset-backed      |       |                                | 113        | ** **                            |       |                            | 6,793      | ** **                                       |       | 8,382 |   |   | 2 |   |   |
| International                    |       |                                | 103        | ** **                            |       |                            | 29,295     | ** **                                       |       | 30,994 |   |   | 6 |   |   |
| Total asset-backed obligations   |       |                                | 720        | ** **                            |       |                            | 108,267    | ** **                                       |       | 116,776 |   |   | 22 |   |   |
| Total                            |       |                                | 10,756     | ** **                            |       |                            | $          | 359,560                                          | ** ** |   | $ | 531,421 |   |   | 100 | % |   |

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(1)          Excludesintercompany insurance of $16,558 million in net par outstanding and$20,850 million in net par and interest outstanding relating to FSA-insuredGICs issued by the GIC Affiliates.

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***Obligation Type***

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

**Annual New BusinessInsured by Obligation Type**
|                                                            | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Public finance obligations**                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| General  obligation                                        |       |                                       | 27         | % |   |   | 30 | % |   |   | 20 | % |   |   | 28 | % |   |   | 19 | % |   |
| Tax-supported                                              |       |                                       | 9          |   |   |   | 12 |   |   |   | 7 |   |   |   | 15 |   |   |   | 9 |   |   |
| Municipal utility  revenue                                 |       |                                       | 8          |   |   |   | 8 |   |   |   | 5 |   |   |   | 12 |   |   |   | 9 |   |   |
| Health care  revenue                                       |       |                                       | 3          |   |   |   | 3 |   |   |   | 3 |   |   |   | 2 |   |   |   | 1 |   |   |
| Housing revenue                                            |       |                                       | 1          |   |   |   | 1 |   |   |   | 2 |   |   |   | 3 |   |   |   | 2 |   |   |
| Transportation  revenue                                    |       |                                       | 2          |   |   |   | 4 |   |   |   | 2 |   |   |   | 5 |   |   |   | 4 |   |   |
| Education                                                  |       |                                       | 1          |   |   |   | 1 |   |   |   | 1 |   |   |   | 2 |   |   |   | 1 |   |   |
| International                                              |       |                                       | 7          |   |   |   | 5 |   |   |   | 2 |   |   |   | 2 |   |   |   | 2 |   |   |
| Total public  finance obligations                          |       |                                       | 58         |   |   |   | 64 |   |   |   | 42 |   |   |   | 69 |   |   |   | 47 |   |   |
| **Asset-backed and other  non-public finance obligations** |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential  mortgages                                     |       |                                       | 10         |   |   |   | 9 |   |   |   | 29 |   |   |   | 7 |   |   |   | 9 |   |   |
| Consumer  receivables                                      |       |                                       | 10         |   |   |   | 5 |   |   |   | 3 |   |   |   | 6 |   |   |   | 10 |   |   |
| Pooled corporate                                           |       |                                       | 11         |   |   |   | 13 |   |   |   | 14 |   |   |   | 5 |   |   |   | 14 |   |   |
| Other domestic  asset-backed(1)                            |       |                                       | 1          |   |   |   | 1 |   |   |   | 4 |   |   |   | 2 |   |   |   | 1 |   |   |
| International                                              |       |                                       | 10         |   |   |   | 8 |   |   |   | 8 |   |   |   | 11 |   |   |   | 19 |   |   |
| Total asset-backed  obligations                            |       |                                       | 42         |   |   |   | 36 |   |   |   | 58 |   |   |   | 31 |   |   |   | 53 |   |   |
| Total                                                      |       |                                       | 100        | % |   |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |

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(1)          Excludes intercompanytransactions relating to FSA-insured GICs issued by the GIC Affiliates.

***Terms to Maturity***

The table below sets forththe contractual terms to maturity of the Company’s policies as of December 31,2006 and 2005:

**ContractualTerms to Maturity of Net Par Outstanding of Insured Obligations(1)**
|                                | ** ** | **As of December 31, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|--------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| **Term to Maturity** | ** ** | ** **                                      | ** ** | **Public Finance**                         | ** ** | **Asset-  Backed(2)** | ** ** | **Public Finance** | ** ** | **Asset-  Backed(2)** | ** ** |
| ** **                     | ** ** | **(in millions)**                          | ** ** |
| 0 to 5 years                   |       |                                            | $          | 48,273                                          |       |   | $ | 41,582 |   |   | $ | 44,272 |   |   | $ | 41,955 |   |
| 5 to 10 years                  |       |                                            | 53,242     |                                            |       | 31,097 |   |   | 49,935 |   |   | 31,395 |   |
| 10 to 15 years                 |       |                                            | 47,865     |                                            |       | 12,301 |   |   | 44,392 |   |   | 12,180 |   |
| 15 to 20 years                 |       |                                            | 41,489     |                                            |       | 1,860 |   |   | 36,737 |   |   | 744 |   |
| 20 years and above             |       |                                            | 60,424     |                                            |       | 21,427 |   |   | 51,724 |   |   | 24,149 |   |
| Total                          |       |                                            | $          | 251,293                                         |       |   | $ | 108,267 |   |   | $ | 227,060 |   |   | $ | 110,423 |   |
|                                |            |                                                 |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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

(2)          Excludesintercompany insurance of $16,558 million in 2006 and $13,463 millionin 2005 relating to FSA-insured GICs issued by the GIC Affiliates.

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***Issue Size***

The table below sets forththe net par outstanding as of December 31, 2006, broken out by originalnet par amount:

**NetPar Amount Outstanding**
|                                            | ** ** | **As of December 31, 2006** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------|------------|
| **Original Net Par Amount** | ** ** | ** **                                      | ** ** | **Public Finance** | ** ** | **Asset-Backed(1)** | ** ** |
| ** **                                 | ** ** | **(dollars in millions)**             | ** ** |
| Less than $10  million                     |       |                                            | $          | 35,308 |   |   |   | $ | 145 |   |   |
| $10 to $50  million                        |       |                                            | 69,890     |   |   |   | 4,003 |   |   |
| $50 million to  $100 million               |       |                                            | 39,353     |   |   |   | 7,687 |   |   |
| $100 million or  greater                   |       |                                            | 106,742    |   |   |   | 96,432 |   |   |
| Total                                      |       |                                            | $          | 251,293 |   |   |   | $ | 108,267 |   |   |
|                                            |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |

----

(1)          Excludesintercompany insurance of $16,558 million relating to FSA-insured GICsissued by the GIC Affiliates.

***Geographic Concentration***

The Company seeks tomaintain a diversified portfolio of insured public finance obligations designedto spread its risk across a number of geographic areas. The table below setsforth those jurisdictions in which municipalities issued an aggregate of 2% ormore of the total net par amount outstanding of FSA-insured public financesecurities:

**PublicFinance Insured Portfolio by Jurisdiction**
|                               | ** ** | **As of December 31, 2006** | ** ** |
|-------------------------------|------------|-------------------------------------------------|------------|
| **Jurisdiction**              | ** ** | ** **                                      | ** ** | **Number  of Risks** | ** ** | **Net Par  Amount  Outstanding** | ** ** | **Percent of Total  Net  Par Amount  Outstanding** | ** ** |
| ** **                    | ** ** | **(dollars in millions)**             | ** ** |
| California                    |       |                                            | 1,022      |   |   |   | $ | 31,724 |   |   |   | 12.7 | % |   |
| New York                      |       |                                            | 703        |   |   |   | 19,800 |   |   |   | 7.9 |   |   |
| Texas                         |       |                                            | 760        |   |   |   | 17,123 |   |   |   | 6.8 |   |   |
| Pennsylvania                  |       |                                            | 782        |   |   |   | 16,429 |   |   |   | 6.5 |   |   |
| Florida                       |       |                                            | 270        |   |   |   | 13,061 |   |   |   | 5.2 |   |   |
| Illinois                      |       |                                            | 682        |   |   |   | 12,641 |   |   |   | 5.0 |   |   |
| New Jersey                    |       |                                            | 609        |   |   |   | 10,817 |   |   |   | 4.3 |   |   |
| Michigan                      |       |                                            | 542        |   |   |   | 10,173 |   |   |   | 4.0 |   |   |
| Washington                    |       |                                            | 332        |   |   |   | 9,067 |   |   |   | 3.6 |   |   |
| Massachusetts                 |       |                                            | 210        |   |   |   | 6,304 |   |   |   | 2.5 |   |   |
| Ohio                          |       |                                            | 376        |   |   |   | 6,160 |   |   |   | 2.5 |   |   |
| Indiana                       |       |                                            | 271        |   |   |   | 5,451 |   |   |   | 2.2 |   |   |
| Georgia                       |       |                                            | 114        |   |   |   | 5,050 |   |   |   | 2.0 |   |   |
| Wisconsin                     |       |                                            | 453        |   |   |   | 4,982 |   |   |   | 2.0 |   |   |
| All other U.S.  jurisdictions |       |                                            | 2,767      |   |   |   | 64,205 |   |   |   | 25.5 |   |   |
| International                 |       |                                            | 143        |   |   |   | 18,306 |   |   |   | 7.3 |   |   |
| Total                         |       |                                            | 10,036     |   |   |   | $ | 251,293 |   |   |   | 100.0 | % |   |
|                               |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In its asset-backed business, the Companyconsiders geographic concentration as a factor in underwriting insurance forsecuritizations of pools of assets, such as residential mortgage loans or 

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consumer receivables.However, the geographic concentration of the underlying assets may change overthe life of the policy. In addition, in writing insurance for other types ofasset-backed obligations, such as securities primarily backed bygovernment or corporate debt, geographic concentration may not be a significantcredit factor given other more relevant measures of diversification, such asissuer or industry diversification.

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

**TotalRevenues From External Customers**

| ** **     | ** ** | **Year Ended December 31,** | ** ** |
|----------------|------------|--------------------------------------------|------------|
| ** **     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **     | ** ** | **(in thousands)**                    | ** ** |
| United States  |       | $                                          | 1,633,820  |   | $ | 933,079 |   | $ | 1,095,914 |   |
| International  |       | 57,048                                     |       | 48,156 |   | 52,355 |   |
| Total revenues |       | $                                          | 1,690,868  |   | $ | 981,235 |   | $ | 1,148,269 |   |

 

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

See Note 20 to theConsolidated Financial Statements in Item 8 for revenues from externalcustomers, pre-tax earnings and total assets by segment.

***Issuer Concentration***

The Company has adoptedunderwriting and exposure management policies designed to limit the net parinsured or net retained credit gap for any one risk. Credit gap is a conceptemployed by S&P to estimate the at-risk amount (worst-case risk) on aninsured exposure. FSA has also established procedures to ensure compliance withregulatory single-risk limits applicable to bonds it has insured. In manycases, the Company uses reinsurance to limit net exposure to any one risk. Asof December 31, 2006, the ten largest net insured public finance risksrepresented $11.1 billion, or 3.1%, of the total net par amount outstanding andthe ten largest net insured asset-backed transactions represented$23.4 billion, or 6.2%, of the total net par amount outstanding. Forpurposes of the foregoing, different issues of asset-backed securities bythe same originator have not been aggregated. However, the Company’sunderwriting policies establish single-risk guidelines applicable to asset-backedsecurities of the same originator. 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 insured risks. Instead, FSAaddresses these risks through structural elements of the transactions and bylimiting its exposure to the CDO sector in the aggregate. In addition to thesingle-risk limits established by its underwriting guidelines, the Company issubject to regulatory limits and rating agency guidelines on exposures tosingle risks.

**Credit UnderwritingGuidelines, Standards and Procedures**

***Financial Guaranty Business***

Financial guaranty insurance written by FSA generallyrelies on an assessment of the adequacy of various payment sources to meet debtservice or other obligations in a specific transaction without regard topremiums paid or income from investment of premiums. FSA’s underwriting policyis to insure public finance and asset-backed obligations that itdetermines are investment grade without the benefit of FSA’s insurance. To thisend, each policy FSA writes or reinsures is designed to satisfy the generalunderwriting guidelines and specific standards for particular types ofobligations approved by its Board of Directors. In addition, the Company’sBoard of Directors has established an Underwriting Committee that reviews 

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completed transactions,generally on a quarterly basis, to ensure conformity with underwritingguidelines and standards.

FSA’s underwriting guidelines for public financeobligations 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 obligoris a governmental entity with taxing power or providing an essential publicservice 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 obligor maybe required to provide a rate covenant and a pledge of additional security(e.g., mortgages on real property, liens on equipment or revenue pledges) tosecure the insured obligation.

FSA’s underwriting guidelines for asset-backedobligations are premised on the concept of multiple layers of protection, andvary by obligation type in order to reflect different structures and types ofcredit support. FSA seeks to insure asset-backed obligations thatgenerally provide for one or more forms of overcollateralization (such asexcess collateral value, excess cash flow or “spread,” reserves or, in the caseof CDS, a deductible) or third-party protection (such as bank letters ofcredit, guarantees, net worth maintenance agreements, indemnity agreements, CDSor reinsurance agreements). Asset-backed obligations insured by FSA oftenbenefit from self-adjusting mechanisms, such as cash traps or acceleratedamortization that take effect upon a failure to satisfy performance-basedtriggers.

Overcollateralization or third-party protectiondoes not need to protect FSA against all risk of loss, but is generallyintended to assume the primary risk of financial loss. Overcollateralizationand third-party protection may not be required in transactions in whichFSA is insuring the obligations of certain highly rated issuers that typicallyare regulated, have implied or explicit government support, or are short term.

FSA’s underwriting policy allows for FSA to insuresecurities issued to refinance other securities insured by FSA as to which theissuer is or may be in default. Overcollateralization and third-partyprotection may not be required in such transactions.

In addition, FSA may insure so-called “future flow,” “diversifiedpayment right,” “triple-X,” “airplane enhanced equipment trust certificate” and“whole business” securitizations in which FSA may be exposed to a level ofcorporate risk greater than found in traditional asset-backed securities. FSAhas also insured “extreme mortality” transactions, which, like “triple-X”securitizations insured by FSA, expose FSA to investment-grade levels ofmortality risk.

FSA’s general policy has been to insure 100% of theprincipal, interest and other amounts due in respect of funded asset-backedobligations rather than providing partial or first-loss coverage sufficient toconfer a Triple-A rating on the senior obligations. In the CDS sector, FSAoften insures risks, and in the funded sector FSA sometimes insures securities,on a “compressed” or “mezzanine” basis in which the obligations insured by FSAare subordinate, in whole or in part, to more senior uninsured obligations andwhere the risk insured by FSA is typically Triple-A without the benefit of FSA’sinsurance.

The rating agencies participate to varying degrees inthe underwriting process. Most asset-backed and international obligationsinsured by FSA are reviewed prior to issuance by both S&P and Moody’s toevaluate the risk proposed to be insured. In the case of domestic municipalobligations, prior rating agency review is a function of the type of insuredobligation and the risk elements involved. The independent review of FSA’sunderwriting practices performed by the rating agencies further strengthens theunderwriting process.

The Company’s Risk Management Committee reviews theCompany’s insured portfolio on a periodic basis. The Risk Management Committeeincludes FSA’s Chief Risk Management Officer and the four Chief UnderwritingOfficers (Domestic, International, International Structured Finance andMunicipal 

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Underwriting), as well asthe Chief Executive Officer, President, General Counsel and Chief FinancialOfficer.

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

Each underwriting group in the Financial GuarantyGroup is responsible for confirming that each transaction proposed by theFinancial Guaranty Group conforms to the underwriting guidelines and standards.This evaluation is reviewed by the chief underwriting officer for theparticular sector. This review may take place while the transaction is in itsformative stages, thus facilitating the introduction of further enhancements ata 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 andinternational transactions and from FSA’s Municipal Underwriting Committee (the“MUNC”) for domestic municipal transactions. Approval is usually based uponboth a written and an oral presentation by the underwriting group to therespective committee. Following approval, the Chair of the applicableunderwriting committee may approve minor transaction modifications. Majorchanges require the concurrence of the applicable underwriting committee.

The MRC is composed of FSA’s Chief Executive Officer,President, Chief Risk Management Officer, Chief Domestic Underwriting Officer,Chief International Underwriting Officer, Chief International StructuredFinance Officer, General Counsel and Associate General Counsel for Asset-BackedTransactions. The Chief Executive Officer, President, General Counsel and ChiefRisk Management Officer are not required to participate in MRC meetings fortransactions meeting certain criteria. The MRC may delegate approval authorityfor certain highly rated asset-backed transactions that fall below establishedmonetary thresholds.

The MUNC iscomposed 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

·       an Associate General Counsel for MunicipalTransactions.

Subject to applicablelimits, public finance transactions satisfying credit and return requirementsmay be approved by a committee (the “Demi-MUNC”) composed of at least twovoting members, one of whom must be the Chief Municipal Underwriting Officer,Municipal Underwriting Officer or Managing Director for Municipal Operations,and any one of certain managing directors and directors designated by the MUNC.

***Financial Products Business***

The Company’s GIC Affiliates issue GICs and FSAM andits UK subsidiary FSA-PAL make investments in accordance with the FPunderwriting guidelines. These underwriting guidelines require that each GICand investment meet the funding strategy of the FP business. The fundingstrategy, in turn, reflects the Company’s short-term liquidity needs to meetwithdrawals and purchase assets, the Company’s collateral posting obligationsunder collateralized GICs, the availability of attractive investments, the riskthat actual GIC withdrawals may vary from expected withdrawals and otherfactors.

FP’s underwriting guidelines also govern FSAM’sinvestment of funds raised from the issuance of GICs. In general, investmentsare obligations that would qualify for FSA insurance from a credit 

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perspective, and musttherefore be investment-grade quality. The Company manages its GIC investmentportfolio to maintain sufficient liquidity to address expected and unexpectedGIC withdrawals and to maintain sufficient eligible collateral to supportcollateralized GICs.

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

Final transaction approvalfor an investment by FSAM or FSA-PAL depends on the investment sector, creditrating, amount and other factors. The FP underwriting guidelines require thatthe head of the FP group approve all investments and specify whether approvalsfrom FSA’s Chief Executive Officer, President, Chief Risk Management Officerand/or other officers is also required.

***Corporate Research***

FSA’s Corporate ResearchDepartment is composed of a professional staff under the direction of the ChiefRisk Management Officer. The Corporate Research Department is responsible forevaluating the credit quality of entities participating in or providingrecourse on obligations insured by FSA. It also provides analysis of industrysegments. Members of the Corporate Research Department generally report theirfindings directly to the appropriate underwriting committee in the context oftransaction review and approval, and to the Risk Management Committee as partof periodic portfolio reviews.

***Transaction Oversight and Transaction Services***

FSA’s Transaction Oversight Groups and its workoutsubsidiary TSC are independent of the analysts and credit officers involved inthe underwriting process. The Municipal and Asset-Backed TransactionOversight Groups are responsible for monitoring the performance of outstandingtransactions. The Transaction Oversight Groups and TSC are responsible fortaking remedial actions for underperforming transactions as appropriate. Themanagers of the transaction oversight and transaction services functions reportto the Chief Risk Management Officer. The Underwriting Committee of the Boardof Directors receives quarterly reports describing the changes in the overallinsured portfolio during the quarter and developments with respect to poorlyperforming transactions. The Transaction Oversight Groups review insuredtransactions to confirm compliance with transaction covenants, monitor creditand other developments affecting transaction participants and collateral, andtogether with TSC and the Risk Management Committee determine the steps, ifany, required to protect the interests of FSA and the holders of FSA-insuredobligations.

Reviews of transactions typically include anexamination of reports provided by, and (as circumstances warrant) discussionsor site visits with, issuers, obligors, originators, servicers, collateralmanagers, trustees and other transaction participants. Review of reports mayinclude financial audits, servicer audits, evaluations by third-partyappraisers, engineers, consultants or reports by other experts retained by theobligor or FSA. The Transaction Oversight Groups review transactions todetermine the level of ongoing attention required. These judgments relate tocurrent credit quality and other factors, including compliance with reportingor other requirements, legal or regulatory actions involving transactionparticipants and liquidity or other concerns that may not have a direct bearingon credit quality. Transactions with the highest risk profile are generallysubject to more intensive review and, if appropriate, remedial action. TheTransaction Oversight Groups and TSC work together with the Legal Departmentand Corporate Research in monitoring these transactions, negotiatingrestructurings and pursuing appropriate legal remedies.

The Company’s Transaction Oversight Groups maintainand update internal credit ratings. They also categorize each credit tofacilitate appropriate allocation of resources to loss mitigation efforts andto 

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efficiently communicatethe relative credit condition of each risk exposure, as well as the overallhealth of the insured portfolio. Such categorization is determined in part bythe risk of loss and in part by the level of routine involvement required andmonitoring cycle deemed appropriate. Each credit in the insured portfolio isdesignated one of five surveillance rating categories.

Categories I and II represent fundamentally soundtransactions requiring routine monitoring, with Category II indicating thatroutine monitoring is more frequent, due, for example, to the sector or a needto monitor triggers.

Category III represents transactions with somedeterioration in asset performance, financial health of the issuer, or otherfactors, but for which losses are deemed unlikely. Active monitoring andintervention is employed for Category III transactions.

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

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

The table below presentsthe gross and net par outstanding and the gross and net reserves for risksclassified as described above, as of December 31, 2006 and 2005.

**ParOutstanding**
|                                 | ** ** | **As of December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|
| ** **                      | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **                      | ** ** | **Gross**                             | ** ** | **Net** | ** ** | **Gross** | ** ** | **Net** | ** ** |
| ** **                      | ** ** | **(in millions)**                | ** ** |
| Categories I and  II            |       | $                                     | 471,588    |   | $ | 353,819 |   | $ | 450,967 |   | $ | 331,821 |   |
| Category III                    |       | 8,851                                 |       | 4,906 |   | 6,244 |   | 4,900 |   |
| Category IV                     |       | 468                                   |       | 435 |   | 266 |   | 242 |   |
| Category V no  claim payments   |       | 399                                   |       | 360 |   | 506 |   | 463 |   |
| Category V with  claim payments |       | 84                                    |       | 40 |   | 107 |   | 57 |   |
| Total                           |       | $                                     | 481,390    |   | $ | 359,560 |   | $ | 458,090 |   | $ | 337,483 |   |

 

**CaseReserves**
|                                 | ** ** | **As of December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|
| ** **                      | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **                      | ** ** | **Gross**                             | ** ** | **Net** | ** ** | **Gross** | ** ** | **Net** | ** ** |
| ** **                      | ** ** | **(in millions)**                | ** ** |
| Category V no  claim payments   |       | $                                     | 48.4       |   | $ | 39.3 |   | $ | 49.3 |   | $ | 40.6 |   |
| Category V with  claim payments |       | 41.9                                  |       | 13.7 |   | 40.7 |   | 13.1 |   |
| Total                           |       | $                                     | 90.3       |   | $ | 53.0 |   | $ | 90.0 |   | $ | 53.7 |   |

 

 

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***Legal***

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

***Finance andAccounting***

The Company’s Finance andAccounting Department is composed of a professional staff of accountants andfinancial analysts under the direction of the Chief Financial Officer. TheCompany’s Finance and Accounting Department is divided into two principalsections: Accounting and Treasury. Accounting plays the primary role inestablishing and complying with accounting policies and procedures consistentwith each of the various accounting standards under which the Company and itssubsidiaries prepare its financial statements, including accounting principlesgenerally accepted in the United States of America (“GAAP”), InternationalFinancial Reporting Standards (“IFRS”) for Dexia and various statutory methodsprescribed for its domestic insurance operations and non-U.S. subsidiaries andbranches. Treasury plays the primary role in developing and monitoring theoperating and capital plans. This department is also responsible for optimizingthe Company’s capital structure, ensuring the capital and liquidity resourcesare maintained at Triple-A levels and periodically evaluating returns ondeployed capital. The Finance and Accounting Department works closely with allareas of the Company to ensure that all transactions are well understood,processed in an appropriate and controlled manner, and accounted for properly. Thisdepartment is also responsible for ensuring that the Company maintains adequateinternal control systems and periodically meets to review and discuss financialfilings prior to their submission with the SEC. The Controller is the head ofthe Accounting Department and regularly attends meetings of the Audit Committeeof the Board of Directors. The Treasurer is the leader of the TreasuryDepartment and regularly attends meetings of the Investment Committee of theBoard of Directors.

**Competition and Industry Concentration**

FSA faces competition fromboth other providers of and alternatives to third-party creditenhancement. Most securities are sold without third-party creditenhancement. Accordingly, each transaction FSA proposes to insure mustgenerally compete against an alternative execution that does not employ third-partycredit enhancement. Many financings may be funded by banks through loans or inthe capital markets through the sale of securities. Both types of fundings maybe executed with or without 

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insurance.FSA faces competition from other Triple-A-rated monoline financial guarantyinsurers, primarily Ambac Assurance Corp. (“Ambac”), CIFG Guaranty, FinancialGuaranty Insurance Company (“FGIC”), MBIA Insurance Corp. (“MBIA”) and XLCapital Assurance Inc. Competition is largely based on premium rates,capacity, underwriting requirements and trading levels.

Newentrants to the market provide increasing competition to more establishedmarket participants such as FSA as they attempt to grow their market share.Assured Guaranty Corp. and Radian Asset Assurance Inc., two marketparticipants previously engaged primarily in reinsurance, either directly orthrough affiliates, now focus on the primary financial guaranty insurance market.From time to time other parties consider establishing new financial guarantyinsurers that may compete with the Company. 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.

Traditional creditenhancers such as bank letter of credit providers and mortgage pool insurersprovide competition to FSA as providers of credit enhancement for asset-backedobligations. Actions by securities rating agencies in recent years havesignificantly reduced the number of Triple-A-rated financial institutions thatcan offer a product directly competitive with FSA’s Triple-A guaranty, andrisk-based capital guidelines applicable to banks have generally increasedcosts associated with letters of credit that compete directly with financialguaranty insurance. Nonetheless, bank sponsored commercial paper conduits, bankletter of credit providers and other forms of credit enhancement, such as cashcollateral accounts provided by banks, continue to provide significantcompetition to FSA. In addition, CDS, credit-linked notes and othersynthetic products provide coverage directly competitive with financialguaranty insurance, and expand the universe of participants in the financialrisk market. In recent years, derivative product companies and other structuredinvestment vehicles compete with the Company on a limited basis in the CDSmarket. Bank affiliates may participate in the U.S. insurance business,including the financial guaranty insurance business.

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

Insurance law generallyrestricts multiline insurance companies, such as large property/casualtyinsurers and life insurers, from engaging in the financial guaranty insurancebusiness other than through separately capitalized monoline affiliates.

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

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calculated in accordance with statutory accountingpractices. Net insurance data does not distinguish between quota sharereinsurance and first-loss reinsurance. In light of FSA’s use of first-lossreinsurance in the project finance and, to a lesser extent, asset-backedsectors, the data below tends to overstate FSA’s risk leverage in comparisonwith its industry counterparts. Conversely, FSA also insures mezzanine risksand obtains excess-of-loss credit protection in CDS transactions, which reducesFSA’s reported risk leverage. The statutory capital ratio does not reflect theunderlying credit quality of the insurance in force, which diminishes thecomparative value of the disclosure. Specifically, the credit quality of FSA’sinsured portfolio as measured by S&P and Moody’s is generally higher thanmost of FSA’s industry peers, although FSA’s ratio of net debt service tostatutory capital is also generally higher than most of FSA’s industry peers.

| ** **                                                 | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                 | ** ** | **(dollars in millions)**   | ** ** |
| **Financial guaranty primary  insurers, excluding FSA(1)** | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Capital ratio                                              |       | 144:1                                 |       | 141:1 |   | 147:1 |   |
| **FSA(2)**                                                 |       |                                  |       |   |   |   |   |
| Gross insurance  in force                                  |       | $                                     | 765,632    |   | $ | 686,134 |   | $ | 633,037 |   |
| Net insurance in  force                                    |       | 552,695                               |       | 497,624 |   | 454,359 |   |
| Qualified  statutory capital                               |       | 2,554                                 |       | 2,418 |   | 2,281 |   |
| Capital ratio                                              |       | 216:1                                 |       | 206:1 |   | 199:1 |   |
|                                                            |            |                                       |            |  |  |  |  |  |  |  |

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(1)          Financialguaranty primary insurers for which data is included in this table are Ambac,FGIC and MBIA. Information relating to the financial guaranty primary insurersis derived from data from statutory accounting financial information publiclyavailable from each insurer as of December 31, 2006, 2005 and 2004.

(2)          Includesgross and net insurance in force relating to FSA-insured GICs issued by the GICAffiliates of $20,850 million for 2006, $16,878 million for 2005, and$8,753 million for 2004.

In December 2004, FSAobtained CDS protection on an excess-of-loss basis (exceeding very largedeductibles) on a number of FSA-insured synthetic CDO transactions shadow rated“Super Triple-A” at inception. As of December 31, 2006, the CDS providedapproximately $4.6 billion of credit protection. Given the high credit qualityof the risk transferred to the CDS provider, the main effect of this CDS was toimprove FSA’s statutory capital ratios and increase FSA’s margin underregulatory risk limits on aggregate insured exposures. This CDS protection wasterminated by FSA in January 2007.

**Reinsurance**

Reinsurance is thecommitment by one insurance company, the “reinsurer,” to reimburse anotherinsurance company, the “ceding company,” for a specified portion of theinsurance risks underwritten by the ceding company in consideration for aportion of the premiums received. The ceding company typically but not alwaysreceives a ceding commission to cover the cost of business generation. Becausethe insured party contracts for coverage solely with the ceding company, thefailure of the reinsurer to perform does not relieve the ceding company of itsobligation to the insured party under the terms of the insurance contract.

As of December 31,2006, FSA reinsured approximately 24.5% of its principal amount outstanding.FSA obtains reinsurance to increase its policy writing capacity, both on anaggregate-risk and a single-risk basis, to:

·       meetinternal, rating agency and regulatory limits,

·       diversifyrisks,

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·       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. By annual treaty, FSA employs “automatic facultative”reinsurance that permits FSA to apply reinsurance to transactions it selectssubject to certain limitations. The remainder of FSA’s treaty reinsuranceprovides coverage for a portion, subject in certain cases to adjustment at FSA’selection, of the exposure from all qualifying policies issued during the termof the treaty. The reinsurer’s participation in a treaty is either cancelableannually upon 90 days’ prior notice by either FSA or the reinsurer or hasa one-year term. Treaties generally provide coverage for the full term of thepolicies reinsured during the annual treaty period, except that, upon afinancial deterioration of the reinsurer or the occurrence of certain otherevents, FSA generally has the right to reassume all or a portion of thebusiness reinsured. Reinsurance agreements may be subject to other terminationconditions as required by applicable state law. FSA monitors the financialcondition of its reinsurers.

Primary insurers, such as FSA, are required to fulfilltheir obligations to policyholders if reinsurers fail to meet theirobligations. The financial condition of reinsurers is important to FSA, and FSAendeavors to place its reinsurance with financially strong reinsurers. FSA’streaty reinsurers as of December 31, 2006 were Assured Guaranty ReInternational Ltd. (formerly ACE Capital Re International Ltd.);BluePoint Re, Limited; Mitsui Sumitomo Insurance Company, Limited; Radian AssetReinsurance Inc. (successor to Radian Reinsurance Inc., formerlyEnhance Reinsurance Company); RAM Reinsurance Co. Ltd.; Swiss ReinsuranceCompany; Tokio Marine and XLFA. FSA also has reciprocal surplus sharereinsurance treaties with Ambac and FGIC, which provide quota share reinsuranceon transactions exceeding specified par amounts insured.

Securities rating agencies allow FSA “credit” forreinsurance based on the reinsurer’s ratings. Generally, 95-100% creditis allowed for Triple-A reinsurance and 65-90% credit is allowed forDouble-A reinsurance. In addition, a number of FSA’s reinsurers are required topledge collateral to secure their reinsurance obligations to FSA. In somecases, the pledged collateral augments the rating agency credit for thereinsurance provided to FSA. Given the financial strength of its reinsurers,FSA requires collateral from reinsurers primarily to (a) receive statutorycredit for the reinsurance, (b) provide liquidity to FSA in the event ofclaims on the reinsured exposures, and (c) enhance rating agency creditfor the reinsurance.

In recent years, a number of FSA’s reinsurers havebeen downgraded from Triple-A to Double-A or lower by one or more ratingagency. While ceding commissions or premium allocation adjustments maycompensate in part for such downgrades, the effect of such downgrades, ingeneral, is to decrease the financial benefits of using reinsurance underrating agency capital adequacy models.

In 2004, the insurance laws of the State of New York(the “New York Insurance Law”) were amended to allow financial guarantyinsurers such as FSA to treat qualifying CDS from highly rated financialinstitutions as collateral for purposes of satisfying risk limits and certainreserve requirements. These amendments allow financial guaranty insurers toemploy CDS as collateral for statutory accounting purposes, with the collateralhaving effects similar to reinsurance in reducing single and aggregate risksfor statutory purposes. In December 2004, FSA obtained CDS protection onan excess-of-loss basis (exceeding very large deductibles) on a number ofFSA-insured synthetic CDO transactions shadow rated “Super 

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Triple-A” at inception. Asof December 31, 2006, the CDS provided approximately $4.6 billion ofcredit protection. Given the high credit quality of the risk transferred to theCDS provider, the main effects of this CDS were to improve FSA’s statutorycapital ratios and increase FSA’s margin under regulatory risk limits onaggregate insured exposures. This CDS was terminated by FSA in January 2007.

FSA, FSAIC and FSA International are party to a quotashare reinsurance pooling agreement pursuant to which, after reinsurancecessions to other reinsurers, the FSA companies share in the net retained riskinsured by each of these companies or reinsured by FSA from FSAUK. Under thepooling agreement, FSA, FSAIC and FSA International share the net retained riskin proportion to their policyholders’ surplus and contingency reserves, or “statutorycapital,” at the end of the prior calendar quarter.

FSA-UK and FSA areparty to a 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 in proportionto the statutory capital of FSA-UK to the total statutory capital of FSA andits subsidiary insurers (including FSA-UK); and

·       subject to certain limits, FSA is required to make paymentsto FSA-UK when FSA-UK’s annual net incurred losses and expenses exceedsFSA-UK’s annual net earned premiums plus draws on FSA-UK’s equalizationreserves to pay incurred losses.

Under this agreement,FSA-UK ceded to FSA approximately 97.4% of its retention after third-partyreinsurance of its policies issued in 2006.

**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 (“Fitch”) and Rating and InvestmentInformation, Inc. Such ratings reflect only the views of the respectiverating agencies, are not recommendations to buy, sell or hold securities andare subject to revision or withdrawal at any time by such rating agencies.

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

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

·       capital charges or other assessments of credit risksfor FSA’s insured portfolio, including the degree of risk embedded in FSA-insuredGICs;

·       the quality of FSA’s assets and other investments;

·       the credit quality of FSA’s reinsurers and the type ofreinsurance and the collateral, if any, provided thereby;

·       credit lines and other capital support arrangements (“softcapital”);

·       premium revenues expected to be generated fromoutstanding policies;

·       anticipated future new business originations andanticipated future losses; and

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·       holding company financial strength and leverage.

Given the importance ofits ratings to its on-going business, FSA’s underwriting process generallyincludes an analysis of the impact on rating agency capital adequacydeterminations in addition to other measures of creditworthiness. Reference ismade to the published reports of Moody’s, S&P and Fitch regarding theCompany, capital adequacy models, the bond insurance business in general andFSA’s standing relative to its industry peers on the basis of capital adequacyand profitability.

**InsuranceRegulatory Matters**

***General***

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

FSA International is a Bermuda-domiciled insurancecompany subject to applicable requirements of Bermuda law. FSA Internationalmaintains its principal executive offices in Hamilton, Bermuda. FSAInternational does not intend to transact business or establish a permanentplace of business in the United States or Europe.

FSA-UK is a United Kingdom domiciled insurance companysubject to applicable requirements of English law. FSA-UK maintains itsprincipal executive offices in London, England. Pursuant to European UnionDirectives, FSA-UK is generally authorized to write business out of its Londonoffice in other member countries of the European Union, subject to thesatisfaction of perfunctory registration requirements.

FSA has a Tokyo branchauthorized to transact insurance business in Japan and subject to regulation byJapanese authorities and a Singapore branch authorized to transact insurancebusiness in Singapore and subject to regulation by Singapore authorities. FSAMexico is currently seeking a license to transact financial guaranty insurancein Mexico.

***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.

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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 Insurance Commissioner.“Control” is defined as the direct or indirect power to direct or cause thedirection of the management and policies of a person, whether through theownership of voting securities, by contract or otherwise. Any purchaser of 10%or more of the outstanding voting securities of a corporation is presumed tohave 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.

***New York FinancialGuaranty Insurance Law***

Article 69 of the NewYork Insurance Law (“Article 69”), a comprehensive financial guarantyinsurance statute, governs all financial guaranty insurers licensed to do businessin New York, including FSA. This statute limits the business of financialguaranty insurers to financial guaranty insurance and related lines (such assurety).

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:

·       with respect to policies writtenprior to July 1, 1989 in an amount equal to 50% of earned premiums;and

·       with respect to policies writtenon and after July 1, 1989, quarterly on a pro rata basis over aperiod of 20 years for municipal bonds and 15 years for all otherobligations, in an amount equal to the greater of 50% of premiums written forthe relevant category of insurance or a percentage of the principal guaranteed,varying from 0.55% to 2.50%, depending on the type of obligation guaranteed,until the contingency reserve amount for the category equals the applicablepercentage of net unpaid principal.

This reserve must bemaintained for the periods specified above, except that reductions by theinsurer may be permitted under specified circumstances in the event that actualloss experience exceeds certain thresholds or if the reserve accumulated isdeemed excessive in relation to the insurer’s outstanding insured obligations.FSA has in the past sought and obtained releases of excessive contingencyreserves from the New York Insurance Department. Financial guaranty insurersare also required to maintain reserves for losses and loss adjustment expenseson a case-by-case basis and reserves against unearned premiums.

For purposes of Article 69,“municipal bonds” includes qualifying project finance transactions, sovereignissuances and securitizations of government-supported receivables.

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

·       the insured average annual debtservice for a single 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,

may not exceed 10% of thesum of the insurer’s policyholders’ surplus and contingency reserves, subjectto certain conditions.

Under the limit applicableto municipal obligations, the insured average annual debt service for a singlerisk, net of qualifying reinsurance and collateral, may not exceed 10% of thesum of the insurer’s 

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policyholders’surplus and contingency reserves. In addition, insured principal of municipalobligations attributable to any single risk, net of qualifying reinsurance andcollateral, is limited to 75% of the insurer’s policyholders’ surplus andcontingency reserves. Single-risk limits are also specified for othercategories of insured obligations, and generally are more restrictive thanthose listed for asset-backed or municipal obligations. Obligations notqualifying for an enhanced single-risk limit are generally subject to the “corporate”limit (applicable to insurance of unsecured corporate obligations) equal to 10%of the sum of the insurer’s policyholders’ surplus and contingency reserves. Forexample, “triple-X” and “future flow” securitizations, as well as unsecuredinvestor-owned utility obligations, are generally subject to these “corporate”single-risk limits.

Article 69 alsoestablishes aggregate risk limits on the basis of aggregate net liabilityinsured as compared with statutory capital. “Aggregate net liability” isdefined as outstanding principal and interest of guaranteed obligationsinsured, net of qualifying reinsurance and collateral. Under these limits,policyholders’ surplus and contingency reserves must not be less than apercentage of aggregate net liability equal to the sum of various percentagesof aggregate net liability for various categories of specified obligations. Thepercentage varies from 0.33% for certain municipal obligations to 4% forcertain non-investment-grade obligations.

***DividendRestrictions***

FSA’sability to pay dividends is dependent on FSA’s financial condition, results ofoperations, cash requirements, rating agency confirmation of non-impairment ofFSA’s ratings and other related factors, and is also subject to restrictionscontained in the New York Insurance Law. Under New York Insurance Law, FSAmay pay dividends out of statutory earned surplus, provided that, together withall dividends declared or distributed by FSA during the preceding12 months, the dividends do not exceed the lesser of:

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

·       adjustednet investment income during this period.

Based on FSA’s statutorystatements for 2006, the maximum amount available for payment of dividends byFSA without regulatory approval over the 12 months following December 31,2006 was approximately $156.6 million.

***Financial GuarantyInsurance Regulation in Other Jurisdictions***

FSA is subject to laws andregulations of jurisdictions other than the State of New York concerning thetransaction of financial guaranty insurance. The laws and regulations of theseother jurisdictions are generally not more stringent in any material respectthan the New 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 guarantees 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 and the Japan Financial Services Authority regulates theactivities of FSA’s Tokyo branch. Upon receipt of a license to transact financialguaranty insurance in Mexico, FSA Mexico will become subject to regulation bythe Ministry of Finance and the Mexican National Commission of Insurance andFinance.

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

Dexiaindirectly owns 99.7% of the Company’s common stock. Because Dexia has anon-U.S. bank subsidiary with a branch in the U.S., Dexia and all of itssubsidiaries, including the Company and its subsidiaries, are subject to theU.S. Bank Holding Company Act (the “BHC Act”). In general, the BHC 

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Act restricts the activities of banking organizationsand their affiliates to the ownership and operation of banks and to otheractivities that are “closely related to banking” as determined by the Board ofGovernors of the Federal Reserve System. Insurance activities such as thoseconducted by certain of the Company’s subsidiaries are generally notpermissible under this restriction. Under the BHC Act, however, an organizationthat qualifies as a “financial holding company” is permitted to engage in abroader range of permissible “financial activities.” “Financial activities”include insurance underwriting and agency activities as well as merchantbanking. For Dexia to qualify as a “financial holding company,” it and itsnon-U.S. bank subsidiary with a branch in the U.S. must be both:

·       “wellcapitalized,” which requires a Tier I capital to risk-based assets ratio of atleast 6% and a total capital to risk-based assets ratio of at least 10%, ascalculated under home country standards (Tier I, or core, capital includes equitycapital less certain intangibles), and

·       “wellmanaged,” which requires a composite U.S. banking office examination rating bythe relevant U.S. bank regulator of at least “satisfactory.”

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

**Investments**

In addition to theinvestment portfolios maintained by the Company’s insurance companysubsidiaries and directly by FSA Holdings (collectively, the “GeneralInvestment Portfolio”), the Company maintains investments from proceeds ofFSA-insured GICs (the “FP Investment Portfolio”), the portfolio of securitiesowned by the VIEs (the “VIE Investment Portfolio”) and assets acquired fromrefinancing transactions. The FP Investment Portfolio and the VIE InvestmentPortfolio together constitute the “FP Segment Investment Portfolio.”

As of December 31,2006, the Company also had investments in strategic partners, including:

·       XLFA;and

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

On October 4, 2005,the Company sold its investment in SPS Holding Corp. (“SPS”) (formerlyFairbanks Capital Holding Corp.), a residential mortgage loan servicer, to anunaffiliated third party. For its interest in SPS, the Company was paid $42.9million in cash. The Company has subsequently received an additional net amountof $11.2 million, and expects to receive additional amounts from time to timethrough March 31, 2008, out of income earned by SPS through December 31,2007 from certain of its mortgage servicing activities. Under the saledocuments, the Company’s subsidiary that owned the SPS investment maderepresentations and warranties to, and undertook specified indemnificationobligations for the benefit of, the purchaser.

***Investments Insuredby the Company***

Both the GeneralInvestment Portfolio and the FP Investment Portfolio include fixed-incomeinvestments insured by FSA (“FSA-Insured Investments”).  At December 31, 2006, the GeneralInvestment Portfolio included $303.3 million of FSA-Insured Investments,representing approximately 6.3% of the portfolio, and the FP InvestmentPortfolio included $732.1 million of FSA-Insured Investments, measured atfair value, representing approximately 4.4% of the portfolio.

The Company, like itsindustry peers, records these investments as available-for-sale securities andcarries them at fair value, which includes the effect of the embedded FSAguaranty. The Company’s accounting treatment of the FSA-Insured Investments isbased on Statement of Financial Accounting Standards No. 115, “Accountingfor Certain Investments in Debt and Equity Securities,” which requires 

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thatinvestment securities be carried at fair value, applying quoted prices whereavailable. Quoted prices reflect the value of the embedded FSA insurance policyand related Triple-A rating.

***General InvestmentPortfolio***

Management’s primaryobjective in managing the General Investment Portfolio is to generate anoptimal level of after-tax investment income while preserving capital andmaintaining adequate liquidity, subject to rating agency capital adequacycriteria that reduce credit for investments based on their ratings to theextent rated less than Triple-A. The General Investment Portfolio is managed byunaffiliated professional investment managers and the Company’s affiliate FSAPortfolio Management, which manages the majority of the Company’s municipalportfolio. The investment management function is overseen by the InvestmentCommittee of the Company’s Board of Directors.

To accomplish itsobjectives, the Company has established guidelines for eligible fixed-incomeinvestments by FSA, requiring that at least 95% of such investments be rated atleast Single-A at acquisition and the overall portfolio be rated Double-A on average.Fixed-income investments falling below the minimum quality level are disposedof at such time as management deems appropriate. For liquidity purposes, theCompany’s policy is to invest primarily in readily marketable investments withno legal or contractual restrictions on resale. Eligible fixed-incomeinvestments include U.S. Treasury and agency obligations, corporate bonds,tax-exempt bonds, asset-backed securities and mortgage-backed securities.In applying its investment guidelines, the Company uses the published ratingfor FSA-Insured Investments, rather than the rating that such securities wouldhave without giving effect to the FSA guaranty, referred to as the “shadowrating.”  The Company’s currentinvestment strategy is to invest in quality, readily marketable instruments ofintermediate average duration so as to generate stable investment earnings withminimal market value or credit risk.

The weighted averagematurity of the fixed-income securities in the General Investment Portfolio asof December 31, 2006 was approximately 12 years.

The Company’s investmentin XLFA preferred stock is included in the General Investment Portfolio.

The following tables setforth certain information concerning the fixed-income securities in the Company’sGeneral Investment Portfolio based on amortized cost:

**General InvestmentPortfolio Fixed-income Securities by RatingAs of December 31, 2006(1)**

| **Rating**    | ** ** | ** ** | ** ** | **Percent of  Investment  Portfolio** | ** ** |
|---------------|------------|------------|------------|--------------------------------------------|------------|
| AAA(2)        |       |       | 85.8       | %                                          |       |
| AA            |       |       | 11.2       |                                       |       |
| A   |       |       | 2.9        |                                       |       |
| NR            |       |       | 0.1        |                                       |       |
| Total         |       |       | 100.0      | %                                          |       |

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(1)          Excludes equitysecurities held in the General Investment Portfolio. As of December 31,2006, equity securities accounted for 1.2% of the General Investment Portfolio’samortized cost and are not rated. Ratings are based on the lower of Moody’s orS&P ratings available as of December 31, 2006. 6.2% of the bondsincluded in the General Investment Portfolio were rated Triple-A by virtue ofinsurance provided by FSA. Over 95% of the FSA-Insured Investments wereinvestment grade without giving effect to the FSA insurance. The average shadowrating of the FSA-Insured Investments was in the Double-A range.

(2)          IncludesU.S. Treasury obligations, which comprised 4.0% of the portfolio as of December 31,2006.

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**Summaryof Investments**
|                                | ** ** | **As of December 31,** | ** ** |
|--------------------------------|------------|---------------------------------------|------------|
| ** **                     | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| **Investment Category**   | ** ** | ** **                            | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **                     | ** ** | **(dollars in thousands)**  | ** ** |
| Long term investments:         |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Taxable bonds                  |       | $                                     | 882,326    |   |   | 4.92 | % |   | $ | 788,298 |   |   | 4.61 | % |   |
| Tax-exempt bonds               |       | 3,663,821                             |       |   | 4.91 |   |   | 3,431,046 |   |   | 4.77 |   |   |
| Total long-term investments    |       | 4,546,147                             |       |   | 4.91 |   |   | 4,219,344 |   |   | 4.74 |   |   |
| Short-term  investments        |       | 96,055                                |       |   | 4.55 |   |   | 159,133 |   |   | 3.06 |   |   |
| Total fixed-income investments |       | 4,642,202                             |       |   | 4.91 |   |   | 4,378,477 |   |   | 4.68 |   |   |
| Equity  investments            |       | 54,291                                |       |   |   |   |   | 54,370 |   |   |   |   |   |
| Total investments              |       | $                                     | 4,696,493  |   |   |   |   |   | $ | 4,432,847 |   |   |   |   |   |
|                                |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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

**General InvestmentPortfolio by Security Type**
|                                        | ** ** | **As of December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| **Investment Category**           | ** ** | ** **                            | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**  | ** ** |
| U.S. government  and agency securities |       | $                                     | 165,530    |   |   | 4.72 | % |   | $ | 195,495 |   |   | 4.49 | % |   |
| Mortgage-backed  securities            |       | 262,651                               |       |   | 5.37 |   |   | 250,001 |   |   | 5.24 |   |   |
| Municipal bonds                        |       | 3,663,821                             |       |   | 4.91 |   |   | 3,431,046 |   |   | 4.77 |   |   |
| Asset-backed  securities               |       | 22,858                                |       |   | 4.60 |   |   | 40,216 |   |   | 3.84 |   |   |
| Corporate  securities                  |       | 218,222                               |       |   | 4.96 |   |   | 186,369 |   |   | 4.66 |   |   |
| Foreign  securities                    |       | 213,065                               |       |   | 4.54 |   |   | 116,217 |   |   | 3.62 |   |   |
| Total long-term  investments           |       | 4,546,147                             |       |   | 4.91 |   |   | 4,219,344 |   |   | 4.74 |   |   |
| Short-term  investments                |       | 96,055                                |       |   | 4.55 |   |   | 159,133 |   |   | 3.06 |   |   |
| Total fixed-income investments         |       | 4,642,202                             |       |   | 4.91 |   |   | 4,378,477 |   |   | 4.68 |   |   |
| Equity  investments                    |       | 54,291                                |       |   |   |   |   | 54,370 |   |   |   |   |   |
| Total investments                      |       | $                                     | 4,696,493  |   |   |   |   |   | $ | 4,432,847 |   |   |   |   |   |
|                                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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

The amortized cost andfair value of bonds in the General Investment Portfolio as of December 31,2006 and 2005, by contractual maturity, are shown below. Actual maturitiescould differ from contractual maturities because borrowers have the right tocall or prepay certain obligations with or without call or prepaymentpenalties.

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**Distributionof Fixed-Income Investments by Contractual Maturity**
|                                         | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                              | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| **Investment Category**            | ** ** | ** **                            | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| ** **                              | ** ** | **(in thousands)**               | ** ** |
| Due in one year  or less                |       | $                                     | 212,414    |   | $ | 212,768 |   | $ | 251,443 |   | $ | 251,505 |   |
| Due after one  year through five years  |       | 1,167,172                             |       | 1,223,913 |   | 1,188,212 |   | 1,248,314 |   |
| Due after five  years through ten years |       | 865,890                               |       | 894,927 |   | 670,694 |   | 701,085 |   |
| Due after ten  years                    |       | 2,111,217                             |       | 2,204,144 |   | 1,977,911 |   | 2,054,046 |   |
| Mortgage-backed  securities             |       | 262,651                               |       | 259,468 |   | 250,001 |   | 246,246 |   |
| Asset-backed  securities                |       | 22,858                                |       | 22,870 |   | 40,216 |   | 39,974 |   |
| Total  fixed-income investments         |       | $                                     | 4,642,202  |   | $ | 4,818,090 |   | $ | 4,378,477 |   | $ | 4,541,170 |   |
|                                         |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Mortgage-BackedSecuritiesCost and Market Value by Investment Category**
|                                                      | ** ** | **As of December 31, 2006** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                           | ** ** | **Par Value**                              | ** ** | **Amortized  Cost** | ** ** | **Fair Value** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                         | ** ** |
| Pass-through  securities—U.S. Government agency |       | $                                               | 238,442    |   | $ | 238,848 |   | $ | 235,970 |   |
| CMOs—U.S.  Government agency                    |       | 8,683                                           |       | 8,820 |   | 8,715 |   |
| CMOs—non-agency                                 |       | 14,820                                          |       | 14,983 |   | 14,783 |   |
| Total mortgage-backed  securities                    |       | $                                               | 261,945    |   | $ | 262,651 |   | $ | 259,468 |   |

 

The Company’s investments in mortgage-backedsecurities primarily consisted of pass-through certificates and collateralizedmortgage obligations (“CMOs”), which are backed by mortgage loans guaranteed orinsured by agencies of, or sponsored by, the federal government. Thesesecurities are highly liquid with readily determinable market prices. TheCompany also held, as of December 31, 2006, Triple-A-rated CMOs which arenot guaranteed by government agencies. Secondary-market quotations areavailable for these securities, although they are not as liquid as governmentagency-backed securities.

The CMOs held as of December 31, 2006 have statedmaturities ranging from two to 29 years and expected average lives rangingfrom one to 16 years based on anticipated prepayments of principal.

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

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***FP Investment Portfolio***

The following tables setforth certain information concerning the FP Investment Portfolio based onamortized cost:

**FP InvestmentPortfolio by RatingAs of December 31, 2006(1)(2)**

| **Rating** | ** ** | ** ** | ** ** | **Percent of Investment  Portfolio** | ** ** |
|------------|------------|------------|------------|------------------------------------------------|------------|
| AAA        |       |       | 91.9       | %                                              |       |
| AA         |       |       | 7.0        |                                           |       |
| A     |       |       | 1.1        |                                           |       |
| Total      |       |       | 100.0      | %                                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available as of December 31, 2006.

(2)          4.4%of the FP Investment Portfolio was rated Triple-A by virtue of insuranceprovided by FSA. Over 97% of the FSA-Insured Investments were investment gradewithout giving effect to the FSA insurance. The average shadow rating of theFSA-Insured Investments was in the Triple-B range.

**Summaryof FP Investment Portfolio**
|                          | ** ** | **December 31,**                | ** ** |
|--------------------------|------------|--------------------------------------|------------|
| ** **               | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **               | ** ** | **Amortized  Cost**                  | ** ** | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **               | ** ** | **(dollars in thousands)** | ** ** |
| FP Investment Portfolio: |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Taxable bonds            |       | $                                    | 15,681,969 |   |   | 5.57 | % |   | $ | 11,754,330 |   |   | 3.54 | % |   |
| Short-term investments   |       | 640,226                              |       |   | 5.26 |   |   | 1,015,509 |   |   | 3.31 |   |   |
| Total investments        |       | $                                    | 16,322,195 |   |   | 5.53 |   |   | $ | 12,769,839 |   |   | 3.53 |   |   |

----

(1)          Yieldsare stated on a pre-tax basis. The weighted average yield presented isnet of the effects of derivative instruments used to economically convertinterest rates from fixed to floating rate.

**FPInvestment Portfolio by Security Type**
|                                        | ** ** | **As of December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| **Investment Category**           | ** ** | ** **                            | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** | **Amortized  Cost** | ** ** | **Weighted  Average  Yield(1)** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**  | ** ** |
| Mortgage-backed  securities            |       | $                                     | 7,639,645  |   |   | 5.58 | % |   | $ | 2,821,562 |   |   | 3.31 | % |   |
| Municipal bonds                        |       | 1,195,326                             |       |   | 4.75 |   |   | 809,856 |   |   | 3.93 |   |   |
| U.S. government  and agency securities |       | 217,754                               |       |   | 5.64 |   |   | 175,703 |   |   | 3.31 |   |   |
| Asset-backed  and other securities     |       | 6,629,244                             |       |   | 5.72 |   |   | 7,947,209 |   |   | 3.56 |   |   |
| Total fixed maturities                 |       | 15,681,969                            |       |   | 5.57 |   |   | 11,754,330 |   |   | 3.54 |   |   |
| Short-term  investments                |       | 640,226                               |       |   | 5.26 |   |   | 1,015,509 |   |   | 3.31 |   |   |
| Total investments                      |       | $                                     | 16,322,195 |   |   | 5.53 |   |   | $ | 12,769,839 |   |   | 3.53 |   |   |
|                                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

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

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The amortized cost andfair value of bonds in the FP Investment Portfolio as of December 31,2006, by contractual maturity, are shown below. Actual maturities could differfrom contractual maturities because borrowers have the right to call or prepaycertain obligations with or without call or prepayment penalties.

**Distributionof FP Investments by Contractual Maturity**
|                                                                         | ** ** | **As of December 31, 2006** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| **Investment Category**                                            | ** ** | ** **                                      | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| ** **                                                              | ** ** | **(in thousands)**                         | ** ** |
| Due in one year  or less                                                |       | $                                               | 640,226    |   | $ | 640,226 |   |
| Due after five  years through ten years                                 |       | 28,429                                          |       | 28,386 |   |
| Due after ten  years                                                    |       | 1,384,651                                       |       | 1,416,372 |   |
| Mortgage-backed  securities (stated maturities of 4 to 39 years)        |       | 7,639,645                                       |       | 7,657,942 |   |
| Asset-backed  and other securities (stated maturities of 1 to 49 years) |       | 6,629,244                                       |       | 6,646,448 |   |
| Total investments                                                       |       | $                                               | 16,322,195 |   | $ | 16,389,374 |   |
|                                                                         |            |                                                 |            |  |  |  |  |  |  |

 

***VIE Investment Portfolio***

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

All bonds in the VIEInvestment Portfolio are insured by FSA. The credit quality of the VIEInvestment Portfolio, without the benefit of FSA’s insurance, as of December 31,2006 was as follows:

**VIE InvestmentPortfolio by Rating(1)**

| **Rating** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|------------|------------|------------|------------|--------------------------------|------------|
| AAA        |       |       | 1.5        | %                              |       |
| A     |       |       | 80.8       |                           |       |
| NR         |       |       | 17.7       |                           |       |
| Total      |       |       | 100.0      | %                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available as of December 31, 2006.

Theamortized cost and estimated fair value of bonds in the VIE Investment Portfoliowere as follows:

| ** **                                             | ** ** | **As of December 31, 2006** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                             | ** ** | **Amortized Cost**                         | ** ** | **Fair Value** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                         | ** ** |
| Obligations of  U.S. states and political subdivisions |       |                                            | $          | 15,750 |   |   | $ | 15,750 |   |
| Foreign                                                |       |                                            | 9,086      |   |   | 9,643 |   |
| Asset-backed  securities(1)                            |       |                                            | 1,102,862  |   |   | 1,102,862 |   |
| Short term  investments                                |       |                                            | 19,478     |   |   | 19,478 |   |
| Total                                                  |       |                                            | $          | 1,147,176 |   |   | $ | 1,147,733 |   |

 

 

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

----

(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, as is primarily the case. Management believes thatamortized cost closely approximates fair value for these securities.

Theamortized cost and fair value of bonds in the VIE Investment Portfolio as of December 31,2006, by contractual maturity, are shown below. Actual maturities could differfrom contractual maturities because borrowers have the right to call or prepaycertain obligations with or without call or prepayment penalties.

| ** **                                                    | ** ** | **As of December 31, 2006** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                    | ** ** | **Amortized Cost**                         | ** ** | **Fair Value** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                         | ** ** |
| Due in one year  or less                                      |       |                                            | $          | 19,478 |   |   | $ | 19,478 |   |
| Due after one  year through five years                        |       |                                            | 9,086      |   |   | 9,643 |   |
| Due after ten  years                                          |       |                                            | 15,750     |   |   | 15,750 |   |
| Asset-backed  securities (stated maturities of 2 to 14 years) |       |                                            | 1,102,862  |   |   | 1,102,862 |   |
| Total                                                         |       |                                            | $          | 1,147,176 |   |   | $ | 1,147,733 |   |

 

**Employees**

As of December 31,2006, the Company had 375 employees. None of its employees are covered bycollective bargaining agreements. The Company considers its employee relationsto be satisfactory.

**AvailableInformation**

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

**Forward-LookingStatements**

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.

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In its filings withthe Securities and Exchange Commission (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 Companycautions that a number of important factors could cause actual results todiffer materially from the plans, objectives, expectations, estimates andintentions expressed in forward-looking statements made by the Company.These factors include:

·       therisks discussed in Item 1A of this report;

·       changesin capital requirements or other criteria of securities rating agenciesapplicable to FSA;

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

·       changes in domestic or foreign laws or regulationsapplicable to the Company, its competitors or its clients;

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

·       an economic downturn or other economic conditions(such as a rising interest rate environment) adversely affecting transactionsinsured by FSA or its General Investment Portfolio;

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

·       disruptionsin cash flow on FSA-insured structured transactions attributable to legalchallenges to such structures;

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

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

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

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

·       prepayment speeds on FSA-insured asset-backedsecurities and other factors that may influence the amount of installmentpremiums paid to FSA; 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.

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**Item 1A.**                RiskFactors.

The information containedin this report may contain “forward-looking statements” within the meaning of Section 27Aof the Securities Act and Section 21E of the Exchange Act. See “Item 1. Business—Forward-LookingStatements” for important factors that could cause actual results to differmaterially from the plans, objectives, expectations, estimates and intentionsexpressed in forward-looking statements made by the Company. The Company’sactual future results may differ materially depending on a variety of factorsincluding, but not limited to, the risks and uncertainties expressed below.

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

FSA’s ability to originatenew insurance business is based upon the perceived financial strength of FSA’sinsurance, which in turn is based in large part upon the financial strengthratings assigned to FSA by the major securities rating agencies. The ratingagencies base their ratings upon a number of objective and subjective factors.Credit deterioration in FSA’s insured portfolio or changes to rating agencycapital adequacy requirements could impair FSA’s ratings. For a discussion ofother factors that might impair FSA’s ratings, see “Item 1. Business—RatingAgencies.”  Most of the risk factorsmentioned below would be expected to be considered by the rating agencies inassessing FSA’s financial strength.

**The Company’s lossreserves may prove inadequate.**

The Company’s insurancepolicies guarantee financial performance of obligations over specified periodsof time, in some cases over 30 years, and are generally non-cancelable. TheCompany projects expected deterioration and ultimate loss amounts based onhistorical experience in order to estimate probable loss. If an individualpolicy risk has a probable and reasonably estimable loss as of the balancesheet date, the Company establishes a case reserve. For the remaining policyrisks in the portfolio, the Company establishes a non-specific reserve toaccount for inherent credit losses. The establishment of these reserves is asystematic process that considers quantitative and statistical informationtogether with qualitative factors, resulting in management’s best estimate ofinherent losses associated with providing credit protection at a given date.However, the process is inherently uncertain, and the Company cannot assurethat its reserves will prove adequate. If losses in its insured portfoliomaterially exceed the Company’s loss reserves, it could have a material adverseeffect on the financial ratings, results of operations and financial conditionof the Company. For additional discussion of the Company’s reservemethodologies, see “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Results of Operations—Losses and LossAdjustment Expenses.”

**The Company isexposed to large risks.**

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

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**FSA is expandinginto new business lines having a higher potential loss severity.**

In recent years, anincreasing percentage of FSA’s business has included insurance of risks withpotential higher loss severity than its traditional municipal and asset-backedbusiness. FSA expects to continue to expand its participation in these morevolatile business lines, including project finance transactions, future flowsecuritizations and whole business securitizations.

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

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

**Narrow creditspreads could continue to reduce demand and premiums for financial guarantyinsurance.**

Demand for financialguaranty insurance generally reflects prevailing credit spreads. When interestrates are lower or when the market is otherwise relatively non-risk adverse,the spread between insured and uninsured obligations typically narrows and, asa result, financial guaranty insurance typically provides lower cost savings toissuers than it would during periods of relatively wider spreads. These lowercost savings generally lead to a corresponding decrease in demand or premiumsobtainable for financial guaranty insurance.

**Widening creditspreads would reduce the market value of the Company’s FP Investment Portfolio.**

As of December 31,2006, more than 90% of the $16.3 billion in the Company’s FP InvestmentPortfolio was invested in bonds, primarily asset-backed and mortgage-backedbonds. The Company’s objective for its FP business is to generate net interestmargin through borrowing funds at attractive rates in the municipal GIC andother markets and investing the proceeds in obligations satisfying the Company’sunderwriting criteria while minimizing the Company’s exposure to interest ratechanges.  Nonetheless, any increase inprevailing credit spreads would reduce the market value of securities in theCompany’s FP Investment Portfolio, which would in turn reduce the Company’scapital as measured under GAAP.

**Increase in prevailing interest rates would result ina decline in the market value of the Company’s General Investment Portfolio.**

As of December 31,2006, the Company’s General Investment Portfolio was approximately $4.8 billiondollars, almost entirely invested in bonds, primarily municipal bonds. TheCompany’s investment strategy is to invest in highly rated marketableinstruments of intermediate average duration so as to generate stableinvestment earnings with minimal market value or credit risk. Nonetheless, anyincrease in prevailing interest rates would reduce the market value ofsecurities in the Company’s General Investment Portfolio, which would in turnreduce the Company’s capital as measured under GAAP.

**Marking to market the Company’s insured CDS portfoliomay subject the Company’s reported earnings to extreme volatility.**

The Company is required tomark to market certain derivatives, including FSA-insured CDS consideredderivatives, under GAAP. As a result of such treatment, and given the largeprincipal balance of FSA’s insured CDS portfolio, small changes in the marketpricing for insurance of CDS will generally result in recognition by theCompany of material gains or losses, with material market price increases 

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generallyresulting in large reported losses under GAAP. In addition, any previouslyreported mark-to-market gains in respect of FSA’s insured portfolio would beexpected to be reversed through the recognition of losses over the remainingterms of the insured risks. At December 31, 2006, the inception-to-datenet gain on the Company’s insured CDS portfolio was $89.2 million. While management believes thatreported mark to market gains or losses on insured CDS generally do notrepresent true economic gains or losses, certain constituents, includingcapital market participants, may rely upon reported GAAP results. As a result,the Company’s access to capital markets might be impaired if its reportingearnings were considered unusually volatile. See “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Resultsof Operations—Operating Earnings and Adjusted Book Value.”

**Change in industry and other accounting practicescould impair the Company’s reported financial results and impede its ability todo business.**

The Financial AccountingStandards Board (the “FASB”) is evaluating various accounting standardsapplicable to financial guaranty insurers under GAAP, including accounting forclaims liability recognition and premium recognition. The Company and itsindustry peers will be required to implement any changes to GAAP reportingrequirements adopted by the FASB. Any such changes may have an adverse effecton the Company’s reported financial results, including future revenues andnon-GAAP adjusted book value. In addition, changes in the interpretation ofcurrent accounting guidance or the issuance of other new accounting standardsmay affect reported profitability or affect reported earnings during the termsof outstanding risks (so-called “earnings volatility”) and, as such, mayinfluence the types and/or volume of business that management may choose topursue.

**The Company has received subpoenas related to aninvestigation of the municipal GIC industry by the Department of Justice andthe SEC.**

On November 15, 2006,the Company received a subpoena from the Antitrust Division of the U.S.Department of Justice (the “DOJ”) issued in connection with an ongoing criminalinvestigation of bid rigging of awards of municipal GICs. On November 16,2006, FSA received a subpoena from the SEC related to an ongoing industry-widecivil investigation of brokers of municipal GICs. The Company issues municipalGICs through the FP Segment, but does not serve as a GIC broker. The subpoenasrequest that the Company furnish to the DOJ and SEC records and otherinformation with respect to the Company’s municipal GIC business. The Companyis cooperating with the investigations by the DOJ and the SEC. The Company is at risk thatinformation provided pursuant to the subpoenas or otherwise provided to thegovernment in the course of its investigation will lead to indictments of theCompany and/or its employees, with the potential for convictions or settlementsproviding for the payment of fines, restrictions on future business activitiesand, in the case of individual employees, imprisonment. Such an adverse outcomewould damage the reputation of the Company and might impair the ability of theCompany to conduct its financial products business and its financial guarantybusiness.

**Change inapplicable law could impede the Company’s ability to do business.**

The Company’s businessesare subject to direct and indirect regulation under, among other things, stateinsurance laws, federal securities law, the U.S. Bank Holding Company Act, taxlaw and legal precedents affecting public finance and asset-backed obligations,as well as applicable law in the other countries in which the Company operates.Future legislative, regulatory or judicial changes in the U.S. or abroad couldadversely affect the Company’s business by, among other things, placing limitson the Company’s ability to carry out its non-insurance business, loweringapplicable single or aggregate risk limits, increasing the level of supervisionor regulation to which its operations may be subject, or creating restrictionsthat make the Company’s products less attractive to potential buyers. Foradditional 

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informationregarding the regulations to which the Company is subject, see “Item 1.Business—Insurance Regulatory Matters” and “—U.S. Bank Holding Company Act.”

**Change in management personnel or share ownership mayhave an adverse effect on the Company’s business.**

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

**Losses may result from the ineffectiveness of hedgesor unanticipated timing of withdrawals of funds in the Company’s FP Segment.**

The Company hedgesinterest rate risks in its FP Segment by investing in floating rate instrumentsand issuing floating rate liabilities, or by employing derivative products toobtain the same economic result. Judgments are made in this process regardingthe expected timing of withdrawals of funds under GICs and other financialproducts. The Company may be exposed to unexpected losses if its hedgingstrategy proves ineffective or its judgments prove inaccurate.

**The Company’s ability to make debt service payments onits outstanding debt is subject to its insurance company operations.**

Because it is a holdingcompany, the registrant does not conduct operations or generate materialincome. Instead, the Company’s financial condition and results of operations,and thus its long-term ability to service its debt, will largely depend on itsreceipt of dividends from, or payment on surplus notes or share repurchases by,FSA. FSA’s ability to declare and pay dividends to the Company depends, amongother factors, upon FSA’s financial condition, results of operations, cashrequirements, and compliance with rating agency requirements for maintainingits Triple-A ratings, and is also subject to restrictions contained in theapplicable insurance laws and regulations. Based on FSA’s statutory statementsfor 2006, the maximum amount available for payment of dividends by FSA withoutregulatory approval over the 12 months following December 31, 2006 isapproximately $156.6 million. Payments on surplus notes or sharerepurchases by FSA require regulatory approval.

**Downgrade or default of one or more of the Company’sreinsurers could reduce the Company’s capital adequacy and return on equity.**

As of December 31,2006, the Company had reinsured approximately 24.5% of its principal amount ofinsurance outstanding. In evaluating the credits insured by the Company,securities rating agencies allow “credit” for reinsurance, based on thereinsurers’ ratings. In recent years, a number of the Company’s reinsurers weredowngraded by one or more rating agencies, resulting in decreases in the creditallowed for reinsurance and in the financial benefits of using reinsuranceunder existing rating agency capital adequacy models. By itself, a downgrade ofall reinsurers to Double-A would not impair the Company’s Triple-Aratings. However, it would reduce the “margin of safety” by which the Companywould survive a theoretical catastrophic depression, and a more significantdowngrade of the reinsurers could impair the Company’s Triple-A ratings. TheCompany could be required to raise additional capital to replace the lostreinsurance credit in order to meet capital adequacy requirements. The ratingagencies’ reduction in credit for reinsurance could also ultimately reduce theCompany’s return on equity to the extent that ceding commissions paid to theCompany by the reinsurers were not increased to compensate for such reduction.For further information regarding the Company’s use of reinsurance, see “Item1. Business—Reinsurance.”

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**The Company’sinternational operations expose it to less predictable credit and legal risks.**

The Company pursuesopportunities in international markets and currently operates in variouscountries in Europe, the Asia Pacific region and Latin America. Theunderwriting of obligations of an issuer in a foreign country involves the sameprocess as that for a domestic issuer, but additional risks must be addressed,such as the evaluation of foreign currency exchange rates, foreign business andlegal issues, and the economic and political environment of the foreign countryor countries in which an issuer does business. Changes in such factors couldimpede the Company’s ability to insure, or increase the risk of loss frominsuring, obligations in the countries in which it currently does business andlimit its ability to pursue business opportunities in other countries.

**Item 1B.**               UnresolvedStaff Comments.

Item 1B is not applicableto the Company, because the Company is not an accelerated filer or largeaccelerated filer, as defined in Rule 12b-2 of the Exchange Act, ora well-known seasoned issuer, as defined in Rule 405 of the SecuritiesAct.

**Item 2.**                        Properties.

The principal executive offices of the Company and FSAare located at 31 West 52nd Street, New York, New York, 10019, and 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), Mexico City (Mexico), Paris (France), Singapore, Sydney (Australia)and Tokyo (Japan). The Company and its subsidiaries do not own any materialreal property.

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

**Item 3.**                        LegalProceedings.

In the ordinary course of business, the Company andcertain subsidiaries are parties to litigation. The Company is not subject toany material pending legal proceedings.

On November 15, 2006,the Company received a subpoena from the Antitrust Division of the U.S.Department of Justice issued in connection with an ongoing criminalinvestigation of bid rigging of awards of municipal GICs. On November 16,2006, FSA received a subpoena from the SEC related to an ongoing industry-widecivil investigation of brokers of municipal GICs. The Company issues municipalGICs through the FP Segment, but does not serve as a GIC broker. The subpoenasrequest that the Company furnish to the DOJ and SEC records and otherinformation with respect to the Company’s municipal GIC business. The Companyis cooperating with the investigations by the DOJ and the SEC. See “Item 1A. RiskFactors—The Company has received subpoenas related to an investigation of themunicipal GIC industry by the Department of Justice and the SEC.”

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

No matter was submitted to a vote of security holdersduring the three month period ended December 31, 2006.

42

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**PART II**

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

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

As of March 15, 2007, the only holders of theCompany’s common stock were Dexia Holdings and four current and formerdirectors of the Company who own shares of the Company’s common stock oreconomic interests therein as described in “Item 11. Executive Compensation—Compensationof Directors—Director Share Purchase Program.”

After a period of suspension of dividends, the Companybegan payment of regular quarterly dividends in May 2004, paying$22.9 million in aggregate for 2004 and $71.1 million in aggregatefor 2005. In 2006, the Company paid regular quarterly dividends of $130.0million in aggregate, an extraordinary dividend of $300 million in November 2006and an extraordinary dividend of $100 million in December 2006. In February 2007,the Board of Directors declared a regular quarterly dividend on the Company’scommon stock of $0.91 per share, totaling $30.5 million in aggregate, to bepaid on or before March 31, 2007. Information concerning restrictions onthe payment of dividends is set forth in “Item 1. Business—Insurance RegulatoryMatters—Dividend Restrictions.”

Information about securities authorized for issuanceunder the Company’s equity compensation plans is set forth in “Item 12.Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters—Securities Available Under Equity Compensation Plans.”

The Company does not haveequity securities registered pursuant to Section 12 of the Exchange Act.

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**Item 6.**                        SelectedFinancial Data.

Thefollowing Selected Consolidated Financial Data should be read in conjunctionwith the Consolidated Financial Statements and accompanying notes includedelsewhere herein.

| ** **                                       | ** ** | **As of and for the Year Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                       | ** ** | **(in millions)**                                                                | ** ** |
| **SUMMARY OF OPERATIONS(a)**                     | ** ** | ** **                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross premiums  written                          |       | $                                                                                     | 816.0      |   | $ | 833.8 |   | $ | 832.0 |   | $ | 895.8 |   | $ | 803.7 |   |
| Net premiums  written                            |       | 527.2                                                                                 |       | 577.7 |   | 587.8 |   | 614.3 |   | 532.7 |   |
| Net premiums earned                              |       | 388.7                                                                                 |       | 404.1 |   | 395.0 |   | 356.4 |   | 314.9 |   |
| Net investment  income                           |       | 218.9                                                                                 |       | 200.8 |   | 172.1 |   | 154.0 |   | 139.1 |   |
| Net income                                       |       | 424.2                                                                                 |       | 326.1 |   | 378.6 |   | 298.1 |   | 197.0 |   |
| **BALANCE SHEET DATA(a)**                        | ** ** | ** **                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total investment  portfolio(b)                   |       | 22,747.4                                                                              |       | 19,065.4 |   | 14,577.7 |   | 10,000.2 |   | 5,037.4 |   |
| Total assets(b)                                  |       | 25,773.6                                                                              |       | 22,001.6 |   | 17,081.0 |   | 12,407.6 |   | 7,045.8 |   |
| Deferred premium  revenue                        |       | 2,653.3                                                                               |       | 2,375.1 |   | 2,095.4 |   | 1,845.0 |   | 1,448.2 |   |
| Losses and loss  adjustment expense              |       | 228.1                                                                                 |       | 205.7 |   | 179.9 |   | 233.4 |   | 223.6 |   |
| Notes payable                                    |       | 730.0                                                                                 |       | 430.0 |   | 430.0 |   | 430.0 |   | 430.0 |   |
| GIC and VIE  debt(b)                             |       | 18,349.7                                                                              |       | 14,947.1 |   | 10,444.1 |   | 6,639.4 |   | 2,409.9 |   |
| Common  shareholders’ equity                |       | 2,722.3                                                                               |       | 2,822.9 |   | 2,611.3 |   | 2,219.2 |   | 1,919.4 |   |
| **ADDITIONAL DATA**                              | ** ** | ** **                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Qualified  statutory capital(c)                  |       | 2,554.1                                                                               |       | 2,417.5 |   | 2,280.9 |   | 2,104.3 |   | 1,876.1 |   |
| Total claims-paying  resources(d)                |       | 6,055.8                                                                               |       | 5,675.8 |   | 5,230.6 |   | 4,657.7 |   | 3,819.1 |   |
| Net par  outstanding                             |       | 359,559.8                                                                             |       | 337,483.0 |   | 317,742.6 |   | 289,200.2 |   | 263,010.5 |   |
| Net insurance in  force (principal and interest) |       | 531,421.0                                                                             |       | 480,184.5 |   | 444,511.5 |   | 403,019.4 |   | 364,908.5 |   |
| Total dividends                                  |       | 530.0                                                                                 |       | 71.1 |   | 22.9 |   | — |   | 11.7 |   |
|                                                  |            |                                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(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 is 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.

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**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 public financeand asset-backed obligations and attractively priced guaranteedinvestment contracts (“GICs”), in order to produce a reliable, predictableearnings stream. Strategically, the Company seeks to maintain balancedcapabilities across domestic and international public finance and asset-backedmarkets in order to allow the flexibility to pursue the most attractiveopportunities available at any point in the business cycle. References to the “Company”are to Financial Security Assurance Holdings Ltd. together with itssubsidiaries.

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 2006 GAAPresults with those of 2005, the Company’s net income increased 30.1% to $424.2million. Gross premiums written decreased 2.1% to $816.0 million. Shareholders’equity decreased 3.6% to $2.7 billion.

**Results ofOperations**

***Premiums***

**Net Earned andWritten Premiums**

| ** **                                                | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                | ** ** | **(in millions)**                     | ** ** |
| Premiums written,  net of reinsurance                     |       | $                                          | 527.2      |   | $ | 577.7 |   | $ | 587.8 |   |
| Premiums earned,  net of reinsurance                      |       | 388.7                                      |       | 404.1 |   | 395.0 |   |
| Net premiums earned  excluding refundings and prepayments |       | 339.9                                      |       | 349.8 |   | 350.6 |   |
|                                                           |            |                                            |            |  |  |  |  |  |  |  |

 

Net premiums earneddecreased 3.8% in 2006 and increased 2.3% in 2005. Excluding the effects ofrefundings and prepayments, net premiums earned decreased 2.8% in 2006 and 0.2%in 2005. Refundings and prepayments result from interest rate movements andother factors outside the Company’s control, and no assurance can be given thatrefundings and prepayments will continue at the recent level. The decline innet premiums earned reflects a decrease in asset-backed premiums, offset inpart by an increase in public finance earned premiums.

***New Business Production***

For each accountingperiod, the Company estimates the present value of originations (“PV originations”).This non-GAAP measure consists of the total present value of premiumsoriginated (“PV premiums originated”) by Financial Security Assurance Inc.and its subsidiaries (“FSA”) and the present value of future net interestmargin (“PV NIM”) originated by the Company’s financial products (“FP”)business (the “FP Segment”). The Company generated PV originations of$910.2 million in 2006, $1,014.0 million in 2005 and $927.2 million in2004. Management believes that by disclosing the components of PV originationsin addition to premiums written, the Company provides investors with a morecomprehensive description of its new business activity in a given period.

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*Present Value ofPremiums Originated*

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

The Company’s insurance policies and insured creditderivative contracts are generally non-cancelable and remain outstandingfor years from date of inception, in some cases 30 years or longer.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 and foreign exchange rate fluctuation, 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 insurance policy.Future installment premiums are not captured in premiums earned or premiumswritten, the most comparable GAAP measures. Management therefore uses PVpremiums originated to evaluate current business production.

PV premiums originated reflects estimated futureinstallment premiums discounted to their present value, as well as upfrontpremiums, for business originated during the reporting period. To calculate PVpremiums originated, management discounts an estimate of all future installmentpremium receipts. The Company calculates the discount rate for PV premiumsoriginated as the average pre-tax yield on its insurance investmentportfolio for the previous three years. This rate serves as a proxy for thereturn that could be achieved if the premiums had been received upfront. Theestimated installment premium receipts are determined based on each installmentpolicy’s projected par balances outstanding multiplied by its premium rate. TheCompany’s Transaction Oversight Groups estimate the relevant schedule of futurepar balances outstanding for each insurance policy with installment premiums.At the time of origination, projected debt schedules are generally based ongood faith estimates developed and used by the parties negotiating thetransaction.

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 5.07% for 2006 originations, 5.30% for 2005 originationsand 5.62% for 2004 originations. Management intends to revise the discount ratein future years according to the same methodology, in order to reflect specificreturn results realized by the Company.

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

| ** **                                          | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                          | ** ** | **(in millions)**                     | ** ** |
| Gross premiums  written                             |       | $                                          | 816.0      |   | $ | 833.8 |   | $ | 832.0 |   |
| Gross installment  premiums received                |       | (241.9                                     | )          | (280.5 | ) | (332.4 | ) |
| Gross upfront  premiums originated                  |       | 574.1                                      |       | 553.3 |   | 499.6 |   |
| Gross PV estimated  installment premiums originated |       | 215.6                                      |       | 368.1 |   | 353.9 |   |
| Gross PV premiums  originated                       |       | $                                          | 789.7      |   | $ | 921.4 |   | $ | 853.5 |   |

 

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*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 majorbusiness sectors for transactions closed in the period.

**PublicFinance New Originations**

| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **United States:**                          |       |                                       |       |   |   |   |   |
| Gross par insured  (in billions)            |       | $                                          | 46.5       |   | $ | 64.8 |   | $ | 49.0 |   |
| Gross PV premiums  originated (in millions) |       | 309.6                                      |       | 484.5 |   | 433.5 |   |
| **International:**                          |       |                                       |       |   |   |   |   |
| Gross par insured  (in billions)            |       | $                                          | 9.4        |   | $ | 7.5 |   | $ | 2.7 |   |
| Gross PV premiums  originated (in millions) |       | 317.7                                      |       | 185.3 |   | 127.5 |   |

 

After strong new-issue volume in the fourth quarter,total issuance in the U.S. municipal bond market reached $387.7 billion for theyear on a sale-date basis. This reflected a decline of approximately 5% from$408.3 billion in 2005, which was up 13% from $359.7 billion in 2004. Reducedrefunding volume during 2006 was largely offset by growth in new-moneyissuance. Insurance penetration was approximately 49%, compared with 57% in 2005and 54% in 2004. In all three years, low interest rates and continuing needsfor infrastructure investment drove municipal borrowing levels. Of the insuredpar amount of municipal bonds sold each year, FSA guaranteed approximately 24%in 2006, 26% in 2005 and 24% in 2004.

Including both primary and secondary obligations withclosing dates in 2006, FSA’s U.S. public finance par insured declined 28.3%,and PV premiums originated declined 36.1%, as FSA increased its strategic focuson core municipal sectors where high-quality transactions provided greaterrelative value.

In 2005, FSA’s U.S. public finance par originationincreased 32.3% and the related PV premium originated increased 11.8%. The mixof business shifted toward a greater volume of general obligations, includingschool bonds, and other tax-backed transactions that tend to have lowerabsolute premiums than revenue bonds because of their lower risk.

In international publicfinance, originations grew 26.7% in par insured in 2006, while PV premiums grewat a higher rate, 71.4%, because of longer average lives. Originations werestrongest in the United Kingdom and Australia, but FSA also guaranteed publicfinance transactions in Western and Central Europe, Asia and the Americas. In2005, international public finance originations grew 173.0% in par insured and45.3% in PV premiums. FSA insured infrastructure transactions in the UnitedKingdom, Australia, Canada, Western Europe and Asia. Expanding use ofpublic-private partnership financings has helped drive growth in this sector.

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**Asset-BackedNew Originations**

| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **United States:**                          |       |                                       |       |   |   |   |   |
| Gross par insured  (in billions)            |       | $                                          | 28.6       |   | $ | 24.5 |   | $ | 48.6 |   |
| Gross PV premiums  originated (in millions) |       | 113.4                                      |       | 195.4 |   | 234.2 |   |
| **International:**                          |       |                                       |       |   |   |   |   |
| Gross par insured  (in billions)            |       | $                                          | 9.3        |   | $ | 6.6 |   | $ | 7.5 |   |
| Gross PV premiums  originated (in millions) |       | 49.0                                       |       | 56.2 |   | 58.3 |   |

 

The Company’s U.S. asset-backed gross parinsured increased 17.0% in 2006 and decreased 49.7% in 2005. The Company’sassociated U.S. PV premiums originated decreased 42.0% in 2006 and 16.6% in2005. Throughout 2006, the asset-backed market was characterized by tightcredit spreads, excess market liquidity and aggressive uninsured structures,which had a negative impact on pricing. Additionally, 2006 originations hadshorter average lives. In 2005, PV premiums originated declined less than paroriginated due to a shift toward longer duration transactions in the mix ofbusiness. Declines in PV premiums from high-premium net interest marginmortgage-backed transactions, which are generally designed to securitize excesscash flow generated by an issuer’s residential mortgage loan securitization,and other residential mortgage transactions represented most of the decrease inPV premiums originated.

Outside the United States,FSA increased international asset-backed par originations by 39.8% in 2006,while PV premiums originated declined 12.7%. This compares with decreases in2005 of 11.2% in the par amount originated and 3.7% in PV premium production. Asin the United States, credit spreads were narrow in international asset-backedmarkets in both 2006 and 2005. In both years, 90% or more of the net par volumeof originations was of Triple-A or Super Triple-A quality. “Super Triple-A”indicates underlying loss protection greater than the Triple-A standard.

*Financial ProductsOriginations*

The FP Segment, in which the Company conducts businessthrough affiliates (the “GIC Affiliates”) and variable interest entities (“VIEs”)produces net interest margin (“FP NIM”) rather than insurance premiums. Likeinstallment premiums, the PV NIM originated is expected to be earned andcollected in future periods.

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

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

Net interest income and net interest expense arereflected in the statements of operations and comprehensive income but arelimited to current-year earnings. As GIC contracts extend beyond thecurrent period, management considers the non-GAAP measure PV NIM to be auseful indicator of future FP NIM to be earned and includes it in the non-GAAPmeasure adjusted book value (“ABV”) as an element of intrinsic value that isnot found in GAAP book value.

The majority of municipal GICs issued by the GICAffiliates relate to debt service reserve funds and construction funds insupport of municipal bond transactions. These funds may be drawn unexpectedly, 

48

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with the result that theactual timing and amount of repayments may differ from the original estimates,which in turn would affect the realization of the estimate of PV NIM originatedin a given accounting period.

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

**FinancialProducts PV NIM Originated**

| ** **                                                    | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                    | ** ** | **(in millions)**                     | ** ** |
| Gross present  value of future net interest margin originated |       | $                                          | 120.5      |   | $ | 92.6 |   | $ | 73.7 |   |
|                                                               |            |                                            |            |  |  |  |  |  |  |  |

 

PV NIM originationsincreased 30.1% in 2006 and 25.6% in 2005, reflecting the general growth trendof the FP Segment.

***Operating Earningsand Adjusted Book Value***

In addition to evaluatingthe Company’s GAAP financial information, management evaluates the Company’sbusiness under certain non-GAAP performance measures that management refers toas operating earnings and ABV. Management uses these two metrics to measure theCompany’s performance and to calculate long-term incentive compensation and theannual bonus pool. Management refers to this information in its presentationswith rating agencies and the Board of Directors. While these metrics are notsubstitutes for reported results under GAAP, management regards operatingearnings and ABV as meaningful indicators of operational performance thatsupplement the information available from GAAP measures. While GAAP provides auniform comprehensive basis of accounting, management believes that operatingearnings are an important additional measure for providing a more completeunderstanding of the Company’s results of operations.

TheCompany defines operating earnings as net income before the effects offair-value adjustments for two items:

1.                Economicinterest rate hedges, defined as interest rate derivatives that are intended tohedge fixed rate assets and liabilities but do not meet the criteria for hedgeaccounting treatment under Statement of Financial Accounting Standards No. 133,“Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”),adjusted so that the impact of any residual hedge ineffectiveness remains inoperating earnings; and

2.                FSA-insuredcredit default swaps (“CDS”) that have investment-grade underlying creditquality and must be marked to fair value under SFAS 133.

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

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CDS contracts aregenerally non-cancelable prior to maturity, and management 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 party for economic losses (in excess of some agreed-upondeductible) related to debt obligations of specified obligors, structured suchthat the risk insured is investment grade without the benefit of the creditprotection provided by the Company. In the event a CDS were to migrate belowinvestment grade, the fair-value impact would be fully reflected in operatingearnings.

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 meant only tosupplement GAAP results by providing additional information regarding theoperational and performance indicators management, the Company’s Board ofDirectors and rating agencies follow most closely to assess performance.

Other limitations arisefrom the specific adjustments that management makes to GAAP results to deriveoperating earnings results. For example, in reversing the unrealized gains andlosses that result from application of SFAS 133 to derivatives that do notqualify for hedge accounting, management focuses on the long-term economiceffectiveness of those instruments relative to the underlying hedged item andisolates the effects of interest rate volatility and changing credit spreads onthe fair value of such instruments during the period. Under GAAP, the effectsof these factors on the fair value of the derivative instruments (but not theunderlying hedged item) tend to show more volatility in the short term. Whilethe Company believes that its presentation presents the economic substance ofits FP Segment, the presentation understates GAAP earnings volatility.

Operating earnings also donot reflect 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, and theCompany does not intend to trade these highly rated, highly structuredcontracts. Accordingly, management believes it is probable that the financialimpact of the fair-value adjustments for the insured CDS will sum to zeroover the finite terms of the exposures, which are typically five to ten yearsat inception. For this reason, management believes that the market volatilityof credit-spread pricing, the primary driver of the Company’s change infair-value results, should not influence a measure of the Company’soperating performance and therefore excludes CDS fair-value adjustments fromoperating earnings.

Operating earningsincreased 8.7% in 2006 and 3.1% in 2005.

Thefollowing table reconciles net income to non-GAAP operating earnings:

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

| ** **                                                                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                      | ** ** | **(in millions)**                     | ** ** |
| Net income                                                                      |       | $                                          | 424.2      |   | $ | 326.1 |   | $ | 378.6 |   |
| Less fair-value  adjustments for economic interest rate hedges, net of taxes(1) |       | 40.5                                       |       | (15.0 | ) | 17.1 |   |
| Less fair-value  adjustments for insured CDS, net of taxes                      |       | 20.7                                       |       | 7.2 |   | 37.7 |   |
| Operating  earnings                                                             |       | $                                          | 363.0      |   | $ | 333.9 |   | $ | 323.8 |   |

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(1)          Hedgeineffectiveness remains in operating earnings. Also, see following table for amore detailed presentation of fair-value adjustments for economic interest ratehedges.

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

| ** **                                                      | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                      | ** ** | **(in millions)**                     | ** ** |
| Fair-value  adjustment for economic interest rate hedges        |       | $                                          | 10.3       |   | $ | (19.0 | ) | $ | 106.5 |   |
| VIE minority  interest                                          |       | 52.0                                       |       | (4.1 | ) | (80.2 | ) |
| Tax effect                                                      |       | (21.8                                      | )          | 8.1 |   | (9.2 | ) |
| Total fair-value  adjustments for economic interest rate hedges |       | $                                          | 40.5       |   | $ | (15.0 | ) | $ | 17.1 |   |

 

***Adjusted Book Value***

To calculate ABV,the following adjustments, on an after-tax basis, are made toshareholders’ equity (GAAP “book value”):

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

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

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

4.                subtraction of thedeferred costs of acquiring policies;

5.                elimination offair-value adjustments for investment grade insured CDS;

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

7.                elimination ofunrealized gains or losses on investments; and

8.                InternationalFinancial Reporting Standards (“IFRS”) adjustments.

Management considers ABV an operating measure of theCompany’s intrinsic value. Book value reflects an estimate of loss for allinsured risks made at the time of contract origination. ABV adds back certainGAAP liabilities and deducts certain GAAP assets (adjustments 1, 4, 5, 6 and 7in the calculation above) and also captures the estimated value of futurecontractual cash flows related to transactions in force as of the balance sheetdate (adjustments 2 and 3 in the calculation above) because installment paymentcontracts, whether in the form of premiums or NIM, are generally non-cancelableand represent a claim to future cash flows. Beginning in 2006, ABV also reflectscertain IFRS adjustments in order to better align the interests of employeeswith the interests of Dexia S.A. (“Dexia”), the Company’s principalshareholder, whose accounts are maintained under IFRS. An investor attemptingto evaluate the Company using GAAP measures alone would not have the benefit ofthis information. In addition, investors may consider the growth of ABV to be aperformance measure indicating the degree to which management has succeeded inbuilding a reliable source of future earnings. Certain of the Company’scompensation formulas are based, in part, on the ABV growth rate or ABV growthrate before IFRS adjustments.

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The limitations of the ABV metric are that it reflectsthe accelerated realization of certain assets and liabilities through equityand relies on an estimate of the amount and timing of the receipt ofinstallment premiums and future net interest margin. Actual installment premiumreceipts could vary from the amount estimated due to differences between actualand estimated insured debt balances outstanding. Actual net interest marginresults could vary from the amount estimated based on sales of investments priorto maturity and variances in the actual timing and amount of repaymentassociated with flexible-draw GICs that the Company issues. ABV excludesthe fair-value adjustments for investment-grade insured CDS and theeffective portion of fair-value adjustments for derivatives that hedge interestrate risk but do not qualify for hedge accounting under SFAS 133.

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

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

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

Through adjustments 5 and 6, the effect of certainitems that are excluded from operating earnings is also excluded from ABV. Asexplained in the preceding discussion of operating earnings, management expectsthe financial impact of the CDS fair-value adjustments, reflected inadjustment 5, to sum to zero over the finite terms of the related exposures.Derivatives reflected in adjustment 6 reduce, on an economic basis, theinterest rate risk of fixed rate assets and liabilities held in the FP Segment,which includes the FSA Global portfolios, although they do not meet SFAS 133hedge-accounting requirements. The Company uses such derivatives to hedgeagainst interest rate volatility, rather than to speculate on the direction ofinterest rates. The intent of management is to hold the derivatives untilexpected maturity along with the related hedged fixed rate assets orliabilities. In addition, through adjustment 7, ABV excludes the effect offair-value adjustments made to investments and reflected in other comprehensiveincome. As the objective is to optimize long-term stable earnings, managementgenerally seeks to minimize turnover and therefore any unrealized investmentgain or loss is subtracted from book value to exclude it from the ABV metric.In the event that an investment is liquidated prior to its maturity, anyrelated gain or loss is reflected in both earnings and ABV without furtheradjustment. Adjustment 8 reflects IFRS accounting treatment of items for whichGAAP and IFRS treatments differ. These accounting differences relate primarilyto foreign exchange, contingencies and fair-value adjustments.

Shareholders’ equity was $2.7 billion and non-GAAPABV was $3.9 billion at December 31, 2006. During 2006, ABV (IFRS basis)grew 14.0%.

The following tablereconciles book value to non-GAAP ABV:

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

| ** **                                                     | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | **(in millions)**                | ** ** |
| Shareholders’  equity (U.S. GAAP)                         |       | $                                     | 2,722.3    |   | $ | 2,822.9 |   |
| After-tax  adjustments:                                        |       |                                  |       |   |   |
| Plus net unearned premium revenues                             |       | 1,071.4                               |       | 981.4 |   |
| Plus present value future net installment premiums  and PV NIM |       | 627.2                                 |       | 556.0 |   |
| Less net deferred acquisition costs                            |       | 221.4                                 |       | 217.8 |   |
| Less fair-value adjustments for insured CDS                    |       | 58.0                                  |       | 37.4 |   |
| Less fair value of economic interest rate hedges               |       | 72.6                                  |       | 42.7 |   |
| Less unrealized gains on investments                           |       | 154.9                                 |       | 131.0 |   |
| Adjusted book  value before IFRS adjustments                   |       | 3,914.0                               |       | 3,931.4 |   |
| IFRS adjustments                                               |       | 4.8                                   |       | (22.1 | ) |
| Adjusted book  value (IFRS basis)                              |       | $                                     | 3,918.8    |   | $ | 3,909.3 |   |

 

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

Net investment income fromthe General Investment Portfolio increased 9.0% in 2006, 16.7% in 2005 and11.7% in 2004, primarily due to higher invested balances arising from newbusiness writings and dividend income from the Company’s equity investment inXL Financial Assurance Ltd (“XLFA”). The dividend rate on the XLFA investmentwas reduced in 2006 from an effective rate of 19% in 2005 to a fixed rate of8.25% in 2006.

**Incomefrom Investments**

| ** **                                                                               | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                               | ** ** | **(in millions)**                     | ** ** |
| Net investment  income                                                                   |       | $                                          | 218.9      |   | $ | 200.8 |   | $ | 172.1 |   |
| Net realized  gains (losses)                                                             |       | (8.3                                       | )          | 6.4 |   | (0.5 | ) |
| Effective tax rate on  investment income, excluding effects of realized gains and losses |       | 12.2                                       | %          | 13.2 | % | 9.2 | % |
|                                                                                          |            |                                            |            |  |  |  |  |  |  |  |

 

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

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***Losses and Loss Adjustment Expenses***

Activityin the liability for losses and loss adjustment expenses, which consists ofcase and non-specific reserves, is summarized as follows:

| ** **                            | ** ** | **Case Reserve Activity for the  Year Ended December 31,** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                            | ** ** | **(in millions)**                                                                        | ** ** |
| Gross balance at  January 1      |       | $                                                                                             | 90.0       |   | $ | 80.6 |   | $ | 121.9 |   |
| Less reinsurance recoverable          |       | 36.3                                                                                          |       | 35.4 |   | 59.2 |   |
| Net balance at  January 1        |       | 53.7                                                                                          |       | 45.2 |   | 62.7 |   |
| Transfer from non-specific  reserve   |       | 1.2                                                                                           |       | 10.5 |   | 30.7 |   |
| Restructured  transactions            |       | —                                                                                        |       | — |   | (13.9 | ) |
| Paid (net of recoveries)  related to: |       |                                                                                          |       |   |   |   |   |
| Current year                          |       | —                                                                                        |       | — |   | — |   |
| Prior year                            |       | (1.9                                                                                          | )          | (2.0 | ) | (34.3 | ) |
| Total paid                            |       | (1.9                                                                                          | )          | (2.0 | ) | (34.3 | ) |
| Net balance at  December 31      |       | 53.0                                                                                          |       | 53.7 |   | 45.2 |   |
| Plus reinsurance recoverable          |       | 37.3                                                                                          |       | 36.3 |   | 35.4 |   |
| Gross balance at  December 31    |       | $                                                                                             | 90.3       |   | $ | 90.0 |   | $ | 80.6 |   |

 

| ** **                            | ** ** | **Non-Specific Reserve  Activity for the  Year Ended December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                            | ** ** | **(in millions)**                                                                            | ** ** |
| Balance at  January 1            |       | $                                                                                                 | 115.7      |   | $ | 99.3 |   | $ | 111.5 |   |
| Provision for  losses                 |       |                                                                                              |       |   |   |   |   |
| Current year                          |       | 17.8                                                                                              |       | 20.4 |   | 20.4 |   |
| Prior year                            |       | 5.5                                                                                               |       | 5.0 |   | 0.2 |   |
| Transfers to case  reserves           |       | (1.2                                                                                              | )          | (10.5 | ) | (30.7 | ) |
| Restructured transactions             |       | —                                                                                            |       | 1.5 |   | (2.1 | ) |
| Balance at  December 31          |       | 137.8                                                                                             |       | 115.7 |   | 99.3 |   |
| Total case and non-specific  reserves |       | $                                                                                                 | 228.1      |   | $ | 205.7 |   | $ | 179.9 |   |

 

The gross and net par amounts outstanding ontransactions with case reserves were $483.4 million and$399.6 million, respectively, at December 31, 2006. Net case reservesconsisted primarily of five collateralized debt obligation (“CDO”) risks andtwo municipal risks, which collectively accounted for approximately 94.9% ofthe total net case reserve. The remaining eight exposures were in varioussectors.

Case and non-specific reserves for losses and lossadjustment expenses are discounted when established using the risk-freerate appropriate for the term of the insured obligation at the time the reserveis established.

During 2006, the Company charged $23.3 million to lossexpense, consisting of $17.8 million for originations of new business and $5.5million related to accretion on the reserve for in-force business. Netcase reserves decreased $0.7 million, due primarily to******loss payments and someimprovement in the CDO transactions, offset in part by the establishment of anew case reserve for a municipal health care transaction.

During 2005, the Company charged $25.4 million toloss expense, consisting of $20.4 million for originations of new businessand $5.0 million related to accretion on the reserve for in-forcebusiness. The non-specific reserve increased $16.4 million in 2005,primarily due to loss expense of $25.4 million, partially 

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offset by transfers fromthe non-specific reserve to case reserves of $10.5 million. Casereserves increased $8.5 million due primarily to deterioration ofspecific CDO risks.

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 revised estimate of loss, actual lossexperience, its mix of business and economic conditions.

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

| ** **                          | ** ** | **As of December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Case reserve  discount rate         |       | 3.13%–5.90%                      |       | 3.13%–5.90% |   |
| Non-specific  reserve discount rate |       | 1.20%–7.95%                      |       | 1.20%–7.95% |   |
| Current experience  factor          |       | 1.6                                   |       | 1.8 |   |

 

At December 31,2006, the reinsurance recoverable on unpaid losses from reinsurers and cededpar outstanding, by Standard & Poor’s Ratings Services (“S&P”)rating levels, were as follows:

| **Reinsurer’s S&P Rating** | ** ** | ** **             | ** ** | **Reinsurance  Recoverable** | ** ** | **Ceded Par  Outstanding** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **(in millions)** | ** ** |
| AAA                                           |       |                   | $          | 2.0                          |       |                            | $          | 22,967.2 |   |
| AA                                            |       |                   | 33.7       |                         |       | 92,701.9                        |       |
| A                                        |       |                   | 1.6        |                         |       | 6,161.2                         |       |
| Total                                         |       |                   | $          | 37.3                         |       |                            | $          | 121,830.3 |   |

 

The primary estimates affecting the statisticalcalculation are probability of default and severity of loss given default. TheCompany applies its experience factor to the statistical calculation to reflectactual loss experience in terms of both frequency and severity. Historically,defaults on guaranteed obligations have been infrequent, but the size ofresulting claims have varied widely due to both the differing sizes of theobligations guaranteed and the significant variability of the severityexperienced. Severity represents the magnitude of loss, which is calculated asclaims paid minus total recoveries, expressed as a percentage of parguaranteed. Recoveries include salvage value of assets and amounts due fromreinsurers. Actual claim frequency and severity experience may evolve over time,affected by many factors, including changes in the insured portfolio’sdistribution across sectors and underlying ratings, as well as changes in theeconomy and the political environment. The Company’s loss reserving methodologyis designed to reflect these factors. Changes in the sectors and underlyingcredit quality of the transactions are captured in the formula directly, whilechanges in the economy and political environment are captured in the experiencefactor.

Given the broad diversification of FSA’s insuredportfolio, management believes that a significant 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, public finance credits and asset-backedobligations.

Management believes that a material adverse change tothe loss estimate in its public finance risk sectors, excluding the health carecategory, would not occur under any reasonably possible scenario. While theCompany has not experienced a loss in the health care sector, the potential severityof health care losses 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 

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is likely to be in astress scenario. FSA addresses the severity risk in this sector throughinternal policies that limit exposure to any single credit.

In an S&P scenario analysis, S&P assumed 75%loss severity for health care credits, which means that a loss would equal 75%of par insured. If losses of this severity occurred in the lowest ratedhospital exposures in FSA’s insured portfolio, the estimated loss would be asmuch as $50.0 million on a pre-tax basis, net of reinsurance. Thiscalculation includes the amount the Company recorded as a case reserve in 2006for one health care risk.

A material adverse change from management’s currentestimate of loss for public finance transactions with case reserves isconsidered unlikely because the largest such case reserve is set near the fullpolicy amount. The additional estimated loss, assuming 75% loss severity, forthe health care case reserve is included in the estimated loss above.

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

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 statements of operations and comprehensive income, as well asan increase in the Company’s loss experience rate. Yet, even under thisunprecedented stress scenario, the severity of the largest single loss wasrelatively 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 establish 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 $17.3 million.

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

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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, or be accompanied by, changes in another, which mightmagnify or counteract the sensitivities.

Management is aware thatthere are differences regarding the method of defining and measuring both casereserves and non-specific reserves among participants in the financialguaranty industry. Other financial guarantors may establish case reserves onlyafter a default and use different techniques to estimate probable loss. Otherfinancial guarantors may establish the equivalent of non-specificreserves, but refer to these reserves by various terms such as, but not limitedto, “unallocated losses,” “active credit reserves” and “portfolio reserves,” ormay use different statistical techniques from those the Company uses todetermine loss at a given point in time. Management and the industry expectaccounting literature specific to the financial guaranty industry to evolve;however, management cannot predict or estimate the scope of the guidance orpotential impact on the Company’s financial statements at this time. SeeNote 2 to the Consolidated Financial Statements in Item 8.

***Impact of 2005 Hurricanes***

The Company monitors its exposure to credits affectedby the 2005 hurricanes in Louisiana and Mississippi. The Company believes thatits estimate of its total loss liability is adequate given its current riskinformation and has not established a case reserve related to its 2005hurricane-affected exposure.

As of December 31, 2006, FSA had not receivednotice of payment default on any hurricane-related exposures. The Company’s 11credits that have suffered the most significant economic and property loss fromthe 2005 hurricanes had an aggregate net par exposure of $181.7 million at December 31,2006. FSA-insured bonds are protected by various sources of support that wouldbe invoked before FSA would incur losses. These sources include access topledged taxes or revenues, reserve funds, property and casualty insurance andstate and federal monies. The issuers of these insured bonds have generallycontinued to improve financially and management does not expect that FSA willsustain permanent losses.

In addition, to provide relief to local governmentsfacing difficulties meeting debt service obligations during this recoveryperiod, the State of Louisiana issued an aggregate of $400 million of Gulf TaxCredit and matching State General Obligation Bonds on July 19, 2006. Thebond proceeds funded a State Debt Service Assistance Fund to provide loans tohelp qualifying local governments meet debt service obligations for the nextseveral years. All of the qualifying entities are located in the New Orleansmetropolitan area.

Among the exposures affected by the hurricane are$38.1 million of FSA-insured Orleans Levee District (the “District”) bonds. TheDistrict has explored the possibility of seeking bankruptcy protection, but hasnot received the authority from the State that is required to do so. In anyevent, FSA does not believe that payment of the FSA-insured bonds would beimpaired by a bankruptcy filing. In addition, the District is a loan recipientunder the State Debt Service Assistance Fund, with FSA-insured bonds receivingassistance through May 1, 2009.

Asset-backed transactions insured by FSA, backed bypools of geographically diverse assets, show no unusual concentrations in theaffected areas.

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

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***Other Operating Expenses***

Other operating expenses increased 33.1% in 2006,compared with a decrease of 5.5% in 2005. Excluding compensation expensesrelated to the Company’s deferred compensation and supplemental executiveretirement plans, other operating expenses were $110.2 million in 2006, $91.4million in 2005 and $80.8 million in 2004. The increases in 2006 and 2005relate primarily to a reduction in deferral rates and increases in personnelcosts and premises and equipment expense as a result of the move to theCompany’s new headquarters. The Company purchases assets selected byparticipants in the deferred compensation and supplemental executive retirementplans to economically defease the Company’s liability under these plans.Deferred compensation and supplemental executive retirement plan expenses arerecorded in other operating expenses, and the related income on the assets isrecorded in other income. Such expenses and income therefore have no effect onnet income.

***Financial Products Spread Portfolio Net InterestMargin***

FP spread portfolio NIM, a non-GAAP measure, isdefined as the FP Segment net interest margin excluding variable interestentities net interest margin (“VIE NIM”) and fair-value adjustments foreconomic interest rate hedges. Management uses FP spread portfolio NIM as a keyperformance measure of the Company’s growing FP business. FP spreadportfolio NIM was $68.8 million in 2006, $40.5 million in 2005 and$23.5 million in 2004. The increases in FP spread portfolio NIM wererelated primarily to growth in the GIC portfolio. FP spread portfolio NIM iscomparable to FP operating NIM, which the Company reported for periods prior toDecember 31, 2006. Beginning in the fourth quarter of 2006, FP Segmentreporting includes the results of VIEs, which formerly were reported in thefinancial guaranty segment.

NIM shown in accordance with classifications requiredunder GAAP on the consolidated statements of operations and comprehensiveincome (“Total NIM”) is calculated as net interest income from the FP Segment,plus FP net realized gains (losses), less net interest expense from the FPSegment. Total NIM was $93.3 million for 2006, negative $11.2 million for2005 and negative $70.7 million for 2004, and primarily represents fixedrate liabilities (which are swapped to a floating rate obligation) fundingfloating rate assets.

The table below reconcilesTotal NIM with FP Segment NIM and FP spread portfolio NIM:

**Reconciliationof Total NIM to Non-GAAP FP Spread Portfolio NIM**

| ** **                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                         | ** ** | **(in millions)**                     | ** ** |
| Total NIM                                                                          |       | $                                          | 93.3       |   | $ | (11.2 | ) | $ | (70.7 | ) |
| Realized gains  (losses) from and ineffectiveness of economic interest rate hedges |       | (40.7                                      | )          | 27.6 |   | 75.6 |   |
| Intersegment  income related to refinanced transactions                            |       | 20.0                                       |       | 28.2 |   | 24.8 |   |
| Intercompany  adjustments                                                          |       | —                                     |       | — |   | (1.4 | ) |
| FP Segment NIM                                                                     |       | 72.6                                       |       | 44.6 |   | 28.3 |   |
| Less: VIE NIM(1)                                                                   |       | 3.8                                        |       | 4.1 |   | 4.8 |   |
| FP spread  portfolio NIM                                                           |       | $                                          | 68.8       |   | $ | 40.5 |   | $ | 23.5 |   |

----

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

Net realized interest income and expense associatedwith economic interest rate hedges are recorded in realized and unrealizedgains and losses on derivative instruments and are added back to calculate FPspread portfolio NIM. Derivatives thatqualify for hedge accounting are classified in the consolidated statements ofoperations and comprehensive income with the underlying item being hedged.Gains and losses on derivatives that do not qualify for hedge accounting areshown under the caption net realized and 

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unrealizedgains (losses) on derivative instruments. Ineffectiveness related toderivatives that do not qualify for hedge accounting is added back to calculateFP spread portfolio NIM.

Intersegment income relates primarily to intercompanynotes held in the FP Investment Portfolio. In connection with the Company’srefinancing transactions, FSA obtains funds from the FP operations to fundclaim payments, as discussed further in Note 5 to the ConsolidatedFinancial Statements in Item 8, creating an interest-bearingintercompany note. This intercompany note is included in the assets of the FPSegment, with the related net interest income added to FP Segment NIM, butis eliminated from the consolidated Total NIM.

VIE and FP net interestincome are combined on the consolidated statements of operations andcomprehensive income, as are VIE and FP net interest expense. VIE NIM pertainsto the net interest margin derived from transactions executed by FSA Global andPremier International Funding Co. (“Premier”). The VIE NIM relates to apassively managed portfolio, while the growing GIC portfolio is activelymanaged. Accordingly, the VIE NIM is shown separately from the FP spreadportfolio NIM.

***Net Realized and Unrealized Gains (Losses) onDerivative Instruments***

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

| ** **                                                            | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                            | ** ** | **(in millions)**                     | ** ** |
| FP Segment  derivatives                                               |       | $                                          | 130.0      |   | $ | (181.2 | ) | $ | 272.4 |   |
| FSA-Insured CDS                                                       |       | 31.8                                       |       | 11.1 |   | 56.4 |   |
| Other                                                                 |       | 1.2                                        |       | (2.4 | ) | 0.5 |   |
| Net realized and  unrealized gains (losses) on derivative instruments |       | $                                          | 163.0      |   | $ | (172.5 | ) | $ | 329.3 |   |

 

*Credit DefaultSwaps*

FSA’s financial guaranty business includes insuranceof CDS. The net par outstanding was $74.7 billion relating to thesetransactions at December 31, 2006 and $66.6 billion at December 31,2005. Many of these transactions require periodic accounting adjustments toreflect an estimate of fair value (or the replacement cost of the Company’sfinancial guaranty 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 $31.8 million for 2006, $11.1 million for 2005 and$56.4 million for 2004. The benefits during 2006, 2005 and 2004 resultedprimarily from tightening credit spreads in the CDS market. None of theseadjustments indicate any material improvement or deterioration in theunderlying credit quality of FSA’s insured CDS portfolio. The gain or losscreated by estimated fair-value adjustments will rise or fall eachquarter based on estimated market pricing of highly rated swap guarantees andis not expected to be an indication of potential claims under FSA’s guaranty oran indication of potential gains to be received from the derivativetransactions.

Fair value is defined asthe price at which an asset or a liability could be bought or sold in a currenttransaction between willing parties. Fair value is determined based on quotedmarket prices, if available. If quoted market prices are not available, as isprimarily the case with CDS on pools of assets, then the determination of fairvalue is based on internally developed estimates. Management applies judgmentwhen developing these estimates and considers factors such as current pricescharged for similar agreements, performance of underlying assets, changes ininternal shadow 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 unrealized 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 

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valuewill be reversed by an equivalent “gain” at or prior to the expiration of theguaranty, and any “gain” recorded will be reversed by an equal “loss” over theremaining life of the transaction. The average remaining life of thesecontracts is 3.1 years. The inception-to-date pre-tax gain onthe CDS portfolio was $89.2 million at December 31, 2006 and $57.4 millionat December 31, 2005. Given the very high credit quality of FSA’s insuredCDS portfolio and the Company’s intent to hold to maturity, management believesthat “losses” or “gains” attributable to marking these exposures to fair valuedo not reflect on the profitability of the Company in a meaningful way.

*FP and VIEDerivatives*

The Company utilizesinterest rate derivatives to hedge against fluctuations in interest rates, andforeign currency derivatives to hedge against fluctuations in exchange rates.All gains and losses from changes in the fair-value of derivatives that do notqualify for hedge accounting under SFAS 133 are recognized immediately inthe consolidated statements of operationsand comprehensive income under the caption net unrealized and realizedgains (losses) on derivatives. Hedge accounting is applied to derivativesdesignated as hedging instruments in a fair-value hedge, provided certaincriteria are met. Hedge accounting is applied to certain interest rate swapsused to hedge the GIC liabilities.

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

Income from assetsacquired in refinancing transactions, excluding realized gains or losses, was$24.7 million in 2006, $35.2 million in 2005 and $31.6 million in 2004.The increase in 2005 reflects the impact of a full year of income fromtransactions that were refinanced at various times during 2004, while 2006reflects lower invested balances due to paydowns and dispositions of assetswithin this portfolio.

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

Total equity in earnings of unconsolidated affiliateswas a pre-tax gain of $1.2 million in 2005 and a pre-tax loss of $3.3 millionin 2004. There was none in 2006.

As of December 31, 2004, the Company owned 34.1%of SPS Holding Corp. (“SPS”), formerly Fairbanks Capital Holding Corp., and theCompany’s interest in SPS had a book value of $49.6 million. In the thirdquarter of 2004, the Company determined that its $7.6 million of goodwillassociated with its investment in SPS was impaired as a result of challengesencountered by SPS in acquiring new business. The Company’s equity in earningsfrom SPS was a pre-tax gain of $1.2 million in 2005 and a pre-tax loss of $7.1million in 2004.

In October 2005, the Company sold its investmentin SPS to an unaffiliated third party. For its interest in SPS, the Company waspaid $42.9 million in cash at closing and expects to receive additionalamounts, from time to time through March 31, 2008, out of income earned bySPS through December 31, 2007 from certain of its mortgage servicingactivities. Under the sale documents, the Company’s subsidiary that owned theSPS investment made customary representations and warranties to, and undertookspecified indemnification obligations for the benefit of, the purchaser. Basedon an estimate of the assets retained and liabilities assumed, the Companyrecorded a $0.4 million loss on the sale of SPS. Under the terms of theagreement, the Company will receive cash payments through the first quarter of2008 from a residual interest in mortgage servicing assets. The Companyrecorded an asset of $12.6 million representing this contingent paymentasset. The Company and other prior shareholders indemnified the buyer forcertain liabilities relating to SPS’s operations, including litigation andregulatory actions. The maximum indemnification obligation for SPS’s operationswill not exceed approximately $34.0 million. The Company’s portion of thisobligation is 37.4%, or $12.7 million. As of December 31, 2005, theCompany recorded a $5.1 million liability related to this indemnification,representing the expected liability. As of December 31, 2006, theliability had a balance of $3.3 million. The Company has received a net amountof 

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$11.2 million related tothis asset and liability. The Company will continue to evaluate the appropriatecarrying value of the liabilities assumed.

FSA’s 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 Companycarries this investment at the lesser of the current calculated redemptionvalue or the redemption value as of the next January first, which wouldexclude its share of accrued current-year earnings to the extent the cap hadbeen otherwise met. Consistent with this policy, in the third quarter of 2004,the Company charged a pre-tax amount of $11.7 million to equity in earnings ofunconsolidated affiliates and reduced its carrying value in this investment to$56.4 million.

For the first three quarters of 2004 and all prioryears, equity in earnings of unconsolidated affiliates included the results ofXLFA. In accordance with EITF 02-14, “Whether an Investor Should Applythe Equity Method of Accounting for Investments Other Than Common Stock,” theCompany no longer accounts for its investment in XLFA under the equity methodof accounting. Effective October 1, 2004, the Company’s investment in XLFAhas been included in equity securities as an available-for-salesecurity. The fair value of the investment at December 31, 2006 was $54.0million and at December 31, 2005 was $54.3 million. In March 2006,the XLFA Board of Directors approved a by-law amendment changing the coupon onXLFA’s preferred shares from the participating dividend described above to an8.25% per annum fixed dividend effective January 1, 2006. The Companyrecognized dividend income from XLFA of $4.5 million during 2006.

FSA has an investment inTheMuniCenter with a fair value of $3.2 million at December 31, 2006 and$6.0 million at December 31, 2005. The Company wrote down the value ofTheMuniCenter in the third quarter of 2006 by $3.0 million. The MuniCenter isan electronic municipal bond trading platform though which FSA providessecondary-market bond insurance.

***Taxes***

The Company’s effective tax rates were 28.8% in 2006,27.3% in 2005 and 19.0% in 2004. The 2006 rate differs from the statutory rateof 35% due primarily to tax-exempt interest and minority interest. In 2005, therate differed from the statutory rate of 35% due primarily to tax-exemptinterest, minority interest, the Company’s reorganization of Financial SecurityAssurance International Ltd. (“FSA International”) and its intention torepatriate FSA International’s future earnings. The 2004 rate differed from thestatutory rate of 35% primarily due to tax-exempt interest, income from FSAInternational, minority interest, the White Mountains indemnity payment (seebelow) and the expected repatriation of earnings of FSA International in 2005.

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

In December 2005, the Company repatriatedearnings from FSA International to avail itself of the reduced effective taxrate of 5.25% (compared with the normal effective tax rate of 35%) applicableto certain earnings and profits of offshore subsidiaries repatriated during2005 and invested in the United States pursuant to a qualifying reinvestmentplan in accordance with the Act. In connection with such repatriation, theCompany recapitalized FSA International in October of 2005 to become awholly owned 

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subsidiary and declaredthat it no longer intends to leave future earnings of that subsidiarypermanently offshore, with the effect that 2005 and future income from FSAInternational have become subject to an increased effective U.S. tax rate. Theimpact on earnings reflects (a) a tax liability of $15.1 million inrespect of earnings of FSA International that have previously been recognizedfor GAAP but not yet for tax and (b) $14.2 million related to 2005earnings.

Following a change in SPS’s investors in 2002, the Companydetermined that it would be appropriate to apply the 80% dividend-receiveddeduction allowed by the Internal Revenue Service when calculating the tax onits equity earnings from SPS, based on management’s expectation that it wouldrealize its gain on such investment through dividend distributions rather thanthrough sale of its investment. Accordingly, for 2004, equity in earnings fromSPS was taxed at an effective rate of 7.0%. In the first quarter of 2005, theCompany, due to the pending sale of its investment in SPS, eliminated theassumption that accumulated earnings of SPS would be distributed in the form ofdividends eligible for a dividend-received deduction. The net effect of thiswas to reserve for additional taxes of approximately $1.6 million.

In connection with Dexia’sacquisition of the Company in July 2000, the Company became the successor,for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH hadpreviously sold an insurance subsidiary to a third party that was indemnifiedby White Mountains for certain future adverse loss development up to $50.0million. In 2004, the Company made an indemnity payment of $47.0 million to thethird party with funds provided for such purpose by White Mountains InsuranceGroup. While the Company had no legal liability in connection with theindemnity payment, the payment is treated for tax purposes as a $47.0 millionloss deduction to the Company, as successor to WMH. The Company thereforerecorded a deferred tax asset with a corresponding deferred tax benefit of$16.5 million. There can be no assurance that the deferred tax benefit will notbe reversed in the future. In addition, the Company has agreed to share 50% ofthe deferred tax benefit with White Mountains Insurance Group under certaincircumstances, but did not satisfy the standards for recording a liability foraccounting purposes as of December 31, 2006.

**Critical AccountingPolicies**

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

**Liquidity and CapitalResources**

***Liquidity***

The Company’s consolidated invested assets at December 31,2006, net of unsettled security transactions, were $21,261.4 million, comparedwith the December 31, 2005 balance of $17,392.3 million. These balancesinclude the change in the market value of the Company’s various portfolios,which had an unrealized gain position of $333.1 million at December 31,2006, compared with an unrealized gain position of $236.2 million at December 31,2005. These balances exclude assets in the VIE Investment Portfolio andassets acquired under refinancing transactions that the Company’s managementbelieves are beyond the reach of the Company and its creditors.

The Company includes variable rate demand notes (“VRDN”)and auction rate securities (“ARS”), which totaled $746.5 million at December 31,2006 and $867.2 million at December 31,2005, in its long-term bond portfolios. VRDNs are long-term bonds thatbear floating interest rates and provide investors with the option to tender orput the bonds at par, generally on a daily, weekly or monthly basis. ARS arelong-term securities with interest rate reset features and are traded in themarketplace through a bidding process. For management purposes, VRDN and ARSare managed as cash equivalents.

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Cash flow from operations was $611.2 million in2006, $654.3 million in 2005 and $550.8 million in 2004. The decrease in cashflow from operations in 2006 is attributable primarily to the decrease inpremiums and the activity in the trading portfolio, partially offset by anincrease in net interest received from the FP Segment and a reduction in taxespaid. In 2005, the increase in cash flow from operations was primarilyattributable to net interest received from the FP Segment, due to growth in theFP book of business, and to premiums, partially offset by increases inoperating expenses and taxes paid. The increase in premium receipts was dueprimarily to increased refunding activity. The increase in taxes paid was dueprimarily to the repatriation of FSA International earnings.

At December 31, 2006, Financial SecurityAssurance Holdings Ltd. (as a separate holding company, “FSA Holdings”) hadcash and investments of $42.7 million available to fund the liquidity needs ofits non-insurance operations. Because the majority of the Company’s operationsare conducted through FSA, the long-term ability of FSA Holdings toservice its debt will largely depend on its receipt of dividends from, orpayment on surplus notes by, FSA.

In its financial guaranty business, premiums andinvestment income are the Company’s primary sources of funds to pay itsoperating expenses, insured losses and taxes. In its FP Segment, the Companyrelies on net interest income to fund its net interest expense and operatingexpenses. Management believes that the Company’s operations provide sufficientliquidity to pay its obligations. If additional liquidity is needed or cashflow from operations significantly decreases, the Company can liquidate orutilize its investment portfolio as a source of funds in addition to itsalternative liquidity arrangements, as discussed further below. The Company’scash flows from operations are heavily dependent on market conditions, thecompetitive environment and the mix of business originated. In addition, paymentsmade in settlement of the Company’s obligations in its insured portfolio may,and often do, vary significantly from year to year depending primarily on thefrequency and severity of payment defaults and its decisions regarding whetherto exercise its right to accelerate troubled insured transactions in order tomitigate future losses. In each of the three years reported, the Company hasnot drawn on any alternative sources of liquidity to meet its obligations,except that the Company has refinanced certain transactions using funds raisedthrough its GIC Affiliates.

The following is a summaryof the Company’s contractual obligations at December 31, 2006:

**ContractualObligations**

| ** **                       | ** ** | **Less than  1 Year** | ** ** | **1–3 Years** | ** ** | **3–5 Years** | ** ** | **Greater than  5 years** | ** ** | **Total** | ** ** |
|----------------------------------|------------|---------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------------------|------------|-----------|------------|
| ** **                       | ** ** | **(in millions)**          | ** ** |
| Loss reserves(1)                 |       | $                               | 5.0        |                    | $          | 17.1                    |       | $                                   | 44.8       |      |       | $ | 239.1 |   |   | $ | 306.0 |   |
| GIC and VIE debt  obligations(2) |       | 4,701.9                         |       | 4,941.5                 |       | 4,569.8                 |       |                                | 12,495.7   |      |       | 26,708.9 |   |
| Corporate debt  obligations(3)   |       | 48.1                            |       | 92.1                    |       | 92.1                    |       |                                | 3,623.8    |      |       | 3,856.1 |   |
| Operating lease  obligations     |       | 9.2                             |       | 16.4                    |       | 16.3                    |       |                                | 111.7      |      |       | 153.6 |   |
| Total                            |       | $                               | 4,764.2    |                    | $          | 5,067.1                 |       | $                                   | 4,723.0    |      |       | $ | 16,470.3 |   |   | $ | 31,024.6 |   |

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(1)          Amountsrepresent the undiscounted estimated claim payments.

(2)          Amountsinclude future implied interest accretion on zero-coupon obligations and futureinterest payments. Foreign amounts are calculated using spot rates as ofDecember 31, 2006. Future interest payments are assumed to be at the ratesin effect as of December 31, 2006 for floating rate debt.

(3)          Amountsinclude principal and interest payments for the minimum contractual period.

Downgrades of FSA’sTriple-A financial strength ratings would adversely affect FSA’s ability tocompete for business. Credit ratings are an important component of a financialinstitutions’ ability to compete in the financial guaranty, derivative,investment agreement and structured transaction markets. If FSA weredowngraded, FSA might be required to post incremental collateral to itsinvestment agreement 

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andderivative counterparties, introducing liquidity risk. In addition, mostinvestment agreements provide certain remedies for the investment agreementpurchaser in the event of a downgrade of FSA’s credit rating, typically belowAa3 by Moody’s or AA- by S&P. Such remedies include termination of theinvestment agreement contract. In most cases FSA is permitted to postcollateral or otherwise enhance its credit prior to an actual termination ofthe investment agreement.

At December 31, 2006,FSA Holdings held $108.9 million of FSA surplus notes. Payments of principal orinterest on such notes may be made only with the approval of the Superintendentof Insurance of the State of New York (the “New York Superintendent”). FSAHoldings employs surplus note purchases in lieu of capital contributions inorder to allow it to withdraw funds from FSA through surplus note paymentswithout reducing earned surplus, thereby preserving the dividend capacity ofFSA.

FSA Holdings paiddividends of $530.0 million in 2006, $71.1 million in 2005 and $22.9 million in2004.

On November 22, 2006,FSA Holdings issued $300.0 million principal amount of Junior SubordinatedDebentures with a scheduled maturity date of December 15, 2036 and a finalrepayment date of December 15, 2066. The final repayment date of December 15,2066 may be automatically extended up to four times in five-year incrementsprovided certain conditions are met. The debentures are redeemable, in whole orin part, at any time prior to December 15, 2036 at their principal amountplus accrued and unpaid interest to the date of redemption. Interest on thedebentures will accrue from November 22, 2006 to December 15, 2036 atthe annual rate of 6.40%. If any amount of the debentures remains outstandingafter December 15, 2036, then the principal amount of the outstandingdebentures will bear interest at a floating interest rate equal to one-monthLIBOR plus 2.215% until repaid. FSA Holdings may elect at one or more times todefer payment of interest on the debentures for one or more consecutiveinterest periods that do not exceed ten years. In connection with thecompletion of this offering, FSA Holdings entered into a replacement capitalcovenant for the benefit of persons that buy, hold or sell a specified seriesof FSA Holdings long-term indebtedness ranking senior to the debentures. Underthe covenant, the debentures will not be repaid, redeemed, repurchased ordefeased by FSA Holdings or any of its subsidiaries on or before the date thatis 20 years prior to the final repayment date, except to the extent that FSAHoldings has received proceeds from the sale of replacement capital securities.The proceeds from this offering were used to pay a dividend to the shareholdersof FSA Holdings.

On July 31, 2003, FSAHoldings 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 anytime on or after July 31, 2008. Debt issuance costs of $3.3 million arebeing amortized over the life of the Notes.

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 anytime on or after November 26, 2007. Debt issuance costs of$7.4 million are being amortized over the life of the debt. FSA Holdingsused a portion of the proceeds of this issuance to redeem in whole FSA Holdings’$130.0 million principal amount of 7.375% Senior QUIDS due September 30,2097.

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

FSA’s ability to pay dividends depends, among otherthings, upon FSA’s financial condition, results of operations, cashrequirements and compliance with rating agency requirements for maintaining itsTriple-A ratings, and is also subject to restrictions contained in theinsurance laws and related regulations of New York and other states. Under theinsurance laws of the State of New York (the “New York Insurance Law”), FSA maypay dividends out of earned surplus, provided that, together with all dividendsdeclared or distributed by FSA during the preceding 12 months, the dividends donot exceed the lesser of (a) 10% of policyholders’ surplus as of its laststatement filed with the New York Superintendent or (b) adjusted netinvestment income during this period. Based on FSA’s statutory statements for2006, and 

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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, 2006 is approximately $156.6 million. FSA paiddividends of $140.0 million in 2006, $87.0 million in 2005 and $30.0 millionin 2004.

FSA may repurchase shares of its common stock from itsshareholders subject to the New York Superintendent’s approval. The New YorkSuperintendent has approved the repurchase by FSA of up to $500.0 millionof its shares from FSA Holdings through December 31, 2008. In 2006, FSArepurchased $100 million of shares of its common stock from FSA Holdings andretired such shares.

FSA International paid preferred dividends of $6.9million in 2005 and $7.0 million in 2004 to XL Capital Ltd, its minorityinterest owner. In October 2005, FSA purchased all the preferred shares ofFSA International owned by XL Insurance (Bermuda) Ltd. for a cash purchaseprice of $39.1 million, in anticipation of the repatriation of earnings andprofits of FSA International. Giving effect to such purchase, FSA Internationalbecame an indirect wholly owned subsidiary of the Company.

***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 Holdings. FSA’s funds are also required to satisfyclaims under insurance policies in the event of default by an issuer of aninsured obligation and the unavailability or exhaustion of other paymentsources in the transaction, such as the cash flow or collateral underlying theobligations. FSA seeks to structure asset-backed transactions to addressliquidity risks by matching insured payments with available cash flow or otherpayment sources. Insurance policies issued by FSA guaranteeing payments underbonds and other securities provide, in general, that payments of principal,interest and other amounts insured by FSA may not be accelerated by the holderof the obligation but are paid by FSA in accordance with the obligation’soriginal payment schedule or, at FSA’s option, on an accelerated basis.Insurance policies issued by FSA guaranteeing payments under CDS may providefor acceleration of amounts due upon the occurrence of certain credit eventssubject to single-risk limits specified in the New York Insurance Law. Thesepolicy provisions prohibiting or limiting acceleration of certain claims aremandatory under Article 69 of the New York Insurance Law and serve toreduce FSA’s liquidity requirements.

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

FSA has a credit arrangement aggregating $150.0million, provided by commercial banks and intended for general application totransactions insured by FSA. If FSA is downgraded below Aa3 and AA-, thelenders may terminate the commitment, and the commitment commission becomes dueand payable. If FSA is downgraded below Baa3 and BBB-, any outstandingloans become due and payable. At December 31, 2006, there were noborrowings under this arrangement, which expires on April 21, 2011, if notextended.

FSA has a standby line of credit in the amount of$350.0 million with a group of international banks to provide loans to FSAafter it has incurred, during the term of the facility, cumulative municipallosses (net of any recoveries) in excess of the greater of $350.0 millionor the average annual debt service of the covered portfolio multiplied by5.00%, which amounted to $1,328.3 million at December 31, 2006. Theobligation to repay loans under this agreement is a limited recourse obligationpayable solely 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 ten-yearterm expiring on April 30, 2015 and contains an annual renewal provision,commencing April 30, 2008, subject to approval by the banks. A ratingsdowngrade of FSA would result in an increase in the commitment fee. No amountshave been utilized under this commitment as of December 31, 2006.

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In June 2003, $200.0 million of money marketcommitted preferred trust securities (the “CPS Securities”) were issued bytrusts created for the primary purpose of issuing the CPS Securities, investingthe proceeds in high-quality commercial paper and providing FSA with putoptions for issuing to the trusts non-cumulative redeemable perpetualpreferred stock (the “Preferred Stock”) of FSA. If FSA were to exercise a putoption, the applicable trust would transfer the portion of the proceedsattributable to principal received upon maturity of its assets, net ofexpenses, to FSA in exchange for Preferred Stock of FSA. FSA pays a floatingput premium to the trusts. The cost of the structure was $1.0 million for 2006and $1.3 million for 2005 and was recorded as other operating expense in theCompany’s Consolidated Financial Statements. The trusts are vehicles forproviding FSA access to new capital at its sole discretion through the exerciseof the put options. The Company does not consider itself to be the primarybeneficiary of the trusts under Financial Accounting Standards BoardInterpretation No. 46, “Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51” (revised December 2003) (“FIN 46-R”)because 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 InvestorsService, Inc. (“Moody’s”) or AA- by S&P, unless the GIC providerposts collateral or otherwise enhances its credit. Some FSA-insured GICsalso allow for withdrawal of GIC funds in the event of a downgrade of FSA,typically below A3 by Moody’s or A- by S&P, with no right of the GICprovider to avoid such withdrawal by posting collateral or otherwise enhancingits credit. The Company manages this risk through the maintenance of liquidcollateral and bank liquidity facilities.

FSA Asset Management LLC (“FSAM”) has a $100.0 millionline of credit with UBS Loan Finance LLC, which expires December 7, 2007,unless extended. This line of credit provides an additional source of liquidityshould there be unexpected draws on GICs issued by the GIC Affiliates. Therewere no borrowings under this arrangement at December 31, 2006. Borrowingsunder this agreement are conditioned on FSA having a Triple-A rating by eitherMoody’s or S&P, and on neither Moody’s nor S&P having issued a ratingto FSA below Aa1 or AA+, respectively.

Certain FSA Global debtissuances contain provisions that could extend the stated maturities of thosenotes. To ensure FSA Global will have sufficient cash flow to repay its fundingrequirements, it entered into four liquidity facilities with Dexia for amountstotaling $419.4 million.

***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, as well as any collateral provided by the reinsurer. Capital chargeson outstanding insured transactions and reinsurer ratings are subject to changeby S&P at 

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any time. In recent years,a number of Triple-A rated reinsurers employed by FSA have beendowngraded by 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 such reduction.FSA employs considerable reinsurance in its business to manage its single-riskexposures on insured credits. Any material increase in capital charges byS&P on FSA’s insured portfolio would likewise be expected to have anadverse effect on FSA’s margin of safety under the S&P capital adequacymodel and, ultimately, the Company’s return on equity. The Company may seek toraise additional capital to replenish capital eliminated by any of the ratingagencies in 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, the credit quality of insuredexposures, correlations that exist between transactions, the credit quality ofFSA’s reinsurers and the term to maturity of FSA’s insured portfolio. Thepublished results compare levels of theoretical loss in the tail of thisdistribution to various measures of FSA’s claims-paying resources.

***Capital Expenditures***

The Company incurredapproximately $3.4 million in capital expenditures in 2006 for leaseholdimprovements, furniture and fixtures, which were funded from cash flows fromoperations.

**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 (a) the GeneralInvestment Portfolio, (b) the portfolio of insured CDS, (c) theportfolio of assets acquired in refinancing transactions, and (d) the FPSegment Investment Portfolio. Substantially all of the income statementvolatility related to changes in foreign exchange rates is mitigated throughthe use of cross-currency swaps.

***General Investment Portfolio***

Over 98.8% of the Company’s General InvestmentPortfolio was invested in fixed-income securities at December 31,2006. Changes in interest rates affect the value of the Company’s fixed-incomeportfolio. As interest rates rise, the fair value of fixed-incomesecurities decreases.

Management’s primary objective in managing the Company’sGeneral Investment Portfolio is to generate an optimal level of after-taxinvestment income while preserving capital, maintaining adequate liquidity andmeeting rating agency capital adequacy criteria that apply discount factors toinvestments based on their ratings. The Company bases its investment strategieson many factors, including the Company’s tax position, anticipated changes ininterest rates, regulatory and rating agency criteria and other market factors.One internal investment manager and two external investment managers buyprimarily fixed-income investments on behalf of the Company. Management,with the approval of the Board of Directors, establishes guidelines forinvestment decisions.

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Sensitivity of the Company’s General InvestmentPortfolio to interest rate movements can be estimated by projecting ahypothetical increase in interest rates of 1.0%. Based on market values andinterest rates at year-end 2006 and 2005, this hypothetical increase ininterest rates of 1.0% across the entire yield curve would result in anestimated after-tax decrease of $124.7 million and $130.2 million,respectively, in the fair value of the Company’s fixed-income portfolio,which would be recorded in other comprehensive income.

The Company’s GeneralInvestment Portfolio 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 parallel shift in the municipal Triple-A obligationcurve that would be equivalent to a 1.0% taxable interest rate change based onthe average taxable/tax-exempt ratios for the prior 12 months. Thetax-exempt simulation utilizes duration, which takes into account theapplicable call date if the bond is priced at a premium or the maturity date ifthe bond is priced at a discount.

***Credit Default Swaps***

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

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

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

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

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The Company has evaluatedthe sensitivity of the CDS contracts by calculating the effect of percentagechanges in pricing. The following table summarizes the estimated pre-tax effectof hypothetical changes in the fair value of the Company’s portfolio of CDScontracts, which are defined as derivatives for accounting purposes. In 2006,the effect of changes in premiums was lower due to lower prices, notably in theinvestment-grade and high-yield sectors. In accordance with SFAS 133, anychanges in pricing would be recorded in the statements of operations.

**Effectof Hypothetical Increase in CDS Premiums**

| ** ** | ** ** | **Estimated pre tax loss**                | ** ** |
|------------|------------|----------------------------------------------------------|------------|
| ** ** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |
| ** ** | ** ** | **(in millions)**                                   | ** ** |
| +25%       |       |                                                     | $          | 42.8 |   |   |   | $ | 56.4 |   |   |
| +50%       |       |                                                     | 85.5       |   |   |   | 112.7 |   |   |
| +75%       |       |                                                     | 128.3      |   |   |   | 169.1 |   |   |

 

***Assets Acquired in Refinancing Transactions***

As of December 31,2006 and 2005, a hypothetical increase in interest rates of 1.0% would resultin an estimated after-tax decrease of $8.3 million and$11.3 million, respectively, in the fair value of certain assets acquiredunder refinancing transactions, offset by an after-tax gain of $9.9 million and$11.9 million, respectively, on derivatives used to economically hedge theportfolio of assets acquired under refinancing transactions.

***Financial Products Segment***

FSAM manages the FP Investment Portfolio, whichsupports the GIC liabilities. The primary objectives in managing this portfolioare to generate a stable net interest margin, to maintain liquidity and tooptimize risk-adjusted returns.

Theassets and liabilities supporting the GIC business are hedged using interestrate swaps or futures. Certain categories of assets and liabilities areeconomically hedged, without the use of derivatives. A hypothetical increase ininterest rates of 1% would have the following after-tax effect: 

| ** **                                                  | ** ** | **2006**               | ** ** | **2005** | ** ** |
|-------------------------------------------------------------|------------|------------------------|------------|----------|------------|
| ** **                                                  | ** ** | **(in millions)** | ** ** |
| Change in fair  value of assets(1)                          |       | $                      | (129.2     | )        | $          | (95.0 | ) |
| Change in fair  value of derivatives hedging assets(2)      |       | 107.0                  |       | 80.3     |       |
| Change in fair  value of liabilities(3)                     |       | 245.9                  |       | 223.5    |       |
| Change in fair  value of derivatives hedging liabilities(2) |       | (225.2                 | )          | (208.1   | )          |
| Net changes in  fair value                                  |       | $                      | (1.5       | )        | $          | 0.7 |   |

----

(1)          Recorded in othercomprehensive income.

(2)          Recorded in currentincome.

(3)          Changes in the fairvalue of the liability portfolio are not recorded in the financial statementsunless they are designated as hedges for accounting purposes in accordance withSFAS 133.

There were no assets in a designated hedgingrelationship as of December 31, 2006 and 2005. Approximately $3.3 billionin liabilities are marked to market in income because designated SFAS 133hedges have been applied. A 1% increase in interest rates would result inhigher reported net income of $80.9 million in 2006 and lower reported netincome of $127.8 million in 2005, which represents the change in fair value onall derivatives used to economically hedge the assets and liabilities and thechange in fair 

69

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value on liabilities inSFAS 133-qualifying hedging relationships. The decrease in the effect onnet income from 2005 to 2006 is primarily due to the impact of hedge accountingin accordance with SFAS 133 in 2006 for certain hedging relationships in theliability portfolio, which allows the changes in fair value of hedged risks tobe included in net income. Since the Company does not expect to trade theinvestments or derivatives prior to maturity absent an unusually large demandfor funds, it does not expect to recognize any material adverse impact to cashflows under the above scenario.

The FP Investment Portfolio consists primarily of U.S.dollar-denominated asset-backed securities, U.S. agency andgovernment securities and mortgage-backed securities. FSAM generallyconverts all fixed rate assets and liabilities to floating U.S. dollar interestrates using hedging instruments. As interest rates change, and assuming aneconomically effective fair-value hedging arrangement, the change invalue of the fixed-income securities will be substantially offset by asimilar but opposite change in value of the related hedging instruments. To theextent the Company does not qualify for hedge accounting, such economic offsetscannot be presented in the financial statements, resulting in greater reportedvolatility arising from changes in interest rates.

Assets supporting VIE liabilities (the VIE InvestmentPortfolio) are generally held until maturity. The VIE fixed rate liabilitiesare economically hedged against changes in interest rates largely through theuse of swap contracts, which convert fixed interest rates to floating U.S.dollar interest rates.

FSA Global is managed as a “match funded vehicle,” inwhich the proceeds from the sale of FSA Global notes are invested inobligations chosen to provide cash flows substantially matched to those of thenotes (taking into account, in some cases, dedicated third-party liquidity).This match funded structure is designed to minimize the market risks borne byFSA Global and FSA.

FSA Global generally raises funds that are denominatedin U.S. dollars or converted into U.S. dollars at LIBOR-based floatingborrowing rates. In recent years, the funds FSA Global raises have generallybeen invested in FSA-insured GICs, but it may invest, and has in the pastinvested, in other FSA-insured obligations. FSA Global invests with a view torealizing the yield difference between the notes issued and the obligationspurchased with the note proceeds. While the majority of FSA Global’sinvestments are either denominated in U.S. dollars or converted into U.S.dollars at LIBOR-based floating rates, it also holds investments in othercurrencies.

FSA Global’sinvestments:

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

·       paya higher interest rate than the interest rate on the related FSA Global notes.

The VIE fixed rate investments and liabilities areeconomically hedged against changes in interest rates largely through the useof interest rate swap contracts, which convert fixed interest rates to floatingrates. A hypothetical increase in interest rates of 1% would result in anapproximate after-tax loss of $74.2 million on the derivatives used toeconomically hedge the VIE asset and liability portfolios and would be recordedin current income.

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

**FinancialSecurity Assurance Holdings Ltd. and SubsidiariesIndex to Consolidated Financial Statements and Schedule**

|                                                                                                                                                                                      | ** ** | Page   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------|------------|
| Report of Independent Registered Public Accounting  Firm                                                                                                                             |       |   | 72         |   |   |
| Consolidated Balance Sheets as of December 31,  2006 and 2005                                                                                                                   |       |   | 73         |   |   |
| Consolidated Statements of Operations and  Comprehensive Income for the Years Ended December 31, 2006, 2005 and 2004                                                            |       |   | 74         |   |   |
| Consolidated Statements of Changes in Shareholders’  Equity for the Years Ended December 31, 2006, 2005 and 2004                                                           |       |   | 75         |   |   |
| Consolidated Statements of Cash Flows for the Years  Ended December 31, 2006, 2005 and 2004                                                                                     |       |   | 76         |   |   |
| Notes  to Consolidated Financial Statements                                                                                                                                          |       |   | 78         |   |   |
| Schedule:                                                                                                                                                                            |       |   |       |   |   |
| I Condensed Financial Statements of Financial Security  Assurance Holdings Ltd. as of December 31, 2006 and 2005 and for the  Years Ended December 31, 2006, 2005 and 2004 |       |   | 164        |   |   |

 

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**Reportof Independent Registered Public Accounting Firm**

To Board of Directors andShareholdersof Financial Security Assurance Holdings Ltd.:

In ouropinion, the consolidated financial statements listed in the accompanying indexpresent fairly, in all material respects, the financial position of FinancialSecurity Assurance Holdings Ltd. and Subsidiaries (the “Company”) at December 31,2006 and December 31, 2005, and the results of their operations and theircash flows for each of the three years in the period ended December 31,2006 in conformity with accounting principles generally accepted in the UnitedStates of America. In addition, in our opinion, the financial statementschedule listed in the accompanying index presents fairly, in all materialrespects, the information set forth therein when read in conjunction with therelated consolidated financial statements. These financial statements andfinancial statement schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements and financial statement schedule based on our audits. We conductedour audits of these statements in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.
| /s/ PricewaterhouseCoopers  LLP |   |   |
|---------------------------------|--------|--------|
| New York, New York              |   |   |
| March 29, 2007             |   |   |

 

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

| ** **                                                                                     | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                     |       |                                  |       |   |   |
| General Investment  Portfolio:                                                                 |       |                                  |       |   |   |
| Bonds at fair value (amortized cost of $4,546,147  and $4,219,344)                             |       | $                                     | 4,721,512  |   | $ | 4,382,037 |   |
| Equity securities at fair value (cost of $54,291 and  $54,370)                                 |       | 54,325                                |       | 54,370 |   |
| Short-term investments (cost of $96,055 and  $159,133)                                         |       | 96,578                                |       | 159,133 |   |
| Financial Products  Segment Investment Portfolio:                                              |       |                                  |       |   |   |
| Bonds at fair value (amortized cost of $16,692,183  and $12,910,162)                           |       | 16,757,979                            |       | 12,983,816 |   |
| Short-term investments                                                                         |       | 659,704                               |       | 1,018,183 |   |
| Trading portfolio at fair value                                                                |       | 119,424                               |       | — |   |
| Assets acquired in  refinancing transactions:                                                  |       |                                  |       |   |   |
| Bonds at fair value (amortized cost of $40,133 and  $65,865)                                   |       | 41,051                                |       | 68,421 |   |
| Securitized loans                                                                              |       | 241,785                               |       | 296,965 |   |
| Other                                                                                          |       | 55,036                                |       | 102,487 |   |
| Total investment portfolio                                                                     |       | 22,747,394                            |       | 19,065,412 |   |
| Cash                                                                                           |       | 32,471                                |       | 43,629 |   |
| Deferred  acquisition costs                                                                    |       | 340,673                               |       | 335,129 |   |
| Prepaid  reinsurance premiums                                                                  |       | 1,004,987                             |       | 865,192 |   |
| Reinsurance  recoverable on unpaid losses                                                      |       | 37,342                                |       | 36,339 |   |
| Other assets (See  Notes 16 and 21)                                                            |       | 1,610,759                             |       | 1,655,941 |   |
| TOTAL ASSETS                                                                                   |       | $                                     | 25,773,626 |   | $ | 22,001,642 |   |
| **LIABILITIES,  MINORITY INTEREST AND SHAREHOLDERS’ EQUITY**                              |       |                                  |       |   |   |
| Deferred premium  revenue                                                                      |       | $                                     | 2,653,321  |   | $ | 2,375,059 |   |
| Losses and loss  adjustment expenses                                                           |       | 228,122                               |       | 205,718 |   |
| Guaranteed  investment contracts and variable interest entities’ debt                     |       | 18,349,665                            |       | 14,947,118 |   |
| Deferred federal  income taxes                                                                 |       | 298,542                               |       | 231,265 |   |
| Notes payable                                                                                  |       | 730,000                               |       | 430,000 |   |
| Accrued expenses,  other liabilities and minority interest (See Note 16)                  |       | 791,664                               |       | 989,580 |   |
| TOTAL LIABILITIES AND MINORITY INTEREST                                                        |       | 23,051,314                            |       | 19,178,740 |   |
| COMMITMENTS AND  CONTINGENCIES (See Note 17)                                                   |       |                                  |       |   |   |
| Common stock  (200,000,000 shares authorized; 33,517,995 issued; par value of $.01 per  share) |       | 335                                   |       | 335 |   |
| Additional paid-in  capital—common                                                        |       | 906,687                               |       | 905,190 |   |
| Accumulated other  comprehensive income (net of deferred income taxes of $86,119 and $84,123)  |       | 160,038                               |       | 156,229 |   |
| Accumulated  earnings                                                                          |       | 1,655,252                             |       | 1,761,148 |   |
| Deferred equity  compensation                                                                  |       | 19,225                                |       | 20,177 |   |
| Less treasury  stock at cost (241,978 and 254,736 shares held)                                 |       | (19,225                               | )          | (20,177 | ) |
| TOTAL SHAREHOLDERS’ EQUITY                                                                |       | 2,722,312                             |       | 2,822,902 |   |
| TOTAL  LIABILITIES, MINORITY INTEREST AND SHAREHOLDERS’ EQUITY                            |       | $                                     | 25,773,626 |   | $ | 22,001,642 |   |

 

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

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

| ** **                                                                                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **REVENUES:**                                                                                                                               | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net premiums written                                                                                                                        |       | $                                          | 527,177    |   | $ | 577,694 |   | $ | 587,769 |   |
| Net premiums earned                                                                                                                         |       | $                                          | 388,709    |   | $ | 404,059 |   | $ | 395,015 |   |
| Net investment income                                                                                                                       |       | 218,850                                    |       | 200,827 |   | 172,051 |   |
| Net realized gains (losses)                                                                                                                 |       | (8,328                                     | )          | 6,392 |   | (473 | ) |
| Net interest income from  financial products segment                                                                                        |       | 861,772                                    |       | 487,916 |   | 194,675 |   |
| Net realized gains (losses)  from financial products segment                                                                                |       | 108                                        |       | (7,473 | ) | 2,217 |   |
| Net realized and unrealized  gains (losses) on derivative   instruments                                                                     |       | 163,046                                    |       | (172,475 | ) | 329,259 |   |
| Income from assets acquired  in refinancing transactions                                                                                    |       | 24,661                                     |       | 35,190 |   | 31,634 |   |
| Net realized gains from  assets acquired in refinancing transactions                                                                        |       | 12,729                                     |       | 5,601 |   | — |   |
| Other income                                                                                                                                |       | 29,321                                     |       | 21,198 |   | 23,891 |   |
| TOTAL REVENUES                                                                                                                              |       | 1,690,868                                  |       | 981,235 |   | 1,148,269 |   |
| **EXPENSES:**                                                                                                                               | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Losses and loss adjustment  expenses                                                                                                        |       | 23,303                                     |       | 25,365 |   | 20,599 |   |
| Interest expense                                                                                                                            |       | 29,096                                     |       | 26,990 |   | 26,993 |   |
| Policy acquisition costs                                                                                                                    |       | 63,012                                     |       | 68,340 |   | 62,201 |   |
| Foreign exchange (gains)  losses from financial products segment                                                                            |       | 159,424                                    |       | (189,785 | ) | 91,309 |   |
| Net interest expense from  financial products segment                                                                                       |       | 768,583                                    |       | 491,640 |   | 267,599 |   |
| Other operating expenses                                                                                                                    |       | 124,622                                    |       | 93,614 |   | 99,054 |   |
| TOTAL EXPENSES                                                                                                                              |       | 1,168,040                                  |       | 516,164 |   | 567,755 |   |
| INCOME BEFORE INCOME TAXES,  MINORITY INTEREST AND EQUITY IN LOSSES OF UNCONSOLIDATED AFFILIATES                                       |       | 522,828                                    |       | 465,071 |   | 580,514 |   |
| Provision  (benefit) for income taxes:                                                                                                      |       |                                       |       |   |   |   |   |
| Current                                                                                                                                     |       | 85,454                                     |       | 127,479 |   | 53,472 |   |
| Deferred                                                                                                                                    |       | 65,226                                     |       | (606 | ) | 57,084 |   |
| Total provision                                                                                                                             |       | 150,680                                    |       | 126,873 |   | 110,556 |   |
| NET INCOME BEFORE MINORITY  INTEREST AND EQUITY IN LOSSES OF UNCONSOLIDATED AFFILIATES                                                      |       | 372,148                                    |       | 338,198 |   | 469,958 |   |
| Less: Minority interest                                                                                                                     |       | (52,006                                    | )          | 11,224 |   | 87,408 |   |
| Plus: Equity in losses of  unconsolidated affiliates, net of income tax provisions of $2,026 and  $604                                 |       | ——                               |       | (866 | ) | (3,943 | ) |
| NET INCOME                                                                                                                                  |       | 424,154                                    |       | 326,108 |   | 378,607 |   |
| **OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX:**                                                                                          | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unrealized gains (losses)  arising during the period, net of deferred income tax provision  (benefit) of $5,438, $(13,427) and $18,698 |       | 10,202                                     |       | (32,012 | ) | 36,164 |   |
| Less: Reclassification  adjustment for gains included in net income, net of deferred income tax  provision of $3,442, $6,205 and $237       |       | 6,393                                      |       | 11,523 |   | 1,017 |   |
| Other comprehensive income  (loss)                                                                                                          |       | 3,809                                      |       | (43,535 | ) | 35,147 |   |
| COMPREHENSIVE INCOME                                                                                                                        |       | $                                          | 427,963    |   | $ | 282,573 |   | $ | 413,754 |   |

 

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

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**FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. ANDSUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY(in thousands)**

| ** **                                                                                               | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital-  Common** | ** ** | **Unrealized  Gain  on  Investments** | ** ** | **Accumulated  Earnings** | ** ** | **Deferred  Equity  Compensation** | ** ** | **Treasury  Stock** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------------------------------|------------|---------------------------------------|------------|---------------------------|------------|------------------------------------|------------|---------------------|------------|-----------|------------|
| BALANCE, December 31,  2003                                                                         |       |              | $          | 335                                       |       |                                  |       | $                         | 903,829    |                               |       |                | $          | 164,617   |       |   |   | $ | 1,150,368 |   |   |   | $ | 23,445 |   |   | $ | (23,445 | ) | $ | 2,219,149 |   |
| Net income for the year                                                                                  |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |      | 378,607    |   |   |   |   |   |   |   |   | 378,607 |   |
| Net change in accumulated  other comprehensive income, net of deferred income tax expense of $18,461     |       |              |       |                                      |       |                                  |       |                      |       |                               | 35,147     |                |       |      |       |   |   |   |   |   |   |   |   | 35,147 |   |
| Capital contribution                                                                                     |       |              |       |                                      |       |                                  | 1,251      |                      |       |                               |       |                |       |      |       |   |   |   |   |   |   |   |   | 1,251 |   |
| Dividends paid on common  stock                                                                          |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |      | (22,876    | ) |   |   |   |   |   |   |   | (22,876 | ) |
| Deferred equity payout                                                                                   |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |      |       |   |   |   | 83 |   |   | (83 | ) | — |   |
| BALANCE, December 31,  2004                                                                         |       |              | 335        |                                      |       |                                  | 905,080    |                      |       |                               | 199,764    |                |       |      | 1,506,099  |   |   |   | 23,528 |   |   | $ | (23,528 | ) | 2,611,278 |   |
| Net income for the year                                                                                  |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |      | 326,108    |   |   |   |   |   |   |   |   | 326,108 |   |
| Net change in accumulated  other comprehensive income, net of deferred income tax (benefit) of ($19,632) |       |              |       |                                      |       |                                  |       |                      |       |                               | (43,535    | )                   |       |      |       |   |   |   |   |   |   |   |   | (43,535 | ) |
| Capital contribution                                                                                     |       |              |       |                                      |       |                                  | 110        |                      |       |                               |       |                |       |      |       |   |   |   |   |   |   |   |   | 110 |   |
| Dividends paid on common  stock                                                                          |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |      | (71,059    | ) |   |   |   |   |   |   |   | (71,059 | ) |
| Deferred equity payout                                                                                   |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |      |       |   |   |   | (3,351 | ) |   | 3,351 |   | — |   |
| BALANCE, December 31,  2005                                                                         |       |              | 335        |                                      |       |                                  | 905,190    |                      |       |                               | 156,229    |                |       |      | 1,761,148  |   |   |   | 20,177 |   |   | (20,177 | ) | 2,822,902 |   |
| Net income for the year                                                                                  |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |      | 424,154    |   |   |   |   |   |   |   |   | 424,154 |   |
| Net change in accumulated  other comprehensive income, net of deferred income tax expense of $1,996      |       |              |       |                                      |       |                                  |       |                      |       |                               | 3,809      |                |       |      |       |   |   |   |   |   |   |   |   | 3,809 |   |
| Capital contribution                                                                                     |       |              |       |                                      |       |                                  | 1,497      |                      |       |                               |       |                |       |      |       |   |   |   |   |   |   |   |   | 1,497 |   |
| Dividends paid on common  stock                                                                          |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |      | (530,050   | ) |   |   |   |   |   |   |   | (530,050 | ) |
| Deferred equity payout                                                                                   |       |              |       |                                      |       |                                  |       |                      |       |                               |       |                |       |      |       |   |   |   | (952 | ) |   | 952 |   | — |   |
| BALANCE, December 31, 2006                                                                          |       |              | $          | 335                                       |       |                                  |       | $                         | 906,687    |                               |       |                | $          | 160,038   |       |   |   | $ | 1,655,252 |   |   |   | $ | 19,225 |   |   | $ | (19,225 | ) | $ | 2,722,312 |   |

 

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

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**FINANCIAL SECURITYASSURANCE HOLDINGS LTD. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)**

| ** **                                                          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                               |       |                                        |       |   |   |   |   |
| Premiums received, net                                              |       | $                                           | 523,416    |   | $ | 594,390 |   | $ | 571,696 |   |
| Policy acquisition and  other operating expenses paid, net          |       | (176,425                                    | )          | (167,947 | ) | (141,875 | ) |
| Salvage and subrogation                                             |       | 1,745                                       |       | (362 | ) | 7,327 |   |
| Losses and loss  adjustment expenses paid, net                      |       | (405                                        | )          | (1,124 | ) | (42,936 | ) |
| Net investment income  received                                     |       | 215,656                                     |       | 204,460 |   | 171,915 |   |
| Federal income taxes paid                                           |       | (92,394                                     | )          | (122,754 | ) | (62,723 | ) |
| Interest paid on notes  payable                                     |       | (26,878                                     | )          | (26,957 | ) | (27,789 | ) |
| Interest paid in  financial products segment                        |       | (511,226                                    | )          | (274,649 | ) | (74,608 | ) |
| Interest received in  financial products segment                    |       | 784,480                                     |       | 432,821 |   | 139,181 |   |
| Net derivative payments in  financial products segment              |       | (48,457                                     | )          | (21,016 | ) | (18,848 | ) |
| Income received from  refinanced assets                             |       | 41,525                                      |       | 37,359 |   | 28,485 |   |
| Purchases of trading  portfolio securities                          |       | (117,483                                    | )          | — |   | — |   |
| Other                                                               |       | 17,597                                      |       | 103 |   | 1,023 |   |
| Net cash provided by  (used for) operating activities               |       | 611,151                                     |       | 654,324 |   | 550,848 |   |
| Cash flows from investing activities:                               |       |                                        |       |   |   |   |   |
| Proceeds from sales of  bonds in general investment portfolio       |       | 1,637,339                                   |       | 1,757,590 |   | 1,187,349 |   |
| Proceeds from maturities  of bonds                                  |       | 163,257                                     |       | 130,900 |   | 267,800 |   |
| Purchases of bonds                                                  |       | (2,161,561                                  | )          | (2,217,506 | ) | (1,918,477 | ) |
| Net change in short-term  investments                               |       | 64,296                                      |       | (47,672 | ) | (32,106 | ) |
| Proceeds from sales of  bonds in financial products segment         |       | 4,512,453                                   |       | 5,635,291 |   | 2,511,815 |   |
| Proceeds from maturities  of bonds in financial products segment    |       | 4,509,784                                   |       | 1,605,170 |   | 132,245 |   |
| Purchases of bonds in  financial products segment                   |       | (12,830,545                                 | )          | (11,107,956 | ) | (6,197,067 | ) |
| Securities purchased  under agreements to resell                    |       | 200,000                                     |       | (350,000 | ) | 175,000 |   |
| Net change in financial  products segment short-term investments    |       | 358,481                                     |       | (748,863 | ) | (29,385 | ) |
| Purchases of property,  plant and equipment                         |       | (3,441                                      | )          | (32,973 | ) | (5,427 | ) |
| Assets acquired in  refinancing transactions                        |       | —                                      |       | — |   | (378,672 | ) |
| Paydowns of assets  acquired in refinancing transactions            |       | 88,477                                      |       | 92,514 |   | 102,534 |   |
| Proceeds from sales of  assets acquired in refinancing transactions |       | 13,642                                      |       | 182,701 |   | 60,953 |   |
| Other investments                                                   |       | 24,100                                      |       | 46,877 |   | 247 |   |
| Net cash provided  by (used for) investing activities               |       | (3,423,718                                  | )          | (5,053,927 | ) | (4,123,191 | ) |
| Cash flows from financing activities:                               |       |                                        |       |   |   |   |   |
| Issuance of notes payable                                           |       | 295,788                                     |       | — |   | — |   |
| Distribution to minority  shareholder                               |       | —                                      |       | (55,443 | ) | (6,980 | ) |
| Dividends paid                                                      |       | (530,050                                    | )          | (71,059 | ) | (22,876 | ) |
| Securities sold under  repurchase agreements                        |       | —                                      |       | (5,656 | ) | (58,309 | ) |
| Proceeds from issuance of  financial products segment debt          |       | 6,751,556                                   |       | 8,289,950 |   | 6,586,020 |   |
| Repayment of financial  products segment debt                       |       | (3,715,670                                  | )          | (3,734,635 | ) | (2,931,057 | ) |
| Capital issuance costs                                              |       | (964                                        | )          | (1,343 | ) | (1,260 | ) |
| Capital contribution                                                |       | —                                      |       | 110 |   | — |   |
| Repayment of preferred  stock                                       |       | —                                      |       | — |   | (6,300 | ) |
| Net cash provided by  (used for) financing activities               |       | 2,800,660                                   |       | 4,421,924 |   | 3,559,238 |   |
| Effect of changes  in foreign exchange rates on cash balances       |       | 749                                         |       | (1,330 | ) | 1,966 |   |
| Net (decrease)  increase in cash                                    |       | (11,158                                     | )          | 20,991 |   | (11,139 | ) |
| Cash at beginning  of year                                          |       | 43,629                                      |       | 22,638 |   | 33,777 |   |
| Cash at end of  year                                                |       | $                                           | 32,471     |   | $ | 43,629 |   | $ | 22,638 |   |

 

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

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**FINANCIAL SECURITYASSURANCE HOLDINGS LTD. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED(in thousands)**

| ** **                                                                                               | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Reconciliation of net income to net cash flows from  operating activities:                               |       |                                       |       |   |   |   |   |
| Net income                                                                                               |       | $                                          | 424,154    |   | $ | 326,108 |   | $ | 378,607 |   |
| Increase in  accrued investment income                                                                   |       | (25,516                                    | )          | (14,126 | ) | (15,976 | ) |
| Increase in  deferred premium revenue, net of prepaid reinsurance premiums                               |       | 138,467                                    |       | 173,635 |   | 169,670 |   |
| Increase in  deferred acquisition costs                                                                  |       | (5,544                                     | )          | (27,114 | ) | (34,369 | ) |
| Increase  (decrease) in current federal income taxes payable                                             |       | (11,935                                    | )          | 5,921 |   | 7,430 |   |
| Increase  (decrease) in unpaid losses and loss adjustment expenses, net of  reinsurance recoverable |       | 21,401                                     |       | 24,856 |   | (29,651 | ) |
| Provision  (benefit) for deferred income taxes                                                           |       | 65,226                                     |       | 1,330 |   | 57,689 |   |
| Net realized  losses (gains) on investments                                                              |       | (5,734                                     | )          | (5,427 | ) | (1,744 | ) |
| Depreciation and  accretion of discount                                                                  |       | 102,818                                    |       | 96,907 |   | 29,639 |   |
| Minority interest  and equity in earnings of unconsolidated affiliates                                   |       | (52,006                                    | )          | 14,116 |   | 90,746 |   |
| Change in other  assets and liabilities                                                                  |       | (40,180                                    | )          | 58,118 |   | (101,193 | ) |
| Cash provided by  operating activities                                                                   |       | $                                          | 611,151    |   | $ | 654,324 |   | $ | 550,848 |   |

 

The Company received no tax benefits in 2006 or 2005and received tax benefits of $1.2 million in 2004 from its parent company,which was recorded as a capital contribution. See Note 12 for disclosureof non-cash transactions relating to restricted treasury stocktransactions.

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

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**FINANCIAL SECURITYASSURANCE HOLDINGS LTD. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**

**1.**   ORGANIZATIONAND OWNERSHIP

Financial Security Assurance Holdings Ltd. (“FSAHoldings,” or together with its consolidated entities, the “Company”) is aholding company incorporated in the State of New York. The Company isprincipally engaged, through its insurance company subsidiaries, in providingfinancial guaranty insurance on public finance and asset-backed obligations.Its primary insurance company subsidiary is Financial Security Assurance Inc. (“FSA”).The Company’s underwriting policy is to insure public finance and asset-backedobligations that it determines would be investment-grade quality withoutthe benefit of the Company’s insurance. Public finance obligations insured bythe Company consist primarily of general obligation bonds that are supported bythe issuers’ taxing powers and special revenue bonds and other specialobligations of states and local governments that are supported by the issuers’abilities to impose and collect fees and charges for public services orspecific projects. Public finance obligations include obligations backed by thecash flow from leases or other revenues from projects serving substantialpublic purposes, including government office buildings, toll roads, health carefacilities and utilities. Asset-backed obligations insured by the Companyare generally issued in structured transactions and are backed by pools ofassets, such as residential mortgage loans, consumer receivables, securities orother assets having an ascertainable cash flow or market value. The Companyalso insures synthetic asset-backed obligations that generally take theform of credit default swap (“CDS”) obligations or credit-linked notesthat reference pools of securities or loans, with a defined deductible to covercredit risks associated with the referenced securities or loans.

Financial guaranty insurance written by the Companyguarantees scheduled payments on an issuer’s obligation. In the case of apayment default on an insured obligation, the Company is generally required topay the principal, interest or other amounts due in accordance with theobligation’s original payment schedule or, at its option, to pay such amountson an accelerated basis.

The Company expects to continue to emphasize adiversified insured portfolio characterized by insurance of both public financeand asset-backed obligations, with a broad geographic distribution and avariety of revenue sources and transaction structures. The Company’s insuredportfolio consists primarily of public finance and asset-backedobligations originated in the United States of America, but the Company hasalso written and continues to pursue business in Europe, the Asia Pacificregion and elsewhere in the Americas.

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. FSAM wholly owns FSA PortfolioAsset Limited (“FSA-PAL”), a U.K. Company that invests in non-U.S. securities.

The Company consolidates the results of certainvariable interest entities (“VIEs”), including FSA Global Funding Limited (“FSAGlobal”) and Premier International Funding Co. (“Premier”). The Companyconsolidates FSA Global in accordance with Financial Accounting Standards BoardInterpretation No. 46, “Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51” 

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(revised December 2003)(“FIN 46-R”). The Company also consolidates Premier as a result ofobtaining control rights.

FSA Global is a special purpose funding vehiclepartially owned by a subsidiary of FSA Holdings. FSA Global issues FSA-insuredmedium term notes and invests the proceeds from the sale of its notes in FSA-insuredobligations with a view to realizing the yield difference between the notesissued and the obligations purchased with the note proceeds. Premier isprincipally engaged in debt defeasance for public finance lease transactions.The GIC Affiliates, FSAM, FSA-PAL, FSA Global and Premier are collectivelyreferred to as the “FP Segment.”

The Company refinanced certain defaulted transactionsby employing refinancing vehicles to raise funds. These refinancing vehiclesare also consolidated. The Company’s management believes that the assets heldby FSA Global, Premier and the refinancing vehicles, including those that areeliminated in consolidation, are beyond the reach of the Company and itscreditors, even in bankruptcy or other receivership.

On July 5, 2000, theCompany completed a merger in which FSA Holdings became a direct subsidiary ofDexia Holdings, Inc. (“Dexia Holdings”), which, in turn, is owned 90% byDexia Crédit Local S.A. (“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 December 31, 2006,Dexia Holdings owned over 99% of FSA Holdings outstanding shares; the onlyother holders of FSA Holdings common stock were certain current and formerdirectors of FSA Holdings who owned shares of FSA Holdings common stock oreconomic interests therein under the Director Share Purchase Program (see Note12). During 2006, Dexia purchased all the shares previously owned by anaffiliate of White Mountains Insurance Group, Ltd. (“White Mountains”).

**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 23). The preparation of financial statementsin conformity with GAAP requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities in the Company’sconsolidated balance sheets at December 31, 2006 and 2005, the reportedamounts of revenues and expenses in the statements of operations andcomprehensive income during the years ended December 31, 2006, 2005 and2004 and disclosure of contingent assets and liabilities. Such estimates andassumptions include, but are not limited to, losses and loss adjustmentexpenses, fair value of financial instruments and the deferral and amortizationof policy acquisition costs. Actual results may differ from those estimates.Significant accounting policies under GAAP are as follows:

***Basis of Presentation***

The Consolidated FinancialStatements include the accounts of FSA Holdings and its direct and indirectsubsidiaries, principally including FSA, FSA Insurance Company, FinancialSecurity Assurance International Ltd. (“FSA International”), Financial SecurityAssurance (U.K.) Limited, the GIC Affiliates, FSAM, FSA Portfolio ManagementInc., Transaction Services Corporation, FSA Services (Australia) Pty Limited,FSA Mexico Holdings Inc. and FSA Services (Japan) Inc. (collectively, the “Subsidiaries”).The Consolidated Financial Statements also include the accounts of certain VIEsand refinancing vehicles. All intercompany accounts and transactions have beeneliminated.

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***Investments***

Investments in debt and equity securities designatedas available for sale are carried at fair value. The unrealized gain or loss oninvestments that are not hedged or are economically hedged but do not qualifyfor hedge accounting is reflected as a separate component of shareholders’equity, net of applicable deferred income taxes. The unrealized gain or lossattributable to the hedged risk on investments that qualify as fair-valuehedges is recorded in income currently. Investments in debt and equitysecurities designated as trading are carried at fair value. The unrealized gainor loss on trading investments are recognized in income currently. The cost ofsecurities sold is based on specific identification of each security.

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 fair value. Changes in fair value ofshort-term investments are due to changes in foreign exchange rates. Amountsdeposited in money market funds and investments with a maturity at time ofpurchase of three months or less are included in short-term investments.

Variable rate demand notes (“VRDNs”) are included inbonds in the General Investment Portfolio. Auction rate securities (“ARS”) areincluded in bonds in the FP Segment Investment Portfolio. The FP SegmentInvestment Portfolio consists of investments supporting GIC liabilities (“FPInvestment Portfolio”) and investments supporting VIE liabilities (“VIEInvestment Portfolio”). The FP Investment Portfolio includes securitiesclassified as trading securities.

VRDNs are long-term bonds that bear floating interestrates and provide investors with the option to tender or put the bonds at par,generally on a daily, weekly or monthly basis. ARS are long-term securitieswith interest rate reset features and are traded in the marketplace through abidding process. The cash flows related to these securities are presented on agross basis in the consolidated statements of cash flows.

Mortgage loans are carried at the lower of cost ormarket on an aggregate basis. Realized gains or losses on sale of investmentsare determined on the basis of specific identification. Investment income isrecorded as earned. Other-than-temporary impairments are reflectedin earnings as a realized loss.

Investments in unconsolidated affiliates are based onthe equity method of accounting (see Note 3). The Company records its share ofunrealized gains or losses of unconsolidated affiliates, net of applicabledeferred taxes, in other comprehensive income.

Included in assetsacquired in refinancing transactions are asset-backed senior notes thatrepresent the Company’s purchase of less than 50% of a refinanced transaction.These assets are designated as available for sale. Certain other asset-backedsecurities are carried at cost, with any reduction in carrying value recognizedas an adjustment to yield in accordance with American Institute of CertifiedPublic Accountants  Statement of Position03-3, “Accounting for Certain Loans or Debt Securities Acquired in aTransfer.”

***Derivatives***

The Company enters into derivative contracts to manageinterest rate and foreign currency risks associated with the Company’s GIC andVIE debt and FP Segment Investment Portfolio. The derivatives are recorded atfair value and generally include interest rate futures and interest rate andcurrency swap agreements, which are primarily utilized to convert the Company’sfixed rate GIC and VIE debt and FP Segment Investment Portfolio into U.S.-dollarfloating rate assets and liabilities. The gains and losses relating toderivatives not designated as fair-value hedges are included in net realizedand unrealized gains (losses) on derivative instruments in the consolidatedstatements of operations and comprehensive income.

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The gains and losses related to derivatives designatedas fair-value hedges are included in either net interest income or net interestexpense from the FP Segment, as appropriate, along with the offsetting changein the fair value of the risk being hedged.

The Company has alsoinsured a number of CDS agreements that it intends, in each case, to hold forthe full term of the agreement. It considers these agreements to be a normalextension of its financial guaranty insurance business, although they areconsidered derivatives for accounting purposes. These agreements are recordedat fair value. The Company believes that the most meaningful presentation ofthe financial statement impact of these derivatives is to record earnedpremiums over the installment period, to record losses and loss adjustmentexpenses as incurred and to record changes in fair value as incurred. Changesin fair value are recorded in net realized and unrealized gains (losses) onderivative instruments and in either other assets or other liabilities, asappropriate. The Company uses quoted market prices, when available, todetermine fair value. If quoted prices are not available, as is generally thecase, management uses internally developed estimates of fair value. Managementapplies judgment when developing these estimates and considers factors such ascurrent prices charged for similar agreements, performance of underlyingassets, changes in internal shadow ratings, the level at which the deductiblehas been set and the Company’s ability to obtain reinsurance for its insuredobligations. Due to a lack of a quoted market for the CDS obligations written bythe Company, estimates generated from the Company’s valuation process maydiffer materially from values that may be realized in market transactions.

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

Securities purchased underagreements to resell and securities sold under agreements to repurchase areaccounted for as collateralized transactions and are recorded at contract valueplus accrued interest. It is the Company’s policy to take possession of securitiesborrowed under agreements to resell.

***Premium Revenue Recognition***

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

For premiums received onan installment basis, the Company earns the premium over the installmentperiod, typically less than one year, throughout the period of coverage.Typically, installment premiums are applicable to insured transactions thatinvolve CDS or special purpose vehicles (“SPVs”) structured to finance pools ofassets such as auto loans or mortgage loans. Premiums on such transactions aretypically paid in installments, as the nature of the assets financed can haveuncertain debt service schedules due to prepayments. When the Company, throughits ongoing credit review process, identifies transactions where premiums arepaid on an installment basis and certain default triggers have been breached,the Company ceases to earn premiums on such transactions. Premium revenuerecognition is subject to change as a result of the FASB project described in “—Lossesand Loss Adjustment Expenses.”

***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 

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a payment default on aninsured obligation, the Company is generally required to pay the principal,interest or other amounts due in accordance with the obligation’s originalpayment schedule or, at its option, to pay such amounts on an acceleratedbasis.

The financial guarantyindustry has emerged over the past 35 years. Management believes that existinginsurance accounting under Statement of Financial Accounting Standards No. 60,“Accounting and Reporting by Insurance Enterprises” (“SFAS 60”), does notspecifically address financial guaranty insurance. Accordingly, the accountingfor loss and loss adjustment expenses within the financial guaranty insuranceindustry has developed based on analogy to the most directly comparableelements of existing literature, including sections of SFAS 60, Statement ofFinancial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS5”) and Emerging Issues Task Force Issue 85-20, “Recognition of fees forguaranteeing a loan” (“EITF 85-20”).

*Company-SpecificPolicy*

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

The Company calculates a loss and LAE liability basedupon identified risks inherent in its insured portfolio. If an individualpolicy risk has a reasonably estimable and probable loss as of the balancesheet date, a case reserve is established. For the remaining policy risks inthe portfolio, a non-specific reserve is established to account for theinherent credit losses that can be statistically 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 guaranty lossesarise from the extension of credit protection and occur as the result of thecredit deterioration of the issuer or underlying assets of the insuredobligations over the lives of those insured obligations. Such deterioration andultimate loss amounts can be projected based on historical experience in orderto estimate probable loss, if any. Accordingly, specific loss events thatrequire case reserves include (1) policies under which claim payments havebeen made and additional claim payments are expected and (2) policiesunder which claim payments are probable and reasonably estimable, but have notyet been made.

The Company establishes a case reserve for the presentvalue of the estimated loss, net of subrogation recoveries, when, inmanagement’s opinion, the likelihood of a future loss on a particular insuredobligation is probable and reasonably estimable at the balance sheet date. Whenan insured obligation has met the criteria for establishing a case reserve andthat transaction pays a premium in installments, those premiums, if expected tobe received 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 (1) scheduled payments on the insuredobligation plus anticipated loss adjustment expenses and (2) anticipatedcash flow from and proceeds to be received on sales of any collateralsupporting the obligation and other anticipated recoveries. The estimated loss,net of recovery, on a transaction is discounted using the risk-free rateappropriate for the term of the insured obligation at the time the reserve isestablished and is not subsequently adjusted.

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

The Company establishes a non-specific reserveon its portfolio of credits because management believes that a portfolio ofinsured obligations will deteriorate over its life and that the existence ofinherent loss can be proven statistically by data such as that published byrating agencies. The establishment of the reserve is a systematic process thatconsiders this quantitative, statistical information obtained primarily fromMoody’s Investors Service, Inc. (“Moody’s”) and Standard & Poor’sRatings Services (“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 amountwith the incurred losses as represented by case reserve activity to develop anexperience factor that is updated and applied to current-year originations. Theprocess results in management’s best estimate of inherent losses associatedwith providing credit protection at each balance sheet date.

The non-specific reserve established considersall levels of protection (e.g., reinsurance and overcollateralization). Net paroutstanding for policies originated in the current period is multiplied by lossfrequency and severity factors, with the resulting amounts discounted at therisk-free rates using the treasury yield curve (the “statisticalcalculation”). The discount rate does not change and is used to accrete theloss for the life of each policy. The loss factors used for the calculation arethe product of default frequency rates obtained from Moody’s and severityfactors obtained from S&P. Moody’s is chosen for default frequency ratesdue to its credibility, large population, statistical format and reliability offuture update. The Moody’s default information is applied to all credit sectorsor asset classes as described below. In its publication of default rates forbonds issued from 1970-2005, Moody’s tracks bonds over a 20-yearhorizon by credit rating at time of issuance. For the purpose of establishingappropriate severity factors, the Company’s methodology segregates theportfolio into asset classes, including health care transactions, all otherpublic finance transactions, pooled corporate transactions, commercial realestate, and all other asset-backed transactions. The severity factors arederived from capital charge assessments provided by S&P. S&P capitalcharges project loss levels by asset class and are incorporated into theircapital 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 each 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, an analysisis performed of the non-specific reserve balance with particular emphasis onthe asset class, if any, driving the experience factor adjustment. Theobjective 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.

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The present value of loss amounts calculated for thecurrent-year originations plus an amount representing the accretion ofdiscount pertaining to prior-year originations are charged to lossexpense and increase the non-specific loss reserve after adjustments that maybe made to reflect observed favorable or adverse experience. The entirenon-specific reserve is available to absorb probable losses inherent in theportfolio. As there are no specific losses provided in the non-specificreserve, there is no identifiable reinsurance recoverable. At the time that acase reserve is identified, the gross loss liability is recognized along withthe reinsurance recoverable, if any. The amount of reinsurance recoverabledepends on the policy ceded and the reinsurance agreements covering suchpolicy. Management cannot predict the specific policies that will emerge ascase-basis losses from the portfolio and is not entitled to recovery fromthe reinsurer in advance 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. Such analyses are performed to quantifyappropriate adjustments that may be either charges or benefits on theconsolidated statements of operations and comprehensive income, as occurred in2004.

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

| ** **                          | ** ** | **As of December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Case reserve  discount rate         |       | 3.13%–5.90%                      |       | 3.13%–5.90% |   |
| Non-specific  reserve discount rate |       | 1.20%–7.95%                      |       | 1.20%–7.95% |   |
| Current experience  factor          |       | 1.6                                   |       | 1.8 |   |

 

*ReservingMethodology Industry Practice*

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

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

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

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changed by the insurer andthat match the maturity terms of the underlying insured obligations, containsprobable and reasonably estimable losses.

The Financial Accounting Standards Board (“FASB”)staff is considering additional guidance regarding financial guarantyinsurance. When and if the FASB reaches a conclusion on this issue, the Companyand the rest of the financial guaranty industry may be required to change someaspects of their loss reserving policies, and the potential changes couldextend to premium recognition. The Company cannot predict how the FASB willresolve this issue and the resulting impact on its financial statements.

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

***Deferred Costs***

*Financial Guaranty*

Deferred acquisition costscomprise expenses primarily related to the production of business, includingcommissions paid on reinsurance assumed, compensation and related costs ofunderwriting and marketing personnel, certain rating agency fees, premium taxesand certain other underwriting expenses, reduced by ceding commission receivedon premiums ceded to reinsurers. Deferred acquisition costs are amortized overthe period in which the related premiums are earned. When an insured issue isretired or defeased prior to the end of the expected period of coverage, theremaining deferred acquisition cost is recognized. A premium deficiency wouldbe recognized if the present value of anticipated losses and loss adjustmentexpenses exceeded the sum of deferred premium revenue and estimated installmentpremiums.

*Financial Products*

The Company does not deferorigination 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 from theFP Segment.

***GIC and VIE Debt***

GIC and VIE debt isrecorded at amortized cost. The Company may enter into transactions in order toreduce the Company’s exposure to fluctuations in interest rates and foreignexchange rates. For GIC and VIE debt in a qualifying accounting hedge, thechange in the fair value of debt adjusts the carrying amount of the debt and isrecognized in income currently. VIE debt may include hybrid debt instrumentsthat contain embedded derivatives. Under certain conditions, GAAP requires thatembedded derivatives be separated from the debt instrument and accounted for atfair value, with all changes in fair value reflected through earnings.

***Foreign Currency Translation***

Monetary assets andliabilities denominated in foreign currencies are translated at the spot rateat the balance sheet date. Non-monetary assets and liabilities aretranslated at historical rates. Revenues and expenses denominated in foreigncurrencies are translated at average rates prevailing during the year.Unrealized gains and losses on available-for-sale securities, netof deferred taxes, resulting from translating investments denominated inforeign currencies are recorded in shareholders’ equity. Gains and losses fromtransactions in foreign currencies are recorded in other income.

***Federal Income Taxes***

The provision for income taxes consists of an amountfor taxes currently payable and an amount for deferred taxes arising fromtemporary differences between the tax bases of assets and liabilities and the 

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reported amounts in thefinancial statements that will result in deductible or taxable amounts infuture years when the reported amounts of assets and liabilities are recoveredor settled.

Non-interest-bearingtax and loss bonds are purchased to prepay 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 in other assets.

***Special Purpose Entities***

Asset-backed and, to a lesser extent, publicfinance transactions insured by FSA may employ special purpose entities for avariety of purposes. A typical asset-backed transaction, for example,employs a special purpose entity as the purchaser of the securitized assets andas the issuer of the insured obligations. FSA’s participation is typicallyrequested by the sponsor of the special purpose entity or the underwriter,either via a bid process or on a sole-source basis. Special purpose entitiesare typically owned by transaction sponsors or charitable trusts, although FSAmay have an ownership interest in some cases. FSA maintains certain contractualrights and exercises varying degrees of influence over special purpose entityissuers of FSA-insured obligations. FSA also bears some of the “risks andrewards” associated with the performance of those special purpose entities’assets. Specifically, as issuer of the financial guaranty insurance policyinsuring a given special purpose entity’s obligations, FSA bears the risk ofasset performance (typically, but not always, after a significant depletion ofovercollateralization, excess spread, a deductible or other credit protection).FSA’s underwriting policy is to insure only obligations that are otherwiseinvestment grade. In addition, the special purpose entity typically pays aperiodic premium to FSA in consideration of the issuance by FSA of itsinsurance policy, with the special purpose entity’s assets typically serving asthe source of such premium, thereby providing some of the “rewards” of thespecial purpose entity’s assets to FSA. Special purpose entities are alsoemployed by FSA in connection with “repackaging” of outstanding securities intonew securities insured by FSA and with refinancing underperforming, non-investment-gradetransactions insured by FSA.

The degree of influence exercised by FSA over thesespecial purpose entities varies from transaction to transaction, as does thedegree to which “risks and rewards” associated with asset performance areassumed by FSA.

FIN 46-R addressesconsolidation of VIEs that have one or both of the following characteristics: (a) theequity investment at risk is not sufficient to permit the entity to finance itsactivities without additional subordinated financial support from otherparties, which is provided through other interests that will absorb some or allof the expected losses of the entity; and (b) the equity investors lackthe direct or indirect ability to make decisions about the entity’s activitiesthrough voting rights or similar rights and do not have the obligation toabsorb the expected losses of the entity if they occur or the right to receivethe expected residual returns of the entity if they occur. In analyzing specialpurpose entities described above, the Company considers reinsurance to be animplicit variable interest. Where the Company determines it is required toconsolidate the special purpose entity, the outstanding exposure is excludedfrom Note 10.

***Recently Issued Accounting Standards***

In June 2006, the FASB issued FASB InterpretationNo. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), aninterpretation of Statement of Financial Accounting Standards No. 109, “Accountingfor Income Taxes” (“SFAS 109”). FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an entity’s financial statements inaccordance with SFAS 109 and prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. FIN 48 alsoprovides guidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure and transition. FIN 48 is applicable forfiscal years beginning after December 15, 2006, with early applicationencouraged if financial statements, including interim financial statements,have not been issued in the 

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period of adoption. TheCompany does not expect FIN 48 to have a material impact on its financialstatements.

In February 2006, the FASB issued Statement ofFinancial Accounting Standards No. 155, “Accounting for Certain HybridFinancial Instruments” (“SFAS 155”), which amends Statement of FinancialAccounting Standards No. 133, “Accounting for Derivative Instruments andHedging Activities” (“SFAS 133”) and Statement of Financial Accounting StandardsNo. 140, “Accounting for Transfers and Servicing of Financial Assets andExtinguishment of Liabilities.”  SFAS 155permits hybrid financial instruments that contain an embedded derivative thatwould otherwise require bifurcation to be irrevocably accounted for at fairvalue, with changes in fair value recognized in the statements of operationsand comprehensive income. The fair-value election may be applied on aninstrument-by-instrument basis. SFAS 155 also eliminates a restriction thatprevents qualifying special purpose entities from holding derivative financialinstruments that pertain to beneficial interests that are not derivativefinancial instruments. SFAS 155 is effective for all financial instrumentsacquired or issued after December 31, 2006. The Company does not expectSFAS 155 to have a material impact on its financial statements.

On September 15, 2006, the FASB issued Statementof Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS157”), which addresses how companies should measure fair value when required touse fair value measures for recognition or disclosure purposes under GAAP. SFAS157 adopted an “exit price” approach to determining fair value and establisheda three-level fair value hierarchy to prioritize the inputs used in valuationtechniques. Level 1 is the highest priority and is defined as observable inputsthat reflect quoted prices (unadjusted) for identical assets or liabilities inactive markets. Level 2 is defined as inputs other than quoted prices includedin Level 1 that are observable for the asset or liability through corroborationwith observable market data. Level 3 is the lowest priority and is defined as avaluation based on unobservable inputs such as a company’s own data. Prioritizationof inputs, as well as other considerations, determine the level of disclosurerequired. SFAS 157 is applicable to financial statements issued for fiscalyears beginning after November 15, 2007 and for interim periods withinthose fiscal years. The Company is in the process of evaluating the impact ofSFAS 157 on its financial statements.

In February 2007, TheFASB issued Statement of Financial Accounting Standards No. 159, “The FairValue Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS159 permits reporting entities to choose to measure at fair value manyfinancial instruments and certain other items that are not currently requiredto be measured at fair value. The fair value option may be applied instrumentby instrument, is irrevocable and is applied only to entire instruments and notto portions of instruments. SFAS 159 is effective for fiscal years beginningafter November 15, 2007. Early adoption is permitted, under certaincircumstances, provided the provisions of SFAS 157 are also applied. TheCompany is currently evaluating the implication of SFAS 159 for its financialstatements.

***Revisions***

The statement of cash flows for the period ended December 31,2006 appropriately segregates the effect of changes in foreign exchange rateson cash balances into a separate line item. The effect of foreign exchangerates on cash balances has historically been included in cash flows fromoperations. As part of the review of these foreign cash accounts, it wasdetermined that certain of these accounts are appropriately classified as cashrather than as short-term investments at December 31, 2006. The statementsof cash flows for the periods ended December 31, 2005 and 2004 have beenrevised to conform to the 2006 presentation. Changes in classification of theseaccounts to cash from short-term investments are also reflected in the balancesheet. The amounts revised for 2005 and 2004 from short-term investments tocash were $23.5 million and $8.3 million, respectively.

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**3.   GENERAL INVESTMENT PORTFOLIO**

Bonds and short-term deposits at an amortized cost of$10.5 million and $9.9 million at December 31, 2006 and 2005,respectively, were on deposit with state regulatory authorities as required byinsurance regulations.

Consolidatednet investment income attributable to the General Investment Portfolioconsisted of the following:

| ** **                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                        | ** ** | **(in thousands)**                    | ** ** |
| Bonds and  short-term investments |       | $                                          | 217,253    |   | $ | 194,736 |   | $ | 174,551 |   |
| Equity  investments               |       | 4,523                                      |       | 8,931 |   | — |   |
| Investment  expenses              |       | (2,926                                     | )          | (2,840 | ) | (2,500 | ) |
| Net investment  income            |       | $                                          | 218,850    |   | $ | 200,827 |   | $ | 172,051 |   |

 

Thecredit quality of bonds in the General Investment Portfolio, based on amortizedcost, at December 31, 2006 was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|
| AAA           |       |       | 85.8       | %                              |       |
| AA            |       |       | 11.2       |                           |       |
| A        |       |       | 2.9        |                           |       |
| NR            |       |       | 0.1        |                           |       |
| Total         |       |       | 100.0      | %                              |       |

 

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(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2006.

The General Investment Portfolio includes bondsinsured by FSA (“FSA-Insured Investments”). Of the bonds included in theGeneral Investment Portfolio, 6.2% were Triple-A by virtue of insuranceprovided by FSA. Over 95% of the FSA-Insured Investments were investment gradewithout giving effect to the FSA insurance. The average shadow rating of theFSA-Insured Investments, which is the rating without giving effect to the FSAinsurance, was in the Double-A range.

Theamortized cost and fair value of the bonds in the General Investment Portfoliowere as follows:

| ** **                                                                             | ** ** | **As of December 31, 2006** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **                                                                             | ** ** | **(in thousands)**                         | ** ** |
| U.S. Treasury  securities and obligations of U.S. government corporations and agencies |       | $                                               | 165,530    |   |   | $ | 2,392 |   |   |   | $ | (1,898 | ) |   | $ | 166,024 |   |
| Obligations of  states and political subdivisions                                      |       | 3,663,821                                       |       |   | 171,564 |   |   |   | (1,182 | ) |   | 3,834,203 |   |
| Mortgage-backed  securities                                                            |       | 262,651                                         |       |   | 1,000 |   |   |   | (4,183 | ) |   | 259,468 |   |
| Corporate  securities                                                                  |       | 218,222                                         |       |   | 1,534 |   |   |   | (2,207 | ) |   | 217,549 |   |
| Foreign  securities                                                                    |       | 213,065                                         |       |   | 8,508 |   |   |   | (175 | ) |   | 221,398 |   |
| Asset-backed  securities                                                               |       | 22,858                                          |       |   | 145 |   |   |   | (133 | ) |   | 22,870 |   |
| Subtotal                                                                               |       | 4,546,147                                       |       |   | 185,143 |   |   |   | (9,778 | ) |   | 4,721,512 |   |
| Short-term  investments                                                                |       | 96,055                                          |       |   | 600 |   |   |   | (77 | ) |   | 96,578 |   |
| Total                                                                                  |       | $                                               | 4,642,202  |   |   | $ | 185,743 |   |   |   | $ | (9,855 | ) |   | $ | 4,818,090 |   |

 

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|                                                                                        | ** ** | **As of December 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **                                                                             | ** ** | **(in thousands)**                         | ** ** |
| U.S. Treasury  securities and obligations of U.S. government corporations and agencies |       | $                                               | 195,495    |   |   | $ | 3,881 |   |   |   | $ | (755 | ) |   | $ | 198,621 |   |
| Obligations of  states and political subdivisions                                      |       | 3,431,046                                       |       |   | 173,279 |   |   |   | (5,457 | ) |   | 3,598,868 |   |
| Mortgage-backed  securities                                                            |       | 250,001                                         |       |   | 809 |   |   |   | (4,564 | ) |   | 246,246 |   |
| Corporate  securities                                                                  |       | 186,369                                         |       |   | 1,797 |   |   |   | (2,124 | ) |   | 186,042 |   |
| Foreign  securities                                                                    |       | 116,217                                         |       |   | 842 |   |   |   | (4,773 | ) |   | 112,286 |   |
| Asset-backed  securities                                                               |       | 40,216                                          |       |   | 10 |   |   |   | (252 | ) |   | 39,974 |   |
| Subtotal                                                                               |       | 4,219,344                                       |       |   | 180,618 |   |   |   | (17,925 | ) |   | 4,382,037 |   |
| Short-term  investments                                                                |       | 159,133                                         |       |   | — |   |   |   | — |   |   | 159,133 |   |
| Total                                                                                  |       | $                                               | 4,378,477  |   |   | $ | 180,618 |   |   |   | $ | (17,925 | ) |   | $ | 4,541,170 |   |

 

Foreign securities consist primarily ofgovernment-issued and corporate securities that are denominated in eitherBritish pound sterling or the euro.

The following table shows the gross unrealized lossesand fair value, aggregated by investment category and length of time thatindividual securities have been in a continuous unrealized loss position:
|                                                                                        | ** ** | **As of December 31, 2006** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                                             | ** ** | **Fair Value**                             | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| ** **                                                                             | ** ** | **(in thousands)**                         | ** ** |
| U.S. Treasury  securities and obligations of U.S. government corporations and agencies |       | $                                               | 76,125     |   |   | $ | (566 | ) |   | $ | 44,776 |   |   | $ | (1,332 | ) |   | $ | 120,901 |   |   | $ | (1,898 | ) |   |
| Obligations of  states and political subdivisions                                      |       | 99,977                                          |       |   | (205 | ) |   | 69,847 |   |   | (977 | ) |   | 169,824 |   |   | (1,182 | ) |   |
| Mortgage-backed  securities                                                            |       | 53,656                                          |       |   | (423 | ) |   | 137,608 |   |   | (3,760 | ) |   | 191,264 |   |   | (4,183 | ) |   |
| Corporate  securities                                                                  |       | 52,097                                          |       |   | (229 | ) |   | 94,357 |   |   | (1,978 | ) |   | 146,454 |   |   | (2,207 | ) |   |
| Foreign  securities                                                                    |       | 23,212                                          |       |   | (103 | ) |   | 2,683 |   |   | (72 | ) |   | 25,895 |   |   | (175 | ) |   |
| Asset-backed  securities                                                               |       | 3,009                                           |       |   | (6 | ) |   | 11,102 |   |   | (127 | ) |   | 14,111 |   |   | (133 | ) |   |
| Total                                                                                  |       | $                                               | 308,076    |   |   | $ | (1,532 | ) |   | $ | 360,373 |   |   | $ | (8,246 | ) |   | $ | 668,449 |   |   | $ | (9,778 | ) |   |

 
|                                                                                        | ** ** | **As of December 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                                             | ** ** | **Fair Value**                             | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| ** **                                                                             | ** ** | **(in thousands)**                         | ** ** |
| U.S. Treasury  securities and obligations of U.S. government corporations and agencies |       | $                                               | 65,922     |   |   | $ | (436 | ) |   | $ | 14,635 |   |   | $ | (319 | ) |   | $ | 80,557 |   |   | $ | (755 | ) |   |
| Obligations of  states and political subdivisions                                      |       | 375,766                                         |       |   | (3,609 | ) |   | 108,031 |   |   | (1,848 | ) |   | 483,797 |   |   | (5,457 | ) |   |
| Mortgage-backed  securities                                                            |       | 141,687                                         |       |   | (2,272 | ) |   | 48,060 |   |   | (2,292 | ) |   | 189,747 |   |   | (4,564 | ) |   |
| Corporate  securities                                                                  |       | 103,144                                         |       |   | (1,492 | ) |   | 23,650 |   |   | (632 | ) |   | 126,794 |   |   | (2,124 | ) |   |
| Foreign  securities                                                                    |       | 91,981                                          |       |   | (4,727 | ) |   | 409 |   |   | (46 | ) |   | 92,390 |   |   | (4,773 | ) |   |
| Asset-backed  securities                                                               |       | 18,540                                          |       |   | (124 | ) |   | 14,813 |   |   | (128 | ) |   | 33,353 |   |   | (252 | ) |   |
| Total                                                                                  |       | $                                               | 797,040    |   |   | $ | (12,660 | ) |   | $ | 209,598 |   |   | $ | (5,265 | ) |   | $ | 1,006,638 |   |   | $ | (17,925 | ) |   |

 

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At December 31, 2006, there were 451 investmentsin fixed-income securities for which amortized cost exceeded fair value; theaggregate amount of the excess over fair value was $9.8 million, or 1.5%.  At December 31, 2005, there were 616 suchinvestments, for which the aggregate amount of the excess over fair value was$17.9 million, or 1.8%. Management has determined that the unrealized losses infixed income securities at December 31, 2006 are primarily attributable tothe current interest rate environment and has concluded that these unrealizedlosses are temporary in nature based upon (a) no principal and interestpayment defaults on these securities; (b) analysis of the creditworthinessof the issuer; and (c) FSA’s ability and current intent to hold thesesecurities until a recovery in fair value or maturity. There were no individualsecurities with material unrealized losses as of December 31, 2006 and 2005.As of December 31, 2006 and 2005, 100% of the securities that were in agross unrealized loss position were rated investment grade.

Theamortized cost and fair value of bonds in the General Investment Portfolio at December 31,2006, by contractual maturity, are shown below. Actual maturities could differfrom contractual maturities because borrowers have the right to call or prepaycertain obligations with or without call or prepayment penalties.
|                                                                  | ** ** | **Amortized  Cost**     | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                                       | ** ** | **(in thousands)** | ** ** |
| Due in one year  or less                                         |       | $                       | 212,414    |                | $          | 212,768 |   |
| Due after one  year through five years                           |       | 1,167,172               |       | 1,223,913           |       |
| Due after five  years through ten years                          |       | 865,890                 |       | 894,927             |       |
| Due after ten  years                                             |       | 2,111,217               |       | 2,204,144           |       |
| Mortgage-backed  securities (stated maturities of 2 to 30 years) |       | 262,651                 |       | 259,468             |       |
| Asset-backed  securities (stated maturities of 1 to 28 years)    |       | 22,858                  |       | 22,870              |       |
| Total                                                            |       | $                       | 4,642,202  |                | $          | 4,818,090 |   |

 

Proceeds from sales ofbonds for the General Investment Portfolio during 2006, 2005 and 2004 were$1,637.3 million, $1,757.6 million and $1,187.3 million, respectively.Proceeds from maturities of bonds for the General Investment Portfolio during2006, 2005 and 2004 were $163.3 million, $130.9 million and $267.8 million, respectively. Gross gains of $0.9 million, $10.9million and $5.2 million and gross losses of $5.8 million, $6.1 million and$5.7 million were realized on sales in 2006, 2005 and 2004, respectively.

***Equity Investments***

*SPS Holding Corp.*

At December 31, 2004, the Company had a 34.1%interest in SPS Holding Corp. (“SPS”) (formerly Fairbanks Capital HoldingCorp.). The Company’s investment in SPS was accounted for using the equitymethod of accounting.

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

In October 2005,the Company sold its investment in SPS to an unaffiliated third party. For itsinterest in SPS, the Company was paid $42.9 million in cash at closing andexpects to receive additional amounts, from time to time through March 31,2008, out of income earned by SPS through December 31, 2007 from certainof its mortgage servicing activities. Under the sale documents, the Company’ssubsidiary that owned the SPS investment made customary representations andwarranties to, and undertook specified indemnification obligations for thebenefit of, the purchaser. Based on an estimate of the assets retained andliabilities assumed, the Company recorded a $0.4 million loss on the sale ofSPS. Under the terms of the agreement, the Company will receive cash paymentsthrough the first quarter of 2008 from a residual 

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interest in mortgage servicing assets. The Companyrecorded an asset of $12.6 million representing this contingent paymentasset. The Company and other prior shareholders indemnified the buyer forcertain liabilities relating to SPS’s operations, including litigation andregulatory actions. The maximum indemnification obligation for SPS’s operationswill not exceed approximately $34.0 million. The Company’s portion of thisobligation is 37.4% or $12.7 million. As of December 31, 2005, theCompany recorded a $5.1 million liability related to this indemnification,representing the expected liability. As of December 31, 2006, theliability had a balance of $3.3 million. The Company has received a net amountof $11.2 million related to this asset and liability. The Company will continueto evaluate the appropriate carrying value of the liabilities assumed. Amountsrecorded by the Company in connection with SPS at December 31, 2005 and2004 were as follows:

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

 

*XL FinancialAssurance Ltd.*

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

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

In March 2006,the XLFA Board of Directors approved a by-law amendment changing the coupon onXLFA’s preferred shares from a participating dividend based on an internal rateof return up to 19% to a fixed rate dividend of 8.25% per annum, effective January 1,2006. Amounts recorded by the Company in connection with XLFA as of and for theyears ending December 31, 2006, 2005 and 2004 are as follows :

| ** **                              | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                              | ** ** | **(in thousands)** | ** ** |
| Equity securities                       |       | $                       | 54,016     |     | $          | 54,300   |       | $ | 54,300 |   |
| Equity in  earnings from XLFA (pre-tax) |       | —                  |       | —   |       | 3,761    |       |
| Dividends earned from  XLFA             |       | 4,518                   |       | 8,926    |       | 14,103   |       |
|                                         |            |                         |            |          |            |          |            |  |  |  |

 

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**4.**   FPSEGMENT INVESTMENT PORTFOLIO

***FP Investment Portfolio***

Netinvestment income for the FP Investment Portfolio consisted of the following:

| ** **                | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------|------------|--------------------------------------------|------------|
| ** **                | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                | ** ** | **(in thousands)**                    | ** ** |
| Bonds available  for sale |       | $                                          | 725,736    |   | $ | 391,125 |   | $ | 137,548 |   |
| Trading portfolio         |       | 3,850                                      |       | —— |   | —— |   |
| Short-term  investments   |       | 49,822                                     |       | 29,639 |   | 3,499 |   |
| Net investment  income    |       | $                                          | 779,408    |   | $ | 420,764 |   | $ | 141,047 |   |

 

Thecredit quality of bonds held in the FP Investment Portfolio based on amortizedcost at December 31, 2006 was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|
| AAA           |       |       | 91.9       | %                              |       |
| AA            |       |       | 7.0        |                           |       |
| A        |       |       | 1.1        |                           |       |
| Total         |       |       | 100.0      | %                              |       |

 

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2006.

Of the bonds included in the FP Investment Portfolio,4.4% were Triple-A by virtue of insurance provided by FSA. Over 97% of theFSA-Insured Investments were investment grade without giving effect to the FSAinsurance. The average shadow rating of the FSA-Insured Investments was in theTriple-B range.

Theamortized cost and fair value of bonds held in the FP Investment Portfolio wereas follows:
|                                                        | ** ** | **As of December 31, 2006** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                             | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                         | ** ** |
| Obligations of  U.S. states and political subdivisions |       | $                                               | 1,413,080  |   |   | $ | 37,776 |   |   |   | $ | (6,098 | ) |   | $ | 1,444,758 |   |
| Mortgage-backed  securities                            |       | 7,639,645                                       |       |   | 19,419 |   |   |   | (1,122 | ) |   | 7,657,942 |   |
| Asset-backed  and other securities                     |       | 6,629,244                                       |       |   | 21,761 |   |   |   | (4,557 | ) |   | 6,646,448 |   |
| Subtotal                                               |       | 15,681,969                                      |       |   | 78,956 |   |   |   | (11,777 | ) |   | 15,749,148 |   |
| Short-term  investments                                |       | 640,226                                         |       |   | — |   |   |   | — |   |   | 640,226 |   |
| Total                                                  |       | $                                               | 16,322,195 |   |   | $ | 78,956 |   |   |   | $ | (11,777 | ) |   | $ | 16,389,374 |   |

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

 

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Thefollowing table shows the gross unrealized losses and fair value for the FPInvestment Portfolio, aggregated by investment category and length of time thatindividual securities have been in a continuous unrealized loss position, at December 31,2006:
|                                                        | ** ** | **As of December 31, 2006** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                             | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                             | ** ** | **Fair Value**                             | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                         | ** ** |
| Obligations of  U.S. states and political subdivisions |       | $                                               | 209,267    |   |   | $ | (3,914 | ) |   | $ | 73,097 |   |   | $ | (2,184 | ) |   | $ | 282,364 |   |   | $ | (6,098 | ) |   |
| Mortgage-backed  securities                            |       | 732,267                                         |       |   | (1,009 | ) |   | 47,498 |   |   | (113 | ) |   | 779,765 |   |   | (1,122 | ) |   |
| Asset-backed  securities                               |       | 511,899                                         |       |   | (1,979 | ) |   | 193,856 |   |   | (2,578 | ) |   | 705,755 |   |   | (4,557 | ) |   |
| Total                                                  |       | $                                               | 1,453,433  |   |   | $ | (6,902 | ) |   | $ | 314,451 |   |   | $ | (4,875 | ) |   | $ | 1,767,884 |   |   | $ | (11,777 | ) |   |

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

 

At December 31, 2006, there were 111 investmentsin fixed-income securities for which amortized cost exceeded fair value; theaggregate amount of the excess over fair value was $11.8 million, or 0.7%.  At December 31, 2005, there were 97 suchinvestments, for which the aggregate amount of the excess over fair value was$4.5 million, or 0.2%. Management has determined that the unrealized losses infixed income securities at December 31, 2006 are attributable primarily tothe current interest rate environment and has concluded that these unrealizedlosses are temporary in nature based upon (a) no principal and interestpayment defaults on these securities; (b) analysis of the creditworthinessof the issuer; and (c) FSA’s ability and current intent to hold thesesecurities until a recovery in fair value or maturity. There were no individualsecurities with material unrealized losses as of December 31, 2006 and2005. As of December 31, 2006 and 2005, 100% of the securities that werein a gross unrealized loss position were rated investment grade.

Theamortized cost and fair value of the FP Investment Portfolio, at December 31,2006, by contractual maturity, are shown below. Actual maturities could differfrom contractual maturities because borrowers have the right to call or prepaycertain obligations with or without call or prepayment penalties.

| ** **                                                              | ** ** | **Amortized  Cost**     | ** ** | **Fair Value** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                                              | ** ** | **(in thousands)** | ** ** |
| Due in one year  or less                                                |       | $                       | 640,226    |                | $          | 640,226 |   |
| Due after one year  through five years                                  |       | —                  |       | —              |       |
| Due after five  years through ten years                                 |       | 28,429                  |       | 28,386              |       |
| Due after ten  years                                                    |       | 1,384,651               |       | 1,416,372           |       |
| Mortgage-backed  securities (stated maturities of 4 to 39 years)        |       | 7,639,645               |       | 7,657,942           |       |
| Asset-backed  and other securities (stated maturities of 1 to 49 years) |       | 6,629,244               |       | 6,646,448           |       |
| Total                                                                   |       | $                       | 16,322,195 |                | $          | 16,389,374 |   |

 

Proceeds from sales ofbonds held in the FP Investment Portfolio during 2006, 2005 and 2004 were $4,512.5 million,$5,635.3 million and $2,511.8 million, respectively. Proceeds frommaturities of bonds for 

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the FPInvestment Portfolio during 2006, 2005 and 2004 were $4,485.1 million, $1,422.0 millionand $65.7 million,respectively. Gross gains of $0.1 million were realized on sales in2006. Gross gains of $0.4 million and gross losses of $7.9 million wererealized on sales in 2005. Gross gains of $2.2 million were realized onsales in 2004.

***VIE Investment Portfolio***

On April 28, 2006, the Company increased its ownershipof the ordinary shares of FSA Global from 29% to 49% through an acquisition ofshares from an unaffiliated third party. Immediately thereafter, FSA Global’scharter documents were amended to create a new class of non-voting preferenceshares, all of which were issued to the Company. Holders of such preferenceshares have exclusive rights to any future dividends and, upon any winding upof FSA Global, all net assets available for distribution to shareholders (aftera distribution of $250,000 to the ordinary shares). As a result of the issuanceof such preference shares, (a) a substantive sale and purchase of aninterest took place between the ordinary shareholders of FSA Global and theCompany, resulting in an assessment and recording of the fair value of theassets and liabilities sold and purchased at the time of such transaction, and (b) theCompany’s minority interest liability associated with FSA Global waseliminated. In the second quarter of 2006, the Company realized a pre-tax gainof $1.8 million as a result of this transaction.

Allthe investments supporting VIE liabilities are insured by FSA. The creditquality of the VIE Investment Portfolio, without the benefit of FSA’sinsurance, at December 31, 2006 was as follows:

| Rating(1) | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|-----------|------------|------------|------------|--------------------------------|------------|
| AAA       |       |       | 1.5        | %                              |       |
| A    |       |       | 80.8       |                           |       |
| NR        |       |       | 17.7       |                           |       |
| Total     |       |       | 100.0      | %                              |       |

----

(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2006.

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

|                                                   | ** ** | **As of December 31, 2006** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                        | ** ** | **Amortized Cost**                         | ** ** | **Fair Value** | ** ** |
| ** **                                        | ** ** | **(in thousands)**                         | ** ** |
| Obligations of  states and political subdivisions |       |                                            | $          | 15,750 |   |   | $ | 15,750 |   |
| Foreign  securities                               |       |                                            | 9,086      |   |   | 9,643 |   |
| Asset-backed  securities(1)                       |       |                                            | 1,102,862  |   |   | 1,102,862 |   |
| Short-term  investments                           |       |                                            | 19,478     |   |   | 19,478 |   |
| Total                                             |       |                                            | $          | 1,147,176 |   |   | $ | 1,147,733 |   |

 

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

----

(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 periodicallymonitors its investment portfolio for individual investments in an unrealizedloss position in order to assess 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 31,2006 and 2005, there were no securities in an unrealized loss position. TheCompany determined that no investments were considered other-than-temporarilyimpaired.

The amortized cost andfair value of bonds in the VIE Investment Portfolio at December 31, 2006,by contractual maturity, are shown below. Actual maturities could differ fromcontractual maturities because borrowers have the right to call or prepaycertain obligations with or without call or prepayment penalties.

| ** **                                                    | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                                    | ** ** | **(in thousands)** | ** ** |
| Due in one year  or less                                      |       |                    | $          | 19,478              |       |   | $ | 19,478 |   |
| Due after one  year through five years                        |       |                    | 9,086      |                |       | 9,643 |   |
| Due after five  years through ten years                       |       |                    | —     |                |       | — |   |
| Due after ten years                                           |       |                    | 15,750     |                |       | 15,750 |   |
| Asset-backed  securities (stated maturities of 2 to 14 years) |       |                    | 1,102,862  |                |       | 1,102,862 |   |
| Total                                                         |       |                    | $          | 1,147,176           |       |   | $ | 1,147,733 |   |

The Company pledges and receives collateral related tocertain business lines or transactions. The following is a description of thosearrangements by transaction type.

***Securities Pledged to Note Holders***

In the normal course ofbusiness, the Company may hold securities purchased under agreements to resell.A portion of these securities may be pledged to the Company’s investmentagreement counterparties (including counterparties with agreements structuredas investment repurchase agreements). However, such securities generally maynot be rehypothecated by the investment agreement counterparty. The Companyalso pledges investments held in the FP Investment Portfolio to investmentagreement counterparties. At December 31, 2006, $4.7 billion of the assetsheld in its FP Investment Portfolio and related accrued interest were pledgedas collateral to investment agreement counterparties. In addition,substantially all the assets of FSA Global are pledged to secure the repayment,on a pro rata basis, of FSA Global’s notes and its other obligations.

95

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***Securities Pledged to Derivative Counterparties***

Securities purchased under agreements to resell areeligible to be pledged to certain interest rate swap counterparties. Ingeneral, under the terms of each of these counterparty-specific derivativeagreements, the Company and its counterparty may be required to pledge collateralor transfer assets as a result of changes in the fair value of those derivativeagreements. The timing and amount are generally dependent on which entity isexposed as well as the credit rating of the party in the payable position. TheCompany and the counterparty typically have identical rights and obligations topledge and rehypothecate collateral according to the terms included within eachof the counterparty-specific derivative agreements.  At December 31, 2006, $7.3 million of theassets held in the FP Investment Portfolio and related accrued interest werepledged as collateral to margin accounts. FSA Global, under the terms of itsderivative agreements, is not required to pledge collateral. Itscounterparties, however, may be required to pledge collateral or transferassets to FSA Global. FSA Global is not permitted to rehypothecate any suchcollateral or assets.

**5.**   ASSETSACQUIRED IN REFINANCING TRANSACTIONS

The Company generally hasrights under its financial guaranty insurance policies and indentures thatallow it to accelerate the insured notes and pay claims under its insurancepolicies upon the occurrence of predefined events of default. To mitigatefuture losses, the Company may elect to purchase the outstanding insuredobligation or its underlying collateral. Generally, refinancing vehiclesreimburse FSA in whole for its claims payments in exchange for assignments ofcertain of FSA’s rights against the trusts. The refinancing vehicles obtaintheir funds from the proceeds of FSA-insured GICs issued in the ordinarycourse of business by the GIC Affiliates. The refinancing vehicles areconsolidated into the Company’s financial statements. The Company maintains itsreinsurance on these transactions.

The following tablepresents the balance sheet components of the assets acquired in refinancingtransactions:

| ** **              | ** ** | **As of December 31,** | ** ** |
|-------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **              | ** ** | **(in thousands)**               | ** ** |
| Securitized loans       |       | $                                     | 241,785    |   | $ | 296,965 |   |
| Bonds                   |       | 41,051                                |       | 68,421 |   |
| Equity securities       |       | 4,434                                 |       | 3,488 |   |
| Mortgage loans          |       | 34,407                                |       | 56,165 |   |
| Short-term  investments |       | 12,662                                |       | 37,512 |   |
| Other assets            |       | 3,533                                 |       | 5,322 |   |
| Total                   |       | $                                     | 337,872    |   | $ | 467,873 |   |

 

The accretable yield onthe securitized loans at December 31, 2006, 2005 and 2004 was $157.3million, $149.7 million and $151.3 million, respectively. The cash flows on thesecuritized loans, net of reinsurance, are monitored and the effective yieldmodified to reflect any change in the cash flow estimate on a prospectivebasis. Since the notes represent 100% of the debt capitalization of the trustsand since FSA maintains all the risk of further asset decline (except asprovided by reinsurance) and maintains control over key decisions regarding thetrusts (such as removal of the servicer, sale of the assets and liquidation ofthe entity), the trusts were consolidated with the Company for accountingpurposes. The Company also consolidated the refinancing vehicles.

Bonds, equity securitiesand mortgage loans represent liquidations of previously insured obligations andsubsequent purchases of the underlying collateral. Bonds and equity securitiesare available for sale and carried at fair value.

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The credit quality ofbonds within the refinanced asset portfolio at December 31, 2006 was asfollows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|
| BBB           |       |       | 13.1       | %                              |       |
| CCC           |       |       | 84.2       |                           |       |
| NR            |       |       | 2.7        |                           |       |
| Total         |       |       | 100.0      | %                              |       |

 

----

(1)          Ratingsare based on internal shadow ratings available at December 31, 2006.

The amortized cost andfair value of fixed-income assets within the refinanced asset portfolio were asfollows:

| ** **               | ** ** | **As of December 31, 2006** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **               | ** ** | **(in thousands)**                         | ** ** |
| Corporate securities     |       |                                            | $          | 1,074 |   |   |   | $ | 29 |   |   |   | $ | — |   |   |   | $ | 1,103 |   |   |
| Asset-backed  securities |       |                                            | 39,059     |   |   |   | 889 |   |   |   | — |   |   |   | 39,948 |   |   |
| Short-term  investments  |       |                                            | 12,662     |   |   |   | — |   |   |   | — |   |   |   | 12,662 |   |   |
| Total                    |       |                                            | $          | 52,795 |   |   |   | $ | 918 |   |   |   | $ | — |   |   |   | $ | 53,713 |   |   |

 

| ** **               | ** ** | **As of December 31, 2005** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **               | ** ** | **(in thousands)**                         | ** ** |
| Corporate securities     |       | $                                               | 5,946      |   |   | $ | 3,199 |   |   |   | $ | — |   |   | $ | 9,145 |   |
| Asset-backed  securities |       | 59,920                                          |       |   | — |   |   |   | (644 | ) |   | 59,276 |   |
| Short-term  investments  |       | 37,512                                          |       |   | — |   |   |   | — |   |   | 37,512 |   |
| Total                    |       | $                                               | 103,378    |   |   | $ | 3,199 |   |   |   | $ | (644 | ) |   | $ | 105,933 |   |

 

The amortized cost andfair value of equities held within the refinanced asset portfolio were asfollows:

| ** **        | ** ** | **As of December 31, 2006** | ** ** |
|-------------------|------------|-------------------------------------------------|------------|
| ** **        | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **        | ** ** | **(in thousands)**                         | ** ** |
| Equity securities |       |                                            | $          | 1,003 |   |   |   | $ | 3,431 |   |   |   | — |   |   |   | $ | 4,434 |   |   |
|                   |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **        | ** ** | **As of December 31, 2005** | ** ** |
|-------------------|------------|-------------------------------------------------|------------|
| ** **        | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **        | ** ** | **(in thousands)**                         | ** ** |
| Equity securities |       |                                            | $          | 2,206 |   |   |   | $ | 1,282 |   |   |   | — |   |   |   | $ | 3,488 |   |   |
|                   |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The amortized cost and fair value of fixed-incomeassets within the refinanced asset portfolio at December 31, 2006, areshown below by contractual maturity. Actual maturities could differ fromcontractual maturities because borrowers have the right to call or prepaycertain obligations with or without call or prepayment penalties.

| ** **                             | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|----------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                             | ** ** | **(in thousands)** | ** ** |
| Due in one year or less                |       |                    | $          | 12,669              |       |   |   | $ | 12,689 |   |   |
| Due after one year  through five years |       |                    | 40,126     |                |       |   | 41,024 |   |   |
| Total                                  |       |                    | $          | 52,795              |       |   |   | $ | 53,713 |   |   |

 

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At December 31, 2006 and 2005, there were nosecurities in an unrealized loss position for a continuous 12-monthperiod or longer. In 2006, the Company determined that there were threesecurities considered other-than-temporarily impaired, and a$2.5 million impairment charge was recorded in the consolidated statementsof operations and comprehensive income. In 2005, the Company determined thatthere were six securities considered other-than-temporarily impaired, and a$4.5 million impairment charge was recorded in the consolidated statementsof operations and comprehensive income.

**6.**   DEFERREDACQUISITION COSTS

Acquisition costs deferredfor amortization against future income and the related amortization charged toexpenses are as follows:

| ** **                                | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                | ** ** | **(in thousands)**                    | ** ** |
| Balance, beginning of  period             |       | $                                          | 335,129    |   | $ | 308,015 |   | $ | 273,646 |   |
| Costs deferred during the period:         |       |                                       |       |   |   |   |   |
| Ceded and assumed  commissions            |       | (79,713                                    | )          | (63,174 | ) | (65,838 | ) |
| Premium taxes                             |       | 14,032                                     |       | 20,894 |   | 16,551 |   |
| Compensation and other  acquisition costs |       | 134,237                                    |       | 137,734 |   | 145,857 |   |
| Total                                     |       | 68,556                                     |       | 95,454 |   | 96,570 |   |
| Costs amortized during  the period        |       | (63,012                                    | )          | (68,340 | ) | (62,201 | ) |
| Balance, end of period                    |       | $                                          | 340,673    |   | $ | 335,129 |   | $ | 308,015 |   |

 

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

Activity in the liabilityfor losses and loss adjustment expenses, which consists of the case and non-specificreserves, is summarized as follows:

| ** **                            | ** ** | **Case Reserve Activity for the  Year Ended December 31,** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                            | ** ** | **(in millions)**                                                                        | ** ** |
| Gross balance at  January 1      |       | $                                                                                             | 90.0       |   | $ | 80.6 |   | $ | 121.9 |   |
| Less reinsurance recoverable          |       | 36.3                                                                                          |       | 35.4 |   | 59.2 |   |
| Net balance at  January 1        |       | 53.7                                                                                          |       | 45.2 |   | 62.7 |   |
| Transfer from non-specific  reserve   |       | 1.2                                                                                           |       | 10.5 |   | 30.7 |   |
| Restructured  transactions            |       | —                                                                                        |       | — |   | (13.9 | ) |
| Paid (net of recoveries)  related to: |       |                                                                                          |       |   |   |   |   |
| Current year                          |       | —                                                                                        |       | — |   | — |   |
| Prior year                            |       | (1.9                                                                                          | )          | (2.0 | ) | (34.3 | ) |
| Total paid                            |       | (1.9                                                                                          | )          | (2.0 | ) | (34.3 | ) |
| Net balance at  December 31      |       | 53.0                                                                                          |       | 53.7 |   | 45.2 |   |
| Plus reinsurance recoverable          |       | 37.3                                                                                          |       | 36.3 |   | 35.4 |   |
| Gross balance at  December 31    |       | $                                                                                             | 90.3       |   | $ | 90.0 |   | $ | 80.6 |   |

 

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| ** **                            | ** ** | **Non-Specific Reserve Activity  for the Year Ended December 31,** | ** ** |
|---------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                            | ** ** | **(in millions)**                                                                                | ** ** |
| Balance at  January 1            |       | $                                                                                                     | 115.7      |   | $ | 99.3 |   | $ | 111.5 |   |
| Provision for losses                  |       |                                                                                                  |       |   |   |   |   |
| Current year                          |       | 17.8                                                                                                  |       | 20.4 |   | 20.4 |   |
| Prior year                            |       | 5.5                                                                                                   |       | 5.0 |   | 0.2 |   |
| Transfers to case  reserves           |       | (1.2                                                                                                  | )          | (10.5 | ) | (30.7 | ) |
| Restructured  transactions            |       | —                                                                                                |       | 1.5 |   | (2.1 | ) |
| Balance at  December 31          |       | 137.8                                                                                                 |       | 115.7 |   | 99.3 |   |
| Total case and non-specific  reserves |       | $                                                                                                     | 228.1      |   | $ | 205.7 |   | $ | 179.9 |   |

 

The gross and net par amounts outstanding on transactionswith case reserves were $483.4 million and $399.6 million,respectively, at December 31, 2006. The net case reserve consistedprimarily of five CDO risks and two municipal risks, which collectivelyaccounted for approximately 94.9% of the total net case reserve. The remainingeight risks were in various sectors.

During 2006, the Companycharged $23.3 million to loss expense, consisting of $17.8 million fororiginations of new business and $5.5 million related to accretion on thereserve for in-force business. Net case reserves decreased $0.7 milliondue primarily to******loss payments and someimprovement in the CDO transactions, offset in part by the establishment of anew case reserve for a municipal health care transaction.

During 2005, the Companycharged $25.4 million to loss expense, consisting of $20.4 millionfor originations of new business and $5.0 million related to accretion on thereserve for in-force business. The non-specific reserve increased$16.4 million in 2005, due primarily to loss expense of$25.4 million, partially offset by transfers from the non-specificreserve to case reserves of $10.5 million. Net reserves increased$8.5 million due primarily to deterioration of specific CDO risks.

During 2004, the Companycharged $20.6 million to loss expense, consisting of $20.4 millionfor originations of new business, $4.6 million for accretion related to prioryears and $3.2 million related to reassumptions of previously cededbusiness, offset by reserve releases related primarily to a large refinancingtransaction in 2004.

In September 2004,FSA exercised its rights to have the collateral of a defaulted collateralizedbond obligation liquidated at a public sale, in which the Company offered thehighest bid. The Company acquired the collateral to gain control of theportfolio in order to mitigate future losses. The previously established casereserve was drawn down to reflect the excess of the purchase amount over thefair value of the collateral. The remaining $9.5 million balance in the casereserve related to this transaction was 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 case reserves to the non-specific reserve was$1.4 million, which also included a transfer from the non-specificreserve to a case reserve for a municipal utility transaction. The CDOportfolio continues to perform within the expectations reflected in previouslyrecorded provisions for CDOs.

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.

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***Impact of 2005 Hurricanes***

The Company monitors its exposure tocredits affected by the 2005 hurricanes in Louisiana and Mississippi. TheCompany believes that its estimate of its total loss liability is adequategiven its current risk information and has not established a case reserverelated to its 2005 hurricane-affected exposure.

As of December 31, 2006, FSA hadnot received notice of payment default on any hurricane-related exposures. TheCompany’s 11 credits that have suffered the most significant economic andproperty loss from the 2005 hurricanes had an aggregate net par exposure of$181.7 million at December 31, 2006.FSA-insured bonds are protected by various sources of support that would beinvoked before FSA would incur losses. These sources include access to pledgedtaxes or revenues, reserve funds, property and casualty insurance and state andfederal monies. The issuers of these insured bonds have generally continued toimprove financially and management does not expect that FSA will sustainpermanent losses.

In addition, to provide relief to localgovernments facing difficulties meeting debt service obligations during thisrecovery period, the State of Louisiana issued an aggregate of $400 million ofGulf Tax Credit and matching State General Obligation Bonds on July 19,2006. The bond proceeds funded a State Debt Service Assistance Fund to provideloans to help qualifying local governments meet debt service obligations forthe next several years. All of the qualifying entities are located in the NewOrleans metropolitan area.

Among the exposures affected by thehurricane are $38.1 million of FSA-insured Orleans Levee District (the “District”)bonds. The District has explored the possibility of seeking bankruptcyprotection, but has not received the authority from the State that is requiredto do so. In any event, FSA does not believe that payment of the FSA-insuredbonds would be impaired by a bankruptcy filing. In addition, the District is aloan recipient under the State Debt Service Assistance Fund, with FSA-insuredbonds receiving assistance through May 1, 2009.

Asset-backed transactions insured byFSA, backed by pools of geographically diverse assets, show no unusualconcentrations in the affected areas.

The loss estimation process involves theexercise of considerable judgment and therefore FSA’s ultimate 2005hurricane-related losses may be materially different from the current estimateand may affect future operating results.

**8.**   GICAND VIE DEBT

Theobligations under GICs issued by the GIC Affiliates may be called at varioustimes prior to maturity based on certain agreed-upon events. As of December 31,2006, interest rates were between 1.6% and 6.1% per annum on outstanding GICsand between 1.98% and 6.20% per annum on VIE debt. Payments due under GICs arebased on expected withdrawal dates and exclude negative hedge accountingadjustments and prepaid interest of $77.6 million, and include accretion of$899.5 million. VIE debt excludes fair-value adjustments of $146.3 million andincludes $1,042.1 million of future interest accretion on zero-couponobligations. The following table presents the combined principal amounts dueunder GICs and VIE debt for 2007 and each of the next four years ending December 31,and thereafter:

| ** ** | ** ** | **Principal  Amount**  | ** ** |
|------------|------------|------------------------|------------|
| ** ** | ** ** | **(in millions)** | ** ** |
| 2007       |       |                   | $          | 3,791.2 |   |   |
| 2008       |       |                   | 1,287.5    |   |   |
| 2009       |       |                   | 2,237.2    |   |   |
| 2010       |       |                   | 2,448.4    |   |   |
| 2011       |       |                   | 1,156.1    |   |   |
| Thereafter |       |                   | 9,302.2    |   |   |
| Total      |       |                   | $          | 20,222.6 |   |   |

** **

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**9.**   LONG-TERMDEBT

On November 22, 2006,FSA Holdings issued $300.0 million principal amount of Junior SubordinatedDebentures with a scheduled maturity date of December 15, 2036 and a finalrepayment date of December 15, 2066. The final repayment date of December 15,2066 may be automatically extended up to four times in five-year incrementsprovided certain conditions are met. The debentures are redeemable, in whole orin part, at any time prior to December 15, 2036 at their principal amountplus accrued and unpaid interest to the date of redemption. Interest on thedebentures will accrue from November 22, 2006 to December 15, 2036 atthe annual rate of 6.40%. If any amount of the debentures remains outstandingafter December 15, 2036, then the principal amount of the outstandingdebentures will bear interest at a floating interest rate equal to one-monthLIBOR plus 2.215% until repaid. FSA Holdings may elect at one or more times todefer payment of interest on the debentures for one or more consecutiveinterest periods that do not exceed ten years. In connection with thecompletion of this offering, FSA Holdings entered into a replacement capitalcovenant for the benefit of persons that buy, hold or sell a specified seriesof FSA Holdings long-term indebtedness ranking senior to the debentures. Underthe covenant, the debentures will not be repaid, redeemed, repurchased ordefeased by FSA Holdings or any of its subsidiaries on or before the date thatis 20 years prior to the final repayment date, except to the extent that FSAHoldings has received proceeds from the sale of replacement capital securities.The proceeds from this offering were used to pay a dividend to the shareholdersof FSA Holdings.

On July 31, 2003, theCompany 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 anytime on or after July 31, 2008. Debt issuance costs of $3.3 million arebeing amortized over the life of the notes.

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 anytime on or after November 26, 2007. Debt issuance costs of$7.4 million are being amortized over the life of the debt.

On December 19, 2001, the Company 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.

**10.**   OUTSTANDINGEXPOSURE AND COLLATERAL

The Company’s policiesinsure the scheduled payments of principal and interest on public finance andasset-backed (including FSA-insured CDS) obligations. The grossamount of financial guarantees in force (principal and interest) was $743.9billion at December 31, 2006 and $668.2 billion at December 31, 2005.The net amount of financial guarantees in force was $531.4 billion at December 31,2006 and $480.2 billion at December 31, 2005.

The net par outstanding asof December 31, 2006 and 2005 and the contractual terms to maturity are asfollows:

| ** **                         | ** ** | **As of December 31, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| **Terms to Maturity(1)** | ** ** | ** **                                      | ** ** | **Public  Finance**                             | ** ** | **Asset-Backed(2)** | ** ** | **Public  Finance** | ** ** | **Asset-Backed(2)** | ** ** |
| ** **                         | ** ** | **(in millions)**                          | ** ** |
| 0 to 5 years                       |       | $                                               | 48,273     |                                            |       | $ | 41,582 |   |   | $ | 44,272 |   |   | $ | 41,955 |   |   |
| 5 to 10 years                      |       | 53,242                                          |       |                                            | 31,097     |   |   | 49,935 |   |   | 31,395 |   |   |
| 10 to 15 years                     |       | 47,865                                          |       |                                            | 12,301     |   |   | 44,392 |   |   | 12,180 |   |   |
| 15 to 20 years                     |       | 41,489                                          |       |                                            | 1,860      |   |   | 36,737 |   |   | 744 |   |   |
| 20 years and  above                |       | 60,424                                          |       |                                            | 21,427     |   |   | 51,724 |   |   | 24,149 |   |   |
| Total                              |       | $                                               | 251,293    |                                            |       | $ | 108,267 |   |   | $ | 227,060 |   |   | $ | 110,423 |   |   |
|                                    |            |                                                 |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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The par amountceded as of December 31, 2006 and 2005 and the terms to maturity are asfollows:

| ** **                         | ** ** | **As of December 31, 2006** | ** ** | **As of December 31, 2005** | ** ** |                |
|------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|---------------------|
| **Terms to Maturity(1)** | ** ** | ** **                                      | ** ** | **Public  Finance**                             | ** ** | **Asset-Backed(2)** | ** ** | **Public  Finance** | ** ** | **Asset-Backed(2)** | ** ** |   |
| ** **                         | ** ** | **(in millions)**                          | ** ** |                                            |
| 0 to 5 years                       |       | $                                               | 14,375     |                                            |       | $                   | 9,091 |   |   |   | $ | 12,950 |   |   |   | $ | 16,180 |   |   |
| 5 to 10 years                      |       | 16,635                                          |       |                                            | 6,485      |                |   |   | 16,332 |   |   |   | 7,011 |   |   |
| 10 to 15 years                     |       | 17,163                                          |       |                                            | 1,847      |                |   |   | 16,954 |   |   |   | 1,477 |   |   |
| 15 to 20 years                     |       | 17,200                                          |       |                                            | 1,905      |                |   |   | 15,180 |   |   |   | 1,474 |   |   |
| 20 years and above                 |       | 33,480                                          |       |                                            | 3,649      |                |   |   | 29,048 |   |   |   | 4,001 |   |   |
| Total                              |       | $                                               | 98,853     |                                            |       | $                   | 22,977 |   |   |   | $ | 90,464 |   |   |   | $ | 30,143 |   |   |
|                                    |            |                                                 |            |                                                 |            |                     |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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

(2)          Excludes intercompanyinsurance of $16,558 million in 2006 and $13,463 million in 2005relating to FSA-insured GICs issued by the GIC Affiliates.

The net par outstanding ofinsured obligations in the public finance insured portfolio includes thefollowing amounts by type of issue:

| ** **                       | ** ** | **Net Par Outstanding  as of December 31,** | ** ** | **Ceded  as of December 31,** | ** ** |
|----------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------|------------|
| **Types of Issues**    | ** ** | ** **                                                           | ** ** | **2006**                                     | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                       | ** ** | **(in millions)**                                               | ** ** |
| General obligation               |       | $                                                                    | 103,112    |                                         | $          | 93,284 |   | $ | 28,143 |   | $ | 26,020 |   |
| Tax-supported                    |       | 46,479                                                               |       | 43,855                                       |       | 18,733 |   | 18,276 |   |
| Municipal utility  revenue       |       | 40,495                                                               |       | 37,245                                       |       | 13,367 |   | 14,091 |   |
| Health care revenue              |       | 13,155                                                               |       | 11,789                                       |       | 10,144 |   | 8,889 |   |
| Housing revenue                  |       | 7,576                                                                |       | 7,585                                        |       | 2,039 |   | 2,153 |   |
| Transportation revenue           |       | 16,164                                                               |       | 15,299                                       |       | 10,337 |   | 9,766 |   |
| Education                        |       | 4,378                                                                |       | 4,065                                        |       | 1,027 |   | 1,184 |   |
| Other domestic public  finance   |       | 1,628                                                                |       | 1,690                                        |       | 509 |   | 531 |   |
| International                    |       | 18,306                                                               |       | 12,248                                       |       | 14,554 |   | 9,554 |   |
| Total public finance obligations |       | $                                                                    | 251,293    |                                         | $          | 227,060 |   | $ | 98,853 |   | $ | 90,464 |   |
|                                  |            |                                                                      |            |                                              |            |  |  |  |  |  |  |  |  |  |  |

 

The Company limits itsexposure to losses from writing financial guarantees by underwriting investment-gradeobligations, diversifying its portfolio and maintaining rigorous collateralrequirements on asset-backed obligations, as well as through reinsurance.The net par outstanding of insured obligations in the asset-backedinsured portfolio includes the following amounts by type of collateral:

| ** **                               | ** ** | **Net Par Outstanding(1)  as of December 31,** | ** ** | **Ceded  as of December 31,** | ** ** |
|------------------------------------------|------------|-------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| **Types of Collateral**        | ** ** | ** **                                                              | ** ** | **2006**                                     | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                               | ** ** | **(in millions)**                                                  | ** ** |
| Residential  mortgages                   |       | $                                                                       | 15,666     |                                         | $          | 18,401 |   | $ | 2,555 |   | $ | 3,056 |   |
| Consumer  receivables                    |       | 10,599                                                                  |       | 8,366                                        |       | 664 |   | 1,569 |   |
| Pooled corporate  obligations            |       | 45,914                                                                  |       | 47,253                                       |       | 8,729 |   | 11,141 |   |
| Other domestic asset-backed  obligations |       | 6,793                                                                   |       | 7,328                                        |       | 2,952 |   | 2,890 |   |
| International  obligations               |       | 29,295                                                                  |       | 29,075                                       |       | 8,077 |   | 11,487 |   |
| Total asset-backed  obligations          |       | $                                                                       | 108,267    |                                         | $          | 110,423 |   | $ | 22,977 |   | $ | 30,143 |   |
|                                          |            |                                                                         |            |                                              |            |  |  |  |  |  |  |  |  |  |  |

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(1)          Excludesintercompany insurance of $16,558 million in 2006 and $13,463 millionin 2005 relating to FSA-insured GICs issued by the GIC Affiliates.

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In its asset-backedbusiness, the Company considers geographic concentration as a factor inunderwriting insurance covering securitizations of pools of such assets as residentialmortgages or consumer receivables. However, after the initial issuance of aninsurance policy relating to such securitizations, the geographic concentrationof the underlying 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.

The Company seeks tomaintain a diversified portfolio of insured public finance obligations designedto spread its risk across a number of geographic areas. The following tablesets forth those states in which municipalities located therein issued anaggregate of 2% or more of the Company’s net par amount outstanding of insuredpublic finance securities as of December 31, 2006:

| **State**                     | ** ** | ** **             | ** ** | **Number of  Risks** | ** ** | **Net Par Amount  Outstanding** | ** ** | **Percent of Total   Net Par Amount  Outstanding** | ** ** | **Ceded Par  Amount  Outstanding** | ** ** |
|-------------------------------|------------|------------------------|------------|---------------------------|------------|-------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                    | ** ** | **(in millions)** | ** ** |
| California                    |       |                   | 1,022      |                      |       |                                      | $          | 31,724                                                                      |       |                                    |       | 12.7 | % |   |   | $ | 10,753 |   |   |
| New York                      |       |                   | 703        |                      |       |                                      | 19,800     |                                                                        |       |                                    | 7.9        |   |   |   | 9,172 |   |   |
| Texas                         |       |                   | 760        |                      |       |                                      | 17,123     |                                                                        |       |                                    | 6.8        |   |   |   | 5,578 |   |   |
| Pennsylvania                  |       |                   | 782        |                      |       |                                      | 16,429     |                                                                        |       |                                    | 6.5        |   |   |   | 4,197 |   |   |
| Florida                       |       |                   | 270        |                      |       |                                      | 13,061     |                                                                        |       |                                    | 5.2        |   |   |   | 4,764 |   |   |
| Illinois                      |       |                   | 682        |                      |       |                                      | 12,641     |                                                                        |       |                                    | 5.0        |   |   |   | 6,140 |   |   |
| New Jersey                    |       |                   | 609        |                      |       |                                      | 10,817     |                                                                        |       |                                    | 4.3        |   |   |   | 5,710 |   |   |
| Michigan                      |       |                   | 542        |                      |       |                                      | 10,173     |                                                                        |       |                                    | 4.0        |   |   |   | 2,266 |   |   |
| Washington                    |       |                   | 332        |                      |       |                                      | 9,067      |                                                                        |       |                                    | 3.6        |   |   |   | 3,715 |   |   |
| Massachusetts                 |       |                   | 210        |                      |       |                                      | 6,304      |                                                                        |       |                                    | 2.5        |   |   |   | 3,513 |   |   |
| Ohio                          |       |                   | 376        |                      |       |                                      | 6,160      |                                                                        |       |                                    | 2.5        |   |   |   | 2,034 |   |   |
| Indiana                       |       |                   | 271        |                      |       |                                      | 5,451      |                                                                        |       |                                    | 2.2        |   |   |   | 1,277 |   |   |
| Georgia                       |       |                   | 114        |                      |       |                                      | 5,050      |                                                                        |       |                                    | 2.0        |   |   |   | 1,426 |   |   |
| Wisconsin                     |       |                   | 453        |                      |       |                                      | 4,982      |                                                                        |       |                                    | 2.0        |   |   |   | 1,326 |   |   |
| All other U.S.  jurisdictions |       |                   | 2,767      |                      |       |                                      | 64,205     |                                                                        |       |                                    | 25.5       |   |   |   | 22,428 |   |   |
| International                 |       |                   | 143        |                      |       |                                      | 18,306     |                                                                        |       |                                    | 7.3        |   |   |   | 14,554 |   |   |
| Total                         |       |                   | 10,036     |                      |       |                                      | $          | 251,293                                                                     |       |                                    |       | 100.0 | % |   |   | $ | 98,853 |   |   |

**11.**   FEDERALINCOME TAXES

Dexia Holdings, theCompany and its Subsidiaries, except FSA International, file a consolidated U.S.federal income tax return. Prior to 2006, a tax-sharing agreement amongthe Subsidiaries provided that each member’s tax benefit or expense iscalculated on a separate-return basis and that any credits or losses availableto the Company are allocated among the members based on each member’s taxableincome. Effective January 1, 2006, the tax sharing agreement was amendedso that Dexia Holdings’ credits are no longer available to the members. For the2006 and 2005 tax years, the Company and its Subsidiaries did not receive anysuch benefits from utilizing Dexia Holdings’ credits.

Except as described below,federal income taxes were not provided on all of the undistributed earnings ofFSA International, since it was the Company’s practice and intent to reinvestsuch earnings in the operations of this subsidiary. The cumulative amount ofsuch untaxed earnings was $22.6 million at December 31, 2004.

The American Jobs CreationAct of 2004 (the “Act”), enacted on October 22, 2004, added Section 965to the Internal Revenue Code. Section 965 provides for the repatriation ofdividends from a controlled foreign corporation to its U.S. shareholder at aneffective tax rate of 5.25%, provided that 

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proceeds from therepatriation are utilized for qualified domestic investment activities. TheU.S. Treasury Department issued Notice 2005-10, which provided guidanceon acceptable investment activities. The Company believes it qualifies for thebeneficial treatment under Section 965 and accordingly accrued a taxliability and expense of $5.3 million at December 31, 2004. This amountapproximated the tax effect on FSA International’s tax dividend distributionmade in the fourth quarter of 2005.

In December 2005, theCompany repatriated earnings from FSA International to avail itself of thereduced effective tax rate of 5.25% (compared with the normal effective taxrate of 35%). In connection with such repatriation, the Company recapitalizedFSA International in October of 2005 to become a wholly owned subsidiaryand declared that it no longer intends to leave future earnings of thatsubsidiary permanently offshore. As a result, FSA International is subject toan increased effective U.S. tax rate on its 2005 and future income. The impacton earnings reflected (a) a tax liability of $15.1 million in respect ofundistributed earnings of FSA International that had previously been recognizedfor GAAP but not yet for tax purposes and (b) $14.2 million related to2005 earnings.

Following a change inownership of SPS in 2002, 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 in earnings from SPS,based on management’s expectation that it would realize its gain on such investmentthrough dividend distributions rather than through sale of its investment. For2004 and 2003, equity in earnings from SPS was taxed at an effective rate of7%. In the first quarter of 2005, due to the pending sale of its investment inSPS, the Company eliminated the assumption that accumulated earnings of SPSwould be distributed in the form of dividends eligible for a dividend-receiveddeduction. The net effect of this was to provide additional taxes on SPS’saccumulated earnings of approximately $1.6 million.

In connection with Dexia’sacquisition of the Company in July 2000, the Company became the successor,for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH hadpreviously sold an insurance subsidiary to a third party that was indemnifiedby White Mountains for certain future adverse loss development up to $50.0million. In 2004, the Company made an indemnity payment of $47.0 million to thethird party with funds provided for such purpose by White Mountains. While theCompany had no legal liability in connection with the indemnity payment, thepayment was treated for tax purposes as a $47.0 million loss deduction to theCompany, 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, the Company has agreed to share 50% of the deferred tax benefitwith White Mountains under certain circumstances, but did not satisfy thestandards for recording a liability for accounting purposes as of December 31,2006.

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The cumulative balancesheet effects of deferred federal tax consequences are as follows:

| ** **                                    | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **                                    | ** ** | **(in thousands)**               | ** ** |
| Deferred acquisition  costs                   |       | $                                     | 106,596    |   | $ | 104,335 |   |
| Deferred premium  revenue adjustments         |       | 57,992                                |       | 36,302 |   |
| Unrealized  capital gains                     |       | 86,119                                |       | 84,058 |   |
| Contingency  reserves                         |       | 135,992                               |       | 114,166 |   |
| Undistributed  earnings                       |       | 18,297                                |       | 16,613 |   |
| Derivative fair-value  adjustments            |       | 154,911                               |       | 15,152 |   |
| Minority interest                             |       | ——                          |       | 63,142 |   |
| Other                                         |       | 5,032                                 |       | 8,212 |   |
| Total deferred federal income tax liabilities |       | 564,939                               |       | 441,980 |   |
| Loss and loss  adjustment expense reserves    |       | (49,079                               | )          | (41,533 | ) |
| Deferred  compensation                        |       | (91,442                               | )          | (90,866 | ) |
| White Mountains  indemnity payment            |       | (16,450                               | )          | (16,450 | ) |
| Foreign currency  transaction loss            |       | (102,927                              | )          | (56,129 | ) |
| Other                                         |       | (6,499                                | )          | (5,737 | ) |
| Total deferred federal income tax assets      |       | (266,397                              | )          | (210,715 | ) |
| Net deferred federal  income tax liability    |       | $                                     | 298,542    |   | $ | 231,265 |   |

 

Management believes it ismore likely than not that the tax benefit of the deferred tax assets will berealized. Accordingly, no valuation allowance was necessary at December 31,2006 or 2005.

A reconciliation of theeffective tax rate with the federal statutory rate follows:

| ** **                                                   | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Tax at statutory  rate                                       |       | 35.0                                       | %          | 35.0 | % | 35.0 | % |
| Tax-exempt  investments                                      |       | (10.4                                      | )          | (9.8 | ) | (7.1 | ) |
| Income of foreign  subsidiary                                |       | ——                               |       | 2.7 |   | (1.2 | ) |
| White Mountains  indemnity payment                           |       | ——                               |       | — |   | (2.8 | ) |
| Minority interest  and equity in unconsolidated subsidiaries |       | 3.5                                        |       | (0.8 | ) | (4.9 | ) |
| Other                                                        |       | 0.7                                        |       | 0.2 |   | — |   |
| Provision for income  taxes                                  |       | 28.8                                       | %          | 27.3 | % | 19.0 | % |

 

**12.**   EMPLOYEEBENEFIT PLANS

The Company maintains both qualified and non-qualified,non-contributory defined contribution pension plans for the benefit ofeligible employees. Contributions are based on a fixed percentage of employeecompensation. Pension expense, which is funded annually, amounted to$7.5 million, $7.0 million and $5.8 million for the years endedDecember 31, 2006, 2005 and 2004, respectively.

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

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

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

In 2004, the Company adopted the 2004 EquityParticipation Plan (the “2004 Equity Plan”), which continues the incentivecompensation program formerly provided under the Company’s 1993 EquityParticipation Plan. The 2004 Equity Plan provides for performance share unitscomprised 90% of performance shares (which provide for payment based upon theCompany’s performance over two specified three-year performance cycles) and 10%of shares of Dexia restricted stock. Performance shares have generally beenawarded on the basis of two sequential three-year performance cycles, withone-third of each award allocated to the first cycle, which commences on thedate of grant, and two-thirds of each award allocated to the second cycle,which commences one year after the date of grant. The total number of performanceshares authorized under this plan was 3.3 million. At December 31, 2006,2.7 million performance shares remained available for distribution.

The Dexia restricted stock component is a fixed plan,where the Company purchases Dexia shares and establishes a prepaid expense forthe amount paid, which is amortized over 2.5-year and 3.5-yearvesting periods. In 2006 and 2005, FSA purchased shares to economically defeaseits liability for $4.6 million and $4.4 million, respectively. Theseamounts are being amortized to expense over the employees’ vesting periods. Forthe years ended December 31, 2006 and 2005, the after-tax amountsamortized into income were $1.9 million and $0.9 million, respectively.

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

| ** ** | ** ** | **Outstanding  at  Beginning of  Year** | ** ** | **Granted  During  the Year** | ** ** | **Paid out  During  the Year** | ** ** | **Forfeited  During the  Year** | ** ** | **Outstanding  at  End of Year** | ** ** | **Price per  Share  at Grant  Date** | ** ** | **Paid During  the Year** | ** ** |
|------------|------------|----------------------------------------------|------------|------------------------------------|------------|------------------------------------------|------------|--------------------------------------|------------|--------------------------------------------|------------|------------------------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** **                                   | ** ** | ** **                         | ** ** | ** **                               | ** ** | ** **                           | ** ** | ** **                                 | ** ** | ** **                                     | ** ** | **(in thousands)**             | ** ** |
| 2004       |       |                                         | 1,280,632  |                               |       | 355,459                                  |       | 398,292                              |       |                                       | 20,038     |                                           |       |                                | 1,217,761  |   |   | $ | 109.71 |   |   | $ | 64,278 |   |   |
| 2005       |       |                                         | 1,217,761  |                               |       | 316,638                                  |       | 313,987                              |       |                                       | 24,434     |                                           |       |                                | 1,195,978  |   |   | 131.30 |   |   | 61,584 |   |   |
| 2006       |       |                                         | 1,195,978  |                               |       | 370,441                                  |       | 340,429                              |       |                                       | 15,696     |                                           |       |                                | 1,210,294  |   |   | 139.22 |   |   | 60,993 |   |   |
|            |            |                                              |            |                                    |            |                                          |            |                                      |            |                                            |            |                                                |            |                                     |            |  |  |  |  |  |  |  |  |  |  |

 

At December 31, 2006, 364,510 outstandingperformance shares were fully vested, with a value of $61.9 million. Theseamounts were paid in the first quarter of 2007. At December 31, 2006, thetotal compensation cost related to non-vested performance shares not yetrecognized was $73.9 million. This amount is expected to be recognized as anexpense over a weighted-average period of 1.14 years.

The estimated final cost of these performance sharesis accrued over the performance period. The after-tax expense for the performanceshares was $39.2 million, $36.3 million and $47.6 million forthe years ended December 31, 2006, 2005 and 2004, respectively.

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Awardsof Dexia restricted stock remain restricted for an additional six months afterthe end of the last year of each vesting period. Shares of Dexia restrictedstock purchased under the 2004 Equity Plan are as follows:

| ** ** | ** ** | **Outstanding  at  Beginning of  Year** | ** ** | **Purchased  During  the Year** | ** ** | **Vested  During  the Year** | ** ** | **Forfeited  During the  Year** | ** ** | **Outstanding  at  End of Year** | ** ** | **Price per  Share at  Purchase  Date** | ** ** |
|------------|------------|----------------------------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|--------------------------------------|------------|--------------------------------------------|------------|---------------------------------------------------|------------|
| 2005       |       |                                         | —     |                                 |       |                              | 194,202    |                                 |       |                                       | 8,756      |                                              |       |   | 5,150 |   |   |   | 180,296 |   |   |   | $ | 22.69 |   |   |
| 2006       |       |                                         | 180,296    |                                 |       |                              | 190,572    |                                 |       |                                       | 22,146     |                                              |       |   | 4,574 |   |   |   | 344,148 |   |   |   | 24.17 |   |   |

 

In the fourth quarter of 2000, the Company purchased304,757 shares of its common stock from Dexia Holdings for $24.0 million.Additional purchases are intended to fund obligations relating to the Company’sDirector Share Purchase Program (“DSPP”), which enables its participants tomake deemed investments in the Company’s common stock under the DeferredCompensation Plan and Supplemental Executive Retirement Plan. Under the DSPP,the deemed investments in the Company’s stock are irrevocable, settlement ofthe deemed investments must be in stock and, after receipt, the participantsmust generally hold the stock for at least six months. Restricted treasurystock is distributed to a director as a DSPP payout at the end of applicablerestriction periods.

TheCompany purchased and distributed shares of its common stock under the DSPP inthe following amounts:
|            | ** ** | **Outstanding  at  Beginning of  Year** | ** ** | **Purchased  During  the Year** | ** ** | **Payouts  During  the Year** | ** ** | **Outstanding  at  End of Year** | ** ** | **Purchase  Amount** | ** ** | **Cost of  Shares  Distributed** | ** ** | **Fair Value  of Shares  Distributed** | ** ** |
|------------|------------|----------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|--------------------------------------------|------------|----------------------|------------|----------------------------------|------------|--------------------------------------------------|------------|
| ** ** | ** ** | **(dollars in thousands)**         | ** ** |
| 2004       |       |                                         | 297,658    |                                 |       |                               | 1,890      |                                       |       |                 | 2,272      |                             |       |                                             | 297,276    |   |   |   | $ | 262.0 |   |   |   | $ | 178.9 |   |   |   | $ | 331.6 |   |   |
| 2005       |       |                                         | 297,276    |                                 |       |                               | —     |                                       |       |                 | 42,540     |                             |       |                                             | 254,736    |   |   |   | — |   |   |   | 3,350.5 |   |   |   | 6,862.5 |   |   |
| 2006       |       |                                         | 254,736    |                                 |       |                               | 532        |                                       |       |                 | 13,290     |                             |       |                                             | 241,978    |   |   |   | 94.8 |   |   |   | 1,046.7 |   |   |   | 2,438.2 |   |   |

 

Statement of FinancialAccounting Standards No. 123 (revised 2004), “Share-Based Payment,” didnot have any impact on the consolidated statements of operations andcomprehensive income.

**13.**   DERIVATIVEINSTRUMENTS

***Credit Default Swaps***

FSA has insured a number of CDS with the expectationthat these transactions will not be subject to a market value termination forwhich the Company would be liable. It considers these agreements to be a normalextension of its financial guaranty insurance business, although they areconsidered derivatives for accounting purposes and therefore are recorded atfair value. The Company recorded $87.2 million, $89.2 million and $69.1million of net earned premium under these agreements for the years ended 2006,2005 and 2004, respectively.

Changes in the fair valueof CDS, which were gains of $31.8 million, $11.1 million and $56.4 million forthe years ended December 31, 2006, 2005, and 2004, respectively, wererecorded in net realized and unrealized gains on derivative instruments in theconsolidated statements of operations and comprehensive income. The Company’snet par outstanding of $74.7 billion and $66.6 billion relating to these CDStransactions at December 31, 2006 and December 31, 2005,respectively, are included in the asset-backed insured balances in Note10. The Company does not believe that the fair-value adjustments are anindication of potential claims under FSA’s guarantees or an indication ofpotential gains to be realized from the derivative transactions. The averageremaining life of these contracts at December 31, 

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2006 was3.1 years. The inception-to-date gain on the balance sheet was $89.2million at December 31, 2006 and $57.4 million at December 31,2005, and was recorded in other assets.

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

The Company enters into derivative contracts to manageinterest rate and foreign currency exposure in its GICs, FP InvestmentPortfolio, VIE debt and VIE Investment Portfolio. The inception-to-datenet unrealized loss on derivatives used to hedge GIC liabilities and the FPInvestment Portfolio of $23.0 million and $56.9 million at December 31,2006 and December 31, 2005, respectively, is recorded in other assets oraccrued expenses, other liabilities and minority interest, as applicable. Theinception-to-date net unrealized gain on the outstandingderivatives used to economically hedge the VIE debt and VIE InvestmentPortfolio of $516.8 million and $433.7 million at December 31, 2006 and December 31,2005, respectively, is recorded in other assets.

Inorder for a derivative to qualify for hedge accounting, it must be highlyeffective at reducing the risk associated with the exposure being hedged. Aneffective hedge is defined as one whose periodic fair value change is 80% to125% correlated with the fair value of the hedged item. The difference betweena perfect hedge (i.e., one that is 100% correlated) and the actual correlationwithin the 80% to 125% range is the ineffective portion of the hedge. A failedhedge is one whose correlation falls outside of the 80% to 125% range. Thetable below presents the net gain related to the ineffective portion of theCompany’s fair-value hedges and net gain related to failed hedges at December 31,2006 (in millions). 

| Ineffective  portion of fair-value hedges(1) |   | $   | 9.3    |   |
|----------------------------------------------|--------|-----|--------|--------|
| Failed hedges                                |   | 3.5 |   |

----

(1)          Includesthe changes in value of hedging instruments related to the passage of time,which have been excluded from the assessment of hedge effectiveness.

***Other Derivatives***

The Company enters intovarious other derivative contracts that do not qualify for hedge accountingtreatment. These derivatives include swaptions, caps and other derivatives,which are used principally as protection against large interest rate movements.Gains and losses on these derivatives are reflected in net realized andunrealized gains (losses) on derivative instruments in the statements ofoperations and comprehensive income.

**14.**   MINORITYINTEREST IN SUBSIDIARY

In 1998, the Company andXL entered into a joint venture, establishing two Bermuda-domiciled financialguaranty insurance companies: FSA International and XLFA. At December 31,2004, XL owned a minority interest in FSA International, and the Company owneda minority interest in XLFA. In October 2005, FSA purchased all thepreferred shares of FSA International owned by XL Insurance (Bermuda), Ltd. fora cash purchase price of $39.1 million in anticipation of the repatriation ofearnings and profits of FSA International. Giving effect to such purchase, FSAInternational became an indirect, wholly owned subsidiary of the Company. Thepreferred shares were Cumulative Participating Voting Preferred Shares that, intotal, had a minimum fixed dividend of $1.5 million per annum. In 2005 and2004, FSA International paid preferred dividends of $16.3 million and$7.0 million, respectively, to XL. For the years ended December 31,2005 and 2004, the Company recognized minority interest of $6.9 million and$7.0 million, respectively.

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**15.**   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 Note21) and unaffiliated reinsurers under quota share, first-loss and excess-of-losstreaties and on a facultative basis.

In the event that any orall of the reinsuring companies are unable to meet their obligations, orcontest such obligations, the Company would be unable to recover such defaultedamounts. Anumber of FSA’s reinsurers are required to pledge collateral to secure theirreinsurance obligations to FSA. Given the financial strengths of itsreinsurers, FSA requires collateral from reinsurers primarily to receivestatutory credit for the reinsurance, to provide liquidity to FSA in the eventof claims on the reinsured exposures, and to enhance rating agency credit forthe reinsurance.

Amountsof ceded and assumed business were as follows:

| ** **                                           | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                    | ** ** |
| Written premiums  ceded                              |       | $                                          | 288,780    |   | $ | 256,087 |   | $ | 244,211 |   |
| Written premiums  assumed                            |       | 12,066                                     |       | 9,474 |   | 11,567 |   |
| Earned premiums  ceded                               |       | 154,997                                    |       | 150,087 |   | 161,733 |   |
| Earned premiums  assumed                             |       | 4,627                                      |       | 3,521 |   | 6,608 |   |
| Losses and loss  adjustment expense payments ceded   |       | 3,486                                      |       | 1,465 |   | 52,372 |   |
| Losses and loss  adjustment expense payments assumed |       | 8                                          |       | 8 |   | 16 |   |
|                                                      |            |                                            |            |  |  |  |  |  |  |  |

 

| ** **                                           | ** ** | **As of December 31,** | ** **  |
|------------------------------------------------------|------------|---------------------------------------|-------------|
| ** **                                           | ** ** | **2006**                              | ** **  | **2005** | ** ** |
| ** **                                           | ** ** | **(in thousands)**               | ** **  |
| Principal  outstanding ceded                         |       | $                                     | 121,830,282 |   | $ | 120,607,468 |   |
| Principal  outstanding assumed                       |       | 3,757,565                             |        | 2,597,375 |   |
| Deferred premium  revenue assumed                    |       | 31,216                                |        | 23,777 |   |
| Losses and loss  adjustment expense reserves assumed |       | 610                                   |        | 643 |   |
|                                                      |            |                                       |             |  |  |  |  |

 

**16.**   OTHERASSETS AND LIABILITIES

Thedetailed balances that comprise other assets and accrued expenses, otherliabilities and minority interest at December 31, 2006 and 2005 are asfollows:

| ** **                                      | ** ** | **2006**                | ** ** | **2005** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                      | ** ** | **(in thousands)** | ** ** |
| Other assets:                                   |       |                    |       |     |       |
| Fair value of VIE swaps                         |       | $                       | 516,762    |     | $          | 433,670 |   |
| Fair value adjustment on CDS                    |       | 89,195                  |       | 57,372   |       |
| VIE other invested assets                       |       | 157,810                 |       | 146,710  |       |
| Securities purchased under agreements to resell |       | 150,000                 |       | 350,000  |       |
| Deferred compensation trust                     |       | 114,181                 |       | 107,140  |       |
| Tax and loss bonds                              |       | 127,150                 |       | 105,324  |       |
| Accrued interest on VIE swaps                   |       | 136,975                 |       | 108,421  |       |
| Accrued interest income                         |       | 92,951                  |       | 76,295   |       |
| Other assets                                    |       | 225,735                 |       | 271,009  |       |
| Total other assets                              |       | $                       | 1,610,759  |     | $          | 1,655,941 |   |

 

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| ** **                                                       | ** ** | **2006**                | ** ** | **2005** | ** ** |
|------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                                       | ** ** | **(in thousands)** | ** ** |
| Accrued expenses  and other liabilities:                         |       |                    |       |     |       |
| Payable for securities purchased                                 |       | $                       | 33,046     |     | $          | 91,529 |   |
| Deferred compensation trust                                      |       | 114,181                 |       | 107,140  |       |
| Equity participation plan                                        |       | 112,688                 |       | 116,887  |       |
| Accrued interest on FP GICs                                      |       | 124,856                 |       | 83,828   |       |
| Fair-value adjustments on derivatives                            |       | 33,230                  |       | 61,924   |       |
| Other liabilities                                                |       | 373,413                 |       | 347,866  |       |
| Minority interest in VIEs                                        |       | 250                     |       | 180,406  |       |
| Total accrued expenses,  other liabilities and minority interest |       | $                       | 791,664    |     | $          | 989,580 |   |

 

**17.**   COMMITMENTSAND CONTINGENCIES

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

| **Year Ended December 31,** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** |
|--------------------------------------------|------------|------------|------------|-------------------------|------------|
| 2007                                       |       |       | 9,163.6    |                    |       |
| 2008                                       |       |       | 8,217.4    |                    |       |
| 2009                                       |       |       | 8,204.7    |                    |       |
| 2010                                       |       |       | 8,141.2    |                    |       |
| 2011                                       |       |       | 8,125.3    |                    |       |
| Thereafter                                 |       |       | 111,723.1  |                    |       |
| Total                                      |       |       | $          | 153,575.3               |       |   |
|                                            |            |            |            |                         |            |  |  |  |

 

Rent expense was$10.7 million in 2006, $10.1 million in 2005 and $7.8 million in2004. Rent expense in 2005 includes a $1.2 million lease termination feerelated to the Company’s former headquarters.

In the ordinary course ofbusiness, the Company and certain Subsidiaries are parties to litigation. TheCompany is not a party to any material pending litigation.

On November 15, 2006,the Company received a subpoena from the Antitrust Division of the U.S.Department of Justice (“DOJ”) issued in connection with an ongoing criminalinvestigation of bid rigging of awards of municipal GICs. On November 16,2006, FSA received a subpoena from the Securities and Exchange Commission (“SEC”)related to an ongoing industry-wide civil investigation of brokers of municipalGICs. The Company issues municipal GICs through the FP Segment, but does notserve as a GIC broker. The subpoenas request that the Company furnish to theDOJ and SEC records and other information with respect to the Company’smunicipal GIC business. The Company is cooperating with the investigations bythe DOJ and SEC.

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**18.**   DIVIDENDSAND CAPITAL REQUIREMENTS

Because the majority ofthe Company’s operations are conducted through FSA, the long-term abilityof FSA Holdings to service its debt will largely depend on its receipt ofdividends from, or payment on surplus notes by, FSA.

FSA’s ability to paydividends depends on FSA’s financial condition, results of operations, cashrequirements, rating agency capital adequacy and other related factors, and isalso subject to restrictions contained in the insurance laws and relatedregulations of New York and other states. Under the insurance laws of the Stateof New York, FSA may pay dividends out of earned surplus, provided that,together with all dividends declared or distributed by FSA during the preceding12 months, the dividends do not exceed the lesser of (a) 10% ofpolicyholders’ surplus as of its last statement filed with the Superintendentof Insurance of the State of New York (the “New York Superintendent”) or (b) adjustednet investment income during this period. FSA paid $140.0 million ofdividends in 2006, $87.0 million in 2005 and $30.0 million in 2004. Basedupon FSA’s statutory statements for December 31, 2006, the maximum amountnormally available for payment of dividends by FSA without regulatory approvalover the following 12 months would be approximately $156.6 million.

At December 31, 2006,FSA Holdings held $108.9 million of FSA surplus notes. Payments of principal orinterest on such notes may be made only with the approval of the Superintendentof Insurance of the State of New York (the “New York Superintendent”). FSAHoldings employs surplus note purchases in lieu of capital contributions inorder to allow it to withdraw funds from FSA through surplus note paymentswithout reducing earned surplus, thereby preserving the dividend capacity ofFSA.

FSA may repurchase sharesof its common stock from shareholders subject to the New York Superintendent’sapproval. The New York Superintendent has approved the repurchase by FSA of upto $500.0 million of its shares from FSA Holdings throughDecember 31, 2008. In 2006, FSA repurchased $100.0 million of shares ofits common stock from FSA Holdings and retired such shares.

FSA Holdings paiddividends of $530.0 million in 2006, $71.1 million in 2005 and $22.9 million in2004.

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

FSA has a creditarrangement aggregating $150.0 million that is provided by commercial banks andintended for general application to insured transactions. If FSA is downgradedbelow Aa3 and AA-, the lenders may terminate the commitment and thecommitment commission becomes due and payable. If FSA is downgraded below Baa3and BBB-, any outstanding loans become due and payable. At December 31,2006, there were no borrowings under this arrangement, which expires on April 21,2011, if not extended.

FSA has a standby line ofcredit commitment in the amount of $350.0 million with a group of internationalbanks to provide loans to FSA after it has incurred, during the term of thefacility, cumulative municipal losses (net of any recoveries) in excess of thegreater of $350.0 million or the average annual debt service of the coveredportfolio multiplied by 5.00%, which amounted to $1,328.3 million at December 31,2006. The obligation to repay loans made under this agreement is a limitedrecourse obligation payable solely from, and collateralized by, a pledge ofrecoveries realized on defaulted insured obligations in the covered portfolio,including certain installment premiums and other collateral. This commitmenthas a term expiring on April 30, 2015 and contains an annual renewalprovision, commencing April 30, 2008, subject to approval by the banks. Noamounts have been utilized under this commitment as of December 31, 2006.

FSAM has a $100.0 millionline of credit with UBS Loan Finance LLC, which expires December 7, 2007,unless extended. This line of credit provides an additional source of liquidityshould there be 

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unexpecteddraws on GICs issued by the GIC Affiliates. There were no borrowings under thisagreement at December 31, 2006. Borrowings under this agreement areconditioned on FSA having a Triple-A rating by either Moody’s or S&P, andon neither Moody’s nor S&P having issued a rating to FSA below Aa1 or AA+,respectively.

In June 2003, $200.0million of money market committed preferred trust securities (the “CPSSecurities”) were issued by trusts created for the primary purpose of issuingthe CPS Securities, investing the proceeds in high-quality commercialpaper and providing FSA with put options for issuing to the trusts non-cumulativeredeemable perpetual preferred stock (the “Preferred Stock”) of FSA. If FSAwere to exercise a put option, the applicable trust would transfer the portionof the proceeds attributable to principal received upon maturity of its assets,net of expenses, to FSA in exchange for Preferred Stock of FSA. FSA pays afloating put premium to the trusts. The cost of the structure was $1.0 millionand $1.3 million for 2006 and 2005, respectively, and was recorded withinother operating expenses. The trusts are vehicles for providing FSA access tonew capital at its sole discretion through the exercise of the put options. TheCompany does not consider itself to be the primary beneficiary of the trustsbecause it does not retain the majority of the residual benefits or expectedlosses.

Certain FSA Global debtissuances contain provisions that could extend the stated maturities of thosenotes. To ensure FSA Global will have sufficient cash flow to repay its fundingrequirements, it has entered into four liquidity facilities with Dexia aggregating$419.4 million.

**20.**   SEGMENT REPORTING

The Company operates in two business segments:financial guaranty and financial products. The financial guaranty segment isprimarily in the business of providing financial guaranty insurance on publicfinance and asset-backed obligations. The FP Segment includes the GICoperations of the Company, which issues GICs to municipalities and other marketparticipants. GICs provide for the return of principal and the payment ofinterest at pre-specified rates. Reflecting the Company’s management ofthe VIEs’ operations, the results of the VIEs are included in the FP Segmentbeginning in 2006. Prior-year disclosures have been reclassified to conform tothe 2006 presentation. The following tables summarize the financial informationby segment as of and for the years ended December 31, 2006, 2005 and 2004:

| ** **                                                                 | ** ** | **For the Year Ended December 31, 2006** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **Financial  Guaranty**                                                | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| ** **                                                                 | ** ** | **(in thousands)**                                                | ** ** |
| Revenues:                                                                  |       |                                                                   |       |   |   |   |   |   |   |   |   |
| External                                                                   |       | $                                                                      | 698,213    |   | $ | 992,655 |   |   | $ | — |   |   | $ | 1,690,868 |   |
| Intersegment                                                               |       | 3,584                                                                  |       | 20,055 |   |   | (23,639 | ) |   | — |   |
| Expenses:                                                                  |       |                                                                   |       |   |   |   |   |   |   |   |   |
| External                                                                   |       | (217,019                                                               | )          | (951,021 | ) |   | — |   |   | (1,168,040 | ) |
| Intersegment                                                               |       | (20,055                                                                | )          | (3,584 | ) |   | 23,639 |   |   | — |   |
| Less:                                                                      |       |                                                                   |       |   |   |   |   |   |   |   |   |
| SFAS 133  fair-value adjustments for CDS and economic interest rate hedges |       | 31,823                                                                 |       | 10,257 |   |   | — |   |   | 42,080 |   |
| Pre-tax segment operating  earnings                                        |       | 432,900                                                                |       | 47,848 |   |   | — |   |   | 480,748 |   |
| Segment assets                                                             |       | $                                                                      | 7,160,055  |   | $ | 18,934,942 |   |   | $ | (321,371 | ) |   | $ | 25,773,626 |   |

 

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| ** **                                                                 | ** ** | **For the Year Ended December 31, 2005** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **Financial  Guaranty**                                                | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| ** **                                                                 | ** ** | **(in thousands)**                                                | ** ** |
| Revenues:                                                                  |       |                                                                   |       |   |   |   |   |   |   |   |   |
| External                                                                   |       | $                                                                      | 682,503    |   | $ | 298,732 |   |   | $ | — |   |   | $ | 981,235 |   |
| Intersegment                                                               |       | 3,947                                                                  |       | 28,162 |   |   | (32,109 | ) |   | — |   |
| Expenses:                                                                  |       |                                                                   |       |   |   |   |   |   |   |   |   |
| External                                                                   |       | (192,906                                                               | )          | (323,258 | ) |   | — |   |   | (516,164 | ) |
| Intersegment                                                               |       | (28,162                                                                | )          | (3,947 | ) |   | 32,109 |   |   | — |   |
| Plus:                                                                      |       |                                                                   |       |   |   |   |   |   |   |   |   |
| Equity in earnings and minority interest in International                  |       | (5,980                                                                 | )          | — |   |   | — |   |   | (5,980 | ) |
| Less:                                                                      |       |                                                                   |       |   |   |   |   |   |   |   |   |
| SFAS 133 fair-value adjustments for CDS and economic  interest rate hedges |       | 11,106                                                                 |       | (18,962 | ) |   | — |   |   | (7,856 | ) |
| Pre-tax segment  operating earnings                                        |       | 448,296                                                                |       | 18,651 |   |   | — |   |   | 466,947 |   |
| Segment assets                                                             |       | $                                                                      | 6,881,422  |   | $ | 15,585,118 |   |   | $ | (464,898 | ) |   | $ | 22,001,642 |   |

 

| ** **                                                                 | ** ** | **For the Year Ended December 31, 2004** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **Financial  Guaranty**                                                | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| ** **                                                                 | ** ** | **(in thousands)**                                                | ** ** |
| Revenues:                                                                  |       |                                                                   |       |   |   |   |   |   |   |   |   |
| External                                                                   |       | $                                                                      | 679,194    |   | $ | 469,075 |   |   | $ | — |   |   | $ | 1,148,269 |   |
| Intersegment                                                               |       | 4,855                                                                  |       | 24,800 |   |   | (29,655 | ) |   | — |   |
| Expenses:                                                                  |       |                                                                   |       |   |   |   |   |   |   |   |   |
| External                                                                   |       | (193,390                                                               | )          | (374,365 | ) |   | — |   |   | (567,755 | ) |
| Intersegment                                                               |       | (24,800                                                                | )          | (4,855 | ) |   | 29,655 |   |   | — |   |
| Plus:                                                                      |       |                                                                   |       |   |   |   |   |   |   |   |   |
| Equity in earnings and minority interest in International                  |       | (10,287                                                                | )          | — |   |   | — |   |   | (10,287 | ) |
| Less:                                                                      |       |                                                                   |       |   |   |   |   |   |   |   |   |
| SFAS 133 fair-value adjustments for CDS and economic  interest rate hedges |       | 56,391                                                                 |       | 106,500 |   |   | — |   |   | 162,891 |   |
| Pre-tax segment  operating earnings                                        |       | 399,181                                                                |       | 8,155 |   |   | — |   |   | 407,336 |   |
| Segment assets                                                             |       | $                                                                      | 6,658,094  |   | $ | 11,178,330 |   |   | $ | (755,416 | ) |   | $ | 17,081,008 |   |

 

Thefollowing tables present reconciliations of segments’ pre-tax operatingearnings to net income.

| ** **                                                                 | ** ** | **For the Year  Ended December 31, 2006** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **Financial  Guaranty**                                                      | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| ** **                                                                 | ** ** | **(in thousands)**                                                      | ** ** |
| Pre-tax operating  earnings                                                |       | $                                                                            | 432,900    |   |   | $ | 47,848 |   |   |   | $ | — |   |   | $ | 480,748 |   |
| SFAS 133  fair-value gain (loss) for CDS and economic interest rate hedges |       | 31,823                                                                       |       |   | 10,257 |   |   |   | — |   |   | 42,080 |   |
| Taxes                                                                      |       | —                                                                       |       |   | — |   |   |   | — |   |   | (150,680 | ) |
| Minority interest                                                          |       | —                                                                       |       |   | — |   |   |   | — |   |   | 52,006 |   |
| Net income                                                                 |       | —                                                                       |       |   | — |   |   |   | — |   |   | $ | 424,154 |   |
|                                                                            |            |                                                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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| ** **                                                                 | ** ** | **For the Year  Ended December 31, 2005** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **Financial  Guaranty**                                                      | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| ** **                                                                 | ** ** | **(in thousands)**                                                      | ** ** |
| Pre-tax operating  earnings                                                |       | $                                                                            | 448,296    |   | $ | 18,651 |   |   | $ | — |   |   | $ | 466,947 |   |
| SFAS 133  fair-value gain (loss) for CDS and economic interest rate hedges |       | 11,106                                                                       |       | (18,962 | ) |   | — |   |   | (7,856 | ) |
| Taxes                                                                      |       | —                                                                       |       | — |   |   | — |   |   | (128,900 | ) |
| Minority interest                                                          |       | —                                                                       |       | — |   |   | — |   |   | (4,083 | ) |
| Net income                                                                 |       | —                                                                       |       | — |   |   | — |   |   | $ | 326,108 |   |
|                                                                            |            |                                                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                                                 | ** ** | **For the Year  Ended December 31, 2004** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **Financial  Guaranty**                                                      | ** ** | **Financial  Products** | ** ** | **Intersegment  Eliminations** | ** ** | **Total** | ** ** |
| ** **                                                                 | ** ** | **(in thousands)**                                                      | ** ** |
| Pre-tax operating  earnings                                                |       | $                                                                            | 399,181    |   | $ | 8,155 |   |   | $ | — |   |   | $ | 407,336 |   |
| SFAS 133  fair-value gain (loss) for CDS and economic interest rate hedges |       | 56,391                                                                       |       | 106,500 |   |   | — |   |   | 162,891 |   |
| Taxes                                                                      |       | —                                                                       |       | — |   |   | — |   |   | (111,160 | ) |
| Minority interest                                                          |       | —                                                                       |       | — |   |   | — |   |   | (80,460 | ) |
| Net income                                                                 |       | —                                                                       |       | — |   |   | — |   |   | $ | 378,607 |   |
|                                                                            |            |                                                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The intersegment assets consist of intercompanynotes issued by FSA and held within the FP Investment Portfolio. Theintersegment revenues and expenses relate to interest income and interestexpense on intercompany notes and premiums paid by FSA Global on FSA-insurednotes.

The amount of SFAS 133fair-value adjustments for CDS is a reconciling item between pre-tax segmentoperating earnings and net income. In addition, management subtracts the impactof economic interest rate hedges when analyzing the segments. By removing theeffect of the one-sided accounting caused by marking the derivatives to fairvalue, but not the hedged assets or liabilities, the measure will more closelyreflect the underlying performance of segment operations.

**21.**   RELATEDPARTY TRANSACTIONS

The table below summarizes amounts included in thefinancial statements and outstanding exposures resulting from various types oftransactions executed with related parties:

| ** **                                | ** ** | **As of December 31,** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|
| ** **                                | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **                                | ** ** | **(in millions)**                | ** ** |
| **XL(1)**                                 |       |                                  |       |   |   |
| Prepaid reinsurance                       |       | $                                     | 109.7      |   | $ | 84.4 |   |
| Reinsurance recoverable for unpaid losses |       | 3.2                                   |       | 1.8 |   |
| **Dexia(2)**                              |       |                                  |       |   |   |
| Other assets(3)                           |       | 353.4                                 |       | 320.4 |   |
| Deferred premium revenue                  |       | 18.2                                  |       | 22.5 |   |
| Variable interest entities debt           |       | 181.8                                 |       | 172.1 |   |
| Gross par outstanding                     |       | 17,034.4                              |       | 22,846.6 |   |
| Other liabilities                         |       | 2.1                                   |       | 2.3 |   |
|                                           |            |                                       |            |  |  |  |  |  |

 

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| ** **                                       | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | **(in millions)**                                       | ** ** |
| **XL(1)**                                        |       |                                                         |       |   |   |   |   |
| Ceded premiums                                   |       | $                                                            | 46.1       |   | $ | 31.6 |   | $ | 35.2 |   |
| Dividends paid                                   |       | —                                                       |       | 16.3 |   | 7.0 |   |
| **Dexia(2)**                                     |       |                                                         |       |   |   |   |   |
| Gross premiums earned                            |       | 26.4                                                         |       | 29.5 |   | 29.3 |   |
| Derivative (gains/losses)                        |       | (7.3                                                         | )          | (2.7 | ) | 104.0 |   |
| Variable interest  entities net interest expense |       | 9.8                                                          |       | 9.3 |   | 8.8 |   |
|                                                  |            |                                                              |            |  |  |  |  |  |  |  |

----

(1)          The Company cededbusiness to XL Capital Ltd. (“XL”), a major Bermuda-based insuranceholding company that owned an interest in FSA International prior to October 2005.The Company maintains an investment in XLFA, an indirect subsidiary of XL.

(2)          Represents business withaffiliates of Dexia.

(3)          Represents primarilyderivative fair-value adjustments and accrued interest.

FSA Global maintainsliquidity facilities with Dexia (see Note 19).

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

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

For bonds and equity securities in the GeneralInvestment Portfolio and the FP Segment Investment Portfolio, the carryingamount represents fair value. The fair value is generally based on quotedmarket price or, in the case of the Company’s investment in XLFA, redemptionvalue.

For short-term investments, including the FPshort-term investment portfolio and the VIE short-term investments,the carrying amount approximates fair market value due to the short maturity ofthe 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,each asset’s fair value is either the present value of expected cash flows or aquoted market price 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 inception. The fair value of deferred premium revenue, net of prepaidreinsurance premiums, is an estimate of the statutory premiums that would bepaid under a reinsurance agreement with a third party to transfer the Company’sfinancial guaranty risk, net of the premiums retained by the Company tocompensate it for originating and servicing the insurance contract.

For notes payable, the carrying amount represents theprincipal amount due at maturity. The fair value is based on the quoted marketprice or other third party sources.

For installment premiums, consistent with industrypractice, there is no carrying amount. Similar to the treatment of deferredpremium revenue, the fair value of installment premiums is the estimatedpresent value of the future contractual premium revenues that would be receivedfrom reinsurers assuming 

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the Company’s financialguaranty risk, net of the premium retained by the Company to compensate it fororiginating and servicing the insurance 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 equal to the presentvalue of the expected cash flows for specifically identified claims plusstatistical losses representing the inherent losses in the Company’s insuredportfolio. Management believes the carrying amount is a reasonable proxy forfair 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:

| ** **                                                                            | ** ** | **As of December 31, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                            | ** ** | **Carrying  Amount**                            | ** ** | **Fair Value**                             | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
| ** **                                                                            | ** ** | **(in thousands)**                         | ** ** |
| Assets:                                                                               |       |                                            |       |                                            |       |   |   |   |   |
| Bonds                                                                                 |       | $                                               | 4,721,512  |                                            | $          | 4,721,512 |   | $ | 4,382,037 |   | $ | 4,382,037 |   |
| Equity securities                                                                     |       | 54,325                                          |       | 54,325                                          |       | 54,370 |   | 54,370 |   |
| Short-term investments                                                                |       | 96,578                                          |       | 96,578                                          |       | 159,133 |   | 159,133 |   |
| FP Segment bond portfolio                                                             |       | 16,757,979                                      |       | 16,757,979                                      |       | 12,983,816 |   | 12,983,816 |   |
| FP Segment short-term investment portfolio                                            |       | 659,704                                         |       | 659,704                                         |       | 1,018,183 |   | 1,018,183 |   |
| Cash                                                                                  |       | 32,471                                          |       | 32,471                                          |       | 43,629 |   | 43,629 |   |
| Assets acquired in refinancing transactions                                           |       | 337,872                                         |       | 333,389                                         |       | 467,873 |   | 460,770 |   |
| Fair-value adjustments for derivatives                                                |       | 616,179                                         |       | 616,179                                         |       | 494,490 |   | 494,490 |   |
| Receivable for investments sold                                                       |       | 161                                             |       | 161                                             |       | 1,382 |   | 1,382 |   |
| Liabilities:                                                                          |       |                                            |       |                                            |       |   |   |   |   |
| Deferred premium revenue, net of prepaid reinsurance  premiums                        |       | 1,648,334                                       |       | 1,449,526                                       |       | 1,509,867 |   | 1,295,312 |   |
| Losses and loss adjustment expenses, net of  reinsurance recoverable on unpaid losses |       | 190,780                                         |       | 190,780                                         |       | 169,379 |   | 169,379 |   |
| GIC and VIE debt                                                                      |       | 18,349,665                                      |       | 19,155,018                                      |       | 14,947,118 |   | 15,185,891 |   |
| Notes payable                                                                         |       | 730,000                                         |       | 726,117                                         |       | 430,000 |   | 423,904 |   |
| Fair-value adjustments for derivatives                                                |       | 40,215                                          |       | 40,215                                          |       | 61,924 |   | 61,924 |   |
| Payable for investments purchased                                                     |       | 33,046                                          |       | 33,046                                          |       | 91,529 |   | 91,529 |   |
| Off-balance-sheet  instruments:                                                       |       |                                            |       |                                            |       |   |   |   |   |
| Installment  premiums                                                                 |       | —                                          |       | 450,215                                         |       | — |   | 438,109 |   |
|                                                                                       |            |                                                 |            |                                                 |            |  |  |  |  |  |  |  |  |

 

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**23.**   STATUTORYACCOUNTING PRACTICES

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

·       upfrontpremiums are earned when related principal and interest have expired ratherthan earned over the expected period of coverage;

·       acquisitioncosts are charged to operations as incurred rather than over the period thatrelated premiums are earned;

·       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 accounted for as insurance contracts rather than as derivativecontracts recorded at fair value;

·       bondsare carried at amortized cost rather than fair value;

·       VIEsand refinancing vehicles are not consolidated;

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

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

Consolidated statutory netincome was $339.6 million for 2006, $293.0 million for 2005 and $242.1 millionfor 2004. Statutory surplus plus contingency reserves totaled $2,554.1 millionfor 2006, $2,417.5 million for 2005 and $2,280.9 million for 2004.

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**24.**   QUARTERLYFINANCIAL INFORMATION (UNAUDITED)

| ** **                                                                                       | ** ** | **First**               | ** ** | **Second** | ** ** | **Third**  | ** ** | **Fourth** | ** ** | **Full Year** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------|------------|------------|------------|------------|------------|--------------------|------------|
| ** **                                                                                       | ** ** | **(in thousands)** | ** ** |
| **2006**                                                                                         | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **         | ** ** |
| Net premiums written                                                                             |       | 88,732                  |       | 150,996    |       | 125,655    |       | 161,794    |       | 527,177            |       |
| Net premiums earned                                                                              |       | 94,495                  |       | 98,461     |       | 91,755     |       | 103,998    |       | 388,709            |       |
| Net investment income                                                                            |       | 53,046                  |       | 53,254     |       | 55,403     |       | 57,147     |       | 218,850            |       |
| Net interest income from financial products segment                                              |       | 176,289                 |       | 207,522    |       | 226,713    |       | 251,248    |       | 861,772            |       |
| Net realized and unrealized gains (losses) on  derivative instruments                            |       | 58,105                  |       | 74,478     |       | (30,200    | )          | 60,663     |       | 163,046            |       |
| Losses and loss adjustment expenses                                                              |       | 3,285                   |       | 7,899      |       | 5,159      |       | 6,960      |       | 23,303             |       |
| Policy acquisition costs                                                                         |       | 16,210                  |       | 14,421     |       | 14,103     |       | 18,278     |       | 63,012             |       |
| Net interest expense from financial products segment                                             |       | 155,660                 |       | 180,983    |       | 203,811    |       | 228,129    |       | 768,583            |       |
| Other operating expenses                                                                         |       | 31,304                  |       | 19,967     |       | 27,842     |       | 45,509     |       | 124,622            |       |
| Income before income taxes and minority interest                                                 |       | 146,464                 |       | 131,525    |       | 121,293    |       | 123,546    |       | 522,828            |       |
| Net income                                                                                       |       | $                       | 130,205    |       | $          | 109,720    |       | $          | 91,479     |               | $          | 92,750 |   | $ | 424,154 |   |
| **2005**                                                                                         | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **         | ** ** |
| Net premiums written                                                                             |       | 109,502                 |       | 143,916    |       | 160,918    |       | 163,358    |       | 577,694            |       |
| Net premiums earned                                                                              |       | 94,881                  |       | 96,254     |       | 116,832    |       | 96,092     |       | 404,059            |       |
| Net investment income                                                                            |       | 49,446                  |       | 50,404     |       | 50,696     |       | 50,281     |       | 200,827            |       |
| Net interest income from financial products segment                                              |       | 85,351                  |       | 95,250     |       | 143,768    |       | 163,547    |       | 487,916            |       |
| Net realized and unrealized gains (losses) on  derivative instruments                            |       | (70,812                 | )          | 18,179     |       | (42,431    | )          | (77,411    | )          | (172,475           | )          |
| Losses and loss adjustment expenses                                                              |       | 3,984                   |       | 6,238      |       | 10,185     |       | 4,958      |       | 25,365             |       |
| Policy acquisition costs                                                                         |       | 15,408                  |       | 16,198     |       | 20,247     |       | 16,487     |       | 68,340             |       |
| Net interest expense from financial products segment                                             |       | 100,642                 |       | 94,353     |       | 144,135    |       | 152,510    |       | 491,640            |       |
| Other operating expenses                                                                         |       | 27,009                  |       | 23,868     |       | 20,151     |       | 22,586     |       | 93,614             |       |
| Income before income taxes, minority interest and  equity in losses of unconsolidated affiliates |       | 82,231                  |       | 235,832    |       | 97,136     |       | 49,872     |       | 465,071            |       |
| Net income                                                                                       |       | $                       | 63,156     |       | $          | 129,307    |       | $          | 73,811     |               | $          | 59,834 |   | $ | 326,108 |   |

 

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**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, 2006.

**Item 9A.**                Controlsand Procedures.

**Evaluation ofDisclosure Controls and Procedures**

TheCompany’s management, with the participation of the Company’s Chief ExecutiveOfficer and Chief Financial Officer, completed an evaluation of the effectiveness of design and operation of the Company’sdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act) as of December 31, 2006.Based on that evaluation, the Company’s Chief Executive Officer and ChiefFinancial Officer have concluded that as of such date the Company’s disclosurecontrols and procedures were effective to ensure that information required tobe disclosed by the Company in reports that it files or submits under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified by the rules and forms of the Securities and ExchangeCommission (the “SEC”), and that such information is accumulated andcommunicated to management, including the Chief Executive Officer and ChiefFinancial Officer, as appropriate, in a manner that allows timely decisionsregarding required disclosure.

**Remediation ofMaterial Weakness**

As disclosed in the Company’s amended annual report onForm 10-K/A for the year ended December 31, 2004, filed December 19,2005, management of the Company had determined that, based on its evaluationand because of the material weakness in internal control over financialreporting discussed below, as of such date the Company’s disclosure controlsand procedures were ineffective. A material weakness is a control deficiency,or combination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. Management of the Company hasaddressed the reported material weakness as discussed below, and has concludedthat this material weakness in internal control over financial reporting hasbeen remediated as of December 31, 2006.

Management concluded that the Company did not maintaineffective controls to ensure that hedge accounting was correctly appliedpursuant to generally accepted accounting principles as of December 31,2005. Specifically, the Company’s accounting documentation for certain hedgingrelationships did not meet the requirements of Statement of FinancialAccounting Standards No. 133, “Accounting for Derivative Instruments andHedging Activities” (“SFAS 133”) and related interpretations and theCompany incorrectly applied the short-cut method of hedge accounting to certainother hedge relationships. This control deficiency resulted in the restatementof the Company’s Consolidated Financial Statements for the years ended December 31,2004, 2003 and 2002, the periods ended March 30, June 30, September 30and December 31, 2003 and 2004 and opening retained earnings at January 1,2002. In addition, this control deficiency could result in a misstatement ofinterest income and expense from financial products and variable interestentities, net realized and unrealized gains and losses on derivativeinstruments, income from assets acquired in refinancing transactions andrelated accounts and disclosures that would cause a material misstatement inthe annual and interim financial statements. Accordingly, management determinedthat this control deficiency constituted a material weakness in internal controlover financial reporting as of December 31, 2004.

To remediate thematerial weakness, the Company:

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

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·       appliedsuch standard to certain liabilities effective January 1, 2006; and

·       strengthenedthe Company’s internal knowledge base regarding hedge accounting throughimproved training designed to ensure that all relevant personnel understand andapply hedge accounting in compliance with SFAS 133.

Based upon the actionstaken and the results of its testing and evaluation of the effectiveness of thecontrols, management has concluded that the material weakness described abovehas been remediated as of December 31, 2006.

**Changes in InternalControl over Financial Reporting**

Other than as described above, there has been nochange in the Company’s internal control over financial reporting (as definedin Rule 13a-15(f) or 15d-15(f) under the ExchangeAct) during the year ended December 31, 2006 that has materially affected,or that is reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

Thereare inherent limitations to the effectiveness of any system of disclosure controlsand procedures, including the possibility of human error and the circumventionor overriding of the controls and procedures. Accordingly, even effectivedisclosure controls and procedures can only provide reasonable assurance ofachieving their control objectives. The Company will continue to improvethe design and effectiveness of its disclosure controls and procedures andinternal control over financial reporting to the extent necessary in the futureto provide management with timely access to such material information and tocorrect any deficiencies that may be discovered in the future.

**Item 9B.**               OtherInformation.

None.

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**PART III**

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

**Directors**

On May 18,2006, 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, 2006 is set forth below and in “Item 12.Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters—Directors and Executive Officers.”
| Robert P. Cochran  |   | Chairman of the Board of  Directors of the Company since                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|--------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Age 57             |   | November 1997, and  Chief Executive Officer and a Director of the Company since August 1990.  Mr. Cochran served as President of the Company and FSA from  August 1990 until November 1997. He has been Chief Executive  Officer of FSA since August 1990, Chairman of FSA since July 1994,  and a director of FSA since July 1988. Prior to joining the Company in  1985, Mr. Cochran was Managing Partner of the Washington, D.C. office of  the Kutak Rock law firm. Mr. Cochran is a Director of White Mountains  Insurance Group, Ltd.                                                                                                                                              |
| Bruno Deletré |   | Director of the  Company since September 2001. In January 2007,                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| Age 45             |   | Mr. Deletré became  a member of the Management Board of Dexia. In January 2006, he became an  Executive Vice President and member of the Executive Committee of Dexia.  Mr. Deletré was a member of the Executive Board of Dexia Crédit Local  from 2001 through January 2006 and Managing Director from  December 2003. Prior to that time, he held various positions in the  French Ministry of Finance—Treasury, and served as Advisor to the French  Minister of Economy and Finance from 1995 to 1997. Mr. Deletré is a  member of the Board of Directors of several banking subsidiaries of Dexia  Crédit Local and of the Board of Directors of Dexia Asset Management. |
| Robert N. Downey   |   | Director of the  Company since August 1994. Mr. Downey has been a                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| Age 71             |   | 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 and Vice Chairman of the Municipal Securities Rulemaking Board.                                                                                         |

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| Jacques Guerber       |   | Director of the  Company since September 2002. In January 2006,                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|-----------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Age 57                |   | Mr. Guerber became  Vice Chairman of the Management Board of Dexia, a Member of the Management Boards of Dexia Crédit Local, Dexia Banque Belgique  S.A., and Dexia Banque Internationale a Luxembourg. He has been a  Member of the Supervisory Board of Financiere Centuria since  January 2002, a Director of Credit du Nord since February 2000, and  Chairman of the Supervisory Board of Dexia Municipal Agency since  August 1999. Mr. Guerber was Chairman of the Executive Board of  Dexia Crédit Local from 2000 through January 2006, and a member of the  Executive Committee of Dexia from December 1999 to January 2006.  Prior to then he was Senior Executive Vice President of Crédit Local de  France (subsequently known as Dexia Crédit Local) from 1996 and a member of  that company’s Management Board from 1988. Earlier, he held management  positions in the Local Development Division of *Caisse des  Dépôts et Consignations*. |
| Rembert von Lowis     |   | Director of the  Company since July 2000. Mr. von Lowis has been a                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| Age 53                |   | Member of the Management  Board of Dexia since October 1996 and of the Management Board of Dexia  Credit Local since January 2006. 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 a 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| Séan W. McCarthy |   | Director of the  Company since February 1999. Mr. McCarthy has been                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| Age 47                |   | 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.                                                                                                                                                                                                                                                                                                                           |
| Axel Miller           |   | Director of the  Company since February 2006. Mr. Miller obtained his law                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| Age 42                |   | degree, a Licence en  droit, from the Université Libre de Bruxelles. After having worked for 14  years as a lawyer specialized in finance law, mergers & acquisitions  and international commercial law, Mr. Miller joined the Dexia Group in  2001 as General Counsel. He became a member of the Management Board of Dexia  Bank in January 2002 and Chairman of the Management Board of Dexia Bank  and Head of Personal Financial Services at Group level in January 2003.  On January 1, 2006, Mr. Miller became CEO and Chairman of the  Management Board of Dexia. He is also a Director of several Dexia Group  companies, Crédit du Nord and LVI Holding (Groupe Carmeuse).                                                                                                                                                                                                                                                                                                        |

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| James H. Ozanne  |   | Director of the  Company since September 2004. Mr. Ozanne previously                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Age 63           |   | served on the Board of  Directors of the Company from January 1990 through May 2003, when  he became Chief Executive Officer of SPS Holding Corp., a mortgage servicing  holding company in which the Company owned a minority interest, a position he  held until September 2004. He served as Vice Chairman of the Board of  Directors of the Company from May 1998 until July 2000. Mr. Ozanne  is Chairman of Greenrange Partners. He was Chairman of Source One Mortgage  Services Corporation, which was a subsidiary of White Mountains (“Source  One”), from March 1997 to May 1999, Vice Chairman of Source One  from August 1996 until March 1997, and a director of Source One  from August 1996 to May 1999. He was Chairman and Director of  Nations Financial Holdings Corporation from January 1994 to  January 1996. He was President and Chief Executive Officer of U S WEST  Capital Corporation (“USWCC”) from September 1989 until  December 1993. Prior to joining USWCC, Mr. Ozanne was Executive  Vice President of General Electric Capital Corporation. Mr. Ozanne is  currently a director of Distributed Energy Services Corp. He was Chairman of  PECO Pallet, a privately owned grocery pallet rental company, from 2000 to  2006. |
| Roger K. Taylor  |   | Director of the  Company since February 1995. Mr. Taylor was a part-time                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| Age 55           |   | employee of the Company  and Vice Chairman of FSA from January 2002 until his retirement in  July 2004. Mr. Taylor served as Chief Operating Officer of the  Company from May 1993 through December 2001 and President of the  Company from November 1997 through December 2001. Mr. Taylor  joined FSA in January 1990, and served FSA as its President from  November 1997 until November 2000, a director since  January 1992 and a Managing Director since January 1991. Prior to  joining FSA, Mr. Taylor was Executive Vice President of Financial  Guaranty Insurance Company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| Xavier de Walque |   | Director of the  Company since May 2006. In 2006, Mr. de Walque became                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| Age 42           |   | a member of the  Management Board of Dexia S.A. From 2004 to 2006, he was chief financial  officer and a member of the management board of Dexia Bank  Belgium.Mr. de Walque joined Dexia S.A. in 2001 as Head of Mergers and  Acquisitions; from 2003 to 2004 he was Deputy Chief Financial Officer. Prior  to then he was responsible for Corporate Finance at Compagnie Benelux Paribas  (“Cobepa”) from 1991 to 2001, serving on the Management Board of Cobepa from  1997 and as head of Belgian Corporate Finance at BNP Paribas from 1999.  Mr. de Walque was an advisor in the cabinet of the Deputy Prime Minister  and the Budget Ministry of Belgium between 1988 and 1990. Xavier de Walque is  chairman of the Board of Directors and member of the audit committee of Dexia  Insurance Belgium.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |

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| George U. Wyper |   | Director of the  Company since September 2004. Mr. Wyper is the founder                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|-----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Age 51          |   | 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 serves on the boards of the Yale School of  Management, the American Numismatic Society and the Museum of Rhode Island  School of Design. |

 

On February 15, 2007,the Board of Directors elected Michèle Colin to the Board of Directors. Informationabout Ms. Colin is set forth below and in “Item 12. Security Ownership ofCertain Beneficial Owners and Management and Related Stockholder Matters—Directorsand Executive Officers.”
| Michèle Colin |   | Director of the Company  since February 2007. In January 2006, Ms. Colin                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|--------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Age 53             |   | became the Head of Risk  Management of Dexia Crédit Local. Ms. Colin was previously the Dexia  Crédit Local Compliance Officer from September 2005 to  September 2006. Ms. Colin joined Dexia Crédit Local in 1997 as  Deputy Head of the Credit Risk Management Department, becoming the Deputy  Head of Human Resources in 2001. Prior to joining Dexia, she served as a  civil servant as Deputy Head of the Financing and Planning Department of the  City of Paris. Ms. Colin is on the Board of Directors of Dexia Crédit Local. |

 

**Executive Officers of the Company**

Inaddition to Messrs. Cochran and McCarthy (who are described above underthe caption “Directors”), the Company’s other executive officers are describedbelow. The Company’s executive officers consist of the members of the ExecutiveManagement Committee.
| Name                 | ** ** | ** ** | ** ** | **Age** | ** ** | **Position**                                                                                 |
|----------------------|------------|------------|------------|---------|------------|----------------------------------------------------------------------------------------------|
| Russell B. Brewer II |       |       | 51         |    |       | Managing Director of the  Company and FSA; Chief Risk Management Officer and Director of FSA |
| Joseph W. Simon      |       |       | 48         |    |       | Managing Director and  Chief Financial Officer of the Company and FSA; Director of FSA       |
| Bruce E. Stern       |       |       | 54         |    |       | Managing Director,  General Counsel and Secretary of the Company and FSA; Director of FSA    |

 

The present principaloccupation and five-year employment history of each of the above-namedexecutive officers of the Company, as well as other directorships ofcorporations currently held by each such person, are set forth below.

Mr. Brewer has been aManaging Director of FSA since March 1989 and the Chief Risk ManagementOfficer of FSA since September 2003. Mr. Brewer was the ChiefUnderwriting 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.

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Mr. Simonwas elected a Managing Director and the Chief Financial Officer of the Companyand FSA in September 2002, having served in such capacity since April 2002.Prior to joining the Company, Mr. Simon was Chief Financial Officer ofIntralinks, a technology company serving the financial markets. From 1993 to1999, he was a senior financial officer, last serving as the Chief FinancialOfficer, of Cantor Fitzgerald. From 1986 to 1993 he was a senior member ofMorgan Stanley’s controller department. Mr. Simon, a certified publicaccountant, began his professional career at Price Waterhouse in 1983.

Mr. Sternhas been a Managing Director, the Secretary and the General Counsel of theCompany since April 1993. Since April 1993, he has been the Secretaryof FSA, and since March 1989, he has been a Managing Director of FSA. Hehas been a director of FSA since August 1990. Prior to joining FSA asGeneral Counsel in 1987, Mr. Stern was an attorney with Cravath, Swaine &Moore.

**Audit Committee**

TheCompany has a separately designated standing Audit Committee established inaccordance with Section 3(a)(58)(A) of the Exchange Act. During January 2005,the Audit Committee consisted of Mr. Ozanne (Chairman), David Maxwell and Mr. Wyper.In February 2006, Mr. Taylor was elected to the Audit Committee and Mr. Maxwellceased to be a member of the Committee. Mr. Maxwell left the Board ofDirectors in May 2006.

Allmembers of the Audit Committee are independent within the meaning of Rule 10A-3(a)(b)(1) ofthe Exchange Act. Because the Company has only debt securities listed on theNYSE, it is not subject to the additional independence standards for directorsimposed by the NYSE.

TheBoard of Directors of the Company has determined that Audit Committee membersJames H. Ozanne and George U. Wyper are audit committee financial experts asdefined by item 407(d)(5) of Regulation S-K of the Exchange Act.

**Code of Ethics**

TheCompany has adopted a code of ethics for directors, officers (including theCompany’s principal executive officer, principal financial officer, andprincipal accounting officer and controller) and employees, known as the Codeof Conduct. The Company has posted its Code of Conduct on its Internet website,*www.fsa.com*. The Company intends tosatisfy the disclosure requirement under Item 5.05 of Form 8-Kregarding amendments to, or waivers from, provisions of its code of ethics thatapplies to its principal executive officer, principal financial officer andprincipal accounting officer and 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*.

**Nomination of Directors**

Holdersof the Company’s registered debt securities are not entitled to recommendnominees to the Company’s Board of Directors.

**Section 16(a) BeneficialOwnership Reporting Compliance**

Section 16of the Exchange Act requires periodic reporting by beneficial owners of morethan 10% of any equity security registered under Section 12 of theExchange Act and directors and executive officers of issuers of such equitysecurities. Upon its merger with a subsidiary of Dexia in July 2000, theCompany’s common stock ceased to be registered under Section 12 of theExchange Act or listed on the NYSE. Consequently, the reporting obligations of Section 16of the Exchange Act do not apply.

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**Item 11.**                 ExecutiveCompensation.

**CompensationDiscussion and Analysis**

The Company’s compensationprogram has been designed to attract, motivate and retain employees while, atthe same time, aligning the interests of the Company’s employees with those ofthe Company’s shareholders. The Company’s compensation program was establishedin substantially its current form in 1994, in connection with the initialpublic offering by the Company. When the Company was acquired by Dexia in 2000,the acquisition documents expressly provided for continuation of the Company’sexisting compensation programs through 2004, with specified changes to thecompensation program to reflect the fact that the Company’s shares were nolonger publicly traded. In 2004, the Human Resources Committee (the “HRCommittee”) of the Board of Directors of the Company reviewed the Company’scompensation program with the advice of the HR Committee’s independentcompensation consultants, Hewitt Associates, and on the basis of that advicedetermined to continue the Company’s compensation program with only minorchanges, concluding that the existing program was successful in achieving itsintended purposes.

***Compensation Philosophy***

The objectivesunderlying the Company’s compensation program include the following:

·       TheCompany seeks to attract and retain quality employees at all levels of theorganization. To this end, the HR Committee has maintained a general target ofcompensating the Company’s employees within the 75th percentile of overall compensation provided bythe Company’s industry peers.

·       TheCompany seeks to align the interests of employees with those of the Company’sparent and, specifically, to motivate employees to grow the value and earningsof the Company. To this end, the Company employs measures of value and earningsgeneration in determining annual and longer term compensation.

·       The Company seeks to haveits employees take a long term view of the Company’s business and the risksthat the Company underwrites. To this end, higher ranking employees of theCompany receive a high percentage of their overall compensation in the form ofincentive compensation that pays out based upon the Company’s performance overthree to four year periods.

***Measures of Value Creation Underlying the Company’s CompensationProgram***

The Company measures itsoverall success on the basis of a number of factors, including growth inadjusted book value (“ABV”) per share and growth in book value per share(adjusted as described below). See “Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Results of Operations—OperatingEarnings and Adjusted Book Value” for a discussion of these measures. ABV andbook value growth are measures of value creation. ABV growth emphasizes newbusiness production, since it captures the present value of insurance premiumsand financial products net interest margin originated during a specified period.Book value growth emphasizes operating earnings, can be considerably morevolatile than ABV growth, and will, for example, be more influenced by negativeevents such as increases in loss reserves. In applying these measures forcompensation purposes, certain aspects of GAAP are eliminated that, in the viewof management and the Board of Directors, distort the Company’s economicresults, most notably the impact of (i) marking to market investment gradeFSA-insured credit default swaps under Statement of Financial AccountingStandards No. 133, “Accounting for Derivative Instruments and HedgingActivities” (“SFAS 133”) and (ii) not applying hedge accountingtreatment for economic hedges under SFAS 133. See “Item 5. Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Resultsof Operations—Operating Earnings and Adjusted Book 

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Value.” TheGrowth in ABV and book value are applied on a per share basis. In order to incentivizemanagement to return capital to the Company’s shareholders to the extent suchcapital is not being deployed, the calculation of the rate of growth per shareis adjusted to offset the effects of dividends and capital contributions, whichdo not affect the number of shares outstanding.

***Components of Compensation Provided by the Company***

The Company’s compensationprogram includes the following basic elements (described in more detailbelow):  (i) salary; (ii) cashbonus; (iii) equity compensation in the form of performance share unitsunder the Corporation’s 2004 Equity Compensation Plan (the “2004 Equity Plan”);(iv) health and other predominately customary benefit plans; and (v) optionalparticipation in Employee Share Plans sponsored by Dexia S.A. In addition, theCompany has employment agreements with its two most senior executive officers. TheCompany’s compensation program is designed, in part, upon the “Wall Street”model. For the more highly compensated employees within the Company, equitycompensation represents the largest component of compensation, followed by cashbonus and salary.

*Salaries*

Employee salaries aregenerally established on the basis of competitive market standards, and arethereafter generally changed to reflect cost of living adjustments and changesin responsibility.

*Cash Bonuses*

Cash bonuses are paid on an annual basis out of abonus pool (the “Bonus Pool”) determined pursuant to a guideline formulaintended to provide employees with a percentage of the growth in value in theCompany during the preceding calendar year. In establishing this guideline, theHR Committee recognized that non-distributed Bonus Pool amounts from prioryears may to a limited extent be accumulated and memorialized in future yearsfor purposes of supplementing the guideline Bonus Pool for future years. The Committeealso recognized that adjustments to the Bonus Pool guideline may be recommendedby management, subject to approval of the HR Committee, to reflect changes incircumstances. Notwithstanding the Bonus Pool guideline, bonuses remain withinthe discretion of the HR Committee, except insofar as otherwise provided in theCompany’s employment agreements. Specifically, aggregate bonuses in any yearmay be more or less than the guideline Bonus Pool for that year, and individualemployee bonuses are not directly tied to the guideline Bonus Pool, exceptinsofar as provided in the Company’s employment agreements.

The current Bonus Pool Guideline (approved by the HRCommittee in November 2004) provides for an annual Bonus Pool equal to apredetermined percentage (the “Specified Percentage”) of the increase in ABV ofthe Company during the applicable year (as derived from the Company’s IFRSfinancial statements), excluding unrealized gains and losses on investments,net of tax, and excluding the mark-to-market, net of tax, of investment gradecredit derivatives, but including a transaction return on equity (“TransactionROE”) modifier described below. ABV growth is considered by management and theHR Committee as a proxy for value creation. For the 2004 Bonus Pool, the HRCommittee set the Specified Percentage at 11.25%. The increase in ABV duringthe applicable year is equal to (a) the percentage growth in ABV per shareduring such year, with credit given for dividends paid, multiplied by (b) ABVas of the beginning of such year. The HR Committee retained the right toevaluate the Bonus Pool formula annually; however, the intent was to maintainthe Bonus Pool formula as long as practicable to promote stability. Since 2004,the Specified Percentage has remained unchanged.

The Transaction ROE modifier adjusts downward thepercentage growth in ABV per share if the Transaction ROE achieved in theaggregate for all transactions insured during the applicable year (the “ActualAverage Transaction ROE”) is less than the “Target Transaction ROE,” with amaximum 

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adjustment of 2%. TheActual Average Transaction ROE is a measure of the return on equity expectedfrom transactions insured and GICs written by the Company during a specifiedperiod, based upon the Company’s internal proprietary capital model. The “TargetTransaction ROE” equals the after-tax book yield on the Company’s investmentportfolio (excluding the investment portfolios for financial products, variableinterest entities and refinanced transactions) (determined as of the December 31immediately preceding the compensation year) plus 9%, with a maximum TargetTransaction ROE of 15%. In the event that the Actual Average Transaction ROE isless than the Target Transaction ROE for any year, then percentage growth inABV per share for such year is reduced by an amount equal to 1⁄2 the excess ofthe Target Transaction ROE (expressed as a percentage) over the Actual AverageTransaction ROE (expressed as a percentage), subject to a maximum reduction of2%. The Transaction ROE modifier was intended to motivate management to use theCompany’s capital prudently in building ABV per share. The HR Committeeconcluded that 9% over the Company’s insurance company investment portfolioyield represented a reasonable target for aggregate transaction returns underthe Company’s internal capital model based upon the historical performance ofthe Company and its industry peers.

Amounts of the Bonus Pool in respect of any year,determined as provided above, that are not distributed to employees for thatyear are credited, but not accrued for accounting purposes, to a “Rainy DayFund” that will be available in subsequent years to fund bonus payments toemployees in excess of the Bonus Pool determined as provided above, providedthat the Rainy Day Fund may not exceed an amount equal to $25 million, adjustedto reflect increases in the Consumer Price Index from and after January 1,2005. The Rainy Day Fund concept was employed to allow management to “save”Bonus Pool allocations for future years when the formula dictates a reducedBonus Pool although staff retention and other considerations might supportlarger bonuses than the formula would dictate. At December 31, 2006, theRainy Day Fund balance was approximately $26.8 million. Neither the Rainy DayFund nor the guideline Bonus Pool, however, provides any entitlement toemployees, since the HR Committee retains full discretion to award or declineto award bonuses, subject, in the case of the Chief Executive Officer and thePresident, to provisions of their employment agreements with the Company. Todate, the Rainy Day Fund has not been used to supplement the guideline BonusPool for any year.

In January 2006, the HR Committee decided thatdeterminations under the Bonus Pool Guideline would be made in accordance withIFRS rather than GAAP, subject to the HR Committee’s obligation to makeadjustments to reflect a change in, or a change in the interpretation orapplication by the Company of, such accounting principles to preserve the valueof the Bonus Pool consistent with the intent that such value should reflecttrue economic financial performance of the Company, with any such adjustmentdetermined by the HR Committee (or, if any director shall object to any suchadjustment, by the Board of Directors of the Company). IFRS was chosen in orderto better align the interests of employees with the interests of the Company’sprincipal shareholder (Dexia), whose accounts are maintained under IFRS.

Section 404 of theSarbanes-Oxley Act of 2002 (“SOX Section 404”) provides that if theCompany must prepare an accounting restatement due to the Company’s materialnoncompliance, as a result of misconduct, with any financial reportingrequirement under the securities laws, the principal executive and financialofficers must reimburse the Company for any bonus or other incentive-based orequity-based compensation received from the Company during the 12-monthperiod following the first public issuance or filing with the SEC of thefinancial document embodying the financial reporting requirement, and anyprofits realized from the sale of securities of the Company during that 12-monthperiod. The Company does not have any other express policy regarding theadjustment or recovery of bonuses if the relevant Company performance measuresupon which the guideline Bonus Pool is based are restated or otherwise adjustedfollowing the bonus payment date in a manner that would reduce the size of theguideline Bonus Pool.

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*Performance ShareUnits*

The 2004 Equity Plan provides for awards ofperformance share units, which represent awards of both performance shares andshares of Dexia restricted stock. The Company has employed performance sharesas its principal form of equity compensation since implementation by theCompany of its 1993 Equity Participation Plan (the “1993 Equity Plan”) inconnection with its 1994 initial public offering. In 2004, the Company adoptedthe 2004 Equity Plan to replace the 1993 Equity Plan and ceased making furtherawards under the 1993 Equity Plan. The 2004 Equity Plan adds Dexia restrictedstock as a component of equity awards in order to further align the interestsof the Company’s employees with its parent, and to give Company employees agreater sense of membership in the Dexia group. The 2004 Equity Plan alsoprovides that book value measurements employed in valuing performance sharesare determined in accordance with IFRS, whereas valuations under the 1993Equity Plan are in accordance with GAAP. Again, IFRS was chosen in order tobetter align the interests of employees with the interests of the Company’sparent, whose accounts are maintained under IFRS. Performance share unitsawarded under the 2004 Equity Plan are comprised 90% of performance shares and10% of Dexia restricted stock. Specifically, in order to determine the numberof shares of Dexia restricted stock allocable to an award of performance sharesunits, the recipient receives the number of Dexia shares that can be purchased(at a purchase price per share historically equal to the average cost indollars paid by the Company to acquire such shares) with the proceeds of 10% ofthe units, with each unit given the value of one outstanding share of theCompany’s common stock valued as of the preceding year-end as described belowwith respect to performance shares. Historically, performance share units havebeen awarded to Company employees no more frequently than once per calendaryear.

*Performance Shares*.   Performanceshares are designed to provide recipients with an interest in the growth invalue of the Company’s shares during specified performance cycles. Performanceshares have generally been awarded on the basis of two sequential three-yearperformance cycles, with 1/3 of each award allocated to the first cycle and 2/3of each award allocated to the second cycle. For example, an award of 300performance shares made in 2007 represents 100 performance shares allocated tothe 2007/2008/2009 performance cycle and 200 performance shares allocated tothe 2008/2009/2010 performance cycle. The length of the cycles are intended toprovide employees with a “longer term” view of the Company’s financialperformance and to provide the Company with retentive value insofar asemployees generally forfeit performance share awards should they voluntarilyterminate employment with the Company prior to the completion of the relatedperformance cycle.

Each performance share represents a right to receiveup to two shares of the Company’s common stock (or the cash value thereof),with the actual number of common shares receivable determined on the basis ofthe increase in ABV and book value per share over a specified performance cycle.The performance shares were designed to provide less compensation toparticipants than stock options if the Company performs poorly and morecompensation to participants if the Company performs well. In particular, theperformance shares were designed to have no value if the Company fails togenerate growth in “value” per share in excess of 7%, which at the time ofinitial program implementation was a proxy for the risk-free yield on treasurysecurities. The actual dollar value received by a holder of performance shares,in general, varies in accordance with the annualized rate of ABV growth andbook value growth per share (the “Internal Rate of Return” or “IRR”) of theCompany’s common stock during an applicable “performance cycle” and the valueof common stock at the time of payout of such performance shares.

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For purposes of theforegoing, ABV per share and book value per share are adjusted to exclude theafter-tax change in accumulated “other comprehensive income” and anymark-to-market adjustments on investment grade CDS and economic interest ratehedges. Accumulated other comprehensive income includes, for example,unrealized gains and losses in the Company’s investment portfolio. Specifically,

·       ifthe IRR is 7% or less per annum for any performance cycle, no shares of commonstock will be earned for the performance cycle;

·       ifthe IRR is 13% per annum for any performance cycle, a number of shares ofcommon stock equal to the number of performance shares will be earned for theperformance cycle; and

·       ifthe IRR is 19% per annum or higher for any performance cycle, a number ofshares of common stock equal to two times the number of performance shares willbe earned for the performance cycle.

If the IRR is between 7% and 19%, the payoutpercentage is interpolated. The median IRR allowing for a 100% payout was setat 13%, which was considered reasonably acceptable Company performance.

So long as the Company’s common stock is not publiclytraded, the Company expects to pay its performance shares in cash rather thanstock, with shares under the 1993 Equity Plan and the 2004 Equity Plan valuedat the greater of (1) the average of (a) 1.15 times ABV per share and(b) 14 times “operating earnings” per share (each such term as defined inthe respective Equity Plans) and (2) 0.85 times ABV per share. The 1.15times ABV and 14 times operating earnings multiples were based upon themultiples of ABV and operating earnings prevailing in the marketplace for theCompany’s industry peers when Dexia acquired the Company in 2000, representinga discount to the multiples (1.4676 times ABV and 17 times operating earnings)paid by Dexia when it acquired the Company in 2000. The 0.85 ABV floor in sharevalue was intended to reflect a minimum value for shares in the face of anadverse earnings environment. At December 31, 2006, the estimated presentvalue of one performance share at a 100% payout was $145.61 per share under the1993 Equity Plan and $149.57 per share under the 2004 Equity Plan. In the caseof performance shares awarded under the 1993 Equity Plan, holders ofperformance shares were entitled at the time of grant to elect to have theirperformance shares valued at the time of payout either including or excludingunrealized gains and losses in the Company’s investment portfolio. In the caseof performance shares awarded under the 2004 Equity Plan, performance sharesexclude unrealized gains and losses in the Company’s investment portfolio. Thismodification was made because unrealized gains and losses in the Company’sinvestment portfolio are only influenced by a few Company employees.

Performance shares awarded under the 1993 Equity Planentitle the holder to additional performance shares equal in number to thenumber of shares of the Company’s common stock having a value equal to anydividends paid on the Company’s common stock during the applicable performancecycle.

Except as otherwise provided in the employmentagreements described below, performance shares (i) are generally forfeitedin the event of a voluntary termination of employment prior to completion ofthe performance cycle; (ii) vest pro-rata in the event of terminationwithout cause or retirement; and (iii) vest fully in the event of death,disability or, in the case of awards under the 1993 Equity Plan, absent acontinuation of the Equity Plan by the Board of Directors of the Company, achange in control.

Since the inception of the 2004 Equity Plan, up to3,300,000 shares of common stock have been available for distribution 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.

Except as provided by SOX Section 404, theCompany does not have any express policy regarding the adjustment or recoveryof performance share payouts if the relevant Company performance measures 

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upon which they are basedare restated or otherwise adjusted following the payment date in a manner thatwould reduce the amount of a performance share payout.

*Dexia Restricted Stock*.   Sharesof Dexia restricted stock awarded under the 2004 Equity Plan represent ordinaryshares of Dexia, including the right to receive dividends thereon. Dexiarestricted stock associated with a performance share unit award is allocated (i) 1/3to a 2.5-year vesting period and 3-year restricted period and (ii) 2/3to a 3.5-year vesting period and 4-year restricted period. Exceptas otherwise provided in the employment agreements described below, unvestedDexia restricted stock (i) is generally forfeited in the event of avoluntary termination of employment prior to completion of the performancecycle; (ii) vests pro-rata in the event of termination without cause oreligibility for retirement (generally at age 55); and (iii) vests in theevent of death or disability. The restricted period (during which Dexiarestricted stock may not be traded) lapses six months after vesting. Shortsales of Dexia stock by any Company employee are prohibited as a matter ofcorporate policy, absent prior approval of the Company’s Executive ManagementCommittee.

*Benefit Plans andPrograms*

Benefit plans andprograms generally available at the Company for all full time U.S. residentemployees are, for the most part, customary in nature, and include:

·       medical,prescription drug and dental plans;

·       aqualified defined contribution “money purchase pension plan” (the “Pension Plan”)with an annual contribution by the Company equal to 9% of prior year salary andbonus, subject to a salary/bonus cap provided under the Internal Revenue Code;

·       acash or deferred (“401(k)”) plan, that does not include Company contributions,allowing pre-tax employee contributions up to limits provided under theInternal Revenue Code;

·       aflexible spending plan (the “Flex Plan”) allowing employees to pay certainmedical, dependent care, mass transit and parking expenses with pre-taxdollars;

·       aseverance plan;

·       lifeinsurance coverage (the “Life Insurance Program”) in the amount of two timesannual salary up to a limit of $500,000;

·       aprogram (the “Travel Incentive Program”) under which employees share a portionof the savings from flying a lower class or less expensive flight pattern thanallowed under the Company’s travel policy or for using non-refundable tickets;

·       anoptional retiree medical program under which Company retirees are entitled toparticipate in the Company’s medical plan following retirement provided thatthey pay the full cost plus a 5% administrative fee to the Company;

·       $65per month of “transit cheks” for commutation expenses (the “Transit ChekProgram”);

·       reimbursementof up to $400 per annum for health club expenses (the “Health Club Program”);

·       amatching gift program for gifts to qualifying charities of up to $20,000 perannum in the aggregate (the “Matching Gift Program”); and

·       customaryvacation, leave of absence, bereavement and similar policies.

The Company also maintains “top hat” plans, which areunfunded and unsecured non-qualified plans restricted under the tax laws to alimited number of highly compensated employees, and consist of (i) supplementalexecutive retirement plans (each, a “SERP”) under which the Company makes anannual 

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contribution equal to 9%of prior year salary and bonus in excess of the money purchase plansalary/bonus cap (but disregarding salary/bonus in excess of $1 million)payable upon termination of employment unless deferred by the employee, withsuch contributed amounts generally credited with returns on mutual funds orsecurities selected by the participants and “match funded” by the Company and (ii) deferredcompensation plans (each, a “DCP”) under which participants are entitled todefer receipt (generally for a minimum deferral period of three years) of bonusand performance share compensation otherwise payable to them by the Company,with such deferred amounts generally credited with returns on mutual funds orsecurities selected by the participants and “match funded” by the Company. TheCompany maintains two SERPs and two DCPs due to tax law changes adopted in 2004under Section 409A of the Internal Revenue Code with respect to “deferredcompensation arrangements.”  The Companyadopted a new SERP and new DCP in 2004 conforming with the new tax lawrequirements to receive all new contributions, while the pre-existing SERP andDCP were “grandfathered” under the pre-existing tax law but were closed tofurther contributions. As described in more detail below, the Company maintainsa separate severance plan for members of its Executive Management Committee andhas employment agreements providing severance arrangements for its two mostsenior executive officers.

Different benefit plansand programs may apply to Company employees who are not United Statesresidents.

*Dexia EmployeeShare Plans*

Company employees areentitled to participate in Employee Share Plans sponsored and funded by DexiaS.A. Under the Dexia Employee Share Plans, Company employees are generallyentitled to invest up to 25% of their prior year compensation (comprisedprimarily of salary, bonus and performance share payout for such year) in Dexiashares subject to a 5-year minimum investment period (with specifiedrights to withdraw funds in the event of termination of employment or specialcircumstances). The investment alternatives include (i) a “classic option”under which U.S. resident employees may purchase Dexia shares at a 15% discount(up to a limit prescribed annually under Section 423 of the InternalRevenue Code, which was $21,250 for 2006); and (ii) leveraged options,under which employees may purchase Dexia shares at a 20% discount employing 90%leverage pursuant to which (a) the discount, dividends and a portion ofany profits from the investment are allocated to the lender, and (b) theemployee receives (i) a guaranteed return of the dollars invested and (ii) either(depending on which option the employee has elected) (A) a multiple (9.5times for shares purchased in 2006) of the Dexia share appreciation over theinitial non-discounted purchase price in euros over the five-year term (the “StandardLeveraged Option”); (B) a multiple (11 times for shares purchased in 2006)of the average monthly increase in Dexia share price over the initialnon-discounted purchase price in euros over 52 months of the five-year term(the “Average Leveraged Option”); and (C) a multiple (5 times for sharespurchased in 2006) of the sum of the annual gains in Dexia share price duringeach year of the 5-year term (the “Click Leveraged Option”).

*EmploymentAgreements and Arrangements*

Each of Messrs. Cochran and McCarthy entered intofour-year employment agreements with the Company effective with the July 2000acquisition of the Company by Dexia. Upon expiration of these initialagreements, each of Messrs Cochran and McCarthy entered into similar employmentagreements with the Company effective July 5, 2004, which agreements wereamended January 1, 2005 to address provisions of Section 409A of theInternal Revenue Code applicable to severance and other deferred compensationarrangements. Each of the employment agreements generally guarantees continuationof compensation and benefits through December 31, 2007, and provides forrenewals and extensions of their initial term for two-year terms, subjectto notice of termination from either party at least six months prior to the endof the expiring 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.

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Underthe agreements, compensation consists of:

·       basesalary at the annual rate in effect immediately prior to the agreement, subjectto increase at the Board’s discretion;

·       annualbonus equal to a minimum percentage of a “bonus pool” determined pursuant toformulae from time to time determined by the HR Committee; and

·       annualawards of performance shares under the 1993 Equity Plan and the 2004 EquityPlan (together, the “Equity Plans”), having an estimated economic value atleast equal to the employee’s 2004 performance share award.

Their employmentagreements provide that Messrs. Cochran and McCarthy are entitled toreceive an annual cash bonus equal to at least 5.0% and 4.0%, respectively, ofthe Company’s annual bonus pool. The employment agreements provide that anadditional 2.0% of the annual bonus pool will be allocated among those twoexecutive officers as determined by the HR Committee.

For a discussion of theterms of the employment agreements relating to payments to Messrs. Cochranand McCarthy at, following or in connection with any termination of employmentwith the Company, retirement or change in control of the Company, see “—PotentialPayments Upon Termination of Employment, Retirement or Change-in-Control.”

***Tax and AccountingConsiderations Bearing on the Company’s Compensation Program***

The Company designedperformance shares so that the cost to the Company is fully expensed, basedupon the principal that fully expensed compensation properly reflects thefinancial performance of the Company, while noting that such treatment puts theCompany at a disadvantage in comparing its financial results to those of itsindustry peers that employ stock options or other equity compensation that isnot fully expensed. The Company designed Dexia restricted stock awarded underthe 2004 Equity Plan to qualify as equity (as opposed to liability) awardsunder Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment” (“SFAS 123-R”). The Company is not subject to Section 162(m) ofthe Internal Revenue Code, which limits the deductibility of non-performancebased compensation paid to executives of corporations having common equitysecurities required to be registered under Section 12 of the Exchange Act.The Company’s various benefit programs described above are intended to complywith applicable tax requirements, including Section 409A of the InternalRevenue Code governing deferred compensation arrangements.

***The Company’s 2006Compensation Process***

The HR Committeedetermines the compensation of the Chief Executive Officer and the ChiefOperating Officer and reviews and approves management’s compensationrecommendations for other employees of the Company. The Committee is comprisedof Messrs. Downey (Chairman), Cochran, Deletré, Miller and Taylor.Mr. Cochran recuses himself from HR Committee deliberations concerning hisown compensation.

In 2006, the HR Committeeengaged Johnson Associates, Inc. (“Johnson Associates”), independentcompensation consultants, to review market compensation levels. JohnsonAssociates prepared a report reviewed by the HR Committee in November 2006.The report was intended as background prior to consideration of 2006 bonuses,2007 salaries and 2007 performance share unit awards under the 2004 Equity Plan.At its November 2006 meeting, the HR Committee also reviewed management’sestimate of (i) the 2006 Bonus Pool determined pursuant to the Bonus Poolguideline described above; (ii) the valuation of performance shares issuedunder the 1993 Equity Plan to be paid out in the first quarter of 2007 relatedto performance cycles ending December 31, 2006; (iii) 2007 salaries;and (iv) 2007 performance share unit awards under the 2004 Equity Plan.

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The Company’s ExecutiveManagement Committee (comprised of Messrs. Cochran, McCarthy, Stern,Brewer and Simon) serves as management’s compensation committee. During thefourth quarter of 2006, managers within the Company prepared compensationrecommendations of 2006 bonuses, 2007 salaries and 2007 performance share unitawards for employees under their supervision, in what management characterizesas a “bottom-up” compensation process, with initial compensationrecommendations originating from lower levels of management. The compensationrecommendations provided by managers took into account an estimated 2006guideline Bonus Pool, which at the time indicated an increase in the guidelineBonus Pool compared with the prior year, counterbalanced by increased dollarcompensation requirements for the Company’s foreign employees attributable tothe decline in the exchange rate for the U.S. dollar against the British poundsterling and the euro. The Executive Management Committee reviewed the managers’recommendations and, in turn, prepared compensation recommendations of 2006bonuses, 2007 salaries and 2007 performance share unit awards for all Companyemployees other than members of the Executive Management Committee. Theserecommendations, along with a review prepared by management of the Company’sperformance in 2006, were reviewed by the HR Committee at its January 2007meeting at which 2006 bonuses, 2007 salaries and 2007 performance share unitawards were approved for all Company employees other than members of theExecutive Management Committee.

At its February 2007meeting, the HR Committee was provided with (i) a 2006 financial guarantyindustry profile prepared by management setting forth comparative financialperformance data for the six largest financial guaranty insurers, (ii) therange of salary, bonus and performance share unit awards payable under theCompany’s employment agreements with the Chief Executive Officer and ChiefOperating Officer and (iii) the Chief Executive Officer’s recommendationof compensation for the other members of the Company’s Executive ManagementCommittee (the General Counsel, the Chief Risk Management Officer and the ChiefFinancial Officer). On the basis of the foregoing information and thecompensation consultant’s reports described below, the HR Committee approved2006 bonuses, 2007 salaries and 2007 performance share unit awards forExecutive Management Committee members.

*The Compensation Consultant’s Reports*

At itsNovember 2006 meeting, the HR Committee reviewed a “2006 Broad CompetitiveMarket Update” provided by Johnson Associates (the “November Report”). Theobjective of the November Report was to provide the HR Committee a highlevel update to be followed by more detailed market compensation analysis andrecommendations for consideration by the HR Committee at its January 2007and February 2007 meetings at which actual compensation decisions weremade. The November Report noted:

·       overall2006 incentive funding (cash bonus and equity long-term awards) was expected toincrease in the 10% range for financial guarantors and in the 15% to 20% rangefor investment banks;

·       stronghiring trends in the financial guaranty sector were expected to accelerate,with increased retention and recruitment issues to be faced by the Company andits industry peers;

·       theCompany’s 2006 projected incentive compensation increases were below those ofits industry peers;

·       littlechange in  2006 equity awards wasexpected among industry peers, with the general move away from stock optionstowards restricted stock having stabilized; and

·       compensationprogram design changes were not anticipated at the Company’s industry peers.

The November Reportincluded comparative compensation data for the top five named executiveofficers for eight corporations in the comparative group, as well ascomparative data by function for the chief executive officer, general counseland chief financial officer. The comparative group was comprised of AmbacFinancial Group Inc.; Assured Guaranty Ltd.; MBIA Inc.; MGIC InvestmentCorporation; PMI Group Inc.; Radian Group Inc.; Security Capital AssuranceLtd.; and XL Capital Ltd. The scope of the 

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comparativegroup was limited because data was not publicly available with respect tocertain industry participants. The Company competes for talent with otherfinancial guaranty insurers, as well as with investment banks and commercialbanks that generally provide higher compensation but less job security thanfinancial guaranty insurers.

At itsJanuary 2007 meeting, the HR Committee reviewed a “2006 Competitive MarketAnalysis” prepared by Johnson Associates (the “January Report”). Theobjective of the January Report was to provide more detailed marketcompensation analysis and recommendations than provided in the November Report.The January Report noted:

·       TheCompany’s proposed 3% increase in combined incentive spending was below theprojected market increase of 10%.

·       TheCompany’s proposed professional staff total compensation positioning was justabove the 50th percentile of the estimated 2006 comparativegroup.

·       TheCompany’s competitive positioning had declined somewhat over the past fewyears.

·       TheCompany’s mix of equity versus cash compensation was slightly higher than themarket’s.

At itsJanuary 2007 meeting, the HR Committee also reviewed the followingmaterials prepared by Johnson Associates at the request of the HR Committee:

·       anhistorical analysis of the actual value of stock option awards made to seniorexecutives of industry peers based on stock prices compared to the actual valueof performance share awards made to senior executives of the Company based onpayout values; and

·       a“Top 10 Market Analysis” comparing the compensation of the Company’s top tenmost highly compensated employees to a broad market and to a narrower definedcomparative group.

At itsFebruary 2007 meeting, the HR Committee reviewed the following materialsprepared by Johnson Associates at the request of the HR Committee:

·       a“2005 Competitor Proxy Analysis” setting forth compensation information for theindustry peer group for the five most highly compensated executives and for thechief executive officer, general counsel and chief financial officer;

·       a“Competitive Long Term Gains Analysis 2001-2005” comparing the value atgrant of 2001-2005 restricted stock, stock options and long termincentive plan awards to the appreciated value actually realized or currentlyprojected for the industry peer group for the chief executive officer and thenumber two most highly compensated executive officer;

·       a“Long-Term Grants Analysis 2001-2005” illustrating long-term values as compared to realized and unrealizedgains from 2001-2005 for the industry peer group for the chief executiveofficer and the number two most highly compensated executive officer; and

·       a“Top 10 Market Analysis” comparing the compensation of the Company’s top tenmost highly compensated employees to a broad market and to a narrower definedcomparative group.

The materials provided byJohnson Associates supported the HR Committee’s conclusions that thecompensation awarded to the named executive officers at the HR Committee’s February 2007meeting was reasonable compared with those of industry peers and the broadercomparative group, taking into account the 2006 financial performance of theCompany and the tenure and experience of the Company’s officers. Thecomparative data reviewed by the Committee addressed the difficulty ofcomparing the value of performance shares awarded by the Company to stockoptions awarded by the Company’s industry peers, noting the disparities invaluing stock options for compensation and financial reporting purposes and thearbitrary compensatory elements of stock option programs during periods ofvolatile stock performance.

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**HR Committee Report**

The HRCommittee has reviewed and discussed with management the CompensationDiscussion and Analysis required by Item 402(b) of Regulation S-K.  Based on such review and discussions, the HRCommittee recommended to the Board of Directors of the Company that theCompensation Discussion and Analysis be included in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2006.

| * * | *Robert N. Downey (Chairman)* |
|----------|-------------------------------|
| * * | *Robert P. Cochran*           |
| * * | *Bruno Deletré*          |
| * * | *Axel Miller*                 |
| * * | *Roger K. Taylor*             |

 

**SummaryCompensation Table**

The table below sets fortha summary of all compensation paid to the chief executive officer, theprincipal financial officer and the three most highly compensated otherexecutive officers of the Company, in each case for services rendered in allcapacities to the Company for the year ended December 31, 2006.

**2006Summary Compensation Table(1)**

| Name and Principal Position | ** ** | ** ** | ** ** | **Year** | ** ** | **Salary** | ** ** | **Bonus(2)** | ** ** | **Stock  Awards(3)** | ** ** | **Nonqualified  Deferred  Compensation  Earnings(4)** | ** ** | **All Other  Compensation(5)** | ** ** | **Total(7)** | ** ** |
|--------------------------------------------|------------|------------|------------|----------|------------|------------|------------|--------------|------------|----------------------|------------|-------------------------------------------------------|------------|-------------------------------------|------------|--------------|------------|
| Robert P. Cochran                          |       | 2006       |       | $        | 500,000    |       | $          | 3,300,000    |       | $                    | 6,721,121  |                                                  |       | $                                   | 491,881    |         |       |   | $ | 357,889 | (6) |   | $ | 10,879,010 |   |
| Chairman of the Board and                  |       |       |       |     |       |       |       |         |       |                 |       |                                                  |       |                                |       |         |       |   |   |
| Chief Executive Officer                    |       |       |       |     |       |       |       |         |       |                 |       |                                                  |       |                                |       |         |       |   |   |
| Séan W. McCarthy                      |       | 2006       |       | 330,000  |       | 3,000,000  |       | 4,773,490    |       |                 | 150,380    |                                                  |       |                                | 116,162    |         |       | 8,219,652 |   |
| President  and                             |       |       |       |     |       |       |       |         |       |                 |       |                                                  |       |                                |       |         |       |   |   |
| Chief  Operating Officer                   |       |       |       |     |       |       |       |         |       |                 |       |                                                  |       |                                |       |         |       |   |   |
| Bruce E. Stern                             |       | 2006       |       | 260,000  |       | 900,000    |       | 1,738,733    |       |                 | —     |                                                  |       |                                | 99,419     |         |       | 2,998,152 |   |
| Managing Director, General                 |       |       |       |     |       |       |       |         |       |                 |       |                                                  |       |                                |       |         |       |   |   |
| Counsel and Secretary                      |       |       |       |     |       |       |       |         |       |                 |       |                                                  |       |                                |       |         |       |   |   |
| Russell B. Brewer II                       |       | 2006       |       | 260,000  |       | 900,000    |       | 1,738,733    |       |                 | —     |                                                  |       |                                | 99,419     |         |       | 2,998,152 |   |
| Managing  Director and                     |       |       |       |     |       |       |       |         |       |                 |       |                                                  |       |                                |       |         |       |   |   |
| Chief  Underwriting Officer                |       |       |       |     |       |       |       |         |       |                 |       |                                                  |       |                                |       |         |       |   |   |
| Joseph W. Simon                            |       | 2006       |       | 260,000  |       | 900,000    |       | 1,255,879    |       |                 | —     |                                                  |       |                                | 98,895     |         |       | 2,514,774 |   |
| Managing Director and                      |       |       |       |     |       |       |       |         |       |                 |       |                                                  |       |                                |       |         |       |   |   |
| Chief Financial Officer                    |       |       |       |     |       |       |       |         |       |                 |       |                                                  |       |                                |       |         |       |   |   |
|                                            |            |            |            |          |            |            |            |              |            |                      |            |                                                       |            |                                     |            |              |            |  |  |  |  |  |  |  |  |  |  |

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(1)             Annual compensation for each year includes amountsdeferred under the DCPs or paid into the Company’s 401(k) plan or FlexPlan.

(2)             The bonus set forth for the specified year was paid tothe named executive officer in February of the subsequent year.

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(3)             The amount under this column reflects theexpense reported by the Company in the specified year under SFAS 123-Rwith respect to performance shares and Dexia restricted stock awarded under theEquity Plans in 2006, 2005, 2004 and 2003, except that (a) estimates offorfeiture related to service-based vesting provisions have not been taken intoaccount in calculating such dollar amounts and (b) for purposes ofdetermining the amount of compensation reflected for pre-2006 awards, the“modified prospective transition method” under SFAS 123-R was employed. Noawards of restricted stock of the Company or options were made to any of theexecutives named in the table during the period covered by the table. Amountsincluded under this column were attributable to performance shares and Dexiarestricted stock as set forth below:

| **Name**              | ** ** | ** ** | ** ** | **Performance  Share  Compensation** | ** ** | **Dexia Restricted  Stock  Compensation** | ** ** |
|-----------------------|------------|------------|------------|--------------------------------------|------------|------------------------------------------------|------------|
| Robert P. Cochran     |       |       | $          | 6,427,750                            |       |                                           |       | $ | 293,371 |   |   |
| Séan W. McCarthy |       |       | 4,557,777  |                                 |       |                                           | 215,713    |   |   |
| Bruce E. Stern        |       |       | 1,661,075  |                                 |       |                                           | 77,658     |   |   |
| Russell B. Brewer  II |       |       | 1,661,075  |                                 |       |                                           | 77,658     |   |   |
| Joseph W. Simon       |       |       | 1,182,648  |                                 |       |                                           | 73,231     |   |   |

 

(4)             The amount under this column reflects the excess, ifany, of (a) income on Company common stock acquired under the DirectorShare Purchase Program described below and credited by the Company toparticipants under the DCPs and SERPs over (b) a market rate of interestidentified by the Internal Revenue Service as a proxy for the rate the Companywould be paying to a lender if the Company had paid out the deferredcompensation up front and did not have the use of funds, equal to 120% of thefederal rate with compounding prescribed under Section 1274(d) of theInternal Revenue Code (5.88% for 2006) (the “Proxy Market Rate”). This columndoes not include earnings on publicly traded securities and mutual fundscredited by the Company to participants under the DCPs and SERPs. The Companycurrently match funds substantially all phantom investments (other than moneymarket fund investments) made by participants in the DCPs and SERPs. Investmentalternatives under the DCPs include mutual funds, shares of individualcompanies and, in the case of director participants, shares under the DirectorShare Purchase Program described below. Since the Company match fundssubstantially all phantom investments under the DCPs and SERPs, the principalcosts associated with these plans (in addition to the amounts actuallycontributed by the Company under the SERPs) come from (i) the delay inrecognition by the Company of compensation expense for the deferred amounts and(ii) the recognition of gains on matched investments if and when realizedby the Company prior to the time that the Company recognizes a deduction forcompensation expense to the employee (at the time payments are made by theplans to the participants). Reference is made to “—Nonqualified DeferredCompensation,” below, for a list of the mutual funds and stock benchmarks underthe DCPs and SERPs and their respective 2006 rates of return. The dollaramounts under this column do not include earnings under the SERPs, whichqualify as “excess benefit plans” under Rule 16(b)-3(b)(2) ofthe Exchange Act, except insofar as SERP investments are in Company commonstock under the Director Share Purchase Program. The dollar amounts under thiscolumn are not included in determining amounts under the “total” compensationcolumn.

(5)             All Other Compensation includes thecontributions by the Company to the Pension Plan and SERPs set forth below:

| **Name**              | ** ** | ** ** | ** ** | **Pension Plan** | ** ** | **SERPs** | ** ** |
|-----------------------|------------|------------|------------|-----------------------|------------|-----------|------------|
| Robert P. Cochran     |       |       | $          | 19,800                |       |      | $          | 70,200 |   |
| Séan W. McCarthy |       |       | 19,800     |                  |       | 70,200    |       |
| Bruce E. Stern        |       |       | 19,800     |                  |       | 70,200    |       |
| Russell B. Brewer  II |       |       | 19,800     |                  |       | 70,200    |       |
| Joseph W. Simon       |       |       | 19,800     |                  |       | 70,200    |       |
|                       |            |            |            |                       |            |           |            |  |  |  |  |

 

Pension Plan and SERP amounts shown were accrued during2006 and paid in February of 2007. The Pension Plan provides for a Companyfunded contribution equal to 9% of cash compensation (salary and bonus) up tothe compensation limit specified by the Internal Revenue Service. The SERPsprovide for an unfunded Company contribution equal to 9% of cash compensationover and above the Pension Plan compensation limit but limited to $1 million ofcompensation. The Pension Plan and SERPs provide for vesting of contributionsover a six-year employment period, after which all subsequentcontributions are 100% vested. Given the tenure with the Company of the namedexecutive officers, all contributions to the Pension Plan and SERPs on behalfof the named executive officers are fully vested when made, except in the caseof Mr. Simon, who was 60% vested in April 2006 and will be 100%vested in April 2008.

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All othercompensation includes dividends on unvested shares of Dexia restricted stockpaid (without adjustment for withholding taxes) by Dexia during 2006 in theamounts set forth below:

| **Name**              | ** ** | **Dollar Value of  Dividends** | ** ** |
|-----------------------|------------|------------------------------------------|------------|
| Robert P. Cochran     |       |                                     | $          | 26,930 |   |   |
| Séan W. McCarthy |       |                                     | 26,162     |   |   |
| Bruce E. Stern        |       |                                     | 9,419      |   |   |
| Russell B. Brewer  II |       |                                     | 9,419      |   |   |
| Joseph W. Simon       |       |                                     | 8,895      |   |   |

 

All othercompensation does not include the dollar value of the Company’s TravelIncentive Program, Transit Chek Program, Health Club Program or group life,health, hospitalization and medical reimbursement plans that do notdiscriminate in scope, terms or operation in favor of the named executiveofficers and that are available generally to all salaried employees. All othercompensation also does not include payments contributed under the Company’sMatching Gift Program. Neither**Mr. Cochrannor Mr. McCarthy receive additional compensation for their services asdirectors of the Company, although such service entitles them to participate inthe Director Share Purchase Program described below.

(6)             All other compensation for Mr. Cochran includesthe excess of (a) realized and unrealized gains on common stock of theCompany, purchased through the Director Share Purchase Program (and not ownedunder the DCPs or SERPs), over (b) the Proxy Market Rate of 5.88%, whichwas $240,959 for 2006. For a discussion of the Director Share Purchase Program,see “—Compensation of Directors—Director Share Purchase Program,” below.

(7)             Total compensation does not include nonqualifieddeferred compensation earnings.

Performance sharesgenerally vest upon completion of the related 3-year performance cycle. Thedollar value of performance share awards reported in the Summary CompensationTable vest as follows, absent termination of employment, death, retirement orchange in control without a plan continuation:

| **Name**              | ** ** | ** ** | ** ** | **2006**  | ** ** | **2007**  | ** ** | **2008** | ** ** |
|-----------------------|------------|------------|------------|-----------|------------|-----------|------------|----------|------------|
| Robert P. Cochran     |       | $          | 2,909,760  |      | $          | 2,013,487 |       | $        | 1,504,503  |   |
| Séan W. McCarthy |       | 1,986,263  |       | 1,465,261 |       | 1,106,253 |       |
| Bruce E. Stern        |       | 751,619    |       | 511,206   |       | 398,250   |       |
| Russell B. Brewer  II |       | 751,619    |       | 511,206   |       | 398,250   |       |
| Joseph W. Simon       |       | 429,418    |       | 384,479   |       | 368,751   |       |
|                       |            |            |            |           |            |           |            |          |            |  |  |  |

 

Generally, onethird of a Dexia restricted stock award vests after 2.5 years and two thirdsvests after 3.5 years, with transfer restrictions lapsing six months after thevesting date. The 2004 Equity Plan provides that, when a participant becomeseligible for retirement at age 55, shares of Dexia restricted stock vestthereafter to the extent the shares would have vested had the employee actuallyretired. Mr. Cochran is the only named executive officer above the age of55. The dollar value of Dexia restricted stock reported in the SummaryCompensation Table for Messrs. Cochran, McCarthy, Stern, Brewer and Simonhave vested or will vest as follows, absent termination of employment, death orretirement:

| **Name**              | ** ** | ** ** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
|-----------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Robert P. Cochran     |       | $          | 293,371    |     | $          | —   |       | $        | —     |     | $          | — |   |
| Séan W. McCarthy |       | —     |       | 36,923   |       | 108,827  |       | 69,963   |       |
| Bruce E. Stern        |       | —     |       | 13,292   |       | 39,178   |       | 25,188   |       |
| Russell B. Brewer  II |       | —     |       | 13,292   |       | 39,178   |       | 25,188   |       |
| Joseph W. Simon       |       | —     |       | 11,817   |       | 36,226   |       | 25,188   |       |
|                       |            |            |            |          |            |          |            |          |            |          |            |  |  |  |  |

 

***Discussion of 2006 Compensation for the NamedExecutive Officers***

Set forth below is adiscussion of the 2006 bonuses, 2007 salaries and 2007 performance share unitawards for the named executive officers. The 2006 compensation of the Chief ExecutiveOfficer and the President was determined with reference to their entitlementsunder their employment agreements with the Company. The compensation of theGeneral Counsel, Chief Risk Management Officer and Chief 

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FinancialOfficer was determined with a premise that these senior officers are partnersin the enterprise and should share similarly in the overall enterprise profitsor losses, consistent with the overall compensation changes for other employeesof the Company. The Company’s “bottom-up” compensation process was conductedduring the fourth quarter of 2006, and was premised upon an expectation thatthe 2006 guideline Bonus Pool would be substantially unchanged from the bonuspool distributed in 2005. Although better than expected fourth quarter 2006financial performance resulted in a 2006 guideline Bonus Pool substantiallylarger than the bonus pool distributed in 2005,**managementelected to exercise restraint and forgo distribution of the increased bonuspool for 2006. Accordingly, the Chief Executive Officer also generallyrecommended 2006 bonuses unchanged as compared with those of the prior year forExecutive Management Committee members. The HR Committee of the Board ofDirectors accepted management’s recommendation.

*2007 Salaries*

The named executiveofficers received salary increases for 2007 in the range of 0 to 4%, primarilyrepresenting cost of living adjustments.

*Chief Executive Officer*.   The2007 salary for the Company’s Chief Executive Officer was set at $500,000,unchanged from his 2006 salary. The Chief Executive Officer’s salary was leftunchanged at his own request, given the flat over-all year-over-yearcompensation increases for employees of the Company as a whole. Under hisemployment agreement with the Company, Mr. Cochran is entitled to a basesalary at the annual rate in effect immediately prior to the effective date ofthe agreement ($490,000), subject to increase at the Board’s discretion.

*Chief Operating Officer*.   The2007 salary for the Company’s Chief Operating Officer was set at $340,000compared to a 2006 salary of $330,000. The salary increase primarily representsa cost of living adjustment. Under his employment agreement with the Company, Mr. McCarthyis entitled to a base salary at the annual rate in effect immediately prior tothe effective date of the agreement ($300,000), subject to increase at theBoard’s discretion.

*General Counsel, Chief Risk Management Officer and ChiefFinancial Officer*.   The 2007 salaries for theCompany’s General Counsel, Chief Risk Management Officer and Chief FinancialOfficer were set at $270,000 compared to 2006 salaries of $260,000. The salaryincreases primarily represent cost of living adjustments.

*2006 Cash Bonuses*

At its November 2006meeting, the HR Committee left the Specified Percentage for the guideline BonusPool unchanged at 11.25%. The effect of the 2006 target Bonus Pool was torequire substantial 2006 ABV growth with a satisfactory Actual AverageTransaction ROE to maintain the Bonus Pool at the level paid in the prior year.As a result of 2006 performance, the 2006 Bonus Pool determined by the BonusPool guideline was $61.4 million, of which $57.3 million was distributed,compared to the 2005 bonus pool formula amount of $55.5 million, of which $55.2million was distributed.  The ChiefExecutive Officer recommended no increase in 2006 bonuses for members of theExecutive Management Committee despite better than expected 2006 performance,in keeping with 2006 bonus levels in general for other Company employees, whichwere determined in advance of better than anticipated financial performance bythe Company in the fourth quarter of 2006.

*Chief Executive Officer*.   The2006 bonus for the Company’s Chief Executive Officer was set at $3,300,000,unchanged from his 2005 bonus. Under his employment agreement with the Company,Mr. Cochran is entitled to receive an annual cash bonus equal to at least5.0% of the Company’s annual bonus pool ($3,071,950) plus an additional 2.0% ofthe annual bonus pool ($1,228,790) is to be allocated between Mr. Cochranand Mr. McCarthy as determined by the HR Committee. Mr. Cochrandeclined any increase in his 2006 bonus in view of the flat over-allyear-over-year bonus increases for other employees of 

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the Company,notwithstanding his entitlement to a greater amount under his employmentagreement with the Company.

*Chief Operating Officer*.   The2006 bonus for the Company’s Chief Operating Officer was set at $3,000,000,unchanged from his 2005 bonus. Under his employment agreement with the Company,Mr. McCarthy is entitled to receive an annual cash bonus equal to at least4.0% of the Company’s annual bonus pool ($2,457,560) plus an additional 2.0% ofthe annual bonus pool ($1,228,790) is to be allocated between Mr. Cochranand Mr. McCarthy as determined by the HR Committee.

*General Counsel, Chief Risk Management Officer and ChiefFinancial Officer*.   The 2006 bonus for theCompany’s General Counsel, Chief Risk Management Officer and Chief FinancialOfficer was set at $900,000 each. The bonuses for the General Counsel and ChiefRisk Management Officer were unchanged from their 2005 bonuses. The bonus forthe Chief Financial Officer was increased from $800,000 in 2005, raising theChief Financial Officer’s bonus to the level of the General Counsel and ChiefRisk Management Officer in recognition of their equal stature as ExecutiveManagement Committee members.

*2007 Performance Share Unit Awards*

As in prior years, thenamed executive officers were awarded performance share units by the HRCommittee in February 2007.

*Chief Executive Officer*.   The2007 performance share unit award for the Company’s Chief Executive Officer was34,000 performance share units, unchanged from his 2006 award. Under hisemployment agreement with the Company, Mr. Cochran is entitled to receiveannual performance share unit awards having an estimated economic value atleast equal to his 2004 performance share award of 40,000 performance shares. Forpurposes of the foregoing, Mr. Cochran’s 2004 performance share award of40,000 performance shares was deemed to have a dollar value of $4,388,400 basedupon the December 31, 2003 estimated present value of one performanceshare at a 100% payout of $109.71, which equates to approximately 29,340 2007performance share units based upon the December 31, 2006 estimated presentvalue of one performance share at a 100% payout (and associated Dexiarestricted stock at fair market value of $29.80 per share). The HR Committeedetermined to leave the Chief Executive Officer’s 2007 performance share unitaward unchanged for the 2006 award in recognition of the overall performance ofthe Company for 2006, comparative compensation data for industry peers andcounterbalancing in part the lack of any increase in his 2006 bonus from theprevious year’s level, recognizing that the 2007 performance share unit awardwas higher than the entitlement under his employment agreement with theCompany.

*Chief Operating Officer*.   The2007 performance share unit award for the Company’s Chief Operating Officer was26,000 performance share units, compared to 25,000 performance share unitsawarded the previous year. Under his employment agreement with the Company, Mr. McCarthyis entitled to receive annual performance share unit awards having an estimatedeconomic value at least equal to his 2004 performance share award of 29,000performance shares. For purposes of the foregoing, Mr. McCarthy’s 2004performance share award of 29,000 performance shares was deemed to have adollar value of $3,181,590 based upon the December 31, 2003 estimatedpresent value of one performance share at a 100% payout of $109.71, whichequates to approximately 21,271 2007 performance share units based upon the December 31,2006 estimated present value of one performance share at a 100% payout (andassociated Dexia restricted stock at market value of $29.80 per share). The HRCommittee determined to increase the Chief Operating Officer’s 2007 performanceshare unit award from the prior year award amount based upon the compensationrecommendation of the Chief Executive Officer, and in recognition of theoverall performance of the Company for 2006, comparative compensation data forindustry peers and counterbalancing in part the lack of any increase in his2006 bonus from the previous year’s level, recognizing that the 2007performance share unit award was higher than the entitlement under hisemployment agreement with the Company.

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*General Counsel, Chief Risk Management Officer and ChiefFinancial Officer*.   The 2007 performanceshare unit awards for the Company’s General Counsel, Chief Risk ManagementOfficer and Chief Financial Officer were 9,000 performance share units each,unchanged from their 2006 awards. The HR Committee accepted the Chief ExecutiveOfficer’s recommendation to leave the 2007 performance share unit awardsunchanged from the prior year’s awards in light of the Company’s overall 2006financial performance modestly exceeding budget, comparative compensation datafrom industry peers and consistent with the partnership compensationmethodology for the General Counsel, Chief Risk Management Officer and ChiefFinancial Officer.

**Grants ofPlan-Based Awards for 2006**

The table set forth belowprovides information with respect to performance share unit awards (comprisedof performance shares and Dexia restricted stock) under the 2004 Equity Plan tothe named executive officers, in each case for the year ended December 31,2006 (which awards were made in February 2007).

**Grantsof Plan-Based Awards for 2006**

| ** **            | ** ** | **Grant**  | ** ** | **Number of  Performance  Share** | ** ** | **Number of  Performance** | ** ** | **Estimated Future Payouts  of Performance Shares Under  Equity Incentive Plan Awards** | ** ** | **All Other  Stock  Awards-#  of Shares of  Stock or** | ** ** | **Full Grant  Date Fair** | ** ** |
|-----------------------|------------|------------|------------|----------------------------------------|------------|---------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|-------------------------------------|------------|
| **Name**              | ** ** | ** ** | ** ** | **Date**                               | ** ** | **Units(1)**                    | ** ** | **Shares(2)**                                                                                                                   | ** ** | **Threshold (3)**                                                     | ** ** | **Target(4)**                       | ** ** | **Maximum(5)** | ** ** | **Units(6)** | ** ** | **Value(7)** | ** ** |
| Robert P. Cochran     |       | 2/14/07    |       |                                   | 34,000     |                            |       |                                                                                                                            | 30,600     |                                                                       |       |                                | $          | 0 |   |   | $ | 4,576,842 |   |   | $ | 9,153,684 |   |   |   | 17,065 |   |   | $ | 5,085,380 |   |
| Séan W. McCarthy |       | 2/14/07    |       |                                   | 26,000     |                            |       |                                                                                                                            | 23,400     |                                                                       |       |                                | 0          |   |   | 3,499,938 |   |   | 6,999,876 |   |   |   | 13,050 |   |   | 3,888,820 |   |
| Bruce E. Stern        |       | 2/14/07    |       |                                   | 9,000      |                            |       |                                                                                                                            | 8,100      |                                                                       |       |                                | 0          |   |   | 1,211,517 |   |   | 2,423,034 |   |   |   | 4,517 |   |   | 1,346,130 |   |
| Russell B. Brewer II  |       | 2/14/07    |       |                                   | 9,000      |                            |       |                                                                                                                            | 8,100      |                                                                       |       |                                | 0          |   |   | 1,211,517 |   |   | 2,423,034 |   |   |   | 4,517 |   |   | 1,346,130 |   |
| Joseph W. Simon       |       | 2/14/07    |       |                                   | 9,000      |                            |       |                                                                                                                            | 8,100      |                                                                       |       |                                | 0          |   |   | 1,211,517 |   |   | 2,423,034 |   |   |   | 4,517 |   |   | 1,346,130 |   |
|                       |            |            |            |                                        |            |                                 |            |                                                                                                                                 |            |                                                                            |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)             These performance share units were awardedunder the 2004 Equity Plan in February 2007 for the year ended December 31,2006. The table excludes performance share units awarded in February 2006for the year ended December 31, 2005, which are set forth in “Item 11. ExecutiveCompensation—Summary Compensation Table” of the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2005.

(2)             This column sets forth the number ofperformance shares included in the performance share units awarded to the namedexecutive officer. One-third of each performance share award relates tothe three-year performance cycle ending December 31, 2009 and two-thirdsof each performance share award relates to the three-year performancecycle ending December 31, 2010.

(3)             The threshold value is the minimum valueof performance shares. There is no minimum value for performance shares. Specifically,performance shares have no value if the IRR is not more than 7% per annum forthe three-year performance cycle.

(4)             The target value for performance shareunits is based upon a 100% payout, which is obtained if the IRR is 13% perannum for each three-year performance cycle. For purposes of the foregoing,Company common shares are valued in accordance with the 2004 Equity Plan at December 31,2006.

(5)             The maximum value for performance shareunits is based upon a 200% payout, which is obtained if the IRR is 19% or moreper annum for each three-year performance cycle. For purposes of the foregoing,Company common shares are valued in accordance with the 2004 Equity Plan at December 31,2006.

(6)             This column sets forth the number ofshares of Dexia restricted stock included in the performance share unitsawarded to the named executive officers.

(7)             This column sets forth the full grant datefair value of the performance share units awarded to the named executiveofficers, with each performance share valued at $149.57 and each share of Dexiarestricted stock valued at $29.80. Performance share values were determined onthe basis of ABV, including IFRS adjustments, and operating income as of December 31,2006. Dexia restricted stock was valued on the basis of the actual purchaseprice, converted into dollars at Euro 1.00 = $1.3026, paid by the Company in February 2007to acquire Dexia ordinary shares to fund the 2007 Dexia restricted stockawards.

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**Outstanding EquityAwards**

The following table setsforth a summary of the outstanding unvested equity awards to each of the namedexecutive officers as of December 31, 2006 (excluding (a) awardsvesting on such date and paid in February 2007 described below under “2004/2005/2006Performance Share Payouts”; and (b) awards for the year ended December 31,2006 made in February 2007 described above under “Grants of Plan BasedAwards”).

**OutstandingEquity Awards at 2006 Fiscal Year-End**

| **Name**              | ** ** | ** ** | ** ** | **Number of  Performance Shares  That Have Not  Vested** | ** ** | **Market Value of  Performance Shares  That Have Not  Vested(1)** | ** ** | **Equity Incentive  Plan Awards:  Number of Shares of  Dexia Restricted  Stock That Have Not  Vested** | ** ** | **Equity Incentive  Plan Awards:  Market Value of  Dexia Restricted  Stock That Have Not  Vested(2)** | ** ** |
|-----------------------|------------|------------|------------|------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Robert P. Cochran     |       |       | 91,442     |                                                                         |       |                                                                                       | $          | 13,557,444                                                                                                                                          |       |                                                                                                                                          |       | 20,179 |   |   |   | $ | 552,659 |   |   |
| Séan W. McCarthy |       |       | 66,925     |                                                                         |       |                                                                                       | 9,923,377  |                                                                                                                                                |       |                                                                                                                                          | 28,869     |   |   |   | 790,662 |   |   |
| Bruce E. Stern        |       |       | 23,761     |                                                                         |       |                                                                                       | 3,523,977  |                                                                                                                                                |       |                                                                                                                                          | 10,393     |   |   |   | 284,643 |   |   |
| Russell B. Brewer  II |       |       | 23,761     |                                                                         |       |                                                                                       | 3,523,977  |                                                                                                                                                |       |                                                                                                                                          | 10,393     |   |   |   | 284,643 |   |   |
| Joseph W. Simon       |       |       | 20,592     |                                                                         |       |                                                                                       | 3,059,092  |                                                                                                                                                |       |                                                                                                                                          | 9,815      |   |   |   | 268,812 |   |   |

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(1)          Market value is basedupon a 100% payout for performance shares using the December 31, 2006share value under the 2004 Equity Plan.

(2)          Marketvalue is based upon the December 31, 2006 closing price of Dexia ordinaryshares converted into dollars at Euro 1.00 = $1.3199, the December 31,2006 exchange rate as reported on the Bloomberg data screen.

**2004/2005/2006Performance Share Payout**

Performance Shares awardedunder the 1993 Equity Plan with respect to the 2004/2005/2006 performance cycle(“2004/2005/2006 performance shares”) vested in accordance with their awardagreements on December 31, 2006 and were paid in January 2007 inaccordance with their terms. The 2004/2005/2006 performance shares held by thenamed executive officers were awarded in February 2003 and February 2004,and disclosed in the Company’s Annual Reports on Form 10-K for theyears ended December 31, 2002 and December 31, 2003, respectively. Thevalue of the 2004/2005/2006 performance shares was approved by the HR Committeeat its January 2007 meeting, based upon calculations prepared bymanagement and verified by the Company’s independent accountants. The tablebelow sets forth the dollar value of 2004/2005/2006 performance shares paid tothe named executive officers.

**2004/2005/2006Performance Share Payout**

| **Name**              | ** ** | ** ** | ** ** | **Dollar Value of Payout** | ** ** |
|-----------------------|------------|------------|------------|-------------------------------------------|------------|
| Robert P. Cochran     |       |       | $          | 7,433,855                                 |       |   |
| Séan W. McCarthy |       |       | 5,062,712  |                                      |       |
| Bruce E. Stern        |       |       | 1,922,549  |                                      |       |
| Russell B. Brewer  II |       |       | 1,922,549  |                                      |       |
| Joseph W. Simon       |       |       | 1,089,444  |                                      |       |

 

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**Dexia RestrictedStock Vested During 2006**

Thefollowing table sets forth a summary of Dexia Restricted Stock awarded to eachof the named executive officers that vested during the year ended December 31,2006:

**DexiaRestricted Stock Vested During 2006**

| **Name**              | ** ** | ** ** | ** ** | **Number of Shares  Acquired on Vesting** | ** ** | **Value Realized  on Vesting** | ** ** |
|-----------------------|------------|------------|------------|---------------------------------------------------------------|------------|------------------------------------------|------------|
| Robert P.  Cochran(1) |       |       | 12,713     |                                                          |       |                                     | $          | 327,915 |   |   |
| Séan W. McCarthy |       |       | —     |                                                          |       |                                     | —     |   |   |
| Bruce E. Stern        |       |       | —     |                                                          |       |                                     | —     |   |   |
| Russell B. Brewer  II |       |       | —     |                                                          |       |                                     | —     |   |   |
| Joseph W. Simon       |       |       | —     |                                                          |       |                                     | —     |   |   |

----

(1)          BecauseMr. Cochran is above the minimum retirement age (55 years old), the 2004Equity Plan provides that shares of Dexia Restricted Stock owned by Mr. Cochranvest pro-rata over the vesting period otherwise applicable to employees belowthe retirement age. The value realized on vesting is based upon the reportedshare price of Dexia ordinary shares as of the last day of each calendarquarter converted into U.S. dollars as reported on the books of the Company.

**NonqualifiedDeferred Compensation**

The following table setsforth a summary of information with respect to the Company’s DeferredCompensation Plans (DCPs) and Supplemental Executive Retirement Plans (SERPs)as of and for the year ended December 31, 2006:

**2006Nonqualified Deferred Compensation**

| **Name**              | ** ** | ** ** | ** ** | **Executive  Contributions  in Last FY  (DCPs)(1)** | ** ** | **Registrant  Contributions  in Last FY  (SERPs)(2)** | ** ** | **Aggregate  Earnings  in Last FY(3)** | ** ** | **Aggregate  Withdrawals/  Distributions  in Last FY** | ** ** | **Aggregate  Balance  at Last FYE** | ** ** |
|-----------------------|------------|------------|------------|---------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| Robert P. Cochran     |       |       | $          | —                                                        |       |                                                            |       | $                                                | 71,100     |                                                             |       |                                          | $          | 2,296,678 |   |   | $ | — |   | $ | 32,497,486 |   |
| Séan W. McCarthy |       |       | —     |                                                          |       |                                                            | 71,100     |                                             |       |                                                             | 442,999    |                                          |       | — |   | 5,449,623 |   |
| Bruce E. Stern        |       |       | —     |                                                          |       |                                                            | 71,100     |                                             |       |                                                             | 246,994    |                                          |       | (2,000,000 | ) | 4,990,542 |   |
| Russell B. Brewer  II |       |       | —     |                                                          |       |                                                            | 71,100     |                                             |       |                                                             | 815,013    |                                          |       | — |   | 11,627,006 |   |
| Joseph W. Simon       |       |       | —     |                                                          |       |                                                            | 71,100     |                                             |       |                                                             | 17,495     |                                          |       | — |   | 171,270 |   |
|                       |            |            |            |                                                               |            |                                                                 |            |                                                  |            |                                                                  |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |

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(1)          This column reflectscompensation otherwise payable in 2006 (i.e., 2005 bonus and payouts ofperformance shares for cycles ending December 31, 2005) voluntarilydeferred by the named executive officer under the DCPs.

(2)          This column reflects contributionsby the Company to the SERPs on behalf of the named executive officers accruedin 2005 and contributed in 2006. These amounts were included in the SummaryCompensation Table. All amounts were 100% vested at December 31, 2006,except that Mr. Simon’s amount was 60% vested as of such date.

(3)          The following portion ofthe amounts included in this column are included in the Summary CompensationTable under the caption “Nonqualified Deferred Compensation Earnings”:  $491,881 for Mr. Cochran, $150,380 for Mr. McCarthyand $0 for Mr. Stern, Mr. Brewer and Mr. Simon.

TheSERPs and DCPs are “top hat” plans, which are unfunded and unsecurednon-qualified plans restricted under the tax laws to a limited number of highlycompensated employees. Under the SERPs, the 

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Company makes an annual contribution equal to 9% ofprior year salary and bonus in excess of the money purchase plan salary/bonuscap (but disregarding salary/bonus in excess of $1 million), with suchcontributed amounts generally credited with returns on mutual funds orsecurities selected by the participants and “match funded” by the Company. Themutual funds and securities employed as investment benchmarks under the DCPsand SERPs in 2006 and their respective 2006 rates of return were as follows:  

| **Name of Mutual Fund or Stock Benchmark**                     | ** ** | ** ** | *** *** | **2006  % Rate of Return** | *** *** |
|----------------------------------------------------------------------------------------------|------------|------------|--------------|-------------------------------------------|--------------|
| Dodge &  Cox Income Fund                                                            |       |       | 5.3          |                                      |         |
| Dodge &  Cox Stock Fund                                                             |       |       | 18.5         |                                      |         |
| Fidelity  Contrafund                                                                         |       |       | 11.5         |                                      |         |
| Fidelity  Investment Grade Bond Fund                                                         |       |       | 4.8          |                                      |         |
| Fidelity Money  Market Portfolio                                                             |       |       | 4.8          |                                      |         |
| Financial  Security Assurance Holdings Ltd. common shares  (Director Share Purchase Program) |       |       | 9.1          |                                      |         |
| Harbor Capital  Appreciation Fund                                                            |       |       | 2.3          |                                      |         |
| Julius Baer  International Fund                                                              |       |       | 32.1         |                                      |         |
| Longleaf Partners  Fund                                                                      |       |       | 21.6         |                                      |         |
| Longleaf Partners  Small Cap Fund                                                            |       |       | 22.3         |                                      |         |
| Montpelier Re  common shares                                                                 |       |       | 0.1          |                                      |         |
| Northern Select  Equities Fund                                                               |       |       | 8.0          |                                      |         |
| Olympus Re common  shares                                                                    |       |       | (7.3         | )                                         |         |
| PIMCO Stocks Plus                                                                            |       |       | 14.7         |                                      |         |
| White Mountains  Insurance Group common shares                                               |       |       | 5.3          |                                      |         |

 

Amounts contributed by theCompany under the SERPs and the earnings thereon are payable upon terminationof employment unless deferred by the employee. Employees are entitled toirrevocably defer receipt of SERP payments for one or more years beyondtermination of employment. Under the DCPs, participants are entitled toirrevocably defer receipt (generally for a minimum deferral period equal to theearlier of three years or termination of employment) of bonus and performanceshare compensation otherwise payable to them by the Company, with such deferredamounts generally credited with returns on mutual funds or securities selectedby the participants and “match funded” by the Company. While the SERPs and DCPsare unfunded plans, the plans contemplate that the Company will make availableto plan participants “deemed” investment alternatives comprised of mutual fundsor securities. Plan participants are generally entitled to select one or moresuch “deemed” investments for their plan balances (and to change suchselections on a quarterly basis) and their plan balances are credited ordebited with the performance of such selected investments. Plan participantsare entitled to elect to receive SERP and DCP payouts in lump sums at thepayout date or in installments (over a period of years elected in advance by theparticipant) commencing with the payout date. The SERPs and DCPs generally donot permit early withdrawals of funds absent extreme financial hardship, butallow for extensions of deferrals to the extent permitted by the InternalRevenue Code.

**Potential PaymentsUpon Termination of Employment, Retirement or Change-in-Control**

Set forth below is adescription of amounts payable to the named executive officers upon terminationof employment with the Company, retirement from the Company or change incontrol of the Company. Amounts set forth below do not include amounts payableunder the Company’s Pension Plan, 401(k) plan, DCPs or SERPs describedabove.

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***Payments Upon Termination of Employment***

*Chief ExecutiveOfficer and Chief Operating Officer*

The employment agreementsprovide for continued participation by Messrs. Cochran and McCarthy in theCompany’s benefit plans and severance benefits in lieu of the Company’sexisting severance policy. Specifically, if the Company terminates Mr. Cochranor Mr. McCarthy without “cause” or either of such executive officersterminates his employment for “good reason,” the terminated employee will beentitled to:

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

·       twicehis annual base salary at the rate then in effect and twice his average annualbonus for the two immediately prior years;

·       vestingof his outstanding performance shares;

·       theminimum annual performance shares that he is entitled to receive through theend of the agreement’s term; and

·       a gross-up payment to hold the employee harmless from anyexcise tax imposed by Section 4999 of the Internal Revenue Code of1986, as amended (“Golden Parachute Tax”).

For purposes of each employment agreement, (a) “cause”means conviction of, or a plea of nolo contendere to, a criminal misdemeanor orfelony materially injurious to the Company, willful and continued failure toperform duties after a specific demand to do so or willful misconduct incarrying out duties directly and materially harmful to the Company’s businessor reputation; and (b) “good reason” means a diminution in the employee’ssignificant duties or responsibilities, breach by the Company of itsobligations under the employment agreement, relocation of the executive morethan 25 miles from New York City, a material adverse change in totalcompensation, or, in the case of Mr. McCarthy, not being named Mr. Cochran’ssuccessor as Chief Executive Officer of the Company.

If his employmentwith the Company had been terminated without cause by the Company on December 31,2006, then pursuant to his employment agreement Mr. Cochran would havebeen entitled to receive a minimum of $29,884,994, comprised of:

(a)          $1,025,055, representing(i) $1,000,000, equal to two times the annual base salary at the 2006rate, plus (ii) interest at the year-end three-month Treasury rate for thesix month period prior to payment;

(b)         $6,867,869, representing (i) $6,700,000,equal to two times the average annual bonus payable for the two yearsimmediately prior to the termination, plus (ii) interest at the year-endthree-month Treasury rate for the six month period prior to payment;

(c)          $16,211,700,representing (i) the vesting of all previously granted outstandingperformance shares valued at $145.61 per share under the 1993 Equity Plan and$149.57 per share under the 2004 Equity Plan, with the payouts for eachcompleted year based on actual results and the payout for uncompleted yearsvalued at 100%, plus (ii) interest at 8% per annum, compoundedsemi-annually, for the two year restricted period described below;

(d)         $646,563, representing (i) thevesting of the 20,179 outstanding shares of Dexia restricted stock previouslygranted under the 2004 Equity Plan, valued as of December 31, 2006 at$27.39 per share, plus (ii) interest at 8% per annum, compoundedsemi-annually, for a two year restricted period;  and

(e)          $5,133,807, representing(i) the minimum annual award of 2007 performance shares entitled to bereceived through the contract term, equal to 29,340 performance shares with anestimated 

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economic value at leastequal to the employee’s 2004 performance share award of 40,000 performanceshares (having an economic value of $4,388,400) and with the payouts for eachcycle valued at 100%, plus (ii) interest at 8% per annum, compoundedsemi-annually, for a two year restricted period.

The foregoing termination payment excludes the minimum2006 bonus ($3,071,950, equal to 5% of the guideline bonus pool) and2004/2005/2006 performance share payout ($7,433,855) that Mr. Cochranwould have been entitled to receive whether or not his employment had beenterminated.

If his employmentwith the Company had been terminated without cause by the Company on December 31,2006, then pursuant to his employment agreement Mr. McCarthy would havebeen entitled to receive a minimum of $23,340,231, comprised of:

(a)          $676,536, representing (i) $660,000,equal to two times the annual base salary at the 2006 rate, plus (ii) interestat the year-end three-month Treasury rate for the six month period prior topayment;

(b)         $6,150,330, representing (i) $6,000,000,equal to two times the average annual bonus payable for the two yearsimmediately prior to the termination, plus (ii)interest at the year-endthree-month Treasury rate for the six month period prior to payment;

(c)          $11,866,392,representing (i) the vesting of all previously granted outstandingperformance shares valued at $145.61 per share under the 1993 Equity Plan and$149.57 per share under the 2004 Equity Plan, with the payouts for eachcompleted year based on actual results and the payout for uncompleted yearsvalued at 100%, plus (ii) interest at 8% per annum, compoundedsemi-annually, for the two year restricted period described below;

(d)         $924,963, representing (i) thevesting of the 28,869 outstanding shares of Dexia restricted stock previouslygranted under the 2004 Equity Plan, valued as of December 31, 2006 at$27.39 per share, plus (ii) interest at 8% per annum, compoundedsemi-annually, for a two year restricted period;  and

(e)          $3,722,010, representing(i) the minimum annual award of 2007 performance shares entitled to bereceived through the contract term, equal to 21,271 performance shares with anestimated economic value at least equal to the employee’s 2004 performance shareaward of 29,000 performance shares (having an economic value of $3,181,590) andwith the payouts for each cycle valued at 100%, plus (ii) interest at 8%per annum, compounded semi-annually, for the two year restricted period.

The foregoing termination payment excludes the minimum2006 bonus ($2,457,560, equal to 4% of the guideline bonus pool) and2004/2005/2006 performance share payout ($5,062,712) that Mr. McCarthywould have been entitled to receive whether or not his employment had beenterminated.

Both employment agreements provide that payments inrespect of salary and bonus are, to the extent otherwise subject to penaltyunder Section 409A of the Internal Revenue Code, payable six months aftertermination of employment and are credited with interest at the three-monthTreasury bill rate until so paid. Payments in respect of performance shares (a) aresubject to forfeiture in the event of a breach by the employee of the covenantnot to compete or covenant not to solicit Company clients or employees during atwo year restricted period following termination of employment, and (b) arepayable in a lump sum following expiration of the restricted period, togetherwith interest accrued at 8% per annum, compounded semi-annually, during therestricted period.

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 and all unvested performanceshares and Dexia restricted stock 

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will be forfeited. If suchtermination occurs after the term of the agreement, he will also be entitled tohis pro-rata annual bonus through the date of termination and hisperformance shares will vest pro rata in proportion to the percentage of theapplicable performance cycle during which he was employed by the Company. Eachemployment agreement contains a non-compete provision extending throughthe greater of two years and the term of the agreement.

If Mr. Cochranbecomes Non-Executive Chairman of the Company, he will be entitled to histhen-current salary and an annual performance share unit award with anestimated economic value at least equal to 50% of normal prior awards, but willnot be entitled to a mandatory annual cash bonus. If Mr. McCarthy becomesthe Chief Executive Officer of the Company, he will be entitled to compensationequal to 90% or more of Mr. Cochran’s latest compensation, includingsalary, bonus and performance share units.

*General Counsel,Chief Risk Management Officer and Chief Financial Officer*

Pursuant to theSeverance Policy for Senior Management, upon termination of employment(including constructive termination) by the Company other than for cause, eachof Messrs. Stern, Brewer and Simon will become entitled to twelve monthsof pay, as well as a gross-up payment to hold the employee harmless from anyexcise Golden Parachute Tax. For purposes of the foregoing:

·       “forcause” means termination for unethical practices, illegal conduct or grossinsubordination, but specifically excludes termination as a result ofsubstandard performance;

·       “constructivetermination” of employment occurs if an eligible employee’s compensationopportunity is significantly reduced out of line with Company results, or ifthere is a material reduction in responsibilities, such that the employee’stermination of employment is an involuntary termination under Section 409Aof the Internal Revenue Code; and

·       “monthsof pay” (a) shall be determined on the basis of the eligible employee’smonthly salary on his separation date and (b) shall include the eligibleemployee’s most recent bonus (or three year average, if higher), withone-twelfth (1/12th) of such bonus amount being allocated to each month of pay.

An eligible employee’s base salary and bonus shallinclude amounts deferred under the DCPs and the 401(k), and amounts allocatedto the Flex Plan. In addition, severance benefits (applicable to all employeesof the Company during their severance period) include:

·       continuationof employee hospital, medical, dental, prescription drug and vision coveragesfor the severance period;

·       continuationof life and disability insurance coverage at the employee’s expense for theseverance period to the extent allowed by the insurer (such coverage is notcurrently allowed by the insurer);

·       reimbursementof life insurance premiums to the extent that such life insurance is continuedduring the severance period; and

·       payment for unused vacationdays.

Payments of severance under the Severance Policy forSenior Management is subject to execution by the employee of a waiver andrelease agreement, and any unpaid severance amounts are subject to up to a 50%reduction when offset by any employment or consulting income of the employeeduring the severance period. If any of Mr. Stern, Mr. Brewer orMr. Simon is terminated for cause or terminates his employment absent“constructive termination”, he will be entitled only to be paid his pro rataannual base salary through the date of termination and all unvested performanceshares and Dexia restricted stock will be forfeited.

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If hisemployment with the Company had been terminated without cause by the Company onDecember 31, 2006, then pursuant to the Severance Policy for SeniorManagement, each of Mr. Stern and Mr. Brewer would have been entitledto receive $2,814,097, comprised of:

(a)          oneyear salary at the 2006 rate of $260,000;

(b)         oneyear bonus at the 2005 rate of $900,000;

(c)          $1,580,344,the estimated value of outstanding performance shares and performance shareunits vested pro-rata under the 1993 Equity Plan and 2004 Equity Plan,representing (i) 9,540 performance shares valued at $1,441,997 based upona 100% pay out and the December 31, 2006 per share value of $145.61 underthe 1993 Equity Plan and $149.57 under the 2004 Equity Plan and (ii) $138,347in respect of 5,051 shares of Dexia restricted stock valued at $27.39 pershare;

(d)         $25,420,representing the estimated cost of continuation of hospital, medical, dental,prescription drug and vision coverages for the severance period; and

(e)          $48,333,representing payment for unused vacation days.

If hisemployment with the Company had been terminated without cause by the Company onDecember 31, 2006, then pursuant to the Severance Policy for SeniorManagement, Mr. Simon would have been entitled to receive $2,390,139, comprisedof:

(a)          oneyear salary at the 2006 rate of $260,000;

(b)         oneyear bonus at the 2005 rate of $800,000;

(c)          $1,284,386,the estimated value of outstanding performance shares and performance shareunits vested pro-rata under the 1993 Equity Plan and 2004 Equity Plan,representing (i) 7,628 performance shares valued at  $1,156,283 based upon a 100% pay out and the December 31,2006 per share value of $145.61 under the 1993 Equity Plan and $149.57 underthe 2004 Equity Plan and (ii) $128,103 in respect of 4,677 shares of Dexiarestricted stock valued at $27.39 per share;

(d)         $23,670,representing the estimated cost of continuation of hospital, medical, dental,prescription drug and vision coverages for the severance period; and

(e)          $22,083,representing payment for unused vacation days.

***Payments UponRetirement***

Their employmentagreements provide that Messrs. Cochran and McCarthy may elect to retireat the end of any employment agreement term after age 60, but thatretirement is mandatory at age 65. Upon any such retirement, each of Mr. Cochranand Mr. McCarthy will be entitled to his pro-rata annual base salaryand annual bonus through the date of retirement and the vesting of hisoutstanding performance shares over time as if he remained employed.Messrs. Cochran and McCarthy are not entitled to any other on-goingretirement compensation except as provided by the Pension Plan and SERPs. Eachof Mr. Cochran and Mr. McCarthy is below the minimum retirement ageof 60 provided in their employment agreements. Each of Mr. Stern, Mr. Brewerand Mr. Simon is below the minimum retirement age of 55 otherwiseapplicable to employees of the Company. Accordingly, none of the namedexecutive officers would be entitled to any payments by reason of retirement atDecember 31, 2006. In addition, under the Company’s Optional RetireeMedical Program applicable to all U. S. Company employees, Messrs. Cochran,McCarthy, Stern, Brewer and Simon are entitled to participate in the Company’smedical plan following retirement provided that they pay the full cost ofcoverage plus a 5% administrative fee to the Company. The Company retains theright to terminate the Optional Retiree Medical Program at any time.

***Payments UponChange in Control***

The Equity Plans providefor accelerated vesting and payment of performance shares and acceleratedvesting of Dexia restricted stock upon the occurrence of certain change incontrol transactions involving 

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theCompany. These provisions are generally applicable to all participants in theEquity Plans. Each of the named executive officers holds performance shares andDexia restricted stock awarded under the Equity Plans.

The 1993 Equity Planprovides that the Company’s Board of Directors may elect to continue the planand the 2004 Equity Plan provides that the plan shall automatically continue ifa change in control occurs. Following a “plan continuation,” performance sharesand Dexia restricted stock are not accelerated, but vest and are payable as ifno change in control had occurred, except that performance shares and Dexiarestricted stock vest in the case of any employee who is terminated withoutcause or leaves for “good reason” following the change in control. If a changein control of the Company occurred at December 31, 2006 and a plancontinuation was not elected under the 1993 Equity Plan, then each participantin the 1993 Equity Plan would be entitled to pro-rata vesting of theiroutstanding performance shares under the 1993 Equity Plan, with an estimatedvalue of $2,987,718 for Mr. Cochran, $2,166,095 for Mr. McCarthy,$746,930 for Mr. Stern, $746,930 for Mr. Brewer and $522,851 for Mr. Simon,in each case valued at the December 31, 2006 share value of $145.61 pershare under the 1993 Equity Plan, with the payouts for each completed cyclebased on actual results and the payout for uncompleted cycles valued at 100%.

**Compensation of Directors**

Thetable below sets forth a summary of all compensation paid to the directors ofthe Company, in each case for services rendered to the Company for the year endedDecember 31, 2006. Employees of the Company and Dexia received noadditional compensation for their services as directors of the Company.

**2006Director Compensation Table**

| **Name**            | ** ** | ** ** | ** ** | **Fees Earned  Or Paid in Cash** | ** ** | **Nonqualified  Deferred Compensation  Earnings(1)** | ** ** | **All Other  Compensation(2)** | ** ** | **Total(3)** | ** ** |
|---------------------|------------|------------|------------|------------------------------------------------------|------------|-----------------------------------------------------------|------------|-------------------------------------|------------|--------------|------------|
| Robert N. Downey    |       |       | $          | 79,000                                               |       |                                                      |       | $                                   | 52,528     |         |       |   | $ | 116,364 |   |   | $ | 195,364 |   |
| James H. Ozanne     |       |       | 102,000    |                                                 |       |                                                      | 141,947    |                                |       |         | —     |   |   | 102,000 |   |
| Roger K. Taylor     |       |       | 88,000     |                                                 |       |                                                      | 556,963    | (4)                                 |       |         | —     |   |   | 88,000 |   |
| George U. Wyper     |       |       | 87,750     |                                                 |       |                                                      | —     |                                |       |         | 35,782     |   |   | 123,532 |   |
| David O. Maxwell(5) |       |       | 23,750     |                                                 |       |                                                      | —     |                                |       |         | 111,400    |   |   | 135,150 |   |
|                     |            |            |            |                                                      |            |                                                           |            |                                     |            |              |            |  |  |  |  |  |  |  |  |  |  |

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(1)    The amount under this column reflects the excess, ifany, of (a) income on Company common stock acquired under the DirectorShare Purchase Program described below and credited by the Company toparticipants under the DCPs over (b) the Proxy Market Rate of 5.88%. Thiscolumn does not include earnings on publicly traded mutual funds credited bythe Company to participants under the DCPs. The Company currently match fundssubstantially all phantom investments (other than money market fundinvestments) made by participants in the DCPs. Since the Company match fundssubstantially all phantom investments under the DCPs, the principal costsassociated with these plans come from (i) the delay in recognition by theCompany of compensation expense for the deferred amounts and (ii) therecognition of gains on matched investments if and when realized by the Companyprior to the time that the Company recognizes a deduction for compensation expenseto the employee (at the time payments are made by the plans to theparticipants). Reference is made to “—Nonqualified Deferred Compensation,”above, for a list of the mutual funds and stock benchmarks under the DCPs andtheir respective 2006 rates of return. The dollar amounts under this column arenot included in determining amounts under the “total” compensation column.

(2)    Amounts under this column reflect the excess of (a) realizedand unrealized gains on common stock of the Company, purchased through theDirector Share Purchase Program (excluding shares held under the DCPs), over (b) theProxy Market Rate of 5.88%. For discussion of the Director Share PurchaseProgram, see “—Director Share Purchase Program,” below.

(3)    Total compensation does not include nonqualifieddeferred compensation earnings.

(4)    The amounts deferred by Mr. Taylor under the DCPsprimarily relate to compensation earned while employed by the Company.

(5)    Mr. Maxwell retired from the Board of Directors ofthe Company in May 2006.

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Each director of theCompany who is not an officer of the Company or Dexia received a fee of $50,000per annum for service as a director and an additional annual fee of $20,000 ifChairman of the Underwriting Committee or Audit Committee of the Board ofDirectors or $5,000 if Chairman of another Committee of the Board of Directors.Each director also received $2,000 for each Board meeting and regular Committeemeeting attended and reimbursement for expenses for each such meeting attended.Each director is entitled to defer fees under the Company’s DCP and toparticipate in the Director Share Purchase Program.

***Director SharePurchase Program***

In the fourth quarter of2000, the Company entered into an agreement with Dexia Holdings and DexiaPublic Finance Bank, now Dexia Crédit Local, to establish the Director SharePurchase Program (the “Director Share Purchase Program”), pursuant to whichCompany directors could invest in shares of the Company’s common stock.  Dexia and the Company established the DirectorShare Purchase Program to encourage directors to have a financial interest inthe Company to better align their financial interests with those of the Company’sshareholders.

TheDirector Share Purchase Program entitles each director of the Company to purchasefrom Dexia (or an affiliate thereof) up to 126,958 restricted shares of theCompany’s common stock (which represented a $10 million investment at thepurchase price at inception of the program) at a price determined in accordancewith 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 purchasesuch shares either directly or through deemed investments under the DCPs or, inthe case of Company employees, the SERPs. Each deemed investment election withrespect to these shares is irrevocable.

The Director SharePurchase Program enables the Company to purchase from Dexia Holdings, at thesame price, the same number of shares of common stock purchased by directorsthrough phantom investments under the DCPs or SERPs. Upon expiration of anyapplicable deferral period, the Company is obligated to pay out the phantominvestments in shares of common stock, which must be held by the participant asif acquired directly from Dexia Holdings for generally a minimum of six months.

The purchase price foreach restricted share acquired by a director or put to Dexia Crédit Local isequal to the product of 1.4676 and adjusted book value per share (“ABV pershare”), with ABV per share determined in accordance with the methodologyemployed for valuing performance share award payouts under the Equity Plans. The1.4676 times ABV multiple was based upon the ABV multiple paid by Dexia when itacquired the Company in 2000. The purchase price per share, determined pursuantto such formula, was $178.16 as of December 31, 2006. ABV per share ismeasured at the close of the calendar quarter in which a director submits arepurchase notice, provided that ABV per share for a terminated directorfreezes at the end of the calendar quarter including the first anniversary ofthe later of the termination of directorship or, in the case of deferredshares, receipt of shares upon expiration of the deferral period.

Sales under the programare not registered under the Securities Act of 1933, as amended, in relianceupon an exemption from registration under Section 4(2) of that Act. Formore information regarding the directors’ share ownership, see “Item 12.Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters—Directors and Executive Officers.”

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**Compensation Committee Interlocks and InsiderParticipation**

As of January 1,2006, the HR Committee consisted of Messrs. Cochran, Deletré, Downey andTaylor as well as David O. Maxwell (chairman) and Pierre Richard, then-membersof the Board of Directors who retired from the board in May 2006. In February 2006,Mr. Downey was named Chairman of the Committee, Mr. Miller waselected to the Committee, and Messrs. Maxwell and Richard ceased to bemembers of the committee in connection with their retirement from the Company’sBoard of Directors.

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. Miller isthe Group Chief Executive Officer and Member of the Board of Directors andChairman of the Management Board of Dexia. Mr. Deletré is a Member of theManagement Board of Dexia. Mr. Richard is the Chairman of the Board ofDirectors of Dexia.

As described in “DirectorShare Purchase Program,” above, members of the HR Committee are entitled toparticipate in a share purchase program available to all directors of theCompany, either directly or through deemed investments under the Company’s DCPsor SERPs.

**Item12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.

**5% Shareholders**

Thefollowing table sets forth certain information regarding beneficial ownershipof the Company’s equity at March 15, 2007 as to each person known by theCompany to beneficially own, within the meaning of the Exchange Act, 5% or moreof the outstanding shares of the common stock, par value $.01 per share, of theCompany.

| **Title of class** | ** ** | ** **                                                                       | ** ** | **Name and address of  beneficial owner** | ** ** | **Amount and nature of  beneficial ownership** | ** ** | **Percent of  class** | ** ** |
|------------------------------|------------|----------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|----------------------------|------------|
| Common stock, par value      |       | Dexia S.A.(1)                                                                    |       | 33,188,616 shares(1)(2)                                       |       |                                                               | 99.7       | %(2)                       |       |
| $.01 per share               |       | 7 à 11 quai André Citröen  BP-1002  75 901 Paris Cedex 15, France |       |                                                          |       |                                                               |       |                       |       |
|                         |       | Place Rogier 11  B - 1210 Brussels, Belgium                                      |       |                                                          |       |                                                               |       |                       |       |

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(1)          Sharesare held indirectly through a subsidiary of Dexia.

(2)          Forpurposes of this table, Dexia is not deemed to be the beneficial owner of 241,978shares acquired by the Company in connection with the Director Share PurchaseProgram described in “Item 11. Executive Compensation—Compensation of Directors—DirectorShare Purchase Program.” Ownership percentage is calculated based on 33,276,017shares of common stock outstanding at March 15, 2007, which excludes suchshares acquired by the Company.

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**Directors andExecutive Officers**

***Ownership ofCompany Common Stock***

The following table sets forth certain informationregarding beneficial and economic ownership of the Company’s common stock atMarch 15, 2007 for (a) each director of the Company, (b) eachnamed executive officer named in the “Summary Compensation Table” in Item 11,and (c) all executive 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. 

| **Name of Beneficial Owner**                   | ** ** | ** ** | ** ** | **Amount and  Nature of Beneficial  Ownership(1)** | ** ** | **Economic  Ownership(1)** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------|------------|----------------------------|------------|
| Robert P. Cochran                                             |       |       | 41,744     |                                                              |       |                       | 245,425    |   |   |
| Michèle Colin(2)                                         |       |       | —     |                                                              |       |                       | —     |   |   |
| Bruno Deletré(2)                                         |       |       | —     |                                                              |       |                       | —     |   |   |
| Robert N. Downey                                              |       |       | 20,159     |                                                              |       |                       | 29,259     |   |   |
| Jacques Guerber(2)                                            |       |       | —     |                                                              |       |                       | —     |   |   |
| Rembert von Lowis(2)                                          |       |       | —     |                                                              |       |                       | —     |   |   |
| Séan W. McCarthy                                         |       |       | —     |                                                              |       |                       | 113,785    |   |   |
| Axel Miller(2)                                                |       |       | —     |                                                              |       |                       | —     |   |   |
| James H. Ozanne                                               |       |       | —     |                                                              |       |                       | 25,123     |   |   |
| Roger K. Taylor                                               |       |       | —     |                                                              |       |                       | 96,489     |   |   |
| Xavier de Walque(2)                                           |       |       | —     |                                                              |       |                       | —     |   |   |
| George U. Wyper                                               |       |       | 6,199      |                                                              |       |                       | 6,199      |   |   |
| Bruce E. Stern                                                |       |       | —     |                                                              |       |                       | 30,967     |   |   |
| Russell B. Brewer II                                          |       |       | —     |                                                              |       |                       | 30,967     |   |   |
| Joseph W. Simon                                               |       |       | —     |                                                              |       |                       | 28,067     |   |   |
| All executive officers and directors as a group (15  persons) |       |       | 68,102     |                                                              |       |                       | 606,281    |   |   |

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(1)          Sharesbeneficially owned were acquired under the Company’s Director Share PurchaseProgram described under “Item 11. Executive Compensation—Compensation ofDirectors—Director Share Purchase Program.” To the extent shares economicallyowned exceed shares beneficially owned, such economic ownership is attributableto (a) deemed investments in the Company’s common stock under the DirectorShare Purchase Program, and  (b) performanceshares, with each performance share treated as one share of common stock, inthe amounts shown below (excluding fractional shares):

| **Officer**           | ** ** | ** ** | ** ** | **Performance Shares** | ** ** |
|-----------------------|------------|------------|------------|-----------------------------|------------|
| Robert P. Cochran     |       |       | 118,467    |                        |       |
| Séan W. McCarthy |       |       | 87,733     |                        |       |
| Bruce E. Stern        |       |       | 30,967     |                        |       |
| Russell B. Brewer II  |       |       | 30,967     |                        |       |
| Joseph W. Simon       |       |       | 28,067     |                        |       |

 

In December 2000,the Company acquired 304,757 shares of its common stock from Dexia Holdings tosatisfy most of its obligations under the Director Share Purchase Program in anamount equal to the number of shares deemed invested by directors at theProgram’s inception date under the DCP and SERP. The Company held 241,978 ofthose shares as of December 31, 2006.

(2)          Ms. Colinand Messrs. Deletré, Guerber, von Lowis, Miller and de Walque aredirectors of the Company and officers of Dexia or its subsidiaries. Dexiaindirectly owns 99.7% of the Company’s common stock.

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The Company is not awareof any arrangements that may result in a change in control of the Company.

***Ownership of Dexia Common Stock***

Thefollowing table sets forth beneficial ownership of common shares of the Company’sparent, Dexia, at March 15, 2007, for (a) each director of theCompany, (b) each executive officer and (c) all executive officersand directors of the Company as a group. Beneficial ownership is less than 1%for each executive officer and director listed, individually and as a group.

| **Directors and Executive Officers(1)**        | ** ** | ** ** | ** ** | **Amount and Nature of  Beneficial Ownership** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------|------------|
| Robert P. Cochran(2)                                          |       |       | 632,458    |                                                               |       |
| Michèle Colin                                            |       |       | 3,490      |                                                               |       |
| Bruno Deletré                                            |       |       | 1,435      |                                                               |       |
| Robert N. Downey                                              |       |       | —     |                                                               |       |
| Jacques Guerber                                               |       |       | 10,677     |                                                               |       |
| Rembert von Lowis                                             |       |       | 26,053     |                                                               |       |
| Séan W. McCarthy(2)                                      |       |       | 611,459    |                                                               |       |
| Axel Miller                                                   |       |       | 100        |                                                               |       |
| James H. Ozanne                                               |       |       | —     |                                                               |       |
| Roger K. Taylor                                               |       |       | —     |                                                               |       |
| Xavier de Walque                                              |       |       | 49,484     |                                                               |       |
| George U. Wyper                                               |       |       | —     |                                                               |       |
| Bruce E. Stern(2)                                             |       |       | 215,508    |                                                               |       |
| Russell B. Brewer II(2)                                       |       |       | 210,538    |                                                               |       |
| Joseph W. Simon(2)                                            |       |       | 58,112     |                                                               |       |
| All executive officers and directors as a group (15  persons) |       |       | 1,819,314  |                                                               |       |

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(1)          Dexiahas provided the Company with information regarding shares owned by Ms. Colinand Messrs. Deletré, Guerber, von Lowis, Miller and de Walque, and hasadvised the Company that:

(a)          sharespresented for those directors include only shares owned directly by suchdirectors or shares for which those directors can cast a vote and excludewarrants, and

(b)         as of December 31,2006, the total number of outstanding Dexia shares was 1,163,184,325, so thattogether the Company’s executive officers and directors owned 0.16% of theDexia shares and the maximum amount owned by any of the Company’s executiveofficers and directors represents 0.05% of the Dexia shares.

Amajority of the shares set forth above were acquired under the Dexia EmployeeShare Plans, as described in “Item 11. Executive Compensation—Components of Compensation Provided bythe Company—Dexia Employee Share Plans.” Under the Plans, the investment alternatives include a “classic option,”under which U.S. resident employees may purchase Dexia shares at a 15% discount(up to a limit prescribed annually under Section 423 of the InternalRevenue Code, which was $21,250 for 2006), and three leveraged options. The following table shows the number ofleveraged shares beneficially held by each of the named executive officers asof March 15, 2006: 

| **Officer**           | ** ** | ** ** | ** ** | **Leveraged Shares** | ** ** |
|-----------------------|------------|------------|------------|---------------------------|------------|
| Robert P. Cochran     |       |       | 591,860    |                      |       |
| Séan W. McCarthy |       |       | 569,540    |                      |       |
| Bruce E. Stern        |       |       | 190,110    |                      |       |
| Russell B. Brewer II  |       |       | 190,600    |                      |       |
| Joseph W. Simon       |       |       | 43,780     |                      |       |

 

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(2)          Includesshares granted under the 2004 Equity Plan, as described in “Item 11. ExecutiveCompensation—Compensation Discussion and Analysis—Components of CompensationProvided by the Company—Performance Share Units.” Generally, one-third of anaward of Dexia restricted stock vests after 2.5 years and two-thirds vestsafter 3.5 years, with transfer restrictions lapsing on one-third of each awardafter three years and on two thirds of each award after four years.

**Securities Available under Equity Compensation Plans**

The following table setsforth information as of December 31, 2006 with respect to eachcompensation plan of the Company under which equity securities of the Companyare authorized for issuance.

**EquityCompensation Plan Information**

| **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              |                                                                                                                                                |       |                                                                                                                | —     |                                                                                                                                                                                                        |       |   | 2,705,775 | (3) |   |
| Equity compensation  plans not approved by security holders(2) |       |       | Not applicable |                                                                                                                                                |       |                                                                                                                | —     |                                                                                                                                                                                                        |       |   | Not applicable |   |   |
| Total                                                               |       |       | 0              |                                                                                                                                                |       |                                                                                                                | —     |                                                                                                                                                                                                        |       |   | 2,705,775 |   |   |

----

(1)          TheCompany currently maintains one such plan, the 2004 Equity Plan. A second plan,the Director Share Purchase Program, permits each director of the Company topurchase, directly from Dexia Holdings or through “phantom” investments in theCompany’s DCP or SERP, up to 126,958 shares of common stock. However, suchshares are already issued and outstanding. As of December 31, 2006, therewere 1,086,458 shares available under the Director Share Purchase Program,based on the number of directors as of December 31, 2006 (11) anddeducting shares that have already been purchased. See “Item 11. ExecutiveCompensation—Compensation Discussion and Analysis—Components of Compensation Providedby the Company” and “—Compensation of Directors—Director Share Purchase Program”for further discussion of these plans.

(2)          Allof the Company’s equity compensation plans have been approved by the Company’sshareholders.

(3)          Sharesavailable for future issuance under the 2004 Equity Plan. Since its inception,up to 3,300,000 shares of common stock have been available for distributionunder the 2004 Equity Plan in respect of performance shares. Such shares may benewly issued shares, treasury shares or shares purchased in the open market. Ifperformance shares awarded under the 2004 Equity Plan are forfeited, the sharesallocated to such awards are again available for distribution in connectionwith future awards under the Plan. So long as the Company’s common stock is notregistered under the Exchange Act, the Company expects to pay its performanceshares in cash rather than stock.

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

**Financial Guaranty Transactions**

Since the Company’s mergerwith a subsidiary of Dexia in July 2000, various affiliates of Dexia,including certain wholly owned bank subsidiaries and/or their U.S. branches,have participated in transactions in which subsidiaries of the Company haveprovided financial guaranty insurance. For example, Dexia affiliates haveprovided liquidity facilities and letters of credit in FSA-insuredtransactions, and have been the beneficiaries of financial guaranty insurancepolicies issued by insurance company 

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subsidiariesof the Company. 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. See Note 21 to the Consolidated FinancialStatements in Item 8.

**Director Share Purchase Program**

As ofDecember 31, 2006, each director was entitled to purchase up to 126,958actual or phantom shares of the Company’s common stock, as described in “Item11. Executive Compensation—Compensation of Directors—Director Share PurchaseProgram.”

**Other Relationships**

Under a cost-sharingagreement, the Company reimburses Dexia Crédit Local for the portion ofdirector Bruno Deletré’s Dexia Crédit Local compensation that relates to hiswork as liaison with the Company on behalf of Dexia.

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

**Review, Approval or Ratification of Transactions withRelated Persons**

The Company’s ability toenter into related party transactions is limited by law. Under the New YorkInsurance Holding Company Act, the Company is required to obtain the priorapproval of the New York Superintendent of the following transactions withrelated parties in amounts greater than 5% of the Company’s admittedassets:  sales, purchases, exchanges,loans or extensions of credits or investments. The Company must provide the NewYork Superintendent with 30 days’ prior notice of such transactions withrelated parties in amounts equal to 0.5%-5% of the Company’s admittedassets or involving reinsurance treaties or agreements or the rendering ofservices on a regular or systematic basis. For these purposes, an entity ispresumed to be a “related party” if the direct or indirect voting control is10% or greater. Absent a determination by the New York Superintendent ofnon-control, acquisition of a voting interest of 10% or more of Dexia wouldrequire prior approval of the New York Superintendent.

The Company provides anannual report to the New York Superintendant and the Board of Directors of theCompany of all transactions with Dexia and its affiliates that are not membersof the FSA group.

Alldirectors and officers are subject to the “Corporate Policy for Directors andOfficers on Conflicts of Interest,” pursuant to which no director or officermay have, directly or indirectly:

·       apersonal or financial interest in any transaction adverse to the Company; or

·       withoutprompt disclosure to the Board of Directors or Executive Management Committeeof the Company, a financial interest in any insurance agency, brokeragebusiness or other business enterprise (a) with which the Company engagesin the purchase, sale or exchange of property, or the rental of real orpersonal property, or (b) to which it renders or from which it securesservices.

For these purposes, “interest” includes the interestof the spouse or dependents of a director or officer, and “financial interest”does not include ownership of less than 1/10 of one percent of the outstandingstock of any corporation listed on a national securities exchange or less than$10,000 of the outstanding stock of any corporation whose stock is regularlysold at least once a week on the over-the-counter market in the U.S. In addition,pursuant to the bylaws of the Company, the Board of Directors must ratify anyloans or debt of the Company. The Company does not have any other writtenpolicies and procedures for the review, approval or ratification of relatedparty transactions.

As noted above, affiliatesof Dexia have participated in transactions in which subsidiaries of the Companyhave provided financial guaranty insurance, including by providing liquidityfacilities and letters of credit in FSA-insured transactions, and have beenbeneficiaries of financial guaranty insurance policies 

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issuedby insurance company subsidiaries of the Company. Such transactions are theprincipal context in which affiliates of Dexia participate in transactions withthe Company, and are subject to the same credit committee reviews astransactions in which no Dexia affiliates participate. In the opinion ofmanagement of the Company, the terms of these arrangements are no lessfavorable to the Company than the terms that could be obtained from unaffiliatedparties.

**Director Independence**

Board members Robert N.Downey, James H. Ozanne, Roger K. Taylor and George U. Wyper are independentwithin the meaning of Rule 10A-3 of the Exchange Act and MessrsDowney, Taylor and Wyper satisfy the requirements for independence of the NYSE.Messrs. Ozanne (Chairman), Taylor and Wyper comprise the Audit Committeeof the Board of Directors and Messrs. Downey and Taylor are members of theHuman Resources Committee of the Board of Directors.

In determining whether ornot a director is independent, the Company uses the standards set out in Rule 10A-3(a)(b)(1) ofthe Exchange Act. Because the Company has only debt securities listed on theNYSE, it is not subject to the additional independence standards imposed by theNYSE, and is not subject to the NYSE requirement that a majority of the membersof a board of directors and all members of a human resources committee beindependent.

**Item 14.**                 PrincipalAccounting Fees and Services.

Aggregatefees (in thousands) for professional services by PricewaterhouseCoopers LLP for2006 and 2005 were:

| ** **      | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------|------------|----------|------------|----------|------------|
| Audit           |       | $        | 1,498.3    |     | $          | 2,033.9 |   |
| Audit related   |       | 416.6    |       | 392.1    |       |
| Tax             |       | 15.0     |       | 328.0    |       |
| Other non-audit |       | 31.4     |       |     |       |
| Total           |       | $        | 1,961.3    |     | $          | 2,754.0 |   |

 

Audit fees for the yearsended December 31, 2006 and 2005 were for professional services renderedfor the audits of the Company’s Consolidated Financial Statements, audits ofthe Subsidiaries, and issuance of consents and comfort letters. Included inthis amount is $0.1 million and $0.2 million in fees relating to consents thatare reimbursed to the Company by the issuers of FSA-insured deals for theyears ended December 31, 2006 and 2005, respectively.

Audit related fees for theyears ended December 31, 2006 and 2005 were for assurance and relatedservices related to the Company’s retirement plans, actuarial certificationsand consultations concerning financial accounting and reporting standards.

Tax fees for the yearended December 31, 2006 were related to tax compliance. Tax fees for theyear ended December 31, 2005 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.

**Other non-audit fees for the yearended December 31, 2006 were related primarily to work performed inconjunction with the licensing of the Company’s Tokyo branch.**

**Audit Committee Pre-ApprovalPolicies and Procedures**

The Audit Committee of the Company’s Board ofDirectors pre-approves all audit and non-audit related fees paid tothe Company’s auditors.

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**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                                                                    |   | 72 |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|----|--------|
| Consolidated  Balance Sheets at December 31, 2006 and 2005                                                             |   | 73 |   |
| Consolidated  Statements of Operations and Comprehensive Income for the Years Ended  December 31, 2006, 2005 and 2004  |   | 74 |   |
| Consolidated  Statements of Changes in Shareholders’ Equity for the Years Ended  December 31, 2006, 2005 and 2004 |   | 75 |   |
| Consolidated  Statements of Cash Flows for the Years Ended December 31, 2006, 2005 and  2004                           |   | 76 |   |
| Notes to Consolidated  Financial Statements                                                                                 |   | 78 |   |

** **

**2.****                 FinancialStatement Schedules**

Thefollowing financial statement schedule is filed as part of this Report.
| Schedule | ** ** | **Title**                                                                                                                                                                                      |
|----------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| I        |       | Parent Company Condensed Financial Information at  December 31, 2006 and 2005 and for the Years Ended December 31,  2006, 2005 and 2004.                                             |
|     |       | The report of the  Independent Registered Public Accounting Firm with respect to the above  listed financial statement schedule is set forth under Item 8 of this Report.                      |
|     |       | All other schedules are  omitted because they are either inapplicable or the required information is  presented in the Consolidated Financial Statements of the Company or the  notes thereto. |

 

**3.****                 Exhibits**

Thefollowing are annexed as exhibits to this Report:
| Exhibit No. | ** ** | **Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1              |       | Agreement and Plan of Merger dated as of  March 14, 2000 by and among Dexia S.A., Dexia Crédit Local  de France S.A., PAJY Inc. and the Company. (Previously filed as  Exhibit 2.1 to Current Report on Form 8-K (Commission File  No. 1-12644) dated March 14, 2000, and incorporated herein by  reference.)                                                                                               |
| 3.1              |       | Restated Certificate of  Incorporation of the Company. (Previously filed as Exhibit 3.1 to the  Company’s Registration Statement on Form S-3 (Reg. No. 333-74165)  (the “Form S-3”), and incorporated herein by reference.)                                                                                                                                                                                           |
| 3.1A             |       | 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.) |

157

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| 3.1B |   | 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.)                 |
| 4.1A |   | 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.)                           |
| 4.1B |   | 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.)                                                                                                                                         |
| 4.1C |   | 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.)                                               |
| 4.1D |   | 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.)                                                                                                                              |
| 4.1E |   | 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.)                                                           |
| 4.1F |   | 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.)                                                                                                                                        |
| 4.2  |   | Indenture, dated as of  November 22, 2006, between Financial Security Assurance Holdings Ltd.  and The Bank of New York, as Trustee. (Previously filed as Exhibit 4.1  to Current Report on Form 8-K (Commission File No. 1-12644)  dated November 22, 2006 (the “November 2006 8-K”), and  incorporated herein by reference.)     |
| 4.2A |   | Financial Security  Assurance Holdings Ltd., Officer’s Certificate Pursuant to Sections 1.02 and  3.01 of the Indenture, dated as of November 22, 2006, between Financial  Security Assurance Holdings Ltd. and The Bank of New York, as Trustee.  (Previously filed as Exhibit 10.2 to the November 2006 8-K,  and incorporated herein by reference.) |
| 4.2B |   | Form of Junior  Subordinated Debenture, Series 2006-1. (Previously filed as  Exhibit 10.3 to the November 2006 8-K, and incorporated  herein by reference.)                                                                                                                                                                                            |

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| 10.1         |   | Amended and Restated  Agreement, dated as of April 21, 2006, among Financial Security  Assurance Inc., the additional borrowers party thereto, various banks and The  Bank of New York, as agent. (Previously  filed as Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q  (Commission File No. 1-12644) for the quarterly period ended  March 31, 2006, and incorporated herein by reference.)                                                                                                          |
|--------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2         |   | Third Amended and  Restated Credit Agreement dated as of April 30, 2005, among Financial  Security Assurance Inc., FSA Insurance Company, the Banks party thereto from  time to time and Bayerische Landesbank, acting through its New York Branch,  as Agent. (Previously filed as  Exhibit 10.2 to the 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.) |
| 10.3†   |   | 1989 Supplemental  Executive Retirement Plan (amended and restated as of December 17,  2004). (Previously filed as Exhibit 10.4 to the Company’s Current Report  on Form 8-K (Commission File No. 1-12644) dated  December 17, 2004 and filed on December 17, 2004 (the  “December 2004 Form 8-K”), and incorporated herein by  reference.)                                                                                                                                               |
| 10.4†   |   | 2004 Supplemental  Executive Retirement Plan, dated as of December 17, 2004. (Previously  filed as Exhibit 10.3 to the December 2004 Form 8-K, and  incorporated herein by reference.                                                                                                                                                                                                                                                                                                                                        |
| 10.4A†  |   | 2004 Supplemental Executive  Retirement Plan, as amended on May 18, 2006. (Previously filed as  Exhibit 10.1 to the Current Report on Form 8-K (Commission  File No. 1-12644) dated May 18, 2006 (the “May 2006 8-K”),  and incorporated herein by reference.)                                                                                                                                                                                                                                           |
| 10.5†   |   | Amended and Restated  1993 Equity Participation Plan (amended and restated as of May 17,  2001). (Previously filed as Exhibit 10.1 to the Company’s Quarterly  Report on Form 10-Q (Commission File No. 1-12644) for  the quarterly period ended June 30, 2001 (the “June 30, 2001 10-Q”),  and incorporated herein by reference.)                                                                                                                                                                  |
| 10.6†   |   | 2004 Equity  Participation Plan (Previously filed as Exhibit 10.1 to the Company’s  current report on Form 8-K (Commission File No. 1-12644)  dated November 18, 2004 and filed on November 23, 2004 (the “November 2004  Form 8-K”) and incorporated herein by reference.)                                                                                                                                                                                                                    |
| 10.6A†  |   | 2004 Equity  Participation Plan, as amended on September 15, 2005. (Previously filed  as Exhibit 10.1 to Current Report on Form 8-K (Commission  File No. 1-12644) dated September 16, 2005, and incorporated  herein by reference.)                                                                                                                                                                                                                                                                                    |
| 10.6B†  |   | 2004 Equity  Participation Plan, as amended on February 16, 2006. (Previously filed  as Exhibit 10.1 to Current Report on Form 8-K (Commission  File No. 1-12644) dated February 16, 2006 (the  “February 16, 2006 8-K”), and incorporated herein by reference.)                                                                                                                                                                                                                                         |
| 10.6C†  |   | Form of Financial  Security Assurance Holdings Ltd. Agreement Evidencing an Award of Dexia  Restricted Stock. (Previously filed as  Exhibit 10.4 to the March 31, 2005 10-Q, and incorporated  herein by reference.)                                                                                                                                                                                                                                                                                                              |
| 10.6D†  |   | Form of Financial  Security Assurance Holdings Ltd. Agreement Evidencing an Award of Dexia  Restricted Stock, as amended on February 16, 2006. (Previously filed as Exhibit 10.2 to the  February 16, 2006 8-K, and incorporated herein by reference.)                                                                                                                                                                                                                                                                       |
| 10.6E†* |   | Form of Financial  Security Assurance Holdings Ltd. Agreement Evidencing an Award of Dexia  Restricted Stock, as amended on February 14, 2007.                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.6F†* |   | Amendment to Financial  Security Assurance Holdings Ltd. Agreement Evidencing an Award of Dexia  Restricted Stock to Robert P. Cochran, dated as of February 14, 2007.                                                                                                                                                                                                                                                                                                                                                                      |

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| 10.6G†  |   | 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.)                                                                                                                           |
|--------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.6H†  |   | Form of Financial  Security Assurance Holdings Ltd. Agreement Evidencing an Award of  Performance Shares, as amended on February 16, 2006. (Previously filed as Exhibit 10.3 to the  February 16, 2006 8-K, and incorporated herein by reference.)                                                                                                                                                           |
| 10.7†   |   | Financial Security  Assurance Inc. Overseas Pension Plan. (Previously filed as Exhibit 10.3  to the February 16, 2006 8-K, and incorporated herein by  reference.)                                                                                                                                                                                                                                                          |
| 10.8†   |   | 1995 Deferred  Compensation Plan (amended and restated as of December 17, 2004).  (Previously filed as Exhibit 10.2 to the December 2004 8-K,  and incorporated herein by reference.)                                                                                                                                                                                                                                  |
| 10.9†   |   | 2004 Deferred  Compensation Plan, dated December 17, 2004. (Previously filed as  Exhibit 10.1 to the December 2004 8-K, and incorporated  herein by reference.)                                                                                                                                                                                                                                                        |
| 10.9A†  |   | 2004 Deferred  Compensation Plan, as amended on May 18, 2006. (Previously filed as  Exhibit 10.2 to the May 2006 8-K, and incorporated herein by  reference.)                                                                                                                                                                                                                                                          |
| 10.10†  |   | Severance Policy for  Senior Management (amended and restated as of November 13, 2003).  (Previously filed as Exhibit 10.7 to the Company’s Annual Report on  Form 10-K (Commission File No. 1-12644) for the fiscal  year ended December 31, 2003, and incorporated herein by reference.)                                                                                                              |
| 10.10A† |   | Severance Policy for  Senior Management, as amended on May 18, 2006. (Previously filed as  Exhibit 10.3 to the May 2006 8-K, and incorporated herein by  reference.)                                                                                                                                                                                                                                                   |
| 10.11†  |   | Share Purchase Program  Agreement dated as of December 15, 2000, among Dexia Public Finance  Bank, Dexia Holdings, Inc. and the Company. (Previously filed as  Exhibit 10.9(B) to the Company’s Annual Report on Form 10-K  (Commission File No. 1-12644) for the fiscal year ended  December 31, 2000 (the “December 31, 2000 10-K”), and  incorporated herein by reference.) |
| 10.12†  |   | Employment Agreement by  and between the Company and Robert P. Cochran, as amended on  May 18, 2006. (Previously filed as Exhibit 10.4 to the  May 2006 8-K, and incorporated herein by reference.)                                                                                                                                                                                                               |
| 10.13†  |   | Employment Agreement by  and between the Company and Séan W. McCarthy, as amended on May 18,  2006. (Previously filed as Exhibit 10.5 to the May 2006 8-K,  and incorporated herein by reference.)                                                                                                                                                                                                                |
| 10.14†* |   | Financial Security  Assurance Holdings Ltd. Annual Bonus Pool Guideline.                                                                                                                                                                                                                                                                                                                                                         |
| 10.15        |   | Put Option Agreement,  dated as of June 23, 2003 by and between FSA and Sutton Capital  Trust I. (Previously filed as Exhibit 99.5 to the Company’s  Quarterly Report on Form 10-Q (Commission File No. 1-12644)  for the quarterly period ended June 30, 2003 (the “June 30, 2003 10-Q”),  and incorporated herein by reference.)                                                  |
| 10.16        |   | Put Option Agreement,  dated as of June 23, 2003 by and between FSA and Sutton Capital  Trust II. (Previously filed as Exhibit 99.6 to the June 30,  2003 10-Q, and incorporated herein by reference.)                                                                                                                                                                                                            |

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| 10.17  |   | Put Option Agreement,  dated as of June 23, 2003 by and between FSA and Sutton Capital  Trust III. (Previously filed as Exhibit 99.7 to the June 30,  2003 10-Q, and incorporated herein by reference.)                                                                                                                                                                                                                                                                                                                                                        |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.18  |   | Put Option Agreement,  dated as of June 23, 2003 by and between FSA and Sutton Capital  Trust IV. (Previously filed as Exhibit 99.8 to the June 30,  2003 10-Q, and incorporated herein by reference.)                                                                                                                                                                                                                                                                                                                                                         |
| 10.19  |   | Contribution Agreement,  dated as of November 22, 2006, between Dexia S.A. and Financial Security  Assurance Holdings Ltd. (Previously filed as Exhibit 10.4 to the  November 2006 8-K, and incorporated herein by reference.)                                                                                                                                                                                                                                                                                                                                      |
| 10.20  |   | Replacement Capital  Covenant, dated as of November 22, 2006, by Financial Security Assurance  Holdings Ltd. (Previously filed as Exhibit 10.5 to the  November 2006 8-K, and incorporated herein by reference.)                                                                                                                                                                                                                                                                                                                                                    |
| 10.21  |   | Purchase Agreement,  dated November 17, 2006, among Goldman, Sachs & Co., Lehman  Brothers Inc., JPMorgan Securities Inc., UBS Securities LLC and Wachovia  Capital Markets, LLC, as Initial Purchasers, and Financial Security Assurance  Holdings Ltd. (Previously filed as Exhibit 10.1 to the  November 2006 8-K, and incorporated herein by reference.)                                                                                                                                                                                               |
| 21*    |   | List of Subsidiaries.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 23*    |   | Consent of  PricewaterhouseCoopers LLP.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 24.1   |   | Powers of Attorney.  (Previously filed as Exhibit 24 to the Company’s Annual Report on  Form 10-K (Commission File No. 1-12644) for the fiscal  year ended December 31, 2002, 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 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, 2006 and  incorporated herein by reference.) |
| 24.2*  |   | Power of Attorney.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 31.1*  |   | Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 31.2*  |   | Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 32.1** |   | Certification pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 32.2** |   | Certification pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 99.1*  |   | Financial Security  Assurance Inc. and Subsidiaries 2006 Consolidated Financial Statements  and Report of Independent Registered Public Accounting Firm.                                                                                                                                                                                                                                                                                                                                                                                                                      |

----

*                    Filedherewith.

**             Furnished herewith.

†                    Managementcontract of compensatory plan or arrangement.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
|        | FINANCIAL SECURITY ASSURANCE  HOLDINGS LTD. |
|--------|---------------------------------------------|
|   | By:                                         | /s/ ROBERT P. COCHRAN |
|   |                                        | Name: Robert P. Cochran |
|   |                                        | Title: Chairman and Chief Executive Officer |
|   |                                        | Dated: April 2, 2007 |

 

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  |       | April 2, 2007 |
| Robert P. Cochran          |       | Director (Principal Executive Officer)  |       |               |
| /s/  SÉAN W. MCCARTHY |       | President, Chief  Operating Officer and |       | April 2, 2007 |
| Séan W. McCarthy      |       | Director                                |       |               |
| /s/ JOSEPH W. SIMON        |       | Managing Director and  Chief Financial  |       | April 2, 2007 |
| Joseph W. Simon            |       | Officer (Principal Financial Officer)   |       |               |
| /s/  LAURA A. BIELING      |       | Managing Director and  Controller       |       | April 2, 2007 |
| Laura A. Bieling           |       | (Principal Accounting Officer)          |       |               |
| /s/ MICHÈLE COLIN     |       | Director                                |       | April 2, 2007 |
| Michèle Colin         |       |                                    |       |               |
| /s/  BRUNO DELETRÉ    |       | Director                                |       | April 2, 2007 |
| Bruno Deletré         |       |                                    |       |               |
| /s/ ROBERT N. DOWNEY       |       | Director                                |       | April 2, 2007 |
| Robert N. Downey           |       |                                    |       |               |
| /s/  JACQUES GUERBER       |       | Director                                |       | April 2, 2007 |
| Jacques Guerber            |       |                                    |       |               |
| /s/ AXEL MILLER            |       | Director                                |       | April 2, 2007 |
| Axel Miller                |       |                                    |       |               |
| /s/  JAMES H. OZANNE       |       | Director                                |       | April 2, 2007 |
| James H. Ozanne            |       |                                    |       |               |
| /s/ ROGER K. TAYLOR        |       | Director                                |       | April 2, 2007 |
| Roger K. Taylor            |       |                                    |       |               |
| /s/  REMBERT VON LOWIS     |       | Director                                |       | April 2, 2007 |
| Rembert von Lowis          |       |                                    |       |               |

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| /s/ XAVIER DE WALQUE |   | Director |   | April 2, 2007 |
|----------------------|--------|----------|--------|--------------------|
| Xavier de Walque     |   |     |   |               |
| /s/ GEORGE U.  WYPER |   | Director |   | April 2, 2007 |
| George U. Wyper      |   |     |   |               |

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*                    RobertP. Cochran, by signing his name hereto, does hereby sign this Annual Report on Form 10-Kon behalf of himself and on behalf of each of the Directors and Officers of theRegistrant named above after whose typed names asterisks appear pursuant topowers of attorney duly executed by such Directors and Officers and filed withthe Securities and Exchange Commission as exhibits to this Report.
|          |     | By:      | /s/ ROBERT P. COCHRAN |
|----------|----------|----------|-----------------------|
|     |     |     | Robert P. Cochran     |
| * * | * * | * * | *Attorney  in fact*   |

 

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**Schedule IParent Company Condensed Financial Information**

**CondensedBalance Sheets(in thousands)**
|                                                                | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Assets:                                                        |       |                  |       |   |   |
| Bonds at market  value (amortized cost of $39,839 and $10,923) |       | $                     | 39,956     |   | $ | 11,158 |   |
| Short-term  investments                                        |       | 1,900                 |       | 47,140 |   |
| Cash                                                           |       | 844                   |       | 1,895 |   |
| Investment in  subsidiaries                                    |       | 3,407,902             |       | 3,158,563 |   |
| Deferred  compensation                                         |       | 114,181               |       | 107,140 |   |
| Deferred taxes                                                 |       | 1,899                 |       | 34,011 |   |
| Other assets                                                   |       | 49,370                |       | 40,836 |   |
| Total Assets                                                   |       | $                     | 3,616,052  |   | $ | 3,400,743 |   |
| Liabilities and  Shareholders’ Equity:                    |       |                  |       |   |   |
| Notes Payable                                                  |       | $                     | 730,000    |   | $ | 430,000 |   |
| Other Liabilities                                              |       | 36,960                |       | 30,293 |   |
| Deferred  compensation                                         |       | 114,181               |       | 107,140 |   |
| Taxes payable                                                  |       | 12,599                |       | 10,408 |   |
| Shareholders’  equity                                     |       | 2,722,312             |       | 2,822,902 |   |
| Total Liabilities  and Shareholders’ Equity               |       | $                     | 3,616,052  |   | $ | 3,400,743 |   |

 

**CondensedStatements of Income(in thousands)**
|                                                          | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Investment Income                                        |       | $                                          | 3,018      |   | $ | 1,266 |   | $ | 679 |   |
| Net realized gains  (losses)                             |       | (108                                       | )          | (395 | ) | 497 |   |
| Other income  (loss)                                     |       | 14,831                                     |       | 2,152 |   | 18,138 |   |
| Interest and  amortization expense                       |       | (29,096                                    | )          | (26,993 | ) | (26,993 | ) |
| Other expenses                                           |       | (20,403                                    | )          | (6,539 | ) | (18,451 | ) |
| Net unrealized  gains (losses) on derivative instruments |       | 761                                        |       | (304 | ) | 1,589 |   |
|                                                     |       | (30,997                                    | )          | (30,813 | ) | (24,541 | ) |
| Equity in income  of subsidiaries                        |       | 473,652                                    |       | 338,177 |   | 374,839 |   |
| Income before  taxes                                     |       | 442,655                                    |       | 307,364 |   | 350,298 |   |
| Income tax  (provision) benefit                          |       | (18,501                                    | )          | 18,744 |   | 28,309 |   |
| Net Income                                               |       | $                                          | 424,154    |   | $ | 326,108 |   | $ | 378,607 |   |

 

The Parent CompanyCondensed Financial Information should be read in conjunction with theConsolidated Financial Statements and Notes to Consolidated FinancialStatements included in Item 8.

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**CondensedStatements of Cash Flows(in thousands)**
|                                                       | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                 |       |                                       |       |   |   |   |   |
| Other operating expenses  paid, net                   |       | $                                          | (3,758     | ) | $ | (1,678 | ) | $ | (1,271 | ) |
| Net investment income  received                       |       | 7,520                                      |       | 6,869 |   | 8,858 |   |
| Federal income taxes  received                        |       | 1,991                                      |       | — |   | — |   |
| Interest paid                                         |       | (26,878                                    | )          | (26,993 | ) | (26,850 | ) |
| Dividend from subsidiary                              |       | 140,000                                    |       | 87,000 |   | 30,000 |   |
| Other                                                 |       | (1,057                                     | )          | (2,689 | ) | 1,489 |   |
| Net cash provided by  (used for) operating activities |       | 117,818                                    |       | 62,509 |   | 12,226 |   |
| Cash flows from investing activities:                 |       |                                       |       |   |   |   |   |
| Proceeds from sales of  bonds                         |       | 55,650                                     |       | 41,837 |   | 31,600 |   |
| Proceeds from maturities  of bonds                    |       | 2,410                                      |       | — |   | — |   |
| Purchases of bonds                                    |       | (87,098                                    | )          | (27,830 | ) | (36,103 | ) |
| Capital contribution                                  |       | (1,500                                     | )          | (5,700 | ) | (29,500 | ) |
| Return of capital from  subsidiary                    |       | —                                     |       | 48,000 |   | — |   |
| Repurchase of stock by  subsidiary                    |       | 100,000                                    |       | — |   | — |   |
| Surplus notes redeemed                                |       | —                                     |       | — |   | 44,000 |   |
| Net change in short-term  investments                 |       | 45,931                                     |       | (46,920 | ) | 465 |   |
| Net cash provided by  (used for) investing activities |       | 115,393                                    |       | 9,387 |   | 10,462 |   |
| Cash flows from financing activities:                 |       |                                       |       |   |   |   |   |
| Issuance of notes  payable                            |       | 295,788                                    |       | — |   | — |   |
| Dividends paid                                        |       | (530,050                                   | )          | (71,059 | ) | (22,876 | ) |
| Net cash provided by  (used for) financing activities |       | (234,262                                   | )          | (71,059 | ) | (22,876 | ) |
| Net (decrease) increase  in cash                      |       | (1,051                                     | )          | 837 |   | (188 | ) |
| Cash at beginning of  year                            |       | 1,895                                      |       | 1,058 |   | 1,246 |   |
| Cash at end of year                                   |       | $                                          | 844        |   | $ | 1,895 |   | $ | 1,058 |   |

 

In 2006, 2005 and 2004,the Company’s subsidiaries received a tax benefit (expense) of $(1,200), $4,624and $20,164, respectively, by utilizing the Company’s losses. These balanceswere recorded as capital contributions.

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,** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Reconciliation of net income to net cash provided by  operating activities: |       |                                       |       |   |   |   |   |
| Net income                                                                  |       | $                                          | 424,154    |   | $ | 326,108 |   | $ | 378,607 |   |
| Equity in undistributed  net income of subsidiary                           |       | (329,566                                   | )          | (245,735 | ) | (339,849 | ) |
| Decrease (increase) in  accrued investment income                           |       | (269                                       | )          | 154 |   | 1,373 |   |
| Increase (decrease) in  accrued income taxes                                |       | 2,191                                      |       | (6,676 | ) | (10,821 | ) |
| Provision (benefit) for  deferred income taxes                              |       | 20,775                                     |       | (12,166 | ) | (10,932 | ) |
| Net realized losses  (gains) on investments                                 |       | 108                                        |       | 395 |   | (497 | ) |
| Accretion of bond  discount                                                 |       | (509                                       | )          | (23 | ) | 96 |   |
| Change in other assets  and liabilities                                     |       | 934                                        |       | 452 |   | (5,751 | ) |
| Cash used for operating activities                                          |       | $                                          | 117,818    |   | $ | 62,509 |   | $ | 12,226 |   |

 

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

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

1.                 CondensedFinancial Statements

Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America have beencondensed or omitted. These condensed financial statements should be read inconjunction with the Company’s Consolidated Financial Statements and the notesthereto. Certain reclassifications have been made to conform to the currentyear presentation.

The Company previously reported ‘dividends fromsubsidiary’ as cash provided by investing activities and ‘surplus notesredeemed’ as cash provided by financing activities. In 2006, The Companyappropriately reported ‘dividends from subsidiary’ as a cash flow fromoperating activities with conforming changes to 2005 and 2004 and ‘surplusnotes redeemed’ as a cash flow from investing activities in 2004.

2.                 SignificantAccounting Policies

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

3.                 Long-TermDebt

On November 22, 2006, FSA Holdings issued $300.0million principal amount of Junior Subordinated Debentures with a scheduledmaturity date of December 15, 2036 and a final repayment date of December 5,2066. The final repayment date of December 5, 2066 may be automaticallyextended up to four times in five-year increments provided certain conditionsare met. The debentures are redeemable, in whole or in part, at any time priorto December 15, 2036 at their principal amount plus accrued and unpaidinterest to the date of redemption. Interest on the debentures will accrue fromNovember 22, 2006 to December 15, 2036 at the annual rate of 6.40%.If any amount of the debentures remains outstanding after December 15,2036, then the principal amount of the outstanding debentures will bearinterest at a floating interest rate equal to one-month LIBOR plus 2.215% untilrepaid. FSA Holdings may elect at one or more times to defer payment ofinterest on the debentures for one or more consecutive interest periods that donot exceed ten years. The proceeds from this offering were used to pay adividend to the shareholders of FSA Holdings.

On July 31, 2003, FSA Holdings 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.

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. 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.

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.

4.                 Taxes

In connection withthe Dexia group’s acquisition of the Company in July 2000, the Companybecame the successor, for tax purposes, to White Mountains Holdings, Inc.(“WMH”). WMH had previously sold an insurance subsidiary to a third party thatwas indemnified by White Mountains Insurance Group for certain future adverseloss development up to $50.0 million. In 2004, the Company made an indemnity 

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paymentof $47.0 million to the third party with funds provided for such purpose byWhite Mountains 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, theCompany has agreed to share 50% of the deferred tax benefit with WhiteMountains Insurance Group under certain circumstances but did not satisfy thestandards for recording a liability for accounting purposes as of December 31,2006.

5.                 Notes receivablefrom subsidiary

At December 31, 2006, 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. FSA Holdings employs surplus note purchases in lieu of capitalcontributions in order to allow it to withdraw funds from FSA through surplusnote payments without reducing earned surplus, thereby preserving dividendcapacity of FSA.

6.                 Legal proceedings

In the ordinary course of business, the Company andcertain Subsidiaries are parties to litigation. The Company is not a party toany material pending litigation.

On November 15, 2006, the Company received asubpoena from the Antitrust Division of the U.S. Department of Justice (“DOJ”)issued in connection with an ongoing criminal investigation of bid rigging ofawards of municipal GICs. On November 16, 2006, FSA received a subpoenafrom the Securities and Exchange Commission (“SEC”) related to an ongoingindustry-wide civil investigation of brokers of municipal GICs. The Companyissues municipal GICs through the FP Segment, but does not serve as a GICbroker. The subpoenas request that the Company furnish to the DOJ and SECrecords and other information with respect to the Company’s municipal GICbusiness. The Company is cooperating with the investigations by the DOJ andSEC.

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