**Exhibit 99.1**

**FINANCIAL SECURITYASSURANCE INC. AND SUBSIDIARIES**

Consolidated Financial Statements and Report ofIndependent Registered Public Accounting FirmDecember 31, 2005

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**FINANCIAL SECURITY ASSURANCE INC. ANDSUBSIDIARIES**

**CONSOLIDATED FINANCIAL STATEMENTSAND REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

**YEARSENDED DECEMBER 31, 2005, 2004 AND 2003**
| REPORT OF INDEPENDENT  REGISTERED PUBLIC ACCOUNTING FIRM          |   | 1      |   |
|-------------------------------------------------------------------|--------|--------|--------|
| CONSOLIDATED  FINANCIAL STATEMENTS:                               |   |   |   |
| Consolidated Balance Sheets                                       |   | 2      |   |
| Consolidated Statements of Operations and  Comprehensive Income.  |   | 3      |   |
| Consolidated Statements of Changes in Shareholder’s  Equity. |   | 4      |   |
| Consolidated Statements of Cash Flows                             |   | 5      |   |
| Notes to  Consolidated Financial Statements                       |   | 7      |   |

 

The New York State Insurance Department recognizesonly statutory accounting practices for determining and reporting the financialcondition and results of operations of an insurance company, for determiningits solvency under the New York Insurance Law, and for determining whether itsfinancial condition warrants the payment of a dividend to its stockholders. Noconsideration is given by the New York State Insurance Department to financialstatements prepared in accordance with accounting principles generally acceptedin the United States of America in making such determinations.

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**Reportof Independent Registered Public Accounting Firm**

To Board of Directors and Shareholderof Financial Security Assurance Inc.:

In our opinion, the accompanying consolidated balancesheets and the related consolidated statements of operations and comprehensiveincome, changes in shareholder’s equity, and cash flows present fairly, in allmaterial respects, the financial position of Financial SecurityAssurance Inc. and Subsidiaries (the “Company”) at December 31, 2005and 2004, and the results of their operations and their cash flows for each ofthe three years in the period ended December 31, 2005 in conformity withaccounting principles generally accepted in the United States of America. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

Asdiscussed in Note 20 to the consolidated financial statements, in 2003 theCompany changed its method of accounting for its interest in certain variableinterest entities.
| /s/ PricewaterhouseCoopers LLP |   |   |
|--------------------------------|--------|--------|
| New York, New York             |   |
| March 24, 2006            |   |

 

1

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**FINANCIAL SECURITY ASSURANCE INC. ANDSUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS(in thousands, except per share data)**
|                                                                                                                            | ** ** | **As of**              | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                 | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| **ASSETS**                                                                                                                 |       |                        |       |   |   |   |   |   |   |
| Bonds at fair value  (amortized cost of $4,208,011 and $3,838,115)                                                         |       |                        | $          | 4,370,469 |   |   |   | $ | 4,089,911 |   |   |
| Equity securities at  fair value (cost of $54,370 and $54,300)                                                             |       |                        | 54,370     |   |   |   | 54,300 |   |   |
| Short-term investments                                                                                                     |       |                        | 133,283    |   |   |   | 115,596 |   |   |
| Variable interest  entities’ bonds at fair value (amortized cost of $1,155,832 and $1,342,489)                        |       |                        | 1,155,992  |   |   |   | 1,346,355 |   |   |
| Variable interest  entities’ guaranteed investments contracts at fair value (amortized cost  approximates fair value) |       |                        | 1,021,791  |   |   |   | 961,925 |   |   |
| Variable interest  entities’ short-term investment portfolio                                                          |       |                        | 2,674      |   |   |   | 1,194 |   |   |
| Total investment  portfolio                                                                                                |       |                        | 6,738,579  |   |   |   | 6,569,281 |   |   |
| Assets acquired in refinancing transactions:                                                                               |       |                        |       |   |   |   |   |   |   |
| Bonds at fair value  (amortized cost of $5,945 and $151,895)                                                               |       |                        | 9,145      |   |   |   | 157,036 |   |   |
| Securitized loans                                                                                                          |       |                        | 296,965    |   |   |   | 369,750 |   |   |
| Other                                                                                                                      |       |                        | 161,763    |   |   |   | 222,150 |   |   |
| Total assets acquired in  refinancing transactions                                                                         |       |                        | 467,873    |   |   |   | 748,936 |   |   |
| Cash                                                                                                                       |       |                        | 10,376     |   |   |   | 10,005 |   |   |
| Deferred acquisition  costs                                                                                                |       |                        | 335,129    |   |   |   | 308,015 |   |   |
| Prepaid reinsurance  premiums                                                                                              |       |                        | 865,192    |   |   |   | 759,191 |   |   |
| Reinsurance recoverable  on unpaid losses                                                                                  |       |                        | 36,339     |   |   |   | 35,419 |   |   |
| Other assets                                                                                                               |       |                        | 1,162,562  |   |   |   | 1,125,619 |   |   |
| TOTAL ASSETS                                                                                                               |       |                        | $          | 9,616,050 |   |   |   | $ | 9,556,466 |   |   |
| **LIABILITIES  AND MINORITY INTEREST AND SHAREHOLDER’S EQUITY**                                                       |       |                        |       |   |   |   |   |   |   |
| Deferred premium revenue                                                                                                   |       |                        | $          | 2,380,600 |   |   |   | $ | 2,101,248 |   |   |
| Losses and loss  adjustment expenses                                                                                       |       |                        | 205,718    |   |   |   | 179,941 |   |   |
| Variable interest  entities’ debt                                                                                     |       |                        | 2,708,773  |   |   |   | 2,853,963 |   |   |
| Deferred federal income  taxes                                                                                             |       |                        | 238,342    |   |   |   | 253,772 |   |   |
| Notes payable to  affiliate                                                                                                |       |                        | 463,575    |   |   |   | 753,614 |   |   |
| Surplus notes                                                                                                              |       |                        | 108,850    |   |   |   | 108,850 |   |   |
| Minority interest                                                                                                          |       |                        | 254,123    |   |   |   | 300,052 |   |   |
| Accrued expenses and  other liabilities                                                                                    |       |                        | 353,643    |   |   |   | 307, 791 |   |   |
| TOTAL LIABILITIES AND  MINORITY INTEREST                                                                                   |       |                        | 6,713,624  |   |   |   | 6,859,231 |   |   |
| COMMITMENTS AND CONTINGENCIES                                                                                              |       |                        |       |   |   |   |   |   |   |
| Preferred stock (5,000.1 and 0 shares authorized; 0  shared issued and outstanding; par value of $1,000 per share)    |       |                        |       |   |   |   |   |   |   |
| Common stock (400 shares  authorized; issued and outstanding; par value of $37,500 per share)                              |       |                        | 15,000     |   |   |   | 15,000 |   |   |
| Additional paid-in  capital—common                                                                                    |       |                        | 841,828    |   |   |   | 839,077 |   |   |
| Accumulated other  comprehensive income (net of deferred income taxes of $58,198 and $88,057)                              |       |                        | 108,082    |   |   |   | 170,620 |   |   |
| Accumulated earnings                                                                                                       |       |                        | 1,937,516  |   |   |   | 1,672,538 |   |   |
| TOTAL SHAREHOLDER’S EQUITY                                                                                            |       |                        | 2,902,426  |   |   |   | 2,697,235 |   |   |
| TOTAL LIABILITIES  AND MINORITY INTEREST AND SHAREHOLDER’S EQUITY                                                     |       |                        | $          | 9,616,050 |   |   |   | $ | 9,556,466 |   |   |
|                                                                                                                            |            |                             |            |  |  |  |  |  |  |  |  |  |

 

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

2

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**FINANCIAL SECURITY ASSURANCE INC. ANDSUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME(in thousands)**
|                                                                                                                                                                               | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                                                    | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| **REVENUES:**                                                                                                                                                                 |       |                                       |       |   |   |   |   |
| Net premiums written                                                                                                                                                          |       | $                                          | 604,411    |   | $ | 602,903 |   | $ | 621,824 |   |
| Net premiums earned                                                                                                                                                           |       | $                                          | 431,059    |   | $ | 410,439 |   | $ | 363,913 |   |
| Net investment income                                                                                                                                                         |       | 199,227                                    |       | 170,942 |   | 153,071 |   |
| Net realized gains (losses)                                                                                                                                                   |       | 5,177                                      |       | (970 | ) | 5,195 |   |
| Variable interest entities’ interest income                                                                                                                              |       | 105,561                                    |       | 74,286 |   | 31,076 |   |
| Net realized and unrealized gains (losses) on  derivative instruments                                                                                                    |       | (124,851                                   | )          | 304,843 |   | 228,208 |   |
| Income from assets acquired in refinancing  transactions                                                                                                                      |       | 35,183                                     |       | 31,634 |   | 20,705 |   |
| Net realized gains from assets acquired in  refinancing transactions                                                                                                          |       | 6,508                                      |       | — |   | — |   |
| Other income                                                                                                                                                                  |       | 13,463                                     |       | 6,365 |   | 1,235 |   |
| TOTAL REVENUES                                                                                                                                                                |       | 671,327                                    |       | 997,539 |   | 803,403 |   |
| **EXPENSES:**                                                                                                                                                                 |       |                                       |       |   |   |   |   |
| Losses and loss adjustment expenses                                                                                                                                           |       | 25,365                                     |       | 20,599 |   | 34,486 |   |
| Interest expense                                                                                                                                                              |       | 33,608                                     |       | 31,499 |   | 30,036 |   |
| Variable interest entities’ interest expense                                                                                                                             |       | 124,219                                    |       | 126,793 |   | 58,595 |   |
| Policy acquisition costs                                                                                                                                                      |       | 68,340                                     |       | 62,201 |   | 58,391 |   |
| Variable interest entities’ foreign exchange (gain)  loss                                                                                                                |       | (162,398                                   | )          | 79,270 |   | 118,269 |   |
| Other operating expenses                                                                                                                                                      |       | 74,212                                     |       | 69,835 |   | 49,668 |   |
| TOTAL EXPENSES                                                                                                                                                                |       | 163,346                                    |       | 390,197 |   | 349,445 |   |
| INCOME BEFORE  INCOME TAXES, MINORITY INTEREST, EQUITY IN EARNINGS OF UNCONSOLIDATED  AFFILIATES, AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE                             |       | 507,981                                    |       | 607,342 |   | 453,958 |   |
| Provision for income  taxes:                                                                                                                                                  |       |                                       |       |   |   |   |   |
| Current                                                                                                                                                                       |       | 128,611                                    |       | 62,489 |   | 83,044 |   |
| Deferred                                                                                                                                                                      |       | 14,412                                     |       | 60,929 |   | 19,032 |   |
| Total provision                                                                                                                                                               |       | 143,023                                    |       | 123,418 |   | 102,076 |   |
| NET INCOME BEFORE  MINORITY INTEREST, EQUITY IN EARNINGS OF UNCONSOLIDATED AFFILIATES, AND  CUMULATIVE EFFECT OF ACCOUNTING CHANGE                                            |       | 364,958                                    |       | 483,924 |   | 351,882 |   |
| Minority interest                                                                                                                                                             |       | (12,980                                    | )          | (120,397 | ) | (52,153 | ) |
| Equity in  earnings of unconsolidated affiliates                                                                                                                              |       | —                                     |       | 3,761 |   | 19,077 |   |
| Cumulative effect  of accounting change, net of income taxes of $2,598                                                                                                   |       | —                                     |       | — |   | 4,800 |   |
| NET INCOME                                                                                                                                                                    |       | 351,978                                    |       | 367,288 |   | 323,606 |   |
| OTHER COMPREHENSIVE INCOME  (LOSS), NET OF TAX:                                                                                                                               |       |                                       |       |   |   |   |   |
| Unrealized gains (losses) arising during period [net  of deferred income tax provision (benefit) of $(36,635), $5,676 and $12,329]                                            |       | (49,954                                    | )          | 11,968 |   | 18,929 |   |
| Less: reclassification adjustment for gains (losses)  included in net income [net of deferred income tax provision (benefit) of  $6,776, $(542) and $1,389]    |       | 12,584                                     |       | (428 | ) | 3,965 |   |
| Other comprehensive income (loss)                                                                                                                                             |       | (62,538                                    | )          | 12,396 |   | 14,964 |   |
| COMPREHENSIVE INCOME                                                                                                                                                          |       | $                                          | 289,440    |   | $ | 379,684 |   | $ | 338,570 |   |

 

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

3

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**FINANCIAL SECURITYASSURANCE INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDER’S EQUITY**

**(inthousands)**

| ** **                                                                                                | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital-  Common** | ** ** | **Unrealized  Gain on  Investments** | ** ** | **Accumulated  Earnings** | ** ** | **Total** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|---------------------------|------------|-----------|------------|
| BALANCE, December 31, 2002                                                                           |       | $                 | 15,000     |                                      | $          | 813,002                                   |       |                      | $          | 143,260   |       |   | $ | 1,011,644 |   | $ | 1,982,906 |   |
| Net income for the year                                                                                   |       |              |       |                                      |       |                                      |       |                      |       | 323,606   |       | 323,606 |   |
| Net change in accumulated other comprehensive income  (net of deferred income tax expense of $10,940)     |       |              |       |                                      |       |                                      | 14,964     |                      |       |      |       | 14,964 |   |
| Capital contribution from Parent                                                                          |       |              |       | 10,521                                    |       |                                      |       |                      |       |      |       | 10,521 |   |
| Capital issuance costs                                                                                    |       |              |       | (3,605                                    | )          |                                      |       |                      |       |      |       | (3,605 | ) |
| BALANCE, December 31, 2003                                                                           |       | 15,000            |       | 819,918                                   |       |                                      | 158,224    |                      |       | 1,335,250 |       | 2,328,392 |   |
| Net income for the year                                                                                   |       |              |       |                                      |       |                                      |       |                      |       | 367,288   |       | 367,288 |   |
| Net change in accumulated other comprehensive income  (net of deferred income tax expense of $6,218)      |       |              |       |                                      |       |                                      | 12,396     |                      |       |      |       | 12,396 |   |
| Dividends paid                                                                                            |       |              |       |                                      |       |                                      |       |                      |       | (30,000   | )          | (30,000 | ) |
| Capital contribution from Parent                                                                          |       |              |       | 20,419                                    |       |                                      |       |                      |       |      |       | 20,419 |   |
| Capital issuance costs                                                                                    |       |              |       | (1,260                                    | )          |                                      |       |                      |       |      |       | (1,260 | ) |
| BALANCE, December 31, 2004                                                                           |       | 15,000            |       | 839,077                                   |       |                                      | 170,620    |                      |       | 1,672,538 |       | 2,697,235 |   |
| Net income for the year                                                                                   |       |              |       |                                      |       |                                      |       |                      |       | 351,978   |       | 351,978 |   |
| Net change in accumulated other comprehensive income  (net of deferred income tax (benefit) of $(29,859)) |       |              |       |                                      |       |                                      | (62,538    | )                         |       |      |       | (62,538 | ) |
| Dividends paid                                                                                            |       |              |       |                                      |       |                                      |       |                      |       | (87,000   | )          | (87,000 | ) |
| Capital contributions                                                                                     |       |              |       | 4,094                                     |       |                                      |       |                      |       |      |       | 4,094 |   |
| Capital issuance costs                                                                                    |       |              |       | (1,343                                    | )          |                                      |       |                      |       |      |       | (1,343 | ) |
| BALANCE,  December 31, 2005                                                                          |       | $                 | 15,000     |                                      | $          | 841,828                                   |       |                      | $          | 108,082   |       |   | $ | 1,937,516 |   | $ | 2,902,426 |   |

**Theaccompanying Notes to Consolidated Financial Statements are an integral part ofthese statements.**

4

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** **

**FINANCIAL SECURITYASSURANCE INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(inthousands)**

| ** **                                                               | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                               | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash flows from  operating activities:                                   |       |                                        |       |   |   |   |   |
| Premiums received, net                                                   |       | $                                           | 621,877    |   | $ | 588,341 |   | $ | 599,000 |   |
| Policy  acquisition and other operating expenses paid, net               |       | (165,833                                    | )          | (134,067 | ) | (99,321 | ) |
| Recoverable  advances recovered (paid)                                   |       | (362                                        | )          | 7,327 |   | (959 | ) |
| Losses and loss  adjustment expenses paid                                |       | (1,124                                      | )          | (42,936 | ) | (5,972 | ) |
| Net investment  income received                                          |       | 200,623                                     |       | 170,958 |   | 143,615 |   |
| Variable interest  entities’ net investment income received         |       | 40,599                                      |       | 30,189 |   | 13,964 |   |
| Variable interest  entities’ interest paid                          |       | (6,739                                      | )          | (3,216 | ) | (3,585 | ) |
| Variable interest  entities’ net derivative payments                |       | (25,655                                     | )          | (18,986 | ) | (8,808 | ) |
| Federal income  taxes paid                                               |       | (114,066                                    | )          | (61,863 | ) | (77,815 | ) |
| Interest paid                                                            |       | (33,748                                     | )          | (32,765 | ) | (29,380 | ) |
| Income received  from refinanced assets                                  |       | 37,359                                      |       | 28,485 |   | 25,617 |   |
| Other, net                                                               |       | (4,344                                      | )          | 5,030 |   | 17,257 |   |
| Net cash provided by  operating activities                               |       | 548,587                                     |       | 536,497 |   | 573,613 |   |
| Cash flows from  investing activities:                                   |       |                                        |       |   |   |   |   |
| Proceeds from sales and  maturities of bonds (see  Note 3)               |       | 1,846,654                                   |       | 1,423,549 |   | 1,536,735 |   |
| Purchases of bonds                                                       |       | (2,189,640                                  | )          | (1,882,243 | ) | (2,116,828 | ) |
| Purchases of property  and equipment                                     |       | (32,354                                     | )          | (5,130 | ) | (477 | ) |
| Net decrease (increase)  in short-term investments                       |       | (17,687                                     | )          | (23,955 | ) | 84,496 |   |
| Purchases of variable  interest entities’ bonds                     |       | (309,674                                    | )          | (144,639 | ) | (146,239 | ) |
| Maturity of variable  interest entities’ bonds                      |       | 292,150                                     |       | 213,825 |   | — |   |
| Net decrease in variable  interest entities’ short-term investments |       | (1,479                                      | )          | 9,908 |   | 13,048 |   |
| Assets acquired in  refinancing transactions                             |       | —                                      |       | (378,672 | ) | (53,625 | ) |
| Paydowns of assets  acquired in refinancing transactions                 |       | 92,514                                      |       | 102,534 |   | 51,395 |   |
| Proceeds from sales of  assets acquired in refinancing transactions      |       | 182,701                                     |       | 60,953 |   | — |   |
| Other investments                                                        |       | 2,127                                       |       | 14,305 |   | 4,643 |   |
| Net cash used in  investing activities                                   |       | (134,688                                    | )          | (609,565 | ) | (626,852 | ) |
| Cash flows from  financing activities:                                   |       |                                        |       |   |   |   |   |
| Distribution to minority  shareholder                                    |       | (55,443                                     | )          | (6,980 | ) | (3,290 | ) |
| Surplus notes repaid                                                     |       | —                                      |       | (44,000 | ) | (60,000 | ) |
| Proceeds from issuance  of variable interest entities’ debt         |       | 206,674                                     |       | 102,139 |   | 101,189 |   |
| Issuance of notes  payable                                               |       | —                                      |       | 378,672 |   | 53,625 |   |
| Repayment of notes  payable                                              |       | (287,186                                    | )          | (130,157 | ) | (50,600 | ) |
| Capital issuance costs                                                   |       | (1,343                                      | )          | (1,260 | ) | (3,605 | ) |
| Dividends paid                                                           |       | (87,000                                     | )          | (30,000 | ) | — |   |
| Repayment of variable  interest entities’ preferred stock           |       | —                                      |       | (6,300 | ) | — |   |
| Repayment of variable  interest entities’ debt                      |       | (189,230                                    | )          | (190,681 | ) | — |   |
| Net cash (used in)  provided by financing activities                     |       | (413,528                                    | )          | 71,433 |   | 37,319 |   |
| Net increase (decrease)  in cash                                         |       | 371                                         |       | (1,635 | ) | (15,920 | ) |
| Cash at beginning of  year                                               |       | 10,005                                      |       | 11,640 |   | 27,560 |   |
| Cash at end of year                                                      |       | $                                           | 10,376     |   | $ | 10,005 |   | $ | 11,640 |   |

The accompanyingNotes to Consolidated Financial Statements are an integral part of thesestatements.

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**FINANCIAL SECURITYASSURANCE INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED**

**(inthousands)**

| ** **                                                                 | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Reconciliation of net  income to net cash flows from operating activities: |       |                                        |       |   |   |   |   |
| Net income                                                                 |       | $                                           | 351,978    |   | $ | 367,288 |   | $ | 323,606 |   |
| Increase in accrued investment income                                      |       | (2,471                                      | )          | (4,281 | ) | (9,904 | ) |
| Increase in deferred premium revenue net of prepaid  reinsurance premiums  |       | 173,351                                     |       | 192,464 |   | 259,072 |   |
| Increase in deferred acquisition costs                                     |       | (27,114                                     | )          | (34,369 | ) | (19,869 | ) |
| (Decrease) Increase in current federal income taxes  payable               |       | 13,581                                      |       | (3,113 | ) | 12,756 |   |
| Increase (decrease) in unpaid losses and loss  adjustment expenses         |       | 24,857                                      |       | (29,651 | ) | 28,736 |   |
| Decrease in amounts withheld for others                                    |       | —                                      |       | — |   | (18 | ) |
| Provision (benefit) for deferred income taxes                              |       | 14,412                                      |       | 60,929 |   | 21,630 |   |
| Net realized (gains) losses on investments                                 |       | (11,685                                     | )          | 970 |   | (5,195 | ) |
| Depreciation and accretion of discount                                     |       | 7,905                                       |       | 9,550 |   | 3,899 |   |
| Minority interest and equity in earnings of  unconsolidated subsidiaries   |       | 12,980                                      |       | 116,636 |   | 33,076 |   |
| Change in other assets and liabilities                                     |       | (9,207                                      | )          | (139,926 | ) | (74,176 | ) |
| Cash provided by  operating activities                                     |       | $                                           | 548,587    |   | $ | 536,497 |   | $ | 573,613 |   |

 

On July 1, 2003, the Company consolidated$2.9 billion in assets and $2.9 billion in liabilities relating tovariable interest entities with no corresponding cash movement.

In 2005, 2004 and 2003,the Company received a tax benefit of $4.1 million, $20.4 million and$10.5 million, respectively, by utilizing its Parent’s losses. Theseamounts were recorded as a capital contribution.

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

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**FINANCIAL SECURITYASSURANCE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**FOR THE YEARS ENDEDDECEMBER 31, 2005, 2004 AND 2003**

**1.**   ORGANIZATION ANDOWNERSHIP

Financial Security Assurance Inc. (“FSA” or, withits consolidated entities, the “Company”), a wholly owned subsidiary ofFinancial Security Assurance Holdings Ltd. (the “Parent”), is a New Yorkinsurance company. The Company is engaged in providing financial guarantyinsurance on municipal and asset-backed obligations. The Company’s underwritingpolicy is to insure municipal and asset-backed obligations that it determineswould be of investment-grade quality without the benefit of the Company’sinsurance. The municipal obligations insured by the Company consist primarilyof general obligation bonds that are supported by the issuers’ taxing powersand of special revenue bonds and other special obligations of states and localgovernments that are supported by the issuers’ abilities to impose and collectfees and charges for public services or specific projects. Municipalobligations include obligations backed by the cash flow from leases or otherrevenues from projects serving a substantial public purpose, includinggovernment office buildings, toll roads, healthcare facilities and utilities.The asset-backed obligations insured by the Company are generally issued instructured transactions and are backed by pools of assets, such as residentialmortgage loans, consumer receivables, securities or other assets having anascertainable cash flow or market value. The Company also insures syntheticasset-backed obligations that generally take the form of credit default swap (“CDS”)obligations or credit-linked notes that reference pools of securities or loans,with a defined deductible to cover credit risks associated with the referencedsecurities or loans. Financial guaranty insurance written by the Companyguarantees scheduled payments on an issuer’s obligation. In the case of apayment default on an insured obligation, the Company is generally required topay the principal, interest or other amounts due in accordance with theobligation’s original payment schedule or, at its option, to pay such amountson an accelerated basis. In addition, the Company insures guaranteed investmentcontracts (“GICs”) issued by FSA Capital Management Services LLC (“FSACM”), FSACapital Markets Services (Caymans) Ltd. and, prior to April 2003, FSACapital Markets Services LLC (collectively, the “GIC Affiliates”), affiliatesof the Company.

The Company expects to continue to emphasize adiversified insured portfolio characterized by insurance of both municipal andasset-backed obligations, with a broad geographic distribution and a variety ofrevenue sources and transaction structures. The Company’s insured portfolioconsists primarily of municipal and asset-backed obligations originated in theUnited States of America, but the Company has also written and continues topursue business in Europe and the Asia Pacific region.

The Company consolidates the results of certainvariable interest entities (“VIEs”), including FSA Global Funding Limited (“FSAGlobal”), Premier International Funding Co. (“Premier”) and Canadian GlobalFunding Corporation (“Canadian Global”). The Company consolidated FSA Globaland Canadian Global beginning in the third quarter of 2003 in accordance withFinancial Accounting Standards Board Interpretation No. 46, “Consolidationof Variable Interest Entities, an interpretation of ARB No. 51” (“FIN 46”).The Company also began to consolidate Premier in the third quarter of 2003 as aresult of obtaining control rights. The Company refinanced certain defaultedtransactions by employing refinancing vehicles to raise funds for therefinancings. These refinancing vehicles are also consolidated.

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

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

On July 5, 2000, theParent completed a merger in which the Parent became a direct subsidiary of DexiaHoldings, Inc. (“Dexia Holdings”) which, in turn, is owned 90% by DexiaCrédit Local S.A. (“Dexia Crédit Local”) and 10% by Dexia S.A. (“Dexia”), aBelgiun corporation whose shares are traded on the Euronext Brussels andEuronext Paris markets as well as on the Luxembourg Stock Exchange.

**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 differ in certain material respects from the accounting practicesprescribed or permitted by insurance regulatory authorities (see Note 5).The preparation of financial statements in conformity with GAAP requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities in the Company’s consolidated balance sheets at December 31,2005 and 2004, the reported amounts of revenues and expenses in the statementsof operations and comprehensive income during the years ended December 31,2005, 2004 and 2003 and disclosure of contingent assets and liabilities. Suchestimates and assumptions include, but are not limited to, losses and lossadjustment expenses, fair value of financial instruments and the deferral andamortization of policy acquisition costs. Actual results may differ from thoseestimates. Significant accounting policies under GAAP are as follows:

***Basis of Presentation***

The Consolidated FinancialStatements include the accounts of the Company and its direct and indirectsubsidiaries, principally including FSA Insurance Company, Financial SecurityAssurance International Ltd. (“FSA International”), and Financial SecurityAssurance (U.K.) Limited (collectively, the “Subsidiaries”). The ConsolidatedFinancial Statements also include the accounts of certain VIEs as described inNote 1. All intercompany accounts and transactions have been eliminated.Certain prior-year balances have been reclassified to conform to the currentyear presentation.

***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.

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 prepayment risk maybe significant, assumptions regarding prepayments are evaluated periodicallyand revised as necessary. Any adjustments required due to the resulting changein effective yields are recognized in current income. Short-term investments,which are those investments with a maturity of less than one year at time ofpurchase, are carried at cost, which approximates fair value. Cash equivalentsare amounts deposited in money market funds and investments with a maturity attime of purchase of three months or less and are included in short-terminvestments. Mortgage loans are carried at the lower of cost or market on anaggregate basis. Realized gains or losses on sale of investments are determinedon the basis of specific identification. Investment income is recorded asearned. Other-than-temporary impairments are reflected in earnings as arealized loss.

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Investments inunconsolidated affiliates were based on the equity method of accounting (seeNote 16). The Company records its share of unrealized gains or losses ofthe unconsolidated affiliates, net of applicable deferred taxes, in othercomprehensive income.

***Derivatives***

The Company enters into derivative contracts to manageinterest rate and foreign currency exposure of the VIE debt and VIE bondportfolio. The derivatives are recorded at fair value. These derivativesgenerally include interest-rate and currency swap agreements, which are primarilyutilized to convert the Company’s fixed-rate obligations and investments on itsVIE debt and VIE bond portfolio into U.S. dollar floating-rate obligations. Thegains and losses relating to the fair-value of derivatives are included in netrealized and unrealized gains (losses) on derivative instruments in theconsolidated statements of operations and comprehensive income.

The gains and losses related to derivatives designatedas fair-value hedges are included in net interest income from variable interestentities and net interest expense from variable interest entities, asappropriate, along with the offsetting change in the fair value of the riskbeing hedged.

The Company has alsoinsured a number of CDS agreements that it intends, in each case, to hold forthe full term of the agreement. It considers these agreements to be a normalextension of its financial guaranty insurance business, although they areconsidered derivatives for accounting purposes. These agreements are recordedat fair value. The Company believes that the most meaningful presentation ofthe financial statement impact of these derivatives is to reflect premiums asinstallments are received, to record losses and loss adjustment expenses asincurred and to record changes in fair value as incurred. Changes in fair valueare recorded in net realized and unrealized gains (losses) on derivativeinstruments and in other assets or other liabilities, as appropriate. TheCompany uses quoted market prices, when available, to determine fair value. Ifquoted prices are not available, management uses internally developed estimatesof fair value. Due to a lack of a quoted market for the CDS obligations writtenby the Company, estimates generated from the Company’s valuation process maydiffer materially from values that may be realized in market transactions.

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

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installmentbasis and certain default triggers have been breached, the Company ceases toearn premiums on such transactions.

***Losses and Loss Adjustment Expenses***

*Background*

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

The financial guarantyindustry has emerged over the past thirty-four years. Management believes thatexisting insurance accounting under Statement of Financial Accounting StandardsNo. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”),does not specifically address financial guaranty insurance. Accordingly, theaccounting for loss and loss adjustment expenses within the financial guarantyinsurance industry has developed based on analogy to the most directlycomparable elements of existing literature, including sections of SFAS 60,Statement of Financial Accounting Standards No. 5, “Accounting forContingencies” (“SFAS 5”) and Emerging Issues Task Force Issue 85-20, “Recognitionof fees for guaranteeing a loan” (“EITF 85-20”).

*Company-specificpolicy*

The Company establishes loss liabilities based on itsestimate of specific and non-specific losses. The Company also establishesliabilities for loss adjustment expenses (“LAE”), consisting of the estimatedcost of settling claims, including legal and other fees and expenses associatedwith administering the claims process.

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

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

The Company establishes a case reserve for the presentvalue of the estimated loss, net of subrogation recoveries, when, in management’sopinion, the likelihood of a future loss on a particular insured obligation isprobable and reasonably estimable at the balance sheet date. When an insuredobligation has met the criteria for establishing a case reserve and thattransaction pays a premium in installments, those premiums, if expected to bereceived prospectively, are considered a form of recovery and are no longerearned as premium revenue. A case reserve is determined using cash flow orsimilar models that represent the Company’s estimate of the net present valueof the anticipated shortfall between (1) scheduled 

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payments on the insuredobligation plus anticipated loss adjustment expenses and (2) anticipatedcash flow from and proceeds to be received on sales of any collateralsupporting the obligation and other anticipated recoveries. The estimated loss,net of recovery, on a transaction is discounted using the risk-free rateappropriate for the term of the insured obligation at the time the reserve isestablished and is not subsequently adjusted.

The Company records a non-specific reserve to reflectthe credit risks inherent in its portfolio. The non-specific and case reserves,together represent the Company’s estimate of total reserves. Generally, when aninsured credit deteriorates to a point where claims are expected, a casereserve is established. The establishment of a non-specific reserve for creditsthat have not yet defaulted is a common practice in the financial guarantyindustry, although there are differences in the specific methodologies appliedby other financial guarantors in establishing and measuring these reserves.

The Company establishes a non-specific reserve on itsportfolio of credits because management believes that a portfolio of insuredobligations will deteriorate over its life and that the existence of inherentloss can be proven statistically by data such as rating agency publications.The establishment of the reserve is a systematic process that considers thisquantitative, statistical information obtained primarily from Moody’s InvestorsService, Inc. (“Moody’s”) and Standard & Poor’s Ratings Services(“S&P”), together with qualitative factors such as overall credit qualitytrends resulting from economic and political conditions, recent loss experiencein particular segments of the portfolio and changes in underwriting policiesand procedures. The factors used to establish reserves are evaluatedperiodically by comparing the statistically computed loss amount with theincurred losses as represented by case reserve activity to develop anexperience factor, that is updated and applied to current-year originations.The process results in management’s best estimate of inherent losses associatedwith providing credit protection at each balance sheet date.

The non-specific reserve established considers alllevels 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 “statistical calculation”).The discount rate does not change and is used to accrete the loss for the lifeof each policy. The loss factors used for the calculation are the product ofdefault frequency rates obtained from Moody’s and severity factors obtainedfrom S&P. Moody’s is chosen for default frequency rates due to itscredibility, large population, statistical format and reliability of futureupdate. The Moody’s default information is applied to all credit sectors orasset classes as described below. In its publication of default rates from 1970-2004,Moody’s tracks bonds over a twenty year horizon by credit rating at time ofissuance. For the purpose of establishing appropriate severity factors, theCompany’s methodology segregates the portfolio into asset classes, includinghealth care transactions, all other municipal transactions, pooled corporatetransactions, commercial real estate, and all other asset-backed transactions.The severity factors are derived from capital charge assessments provided byS&P. S&P capital charges project loss levels by asset class and areincorporated into their capital adequacy stress scenario analysis.

The product of the current-year statisticalcalculation multiplied by the current-year experience factor represents thepresent value of loss amounts calculated for current-year originations. Theexperience factor is based on the Company’s inception-to-date historical losses(starting from 1993, when the Company established the non-specific reservemethodology). The experience factor is calculated by dividing cumulativeinception-to-date actual losses incurred by the Company by the cumulativeinception-to-date losses determined by the statistical calculation. Theexperience factor that applies to the whole portfolio is reviewed, and, whereappropriate, updated periodically, but no less than annually.

The present value of loss amounts calculated for thecurrent-year originations is established at inception of the policy and thereis no subsequent change unless significant adverse or favorable loss 

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experience is observed. Inthe event that the experience factor is either increased or decreased based onadverse or favorable loss experience, an analysis is performed of thenon-specific reserve balance with particular emphasis on the asset class, ifany, driving the experience factor adjustment. The objective of such analysisis to quantify the appropriate adjustment to the overall non-specific reserve balancefor the change in experience. The adjustment that increases or decreases thenon-specific reserve is charged or credited to loss expense.

The present value of loss amounts calculated for thecurrent-year originations plus an amount representing the accretion of discountpertaining to prior-year originations are charged to loss expense and increasethe non-specific loss reserve after adjustments that may be made to reflectobserved favorable or adverse experience. The entire non-specific reserve is availableto absorb probable losses inherent in the portfolio. As there are no specificlosses provided in the non-specific reserve, there is no identifiablereinsurance recoverable. At the time that a case reserve is identified, thegross loss liability is recognized along with the reinsurance recoverable, ifany. The amount of reinsurance recoverable depends on the policy ceded and thereinsurance agreements covering such policy. Management cannot predict thespecific policies that will emerge as case-basis losses from the portfolio andis not entitled to recovery from the reinsurer in advance of producing a casereserve.

Since the non-specific reserve contains the inherentlosses of the portfolio, when a case reserve adjustment is deemed appropriate,whether the result of adverse or positive credit developments, accretion or theaddition of a new case reserve, a full transfer is made between thenon-specific reserve and the case reserve balances with no effect to income.The adequacy of the non-specific reserve balance is reviewed periodically andat least annually based on a review of the Company’s inception-to-datecumulative losses divided by the total inception-to-date cumulative net parunderwritten. This inception-to-date result is compared with the product of thenon-specific reserves divided by the net par outstanding as of the balancesheet date. In the event that such ratios are not in line, then furtheranalysis is performed to quantify appropriate adjustments that may be eithercharges or benefits on the statements of operations and comprehensive income,as occurred in 2003, 2004 and 2005.

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

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

 

*ReservingMethodology Industry Practice*

Management is aware that there are differencesregarding the method of defining and measuring both case reserves andnon-specific reserves among participants in the financial guaranty industry.Other financial guarantors may establish case reserves only after a default anduse different techniques to estimate probable loss. Other financial guarantorsmay establish the equivalent of non-specific reserves, but refer to thesereserves by various terms such as, but not limited to, “unallocated losses,” “activecredit reserves” and “portfolio reserves,” or may use different statisticaltechniques from those the Company uses to determine loss at a given point intime.

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 does notfall clearly within the definition 

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of either short-durationor long-duration contracts. Therefore, the Company does not believe that SFAS60 alone provides sufficient guidance for financial guaranty claim liabilityrecognition.

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

In January and February of 2005, theSecurities and Exchange Commission (“SEC”) staff discussed with financialguaranty industry participants, differences in loss recognition practices amongthose participants. Based on discussions with the SEC staff, the Companyunderstands that the Financial Accounting Standards Board (“FASB”) staff isconsidering additional guidance regarding financial guaranty insurance. Whenand if the FASB or SEC reach a conclusion on this issue, the Company and therest of the financial guaranty industry may be required to change some aspectsof their loss reserving policies, and the potential changes could extend topremium and expense recognition. The Company cannot predict how the FASB or SECwill resolve this issue and the resulting impact on its financial statements.

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

***Deferred Acquisition Costs***

Deferred acquisition costsare comprised of expenses 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.

***VIE Debt***

VIE debt is recorded atamortized cost. The Company may enter into associated transactions in order toreduce the Company’s exposure to fluctuations in interest and foreign currencyrates and its related effect on the fair value of the debt. The change in thefair value of the hedged item in a qualifying accounting hedge attributable tothe hedged risk adjusts the carrying amount of the hedged item and isrecognized in income currently. VIE debt may include hybrid debt instrumentsthat contain embedded derivatives. Under certain conditions, embeddedderivatives are required to be separated from the debt instrument and accountedfor at fair value, with all changes 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 are translatedat historical rates. Revenues and expenses denominated in foreign currencies aretranslated at average rates prevailing during the year. 

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Unrealizedgains and losses on available-for-sale securities, net of deferred taxes,resulting from translating investments denominated in foreign currencies arerecorded in shareholders’ equity. Gains and losses from transactions in foreigncurrencies are recorded in income.

***Federal Income Taxes***

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

Non-interest-bearing taxand 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.

***Assets Acquired in Refinancing Transactions***

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

**3.   INVESTMENTS**

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

Consolidatednet investment income, excluding income attributable to the variable interestentities’ bond and short term portfolio (the “VIE portfolio”), consisted of thefollowing (in thousands):

| ** **                        | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Bonds and  short-term investments |       | $                                           | 193,347    |   | $ | 173,849 |   | $ | 155,963 |   |
| Equity  investments               |       | 8,931                                       |       | — |   | — |   |
| Investment  expenses              |       | (3,051                                      | )          | (2,907 | ) | (2,892 | ) |
| Net investment income             |       | $                                           | 199,227    |   | $ | 170,942 |   | $ | 153,071 |   |

 

Thecredit quality of bonds, excluding the VIE portfolio, at December 31, 2005was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of  Bonds** | ** ** |
|---------------|------------|------------|------------|----------------------------|------------|
| AAA           |       |       | 78.4       | %                          |       |
| AA            |       |       | 17.6       |                       |       |
| A** **   |       |       | 4.0        |                       |       |
|          |       |       | 100.0      | %                          |       |

 

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

Of the bonds included in the investment portfolio,excluding the VIE portfolio, 6.9% were Triple-A by virtue of insurance providedby FSA (“FSA-Insured Investments”). Over 95% of the FSA-Insured Investments wereinvestment grade without giving effect to the FSA insurance. The average shadowrating, which is the rating without giving effect to the FSA guaranty, of theFSA-Insured Investments was the Double-A range.

 

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Theamortized cost and fair value of the investment portfolio, excluding the VIEportfolio, were as follows (in thousands):

| **December 31, 2005**                  | ** ** | ** ** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|--------------------------------------------------|------------|------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------|------------|
| U.S. Treasury  securities and obligations of     |       |       |       |                |       |                         |       |                          |       |                |       |   |   |
| U.S. government  corporations and agencies       |       | $          | 189,368    |                |       | $                            | 3,554      |                          |       |                | $          | (748 | ) |   | $ | 192,174 |   |
| Obligations of states and political subdivisions |       | 3,431,046  |       |                | 173,279    |                         |       |                          | (5,457     | )                   |       | 3,598,868 |   |
| Foreign                                          |       | 116,217    |       |                | 1,260      |                         |       |                          | (5,191     | )                   |       | 112,286 |   |
| Mortgage-backed securities                       |       | 245,783    |       |                | 807        |                         |       |                          | (4,487     | )                   |       | 242,103 |   |
| Corporate securities                             |       | 185,381    |       |                | 1,797      |                         |       |                          | (2,114     | )                   |       | 185,064 |   |
| Asset-backed securities                          |       | 40,216     |       |                | 10         |                         |       |                          | (252       | )                   |       | 39,974 |   |
| Subtotal                                         |       | 4,208,011  |       |                | 180,707    |                         |       |                          | (18,249    | )                   |       | 4,370,469 |   |
| Short-term investments                           |       | 133,283    |       |                | —     |                         |       |                          | —     |                |       | 133,283 |   |
| Total                                            |       | $          | 4,341,294  |                |       | $                            | 180,707    |                          |       |                | $          | (18,249 | ) |   | $ | 4,503,752 |   |

 

| **December 31, 2004**                  | ** ** | ** ** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|--------------------------------------------------|------------|------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------|------------|
| U.S. Treasury  securities and obligations of     |       |       |       |                |       |                         |       |                          |       |                |       |   |   |
| U.S. government  corporations and agencies       |       | $          | 143,915    |                |       | $                            | 4,984      |                          |       |                | $          | (347 | ) |   | $ | 148,552 |   |
| Obligations of states and political subdivisions |       | 3,058,967  |       |                | 220,875    |                         |       |                          | (1,987     | )                   |       | 3,277,855 |   |
| Foreign                                          |       | 126,099    |       |                | 19,895     |                         |       |                          | (714       | )                   |       | 145,280 |   |
| Mortgage-backed securities                       |       | 219,834    |       |                | 3,619      |                         |       |                          | (1,322     | )                   |       | 222,131 |   |
| Corporate securities                             |       | 232,457    |       |                | 7,056      |                         |       |                          | (504       | )                   |       | 239,009 |   |
| Asset-backed securities                          |       | 56,843     |       |                | 312        |                         |       |                          | (71        | )                   |       | 57,084 |   |
| Subtotal                                         |       | 3,838,115  |       |                | 256,741    |                         |       |                          | (4,945     | )                   |       | 4,089,911 |   |
| Short-term investments                           |       | 115,596    |       |                | —     |                         |       |                          | —     |                |       | 115,596 |   |
| Total                                            |       | $          | 3,953,711  |                |       | $                            | 256,741    |                          |       |                | $          | (4,945 | ) |   | $ | 4,205,507 |   |

 

The following table shows the gross unrealized lossesand fair value, aggregated by investment category and length of time thatindividual securities, excluding the VIE portfolio, have been in a continuousunrealized loss position, at December 31, 2005 (in thousands):

| ** **                                                                             | ** ** | **As of December 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Less than 12 months**          | ** ** | **12 months or more** | ** ** | **Total** | ** ** |
| ** **                                                                             | ** ** | **Fair  Value**                                 | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
| U.S. Treasury securities  and obligations of U.S. government corporations and agencies |       | $                                               | 65,026     |   |   | $ | (429 | ) |   | $ | 14,635 |   |   | $ | (319 | ) |   | $ | 79,661 |   |   | $ | (748 | ) |   |
| Obligations of states and  political subdivisions                                      |       | 375,766                                         |       |   | (3,609 | ) |   | 108,031 |   |   | (1,848 | ) |   | 483,797 |   |   | (5,457 | ) |   |
| Mortgage-backed securities                                                             |       | 137,833                                         |       |   | (2,195 | ) |   | 48,060 |   |   | (2,292 | ) |   | 185,893 |   |   | (4,487 | ) |   |
| Corporate securities                                                                   |       | 102,576                                         |       |   | (1,482 | ) |   | 23,650 |   |   | (632 | ) |   | 126,226 |   |   | (2,114 | ) |   |
| Foreign                                                                                |       | 37,480                                          |       |   | (5,181 | ) |   | 1,508 |   |   | (10 | ) |   | 38,988 |   |   | (5,191 | ) |   |
| Asset-backed securities                                                                |       | 18,540                                          |       |   | (124 | ) |   | 14,813 |   |   | (128 | ) |   | 33,353 |   |   | (252 | ) |   |
| Total                                                                                  |       | $                                               | 737,221    |   |   | $ | (13,020 | ) |   | $ | 210,697 |   |   | $ | (5,229 | ) |   | $ | 947,918 |   |   | $ | (18,249 | ) |   |

 

15

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| ** **                                                                             | ** ** | **As of December 31, 2004** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Less than 12 months**          | ** ** | **12 months or more** | ** ** | **Total** | ** ** |
| ** **                                                                             | ** ** | **Fair  Value**                                 | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
| U.S. Treasury securities and obligations of U.S. government  corporations and agencies |       | $                                               | 50,812     |   |   | $ | (183 | ) |   | $ | 4,189 |   |   | $ | (164 | ) |   | $ | 55,001 |   |   | $ | (347 | ) |   |
| Obligations of states and political subdivisions                                       |       | 214,194                                         |       |   | (1,266 | ) |   | 67,095 |   |   | (721 | ) |   | 281,289 |   |   | (1,987 | ) |   |
| Mortgage-backed  securities                                                            |       | 32,701                                          |       |   | (304 | ) |   | 38,784 |   |   | (1,018 | ) |   | 71,485 |   |   | (1,322 | ) |   |
| Corporate  securities                                                                  |       | 26,725                                          |       |   | (161 | ) |   | 17,859 |   |   | (343 | ) |   | 44,584 |   |   | (504 | ) |   |
| Foreign                                                                                |       | 1,722                                           |       |   | (39 | ) |   | 40,136 |   |   | (675 | ) |   | 41,858 |   |   | (714 | ) |   |
| Asset-backed  securities                                                               |       | 16,279                                          |       |   | (71 | ) |   | — |   |   | — |   |   | 16,279 |   |   | (71 | ) |   |
| Total                                                                                  |       | $                                               | 342,433    |   |   | $ | (2,024 | ) |   | $ | 168,063 |   |   | $ | (2,921 | ) |   | $ | 510,496 |   |   | $ | (4,945 | ) |   |

 

TheCompany periodically monitors its investment portfolio for individualinvestments in an unrealized loss position in order to assess whether anyinvestment is considered other-than-temporarily impaired. In each case, theCompany determines the nature and cause of the decline and whether the Companymaintains the ability and intent to hold the security until the unrealized lossmay reverse or until maturity. At December 31, 2005, there were 96securities that were in an unrealized loss position for a continuous 12-monthperiod or longer. None of the 96 securities had an unrealized loss thatexceeded book value by 11% at December 31, 2005. At December 31,2005, the Company determined that no investments were consideredother-than-temporarily impaired.

The amortized costand fair value of bonds in the investment portfolio, excluding the VIEportfolio, at December 31, 2005, by contractual maturity, are shown below(in thousands). Actual maturities could differ from contractual maturitiesbecause borrowers have the right to call or prepay certain obligations with orwithout call or prepayment penalties.

| ** **                                                       | ** ** | **Amortized  Cost** | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| Due in one year or less                                          |       | $                   | 225,593    |                | $          | 225,655 |   |
| Due after one year  through five years                           |       | 1,187,634           |       | 1,247,746           |       |
| Due after five years  through ten years                          |       | 670,695             |       | 701,085             |       |
| Due after ten years                                              |       | 1,971,373           |       | 2,047,189           |       |
| Mortgage-backed  securities (stated maturities of 1 to 30 years) |       | 245,783             |       | 242,103             |       |
| Asset-backed securities  (stated maturities of 2 to 29 years)    |       | 40,216              |       | 39,974              |       |
| Total                                                            |       | $                   | 4,341,294  |                | $          | 4,503,752 |   |

 

Proceeds from sales ofbonds for the investment portfolio, excluding the VIE portfolio, during 2005,2004 and 2003 were $1,717.0 million, $1,155.7 million and $1,093.9 million,respectively. Proceeds from maturities of bonds for the investment portfolioduring 2005, 2004 and 2003 were $129.7 million, $267.8 million and$442.8 million, respectively. Gross gains of $10.8 million,$4.5 million and $11.5 million and gross losses of $5.6 million,$5.5 million and $6.3 million were realized on sales in 2005, 2004 and2003, respectively.

**4.**   DEFERREDACQUISITION COSTS

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

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

 

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**5.   STATUTORY ACCOUNTING PRACTICES**

GAAP differs incertain significant respects from statutory accounting practices applicable tothe Company and its insurance company subsidiaries, that are prescribed orpermitted by insurance authorities. The principal differences result from thefollowing statutory accounting practices:

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

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

·        a contingency reserve(rather than a non-specific reserve) is computed based on the followingstatutory 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¤60thor  1¤80thof the total required for each category, less permitted reductions;

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

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

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

·        bondsare carried at amortized cost;

·        VIEsand refinancing vehicles are not consolidated under statutory accountingstandards; and

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

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

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

 

17

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

 

**6.   FEDERAL INCOME TAXES**

Dexia Holdings, the Parent and the Company and itsSubsidiaries, except FSA International, file a consolidated federal income taxreturn.

A tax-sharing agreement between them provides thateach member’s tax benefit or expense is calculated on a separate return basisand that any credits or losses available to the Parent or Dexia Holdings beallocated among the members based on each member’s taxable income. At December 31,2005 and 2004, the Company and its Subsidiaries received benefits fromutilizing the Parent’s credits and losses of $4.1 million and$20.4 million, respectively. These amounts have been recorded as capitalcontributions and reductions in amounts payable to the Parent in the financialstatements.

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

TheAmerican Jobs Creation Act of 2004 (the “Act”), enacted on October 22,2004, added Section 965 to the Internal Revenue Code. Section 965provides for the repatriation of dividends from a controlled foreigncorporation to its U.S. shareholder at an effective tax rate of 5.25%, providedthat proceeds from the repatriation are utilized for qualified domesticinvestment activities. The U.S. Treasury Department issued Notice 2005-10,which provided guidance on acceptable investment activities. The Companybelieves it qualifies for the beneficial treatment under Section 965 andaccordingly accrued a tax liability and expense of $5.3 million atDecember 31, 2004. This amount approximated the tax effect on FSAInternational’s tax dividend distribution made in the fourth quarter of 2005.

InDecember 2005, the Company repatriated earnings from FSA International toavail itself of the reduced effective tax rate of 5.25% (compared with thenormal effective tax rate of 35%). In connection with such repatriation, theCompany recapitalized FSA International in October of 2005 to become awholly owned subsidiary and declared that it no longer intends to leave futureearnings of that subsidiary permanently offshore. FSA International is subjectto an increased effective U.S. tax rate on its 2005 and future income. Theimpact on earnings reflects (1) a tax liability of $15.1 million inrespect of earnings of FSA International that have previously been recognizedfor GAAP but not yet for tax and (2) $14.2 million related to 2005earnings.

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

| ** **                                    | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Deferred  acquisition costs                   |       | $                     | 104,335    |   | $ | 95,736 |   |
| Deferred premium  revenue adjustments         |       | 36,302                |       | 37,826 |   |
| Unrealized capital  gains                     |       | 58,204                |       | 88,902 |   |
| Contingency  reserves                         |       | 114,166               |       | 113,507 |   |
| Undistributed  earnings                       |       | 16,613                |       | — |   |
| Derivative  fair-value adjustments            |       | 86,743                |       | 137,949 |   |
| Other                                         |       | 3,817                 |       | 7,655 |   |
| Total deferred federal income tax liabilities |       | 420,180               |       | 481,575 |   |
| Loss and loss  adjustment expense reserves    |       | (41,533               | )          | (35,540 | ) |
| Deferred  compensation                        |       | (67,277               | )          | (67,944 | ) |
| Foreign currency  transaction loss            |       | (12,300               | )          | (69,139 | ) |
| Minority interest                             |       | (56,437               | )          | (54,424 | ) |
| Other                                         |       | (4,291                | )          | (756 | ) |
| Total deferred federal income tax assets      |       | (181,838              | )          | (227,803 | ) |
| Net deferred federal  income tax liability    |       | $                     | 238,342    |   | $ | 253,772 |   |

 

Managementbelieves it is more likely than not that the tax benefit of the deferred taxassets will be realized. Accordingly, no valuation allowance was necessary at December 31,2005 or 2004.

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

| ** **                    | ** ** | **Years Ended  December 31,** | ** ** |
|-------------------------------|------------|-----------------------------------------|------------|
| ** **                    | ** ** | **2005**                                | ** ** | **2004** | ** ** | **2003** | ** ** |
| Tax at statutory  rate        |       | 35.0                                    | %          | 35.0 | % | 35.0 | % |
| Tax-exempt  investments       |       | (9.0                                    | )          | (8.3 | ) | (8.5 | ) |
| Income of foreign  subsidiary |       | 2.5                                     |       | (1.3 | ) | (2.5 | ) |
| Minority interest             |       | (0.4                                    | )          | — |   | — |   |
| Other                         |       | 0.1                                     |       | (0.2 | ) | 0.3 |   |
| Provision for income  taxes   |       | 28.2                                    | %          | 25.2 | % | 24.3 | % |

 

**7.   DIVIDENDS AND CAPITAL REQUIREMENTS**

FSA’s ability to pay dividends depends on FSA’sfinancial condition, results of operations, cash requirements, rating agencycapital adequacy and other related factors, and is also subject to restrictionscontained in the insurance laws and related regulations of New York and otherstates. Under the insurance laws of the State of New York, FSA may paydividends out of earned surplus, provided that, together with all dividendsdeclared or distributed by FSA during the preceding 12 months, thedividends do not exceed the lesser of (a) 10% of policyholders’ surplus asof its last statement filed with the Superintendent of Insurance of the Stateof New York (the “New York Superintendent”) or (b) adjusted net investmentincome during this period. FSA paid $87.0 million of dividends in 2005 and$30.0 million in 2004. Based upon FSA’s statutory statements for December 31,2005, the maximum amount normally available for payment of dividends by FSAwithout regulatory approval over the following 12 months would beapproximately $153.8 million.

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**8.   CREDIT ARRANGEMENTS AND ADDITIONALCLAIMS-PAYING RESOURCES**

FSAhas a credit arrangement aggregating $150.0 million, that is provided bycommercial banks and intended for general application to insured transactions.If FSA is downgraded below Aa3 and AA-, the lenders may terminate thecommitment and the commitment commission becomes due and payable. If FSA isdowngraded below Baa3 and BBB-, any outstanding loans become due and payable.At December 31, 2005, there were no borrowings under this arrangement, whichexpires on April 21, 2006, if not extended.

FSAhas a standby line of credit commitment in the amount of $350.0 millionwith a group of international banks to provide loans to FSA after it hasincurred, during the term of the facility, cumulative municipal losses (net ofany recoveries) in excess of the greater of $350.0 million or the averageannual debt service of the covered portfolio multiplied by 5.00%, whichamounted to $1,220.0 million at December 31, 2005. The obligation to repayloans made under this agreement is a limited recourse obligation payable solelyfrom, and collateralized by, a pledge of recoveries realized on defaultedinsured obligations in the covered portfolio, including certain installmentpremiums and other collateral. This commitment has a term expiring on April 30,2015 and contains an annual renewal provision, commencing April 30, 2008,subject to approval by the banks. No amounts have been utilized under thiscommitment as of December 31, 2005.

In June 2003,$200.0 million 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 commercial paper andproviding FSA with put options for issuing to the trusts non-cumulativeredeemable perpetual preferred stock (the “Preferred Stock”) of FSA. If FSAwere to exercise a put option, the applicable trust would transfer the portionof the proceeds attributable to principal received upon maturity of its assets,net of expenses, to FSA in exchange for Preferred Stock of FSA. FSA pays afloating put premium to the trusts. The cost of the structure was$1.3 million and $1.3 million for 2005 and 2004 respectively, and wasrecorded in equity. The trusts are vehicles for providing FSA access to newcapital at its sole discretion through the exercise of the put options. TheCompany does not consider itself to be the primary beneficiary of the trustsunder FIN 46R because it does not retain the majority of the residual benefitsor expected losses.

The Company had borrowed $108.9 million from itsParent in the form of Surplus Notes. These notes carry a simple interest rateof 5.0% per annum. Principal and interest on the Surplus Notes may be paid atany time at the option of the Company, subject to prior approval of the NewYork Superintendent and compliance with the conditions to such payments ascontained in the New York Insurance Laws. These notes have no stated maturity.The Company paid interest of $5.4 million, $6.7 million and$9.3 million in 2005, 2004 and 2003, respectively. In 2004 and 2003respectively, with the approval of the New York Superintendent, FSA repaid$44.0 million and $60.0 million of principal on such notes. There wereno repayments in 2005.

**9.   EMPLOYEEBENEFIT PLANS**

TheCompany maintains both qualified and non-qualified non-contributory definedcontribution pension plans for the benefit of eligible employees. Contributionsare based on a fixed percentage of employee compensation. Pension expense,which is funded annually, amounted to $6.1 million, $5.2 million and$4.3 million for the years ended December 31, 2005, 2004 and 2003,respectively.

The Company has an employee retirement savings planfor the benefit of eligible employees. The plan permits employees to contributea percentage of their salaries up to limits prescribed by Internal RevenueService Code, Section 401(k). Contributions by the Company arediscretionary, and none have been made.

Through 2004, performance shares were awarded underthe Parent’s 1993 Equity Participation Plan (the “1993 Equity Plan”). The 1993Equity Plan authorized the discretionary grant of performance shares 

20

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by the Human ResourcesCommittee to key employees. The amount earned for each performance share dependson the attainment of certain growth rates of adjusted book value and book valueper outstanding share over a three-year period.

Performance shares issued prior to January 1,2005 permitted the participant to elect, at the time of award, growth rates includingor excluding realized and unrealized gains and losses on the Parent’sconsolidated investment portfolio excluding invested assets in the VIEportfolio. Performance shares issued after January 1, 2005 do not offerthe option to include the impact of unrealized gains and losses on theinvestment portfolio. No payout occurs if the compound annual growth rate ofthe Parent’s consolidated adjusted book value and book value per outstandingshare over specified three-year performance cycles is less than 7%, and a 200%payout occurs if the compound annual growth rate is 19% or greater. Payoutpercentages are interpolated for compound annual growth rates between 7% and19%.

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 theParent’s consolidated performance over specified three-year performance cyclesas described above) and 10% of shares of Dexia restricted stock. The Dexiarestricted share component is a fixed plan, where the Company purchases Dexiashares and establishes a prepaid expense for the amount paid which is amortizedover 2.5 and 3.5 years vesting periods. In the first quarter of 2005, FSApurchased shares to economically defease itsliability for $4.4 million. This amount is being amortized toexpense over the employees’ vesting period.

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

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

 

The estimated the final cost of these performanceshares is accrued over the performance period. The expense for the performanceshares was $50.6 million, $67.0 million and $58.1 million, forthe years ended December 31, 2005, 2004 and 2003, respectively.

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

**10.   COMMITMENTS AND CONTINGENCIES**

Effective June 2004, the Company entered into a21-year sublease agreement with Deutsche Bank AG for office space at 31West 52nd Street, New York, New York to be used as theCompany’s new headquarters. The Company moved to this new space inJune 2005. The lease contains scheduled rent increases every five yearsafter a 19-month rent-free period, as well as lease incentives forinitial construction costs of up to $6.0 million, as defined in thesublease. The lease contains provisions for rent increases related to increasesin the building’s operating expenses. The lease also contains a renewal optionfor an additional ten-year period, and an option to rent additional officespace at various points in the future, in each case at then-current marketrents. In addition the Company and its subsidiaries lease 

21

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additional office space under non-cancelable operatingleases, which expire at various dates through 2013. Future minimum rentalpayments are as follows (in thousands):

Futureminimum rental payments are as follows (in thousands):

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

 

Rent expense was $9.2 million in 2005,$6.9 million in 2004 and $6.6 million in 2003. Rent expense in 2005includes a $1.1 million lease termination fee related to the Company’s formerheadquarters.

During the ordinary courseof business, the Company and its subsidiaries have become parties to certainlitigation. The Company is not subject to any material pending legal proceedings.

**11.   REINSURANCE**

The Company obtains reinsurance to increase itspolicy-writing capacity on both an aggregate-risk and a single-risk basis; tomeet rating agency, internal and state insurance regulatory limits; todiversify risk; to reduce the need for additional capital; and to strengthenfinancial ratios. The Company reinsures portions of its risks with affiliated(see Note 13) and unaffiliated reinsurers under quota share, first-lossand excess-of-loss treaties and on a facultative basis.

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

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

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

 

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

 

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**12.   OUTSTANDINGEXPOSURE AND COLLATERAL**

The Company’s policies insure the scheduled paymentsof principal and interest on municipal and asset-backed (including insuredFSA-insured CDS) obligations. The gross amount of financial guarantees in force(principal and interest) was $685.1 billion at December 31, 2005 and$631.3 billion at December 31, 2004. The net amount of financialguarantees in force was $497.1 billion at December 31, 2005 and$453.2 billion at December 31, 2004.

Thenet par outstanding as of December 31, 2005 and 2004 and the contractualterms to maturity are as follows (in millions):
|                                    | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| **Terms to Maturity(1)** | ** ** | ** **                      | ** ** | **Asset-Backed(2)**             | ** ** | **Municipal** | ** ** | **Asset-Backed(2)** | ** ** | **Municipal** | ** ** |
| 0 to 5 years                       |       |                            | $          | 41,997                          |       |   | $ | 44,272 |   |   | $ | 46,800 |   |   | $ | 39,448 |   |
| 5 to 10 years                      |       |                            | 31,354     |                            |       | 49,935 |   |   | 29,155 |   |   | 43,165 |   |
| 10 to 15 years                     |       |                            | 12,180     |                            |       | 44,392 |   |   | 10,772 |   |   | 37,174 |   |
| 15 to 20 years                     |       |                            | 744        |                            |       | 36,737 |   |   | 1,084 |   |   | 30,857 |   |
| 20 years and above                 |       |                            | 37,611     |                            |       | 51,724 |   |   | 41,682 |   |   | 44,748 |   |
| Total                              |       |                            | $          | 123,886                         |       |   | $ | 227,060 |   |   | $ | 129,493 |   |   | $ | 195,392 |   |
|                                    |            |                                 |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(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)          Includes related partyinsurance of $13,463 million and $7,143 million, in 2005 and 2004,respectively relating to FSA-insured GICs issued by the GIC Affiliates.

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

 

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

 

TheCompany limits its exposure to losses from writing financial guarantees byunderwriting investment-grade obligations, diversifying its portfolio andmaintaining rigorous collateral requirements on 

23

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asset-backed obligations, as well as throughreinsurance. The net par outstanding of insured obligations in the asset-backedinsured portfolio includes the following amounts by type of collateral (inmillions):
|                                   | ** ** | **Net Par Outstanding (1)  as of December 31,** | ** ** | **Ceded as of  December 31,** | ** ** |
|-----------------------------------|------------|-------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| **Types of Collateral** | ** ** | ** **                                                                    | ** ** | **2005**                                     | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Residential mortgages             |       | $                                                                             | 24,718     |                                         | $          | 35,641 |   | $ | 3,841 |   | $ | 4,997 |   |
| Consumer receivables              |       | 9,835                                                                         |       | 9,540                                        |       | 1,593 |   | 2,241 |   |
| Pooled corporate  obligations     |       | 66,873                                                                        |       | 68,340                                       |       | 20,688 |   | 26,223 |   |
| Other asset-backed obligations    |       | 22,460                                                                        |       | 15,972                                       |       | 4,021 |   | 3,573 |   |
| Total asset-backed obligations    |       | $                                                                             | 123,886    |                                         | $          | 129,493 |   | $ | 30,143 |   | $ | 37,034 |   |
|                                   |            |                                                                               |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Includes related partyinsurance of $13,463 million and $7,143 million, in 2004 and 2003,respectively, relating to FSA-insured GICs issued by the GIC Affiliates.

In its asset-backed business, the Company considersgeographic concentration as a factor in underwriting insurance coveringsecuritizations of pools of such assets as residential mortgages or consumerreceivables. However, after the initial issuance of an insurance policyrelating to such securitizations, the geographic concentration of theunderlying assets may not remain fixed over the life of the policy. Inaddition, in writing insurance for other types of asset-backed obligations,such as securities primarily backed by government or corporate debt, geographicconcentration is not deemed by the Company to be significant, given other morerelevant measures of diversification, such as issuer or industrydiversification.

The Companyseeks to maintain a diversified portfolio of insured municipal obligationsdesigned to spread its risk across a number of geographic areas. The followingtable sets forth those states in which municipalities located therein issued anaggregate of 2% or more of the Company’s net par amount outstanding (inmillions) of insured municipal securities as of December 31, 2005:

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

 

**13.   RELATED PARTY TRANSACTIONS**

Allocable expenses are shared by the Company and itsParent on a basis determined principally by estimates of respective usage asstated in an expense sharing agreement. The agreement is subject to theprovisions of the New York Insurance Law. Amounts included in other assets at December 31,2005 and 2004 are $5.3 million and $11.2 million respectively, forunsettled expense allocations due from the Parent.

24

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For the years ended December 31,2005, 2004, 2003, the Company ceded premiums of $31.6 million,$35.2 million and $48.8 million, respectively, to subsidiaries of XLCapital Ltd (“XL”), a major Bermuda-based insurance holding company,which owned an interest in FSA International prior to October 2005 when itredeemed its interest in exchange for $39.1 million. In 2005, 2004 and 2003,FSA International paid preferred dividends of $16.3 million,$7.0 million and $3.3 million, respectively, to XL. The amountsincluded in prepaid reinsurance premiums at December 31, 2005 and 2004 forreinsurance ceded to subsidiaries of XL were $84.4 million and$70.3 million, respectively. The amounts of reinsurance recoverable forunpaid losses at December 31, 2005 and 2004 for reinsurance ceded tosubsidiaries of XL were $1.8 million and $8.2 million, respectively.

The Company earnedpremiums of $2.5 million in the first half of 2003 relating to theguarantees of debt issued or assets purchased by FSA Global and CanadianGlobal. Inter-company premiums earned relating to VIEs have been eliminated inconsolidation for periods subsequent to July 1, 2003.

The VIE portfolio contains$1,142.1 million at December 31, 2005 and $961.9 million at December 31,2004 of GICs issued by the GIC Affiliates. The Company recognized $38.4 millionand $20.7 million in VIE net interest income during 2005 and 2004respectively, related to these investments.

The Company earnedpremiums of $28.0 million, $28.0 million and $20.5 million forthe years ended December 31, 2005, 2004 and 2003, respectively, relatingto business with affiliates of Dexia. Deferred premium revenue relating tothose transactions was $19.5 million and $17.0 million at December 31,2005 and 2004, respectively. Gross par outstanding relating to thosetransactions was $21.5 billion and $24.0 billion at December 31,2005 and 2004, respectively. The Company also paid Dexia a fee of$0.7 million in 2003 relating to business in which both Dexia and theCompany were involved. No payments were made in 2004 and 2005.

For the years ended December 31,2005 and 2004, the Company, via its interest in VIE holdings, recorded pre-taxincome (loss) of $(16.4) million and $89.8 million relating to swaps whereDexia was the counterparty. The Company recorded other assets of $309.6 millionat December 31, 2005 and $319.7 million at December 31, 2004,primarily relating to swaps where Dexia was the counterparty. In addition, at December 31,2005 and 2004 the Company had $172.1 million and $163.0 million inVIE debt relating to debt issued to Dexia. During 2005 and 2004, the Companyrecorded $9.3 million and $8.8 million in VIE net interest expenserelating to such debt.

The Company had premiumsearned of $27.0 million, $15.4 million and $7.5 million at December 31,2005, 2004 and 2003, respectively, relating to the guaranty of GICs issued bythe GIC Affiliates.

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

The Company determinesfair value using available market information and appropriate valuationmethodologies. However, considerable judgment is necessary to interpret thedata to develop the estimates of fair value. Accordingly, the estimatespresented herein are not necessarily indicative of the amount the Company couldrealize in a current market exchange. The use of different market assumptionsand/or estimation methodologies may have a material effect on the estimatedfair-value amounts.

For bonds, equitysecurities and the VIE bond portfolio, the carrying amount represents fairvalue. The fair value is based on quoted market price or redemption value forthe Company’s investment in XLFA.

For short-terminvestments, including the VIE short-term investments, the carrying amount iscost, which approximates fair market value due to the short maturity of theinstruments.

For cash, receivable forinvestments sold and payable for investments purchased, the carrying amount iscost, which approximates fair value because of the short maturity of theseinstruments.

For assets acquired underrefinancing transactions, the fair value is either the present value of theexpected cash flows or quoted market prices as of the reporting date.

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

For notes payable to affiliate, the carrying amount ofnotes payable represents the principal amount due at maturity. The fair valueis based on the quoted market price.

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

For VIE debt, the fair value is the present value ofthe expected cash flows as of the reporting date.

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

For fair-value adjustmentson derivatives, the carrying amount represents fair value. The Company usesquoted market prices when available, but if quoted market prices are notavailable, management uses internally developed estimates.

The table below shows the carrying amount and fairvalue of the Company’s financial instruments (in thousands):

| ** **                                                                            | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                                                            | ** ** | **Carrying  Amount**            | ** ** | **Fair Value**             | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
| Assets:                                                                               |       |                            |       |                            |       |   |   |   |   |
| Bonds                                                                                 |       | $                               | 4,370,469  |                            | $          | 4,370,469 |   | $ | 4,089,911 |   | $4,089,911 |   |
| Equity securities                                                                     |       | 54,370                          |       | 54,370                          |       | 54,300 |   | 54,300 |   |
| Variable interest  entities’ bonds                                               |       | 1,155,992                       |       | 1,155,992                       |       | 1,346,355 |   | 1,346,355 |   |
| Variable interest  entities’ GICs                                                |       | 1,021,791                       |       | 1,021,791                       |       | 961,925 |   | 961,925 |   |
| Short-term investments                                                                |       | 133,283                         |       | 133,283                         |       | 115,596 |   | 115,596 |   |
| VIE short-term  investments                                                           |       | 2,674                           |       | 2,674                           |       | 1,194 |   | 1,194 |   |
| Cash                                                                                  |       | 10,376                          |       | 10,376                          |       | 10,005 |   | 10,005 |   |
| Assets acquired in  refinancing transactions                                          |       | 467,873                         |       | 460,770                         |       | 748,936 |   | 745,360 |   |
| Fair value adjustments  on derivatives                                                |       | 491,041                         |       | 491,041                         |       | 617,395 |   | 617,395 |   |
| Receivable for  securities sold                                                       |       | 1,382                           |       | 1,382                           |       | 161 |   | 161 |   |
| Liabilities:                                                                          |       |                            |       |                            |       |   |   |   |   |
| Deferred premium  revenue, net of prepaid reinsurance premiums                        |       | 1,515,408                       |       | 1,295,312                       |       | 1,342,057 |   | 1,154,461 |   |
| Losses and loss  adjustment expenses, net of reinsurance recoverable on unpaid losses |       | 169,379                         |       | 169,379                         |       | 144,522 |   | 144,522 |   |
| Notes payable to  affiliate                                                           |       | 463,575                         |       | 455,805                         |       | 753,614 |   | 754,463 |   |
| VIE debt                                                                              |       | 2,708,773                       |       | 2,960,686                       |       | 2,853,963 |   | 3,103,090 |   |
| Surplus notes                                                                         |       | 108,850                         |       | N/A                             |       | 108,850 |   | N/A |   |
| Payable for investments  purchased                                                    |       | 28,947                          |       | 28,947                          |       | 16,533 |   | 16,533 |   |
| Fair value adjustments  on derivatives                                                |       | 1,060                           |       | 1,060                           |       | — |   | — |   |
| Off-balance-sheet instruments:                                                        |       |                            |       |                            |       |   |   |   |   |
| Installment premiums                                                                  |       | —                          |       | 562,404                         |       | — |   | 509,138 |   |
|                                                                                       |            |                                 |            |                                 |            |  |  |  |  |  |  |  |

 

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**15.   LIABILITY FOR LOSSES AND LOSS ADJUSTMENTEXPENSES**

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

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

 

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

 

Thegross and net par amounts outstanding on transactions with case reserves were$612.7 million and $519.5 million, respectively, at December 31, 2005. Thenet case reserve consisted primarily of seven CDO transactions and onemunicipal transaction, which collectively accounted for approximately 94% ofthe total net case reserve. The remaining 11 exposures were in various sectors.

During2005, the Company charged $25.4 million to loss expense, consisting of $20.4million for originations of new business and $5.0 million related to accretionon in-force business. Case reserves increased $8.3 million primarily dueto deterioration of specific CDO risks.

During2004, the Company charged $20.6 million to loss expense, consisting of$20.4 million for originations of new business, $4.6 million for accretionrelated to prior years and $3.2 million related to reassumptions ofpreviously ceded business, offset by reserve releases primarily related to alarge refinancing transaction in 2004. The non-specific reserves decreased$12.2 million in 2004, primarily due to transfers from the non-specificreserve to the case reserves of $30.7 million offset by loss expense of$20.6 million. Case reserves decreased $17.5 million due to (1) alarge, voluntarily accelerated transaction that had a $34.3 millionpayment and (2) reclassifications from reserves to asset valuationaccounts for refinanced transactions of $13.9 million, partially offset bytransfers from the non-specific reserve of $30.7 million. (SeeNote 18).

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 

27

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the collateral. The remaining $9.5 millionbalance in the case reserve related to this transaction was returned to thenon-specific reserve. After reevaluating its requirements for the CDO portionof the non-specific reserve, the Company then reduced the non-specific reserveby $9.5 million, which was partially offset by normal reserve additions.The net amount transferred from the case reserves to the non-specific reservewas $1.4 million, which also included a transfer from the non-specific tothe case reserves for a municipal utility transaction. The CDO portfoliocontinues to perform within the expectations reflected in previously recordedprovisions for CDOs.

During2003, the Company charged $34.5 million to loss expense, comprising$9.2 million related to the CDO portfolio discussed below,$22.4 million for origination of new business and $2.9 million forthe accretion of the discount on prior years’ reserves. The non-specificreserve increased by $21.8 million in 2003, consisting of the lossexpense, a transfer to the non-specific reserve of $1.4 millionrepresenting recoveries received on prior-year transactions and a transfer of$14.1 million from the non-specific reserve to case reserves. In addition,the Company reclassified $2.2 million of case reserves as an assetvaluation account relating to a restructured transaction involving securitizedloans. (see Note 18).

Since case and non-specific reserves are based onestimates, 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.

***Impact ofHurricanes***

TheCompany evaluated its insured portfolio to assess the potential impact ofHurricanes Katrina, Rita and Wilma, which occurred in 2005. The Company recordsa non-specific reserve to reflect the credit risks inherent in its portfolio.Together, the non-specific reserve and case reserves represent the Company’sestimate of total loss liability. The Company believes that its total lossliability is adequate given the current information. Generally, when an insuredcredit deteriorates to a point where unreimbursed claims are expected, a casereserve is established.

Asof March 24, 2006, the Company had not received notice of payment defaulton any exposures related to Hurricanes Katrina, Rita, or Wilma. To date, basedon the Company’s review of its exposure, 11 credits, with aggregate net parexposure of $215.8 million, have the most significant risk of loss. FSA-insuredbonds are protected by various sources of support that would be invoked beforeFSA would incur losses. These sources include access to pledged taxes orrevenues, reserve funds, property and casualty insurance and state and federalmonies. In the case of perpetual obligations the Company may experience claims,but if the population returns in adequate numbers, reimbursement is likely. Eightof the 11 obligations with significant risk of loss are perpetual.

TheCompany monitors its exposure to Hurricanes Katrina and Rita in Louisiana andMississippi and has determined that no case reserve is required. Of the 11credits with significant risk of loss, the Company has identified two highpriority risks. These risks are perpetual obligations, on which the Company mayhave to pay claims of up to $44.0 million in a worst-case scenario. However, inthese two cases the Company expects that, so long as the population returns inadequate numbers, it would suffer only the lost interest income on any claimspaid until the issuer repaid the Company at some point in the future.

Inorder for a community in Louisiana to restructure and potentially reduce itsindebtedness, the Bond Commission, which is headed by the State Treasurer, mustauthorize such action. The State Treasurer has publicly represented that theBond Commission will not permit any Louisiana municipality to declarebankruptcy.

Municipalitiesin Mississippi are not authorized to file for bankruptcy and therefore have nomechanism under law to adjust their payment obligations. Unlike the corporatemarket, the municipal market has no private or equity source of capital andtherefore lacks any means of starting fresh with a clean slate with debts andliabilities rejected or adjusted in bankruptcy. To file for bankruptcy, or toleave rated indebtedness unpaid in a bankruptcy proceeding, would serve totarnish the issuer and the region 

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and effectively deny the subject municipality andsimilar issuers of debt within the state access to capital. Historically,rather than bankruptcy and adjustment of debt, financially distressedmunicipalities have been subjected to supervision and control by state-createdauthorities that act both as issuers of debt, secured by a discrete, newlyidentified revenue stream, and as fiscal monitors.

Boththe federal government and the executive and legislative branches of theaffected states have considered or are expected to consider proposals orlegislation to assist the municipalities and facilitate recovery. An example ofsuch an enactment at the federal level is the Community Disaster Loan Act of2005, under which the federal government has begun to make loans to affectedmunicipalities.

Inaddition, FSA’s asset-backed transactions, which are generally backed by poolsof geographically diverse assets , show no unusual concentrations in theaffected areas.

The loss estimation process involves the exercise ofconsiderable judgment and therefore FSA’s ultimate hurricane-related losses maybe materially different from the current estimate and may affect futureoperating results.

**16.   EQUITYINVESTMENTS**

FSA’s13% investment in preferred shares of  XLFinancial Assurance Ltd (“XLFA”), a financial guaranty insurancesubsidiary of XL, is redeemable by XLFA at a price equal to the fair marketvalue of the preferred shares, subject to a cap defined as the internal rate ofreturn of 19% per annum from the date of the investment through the date ofredemption, plus accrued dividends as if 100% of current year earnings weredistributed. Based on this formula, in 2004, the Company adopted a policy of carrying this investment at the lesserof the current calculated redemption value or the redemption value as of thenext January first, which would exclude its share of accrued current yearearnings to the extent the cap had been otherwise met. Consistent with thispolicy, in the third quarter of 2004, the Company charged $11.7 million toequity in earnings of unconsolidated affiliates and reduced its carrying valuein this investment to $56.4 million.

Until the fourth quarterof 2004 this investment was accounted for using the equity method of accountingbecause the Company has significant influence over XLFA’s operations. In thesecond quarter of 2004, the Emerging Issues Task Force (“EITF”) reached aconsensus that under EITF Issue 02-14, “Whether an Investor Should Applythe Equity of Method of Accounting to Investments Other Than Common Stock” (“EITF02-14”), an investor should only apply the equity method of accountingwhen it has investments in either common stock or in-substance common stock ofa corporation, provided that the investor has the ability to exercisesignificant influence over the operating and financial policies of theinvestee. The EITF 02-14 consensus is applicable to reporting periodsbeginning after September 15, 2004. In accordance with this consensus, theCompany no longer accrues undistributed earnings related to its investment inXLFA. Amounts recorded by the Company in connection with XLFA as of December 31,2005, 2004 and 2003 are as follows (in thousands):

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

 

**17.   MINORITY INTEREST IN SUBSIDIARY**

In 1998, the Company and XL entered into a jointventure, establishing two Bermuda domiciled financial guaranty insurancecompanies—FSA International and XLFA. At December 31, 2004, XL owned aminority interest in FSA International and the Company owned a minorityinterest in XLFA. In October 2005, FSA purchased all the preferred sharesof FSA 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 

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wholly owned subsidiary ofthe Company. The preferred shares were Cumulative Participating VotingPreferred Shares that, in total, had a minimum fixed dividend of $1.5 millionper annum. In 2005, 2004 and 2003, FSA International paid preferred dividendsof $16.3 million, $7.0 million and $3.3 million, respectively, to XL. Forthe years ended December 31, 2005, 2004 and 2003, the Company recognizedminority interest of $6.9 million, $7.0 million and $9.3 million, respectively.

**18.   REFINANCED TRANSACTIONS AND NOTES PAYABLE TOAFFILIATES**

TheCompany generally has rights under its financial guaranty insurance policiesand indentures that allow it to accelerate the insured notes and pay claimsunder its insurance policies upon the occurrence of predefined events ofdefault. To mitigate future losses, the Company may elect to purchase theoutstanding insured obligation or its underlying collateral. Generally,refinancing vehicles reimburse FSA in whole for its claims payments in exchangefor assignments of certain of FSA’s rights against the trusts. The refinancingvehicles obtain their funds from the proceeds of FSA-insured GICs issued in theordinary course 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 components of the assets acquired in refinancing transactions (inthousands):

| ** **                                      | ** ** | **As of December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                      | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| **Assets acquired in refinancing transactions** |       |                                  |       |   |   |
| Securitized loans                               |       | $                                     | 296,965    |   | $ | 369,750 |   |
| Bonds                                           |       | 9,145                                 |       | 157,036 |   |
| Asset-backed senior  notes                      |       | 59,276                                |       | 89,913 |   |
| Equity securities                               |       | 3,488                                 |       | 15,659 |   |
| Mortgage loans                                  |       | 56,165                                |       | 77,462 |   |
| Short term investments                          |       | 37,512                                |       | 27,749 |   |
| Other                                           |       | 5,322                                 |       | 11,367 |   |
| Total                                           |       | $                                     | 467,873    |   | $ | 748,936 |   |

 

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

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

Thecredit quality of bonds within the refinanced asset portfolio at December 31,2005 was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent of Bonds** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|
| BBB           |       |       | 19.0       | %                              |       |
| CCC           |       |       | 67.6       |                           |       |
| D        |       |       | 5.4        |                           |       |
| NR            |       |       | 8.0        |                           |       |
|          |       |       | 100.0%     |                           |       |

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(1)          Ratingsare based on the lower of Moody’s or S&P ratings available at December 31,2005.

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

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

 

| ** **               | ** ** | **As of December 31, 2004** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **Amortized  Cost**                             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| Corporate securities     |       | $                                               | 151,895    |   |   | $ | 5,743 |   |   |   | $ | (602 | ) |   | $ | 157,036 |   |
| Asset-backed  securities |       | 89,500                                          |       |   | 1,016 |   |   |   | — |   |   | 90,516 |   |
| Short-term  investments  |       | 27,749                                          |       |   | — |   |   |   | — |   |   | 27,749 |   |
| Total                    |       | $                                               | 269,144    |   |   | $ | 6,759 |   |   |   | $ | (602 | ) |   | $ | 275,301 |   |

 

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

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

 

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

 

The amortized cost and fair-value of fixed incomeassets within the refinanced asset portfolio at December 31, 2005, areshown below by contractual maturity (in thousands). Actual maturities coulddiffer from contractual maturities because borrowers have the right to call orprepay certain obligations with or without call or prepayment penalties.

| ** **                              | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|---------------------|------------|
| Due in one year or less                 |       |                    | $          | 37,967              |       |   | $ | 37,982 |   |
| Due after one year  through five years  |       |                    | 17,906     |                |       | 17,906 |   |
| Due after five years  through ten years |       |                    | 47,505     |                |       | 50,045 |   |
| Total                                   |       |                    | $          | 103,378             |       |   | $ | 105,933 |   |

 

At December 31, 2005, there were no securities inan unrealized loss position for a continuous 12-month period or longer.The Company determined that there were six securities considered other-than-temporarilyimpaired. For 2005, a $4.5 million impairment was recorded in the statement ofoperations and comprehensive income.

The Company has recorded $463.6 million of notespayable to an affiliate at December 31, 2005 and $753.6 million at December 31,2004. For the years ended December 31, 2005, 2004 and 2003 the Companyrecorded $28.2 million, $24.8 million and $24.1 million,respectively, of interest expense on the notes payable.

Principal payments dueunder these notes for each of the next five years ending December 31 andthereafter are as follows (in thousands):

| **Expected Withdrawal Date** | ** ** | ** ** | ** ** | **Principal  Amount** | ** ** |
|----------------------------------------|------------|------------|------------|-----------------------|------------|
| 2006                                   |       | $          | 51,785     |                  |
| 2007                                   |       | 71,358     |       |
| 2008                                   |       | 56,291     |       |
| 2009                                   |       | 50,401     |       |
| 2010                                   |       | 44,237     |       |
| Thereafter                             |       | 189,503    |       |
| Total                                  |       | $          | 463,575    |                  |

 

**19.   DERIVATIVE INSTRUMENTS**

***Credit Default Swaps***

TheCompany has insured a number of CDS with the expectation that thesetransactions will not be subject to a market value termination for which theCompany would be liable. It considers these agreements to be a normal extensionof its financial guaranty insurance business, although they are consideredderivatives for accounting purposes. These agreements are recorded at fairvalue. The Company believes that the most meaningful presentation of thefinancial statement impact of these derivatives is to reflect premiums asinstallments are received, to record losses and loss adjustment expenses asincurred and to record changes in fair value as incurred. The Company recorded$89.2 million, $69.1 million and $57.7 million of net earnedpremium under these agreements for the years ended 2005, 2004 and 2003,respectively.

Changes in the fair value of CDS, which were gains of$11.1 million, $56.4 million and $34.8 million for the years ended December 31,2005 , 2004, and 2004 respectively, were recorded in net realized andunrealized gains on derivative instruments in the consolidated statements ofoperations and 

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comprehensive income. TheCompany included net par outstanding of $66.6 billion and $66.0 billionrelating to these CDS transactions at December 31, 2005 and December 31,2004, respectively, in the asset-backed balances in Note 12. The gains orlosses recognized by recording these contracts at fair value are determinedeach quarter based on quoted market prices, if available. If quoted marketprices are not available, then the determination of fair value is based oninternally developed estimates. Management applies judgment when developingthese estimates and considers factors such as current prices charged for similaragreements, performance of underlying assets, changes in internal shadowratings, the level at which the deductible has been set and the Company’sability to obtain reinsurance for its insured obligations. The Company does notbelieve that the fair-value adjustments are an indication of potential claimsunder FSA’s guarantees. The average life of these contracts is 3.2 years.The inception-to-date gain (loss) on the CDS portfolio was $57.7 millionat December 31, 2005 and $46.6 million at December 31, 2004, andwas recorded in other assets.

***InterestRate and Foreign Exchange Rate Derivatives***

The Company enters intoderivative contracts to manage interest-rate and foreign currency exposure inits VIE debt and VIE bond portfolio. The derivative contracts are recorded atfair value. These derivatives generally include interest-rate and currency swapagreements, which are primarily utilized to convert fixed-rate debt andinvestments into U.S. dollar floating-rate debt and investments. The gains andlosses related to the fair value of derivatives are included in net realizedand unrealized gains (losses) on derivative instruments. The inception-to-datenet unrealized gain on the outstanding derivatives held by the VIE’s of $433.7million and $570.8 million at December 31, 2005 and December 31,2004, respectively, was recorded in other assets and accrued expenses and otherliabilities as applicable.

**20.**   VARIABLE INTERESTENTITIES

The Company adopted FIN 46 and consolidated forfinancial reporting purposes, effective July 1, 2003, FSA Global andCanadian Global. In addition, as a result of the Company obtaining controlrights of another VIE, Premier, on July 1, 2003, the Company consolidatedPremier beginning July 1, 2003. FIN 46R requires that, uponconsolidation, the Company initially measure the VIE’s assets, liabilities andminority interest at their carrying amounts under existing GAAP as if the entityhad been consolidated from the time the Company was considered its primarybeneficiary (or parent). The increase in total assets and total liabilitiesrelated to the consolidation of these entities was $2.9 billion. Anydifferences upon consolidation were reflected as a cumulative effect of achange in accounting principle. The cumulative effect of a change in accountingprinciple for Canadian Global resulted in additional income of$4.8 million, net of income tax. There were no cumulative income statementeffects from consolidating FSA Global and Premier.

FSA Global is managed as a “matched funded vehicle,”in which the proceeds from the issuance of FSA-guaranteed notes are invested inobligations having cash flows substantially matched to those of, and maturingprior to, such notes. In certain cases, investments of FSA Global consist ofGICs issued by the GIC Affiliates. Similarly, Premier holds GICs issued by theGIC Affiliates in their investment portfolios. The Company’s managementbelieves that the assets held by the VIEs, including those that are eliminatedin consolidation with the Parent, are beyond the reach of the Company and itscreditors, even in bankruptcy or other receivership. All intercompany insuredamounts between FSA and FSA Global and Canadian Global previously included inthe Company’s outstanding exposure are excluded from the Notes 

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to the Condensed Consolidated Financial Statements forDecember 31, 2005 and 2004. During the third quarter of 2004, the majorityof the assets and liabilities of Canadian Global were satisfied.

| ** **                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|
| VIE net interest  income                                    |       | $        | 105,561    |     | $          | 74,286 |   |
| FSA’s net  premiums earned on VIE’ bonds and debt |       | (3,613   | )          | (5,351   | )          |
| Net realized and  unrealized gains (losses) on derivatives  |       | (133,915 | )          | 249,752  |       |
| Total revenues                                              |       | $        | (31,967    | )        | $          | 318,687 |   |
| VIE net interest  expense                                   |       | $        | 124,218    |     | $          | 126,793 |   |
| Other operating  expenses                                   |       | 50       |       | (825     | )          |
| Foreign exchange  loss                                      |       | (162,398 | )          | 79,270   |       |
| Total expenses                                              |       | $        | (38,130    | )        | $          | 205,238 |   |

 

**VIE Investments**

Allbonds in the VIE Portfolio are insured by FSA. The credit quality of the VIEPortfolio, without the benefit of FSA’s insurance, at December 31, 2005was as follows:

| **Rating(1)** | ** ** | ** ** | ** ** | **Percent  of Bonds** | ** ** |
|---------------|------------|------------|------------|----------------------------|------------|
| AAA           |       |       | 2.3        | %                          |       |
| A        |       |       | 95.5       |                       |       |
| BB            |       |       | 2.2        |                       |       |
|          |       |       | 100.0      | %                          |       |

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(1)          Ratings are based on thelower of Moody’s or S&P ratings available at December 31, 2005.Excludes VIE GICs. All VIE GICs are FSA-insured.

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

| **December 31, 2005**                   | ** ** | ** ** | ** ** | **Amortized  Cost** | ** ** | **Fair Value** | ** ** |
|---------------------------------------------------|------------|------------|------------|---------------------|------------|---------------------|------------|
| Obligations of  states and political subdivisions |       | $          | 15,879     |                | $          | 15,879              |       |
| Corporate  securities                             |       | 20,013     |       | 19,327              |       |
| Foreign                                           |       | 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           |       |

 

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

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(1)          Asset-backed securitiesconsist of floating-rate assets, which are valued using readily availablequoted market prices or at amortized cost if there is no readily availablevaluation. Management believes that amortized cost closely approximates fairvalue for these securities.

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The Company periodically monitors its investmentportfolio for individual investments in an unrealized loss position in order toassess whether that investment is considered other-than-temporarily impaired.In each case, the Company determines the nature and cause of the decline andwhether the Company maintains the ability and intent to hold the security untilthe unrealized loss may reverse or until maturity. At December 31, 2005,there were no securities in an unrealized loss position. The Company determinedthat no investments were considered other-than-temporarily impaired.

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

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

 

At December 31, 2005, the interest rates on VIEDebt were between 1.12% and 6.61% per annum.

Theamortized cost and fair value of GICs held within the VIE guaranteed investmentportfolio were as follows (in thousands):

| ** **                              | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|---------------------|------------|
| Due in one year  or less                |       |                    | $          | 79,000              |       |   | $ | 79,000 |   |
| Due after one  year through five years  |       |                    | 613,367    |                |       | 613,367 |   |
| Due after five  years through ten years |       |                    | 52,744     |                |       | 52,744 |   |
| Due after ten  years                    |       |                    | 276,680    |                |       | 276,680 |   |
| Total                                   |       |                    | $          | 1,021,791           |       |   | $ | 1,021,791 |   |

 

Paymentsdue under the VIE Debt (including $1,081.8 million of interest accretion onzero coupon obligations) in each of the next five years ending December 31and thereafter, are as follows (in thousands):

| **Year**   | ** ** | ** ** | ** ** | **Principal  Amount** | ** ** |
|------------|------------|------------|------------|-----------------------|------------|
| 2006       |       | $          | 87.8       |                  |
| 2007       |       | 552.6      |       |
| 2008       |       | 128.6      |       |
| 2009       |       | 17.6       |       |
| 2010       |       | 94.4       |       |
| Thereafter |       | 2,909.6    |       |
| Total      |       | $          | 3,790.6    |                  |

 

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**21.**   OTHERASSETS

Thedetailed balances that comprise other assets at December 31, 2005 and 2004are as follows (in thousands):

| **Other assets:**               | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
| Fair value of VIE  derivatives       |       | $        | 433,670    |     | $          | 570,764 |   |
| VIE other  invested assets           |       | 266,978  |       | 156,540  |       |
| Tax and loss  bonds                  |       | 105,324  |       | 102,193  |       |
| Accrued interest  on VIE derivatives |       | 108,421  |       | 99,794   |       |
| Accrued interest  income             |       | 53,101   |       | 50,632   |       |
| Other assets                         |       | 195,068  |       | 145,696  |       |
| Total other assets                   |       | $        | 1,162,562  |     | $          | 1,125,619 |   |

 

**22.**   RECENTLYISSUED ACCOUNTING STANDARDS

In February 2006, the FASB issued Statement ofFinancial Accounting Standards No.155 “Accounting for Certain Hybrid FinancialInstruments (“SFAS 155”). SFAS 155 provides guidance with respect tobifurcation of embedded credit risk in a special purpose entity. The adoptionof SFAS 155 is not expected to have a material impact on the Company’sfinancial position or results of operations.

In November 2005, the FASB issued FASB StaffPosition (FSP) 115-1, “The Meaning of Other-Than-Temporary Impairment andits Application to Certain Investments,” which supersedes certain requirementsof EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments” and amends SFAS 115 and Accounting PrinciplesBoard Opinion (APB) 18, “The Equity Method of Accounting for Investments inCommon Stocks.” FSP 115-1 outlines a three-step model to identifyinvestment impairments in each reporting period. First, for each reportingperiod, individual securities are determined to be impaired if the fair valueof a security is less than its cost. Second, impaired securities are evaluatedas to whether the impairment is other than temporary based on existingapplicable guidance. Lastly, if the impairment is other than temporary, animpairment loss is recognized in earnings equal to the difference between theinvestment’s cost and fair value as of the reporting date. Under FSP 115-1,the disclosure requirements required by EITF 03-1 issued in December 2003remain in effect. EITF 03-1 requires the Company to disclose certaininformation about unrealized losses on its investment portfolio that have notbeen recognized as other-than-temporary impairments. The requirements under FSP115-1 are effective for reporting periods beginning after December 15,2005. The Company believes that the adoption of FSP 115-1 will not have amaterial effect on the Company’s financial position or results of operations.See Note 3 for disclosures required by EITF 03-1.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123-R, “Share-Based Payment”(“SFAS 123-R”). This Statement is a revision of SFAS 123, “Accountingfor Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees,” and its related implementation guidance. SFAS123-R requires entities to recognize compensation cost for all equity-classifiedawards after the effective date using the fair-value measurement method.SFAS 123-R is effective for annual periods beginning after June 15,2005. The adoption of SFAS 123-R is not expected to have a materialimpact on the Company’s financial position or results of operations.

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