|                                                                                  
|----------------------------------------------------------------------------------
|XL Capital Assurance Inc.
and Subsidiary                                          
|Consolidated
  Financial Statements
  Years Ended December 31, 2006, 2005 and 2004
|(Expressed
  in U.S. Dollars)                                                     

1

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|                                                                                
|--------------------------------------------------------------------------------
|XL Capital Assurance Inc. and Subsidiary                                        
|Contents to Consolidated Financial Statements
  December 31, 2006, 2005 and 2004
|                                                                                

|                                                                                                                               |     
|------------------------------------------------------------------------------------------------------------------------------ | ----
|                                                                                                                               | Page
|                                                                                                                               |     
|Report of Independent Registered Public Accounting Firm                                                                        | 1   
|                                                                                                                               |     
|Consolidated Financial Statements                                                                                              |     
|                                                                                                                               |     
|Consolidated
  Balance Sheets at December 31, 2006 and 2005                                                                    | 2   
|                                                                                                                               |     
|Consolidated
  Statements of Operations and Comprehensive Income (Loss) for the years ended
  December 31, 2006, 2005 and 2004 | 3   
|                                                                                                                               |     
|Consolidated
  Statements of Changes in Shareholders Equity for the years ended
  December 31, 2006, 2005 and 2004            | 4   
|                                                                                                                               |     
|Consolidated
  Statements of Cash Flows for the years ended 
  December 31, 2006, 2005 and 2004                                | 7   
|                                                                                                                               |     
|Notes to
  Consolidated Financial Statements                                                                                   | 839

2

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Report of
Independent Registered Public Accounting Firm

To Board of
Directors and Shareholder of XL Capital Assurance Inc. and Subsidiary:

In our
opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations and comprehensive income (loss), of
changes in shareholders equity and of cash flows present fairly, in all
material respects, the financial position of XL Capital Assurance Inc. and its
subsidiary (the Company), at December 31, 2006 and 2005, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2006 in conformity with accounting principles generally
accepted in the United States of America. These financial statements are the
responsibility of the Companys management. Our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

PricewaterhouseCoopers
LLP 
New York, New York 
March 14, 1007

3

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|                                        
|----------------------------------------
|XL Capital Assurance Inc. and Subsidiary
|Consolidated Balance Sheets             
|December 31, 2006 and 2005              
|                                        

(U.S. Dollars in thousands, except share amounts)

|                                                                                                                                       |  |      |           |      |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | --------- | ---- | - | ------- | -
|                                                                                                                                       |  | 2006 |           | 2005 |  
|                                                                                                                                       |  |      |           |      |   |         |  
|Assets                                                                                                                                 |  |      |           |      |   |         |  
|Investments                                                                                                                            |  |      |           |      |   |         |  
|Debt securities available for sale, at fair
  value 
  (amortized cost: 2006 - $335,532; 2005 - $281,719)                              |  | $    | 332,265   |      | $ | 279,423 |  
|Short-term investments, at fair value 
  (amortized cost: 2006 - $14,979; 2005 - $7,244)                                               |  |      | 14,978    |      |   | 7,242   |  
|Other invested assets                                                                                                                  |  |      |          |      |   | 17,621  |  
|                                                                                                                                       |  |      |           |      |   |         |  
|Total investments                                                                                                                      |  |      | 347,243   |      |   | 304,286 |  
|                                                                                                                                      
|Cash and cash equivalents                                                                                                              |  |      | 82,691    |      |   | 32,337  |  
|Accrued investment income                                                                                                              |  |      | 3,111     |      |   | 2,650   |  
|Prepaid reinsurance premiums                                                                                                           |  |      | 587,508   |      |   | 440,241 |  
|Premiums receivable                                                                                                                    |  |      | 6,984     |      |   | 5,034   |  
|Reinsurance balances recoverable on unpaid
  losses                                                                                    |  |      | 155,597   |      |   | 122,073 |  
|Intangible assets - acquired licenses                                                                                                  |  |      | 11,529    |      |   | 11,529  |  
|Deferred federal income tax asset                                                                                                      |  |      | 17,872    |      |   | 17,569  |  
|Other assets                                                                                                                           |  |      | 12,200    |      |   | 17,987  |  
|                                                                                                                                       |  |      |           |      |   |         |  
|Total assets                                                                                                                           |  | $    | 1,224,735 |      | $ | 953,706 |  
|                                                                                                                                       |  |      |           |      |   |         |  
|Liabilities and Shareholders Equity                                                                                                   |  |      |           |      |   |         |  
|Liabilities                                                                                                                            |  |      |           |      |   |         |  
|Unpaid losses and loss adjustment
expenses                                                                                             |  | $    | 164,907   |      | $ | 131,602 |  
|Deferred premium revenue                                                                                                               |  |      | 666,082   |      |   | 492,406 |  
|Deferred ceding commissions, net                                                                                                       |  |      | 52,720    |      |   | 41,191  |  
|Reinsurance premiums payable                                                                                                           |  |      | 22,548    |      |   | 1,080   |  
|Funds held - affiliate                                                                                                                 |  |      |          |      |   | 15,859  |  
|Accounts payable and accrued expenses                                                                                                  |  |      | 30,706    |      |   | 32,719  |  
|Payable for investments purchased                                                                                                      |  |      | 5,435     |      |   |        |  
|Current federal income tax payable                                                                                                     |  |      | 4,169     |      |   | 1,023   |  
|Intercompany payable to affiliates                                                                                                     |  |      | 27,663    |      |   | 10,878  |  
|                                                                                                                                       |  |      |           |      |   |         |  
|Total liabilities                                                                                                                      |  |      | 974,230   |      |   | 726,758 |  
|                                                                                                                                       |  |      |           |      |   |         |  
|Commitments and Contingencies (Note 12)                                                                                                |  |      |           |      |   |         |  
|                                                                                                                                       |  |      |           |      |   |         |  
|Shareholders Equity                                                                                                                   |  |      |           |      |   |         |  
|Common stock (par value $7,500 per share;
  8,000 shares authorized; 2,000 shares issued and outstanding)                              |  |      | 15,000    |      |   | 15,000  |  
|Additional paid-in capital                                                                                                             |  |      | 264,173   |      |   | 239,173 |  
|Accumulated other comprehensive income
  (loss) (net of deferred federal income tax (assets) liability of: 2006 -
  $(45); 2005 - $57) |  |      | (3,222    | )    |   | (2,355  | )
|Accumulated deficit                                                                                                                    |  |      | (25,446   | )    |   | (24,870 | )
|                                                                                                                                       |  |      |           |      |   |         |  
|Total shareholders equity                                                                                                             |  |      | 250,505   |      |   | 226,948 |  
|                                                                                                                                       |  |      |           |      |   |         |  
|Total liabilities and shareholders
equity                                                                                             |  | $    | 1,224,735 |      | $ | 953,706 |  
|                                                                                                                                       |  |      |           |      |   |         |  

See accompanying notes to consolidated
financial statements.

4

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|                                                                       
|-----------------------------------------------------------------------
|XL Capital Assurance Inc. and Subsidiary                               
|Consolidated Statements of Operations and
  Comprehensive Income (Loss)
|Years Ended December 31, 2006, 2005 and 2004                           
|                                                                       

|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------------ |  | ---- | -------- | ---- | - | -------- | - | - | -------- | -
|(U.S. Dollars in thousands)                                                                                                                      |  | 2006 |          | 2005 |   | 2004     |  
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Revenues                                                                                                                                         |  |      |          |      |   |          |   |   |          |  
|Gross premiums written                                                                                                                           |  | $    | 353,728  |      | $ | 232,590  |   | $ | 232,541  |  
|Ceded premiums written                                                                                                                           |  |      | (309,344 | )    |   | (209,592 | ) |   | (202,863 | )
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Net premiums written                                                                                                                             |  |      | 44,384   |      |   | 22,998   |   |   | 29,678   |  
|                                                                                                                                                
|Change in net deferred premium revenue                                                                                                           |  |      | (26,408  | )    |   | (8,595   | ) |   | (16,554  | )
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Net premiums earned                                                                                                                              |  |      | 17,976   |      |   | 14,403   |   |   | 13,124   |  
|                                                                                                                                                
|Net investment income                                                                                                                            |  |      | 16,698   |      |   | 13,047   |   |   | 10,880   |  
|Net realized gains (losses) on investments                                                                                                       |  |      | (1,406   | )    |   | 8        |   |   | (670     | )
|Net realized and unrealized gains (losses)
  on credit derivatives                                                                               |  |      | (649     | )    |   | (303     | ) |   | 953      |  
|Fee income and other                                                                                                                             |  |      | 1,012    |      |   | 76       |   |   | 100      |  
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Total revenues                                                                                                                                   |  |      | 33,631   |      |   | 27,231   |   |   | 24,387   |  
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Expenses                                                                                                                                         |  |      |          |      |   |          |   |   |          |  
|Net losses and loss adjustment expenses                                                                                                          |  |      | 1,638    |      |   | 5,294    |   |   | 2,673    |  
|Net operating expenses                                                                                                                           |  |      | 30,304   |      |   | 25,347   |   |   | 24,259   |  
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Total expenses                                                                                                                                   |  |      | 31,942   |      |   | 30,641   |   |   | 26,932   |  
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Income (loss) before federal income tax
  benefit                                                                                                |  |      | 1,689    |      |   | (3,410   | ) |   | (2,545   | )
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Current federal income tax expense                                                                                                               |  |      | 2,699    |      |   | 591      |   |   | 4,802    |  
|Deferred federal income tax benefit                                                                                                              |  |      | (434     | )    |   | (916     | ) |   | (3,834   | )
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Total federal income tax (benefit)
expense                                                                                                       |  |      | 2,265    |      |   | (325     | ) |   | 968      |  
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Net loss                                                                                                                                         |  |      | (576     | )    |   | (3,085   | ) |   | (3,513   | )
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Comprehensive Income (Loss)                                                                                                                      |  |      |          |      |   |          |   |   |          |  
|Net loss                                                                                                                                         |  |      | (576     | )    |   | (3,085   | ) |   | (3,513   | )
|Unrealized depreciation of investments
  arising during year (net of deferred federal income tax (benefit) of $(594),
  $(790) and $(100))       |  |      | (1,781   | )    |   | (3,928   | ) |   | (184     | )
|Less: reclassification for gains (losses)
  realized in income (net of deferred federal income tax (benefit) expense of
  $(492), $3 and $(234)) |  |      | (914     | )    |   | 5        |   |   | (435     | )
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Other comprehensive income (loss)                                                                                                                |  |      | (867     | )    |   | (3,933   | ) |   | 251      |  
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  
|Comprehensive loss                                                                                                                               |  | $    | (1,443   | )    | $ | (7,018   | ) | $ | (3,262   | )
|                                                                                                                                                 |  |      |          |      |   |          |   |   |          |  

See accompanying notes to consolidated
financial statements.

5

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|                                                            
|------------------------------------------------------------
|XL Capital Assurance Inc. and Subsidiary                    
|Consolidated Statements of Changes in
  Shareholders Equity
|Years Ended December 31, 2006, 2005 and
  2004              
|                                                            

|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------- | ---- | - | ------- | - | - | ------- | -
|(U.S. Dollars in thousands, except share amounts)                                                                                                          |  | 2006 |         | 2005 |   | 2004    |  
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|Common Shares                                                                                                                                              |  |      |         |      |   |         |   |   |         |  
|Number of shares - beginning of year                                                                                                                       |  |      | 2,000   |      |   | 2,000   |   |   | 2,000   |  
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|Number of shares - end of year                                                                                                                             |  |      | 2,000   |      |   | 2,000   |   |   | 2,000   |  
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|Common Stock                                                                                                                                               |  |      |         |      |   |         |   |   |         |  
|Balance - beginning of year                                                                                                                                |  | $    | 15,000  |      | $ | 15,000  |   | $ | 15,000  |  
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|Balance - end of year                                                                                                                                      |  |      | 15,000  |      |   | 15,000  |   |   | 15,000  |  
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|Additional Paid-In Capital                                                                                                                                 |  |      |         |      |   |         |   |   |         |  
|Balance - beginning of year                                                                                                                                |  |      | 239,173 |      |   | 239,173 |   |   | 239,173 |  
|Capital contribution                                                                                                                                       |  |      | 25,000  |      |   |        |   |   |        |  
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|Balance - end of year                                                                                                                                      |  |      | 264,173 |      |   | 239,173 |   |   | 239,173 |  
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|Accumulated Other Comprehensive Income                                                                                                                     |  |      |         |      |   |         |   |   |         |  
|Balance - beginning of year                                                                                                                                |  |      | (2,355  | )    |   | 1,578   |   |   | 1,327   |  
|Net change in unrealized appreciation of investments, net of deferred
  federal tax (benefit) expense of $(102) in 2006, $(793) in 2005 and $134 in
  2004 |  |      | (867    | )    |   | (3,933  | ) |   | 251     |  
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|Balance - end of year                                                                                                                                      |  |      | (3,222  | )    |   | (2,355  | ) |   | 1,578   |  
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|Accumulated deficit                                                                                                                                        |  |      |         |      |   |         |   |   |         |  
|Balance - beginning of year                                                                                                                                |  |      | (24,870 | )    |   | (21,785 | ) |   | (18,272 | )
|Net
  loss                                                                                                                                                 |  |      | (576    | )    |   | (3,085  | ) |   | (3,513  | )
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|Balance - end of year                                                                                                                                      |  |      | (25,446 | )    |   | (24,870 | ) |   | (21,785 | )
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  
|Total shareholders equity                                                                                                                                 |  | $    | 250,505 |      | $ | 226,948 |   | $ | 233,966 |  
|                                                                                                                                                           |  |      |         |      |   |         |   |   |         |  

See accompanying notes to consolidated
financial statements.

6

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|                                              
|----------------------------------------------
|XL Capital Assurance Inc. and Subsidiary      
|Consolidated Statements of Cash Flows         
|Years Ended December 31, 2006, 2005 and
  2004
|                                              

|                                                                                                     |  |      |          |      |   |          |   |   |          |  
|---------------------------------------------------------------------------------------------------- |  | ---- | -------- | ---- | - | -------- | - | - | -------- | -
|(U.S. Dollars in thousands)                                                                          |  | 2006 |          | 2005 |   | 2004     |  
|                                                                                                     |  |      |          |      |   |          |   |   |          |  
|Cash
  flows provided by operating activities                                                        |  |      |          |      |   |          |   |   |          |  
|Net loss                                                                                             |  | $    | (576     | )    | $ | (3,085   | ) | $ | (3,513   | )
|Adjustments to reconcile
  net loss to net cash provided by operating activities                     |  |      |          |      |   |          |   |   |          |  
|Net realized losses (gains) on sale of
investments                                                   |  |      | 1,406    |      |   | (8       | ) |   | 670      |  
|Net realized and unrealized (gains) losses on
credit derivatives,
  excluding cash received and paid |  |      | 649      |      |   | 303      |   |   | (953     | )
|Amortization of premium on bonds                                                                     |  |      | 550      |      |   | 898      |   |   | 1,147    |  
|Increase (decrease) in unpaid losses and loss
adjustment expenses,
  net                             |  |      | (219     | )    |   | 5,316    |   |   | 1,941    |  
|Increase in deferred premium revenue, net                                                            |  |      | 26,408   |      |   | 8,595    |   |   | 16,554   |  
|Increase in deferred ceding commissions,
net                                                         |  |      | 11,529   |      |   | 3,921    |   |   | 3,532    |  
|Increase (decrease) in reinsurance premiums
payable                                                  |  |      | 21,468   |      |   | (24,769  | ) |   | (7,573   | )
|(Increase) decrease in premiums
receivable                                                           |  |      | (1,950   | )    |   | 1,904    |   |   | (4,226   | )
|Increase in funds held - affiliate                                                                   |  |      |         |      |   | 15,859   |   |   |         |  
|(Increase) in accrued investment income                                                              |  |      | (461     | )    |   | (86      | ) |   | (240     | )
|Increase (decrease) in current federal income tax
payable                                            |  |      | 3,146    |      |   | (1,894   | ) |   | (3,837   | )
|Provision for deferred federal income tax
asset                                                      |  |      | (303     | )    |   | (916     | ) |   | (3,834   | )
|Increase (decrease) in accounts payable and accrued
expenses                                         |  |      | (503     | )    |   | 7,234    |   |   | (2,517   | )
|Increase (decrease) in intercompany payable to
affiliates                                            |  |      | 16,785   |      |   | (9,766   | ) |   | 12,171   |  
|Other                                                                                                |  |      | 3,783    |      |   | 3,975    |   |   | 1,458    |  
|                                                                                                     |  |      |          |      |   |          |   |   |          |  
|Total adjustments                                                                                    |  |      | 82,288   |      |   | 10,566   |   |   | 14,293   |  
|                                                                                                     |  |      |          |      |   |          |   |   |          |  
|Net cash provided by operating activities                                                            |  |      | 81,712   |      |   | 7,481    |   |   | 10,780   |  
|                                                                                                     |  |      |          |      |   |          |   |   |          |  
|Cash
  flows from investing activities                                                               |  |      |          |      |   |          |   |   |          |  
|Proceeds from sale of debt
  securities and short-term investments                                   |  |      | 86,134   |      |   | 107,150  |   |   | 213,442  |  
|Proceeds from maturity of
  debt securities and short-term investments                               |  |      | 11,696   |      |   | 16,587   |   |   | 2,239    |  
|Purchase of debt
  securities and short-term investments                                             |  |      | (159,623 | )    |   | (156,919 | ) |   | (245,277 | )
|Increase in payable for
  securities purchased                                                       |  |      | 5,435    |      |   |         |   |   |         |  
|                                                                                                     |  |      |          |      |   |          |   |   |          |  
|Net cash used in investing activities                                                                |  |      | (56,358  | )    |   | (33,182  | ) |   | (29,596  | )
|                                                                                                     |  |      |          |      |   |          |   |   |          |  
|Cash
  flows from financing activities                                                               |  |      |          |      |   |          |   |   |          |  
|Capital contribution                                                                                 |  |      | 25,000   |      |   |         |   |   |         |  
|                                                                                                     |  |      |          |      |   |          |   |   |          |  
|Net cash provided by financing activities                                                            |  |      | 25,000   |      |   |         |   |   |         |  
|                                                                                                     |  |      |          |      |   |          |   |   |          |  
|Increase (decrease) in cash and cash
equivalents                                                     |  |      | 50,354   |      |   | (25,701  | ) |   | (18,816  | )
|Cash and
  cash equivalents                                                                          |  |      |          |      |   |          |   |   |          |  
|Beginning of year                                                                                    |  |      | 32,337   |      |   | 58,038   |   |   | 76,854   |  
|                                                                                                     |  |      |          |      |   |          |   |   |          |  
|End of year                                                                                          |  | $    | 82,691   |      | $ | 32,337   |   | $ | 58,038   |  
|                                                                                                     |  |      |          |      |   |          |   |   |          |  
|Taxes (received) paid                                                                                |  | $    | (448     | )    | $ | 2,485    |   | $ | 8,639    |  
|                                                                                                     |  |      |          |      |   |          |   |   |          |  

See accompanying notes to consolidated financial statements.

7

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|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
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|   | XL Capital Assurance Inc. and Subsidiary                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | Notes
  to Consolidated Financial Statements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   | December
  31, 2006, 2005 and 2004                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
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|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|1. | Organization
  and Ownership                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
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|   | Through
  June 30, 2006, XL Capital Assurance Inc. (XLCA) was a wholly owned subsidiary
  of XL Reinsurance America, Inc. (XL RE AM), which in turn is an indirect
  wholly owned subsidiary of XL Capital Ltd (XL Capital), a public company
  whose shares are listed on the New York Stock Exchange. On March 17, 2006, XL
  Capital formed Security Capital Assurance Ltd (SCA), a Bermuda based
  holding company, in anticipation of contributing its ownership interests in
  its financial guarantee insurance and financial guarantee reinsurance
  operating businesses to SCA and selling an interest therein to the public
  through an initial public offering of SCA common shares (the IPO). The
  contribution of such businesses to SCA occurred on July 1, 2006 and the IPO
  was consummated on August 4, 2006. The aforementioned operating businesses
  contributed to SCA by XL Capital consisted of: (i) XLCA and its wholly-owned
  subsidiary, XL Capital Assurance (U.K.) Limited (XLCA-UK) (XLCA and XLCA-UK
  hereafter collectively referred to as the Company) and (ii) XL Financial
  Assurance Ltd. (XLFA). After the IPO, a secondary offering by XL Capital,
  the exercise of the underwriters over-allotment option and restricted share
  awards to management of SCA, XL Capitals ownership of SCAs outstanding
  common shares represents approximately a 63% economic interest. As a result of
  limitations on XL Capitals voting power contained in SCAs by-laws, the
  votes conferred by the common shares owned by XL Capital will not exceed,
  with respect to elections of directors, 50.1% of the aggregate voting power
  of all common shares entitled to vote generally at any election of directors
  or, with respect to any other matter presented to SCAs shareholders for
  their action or consideration, 47.5% of the aggregate voting power of all
  common shares entitled to vote on such matter. If, however, the rating
  agencies would permit XL Capitals voting rights to be commensurate with its
  economic interest in SCA, without adversely affecting the ratings of SCA or
  its operating subsidiaries, XL Capitals voting power would automatically
  increase and consequently the voting power of all other shareholders in the
  aggregate would correspondingly decrease, thereby eliminating preferential
  voting rights of all SCAs other shareholders.
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|   | XLCA
  is an insurance company domiciled in the State of New York and is licensed
    to conduct financial guarantee insurance business throughout all 50 of the
  United States, as well as in the Commonwealth of Puerto Rico, the District
    of Columbia, and the U.S. Virgin Islands. In addition, XLCA through XLCA-UK,
  which is an insurance company organized under the laws of England, is
  permitted to conduct financial guarantee business in England, Ireland, Spain,
  France, Portugal, Italy, Norway, The Netherlands, Greece, and Germany. XLCA
  and XLCA-UK are hereafter collectively referred to as the (Company).
  Also, to facilitate distribution of its products XLCA maintains a branch office
  in Singapore and XLCA-UK maintains a branch office in Madrid. In addition XLCA
  has an office in California. XLCA and XLCA-UK have triple-A financial strength
  ratings from Standard & Poors Ratings Services, Moodys Investors
  Service, Inc., and Fitch Inc. The Company is primarily engaged in the
  business of providing credit enhancement on fixed and variable rate income
  securities through the issuance of financial guarantee insurance policies,
  and credit protection on specific referenced credits or on pools of specific
  referenced credits through guarantees of credit default swaps issued by
  trusts established to comply with New York State Insurance Law (the Trusts).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
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|   | Financial
  guarantee insurance provides an unconditional and irrevocable guarantee to
  the holder of a debt obligation of full and timely payment of principal and
  interest. In the event of a default under the obligation, the insurer has
  recourse against the issuer and/or any related collateral (which is more
  common in the case of insured asset-backed obligations or other non-municipal
  debt) for amounts paid under the terms of the policy. Credit default swaps
  are derivative contracts which offer credit protection relating to a
  particular security or pools of specified securities. Under the terms of a
  credit default swap, the seller of credit protection makes a specified
  payment to the buyer of credit protection upon the occurrence of one or more
  specified credit events with respect to a referenced security. Credit
  derivatives typically provide protection to a buyer rather than credit
  enhancement of an issue as in traditional financial guarantee insurance. The
  Companys underwriting policies limit the Company to providing                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

8

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|   | XL Capital Assurance Inc. and Subsidiary                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   | Notes
  to Consolidated Financial Statements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   | December
  31, 2006, 2005 and 2004                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
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|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | credit protection
  on obligations or referenced securities that it determines would be of
  investment-grade quality without the benefit of credit enhancement provided
  by the Company through the issuance of insurance policies and credit default
  swaps. See Note 15 for further details.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|2. | Summary
  of Significant Accounting Policies                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
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|   | Basis
  of Presentation and Consolidation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | The
  accompanying consolidated financial statements include the accounts of the
  Company and have been prepared in accordance with accounting principles
  generally accepted in the United States of America (GAAP), which for
  insurance companies differ in certain respects from the accounting practices
  prescribed or permitted by the New York Insurance Department (NYID) (See
  Note 14). All significant intercompany accounts and transactions have been
  eliminated. The preparation of financial statements in conformity with GAAP
  requires management to make estimates and assumptions that affect the
  reported amounts of assets and liabilities and disclosure of contingent
  assets and liabilities at the date of the financial statements and the
  reported amounts of revenues and expenses during the reporting period. Actual
  results could differ materially from these estimates. Certain comparative
  figures have been reclassified to conform to the current years presentation.                                                                                                                                                                                                                                                                                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | Investments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
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|   | All
  of the Companys investments in debt securities are considered
  available-for-sale and accordingly are carried at fair value. The fair value
  of investments is based on quoted market prices received from a nationally
  recognized pricing service or on dealer quotes. The net unrealized
  appreciation or depreciation on investments, net of deferred federal income
  tax, is included in accumulated other comprehensive income (loss). Any
  unrealized depreciation in value considered by management to be
  other-than-temporary is charged to income in the period that such
  determination is made.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | At
  the end of each accounting period, the Company reviews unrealized losses on
  its investment securities to identify declines in fair value that are
  other-than-temporary. This review involves consideration of several factors
  including: (i) the time period during which the security has been in a
  continuous unrealized loss position, (ii) an analysis of the liquidity,
  business prospects and overall financial condition of the issuer, (iii) the
  significance of the decline, (iv) an analysis of the collateral and other
  credit support, as applicable, of the securities in question and (v) the
  Companys intent and ability to hold the investment for a sufficient period
  of time for the value to recover. Where the Company concludes that a decline
  in fair value is other-than-temporary, the cost of the security is written
  down to fair value and a corresponding loss is realized in the period such
  determination is made. For the year ended December 31, 2006, the Company
  recognized other than temporary impairment charges of $1.4 million relating
  to an investment acquired in satisfaction of a claim See Note 10 (b) for
  further information. For the years ended December 31, 2005 and 2004, there
  were no declines in fair value deemed to be other-than-temporary.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | With
  respect to securities where the decline in value is determined to be
  temporary and the securitys value is not written down, a subsequent decision
  may be made to sell that security and realize a loss. Subsequent decisions on
  security sales are made within the context of overall risk monitoring,
  changing information, general market conditions and assessing value relative
  to other comparable securities.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | Bond
  discounts and premiums are amortized on the effective yield method over the
  remaining terms of securities acquired. For mortgage-backed securities, and
  any other holdings for which prepayment risk may be significant, assumptions
  regarding prepayments are evaluated periodically and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

9

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XL
  Capital Assurance Inc. and SubsidiaryNotes to Consolidated Financial
  StatementsDecember 31, 2006, 2005 and 2004 revised as
necessary. Any adjustments required due to the resulting change in effective
yields are recognized in income. Short-term
investments comprise securities with maturities equal to or greater than 90
days but less than one year at time of purchase. Cash equivalents include
fixed-interest and money market fund deposits with a maturity of less than 90
days when purchased. All
investment transactions are recorded on a trade date basis. Realized gains and
losses on sales of debt securities are determined on the basis of amortized
cost. Investment income is recognized when earned. The
Companys policy is not to invest in obligations which it insures, and there
were no such obligations included in our investment portfolio as of December
31, 2006 or 2005. Other Invested Assets Other
invested assets consisted of certain notes acquired in connection with the
satisfaction of a claim resulting from the default of an insured obligationsee
Note 10 (b). Income on such notes is recognized based on the effective yield
method. Under the effective yield method, the excess of all cash flows expected
from the notes at acquisition over the Companys initial investment in the
notes is recognized as interest income on a level-yield basis over the expected
life of the notes. Subsequent increases in cash flows expected to be collected
are recognized prospectively through adjustment of the notes yield over
its expected remaining life. Decreases in cash flows expected to be collected
will be recognized as impairments and will be reflected in the accompanying
consolidated statement of operations under the caption Net realized losses
on investments. Premium Revenue Recognition Premiums
charged in connection with the issuance of the Companys guaranties are
received either upfront or in installments. Such premiums are recognized as
written when due. Installment premiums written are earned ratably over the
installment period, generally one to three months, which is consistent with the
expiration of the underlying risk or amortization of the underlying insured
principal amount of the debt. Upfront premiums written are earned in proportion
to the expiration of the related risk. The methodology employed to earn upfront
premiums requires that such premiums be apportioned to individual sinking fund
payments of a bond issue according to the bond issues amortization schedule.
The apportionment is based on the ratio of the principal amount of each sinking
fund payment to the total principal amount of the bond issue. After the premium
is allocated to each scheduled sinking fund payment, such allocated premium is
earned on a straight-line basis over the period of that sinking fund payment.
As a result, for upfront premiums on amortizing insured obligations, premium
revenue recognition will tend to be greater in the earlier periods of the
transaction when there is a higher amount of risk or principal outstanding. The
effect of the Companys upfront premium earnings policy is that the Company
recognizes greater levels of upfront premiums in earlier years of each
amortizing insured obligation. Recognizing premium revenue on a straight-line
basis over the life of each amortizing insured obligation without allocating
premiums to the scheduled principal payments would materially change the amount
of premium the Company recognizes in a particular financial reporting period,
but not over the life of the applicable policy. For upfront premiums on
non-amortizing bullet maturity debt obligations, premium revenue recognition is
recognized on a straight-line basis over the life of the underlying insured
obligation. Deferred premium revenue represents the portion of premiums written
that is applicable to the unexpired risk or principal of insured obligations.
For both upfront and installment policies, ceded premium expense is recognized
in earnings in proportion to and at the same time the related premium revenue
is recognized.


10

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XL
  Capital Assurance Inc. and SubsidiaryNotes to Consolidated Financial
  StatementsDecember 31, 2006, 2005 and 2004 The
Companys accounting policies for the recognition of ceded premiums, ceding
commissions and ceded losses and loss adjustment expenses under its ceded
reinsurance contracts mirror the policies described herein for premium revenue
recognition, deferred ceding commissions, and reserves for losses and loss
adjustment expenses. In
addition, when an insured issue is retired early, is called by the issuer or is
in substance paid in advance through a refunding accomplished by placing U.S.
Government securities in escrow, the remaining deferred premium revenue is
earned at that time since there is no longer risk to the Company. Premiums
earned for the years ended December 31, 2006, 2005, and 2004 include $28.1
million ($2.8 net of reinsurance), $11.6 million ($1.1 net of reinsurance) and
$3.8 million ($0.4 net of reinsurance), respectively, related to refunded and
called bonds. Fee Income and Other The
Company collects advisory and structuring fees in connection with certain
transactions.  Depending upon the type
of fee received, the fee is either earned when services are rendered and the
fee is due or deferred and earned over the life of the related
transaction.  Work, waiver and consent,
and termination fees are earned when due and are included in Fee income and
other.  Structuring and commitment fees
are included in premiums and earned on a straight-line basis over the life of
the related transaction. Losses and Loss Adjustment Expenses The
financial guaranties that the Company issues insure scheduled payments of
principal and interest due on various types of financial obligations against
default by the issuers of such obligations. The Company establishes reserves
for losses and loss adjustment expenses on such business based on its best
estimate of the ultimate expected incurred losses. The Companys estimated ultimate
expected incurred losses are comprised of: (i) case basis reserves, (ii)
unallocated reserves, and (iii) cumulative paid losses to date. Establishment
of such reserves requires the use and exercise of significant judgment by
management, including with respect to estimates regarding the occurrence and
amount of a loss on an insured obligation. Estimates of losses may differ from
actual results and such difference may be material due to the fact that the
ultimate dispositions of claims are subject to the outcome of events that have
not yet occurred. Examples of these events include changes in the level of
interest rates, credit deterioration of insured obligations, and changes in the
value of specific assets supporting insured obligations. Both qualitative and
quantitative factors are used in establishing such reserves. In determining the
reserves, management considers all factors in the aggregate, and does not
attribute the reserve provisions or any portion thereof to any specific factor.
Any estimate of future costs is subject to the inherent limitation on the
Companys ability to predict the aggregate course of future events. It should
therefore be expected that the actual emergence of losses and loss adjustment
expenses will vary, perhaps materially, from any estimate. Case
basis reserves on financial guarantee insurance business are established by the
Company with respect to a specific policy or contract upon receipt of a claim
notice or when management determines that: (i) a claim is probable in the
future based on specific credit events that have occurred and (ii) the amount
of the ultimate loss that the Company will incur can be reasonably estimated.
As specific case basis reserves are established, the Company considers whether
any changes are required to the assumptions underlying the calculation of
unallocated reserves (which are discussed below) as a result of such activity.
As case basis reserve activity to date has been almost exclusively limited to
cases discussed in Note 10, the Company has not to date adjusted its
unallocated reserves to reflect such limited case basis reserve activity. The
amount of the case basis reserve is based on the net present value of the
expected ultimate loss and loss adjustment expense payments that the Company
expects to make, net of expected recoveries under salvage and subrogation
rights. Case basis reserves are determined using cash flow or


11

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XL
  Capital Assurance Inc. and SubsidiaryNotes to Consolidated Financial
  StatementsDecember 31, 2006, 2005 and 2004 similar models
to estimate the net present value of the anticipated shortfall between (i)
scheduled payments on the insured obligation plus anticipated loss adjustment
expenses and (ii) anticipated cash flow from the proceeds to be received on sales
of any collateral supporting the obligation and other anticipated recoveries. A
number of quantitative and qualitative factors are considered when determining
or assessing, in managements judgment, the need for a case basis reserve.
These variables may include the creditworthiness of the underlying issuer of
the insured obligation, whether the obligation is secured or unsecured, the
projected cash flow or market value of any assets that collateralize or secure
the insured obligation, and the historical and projected loss rates on such
assets. Other factors that may affect the actual ultimate loss include the
state of the economy, changes in interest rates, rates of inflation and the
salvage values of specific collateral. Case basis reserves are generally
discounted at a rate reflecting the yield on our investment portfolio during
the period the case basis reserve is established. The Company believes this
yield is an appropriate rate to discount its reserves because it reflects the
rate of return on the assets supporting such business. When a case basis
reserve is established for a guaranteed obligation whose premium is paid on an
upfront basis, the Company continues to record premium earnings on such policy
over its remaining life, unless the Company has recorded a full limit loss with
respect to such policy, in which case the remaining deferred premium revenue
relating thereto is immediately reflected in earnings. When a case basis
reserve is established for a guaranteed obligation whose premium is paid on an
installment basis, those premiums, if expected to be received prospectively,
are considered a form of recovery and are no longer earned as premium revenue. In
assessing whether a loss is probable, the Company considers all available
qualitative and quantitative evidence. Qualitative evidence may take various
forms and the nature of such evidence will depend upon the type of insured
obligation and the nature and sources of cash flows to fund the insured
obligations debt service. For example, such evidence with respect to an
insured special revenue obligation such as an obligation supported by cash
flows from a toll road would consider traffic statistics such as highway volume
and related demographic information, whereas an insured mortgage backed
securitization would consider the quality of the mortgage loans supporting the
insured obligation including delinquency and foreclosure rates, loan to value
statistics, market valuation of the mortgaged properties and other pertinent
information. In addition, the Company will make qualitative judgments with
respect to the amount by which certain other structural protections built into
the transaction are expected to limit the Companys loss exposure. Examples of
such structural protections may include: (i) rate covenants, which generally
stipulate that issuers (i.e. public finance issuers) set rates for services at
certain pre-determined levels (i.e. water and sewer rates which support debt
obligations supported by such revenues), (ii) springing liens, which generally
require the issuer to provide additional collateral upon the breach of a
covenant or trigger incorporated into the terms of the transaction, (iii)
consultant call-in rights, which provide, under certain circumstances, for a
consultant to be engaged to make certain binding recommendations, such as
raising rates or reducing expenses, (iv) the ability to transfer servicing of
collateral assets to another party, and (v) other legal rights and remedies
pursuant to representations and warranties made by the issuer and written into
the terms of such transactions. Quantitative information may take the form of
cash flow projections of the assets supporting the insured debt obligation
(which may include, in addition to collateral assets supporting the obligation,
structural protections subordinate to the attachment point of our risk, such as
cash reserve accounts and letters of credit), as well as (to the extent
applicable) other metrics indicative of the performance of such assets and the
trends therein. The Companys ability to make a reasonable estimate of its
expected loss depends upon its evaluation of the totality of both the available
quantitative and qualitative evidence, and no one quantitative or qualitative
factor is dispositive. In
addition to case basis reserves, the Company maintains an unallocated loss
reserve for expected losses inherent in its in-force business that management
expects to emerge in the future. The Companys unallocated loss reserves
represent managements best estimate of the Companys ultimate


12

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XL
  Capital Assurance Inc. and SubsidiaryNotes to Consolidated Financial
  StatementsDecember 31, 2006, 2005 and 2004 liability from
claims expected to be incurred in the future under the Companys in-force
insured policies less outstanding case basis reserves and cumulative paid
claims to date on such policies. The Companys unallocated reserves are
estimated by management based upon an actuarial reserving analysis. The
actuarial methodology applied by management is in accordance with Actuarial
Standards of Practice No. 36, Determination
of Reasonable Provision. The methodology is based on the selection
of an initial expected loss ratio, as well as an expected loss emergence
pattern (i.e., the expected pattern of the expiration of risk on insured
in-force policies). Salvage and subrogation recoveries are implicit in
managements selected expected ultimate loss ratio as such ratio is derived
from industry loss experience, which is net of salvage and subrogation recoveries
(i.e., from the liquidation of supporting or pledged collateral assets). The
implicit inclusion of salvage and subrogation recoveries in managements
selected expected ultimate loss ratio is consistent with managements explicit
consideration of collateral support in the establishment of the Companys case
basis reserves. Management
updates its estimate of reserves for losses and loss adjustment expenses
quarterly and any resulting changes in such reserves are recorded as a charge
or credit to the Companys earnings in the period such estimates are changed.
In connection therewith, the Companys unallocated reserves are adjusted each
period to reflect (i) revisions to managements estimate of expected ultimate
losses, if any, and (ii) the underlying par risk amortization of the related
insured in-force business (i.e., loss emergence pattern). As stated above,
managements estimated ultimate expected incurred losses are comprised of: (i)
case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid
losses to date. As management establishes case basis reserves and pays claims
it may, based on its judgment, reduce or increase the ultimate expected loss
ratio used to determine unallocated reserves to reflect its best estimate of
expected ultimate loss experience. In addition, under the Companys accounting
policy management may, based on its judgment, reduce unallocated reserves in
response to significant case basis reserve and or paid loss activity.
Management would only expect such reductions to occur in limited instances,
such as economic events generating significant loss activity. Management has
not viewed the Companys case basis reserve and unallocated reserve activity to
date to warrant a reduction of the Companys unallocated reserves. In each
quarterly period, there is an interplay between case basis reserves,
unallocated reserves and cumulative paid losses to date, such that the
aggregate thereof represents managements best estimate of the ultimate losses
it expects the Company to incur on its in-force business. The process of
establishing unallocated reserves and periodically revising such reserves to
reflect the underlying par risk amortization and managements current best
estimate of ultimate losses will ultimately cause the cumulative loss
experience over the life of a particular underwriting years business to equal
the cumulative inception-to-date actual paid losses on such business. The
selection of the Companys initial expected loss ratio is based on an analysis,
which management updates annually, of the historic earned premium and ultimate
losses of the financial guarantee industry. The analysis utilizes loss and
premium data filed by the three largest companies in the financial guarantee
insurance industry in Schedule P of their annual statutory financial
statements. These statutory filings provide data for ten calendar years and
exclude unallocated reserves. Information on unallocated reserves is obtained
from Annual Reports filed with the SEC on Form 10-K and is combined with the
Schedule P data to estimate ultimate loss ratios for each of the preceding ten
years. Managements
selection of an initial expected loss ratio (and subsequent periodic updates
thereof) was based on its judgment and considered: (i) the characteristics of
the Companys in-force financial guarantee insurance business (e.g.,
principally the mix of the Companys in-force financial guarantee insurance
business between public finance and structured finance business; however, management
also considered the various bond sectors comprising the Companys insured
in-force business which are discussed in detail in Note 9, as well as the
credit profile of such in-force business), (ii) the Companys actual loss
experience, (iii) the characteristics, as discussed above in relation to the
Companys in-force


13

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XL
  Capital Assurance Inc. and SubsidiaryNotes to Consolidated Financial
  StatementsDecember 31, 2006, 2005 and 2004 financial
guarantee insurance business, of the insured in-force business of companies
comprising the financial guarantee industry and (iv) the actual loss experience
of companies comprising the industry from managements analysis referred to
above. Other factors impacting market default levels and the assumptions important
to the Companys reserving methodology are implicit in the Companys initial
expected loss ratio. Such factors may include interest rates, inflation, taxes,
industry trends in the valuation of certain asset classes and the overall
credit environment. Based on this comparison, management adjusts the Companys
expected loss ratio, as it considers necessary, to ensure that such ratio
continues to be appropriate for the risks inherent in the Companys in-force
business. The
Companys unallocated loss reserve is established on an undiscounted basis and
represents managements best estimate of losses that the Company will incur in
the future as a result of credit deterioration in the Companys in-force
business but which have not yet been specifically identified. The Company does
not attempt to apportion unallocated reserves by type of product. The
Companys total reserves for losses and loss adjustment expenses represent a
small fraction of the Companys insured and reinsured in-force par outstanding,
which reflects the nature of the business the Company underwrites, which is
consistent with that of the financial guarantee insurance industry and the loss
experience of the industry. The Company believes that its reserves are adequate
to cover its expected ultimate losses. However, due to the inherent
uncertainties of estimating reserves for losses and loss adjustment expenses,
actual experience may differ from the estimates reflected in the Companys
consolidated financial statements, and the differences may be material. While
the Company believes that the underlying principles applied to loss reserving
are consistent across the financial guarantee industry, differences may exist
with regard to the methodology and measurement of such reserves. While the
Company believes that the principles it applies are the most appropriate for
the Companys business and have been applied consistently within the periods
presented, alternate methods may produce different estimates as compared to the
current methodology used by the Company. The
Companys loss reserving policy, described above, is based on guidance provided
in SFAS 60, Accounting and Reporting by Insurance Enterprises, SFAS 5,
Accounting for Contingencies and analogies to Emerging Issues Task Force
(EITF) 85-20, Recognition of Fees for Guaranteeing a Loan. SFAS 60 requires
that, for short-duration contracts, a liability for unpaid claim costs relating
to insurance contracts, including estimates of costs relating to incurred but not
reported claims, be accrued when insured events occur. Additionally, SFAS No.
5, requires that a loss be recognized when it is probable that one or more
future events will occur confirming that a liability has been incurred at the
date of the financial statements and the amount of loss can be reasonably
estimated. Although
SFAS 60 provides guidance to insurance enterprises, the Company does not
believe SFAS 60 comprehensively addresses the unique attributes of financial
guarantee insurance contracts, as the standard was developed prior to the
maturity of the financial guarantee industry. SFAS 60 provides guidance with
respect to insurance contracts that are either short-duration or long-duration
in nature. Financial guarantee contracts typically have attributes of both and,
therefore, are difficult to classify as either. For instance, financial
guarantee contracts are reported for regulatory purposes as property and
liability insurance, normally considered short-duration, but have elements of long-duration
contracts in that they are irrevocable and extend over a period that may be in
excess of 30 years. The
Company believes its loss reserving policy reflects the requirements of
applicable accounting literature, as well as the fact that financial guarantee
losses occur over time as a result of credit deterioration, operational
difficulties of the insured obligor or fraud, which may not be specifically
detected when they occur but which can be generally estimated across a
portfolio of insured obligations based on the credit quality and nature of the
portfolio and historical default data. The Company does, however, recognize
premium revenue and policy acquisition costs in a manner consistent with the


14

---



XL
  Capital Assurance Inc. and SubsidiaryNotes to Consolidated Financial
  StatementsDecember 31, 2006, 2005 and 2004 guidance
provided in SFAS 60 for short-duration contracts. If the Company and the rest
of the financial guarantee industry were required to classify its insurance
contracts as either short-duration or long-duration or if new specific guidance
for financial guarantee insurance emerges, different methods of accounting
could apply with respect to loss reserving and liability recognition, and
possibly extend to premium revenue and policy acquisition cost recognition.
Additionally, there are differences in the methodology and measurement of loss
reserves followed by other financial guarantee companies.  See New Accounting Pronouncements and
Developments. Deferred Acquisition Costs Policy
acquisition costs include those expenses that primarily relate to, and vary
with, the production of new business. The Company periodically conducts a study
to estimate the amount of operating costs that are acquisition costs. These costs
include direct and indirect expenses related to underwriting, marketing and
policy issuance, rating agency fees and premium taxes, and are reduced by
ceding commission income on premiums ceded to reinsurers. Policy acquisition
costs are deferred and amortized over the period in which the related premiums
are earned. The
Company will recognize a premium deficiency if the sum of expected losses and
loss adjustment expenses, maintenance costs and unamortized policy acquisition
costs exceed the related unearned premiums, the anticipated present value of
future premiums under installment contracts written, and anticipated investment
income. If the Company was to have a premium deficiency that is greater than
unamortized acquisition costs, the unamortized acquisition costs would be
reduced by a charge to expense, and a liability (if necessary) would be
established for any remaining deficiency. There have been no premium
deficiencies recorded by the Company since its inception. For policies
reinsured with third parties the Company receives ceding commissions to
compensate for acquisition costs incurred. The Company nets ceding commissions
received against deferred acquisition costs and earn these ceding commissions
over the period in which the related premiums are earned. If
an insured issue is retired or defeased prior to the end of the expected period
of coverage, the remaining net amount of DAC with respect to such insured issue
is recognized at such time. Reinsurance In
the normal course of business, the Company seeks to reduce the loss that may
arise from events that could cause unfavorable underwriting results by
reinsuring certain levels of risk in various areas of exposure with other
insurance enterprises or reinsurers.
Reinsurance premiums ceded are earned consistent with the expiration of
the underlying reinsured risk over the period the reinsurance coverage is
provided.  Prepaid reinsurance premiums
represent the portion of premiums ceded which is applicable to the unexpired term
of policies in-force.  Amounts
recoverable from reinsurers are estimated in a manner consistent with the claim
liability associated with the reinsured policy.  Provision is made for any estimated uncollectible
reinsurance.  The Company has not
recorded a provision for uncollectible reinsurance. Intangible Assets - Acquired Licenses Intangible
assets are comprised of licenses to conduct financial guarantee insurance
business in 45 states of the United States. The recoverability of the carrying
value of these intangible assets are evaluated annually for impairment. The
Company has not recorded any adjustments to the carrying value of its
intangible assets since their acquisition. Income Taxes The
Company utilizes the asset and liability method of accounting for income taxes.
Deferred federal income taxes are provided for temporary differences between
the tax and financial reporting basis


15

---



XL
  Capital Assurance Inc. and SubsidiaryNotes to Consolidated Financial
  StatementsDecember 31, 2006, 2005 and 2004 of assets and
liabilities that will result in deductible or taxable amounts in future years
when the reported amounts of the assets or liabilities are recovered or
settled. A valuation allowance is recorded if it is more likely than not that
all, or some portion, of the benefits related to deferred tax assets will not
be realized. Derivative Instruments  Credit Default Swaps Credit
default swaps issued by the Company meet the definition of a derivative under
FASB Statement of Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities (SFAS 133), as amended by SFAS No. 149.
Credit default swaps are recognized at fair value and recorded in either assets
or liabilities in the accompanying consolidated balance sheet. The Company
intends to hold these derivative instruments until maturity. The
fair value of credit default swaps is determined using a model developed by the
Company, the results of which are dependent upon a number of factors including
changes in interest rates, credit spreads, changes in credit quality, expected
recovery rates and other market factors. The change in fair value during the
period resulting from movements in these factors is unrealized as the credit default
swaps are not traded to realize this value. Other elements of the change in
fair value are based upon pricing established at the inception of the contract,
as well as events triggering loss payments under the contracts by the Company. Changes
in the fair value of credit default swaps attributable to earnings from
premiums received by the Company from the issuance of such contracts are
recorded in the line item caption entitled premium in the accompanying
consolidated statement of operations. In addition, changes in the fair value of
credit default swaps attributable to losses from actual and expected payments
to counterparties under such contracts are recorded in the line item caption
entitled Net losses and loss adjustment expenses in the accompanying
consolidated statement of operations, and the remaining components of the
change in fair value of credit defaults swaps, which are attributable to the
market and other factors discussed above, are recorded in the line item caption
entitled Net realized and unrealized gains (losses) on credit derivatives in
the accompanying consolidated statement of operations. This presentation is
applicable only to credit default swaps issued by the Company that it has the
intent and ability to hold to maturity and is consistent with practices in the
financial guarantee insurance industry for reporting the results of such
instruments. Variable Interest Entities The
Company insures obligations issued by variable interest entities (VIEs) in
the ordinary course of the Companys business. The Company provides financial
insurance of structured transactions backed by pools of assets of specified
types, municipal obligations supported by the issuers ability to charge fees
for specified services or projects, and corporate risk obligations including
essential infrastructure projects and obligations backed by receivables from
future sales of commodities and other specified services. The obligations
related to these transactions are often securitized through VIEs. In synthetic
transactions, the Company guarantees payment obligations of counterparties,
including VIEs, through credit default swaps referencing asset portfolios. The
Company only provides financial guarantee insurance of these VIEs for premiums at
market rates but does not hold any equity positions or subordinated debt in
these off-balance sheet arrangements. These financial guarantee contracts
represent variable interests held by the Company in VIEs. In
underwriting financial guarantees, the Company generally requires that
guaranteed obligations be investment-grade prior to the provision of credit
enhancement. Typically, in the case of asset-backed securities and other
structured obligations, such investment grade ratings are based upon subordination,
cash reserves and other structural protections. Consequently, the Company has
determined that it is not


16

---



XL
  Capital Assurance Inc. and SubsidiaryNotes to Consolidated Financial
  StatementsDecember 31, 2006, 2005 and 2004 the primary
beneficiary of any VIEs in which it holds a variable interest. Accordingly,
these VIEs are not consolidated. New Accounting
Pronouncements and Developments In
June 2005, at the request of the Securities and Exchange Commission, the FASB
added a project to their agenda to review and provide guidance for the
accounting for financial guarantee insurance contracts under which it will
consider claims liability recognition, premium recognition, and the related
amortization of deferred policy acquisition costs. Current accounting
literature, specifically FASB Statement of Financial Accounting Standards No.
60, Accounting and Reporting by Insurance Enterprises (SFAS 60), and FASB
Statement of Financial Accounting Standards No. 97, Accounting and Reporting
by Insurance Enterprises for Certain Long-Duration Contracts and for Realized
Gains and Losses from the Sale of Investments (SFAS 97), does not
specifically address the unique characteristics of accounting for financial
guarantee insurance contracts. Consequently, the accounting principles applied
by the industry, as well as the Company, have evolved over time and incorporate
the concepts of both short-duration and long-duration contract accounting under
the provisions of SFAS 60 and SFAS 97, as well as other accounting literature,
such as FASB Statement of Financial Accounting Standards No. 5,  Accounting for Contingencies (SFAS No.
5) and Emerging Issues Task Force (EITF) Issue No. 85-20, Recognition of
Fees for Guaranteeing a Loan. An exposure draft is expected to be issued by
the FASB during the first quarter of 2007.
The Company will continue to apply the accounting policies described
herein until further guidance is provided by the FASB. In
February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid
Financial Instruments (SFAS 155), which amends SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities (SFAS 133) and SFAS No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities (SFAS 140), and addresses issues raised in SFAS 133
Implementation Issue No. D1, Application of Statement 133 to Beneficial
Interests in Securitized Financial Assets. The primary objectives of SFAS 155
are: (i) with respect to SFAS 133, to address the accounting for beneficial
interests in securitized financial assets and (ii) with respect to SFAS 140, to
eliminate a restriction on the passive derivative instruments that a qualifying
special purpose entity may hold. SFAS 155 is effective for all financial
instruments acquired or issued after the beginning of an entitys first fiscal
year that begins after September 15, 2006. The Company adopted SFAS 155 on
January 1, 2007 and it did not have a material effect on the Companys
financial condition or results of operations. In
April 2006, the FASB issued FSP FIN 46(R)-6, Determining the Variability to be
Considered in Applying FIN 46(R), which states that the variability to be
considered when applying FIN 46(R) should be based on an analysis of the design
of an entity, which entails analyzing the nature of the risks in the entity and
determining the purpose for which the entity was created and determining the
variability the entity is designed to create and pass along to its interest
holders. Typically, assets and operations of the entity create the variability
(and thus are not variable interests), while liabilities and equity interests
absorb that variability (and thus, are variable interests). The role of a
contract or arrangement in the design of the entity, regardless of its legal
form or accounting classification, shall dictate whether that interest should
be treated as creating or absorbing variability for the entity. The Company
adopted the guidance in this FSP as of July 1, 2006 and it did not have a
material effect on the Companys financial condition or results of operations. In
July 2006, the FASB issued FASB Interpretation No. 48, Accounting for
Uncertainty in Income Taxes  an interpretation of FASB Statement No. 109
(FIN 48). FIN 48 prescribes a recognition threshold and measurement attribute
for financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return, and also provides guidance on
de-recognition,


17

---



XL Capital Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004 classification, interest and
penalties, accounting in interim periods, disclosure, and transition. The
provision of FIN 48 must be applied beginning January 1, 2007. The adoption of
FIN 48 is not expected to have a material effect on the Companys financial
condition or results of operations. In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS
157) which defines fair value, establishes a framework for measuring fair
value in generally accepted accounting principles, and expands disclosures
about fair value measurements. This Statement is applicable in conjunction with
other accounting pronouncements that require or permit fair value measurements,
where the FASB previously concluded in those accounting pronouncements that
fair value is the relevant measurement attribute. Accordingly, this Statement
does not require any new fair value measurements. SFAS No. 157 is effective for
financial statements issued for fiscal years beginning after November 15, 2007,
and interim periods within those fiscal years. The Company is currently assessing
the impact of the adoption of SFAS 157. In
    February 2007, the FASB issued SFAS 159, The Fair Value Option for
    Financial Assets and Financial Liabilities.  SFAS 159 provides the
    Company an irrevocable option to report selected financial assets and liabilities
    at fair value with changes in fair value
  recorded in earnings. The option is applied, on a contract-by-contract basis,
  to an entire
  contract and not only to specific risks, specific cash flows or other portions
  of that contract.
  Upfront costs and fees related to a contract for which the fair value option
  is elected shall
  be recognized in earnings as incurred and not deferred. SFAS 159 also establishes
  presentation and disclosure requirements designed to facilitate comparisons
  between
  companies that choose different measurement attributes for similar types of
  assets and
  liabilities. SFAS 159 is effective for fiscal years beginning after November
  15, 2007.
  The Company is currently evaluating the effect of SFAS on its financial statements. Segment Reporting As
a monoline financial guarantee insurer, the Company is one reportable operating
segment.


|   |            
|-- | -----------
|3. | Investments

The
Companys primary investment objective is the preservation of capital through
maintenance of high-quality investments with adequate liquidity. A secondary
objective is optimizing long-term, after-tax returns. The
amortized cost and fair value of investments as of December 31, 2006 and 2005
are as follows: As of December 31, 2006(U.S. Dollars in thousands)

Cost or
  Amortized
  Cost

Gross
  Unrealized
  Gains

Gross
  Unrealized
  Losses

Fair
  ValueDebt securitiesU.S. Government and Government agencies

$
66,323

$
710

$
(754
)
$
66,279Corporate


74,911


16


(1,801
)

73,126Mortgage and asset backed securities


193,923


1,080


(2,521
)

192,482U.S. States and political subdivisions of the States


375


3





378Total debt securities

$
335,532

$
1,809

$
(5,076
)
$
332,265Short-term investmentsTotal short-term investments

$
14,979

$


$
(1
)
$
14,978


18

---



XL Capital Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004  As of December 31, 2005(U.S. Dollars in thousands)

Cost or
  Amortized
  Cost

Gross
  Unrealized
  Gains

Gross
  Unrealized
  Losses

Fair
  ValueDebt securitiesU.S. Government and Government agencies

$
50,256

$
1,197

$
(559
)
$
50,894Corporate


78,357


529


(1,506
)

77,380Mortgage and asset backed securities


152,317


425


(2,382
)

150,360U.S. States and political subdivisions of the States


789








789Total debt securities

$
281,719

$
2,151

$
(4,447
)
$
279,423Short-term investmentsTotal short-term investments

$
7,244

$


$
(2
)
$
7,242 Debt
securities investments with an amortized cost and fair value of $6.6 million
and $6.6 million and $6.9 million and $7.0 million at December 31, 2006 and
2005, respectively, were on deposit with various regulatory authorities as
required by insurance laws. The
change in net unrealized gains (losses) consists of: (U.S. Dollars in thousands)




Years Ended December 31,2006

2005

2004Debt securities




$
(971
)
$
(4,723
)
$
387Short-term investments





1


(2
)

(2
)Change in net unrealized gains (losses)




$
(970
)
$
(4,725
)
$
385 The
amortized cost and fair value of bonds at December 31, 2006 and 2005 by
contractual maturity are shown below. Actual maturity may differ from
contractual maturity because issuers may have the right to call or prepay
obligations with or without call or prepayment penalties. (U.S. Dollars in thousands)

As of December 31,2006

2005Amortized
  Cost

Fair
  Value

Amortized
  Cost

Fair
  ValueDue after one year through five years

$
55,768

$
54,598

$
45,007

$
44,073Due after five years through ten years


83,876


82,914


72,005


71,057Due after ten years


1,965


2,269


12,390


13,933141,609


139,781


129,402


129,063Mortgage and asset backed securities


193,923


192,484


152,317


150,360Total

$
335,532

$
332,265

$
281,719

$
279,423


19

---



XL Capital Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004 Proceeds
from sales of debt securities for the years ended December 31, 2006, 2005 and
2004 were $86.1 million, $107.2 million, and $213.4 million, respectively. The
gross realized gains and gross realized losses for the years ended December 31,
2006, 2005, and 2004 related to the sale of investments were as follows: (U.S. Dollars in thousands)

For the years ended2006

2005

2004Gains

Losses

Gains

Losses

Gains

LossesDebt securities

$
498

$
(1,881
)
$
412

$
(399
)
$
797

$
(1,476
)Short-term investments





(23
)

3


(8
)

10


(1
)Total

$
498

$
(1,904
)
$
415

$
(407
)
$
807

$
(1,477
) Net investment income is
derived from the following sources: (U.S.
  dollars in thousands)










Year Ended December 31,2006

2005

2004Debt securities, short term investments and cash
equivalents

$
17,012

$
13,350

$
11,127Less: Investment expenses











(314
)

(303
)

(247
)Net investment income










$
16,698

$
13,047

$
10,880 The
following table presents the Companys investments gross unrealized losses and
fair value, aggregated by investment category and length of time that
individual securities have been in a continuous unrealized loss position, at
December 31, 2006: (U.S.
  Dollars in thousands) As of December 31, 2006Less than 12 months

12 months or more

TotalDescription
  of securities

Fair
  Value

Unrealized
  Losses

Fair
  Value

Unrealized
  Losses

Fair
  Value

Unrealized
  LossesMortgage and asset-backed Securities

$
44,872

$
(190
)
$
87,484

$
(2,331
)
$
132,356

$
(2,521
)U.S. Government and government agencies


9,067


(71
)

23,179


(683
)

32,246


(754
)Corporate


5,777


(23
)

63,108


(1,778
)

68,885


(1,801
)U.S. states and political Subdivisions








403


(1
)

403


(1
)Total fixed matureities and short term Investments

$
59,716

$
(284
)
$
174,174

$
(4,793
)
$
233,890

$
(5,077
)


20

---



XL Capital Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004 (U.S.
  Dollars in thousands) As of December 31, 2005Less than 12 months

12 months or more

TotalDescription
  of securities

Fair
  Value

Unrealized
  Losses

Fair
  Value

Unrealized
  Losses

Fair
  Value

Unrealized
  LossesMortgage and asset-backed Securities

$
81,722

$
(1,324
)
$
34,305

$
(1,060
)
$
116,027

$
(2,384
)U.S. Government and government agencies


37,113


(543
)

488


(16
)

37,601


(559
)Corporate


32,048


(478
)

32,338


(1,028
)

64,386


(1,506
)Total fixed matureities and short term Investments

$
150,883

$
(2,345
)
$
67,131

$
(2,104
)
$
218,014

$
(4,449
) The
high credit quality of the Companys investment portfolio of debt securities
is primarily due to strict adherence to investment guidelines.
Unrealized gains and losses are deemed to be temporary and result from general
interest rate movements.


|   |                                               
|-- | ----------------------------------------------
|4. | Information
  Concerning Parent and Affiliates

Capital Transactions On
August 4, 2006, SCA contributed $25.0 million to XLCA from the proceeds of its
IPO. The funds will be used by the Company to support its continued growth and
for general corporate purposes. Services Agreements with Affiliates Substantially
all of the Companys personnel services are provided by XL Financial
Administrative Services Inc. (XLFAS). Prior to the IPO, XLFAS was an indirect
wholly owned subsidiary of XL Capital. In connection with the IPO, XL Capital
transferred all its direct and indirect ownership interest in XLFAS, along with
XLFASs employees, to SCA. In addition, the Company purchased various services
from affiliates of XL Capital prior to the IPO under various agreements and
continues to purchase services under new agreements that became effective at
the date of the IPO. Such services principally include: (i) information technology
support, (ii) reinsurance and retrocessional consulting and management
services, and (iii) actuarial, legal, finance, internal audit services and
certain investment management services. For the years ended December 31, 2006,
2005 and 2004, the Company incurred costs for personnel services (including
costs associated with employee benefit plans discussed below), as well as the
other services discussed above aggregating $58.0 million, $63.1 million and
$69.7 million, respectively, which are a component of Net operating expenses
in the accompanying consolidated statements of operations. Employee Benefit Plans Prior
to the IPO, XL America, Inc (XLA) maintained a qualified defined contribution
pension plan and a non-qualified deferred compensation plan for the benefit of
all XLFAS eligible employees (collectively, the Plans). Discretionary
contributions to both Plans were based on a fixed percentage of employee
contributions and compensation as defined by the Plans. Such plans were converted
to SCA plans on the effective date of the IPO. The terms and provisions of
SCAs plans are substantially the same as the aforementioned plans of XLA. For
the years ended December 31, 2006, 2005, and 2004, the Company incurred costs
under the aforementioned plans aggregating $2.5 million, $2.0 million, and $1.8
million, respectively, which are reflected in Net operating expenses in the
accompanying consolidated statements of operations.


21

---



XL Capital Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004 Reinsurance Agreements with
Affiliates and Other Guaranties The
Company has the following reinsurance agreements with affiliates. Certain of
the agreements discussed below may be terminated under certain conditions, as
defined in the agreements. 
Effective August 4, 2006,
  XL RE AM indemnified the Company for all losses and loss adjustment expenses
  incurred in excess of its retained reserves at the effective date of the
  agreement relating to an insured project financing described in Note 10 (a).
  In consideration for the aforementioned indemnification the Company is
  obligated to pay XL RE AM approximately $9.8 million on an installment basis
  over the life of the aformentioned project financing. As this premium is due
  irrespective of any early termination of the underlying insurance
  transaction, the Company recorded a liability of approximately $7.0 million
  at the effective date of the indemnification (representing the present value
  of the obligation discounted at 5.0%, which reflects the rate on treasury
  obligations with a term to maturity commensurate with that of the liability)
  and a corresponding deferred cost, which are reflected in the accompanying
  consolidated balance sheet in Reinsurance premiums payable and Prepaid
  reinsurance premiums, respectively. For the year ended December 31, 2006,
  the Company incurred costs under the aforementioned agreements aggregating
  approximately $0.4 million.
Effective August 4, 2006,
  XLA indemnified the Company for any dimunition in value below their carrying
  value at June 30, 2006 of the investment described in Note 10 (b), which
  investment was acquired in connection with the satisfaction of a claim under
  a financial guarantee insurance policy issued by XLCA. In addition, pursuant
  to the aforementioned indemnity, XLA agreed to indemnify the Company for any
  costs arising out of any litigation or future claim in connection with the
  aforementioned insurance policy. See Note 10 (b) for further information
  regarding amounts recovered or recoverable by XLCA under the indemnity.
The Company has a
  facultative quota share reinsurance treaty (Treaty) with XLFA. Under the
  terms of the this Treaty, XLFA agrees to reinsure up to 75% of the guarantee
  business written by the Company provided it meets certain specified
  parameters. Prior to July 1, 2006, XLFA agreed to reinsure up to 90% of the
  Companys acceptable risks under the Treaty. In addition, the Company is
  allowed up to a 30% ceding commission (or such other percentage on an
  arms-length basis) on ceded premiums written under the agreement.
Effective May 1, 2004, XL
  Insurance (Bermuda) Ltd (XLI), an indirect wholly owned subsidiary of XL
  Capital, entered into an agreement with XLCA which unconditionally and
  irrevocably guarantees XLCA the full and complete payment when due of all of
  XLFAs obligations under its facultative quota share reinsurance agreement
  with XLCA, under which agreement XLFA has assumed business from XLCA since
  December 19, 2000. The par value of business guaranteed by XLI under this
  agreement was approximately $83.1 billion and $72.6 billion as of December
  31, 2006 and 2005, respectively. The agreement terminated with respect to any
  new business produced by XLCA and ceded to XLFA pursuant to the faculative
  quota share reinsurance agreement after the effective date of the IPO, but
  the guarantee remains in effect with respect to cessions under the such
  agreement prior to the IPO.


22

---



XL Capital Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004  
Effective November 1,
  2002, XLCA entered into a facultative reinsurance arrangement (the XL Re
  Treaty) with XL RE AM. Under the terms of the XL Re Treaty, XL RE AM agrees
  to reinsure risks insured by XLCA under financial guarantee insurance
  policies up to the amount necessary for XLCA to comply with single risk
  limitations set forth in Section 6904(d) of the New York Insurance Laws. Such
  reinsurance was on an automatic basis prior to the effective date of the IPO
  and is on a facultative basis on and after the effective date of the IPO. The
  reinsurance provided by XL RE AM may be on an excess of loss or quota share
  basis. The Company is allowed up to a 30% ceding commission (or such other
  percentage on an arms-length basis) on ceded premiums written under the
  terms of this agreement.
Effective January 1, 2004,
  XLCA commuted all the reinsurance ceded under the XL RE Treaty through
  December 31, 2003. As a result of the commutation, XL RE AM returned $6.0
  million of premiums to XLCA, XLCA returned ceding commissions of $1.8 million
  to XL RE AM, and XL RE AM paid XLCA $4.2 million.
The Company provides
  financial guarantee insurance policies insuring timely payment of investment
  agreements issued by XL Asset Funding Company I LLC (XLAF), an affiliate of
  the Company. As of December 31, 2006 and 2005, the aggregate face amount of
  such investment agreements insured by the Company was $3.9 billion ($554.8
  million net of reinsurance to XLFA) and $3.7 billion ($366.7 million net of
  reinsurance to XLFA), respectively. In addition, the Company insures XLAFs
  obligations under certain derivative contracts issued and purchased by XLAF.
  As of December 31, 2006 and 2005, the total notional value of such contracts
  insured was $179.1 million and $167.8 million, respectively. For the years
  ended December 31, 2006, 2005, and 2004, the Company recorded earned premiums
  of $3.8 million, $3.0 million and $2.0 million, respectively, relating to the
  aforementioned contracts.
XLI guarantees the
  obligations of XLCA in connection with certain transactions insured by
  XLCA-UK. As of December 31, 2006 and 2005, the gross par outstanding related
  to these transactions were approximately $1,017.8 million ($58.6 million net
  of reinsurance) and $913.3 million ($53.7 million net of reinsurance),
  respectively.


|   |                      
|-- | ---------------------
|5. | Net
  Premiums Earned

Net premiums earned are
comprised of: Year Ended December 31,(U.S. Dollars in thousands)

2006

2005

2004Direct premiums written

$
353,708

$
232,491

$
231,936Assumed premiums written


20


99


605Ceded premiums written


(309,344
)

(209,592
)

(202,863
)Net premiums written


44,384


22,998


29,678Change in direct deferred
  premium revenue


(173,675
)

(86,110
)

(88,556
) (1)Change in assumed deferred
  premium revenue








807Change in prepaid
  reinsurance premiums


147,267


77,515


71,195
(1)Net premiums earned

$
17,976

$
14,403

$
13,124  (1)
Includes $23.3 million of
  earned premium relating to the recognition of a full limit loss on an insured
  transaction  See Note 10.


23

---



XL Capital Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004


|   |                         
|-- | ------------------------
|6. | Net
  Operating Expenses

Net operating expenses are
comprised of: Year Ended December 31,(U.S. Dollars in thousands)

2006

2005

2004Operating
  expensesGross operating expenses

$
98,291

$
77,029

$
76,480Less: Deferred acquisition
  costs (DAC)


32,038


19,553


24,652Add: Amortization of DAC


12,306


9,178


7,223Operating expenses


78,559


66,654


59,051Ceding
  commission revenueGross ceding commission
  revenue


79,516


55,603


55,753Less: Deferred ceding
  commissions (DCC)


51,732


30,167


35,132Add: Amortization of DCC


20,471


15,871


14,171Ceding commission revenue


48,255


41,307


34,792Net operating expenses

$
30,304

$
25,347

$
24,259


|   |                                                             
|-- | ------------------------------------------------------------
|7. | Deferred
  Ceding Commissions and Deferred Acquisition Costs

The ceding commission income
and costs deferred and related amortization are as follows: Year Ended December 31,(U.S. dollars in thousands)

2006

2005

2004Deferred
  ceding commissions, netBeginning of year

$
(41,191
)
$
(37,270
)
$
(33,738
)Ceding
  commission revenueCeding commission revenue
  deferred during the year


(51,732
)

(30,167
)

(35,132
)Ceding commissions
  amortized


20,471


15,871


14,171Acquisition
  costsCosts deferred during the
  year


32,038


19,553


24,652Costs amortized


(12,306
)

(9,178
)

(7,223
)Deferred
  ceding commissions, netEnd of year

$
(52,720
)
$
(41,191
)
$
(37,270
)


24

---



XL Capital Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004


|   |            
|-- | -----------
|8. | Reinsurance

The
Company utilizes reinsurance principally to increase aggregate premium capacity
and to reduce the risk of loss on financial guarantee business underwritten.
This reinsurance includes the Facultative Quota Share Reinsurance Treaties with
affiliates discussed in Note 4 as well as other facultative reinsurance with
non-affiliated reinsurers. Reinsurance does not relieve the Company of its obligations
under its policies of insurance and credit default swap contracts. Accordingly,
the Company is still liable under such policies and contracts even if any or
all of the reinsuring companies are unable to meet their obligations to the
Company, or contest such obligations. The Company regularly monitors the
financial condition of its reinsures and believes there are no material
uncollectible reinsurance balances at December 31, 2006 and 2005. The following
tables set forth certain amounts ceded to affiliate and non-affiliate reinsures
as of and for the years ended December 31, 2006, 2005 and 2004. The affiliated
amounts presented for 2004 do not include the effect of the commutation with XL
RE AM discussed in Note 4. (U.S. Dollars in thousands)

2006Affiliate

Non-Affiliate

TotalYear
  Ended December 31Ceded premiums written

$
307,221

$
2,123

$
309,344Ceded premiums earned


159,739


2,337


162,076Ceding commission revenue


47,720


535


48,255Ceded losses and loss
  adjustment expenses


35,506


584


36,090At
  December 31Par exposure ceded

$
100,448

$
600

$
101,048Reinsurance balances
  recoverable on unpaid losses


153,017


2,580


155,597(U.S. Dollars in thousands)

2005Affiliate

Non-Affiliate

TotalYear
  Ended December 31Ceded premiums written

$
205,902

$
3,690

$
209,592Ceded premiums earned


128,344


3,733


132,077Ceding commission revenue


40,373


934


41,307Ceded losses and loss
  adjustment expenses


32,782


933


33,715At
  December 31Par exposure ceded

$
73,952

$
970

$
74,922Reinsurance balances
  recoverable on unpaid losses


120,077


1,996


122,073


25

---



| |                                             
| | --------------------------------------------
| | XL Capital Assurance Inc. and Subsidiary    
| | Notes
  to Consolidated Financial Statements
| | December
  31, 2006, 2005 and 2004          
| |                                             

| |                                                   |  |           |         |               |   |       |  |   |         | 
| | ------------------------------------------------- |  | --------- | ------- | ------------- | - | ----- |  | - | ------- | 
| | (U.S. Dollars in thousands)                       |  | 2004      |        
| |                                                   |  |           |        
| |                                                   |  | Affiliate |         | Non-Affiliate |   | Total | 
| |                                                   |  |           |         |               |   |       |  |   |         | 
| | Year Ended December 31                            |  |           |         |               |   |       |  |   |         | 
| | Ceded premiums written                            |  | $         | 198,945 |               | $ | 3,918 |  | $ | 202,863 | 
| | Ceded premiums earned                             |  |           | 127,407 |               |   | 4,261 |  |   | 131,668 | 
| | Ceding commission revenue                         |  |           | 33,956  |               |   | 836   |  |   | 34,792  | 
| | Ceded losses and loss adjustment expenses         |  |           | 62,632  |               |   | 1,002 |  |   | 63,634  | 
| | At December 31                                    |  |           |         |               |   |       |  |   |         | 
| | Par exposure ceded                                |  | $         | 58,050  |               | $ | 1,266 |  | $ | 59,316  | 
|
| | Reinsurance balances recoverable on unpaid losses |  |           | 87,243  |               |   | 3,868 |  |   | 91,111  | 

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|9. | Outstanding
  Exposure and Collateral                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | The
  Companys policies insure the scheduled payments of principal and interest on
  insured obligations. The net exposure retained on any risk is subject to the
  Companys underwriting guidelines and regulatory risk limitations. The
  Companys in force business is diversified both domestically and internationally,
  across multiple industries and by type of obligations insured. The total
  principal (or par) amount insured, before reinsurance, as of December 31,
  2006 and 2005 was $116.0 billion and $83.3 billion, respectively. The total
  principal and interest amount insured, before reinsurance, as of December 31,
  2006 and 2005 was $176.2 billion and $122.3 billion, respectively.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | The
  following tables present certain information with respect to the par amounts
  insured by the Company at December 31, 2006 and 2005, before and after
  reinsurance (or on a gross and net basis, respectively):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

| |                                        |  |       |         |      |   |          |  |       |       |     |   |          |  |   |       |  |  |       |  
| | -------------------------------------- |  | ----- | ------- | ---- | - | -------- |  | ----- | ----- | --- | - | -------- |  | - | ----- |  |  | ----- | -
| | Risk   Classes - Par/Notional Exposure |  |       |         |     
|
| |                                        |  | 2006  |         | 2005 |  
| |                                        |  |       |         |      |  
| | (U.S. Dollars in millions)             |  | Gross |         | Net  |   | % of Net |  | Gross |       | Net |   | % of Net | 
| |                                        |  |       |         |      |   |          |  |       |       |     |   |          |  |   |       |  |  |       |  
| | U.S. public finance                    |  | $     | 48,487  |      | $ | 6,261    |  |       | 41.9  | %   | $ | 35,987   |  | $ | 3,885 |  |  | 46.5  | %
| | U.S. structured finance                |  |       | 51,903  |      |   | 7,216    |  |       | 48.3  |     |   | 37,197   |  |   | 3,655 |  |  | 43.8  |  
| | International finance                  |  |       | 15,599  |      |   | 1,464    |  |       | 9.8   |     |   | 10,086   |  |   | 808   |  |  | 9.7   |  
| |                                        |  |       |         |      |   |          |  |       |       |     |   |          |  |   |       |  |  |       |  
| | Total                                  |  | $     | 115,989 |      | $ | 14,941   |  |       | 100.0 | %   | $ | 83,270   |  | $ | 8,348 |  |  | 100.0 | %
| |                                        |  |       |         |      |   |          |  |       |       |     |   |          |  |   |       |  |  |       |  

26

---



| |                                             
| | --------------------------------------------
| | XL Capital Assurance Inc. and Subsidiary    
| | Notes
  to Consolidated Financial Statements
| | December
  31, 2006, 2005 and 2004          
| |                                             

The par amounts insured as
of December 31, 2006 and 2005 and the terms of maturity are as follows:


| |                                           |  |                |        |                    |   |       |  |     |        |  |   |       | 
| | ----------------------------------------- |  | -------------- | ------ | ------------------ | - | ----- |  | --- | ------ |  | - | ----- | 
| |                                           |  | 2006           |       
| |                                           |  |                |       
| | Years to Maturity - Par/Notional Exposure |  |                |        |                    |   |       |  |     |        |  |   |       | 
| |                                           |  | Public Finance |        | Non-Public Finance |  
| |                                           |  |                |        |                    |  
| | (U.S. Dollars in millions)                |  | Gross          |        | Net                |   | Gross |  | Net |       
| |                                           |  |                |        |                    |   |       |  |     |        |  |   |       | 
| | 0 to 5 years                              |  | $              | 1,186  |                    | $ | 126   |  | $   | 9,749  |  | $ | 999   | 
| | 5 to 10 years                             |  |                | 3,269  |                    |   | 352   |  |     | 12,838 |  |   | 1,340 | 
| | 10 to 15 years                            |  |                | 6,170  |                    |   | 753   |  |     | 9,576  |  |   | 1,339 | 
| | 15 to 20 years                            |  |                | 11,305 |                    |   | 1,442 |  |     | 2,566  |  |   | 335   | 
| | 20 years and beyond                       |  |                | 26,557 |                    |   | 3,588 |  |     | 32,773 |  |   | 4,667 | 
| |                                           |  |                |        |                    |   |       |  |     |        |  |   |       | 
| | Total                                     |  | $              | 48,487 |                    | $ | 6,261 |  | $   | 67,502 |  | $ | 8,680 | 
| |                                           |  |                |        |                    |   |       |  |     |        |  |   |       | 

| |                                           |  |                |        |                    |   |       |  |     |        |  |   |       | 
| | ----------------------------------------- |  | -------------- | ------ | ------------------ | - | ----- |  | --- | ------ |  | - | ----- | 
| |                                           |  | 2005           |       
| |                                           |  |                |       
| | Years to Maturity - Par/Notional Exposure |  |                |        |                    |   |       |  |     |        |  |   |       | 
| |                                           |  | Public Finance |        | Non-Public Finance |  
| |                                           |  |                |        |                    |  
| | (U.S. Dollars in millions)                |  | Gross          |        | Net                |   | Gross |  | Net |       
| |                                           |  |                |        |                    |   |       |  |     |        |  |   |       | 
| | 0 to 5 years                              |  | $              | 1,251  |                    | $ | 125   |  | $   | 10,853 |  | $ | 1,001 | 
| | 5 to 10 years                             |  |                | 3,019  |                    |   | 303   |  |     | 11,373 |  |   | 1,074 | 
| | 10 to 15 years                            |  |                | 4,739  |                    |   | 476   |  |     | 5,446  |  |   | 562   | 
| | 15 to 20 years                            |  |                | 7,564  |                    |   | 824   |  |     | 2,107  |  |   | 200   | 
| | 20 years and beyond                       |  |                | 19,414 |                    |   | 2,157 |  |     | 17,504 |  |   | 1,626 | 
| |                                           |  |                |        |                    |   |       |  |     |        |  |   |       | 
| | Total                                     |  | $              | 35,987 |                    | $ | 3,885 |  | $   | 47,283 |  | $ | 4,463 | 
| |                                           |  |                |        |                    |   |       |  |     |        |  |   |       | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The
  Company limits its exposure to losses from writing financial guarantees
  through its credit approval process and by maintaining a surveillance
  function which monitors insured transactions. Additionally, the Company
  mitigates credit risk by underwriting investment-grade transactions,
  diversifying its portfolio and maintaining rigorous collateral requirements
  on asset-backed obligations, as well as through reinsurance.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | As
  of December 31, 2006 and 2005, the insured portfolio was diversified by type
  of insured obligation as shown in the following table:                                                                                                                                                                                                                                                                                                         

27

---



XL Capital Assurance Inc. and
  SubsidiaryNotes to Consolidated Financial StatementsDecember 31, 2006, 2005 and 2004  Type of Insured Obligation -
  Par/Notional Exposure

2006

2005(U.S. Dollars in millions)

Gross

Net

% of Net

Gross

Net

% of NetPooled Debt Obligations

$
25,784

$
3,747

25.3
%

$
14,457

$
1,446

17.5
%General Obligation


20,510


2,456

16.4



15,947


1,595

19.1Consumer ABS


11,410


1,566

10.5



10,576


1,028

12.3Utilities


9,886


1,324

8.9



7,831


926

11.1Transportation


9,344


1,259

8.4



5,343


617

7.4Power & Utilities


9,382


981

6.6



6,859


631

7.6Non Ad Valorem


5,801


901

6.0



3,910


428

5.1Financial Product


6,260


760

5.1



5,798


529

6.3Higher Education


4,887


598

4.0



3,576


354

4.2Commercial ABS


2,979


408

2.7



2,162


216

2.6Infrastructure


3,634


389

2.6



1,028


59

0.7Pre-Insured


1,721


231

1.5



945


95

1.1Future Flow


1,949


125

0.8



3,346


282

3.4Housing and Public
  Buildings


753


75

0.5



666


67

0.8Specialized Risk


505


44

0.3



250


18

0.2Revenue Secured


356


36

0.2



355


35

0.4Sovereign


739


32

0.2



118


12

0.1Whole Business
  Securitization


62


6





103


10

0.1Other


27


3










Total

$
115,989

$
14,941

100.0
%

$
83,270

$
8,348

100.0
% The
Company seeks to maintain a diversified portfolio of insured obligations
designed to spread its risk across a number of geographic areas. As of December
31, 2006 and 2005, the distribution of par exposure by geographic location is set
forth in the following table:


38

---



XL
  Capital Assurance Inc. and SubsidiaryNotes to Consolidated Financial StatementsDecember 31, 2006, 2005 and 2004  Geographic
  Distribution -
  Par/Notional Exposure

2006

2005(U.S. Dollars in millions)

Gross

Net

% of Net

Gross

Net

% of NetCalifornia

$
12,550

$
1,393

9.3
%

$
10,223

$
1,009

12.1
%New York


8,543


1,160

7.8



5,269


515

6.2Delaware


3,156


571

3.8



1,659


165

2.0Alabama


2,976


389

2.6



1,746


155

1.9Texas


2,900


357

2.4



2,057


206

2.5Illinois


2,670


304

2.0



2,532


251

3.0Florida


2,631


866

5.8



1,915


530

6.3Massachusetts


2,268


250

1.7



2,290


225

2.7Pennsylvania


2,172


269

1.8



1,376


138

1.7New Jersey


2,123


232

1.6



2,024


202

2.4Wisconsin


1,908


199

1.3



1,758


176

2.1Michigan


1,706


199

1.3



1,493


149

1.8Colorado


1,491


158

1.1



1,334


133

1.6Georgia


1,420


176

1.2



1,077


99

1.2Tennessee


1,166


147

1.0



383


38

0.5Washington


1,165


190

1.3



648


65

0.8Minnesota


1,134


144

1.0



937


87

1.0Oklahoma


1,094


208

1.4



240


24

0.3District of Columbia


1,083


144

1.0



831


83

1.0Ohio


1,017


107

0.7



971


45

0.5Other U.S. Jurisdictions


10,190


1,261

8.4



6,727


687

8.2International


15,599


1,465

9.8



9,836


783

9.4US Diversified


35,027


4,752

31.7



25,944


2,583

30.8Total

$
115,989

$
14,941

100.0
%

$
83,270

$
8,348

100.0
% In
its asset-backed business, the Company considers geographic concentration as a
factor in its underwriting process. However, the existence of first-loss
protection in a typical asset-backed securitization, in addition to other
factors, makes it difficult to attribute geographic exposure to deals
collateralized by diversified pools of obligations. For asset-backed
transactions, the Company considers the seller/servicer, industry, and type of
collateral to be more relevant measures of diversification. As of December 31, 2006 and 2005, the
distribution of par exposure by form of credit enhancement is set forth in the
following table: Credit
  Enhancement - 
  Par/Notional Exposure

2006

2005(U.S. Dollars in millions)

Gross

Net

% of Net

Gross

Net

% of NetFinancial guaranty insurance policy

$
90,949

$
10,981

73.5
%


72,978

$
7,329

87.8
%Credit default swap


25,040


3,960

26.5



10,292


1,019

12.2Total

$
115,989

$
14,941

100.0
%

$
83,270

$
8,348

100.0
%


29

---



XL Capital Assurance Inc. and
  SubsidiaryNotes to Consolidated Financial StatementsDecember 31, 2006, 2005 and 2004


|    |                                                    
|--- | ---------------------------------------------------
|10. | Liability
  for Losses and Loss Adjustment Expenses

The
Companys liability for losses and loss adjustment expenses consists of case
basis reserves and unallocated reserves. Activity in the liability for losses
and loss adjustment expenses is summarized as follows: As at
  and for the
  Twelve Months Ended
  December 31, 2006

As at
  and for the
  Twelve Months Ended
  December 31, 2005

As at
  and for the
  Twelve Months Ended
  December 31, 2004Case

Unallocated

Case

Unallocated

Case

Unallocated(U.S. dollars in
  thousands)


Reserves

Reserves

Reserves

Reserves

Reserves

ReservesUnpaid losses and loss expenses at beginning of year

$
66,183

$
65,419

$
45,550

$
49,774

$


$
25,009Unpaid losses and loss expenses recoverable


(62,518
)

(59,555
)

(45,588
)

(45,523
)




(22,998
)Net unpaid losses and loss expenses at beginning of year


3,665


5,864


(38
)

4,251





2,011Increase (decrease) in net losses and loss expense incurred in
respect
  of losses occurring in:Current year





1,704


12


1,606


650


2,023Prior years


(66
)




3,676








Less net losses and loss expenses (paid) received &
other


(2,099
)

242


15


7


(688
)

217Net unpaid losses and loss expenses at end of period


1,500


7,810


3,665


5,864


(38
)

4,251Unpaid losses and loss expenses recoverable


82,283


73,314


62,518


59,555


45,588


45,523Unpaid losses and loss expenses at end of period

$
83,783

$
81,124

$
66,183

$
65,419

$
45,550

$
49,774


| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Case
  Basis Reserves for Losses and Loss Adjustment Expenses                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | Set forth below is a
  discussion of certain case basis reserves established by the Company. The
  Company has been indemnified with respect to loss development relating to the
  insurance transactions described under (a) and (b) below by affiliates of
  XL Capital in connection with SCAs IPO. As a result of such indemnifications,
  all adverse loss development on such insurance transactions subsequent to the
  effective date of the IPO, which is in excess of the Companys carried
  reserves for such transactions at the date of the IPO, will be absorbed by
  the aforementioned affiliates of XL Capital. Such protection does not relieve
  the Company of its obligations under the aforementioned insurance
  transactions. Accordingly, the Company is still liable under the insurance
  transactions in the event that the affiliates of XL Capital do not meet their
  obligations under the indemnifications. For further information with respect
  to the indemnifications see Note 4
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | a.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | During the year ended
  December 31, 2004, the Company recorded a provision for losses of
  approximately $42.1 million, representing the present value loss expected to
  be incurred in the future with respect to an insured project financing.
  Because this loss represented a full limit loss to the subordinated tranche
  of the insured transaction, the remaining deferred premium revenue pertaining
  to such tranche, which aggregated approximately $23.3 million, was fully
  earned resulting in a net loss, before reinsurance, of approximately $18.8
  million. The portion of the insured exposure to which this loss relates was
  fully reinsured on a first-loss basis by XLFA and, accordingly, there was no
  net impact on the Companys results of operations from this loss provision.
  During 2005, the company recorded an additional provision for loss relating
  to this transaction of $16.7 million ($2.8

30

---



XL Capital Assurance Inc. and
  SubsidiaryNotes to Consolidated Financial StatementsDecember 31, 2006, 2005 and 2004


| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | 
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | 
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | million after reinsurance
  to XLFA), on a net present value basis, to reflect certain adverse
  developments. During 2006, the Company again recorded an additional provision
  for loss relating to the transaction of $15.2 million, which was fully
  covered under an indemnification discussed above and in Note 4 and,
  accordingly, resulted in no net impact on the Companys results of operations
  in 2006. The total remaining par insured by the Company with respect to this
  transaction, which amortizes over 12 years, aggregated approximately $215.8
  million at December 31, 2006. The estimate of loss was necessarily based on
  assumptions and estimates extending over many years into the future. There is
  currently no payment default with respect to this transaction. Management
  continues to monitor the exposure and will revise its loss estimate as
  necessary.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | b.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | In December 2005, certain
  notes that were insured by the Company and collateralized by loans to medical
  providers (the Insured Notes) defaulted upon their maturity. In
  satisfaction of the resulting claim, the Company purchased the Insured Notes
  for $20.2 million, which represented the remaining outstanding principal and
  accrued interest on the Insured Notes. The Insured Notes were recorded as an
  investment at their estimated fair value of $19.5 million at the date of
  acquisition and were reflected in the accompanying consolidated balance sheet
  at December 31, 2005 under the caption, Other invested assets. The
  difference between the estimated fair value of the Insured Notes at the date
  they were acquired and the consideration paid to acquire the notes was
  recorded as a paid loss of $0.7 million ($0.1 million, net of reinsurance to
  XLFA). The estimate of fair value of the Insured Notes was based on the
  Companys estimate of the fair value of the underlying collateral. During
  2006, the Company recognized an impairment charge of $15.1 million ($1.4
  million net of reinsurance to XLFA and the indemnification discussed above
  and in Note 4) relating to the Insured Notes and the balance of the Insured
  Notes was paid down. In addition, during 2006 the Company recorded a charge
  for $5.0 million relating to other exposures under this transaction which was
  fully indemnified under the indemnification discussed above and in Note 4.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | c.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | During the year ended
  December 31, 2005, the Company recorded a provision for loss of $5.2 million
  ($0.9 million after reinsurance to XLFA) representing the present value loss
  expected to be incurred in the future with respect to two related insured
  residential mortgage securitizations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | During 2006, one of the
  insured debt obligations was retired early as a result of the exercise of
  certain rights by a party to the transaction. As a result of the
  aforementioned retirement, the Company reduced the related case reserve by
  approximately $1.9 million ($0.2 million after reinsurance to XLFA). The
  total remaining par insured by the Company in connection with this
  transaction, which amortizes over many years into the future, aggregated
  approximately $81.0 million ($15.6 million net of reinsurance to XLFA) at
  December 31, 2006. The estimate of loss was necessarily based on assumptions
  and estimates extending over many years into the future. There is currently
  no payment default with respect to this transaction. Management continues to
  monitor the exposure and will revise its loss estimate as necessary, as
  information becomes available.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | The
  financing vehicle through which the insured project financing discussed in
  (a) above was issued is considered a variable interest entity under FASB
  Interpretation 46/46R, Consolidation of
  Variable Interest Entities, however, the Company is not the
  primary beneficiary. If this transaction is restructured or if the Company
  exercises its contractual rights in the event of a default, the primary
  beneficiary in the transaction will have to be reconsidered. If such events
  occur, the Company would likely be required to consolidate the financing
  vehicle.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | Unallocated
  Reserves                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | During
  2004 we adjusted our initial expected loss ratio to 20% from 25%, which was
  utilized since the adoption of our unallocated reserve methodology in
  recognition of the cumulative experience of our business to that point in
  time, as well as the increasing percentage of our in-force business from                                                                                                                                                                                                                                                                           

31

---



XL Capital Assurance Inc. and SubsidiaryNotes to Consolidated Financial Statements
  December 31, 2006, 2005 and 2004public finance insurance.
  This change resulted in approximately a $1.5 million decrease in unallocated
  loss reserves, which decrease was substantially offset by a change in the
  estimated expected loss emergence pattern of our in-force business due to the
  availability of more detailed information as a result of the implementation
  in 2004 of a new automated information system. Management also considered its
  industry studies described above as supportive of managements change
  in the initial expected loss ratio in 2004, for the reasons described above.
  Our updated analyses in 2005 and 2006 indicated that no change was necessary
  in our expected loss ratio of 20% from that in 2004.11.
Income TaxesThe
  Company will file two separate short period U.S. federal income tax returns
  for 2006, one will include the pre-ownership change period and the second
  will include the post-ownership change period. For the pre-ownership change
  period, the Companys federal income tax return will be consolidated with
  XLA and its subsidiaries. For the post-ownership change
  period, the Company will file a consolidated federal income tax return with
  SCA Holdings US Inc (the new US common parent of the SCA group) and its
  subsidiaries. For the pre-ownership change period filing, XLA maintains a tax
  sharing agreement with its subsidiaries, whereby the consolidated U.S.
  federal income tax liability is allocated among affiliates in the ratio that
  each affiliates separate return liability bears to the sum of the separate
  return liabilities of all affiliates that are members of the consolidated
  group. For the post-ownership change period, the Company will maintain a similar
  tax sharing agreement with US affiliates that are a member of the SCA Holdings
  US Inc. consolidated tax filing. In addition, a complementary method is used
  which results in reimbursement by profitable affiliates to loss affiliates
  for tax benefits generated by loss affiliates.  At December 31, 2006 and 2005,
  the Company had a federal income tax payable of $4.2 million and $1.0 million,
  respectivelyThe
  Company has operations in subsidiary and branch form in various other
  jurisdictions around the world, including U.K., Spain and Singapore that are
  subject to relevant taxes in those jurisdictions.The
  U.S. federal income tax rate applicable to ordinary income is 35%.  The actual
    tax expense on income from operations differs from the expected amount for the following reasons:


| |                                  |  |        |       |                               |  |        |   |                               |        |   |  |                               |    |   |       |   |  |       |   
| | -------------------------------- |  | ------ | ----- | ----------------------------- |  | ------ | - | ----------------------------- | ------ | - |  | ----------------------------- | -- | - | ----- | - |  | ----- | --
| |                                  |  | 2006   |       | 2005                          |  | 2004   |  
| |                                  |  |        |       |                               |  |        |  
| | (U.S.
Dollars in thousands)      |  | Amount |       | Percent
  of
  Pre-Tax
  Loss |  | Amount |   | Percent
  of
  Pre-Tax
  Loss |        |   |  | Percent
  of
  Pre-Tax
  Loss |   
| |                                  |  |        |       |                               |  |        |   |                               |        |   |  |                               |    |   |       |   |  |       |   
| | Expected tax expense (benefit)   |  | $      | 593   |                               |  | 35.0   | % | $                             | (1,194 | ) |  | (35.0                         | )% | $ | (873  | ) |  | (35.0 | )%
| | Adjustments                      |  |        |       |                               |  |        |   |                               |        |   |  |                               |    |   |       |   |  |       |   
| | Foreign taxes                    |  |        | 65    |                               |  | 3.8    |   |                               |       |   |  |                              |    |   |      |   |  |      |   
| | Transfer pricing adjustments     |  |        | 528   |                               |  | 31.3   |   |                               | 700    |   |  | 20.5                          |    |   | 1,485 |   |  | 59.6  |   
| | Prior year adjustments           |  |        | 568   |                               |  | 33.6   |   |                               | 20     |   |  | 0.6                           |    |   | 326   |   |  | 13.0  |   
| | Valuation allowance              |  |        | 222   |                               |  | 13.1   |   |                               | 85     |   |  | 2.5                           |    |   |      |   |  |      |   
| | Other
    nondeductible expenses |  |        | 289   |                               |  | 17.1   |   |                               | 64     |   |  | 1.9                           |    |   | 30    |   |  | 1.2   |   
| |                                  |  |        |       |                               |  |        |   |                               |        |   |  |                               |    |   |       |   |  |       |   
| | Actual tax (benefit) expense     |  | $      | 2,265 |                               |  | 133.9  | % | $                             | (325   | ) |  | (9.5                          | )% | $ | 968   |   |  | 38.8  | % 
| |                                  |  |        |       |                               |  |        |   |                               |        |   |  |                               |    |   |       |   |  |       |   

The
components of the net deferred federal income tax position of the Company as of
December 31, 2006 and 2005 are as follows:

32

---



XL Capital Assurance Inc. and SubsidiaryNotes to Consolidated Financial Statements
  December 31, 2006, 2005 and 2004


| |                                          |  |      |        |      |   |        |  
| | ---------------------------------------- |  | ---- | ------ | ---- | - | ------ | -
| | (U.S.
dollars in thousands)              |  | 2006 |        | 2005 |  
| |                                          |  |      |        |      |   |        |  
| | Deferred tax assets                      |  |      |        |      |   |        |  
| | Deferred
  ceding commissions, net       |  | $    | 14,519 |      | $ | 14,895 |  
| | Unpaid
  loss reserve discount           |  |      | 480    |      |   | 486    |  
| | Deferred
  premium revenue               |  |      | 2,928  |      |   | 1,965  |  
| | Foreign
  losses                         |  |      | 741    |      |   | 153    |  
| | Unrealized
  depreciation on investments |  |      | 1,136  |      |   | 803    |  
| | Capital
  loss carry forward             |  |      | 308    |      |   | 86     |  
| | Valuation
  allowance                    |  |      | (1,443 | )    |   | (888   | )
| | Other
  - net                            |  |      |       |      |   | 265    |  
| |                                          |  |      |        |      |   |        |  
| | Total deferred tax assets                |  |      | 18,669 |      |   | 17,765 |  
| |                                          |  |      |        |      |   |        |  
| | Deferred tax liabilities                 |  |      |        |      |   |        |  
| | Accretion
  of discount                  |  |      | (272   | )    |   | (196   | )
| | Other                                    |  |      | (525   | )    |   |       |  
| |                                          |  |      |        |      |   |        |  
| | Total deferred tax liabilities           |  |      | (797   | )    |   | (196   | )
| |                                          |  |      |        |      |   |        |  
| | Net deferred federal income tax asset    |  | $    | 17,872 |      | $ | 17,569 |  
| |                                          |  |      |        |      |   |        |  

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | The
  valuation allowance at December 31, 2006 and 2005 of $1.4 million and $0.9
  million, respectively, relates to net unrealized capital losses and a net
  realized capital loss carryforward that may not be realized within a
  reasonable period.  As of December 31,
  2006, the company has net unrealized capital losses and a net realized
  capital loss carryforward of approximately $1.1 million and $0.3 million,
  respectively, against which a valuation allowance of $1.4 million has been
  established.  The net realized capital
  loss carryforward will expire in 2011.                 
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|    | Management
  believes it is more likely than not that the tax benefit of the remaining
  deferred tax assets will be realized.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|12. | Commitments and Contingencies                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|    | The
  Companys lease commitments are comprised primarily of its office premise
  lease at 1221 Avenue of the Americas, New York, New York, 25 Copthall Ave 
  London, Merrit 7 corporate park, Connecticut and office space lease commitments
  it assumed from an affiliate, Global Credit Analytics, Inc. (GCA), with
  respect to office space at 250 Park Avenue, New York, New York.  The table below presents the Companys
  minimum lease payment obligations under the aforementioned leases, as well as
  estimated sub-lease income from the sub-lease of space at the aforementioned
  locations.

33

---



XL Capital Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004


|                            |  |                              |         |                     |   |       | 
|--------------------------- |  | ---------------------------- | ------- | ------------------- | - | ----- | 
|(U.S. Dollars in Thousands) |  | Minimum 
  Lease 
  Payments |         | Sub-lease 
  Income |  
|                            |  |                              |         |                     |  
|                            |  |                              |         |                     |   |       | 
|2007                        |  | $                            | 7,423   |                     | $ | 904   | 
|2008                        |  |                              | 7,693   |                     |   | 778   | 
|2009                        |  |                              | 7,714   |                     |   | 791   | 
|2010                        |  |                              | 7,743   |                     |   | 795   | 
|2011                        |  |                              | 7,589   |                     |   | 795   | 
|Later years                 |  |                              | 75,022  |                     |   | 2,172 | 
|                            |  |                              |         |                     |   |       | 
|Total                       |  | $                            | 113,184 |                     | $ | 6,235 | 
|                            |  |                              |         |                     |   |       | 

Rent
expense was $5.6 million, $5.0 million and $5.1 million for the years ended December
31, 2006, 2005, and 2004, respectively.

In
the ordinary course of business, the Company is subject to litigation or other
legal proceedings. It is the opinion of management, after consultation with
legal counsel and based upon the information available, that the expected
outcome of any outstanding litigation, individually or in the aggregate, will
not have a material adverse effect on our financial position, results of
operations or liquidity.

The
Company received a grand jury subpoena dated November 15, 2006 from the New
York Office of the Antitrust Division of the U.S. Department of Justice in
connection with an investigation into the municipal guaranteed investment
contract market and related products. Thereafter, the Antitrust Division served
a superseding grand jury subpoena dated November 30, 2006 addressed to XLAF
instead of XLCA. XLAF is not a subsidiary of the Company.

|    |                                                       
|--- | ------------------------------------------------------
|13. | Disclosures About Fair Values of Financial Instruments

The
following estimated fair values have been determined by the Company using
available market information and appropriate valuation methodologies. However,
considerable judgment is necessary to interpret the data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amount the Company could realize in a current
market exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.

Debt securities:

The
carrying amount is fair value, which is based primarily on quoted market prices
received from a nationally recognized pricing service or dealer quotes.

Short-term investments:

The
carrying amount is fair value, which approximates cost due to the short
maturity of these instruments.

Cash and cash equivalents:

The
carrying amount of these items is a reasonable estimate of their fair value due
to the short maturity of these instruments.

Deferred premium revenue, net of prepaid
reinsurance premiums:

The
carrying amount of deferred premium revenue, net of prepaid reinsurance
premiums, represents the Companys future premium revenue, net of reinsurance,
on policies where the premium was received at the inception of the insurance
contract. The fair value of deferred premium revenue, net

34

---



XL Capital Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004


of prepaid
reinsurance premiums, is an estimate of the premiums that would be paid under a
reinsurance agreement with a third party to transfer the Companys financial
guarantee risk, net of that portion of the premiums retained by the Company to
compensate it for originating and servicing the insurance contract.

Losses and loss expenses, net of reinsurance
balances recoverable:

The carrying value is assumed to be fair value, because the provision is
established for non-specific expected levels of losses resulting from credit
failures.

Installment premiums:

The fair value of installment premiums is estimated based on the present value
of the future contractual premium revenues, net of reinsurance, that would be
paid under a reinsurance agreement with a third party to transfer the Companys
financial guarantee risk, net of that portion of the premium retained by the
Company to compensate it for originating and servicing the insurance contract.
The fair value is derived by calculating the present value of the estimated
future cash flow stream (net premium and ceding commissions) discounted at
4.80% and 4.20% at December 31, 2006 and 2005, respectively.

|                                                                                              |  |                    |         |                         |   |                    |  |                         |         |  |   |         | 
|--------------------------------------------------------------------------------------------- |  | ------------------ | ------- | ----------------------- | - | ------------------ |  | ----------------------- | ------- |  | - | ------- | 
|                                                                                              |  | 2006               |         | 2005                    |  
|                                                                                              |  |                    |         |                         |  
|(U.S. Dollars in thousands)                                                                   |  | Carrying 
  Amount |         | Estimated 
  Fair Value |   | Carrying 
  Amount |  | Estimated 
  Fair Value |        
|                                                                                              |  |                    |         |                         |   |                    |  |                         |         |  |   |         | 
|Assets                                                                                        |  |                    |         |                         |   |                    |  |                         |         |  |   |         | 
|Debt securities investments                                                                   |  | $                  | 332,265 |                         | $ | 332,265            |  | $                       | 279,423 |  | $ | 279,423 | 
|Short-term investments                                                                        |  |                    | 14,978  |                         |   | 14,978             |  |                         | 7,242   |  |   | 7,242   | 
|Cash and cash equivalents                                                                     |  |                    | 82,691  |                         |   | 82,691             |  |                         | 32,337  |  |   | 32,337  | 
|                                                                                             
|Liabilities                                                                                   |  |                    |         |                         |   |                    |  |                         |         |  |   |         | 
|Deferred premium revenue, net of prepaid
  reinsurance premiums                               |  |                    | 78,574  |                         |   | 58,259             |  |                         | 52,165  |  |   | 39,117  | 
|Unpaid losses and loss adjustment expenses,
  net of reinsurance recoverable on unpaid losses |  |                    | 9,310   |                         |   | 9,310              |  |                         | 9,529   |  |   | 9,529   | 
|                                                                                             
|Off-Balance Sheet Instruments                                                                 |  |                    |         |                         |   |                    |  |                         |         |  |   |         | 
|Installment premiums                                                                          |  |                    |        |                         |   | 245,777            |  |                         |        |  |   | 106,098 | 
|                                                                                              |  |                    |         |                         |   |                    |  |                         |         |  |   |         | 

|    |                                                         
|--- | --------------------------------------------------------
|14. | Statutory Accounting Practices and Dividend Restrictions

GAAP
differs in certain significant respects from accounting practices prescribed or
permitted by the NYID. The following tables summarize the significant
differences between statutory accounting practices (SAP) and GAAP.

35

---



XL Capital
  Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004


|                                               |  |      |        |      |   |        |   |   |        |  
|---------------------------------------------- |  | ---- | ------ | ---- | - | ------ | - | - | ------ | -
|(U.S. Dollars in thousands)                    |  | 2006 |        | 2005 |   | 2004   |  
|                                               |  |      |        |      |   |        |   |   |        |  
|GAAP net loss                                  |  | $    | (576   | )    | $ | (3,085 | ) | $ | (3,513 | )
|Statutory
  adjustments                        |  |      |        |      |   |        |   |   |        |  
|Premium revenue recognition                    |  |      | (2,189 | )    |   | (1,084 | ) |   | (2,369 | )
|Net losses and loss adjustment expenses        |  |      | 1,566  |      |   | 1,605  |   |   | 2,025  |  
|Deferred Federal income tax benefit            |  |      | 1,082  |      |   | (916   | ) |   | (3,834 | )
|Current Federal income tax benefit             |  |      | (125   | )    |   | 67     |   |   | 385    |  
|Net income (loss) of consolidated
  subsidiary |  |      | (349   | )    |   | 2,795  |   |   | 2,639  |  
|Trusts
    not consolidated under SAP          |  |      | 649    |      |   | 303    |   |   | (953   | )
|Other                                          |  |      | 6      |      |   | (111   | ) |   | (115   | )
|                                               |  |      |        |      |   |        |   |   |        |  
|Statutory net loss                             |  | $    | 64     |      | $ | (426   | ) | $ | (5,735 | )
|                                               |  |      |        |      |   |        |   |   |        |  

|                                                  |  |      |         |      |   |         |   |   |         |  
|------------------------------------------------- |  | ---- | ------- | ---- | - | ------- | - | - | ------- | -
|(U.S. Dollars in thousands)                       |  | 2006 |         | 2005 |   | 2004    |  
|                                                  |  |      |         |      |   |         |   |   |         |  
|GAAP shareholders equity                         |  | $    | 250,505 |      | $ | 226,948 |   | $ | 233,966 |  
|Statutory adjustments                             |  |      |         |      |   |         |   |   |         |  
|Premium revenue recognition                       |  |      | (6,910  | )    |   | (4,721  | ) |   | (3,637  | )
|Deferred Federal income tax (benefit)
  liability |  |      | 10,360  |      |   | 875     |   |   | 2,304   |  
|Current Federal income tax benefit                |  |      | (17     | )    |   | 341     |   |   | 480     |  
|Net unpaid losses and loss adjustment
  expenses  |  |      | 7,811   |      |   | 5,866   |   |   | 4,252   |  
|Contingency reserve                               |  |      | (20,876 | )    |   | (13,031 | ) |   | (7,342  | )
|Non-admitted assets                               |  |      | (25,133 | )    |   | (17,227 | ) |   | (16,511 | )
|Intangible assets - acquired licenses             |  |      | (11,529 | )    |   | (11,529 | ) |   | (11,529 | )
|Unrealized appreciation of investments            |  |      | 3,268   |      |   | 2,298   |   |   | (2,428  | )
|Trusts
    not consolidated under SAP             |  |      | (306    | )    |   | (954    | ) |   | (1,245  | )
|Other                                             |  |      | (160    | )    |   | (27     | ) |   | 133     |  
|                                                  |  |      |         |      |   |         |   |   |         |  
|Statutory policyholders surplus                  |  | $    | 207,013 |      | $ | 188,839 |   | $ | 198,443 |  
|                                                  |  |      |         |      |   |         |   |   |         |  

| |                                                                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | --------------------------------------------------------------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The
  principal differences result from the following statutory accounting
  practices:
| |                                                                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                        | Bonds are
  carried at amortized cost rather than designated as available for sale and
  carried at market value. Unrealized gains or losses are not recognized as a
  separate component of shareholders equity net of applicable deferred Federal
  income taxes.                                                                                                                                                                                                                                                                                                   
| |                                                                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                        | A
  formula-based contingency reserve is established by an appropriation of
  unassigned surplus. This reserve is calculated at the greater of a prescribed
  percentage applied to insured outstanding principal or 50% of premiums
  written, net of ceded reinsurance. The prescribed percentage varies by the
  type of outstanding principal. The reserve is available to be applied to new
  case basis reserves that are established for claims on current outstanding
  insured principal and interest in the future. An unallocated reserve is not
  recorded.
| |                                                                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                        | Current
  Federal income taxes are provided only on taxable income for which income
  taxes are currently payable and deferred tax assets are limited to an amount
  determined to be realizable within one year based on managements estimation
  of the future realizability of deferred tax assets.                                                                                                                                                                                                                                                                
| |                                                                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                        | Under GAAP
  certain subsidiaries are required to be consolidated, whereas under SAP such
  subsidiaries are accounted for under statutory equity method accounting
  principles.                                                                                                                                                                                                                                                                                                                                                                                      
| |                                                                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                        | Acquisition
  costs are charged to operations as incurred rather than as related premiums
  are earned.                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |                                                                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                        | Up-front
  premiums are recognized as earned when the related risk has expired rather
  than over the period of risk.                                                                                                                                                                                                                                                                                                                                                                                                                                                  

36

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XL Capital
  Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004


| |   |                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------
| |  | Certain
  assets designated as non-admitted assets are charged directly to statutory
  surplus, but are reflected as assets under GAAP.

Under
New York Insurance Law, the Company may pay dividends to SCA Holding US Inc.,
without the prior approval of the Superintendent of the NYID, only from earned
statutory policyholders surplus subject to the maintenance of the minimum
capital and surplus requirement. In addition, the dividend, together with all
other dividends declared or distributed by the Company during the preceding twelve
months, may not exceed the lesser of 10% of its policyholders surplus as shown
in the Companys last filed statement, or adjusted net investment income, as
defined, for such twelve-month period. As of December 31, 2006 the Company had
no earned surplus available for the payment of dividends during the next twelve
months.          In addition, in connection with
the IPO, the Company has agreed with certain of the rating agencies that, until
the second anniversary of the effective date of the IPO it will not declare or
grant dividends on its common stock without the prior consent of those rating
agencies, other than to fund certain parent holding company operating expenses
and debt service requirements and to fund dividends on our preferred stock and
nominal dividends on our common stock.

|    |                     
|--- | --------------------
|15. | Credit Default Swaps

Credit
default swaps insured by the Company meet the definition of a derivative under
SFAS No. 133. The Company has recorded these products at fair value, modeled on
prevailing market conditions and certain other factors relating to the
structure and credit quality of the transaction. The Company considers credit
default swaps to be, in substance, financial guarantee contracts as the Company
intends to hold them to maturity. The full change in fair value is included in
net realized and unrealized gains (losses) on credit derivatives.

Credit
default swaps generally cover a portfolio of securities. The credit ratings of
the underlying securities vary and a single rating is calculated for the
Companys exposure at the inception of the transaction by an independent credit
rating agency. In order to effectively price and market the transaction,
different tranches are modeled for the purpose of assigning credit ratings
based upon the level of subordination. Generally, a primary layer of first loss
protection is created with the Company participating in the senior or higher
quality rated tranches of the transaction.

The
Companys exposure is fair valued taking into account changes in credit
spreads, current market conditions, as well as the overall credit quality of
the underlying collateral.

The
Companys credit default swap portfolio generally requires the Company to meet
payment obligations for referenced credits within the portfolio in the event of
specific credit events after exhaustion of various first loss protection
levels. These credit events are contract-specific, but generally cover
bankruptcy, failure to pay and repudiation. The credit default swap portfolio
consists of structured pools of corporate obligations that were awarded
investment-grade ratings at the deals inception. On a net par basis,
approximately 98.8% of the portfolio is rated AAA with the remaining 1.2%
allocated to other investment-grade ratings. The weighted average term of the
contracts in force was 10.83 years. The components of the Companys net credit
default swap asset and liability classified with other assets and accounts
payable and accrued expenses, respectively, at December 31, 2006 and 2005 are
as follows:

37

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XL Capital
  Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004


|                                                    |  |                    |        |      |   |        | 
|--------------------------------------------------- |  | ------------------ | ------ | ---- | - | ------ | 
|(U.S. Dollars in thousands)                         |  | As of December 31, |       
|                                                    |  |                    |       
|                                                    |  | 2006               |        | 2005 |  
|Assets                                              |  |                    |        |      |   |        | 
|Reinsurance
  balances recoverable on unpaid losses |  | $                  | 11,746 |      | $ | 9,334  | 
|Other assets                                        |  |                    | 11,668 |      |   | 16,378 | 
|                                                    |  |                    |        |      |   |        | 
|Total Assets                                        |  | $                  | 23,414 |      | $ | 25,712 | 
|                                                    |  |                    |        |      |   |        | 
|                                                    |  |                    |        |      |   |        | 
|Liabilities                                         |  |                    |        |      |   |        | 
|Unpaid
  losses and loss adjustment expenses        |  | $                  | 12,932 |      | $ | 10,155 | 
|Other
  liabilities                                 |  |                    | 11,362 |      |   | 15,423 | 
|                                                    |  |                    |        |      |   |        | 
|Total Liabilities                                   |  | $                  | 24,294 |      | $ | 25,578 | 
|                                                    |  |                    |        |      |   |        | 

The
components of the Companys net realized and unrealized gains (losses) on
credit derivatives for the years ended December 31, 2006, 2005 and 2004 are as
follows:

|                                                                   |  |                         |        |      |   |        |   |   |        | 
|------------------------------------------------------------------ |  | ----------------------- | ------ | ---- | - | ------ | - | - | ------ | 
|(U.S. Dollars in thousands)                                        |  | Year Ended December 31, |       
|                                                                   |  |                         |       
|                                                                   |  | 2006                    |        | 2005 |   | 2004   |  
|Income Statement                                                   |  |                         |        |      |   |        |   |   |        | 
|Gross Premiums Written                                             |  | $                       | 24,399 |      | $ | 18,154 |   | $ | 21,307 | 
|Net Premiums Earned                                                |  |                         | 2,533  |      |   | 1,665  |   |   | 1,912  | 
|Net realized and unrealized gains (losses)
  on credit derivatives |  |                         | (649   | )    |   | (303   | ) |   | 953    | 
|Net losses and loss adjustment expenses                            |  |                         | 364    |      |   | 150    |   |   | 410    | 

|    |                                            
|--- | -------------------------------------------
|16. | Quarterly Financial Information (Unaudited)

|                                        |  |       |        |        |   |        |  |        |        |   |   |         |  
|--------------------------------------- |  | ----- | ------ | ------ | - | ------ |  | ------ | ------ | - | - | ------- | -
|                                        |  | 2006  |       
|                                        |  |       |       
|(U.S. Dollars in thousands)             |  | First |        | Second |   | Third  |  | Fourth |       
|                                        |  |       |        |        |   |        |  |        |        |   |   |         |  
|Gross premiums written                  |  | $     | 70,780 |        | $ | 99,351 |  | $      | 65,080 |   | $ | 118,517 |  
|Net premiums written                    |  |       | 7,350  |        |   | 10,222 |  |        | 5,050  |   |   | 21,772  |  
|Net premiums earned                     |  |       | 2,823  |        |   | 5,883  |  |        | 3,920  |   |   | 4,282   |  
|Net investment income                   |  |       | 3,716  |        |   | 3,702  |  |        | 4,228  |   |   | 5,052   |  
|Net losses and loss adjustment expenses |  |       | 521    |        |   | 393    |  |        | 496    |   |   | 228     |  
|Income (loss) before income taxes       |  |       | (639   | )      |   | 3,663  |  |        | (878   | ) |   | (457    | )
|Net income (loss)                       |  |       | (654   | )      |   | 3,866  |  |        | (3,301 | ) |   | (487    | )

38

---



XL Capital
  Assurance Inc. and SubsidiaryNotes
  to Consolidated Financial StatementsDecember
  31, 2006, 2005 and 2004


|                                        |  |       |        |            |   |        |   |        |        |   |   |        | 
|--------------------------------------- |  | ----- | ------ | ---------- | - | ------ | - | ------ | ------ | - | - | ------ | 
|                                        |  | 2005  |       
|                                        |  |       |       
|(U.S. Dollars in thousands)             |  | First |        | Second (1) |   | Third  |   | Fourth |       
|                                       
|Gross premiums written                  |  | $     | 37,414 |            | $ | 77,964 |   | $      | 59,269 |   | $ | 57,943 | 
|Net premiums written                    |  |       | 3,706  |            |   | 8,169  |   |        | 4,999  |   |   | 6,124  | 
|Net premiums earned                     |  |       | 3,213  |            |   | 3,367  |   |        | 3,677  |   |   | 4,146  | 
|Net investment income                   |  |       | 3,034  |            |   | 3,167  |   |        | 3,399  |   |   | 3,447  | 
|Net losses and loss adjustment expenses |  |       | 362    |            |   | 4,120  |   |        | 292    |   |   | 520    | 
|Income (loss) before income taxes       |  |       | 2,532  |            |   | (6,185 | ) |        | (810   | ) |   | 1,053  | 
|Net income (loss)                       |  |       | 1,557  |            |   | (4,342 | ) |        | (616   | ) |   | 316    | 

(1) After the release of
XLCAs condensed consolidated financial statements for the three and six months
ended June 30, 2005 management identified an error therein related to an
intercompany transaction with XLFA. Second quarter results presented above has
been adjusted to correct for such error.

39

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