XL
Financial Assurance Ltd.(Incorporated in Bermuda)

Financial Statements
For the years ended December 31, 2006, 2005
and 2004(expressed in U.S. dollars)



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XL Financial Assurance LtdContents to Financial StatementsDecember 31, 2006, 2005 and 2004

|Report of Independent Registered Public Accounting Firm           |  | 2    
|----------------------------------------------------------------- |  | -----
|                                                                  |  |      
|Financial Statements                                              |  |      
|                                                                  |  |      
|Balance Sheets at December 31, 2006 and 2005                      |  | 3    
|                                                                  |  |      
|Statements of Income and Comprehensive Income for the years ended |  |      
|December 31, 2006, 2005 and 2004                                  |  | 4    
|                                                                  |  |      
|Statements of Changes in Shareholders Equity for the years ended |  |      
|December 31, 2006, 2005 and 2004                                  |  | 5    
|                                                                  |  |      
|Statements of Cash Flows for the years ended                      |  |      
|December 31, 2006, 2005 and 2004                                  |  | 6    
|                                                                  |  |      
|Notes to Financial Statements                                     |  | 7
31

1

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Report
of Independent Registered Public Accounting Firm

To
the Board of Directors and Shareholder of
XL Financial Assurance Ltd.

In our
opinion, the accompanying balance sheets and the related statements of income
and comprehensive income, changes in shareholders equity and of cash flows
present fairly, in all material respects, the financial position of XL Financial Assurance Ltd. at December 31,
2006 and 2005, and the results of its operations and its 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.

PricewaterhouseCoopersHamilton, BermudaMarch 14, 2007

2

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|                                                  
|--------------------------------------------------
|XL Financial Assurance Ltd.                       
|Balance Sheets                                    
|As at December 31, 2006 and 2005                  
|                                                  
|(U.S dollars in thousands, except share
  amounts)

|                                                                          |  |      |           |      |   |           |  
|------------------------------------------------------------------------- |  | ---- | --------- | ---- | - | --------- | -
|                                                                          |  | 2006 |           | 2005 |  
|                                                                          |  |      |           |      |  
|Assets:                                                                   |  |      |           |      |   |           |  
|Investments:                                                              |  |      |           |      |   |           |  
|Debt
  securities, at fair value                                          |  |      |           |      |   |           |  
|(amortized
  cost: 2006 - $1,420,391; 2005 - $1,054,356)                  |  | $    | 1,404,197 |      | $ | 1,036,606 |  
|Short-term
  investments, at fair value                                   |  |      |           |      |   |           |  
|(amortized
  cost: 2006 - $207,951; 2005 - $23,772)                       |  |      | 206,923   |      |   | 23,569    |  
|                                                                          |  |      |           |      |   |           |  
|Total investments available for sale                                      |  |      | 1,611,120 |      |   | 1,060,175 |  
|                                                                          |  |      |           |      |   |           |  
|Cash and
  cash equivalents                                               |  |      | 86,528    |      |   | 22,256    |  
|Accrued
  investment income                                               |  |      | 13,355    |      |   | 9,197     |  
|Deferred
  acquisition costs                                              |  |      | 145,929   |      |   | 100,784   |  
|Prepaid
  reinsurance premiums                                            |  |      | 41,915    |      |   | 63,034    |  
|Reinsurance
  balances receivable                                         |  |      | 18,681    |      |   | 2,736     |  
|Unpaid
  losses and loss expenses recoverable                             |  |      | 78,230    |      |   | 66,394    |  
|Amounts due
  from parent and affiliates                                  |  |      | 37        |      |   | 39,572    |  
|Funds
  withheld                                                          |  |      |          |      |   | 15,859    |  
|Net
  receivable for investments sold                                     |  |      | 112       |      |   | 191       |  
|Derivative
  assets                                                       |  |      | 11,148    |      |   | 13,482    |  
|Other assets                                                              |  |      | 340       |      |   | 401       |  
|                                                                          |  |      |           |      |   |           |  
|Total assets                                                              |  | $    | 2,007,395 |      | $ | 1,394,081 |  
|                                                                          |  |      |           |      |   |           |  
|Liabilities, redeemable preferred shares and shareholders equity         |  |      |           |      |   |           |  
|Liabilities:                                                              |  |      |           |      |   |           |  
|Unpaid
  losses and loss expenses                                         |  | $    | 156,733   |      | $ | 134,044   |  
|Deferred
  premium revenue                                                |  |      | 699,264   |      |   | 535,112   |  
|Reinsurance
  balances payable                                            |  |      | 7,308     |      |   | 15,116    |  
|Accounts
  payable and accrued liabilities                                |  |      | 1,962     |      |   | 1,770     |  
|Amounts due
  to parent and affiliates                                    |  |      | 4,076     |      |   | 14,656    |  
|Derivative
  liabilities                                                  |  |      | 4,685     |      |   | 1,864     |  
|Dividend
  payable on preferred shares                                    |  |      |          |      |   | 1,445     |  
|                                                                          |  |      |           |      |   |           |  
|Total liabilities                                                         |  |      | 874,028   |      |   | 704,007   |  
|                                                                          |  |      |           |      |   |           |  
|Contingencies and Commitments (Note 18)                                   |  |      |           |      |   |           |  
|Redeemable preferred shares:                                              |  |      |           |      |   |           |  
|Series A
  Redeemable preferred shares                                    |  | $    | 54,016    |      | $ | 39,000    |  
|                                                                          |  |      |           |      |   |           |  
|Shareholders equity:                                                     |  |      |           |      |   |           |  
|Common
  shares (par value of $120 per share;                             |  |      |           |      |   |           |  
|10,000
  shares authorized; 2,449 issued and outstanding as at            |  |      |           |      |   |           |  
|December 31,
  2006 and 2005, respectively)                               |  |      | 294       |      |   | 294       |  
|Additional
  paid-in capital                                              |  |      | 659,665   |      |   | 345,606   |  
|Accumulated
  other comprehensive loss                                    |  |      | (17,221   | )    |   | (17,953   | )
|Retained
  earnings                                                       |  |      | 436,613   |      |   | 323,127   |  
|                                                                          |  |      |           |      |   |           |  
|Total shareholders equity                                                |  |      | 1,079,351 |      |   | 651,074   |  
|                                                                          |  |      |           |      |   |           |  
|Total liabilities, redeemable preferred
  shares and shareholders equity |  | $    | 2,007,395 |      | $ | 1,394,081 |  
|                                                                          |  |      |           |      |   |           |  

See accompanying Notes to Financial
Statements.

3

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|                                                      
|------------------------------------------------------
|XL Financial Assurance Ltd.                           
|Statements of Income and Comprehensive Income         
|For the years ended December 31, 2006, 2005 and
  2004
|                                                      
|(U.S. dollars in thousands)                           

|                                                                       |  |      |         |      |   |         |   |   |         |  
|---------------------------------------------------------------------- |  | ---- | ------- | ---- | - | ------- | - | - | ------- | -
|                                                                       |  | 2006 |         | 2005 |   | 2004    |  
|                                                                       |  |      |         |      |   |         |  
|Revenues:                                                              |  |      |         |      |   |         |   |   |         |  
|Net premiums
  earned                                                  |  | $    | 166,671 |      | $ | 134,936 |   | $ | 103,665 |  
|Net
  investment income                                                |  |      | 58,977  |      |   | 38,113  |   |   | 24,866  |  
|Net realized
  gains (losses) on investments                           |  |      | (14,873 | )    |   | (3,229  | ) |   | 474     |  
|Fee and
  other income                                                 |  |      | 1,269   |      |   | 675     |   |   |        |  
|Net realized
  and unrealized gains (losses) on derivative instruments |  |      | (7,374  | )    |   | (6,412  | ) |   | 11,959  |  
|                                                                       |  |      |         |      |   |         |   |   |         |  
|                                                                      
|Total revenues                                                         |  |      | 204,670 |      |   | 164,083 |   |   | 140,964 |  
|                                                                       |  |      |         |      |   |         |   |   |         |  
|Expenses:                                                              |  |      |         |      |   |         |   |   |         |  
|Net losses
  and loss expenses                                         |  |      | 14,059  |      |   | 16,852  |   |   | 21,093  |  
|Acquisition
  costs                                                    |  |      | 48,326  |      |   | 41,205  |   |   | 33,151  |  
|Operating
  expenses                                                   |  |      | 9,327   |      |   | 7,637   |   |   | 10,468  |  
|                                                                       |  |      |         |      |   |         |   |   |         |  
|                                                                      
|Total expenses                                                         |  |      | 71,712  |      |   | 65,694  |   |   | 64,712  |  
|                                                                       |  |      |         |      |   |         |   |   |         |  
|                                                                      
|Net income                                                             |  | $    | 132,958 |      | $ | 98,389  |   | $ | 76,252  |  
|                                                                       |  |      |         |      |   |         |   |   |         |  
|                                                                      
|Comprehensive Income:                                                  |  |      |         |      |   |         |   |   |         |  
|Net income                                                             |  | $    | 132,958 |      | $ | 98,389  |   | $ | 76,252  |  
|                                                                      
|Unrealized
    losses on investments                                   |  |      | (14,141 | )    |   | (19,363 | ) |   | (2,519  | )
|Less: reclassification for gains (losses)
  realized in income         |  |      | (14,873 | )    |   | (3,229  | ) |   | 474     |  
|                                                                       |  |      |         |      |   |         |   |   |         |  
|                                                                      
|Other
  comprehensive income (loss)                                    |  |      | 732     |      |   | (16,134 | ) |   | (2,993  | )
|                                                                       |  |      |         |      |   |         |   |   |         |  
|                                                                      
|Comprehensive income                                                   |  | $    | 133,690 |      | $ | 82,255  |   | $ | 73,259  |  
|                                                                       |  |      |         |      |   |         |   |   |         |  

See accompanying Notes to Financial Statements.

4

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|                                                  
|--------------------------------------------------
|XL Financial
  Assurance Ltd.                     
|Statementsof Changes in Shareholders Equity      
|For theyearsended December 31, 2006, 2005 and 2004
|                                                  
|(U.S dollars in thousands, except share amounts)  

|                                                                           |  |      |           |      |   |         |   |   |         |  
|-------------------------------------------------------------------------- |  | ---- | --------- | ---- | - | ------- | - | - | ------- | -
|                                                                           |  | 2006 |           | 2005 |   | 2004    |  
|                                                                           |  |      |           |      |   |         |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|Common Shares  Number issued                                              |  |      |           |      |   |         |   |   |         |  
|Number of
  shares, beginning of year                                      |  |      | 2,449     |      |   | 2,449   |   |   | 2,057   |  
|Issuance of
  common shares                                                |  |      |          |      |   |        |   |   | 392     |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|Number of shares, end of year                                              |  |      | 2,449     |      |   | 2,449   |   |   | 2,449   |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|Common Shares  Issued at par                                              |  |      |           |      |   |         |   |   |         |  
|Balance -
  beginning of year                                              |  | $    | 294       |      | $ | 294     |   | $ | 247     |  
|Issuance of
  common shares                                                |  |      |          |      |   |        |   |   | 47      |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|Balance - end of year                                                      |  |      | 294       |      |   | 294     |   |   | 294     |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|Additional Paid-in Capital                                                 |  |      |           |      |   |         |   |   |         |  
|Balance -
  beginning of year                                              |  |      | 345,606   |      |   | 345,606 |   |   | 220,653 |  
|Capital
  contributions                                                    |  |      | 314,059   |      |   |        |   |   | 124,953 |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|Balance - end of year                                                      |  |      | 659,665   |      |   | 345,606 |   |   | 345,606 |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|Accumulated Other Comprehensive
  Income (Loss)                            |  |      |           |      |   |         |   |   |         |  
|Balance -
  beginning of year                                              |  |      | (17,953   | )    |   | (1,819  | ) |   | 1,174   |  
|Other comprehensive
  income (loss)                                        |  |      | 732       |      |   | (16,134 | ) |   | (2,993  | )
|                                                                           |  |      |           |      |   |         |   |   |         |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|Balance - end of year                                                      |  |      | (17,221   | )    |   | (17,953 | ) |   | (1,819  | )
|                                                                           |  |      |           |      |   |         |   |   |         |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|Retained Earnings                                                          |  |      |           |      |   |         |   |   |         |  
|Balance -
  beginning of year                                              |  |      | 323,127   |      |   | 231,714 |   |   | 169,565 |  
|Net income                                                                 |  |      | 132,958   |      |   | 98,389  |   |   | 76,252  |  
|Dividends on
  Series A redeemable preferred shares                        |  |      | (4,456    | )    |   | (6,976  | ) |   | (14,103 | )
|Accumulated
  undeclared dividends on Series A redeemable preferred shares |  |      | (15,016   | )    |   |        |   |   |        |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|Balance  end of year                                                      |  |      | 436,613   |      |   | 323,127 |   |   | 231,714 |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|                                                                           |  |      |           |      |   |         |   |   |         |  
|Total Shareholders Equity                                                 |  | $    | 1,079,351 |      | $ | 651,074 |   | $ | 575,795 |  
|                                                                           |  |      |           |      |   |         |   |   |         |  

See accompanying Notes to Financial
Statements

5

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|                                                    
|----------------------------------------------------
|XL Financial Assurance Ltd.                         
|Statements of Cash Flows                            
|For theyearsended
  December 31, 2006, 2005 and 2004
|                                                    
|(U.S. dollars in thousands)                         

|                                                                                           |  |      |          |      |   |            |   |   |            |  
|------------------------------------------------------------------------------------------ |  | ---- | -------- | ---- | - | ---------- | - | - | ---------- | -
|                                                                                           |  | 2006 |          | 2005 |   | 2004       |  
|Cash flows provided by operating activities:                                               |  |      |          |      |   |            |   |   |            |  
|Net income                                                                                 |  | $    | 132,958  |      | $ | 98,389     |   | $ | 76,252     |  
|Adjustments to reconcile net income to net
  cash provided by operating activities:        |  |      |          |      |   |            |   |   |            |  
|Net realized (gains) losses on investments                                                 |  |      | 14,873   |      |   | 3,229      |   |   | (474       | )
|Amortization of premium on debt maturities                                                 |  |      | 2,884    |      |   | 3,401      |   |   | 4,525      |  
|Net realized and unrealized (gains) losses
  on credit derivatives and interest rate swaps |  |      | 5,025    |      |   | 4,128      |   |   | (11,978    | )
|Net realized and unrealized (gains) losses
  on put option, excluding cash paid            |  |      | 129      |      |   | (19        | ) |   | 19         |  
|Accrued investment income                                                                  |  |      | (4,159   | )    |   | (2,433     | ) |   | 656        |  
|Unpaid losses
    and loss expenses                                                        |  |      | 22,689   |      |   | 24,893     |   |   | 67,272     |  
|Deferred premium revenue                                                                   |  |      | 164,152  |      |   | 97,458     |   |   | 88,935     |  
|Unpaid losses & loss expenses
  recoverable                                                |  |      | (11,836  | )    |   | (10,953    | ) |   | (47,696    | )
|Deferred acquisition costs                                                                 |  |      | (45,145  | )    |   | (16,916    | ) |   | (32,391    | )
|Amounts due from parent and affiliates                                                     |  |      | 39,535   |      |   | (6,864     | ) |   | (9,070     | )
|Accounts payable and accrued liabilities                                                   |  |      | 192      |      |   | (968       | ) |   | 1,489      |  
|Amount due to parent and affiliates                                                        |  |      | (10,580  | )    |   | 3,174      |   |   | 6,186      |  
|Funds withheld                                                                             |  |      |         |      |   | (15,859    | ) |   |           |  
|Prepaid reinsurance premiums                                                               |  |      | 21,119   |      |   | (10,548    | ) |   | 45,562     |  
|Reinsurance balances receivable                                                            |  |      | (15,945  | )    |   | 38,123     |   |   | (7,413     | )
|Reinsurance balances payable                                                               |  |      | (7,808   | )    |   | 11,094     |   |   | (2,253     | )
|Other assets                                                                               |  |      | 61       |      |   | (263       | ) |   | (85        | )
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|Total adjustments                                                                          |  |      | 175,186  |      |   | 120,677    |   |   | 103,284    |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|Net cash provided by operating activities                                                  |  |      | 308,144  |      |   | 219,066    |   |   | 179,536    |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|Cash flows used in investing activities:                                                   |  |      |          |      |   |            |   |   |            |  
|Proceeds from sale of debt securities and
  short-term investments                         |  |      | 319,128  |      |   | 753,390    |   |   | 2,499,678  |  
|Proceeds from maturity of debt securities
  and short-term investments                     |  |      | 38,826   |      |   | 60,630     |   |   | 543,150    |  
|Purchase of debt securities and short-term
  investments                                   |  |      | (786,909 | )    |   | (1,016,559 | ) |   | (3,222,273 | )
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|Net cash used in investing activities                                                      |  |      | (428,955 | )    |   | (202,539   | ) |   | (179,445   | )
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|Cash flows
      provided by (used in) financing activities:                               |  |      |          |      |   |            |   |   |            |  
|Capital contribution                                                                       |  |      | 190,984  |      |   |           |   |   |           |  
|Issuance of common shares                                                                  |  |      |         |      |   |           |   |   | 876        |  
|Dividends paid on Series A redeemable
  preferred shares                                   |  |      | (5,901   | )    |   | (7,481     | ) |   | (14,103    | )
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|Net cash provided by (used in) financing
  activities                                      |  |      | 185,083  |      |   | (7,481     | ) |   | (13,227    | )
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|Increase (decrease) in Cash and Cash Equivalents                                           |  |      | 64,272   |      |   | 9,046      |   |   | (13,136    | )
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|Cash and Cash Equivalents  Beginning of year                                              |  |      | 22,256   |      |   | 13,210     |   |   | 26,346     |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  
|Cash and Cash Equivalents  End of year                                                    |  | $    | 86,528   |      | $ | 22,256     |   | $ | 13,210     |  
|                                                                                           |  |      |          |      |   |            |   |   |            |  

Supplemental
schedule of non-cash financing activities:Transfer of securities on 12/22/06 with a fair value of
$123,076

See accompanying Notes to Financial Statements.

6

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XL Financial Assurance Ltd. Notes to Financial Statements
For the years ended December 31, 2006, 2005 and 2004
  (U.S. dollars in thousands, except per share
amounts)


|   |                            
|-- | ---------------------------
|1. | Organization
  and Business

XL
Financial Assurance Ltd. (the Company) was incorporated with limited
liability under the Bermuda Companies Act 1981 on October 14, 1998 and is
registered as a Class 3 insurer under The Insurance Act 1978, amendments thereto
and related regulations (The
Act).
Except for its preferred stock interests (see Note 4), through July 1, 2006,
the Company was a wholly owned subsidiary of XL Insurance (Bermuda) Ltd
(XLI), 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 the Company and XL Capital
Assurance Inc. (XLCA), a
New York domiciled financial guarantee insurance company and selling an
interest therein to the public through an initial public offering (IPO)
of SCAs common shares. The contribution by XL Capital of the Company and XLCA to SCA
occurred on July 1, 2006 and the IPO was consummated on August 4, 2006. 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 percent economic interest. As a result of limitations on XL Capitals
voting power contained in SCAs bye-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 our 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.

The Company
is primarily engaged in the business of providing reinsurance of financial
guarantees on asset-backed and municipal obligations underwritten by XLCA, XLI,
and Financial Security Assurance Inc. (FSA), a New York domiciled financial
guarantee insurance company, as well as other monoline and multiline insurance
companies. FSA, through its parent and affiliates, own all of the Companys
preferred shares, but otherwise is independent of the Company and XL Capital
and its affiliates. Guarantees reinsured by the Company may be in the form of
traditional financial guarantee insurance or credit default swaps. The
Companys underwriting policy is to provide reinsurance of asset-backed and
municipal obligations that would be of a lower investment-grade quality without
the benefit of financial guarantee insurance. The asset-backed obligations
reinsured by the Company are generally issued in structured transactions and
are backed by pools of assets such as residential mortgage loans, consumer or
trade receivables, securities or other assets having ascertainable cash flows
or market value. The municipal obligations reinsured by the Company consist
primarily of general obligation bonds that are supported by the issuers taxing
power and of special revenue bonds and other special obligations of states and
local governments that are supported by the issuers ability to impose and
collect fees and charges for public services or specific projects.
Substantially all the Companys reinsurance is written on a proportional basis.
Accordingly, in the event of a payment default on a reinsured obligation, the
Company is generally required to pay its proportionate share of the principal,
interest or other such amounts due in accordance with the insured obligations
original payment schedule or, at the ceding companies option, to pay such
amounts on an accelerated basis. The Company conducts surveillance on its
exposures to try and ensure early identification of any loss events. In
addition, in the normal course of business, the Company seeks to reduce the
loss that may arise from such events by retroceding certain levels of risks in
various areas of exposure with other insurance enterprises or reinsurers.

|   |                                
|-- | -------------------------------
|2. | Significant Accounting Policies

Basis of Preparation

These
financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America. The preparation
of financial statements in conformity with accounting principles generally
accepted in the United States 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

7

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XL Financial Assurance Ltd.
 Notes to Financial Statements
For the years ended December 31, 2006, 2005 and 2004
  (U.S. dollars in thousands, except share
amounts)


differ from these estimates. Certain balances in prior periods have
been reclassified to conform with the current years presentation.

Investments

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 an internationally recognized
    pricing service or on dealer quotes. The net unrealized appreciation or depreciation
    on investments 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 structure 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 years ended December 31, 2006, 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 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.

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 to not invest in obligations which it insures, and there were no such
obligations included in our investment portfolio as of December 31, 2006 or
2005.

Premiums and
Acquisition Costs

Assumed
premiums on an upfront basis are earned in proportion to the
expiration of the underlying guaranteed risk or amortization of the underlying
principal amount of the insured debt. Installment premiums assumed are earned
on a pro-rata basis over the installment period, which is generally one year or
less.

Deferred
premium revenue represents the portion of assumed premiums which is applicable
to the unexpired terms of reinsured policies in force. When a reinsured policy
is retired or defeased prior to the end of the expected period of coverage, the
remaining deferred premium, less any amount credited to a refunding issue
reinsured by the Company, is recognized in income at that time.

Certain
costs incurred, relating to and varying with the production of new business
have been deferred. These costs include ceding commissions and certain taxes
paid to the reinsured company. The Company considers the present value of
future premiums under installment contracts written when determining the
recoverability of

8

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XL Financial
Assurance Ltd.
 Notes to Financial Statements
For the years ended December 31, 2006, 2005 and 2004
  (U.S. dollars in thousands, except share
amounts)


deferred acquisition costs. Deferred acquisition
    costs are amortized in relation to, and over periods in which, the related
    premiums are earned. When a reinsured policy is retired or defeased
    prior to the end of the expected period of coverage, the remaining deferred
    acquisition costs less any amount credited to a refunding issue reinsured
    by the Company is recognized at such
    time.

In
addition, when a reinsured debt obligation 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.
Net premiums earned for the years ended December 31, 2006, 2005, and 2004
include $21.3 million, $12.3 million and $1.0 million, respectively, related to
refunded and called bonds.

Fee and Other Income

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 or deferred and earned over the life of
    the related transaction. Termination fees are earned when due and are included
    in the accompanying statements of operations under the caption Fee
    and other income. Structuring,
waiver and consent, and commitment fees are included in the accompanying statements
of operations as premiums and earned on a straight-line basis over the life of
the related transaction.

Losses and Loss
Expenses

The
financial guarantees reinsured by the Company guarantee 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 managements
best estimate of the Companys ultimate expected incurred losses. Managements
estimate of the Companys ultimate 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 a reinsured 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
reinsured obligations, and changes in the value of specific assets supporting
reinsured 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.

The
Companys case basis reserves on financial guarantee reinsurance assumed
are generally established by management upon notification from ceding companies.
Based on managements evaluation of the loss activity reported to the Company
from its ceding companies, as well as the results from managements periodic
reviews of ceding companies underwriting and surveillance procedures,
management may, in its judgment, establish case reserves greater or less than
those reported by ceding companies. The Companys reinsurance contracts
require ceding companies to submit monthly statements of premium and loss activity
for the period, as well as information regarding the performance of reinsured
contracts. This information is recorded into the Companys records upon
receipt of the monthly statements. Due to the timing of the receipts of such
statements from the Companys ceding companies, the Company records such
activity on a one month lag. Therefore, each annual reporting period includes
a full twelve months of actual activity based on reports for each of the months
from December of the prior calendar year through November of the reporting year.
Because such activity principally consists of premium and related activity, the
Company believes that reporting such activity on a one month lag allows the Company
to record more accurate information than if it were to estimate such activity
for one month, and the Company compares its calendar year results to its results
recorded on a one month lag for reasonableness. Furthermore, because only a
small percentage of premium written recorded in a particular month is earned
in the same month, the impact of the one month lag on earned premiums is not
material.

9

---



XL Financial Assurance Ltd.Notes to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004(U.S. dollars in thousands, except share amounts)


| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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 liability from
  claims expected to be incurred in the future under the Companys in-force
  insured and reinsured 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
  reinsured 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 business (e.g., principally the
  mix of the Companys in-force financial guarantee business between public
  finance and structured finance business; however, management also considered
  the various bond sectors comprising the Companys 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
  financial guarantee 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                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

10

---



XL Financial Assurance Ltd.Notes to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004(U.S. dollars in thousands, except share amounts)


| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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. In assessing whether a loss is probable, management considers all
  available quantitative and qualitative evidence.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | The
  Companys total reserves for losses and loss adjustment expenses represent a
  small fraction of the Companys 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 loss and loss adjustment expenses,
  actual experience may differ from the estimates reflected in the Companys
  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 where 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 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.

11

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XL Financial Assurance Ltd.Notes to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004(U.S. dollars in thousands, except share amounts)


| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Reinsurance                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | In
  the normal course of business, the Company will retrocede business
  principally to increase its aggregate capacity, manage its risk guidelines
  and reduce the risk of loss on business assumed. Reinsurance premiums ceded
  under such retrocession agreements are expensed and commissions received
  thereunder are earned in proportion to the expiration of the underlying
  reinsured risk or amortization of the underlying principal amount of the
  reinsured debt over the period the reinsurance coverage is provided. Prepaid
  reinsurance premiums represent the portion of premiums ceded that is
  applicable to the unexpired term of retroceded policies in force. Amounts
  recoverable from reinsurers are estimated in a manner consistent with the claim
  liability associated with the reinsured policy. A provision is made for any
  estimated unrecoverable reinsurance.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Cash and Cash Equivalents                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Cash
  equivalents include fixed interest deposits with a maturity of less than 90
  days when purchased.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Derivative Instruments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Credit
  default swaps guaranteed 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 as either assets or liabilities in the accompanying balance sheet.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | 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
  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 guaranteeing such contracts are
  recorded in the line item caption entitled net premiums earned in
  the accompanying 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 expenses in the
  accompanying 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 derivative instruments in
  the accompanying statement of operations. This presentation is consistent with
  practices in the financial guarantee insurance industry for reporting the
  results of such instruments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | 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 in 2007. The Company will continue to apply the accounting
  policies described herein until further guidance is provided by the FASB.

12

---



XL Financial Assurance Ltd.Notes to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004(U.S. dollars in thousands, except share amounts)


|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   | 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
  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 159 on its financial statements.                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|3. | Investments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   | Net
  investment income is derived from the following sources:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

| |                                                                         |  |      |        |      |   |        |   |   |        |  
| | ----------------------------------------------------------------------- |  | ---- | ------ | ---- | - | ------ | - | - | ------ | -
| |                                                                         |  | 2006 |        | 2005 |   | 2004   |  
| |                                                                         |  |      |       
| |                                                                         |  |      |        |      |   |        |   |   |        |  
| | Debt securities, short-term investments and
  cash and cash equivalents |  | $    | 60,847 |      | $ | 39,431 |   | $ | 26,056 |  
| | Investment expenses                                                     |  |      | (1,870 | )    |   | (1,318 | ) |   | (1,190 | )
| |                                                                         |  |      |        |      |   |        |   |   |        |  
| |                                                                         |  |      |        |      |   |        |   |   |        |  
| | Net investment income                                                   |  | $    | 58,977 |      | $ | 38,113 |   | $ | 24,866 |  
| |                                                                         |  |      |        |      |   |        |   |   |        |  

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Investment
  expenses include $380, $587 and $397 in expenses from an affiliate for
  investment management fees during the years ended December 31, 2006, 2005 and
  2004, respectively. Proceeds from sales and maturities of debt securities and short-term
  investments during the years ended December 31, 2006, 2005 and 2004 were
  $357,954, $814,020 and $2,992,828, respectively. Gross gains of $913, $4,840
  and $8,126 and gross losses of $15,786, $1,611 and $7,659 were realized on
  these sales for the years ended December 31, 2006, 2005 and 2004,
  respectively. The amortized cost, market value and related unrealized gains
  (losses) of investments are as follows:

13

---



XL Financial Assurance Ltd.Notes to Financial StatementsFor the years ended December 31, 2006, 2005 and 2004(U.S.
  dollars in thousands, except share amounts)  December
  31, 2006

Amortized
  Cost

Gross
  Unrealized
  Gains

Gross
  Unrealized
  Losses

Market
  ValueDebt
  securities:U.S. Government and Govt
  Agencies

$
257,414

$
181

$
(6,319
)
$
251,276Corporate bonds


268,398


1,039


(4,310
)

265,127Mortgage-backed securities


884,450


2,242


(8,915
)

877,777Non-U.S. Sovereign
  Government bonds


10,129


90


(202
)

10,017Total debt securities

$
1,420,391

$
3,552

$
(19,746
)
$
1,404,197Short-term
  investments:Total short-term
  investments

$
207,951

$
75

$
(1,103
)
$
206,923  December
  31, 2005

Amortized
  Cost

Gross
  Unrealized
  Gains

Gross
  Unrealized
  Losses

Market
  ValueDebt
  securities:U.S. Government and Govt
  Agencies

$
420,646

$
241

$
(6,023
)
$
414,864Corporate bonds


190,351


926


(3,801
)

187,476Mortgage-backed securities


433,681


284


(9,297
)

424,668Non-U.S. Sovereign
  Government bonds


9,678


154


(234
)

9,598Total debt securities

$
1,054,356

$
1,605

$
(19,355
)
$
1,036,606Short-term
  investments:Total short-term
  investments

$
23,772

$
11

$
(214
)
$
23,569


The
following table shows our 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 and
2005:


Less than 12 months

More than 12 months

Total2006

Market
  Value

Unrealized
  Losses

Market
  Value

Unrealized
  Losses

Market
  Value

Unrealized
  LossesU.S. Government and Government agencies

$
51,646

$
(504
)
$
338,653

$
(6,888
)
$
390,299

$
(7,392
)Corporate bonds


40,667


(180
)

148,120


(4,135
)

188,787


(4,315
)Mortgage-backed securities


175,192


(742
)

284,190


(8,173
)

459,382


(8,915
)Non-U.S. Sovereign Government bonds


504


(1
)

8,424


(200
)

8,928


(201
)U.S. States and political subdivisions of the states








1,824


(26
)

1,824


(26
)Total

$
268,009

$
(1,427
)
$
781,211

$
(19,422
)
$
1,049,220

$
(20,849
)


14

---



XL Financial Assurance Ltd.Notes to Financial StatementsFor the years ended December 31, 2006, 2005 and 2004(U.S.
  dollars in thousands, except share amounts)  Less than 12 months

More than 12 months

Total2005

Market
  Value

Unrealized
  Losses

Market
  Value

Unrealized 
  Losses

Market 
  Value

Unrealized
  LossesU.S. Government and Government agencies

$
317,232

$
(3,844
)
$
83,586

$
(2,238
)
$
400,818

$
(6,082
)Corporate bonds


107,709


(1,507
)

60,703


(2,353
)

168,412


(3,860
)Mortgage-backed securities


147,573


(2,608
)

210,149


(6,785
)

357,722


(9,393
)Non-U.S. Sovereign Government bonds








8,445


(234
)

8,445


(234
)Total

$
572,514

$
(7,959
)
$
362,883

$
(11,610
)
$
935,397

$
(19,569
)


The
Company has gross unrealized losses which it considers to be temporary
impairments. Individual security positions comprising this balance have been
evaluated by management, based on specified criteria, to determine if these
impairments should be considered other than temporary. These criteria include
an assessment of the severity and length of time securities have been impaired,
along with managements ability and intent to hold the securities to recovery,
among other factors. The Company has considered the continuous unrealized loss
position greater than twelve months or more and, in its opinion, no other than
temporary impairment in value has occurred as at December 31, 2006. The
contractual maturities of debt securities are shown below. Actual maturities
may differ from contractual maturities because borrowers may have the right to
call or prepay obligations with or without call or prepayment penalties:


December 31, 2006

December 31, 2005Amortized
  Cost

Market
  Value

Amortized
  Cost

Market
  ValueDue after 1 year through 5
  years

$
277,613

$
273,345

$
434,950

$
427,961Due after 5 through 10
  years


217,891


212,937


163,535


161,345Due after 10 years


40,437


40,138


22,190


22,632Mortgage-backed
  investments


884,450


877,777


433,681


424,668Total debt securities

$
1,420,391

$
1,404,197

$
1,054,356

$
1,036,606


|   |                                                                
|-- | ---------------------------------------------------------------
|4. | Minority
  Interest  Redeemable Preferred Shares of Subsidiary

The
    Company
was originally formed in 1998 as part of an investment venture between XL
Capital and Financial Security Assurance Holdings Ltd. (FSAH), the
parent company of FSA, and was initially capitalized through a series of transactions
resulting in the issuance by the
    Company of 2,057 common shares to XLI for
consideration of $221.0 million and the issuance by the
    Company of 363 shares of
Series A Redeemable Preferred Shares to FSAH and its subsidiaries for
consideration of $39.0 million. On December 7, 2004, the
    Company issued an additional
392 common shares to XLI in exchange for $125.0 million and on July 1, 2006 all
of XL Capitals direct and indirect ownership interest in the
    Company was contributed
to SCA See Note 1. In addition, on August 4, 2006 and December 22, 2006,
SCA contributed $175.0 million and $123.1 million, respectively, to the
    Company from
the net proceeds of its IPO. There were no common or other shares of equity capital
issued by the
  Company to SCA in exchange for such contributions.


15

---



XL Financial Assurance Ltd.Notes
  to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004(U.S. dollars in
  thousands, except share amounts)


|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   | Pursuant
  to the Companys corporate bye-laws each share of common stock of the
  Company is entitled to 3 votes with respect to matters requiring a vote of
  shareholders and each share of the Series A Redeemable Preferred Shares are
  entitled to 1 vote. Accordingly, at December 31, 2006 and 2005 holders of
  the Companys
  Series A Redeemable Preferred Shares as a group had approximately a 5% voting
  interest in  the Company, whereas holders of  the Companys common shares had
  an approximate 95% voting interest.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | Under
   the Companys corporate bye-laws the Series A Redeemable Preferred Shares
   were originally structured to provide for: (i) a 5% fixed annual dividend,
   (ii) an annual participating dividend according to certain criteria including
   a formula based on the financial guarantee industry average for dividends
   paid, and (iii) a payment upon redemption. Under the Companys
  amended corporate bye-laws the Series A Redeemable Preferred Shares may be
   redeemed by the Company: (i)


 at any time, in whole or in part, at its sole option; provided that no partial
 redemption by the Company shall cause the value of the remaining outstanding
   Series A Redeemable Preferred Shares to be less than 10% of the total equity
   capitalization of the Company; or (ii)

 in whole but not in part, at any time after  the tenth
   anniversary of the date of their initial issue. Dividends under
  the Series A Preferred Shares are cumulative.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | Pursuant
  to a resolution of the Companys shareholders on April 5, 2006, the Company restructured
  the terms of its Series A Redeemable Preferred Shares and changed its bye-laws
  accordingly.  In accordance with the
  resolution, the participating dividend of the
  preferred shares was eliminated, the stated value of the preferred shares
  held by FSAH and its subsidiaries was increased to $54.0 million in the
  aggregate, and the fixed dividend rate of the preferred shares was increased
  from 5.00% to 8.25%.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | For the
  year ended December 31, 2006, the Company recorded $4.5 million of dividends
  on its Series A Redeemable Preferred Shares.
  For the years ended December 31, 2005 and 2004, the Company recorded
  $7.0 million and $14.1 million of fixed and participating dividends and
  accreted redemption value, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | On
    February 27, 2007, the board of directors of the Company approved: (i) an
    extraordinary dividend of $15.0 million on its Series A Redeemable Preferred
    Shares, and (ii) a reduction in the stated value of the remaining outstanding
    Series A Redeemable Preferred Shares by a corresponding amount. The
    extraordinary dividend and the reduction in the stated value of the Series
    A Redeemable Preferred Shares are expected to take place in March 2007.
 There was no change in the voting interest of the holders of the Series A Redeemable
 Preferred shares as a result of the extraordinary dividend and reduction in
 the stated value of the Series A Redeemable Preferred Shares.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|5. | Capital Facility                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In
  December 2004, the Company entered into a put option agreement and an expense
  reimbursement agreement (the Asset Trust Expense Reimbursement Agreement)
  with Twin Reefs Asset Trust (the Asset Trust). The put option agreement
  provides the Company with the irrevocable right to require the Asset Trust
  at any time and from time to time to purchase the Companys non-cumulative
  perpetual Series B Preferred Shares with an aggregate liquidation preference
  of up to $200 million. The Company is obligated to reimburse the Asset Trust
  for certain fees and ordinary expenses. To the extent that any Series B Preferred
  Shares are put to the Asset Trust and remain outstanding, a corresponding portion
  of such fees and ordinary expenses will be payable by the Company pursuant
  to the Asset Trust Expense Reimbursement Agreement. The put option agreement
  is perpetual but would terminate on delivery of notice by the Company on or
  after December 10, 2009, or under certain defined circumstances, such as the
  failure of the Company to pay the put option premium when due or bankruptcy.
  The put option is recorded at fair value with changes in fair value recognized
  in earnings under the caption in the statements of operations entitled Net realized and unrealized
  gains (losses) on derivative instruments. The impact on earnings of the fair
  value adjustments related to the put option for the years ended December 31,
  2006, 2005, and 2004 were $2.3 million, $2.3 million, and $0.1 million,
  respectively.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | The
    Companys
  Series B Preferred Shares were created in conjunction with the establishment
  of the Asset Trust. The Series B Preferred Shares are non-cumulative
  redeemable perpetual preferred shares with a par value of $120 per share. The
  Series B Preferred Shares rank prior to the Companys common and Series
  A Redeemable Preferred Shares (see Note 4) and have a liquidation preference
  of $100,000 per share. In the event that the Company exercises its put option
  to the Asset Trust and the Series B preferred shares are issued,
    the holders of outstanding Series B Preferred Shares shall be entitled to
  receive, in preference to the holders of the Companys common and Series
  A Redeemable Preferred Shares, cash dividends at a percentage rate per Series
  B Preferred Share as follows:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

16

---



XL Financial Assurance Ltd.Notes
  to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004(U.S. dollars in
  thousands, except share amounts)


| | 
| | 

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |     |                                                                                                                                                 
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --- | ------------------------------------------------------------------------------------------------------------------------------------------------
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | (1) | for any
  Dividend Period ending on or prior to December 9, 2009, One Month LIBOR plus
  1.00% per annum, calculated on an Actual/360 Basis; and
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |     |                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | (2) | for any
  subsequent Dividend Period, One-Month LIBOR plus 2.00% per annum, calculated
  on an Actual/360 Basis.                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |     |                                                                                                                                                 
|   | The
  holders of the Series B Preferred Shares will not be entitled to any voting
  rights as shareholders of the Company and their consent will not be required for
  taking any corporate action. The Series B Preferred Shares may be redeemed,
  in whole or in part, at the option of the Company at any time or from time to time
  for cash at a redemption price equal to the liquidation preference per share
  plus any accrued and unpaid dividends thereon to the date of redemption
  without interest on such unpaid dividends. However, the Series B Preferred
  Shares may not be redeemed, in whole or in part, at the option of the Company
  at any time prior to December 10, 2009.                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |     |                                                                                                                                                 
|6. | Related Party Transactions                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |     |                                                                                                                                                 
|   | Capital Transactions                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |     |                                                                                                                                                 
|   | In
  connection with SCAs IPO on August 4, 2006, XLI contributed $15.0 million
  to the Company. There were
  no common or other shares of equity capital issued by the Company to SCA in
  exchange for such contributions. Refer to Note 4 for capital contributions received from SCA.                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |     |                                                                                                                                                 
|   | Services Arrangements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |     |                                                                                                                                                 
|   | The
  Company purchased various services from affiliates of XL Capital prior to the
  IPO under various agreements and continues to purchase certain services indirectly
  through SCA Administrative Bermuda Ltd, a wholly owned subsidiary of
  SCA.  Such services principally
  include: (i) information technology support, (ii) actuarial, finance,
  internal audit services, and (iii) certain investment management
  services.  For the years ended
  December 31, 2006, 2005 and 2004, the Company incurred costs for such
  services aggregating $3.5 million, $4.2 million and $2.9 million, respectively,
  which are a component of operating expenses in the accompanying statements
  of operations.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |     |                                                                                                                                                 
|   | Reinsurance Treaties with Affiliates                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The Company
  has a facultative quota share reinsurance treaty (Treaty) with
  XLCA. Under the terms of the Treaty, the Company agrees to reinsure up to 75%
  of business written by XLCA provided it meets certain specified parameters.
  Prior to July 1, 2006, the Company had agreed under the Treaty to reinsure
  up to 90% of such business. In addition, pursuant to
  the Treaty XLCA charges up to a 30% ceding commission (or such other
  percentage on an arms-length basis) on ceded premiums written under the
  agreement.                                                                                                                                                                                                    
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |  | XLI entered
  into an agreement with XLCA which unconditionally and irrevocably guarantees
  to XLCA the full and complete payment when due of all of the Companys
  obligations under its facultative quota share reinsurance agreement with XLCA,
  under which agreement the Company has assumed business from XLCA since December
  19, 2000. The par value of business guarantied by XLI under this agreement
  was approximately $83.1 billion and $72.6 billion as of December 31, 2006 an
  2005, respectively. The XLI guarantee agreement terminated with respect to
  any new business produced by XLCA and ceded to the Company pursuant to the
  facultative quota share reinsurance agreement after the effective date of the
  IPO.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |  | The Company
  has entered into the following reinsurance agreements with XLI:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

17

---



XL Financial Assurance Ltd.Notes
  to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004(U.S. dollars in
  thousands, except share amounts)


| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | (a)                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Effective
  October 3, 2001, the Company entered into an excess of loss reinsurance
  agreement with XLI. This agreement covers a portion of the Companys
  liability arising as a result of losses on policies reinsured by the Company
  that are in excess of certain limits and are not covered by other reinsurance
  agreements. This agreement provides indemnification only for the portion of
  any loss covered by this agreement in excess of 10% of XLFAs surplus, up to
  an aggregate amount of $500 million.
  For each of the three years ended December 31, 2006, 2005 and 2004,
  the Company incurred expense under this agreement of approximately $0.5
  million.                                                                                                                                        
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |   | (b)                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Effective
  August 17, 2001, the Company entered into a facultative quota share
  reinsurance treaty with XLI. This treaty allows the Company to propose to
  cede to XLI a portion of a risk, which risk XLI may then accept or reject in
  its sole discretion. Under this treaty, XLI pays the Company a ceding
  commission of 30% on the premiums ceded unless otherwise
  specified.  On August 4, 2006, the
  Company and XLI terminated certain reinsurance cessions ceded under this
  agreement to XLI.  As a result of the
  termination of the aforementioned cessions, XLI returned $26.5 million of
  premiums to the Company, the Company returned ceding commissions of $7.8
  million to XLI,  and XLI paid the
  Company $18.7 million.                                                                       
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |   | (c)                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Effective
  December 31, 1999, the Company entered into a facultative quota share
  reinsurance treaty with XLI. This treaty allows XLI to propose to cede to the
  Company a portion of a risk it insured, which risk XLFA may then accept or
  reject in its sole discretion. Under this treaty, the Company pays XLI a
  ceding commission of 12% on the premiums ceded under this treaty unless
  otherwise specified.  On August 4,
  2006, the Company and XLI agreed to cancel from inception the reinsurance of
  certain business ceded under this arrangement.  As a result of this cancellation, the Company paid XLI $0.2
  million, XLI assumed the Companys obligation for $1.2 million of reserves
  for losses and loss adjustment expenses, and the Company recorded a capital
  contribution of $1.0 million.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                           | In addition,
  on August 4, 2006, the Company entered into certain reinsurance cessions with
  XLI pursuant to the aforementioned facultative quota share reinsurance
  treaty.  As a result of these
  cessions, the Company recorded assumed premiums of approximately $8.0
  million, ceding commissions of approximately $1.0 million and received cash
  from XLI of approximately $7.0 million.                                                                                                                                                                                                                                                                                                                                                                                                                           
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |   | (d)                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Effective
  August 4, 2006, XLI, at no cost to the Company, indemnfied 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |  | The Company
  has entered into the following reinsurance agreements with certain
  subsidiaries and affiliates of FSAH. Premiums assumed from FSAH affiliates
  represented 11.0%, 13.4% and 13.3% of the Companys total reinsurance
  premiums assumed for the three years ended December 31, 2006, 2005 and 2004,
  respectively.  All of the agreements
  discussed below may be terminated under certain conditions, as defined in the
  agreements:
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |   | (a)                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Effective
  November 3, 1998, the Company entered into a master facultative reinsurance
  agreement with FSA. This agreement allows FSA to propose to cede a portion
    of a risk insured by it to the Company, which risk the Company may then accept
  or reject solely in its discretion. The ceding commission that the Company
  pays FSA on the premiums ceded under this agreement is determined on a
  case-by-case basis. The Companys obligations under this agreement are
  guarantied by XLI.  The XLI guarantee
  agreement terminated with respect to any new business produced by FSA and
  ceded to the Company pursuant to the master faculative reinsurance agreement
  after the effective date of the IPO.                                                                                                
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |   | (b)                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Effective
  January 1, 2004, the Company entered into a reinsurance treaty with FSA to
  reinsure certain policies they issued insuring the timely payment of the
  principal of and interest on certain asset-backed securities and pools of
  consumer debt obligations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

18

---



XL Financial Assurance Ltd. Notes to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004 (U.S.
dollars in thousands, except share amounts)
  (c)
Effective
  January 1, 2004, the Company entered into a reinsurance treaty with FSA to
  reinsure certain policies they issued insuring the timely payment of the
  principal and interest on securities and obligations that provide financing
  for governmental or public purpose infrastructure projects located outside of
  the United States and its territories, excluding certain countries.
The Company
  has guarantied certain of XLIs obligations in connection with certain
  transactions where XLIs customer required such credit enhancement. Each of
  these transactions has a double trigger structure, meaning that the Company
  does not have to pay a claim unless both the underlying transaction and XLI
  default. For each of these transactions, the Company has entered into a
  reimbursement agreement with XLI, pursuant to which XLI pays the Company a fee
  for providing its guarantee and XLI grants the Company a security interest in
  a portion of the payments received by it from its client. As of December 31,
  2006 and 2005, the Companys aggregate net par outstanding relating to such
  guarantees was $522.8 million and $526.8 million, respectively.


|   |                                                                        | 
|-- | ---------------------------------------------------------------------- | 
|   |                                                                        | 
|7. | Premiums
  and Reinsurance                                            
|   |                                                                        | 
|   | The effect
  of reinsurance activity is shown below  See also Note 2:

| |                                                                |  |      |          |      |   |         |   |   |          |  
| | -------------------------------------------------------------- |  | ---- | -------- | ---- | - | ------- | - | - | -------- | -
| |                                                                |  | 2006 |          | 2005 |   | 2004    |  
| |                                                                |  |      |          |      |   |         |  
|
| | Reinsurance
  premiums assumed                                 |  | $    | 349,772  |      | $ | 255,624 |   | $ | 248,907  |  
| | Reinsurance
  premiums ceded                                   |  |      | 1,776    |      |   | (33,778 | ) |   | (10,746  | )
| |                                                                |  |      |          |      |   |         |   |   |          |  
|
| | Net premiums
  assumed                                         |  |      | 351,548  |      |   | 221,846 |   |   | 238,161  |  
| | Change in
  deferred premiums and prepaid reinsurance premiums |  |      | (184,877 | )    |   | (86,910 | ) |   | (134,496 | )
| |                                                                |  |      |          |      |   |         |   |   |          |  
|
| | Net
  reinsurance premiums earned                              |  | $    | 166,671  |      | $ | 134,936 |   | $ | 103,665  |  
| |                                                                |  |      |          |      |   |         |   |   |          |  

| |                                                                                                                                           
| | ------------------------------------------------------------------------------------------------------------------------------------------
| | Following is
  a summary of all assumed and ceded business to affiliates as of and for the
  years ended December 31, 2006, 2005 and 2004:

| |                                             |  |      |          |     |   |         |   |       |          |   |   |          |  
| | ------------------------------------------- |  | ---- | -------- | --- | - | ------- | - | ----- | -------- | - | - | -------- | -
| | 2006                                        |  | XLCA |          | XLI |   | FSA     |   | TOTAL |         
| |                                             |  |      |          |     |   |         |   |       |         
| | Assumed and ceded transactions:             |  |      |          |     |   |         |   |       |          |   |   |          |  
| | Assumed
  premiums                          |  | $    | 294,501  |     | $ | 9,162   |   | $     | 38,513   |   | $ | 342,176  |  
| | Reinsurance
  premiums ceded                |  |      |         |     |   | 18,292  |   |       | 21       |   |   | 18,313   |  
| | Change in
  deferred premium                |  |      | (136,039 | )   |   | (4,982  | ) |       | (25,509  | ) |   | (166,530 | )
| | Change in
  prepaid reinsurance premiums    |  |      |         |     |   | (27,686 | ) |       |         |   |   | (27,686  | )
| | Loss and
  loss expenses recoverable        |  |      |         |     |   | (7,669  | ) |       |         |   |   | (7,669   | )
| | Loss and
  loss expenses incurred           |  |      | (25,861  | )   |   | (217    | ) |       | (3,457   | ) |   | (29,535  | )
| | Assumed
  commission expenses               |  |      | (48,894  | )   |   | 431     |   |       | (3,444   | ) |   | (51,907  | )
| | Ceding
  commission income                  |  |      |         |     |   | 2,515   |   |       | (6       | ) |   | 2,509    |  
| |                                             |  |      |          |     |   |         |   |       |          |   |   |          |  
| |                                             |  | XLCA |          | XLI |   | FSA     |   | TOTAL |         
| |                                             |  |      |          |     |   |         |   |       |         
| | Assumed and ceded balances:                 |  |      |          |     |   |         |   |       |          |   |   |          |  
| | Deferred
  acquisition costs                |  |      | 133,851  |     |   | 1,215   |   |       | 26,497   |   |   | 161,563  |  
| | Reinsurance
  balances receivable           |  |      | 12,729   |     |   | 4,055   |   |       | 1,929    |   |   | 18,713   |  
| | Unpaid loss
  and loss expenses recoverable |  |      |         |     |   | 57,956  |   |       |         |   |   | 57,956   |  
| | Deferred
  premiums                         |  |      | (569,440 | )   |   | (9,182  | ) |       | (104,364 | ) |   | (682,986 | )
| | Deferred
  ceding commission income         |  |      |         |     |   | (10,271 | ) |       |         |   |   | (10,271  | )
| | Unpaid loss
  and loss expenses             |  |      | (139,300 | )   |   | 1,077   |   |       | (14,628  | ) |   | (152,851 | )
| | Reinsurance
  balances payable              |  |      |         |     |   | (1,470  | ) |       |         |   |   | (1,470   | )

19

---



XL Financial Assurance Ltd.Notes to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004(U.S. dollars in thousands, except share amounts)


| |                                             |  |      |          |     |   |         |   |       |         |   |   |          |  
| | ------------------------------------------- |  | ---- | -------- | --- | - | ------- | - | ----- | ------- | - | - | -------- | -
| | 2005                                        |  | XLCA |          | XLI |   | FSA     |   | TOTAL |        
| |                                             |  |      |          |     |   |         |   |       |        
| | Assumed and ceded transactions:             |  |      |          |     |   |         |   |       |         |   |   |          |  
| | Assumed
  premiums                          |  | $    | 203,453  |     | $ | 2,874   |   | $     | 34,274  |   | $ | 240,601  |  
| | Reinsurance
  premiums ceded                |  |      |         |     |   | (21,388 | ) |       | (41     | ) |   | (21,429  | )
| | Change in
  deferred premium                |  |      | (75,644  | )   |   | 991     |   |       | (18,417 | ) |   | (93,070  | )
| | Change in
  prepaid reinsurance premiums    |  |      |         |     |   | 5028    |   |       |        |   |   | 5,028    |  
| | Loss and
  loss expenses recoverable        |  |      |         |     |   | 7,783   |   |       | 10      |   |   | 7,793    |  
| | Loss and
  loss expenses incurred           |  |      | (32,679  | )   |   | (2,952  | ) |       | (15     | ) |   | (35,646  | )
| | Assumed
  commission expenses               |  |      | (40,297  | )   |   | (647    | ) |       | (4,372  | ) |   | (45,316  | )
| | Ceding
  commission income                  |  |      |         |     |   | 4,746   |   |       | 12      |   |   | 4,758    |  
| |                                             |  |      |          |     |   |         |   |       |         |   |   |          |  
| |                                             |  | XLCA |          | XLI |   | FSA     |   | TOTAL |        
| |                                             |  |      |          |     |   |         |   |       |        
| | Assumed and ceded balances:                 |  |      |          |     |   |         |   |       |         |   |   |          |  
| | Deferred
  acquisition costs                |  |      | 103,732  |     |   | 618     |   |       | 20,143  |   |   | 124,493  |  
| | Reinsurance
  balances receivable           |  |      |         |     |   | 414     |   |       | 1,960   |   |   | 2,374    |  
| | Unpaid loss
  and loss expenses recoverable |  |      |         |     |   | 63,250  |   |       |        |   |   | 63,250   |  
| | Deferred
  premiums                         |  |      | (433,401 | )   |   | (2,857  | ) |       | (80,198 | ) |   | (516,456 | )
| | Deferred
  ceding commission income         |  |      |         |     |   | (18,690 | ) |       |        |   |   | (18,690  | )
| | Unpaid loss
  and loss expenses             |  |      | (108,897 | )   |   | (3,248  | ) |       | (11,171 | ) |   | (123,316 | )
| | Reinsurance
  balances payable              |  |      | (7,733   | )   |   | (6,285  | ) |       |        |   |   | (14,018  | )
| |                                             |  |      |          |     |   |         |   |       |         |   |   |          |  
| | 2004                                        |  | XLCA |          | XLI |   | FSA     |   | TOTAL |        
| |                                             |  |      |          |     |   |         |   |       |        
| | Assumed and ceded transactions:             |  |      |          |     |   |         |   |       |         |   |   |          |  
| | Assumed
  premiums                          |  | $    | 204,875  |     | $ | 3,774   |   | $     | 33,191  |   | $ | 241,840  |  
| | Reinsurance
  premiums ceded                |  |      |         |     |   | 4,620   |   |       |        |   |   | 4,620    |  
| | Change in
  deferred premium                |  |      | (76,654  | )   |   | 1,186   |   |       | (14,408 | ) |   | (89,876  | )
| | Change in
  prepaid reinsurance premiums    |  |      |         |     |   | (56,300 | ) |       |        |   |   | (56,300  | )
| | Loss and
  loss expenses recoverable        |  |      |         |     |   | 48,662  |   |       |        |   |   | 48,662   |  
| | Loss and
  loss expenses incurred           |  |      | (60,544  | )   |   | (536    | ) |       | (5,545  | ) |   | (66,625  | )
| | Assumed
  commission expenses               |  |      | (34,257  | )   |   | (835    | ) |       | (4,470  | ) |   | (39,562  | )
| | Ceding
  commission income                  |  |      |         |     |   | 8,672   |   |       |        |   |   | 8,672    |  
| |                                             |  |      |          |     |   |         |   |       |         |   |   |          |  
| |                                             |  | XLCA |          | XLI |   | FSA     |   | TOTAL |        
| |                                             |  |      |          |     |   |         |   |       |        
| | Assumed and ceded balances:                 |  |      |          |     |   |         |   |       |         |   |   |          |  
| | Deferred
  acquisition costs                |  |      | 89,999   |     |   | 797     |   |       | 15,482  |   |   | 106,278  |  
| | Reinsurance
  balances receivable           |  |      | 25,579   |     |   | 14,266  |   |       | 639     |   |   | 40,484   |  
| | Unpaid loss
  and loss expenses recoverable |  |      |         |     |   | 56,213  |   |       |        |   |   | 56,213   |  
| | Deferred
  premiums                         |  |      | (357,757 | )   |   | (3,848  | ) |       | (62,010 | ) |   | (423,615 | )
| | Deferred
  ceding commission income         |  |      |         |     |   | (17,477 | ) |       |        |   |   | (17,477  | )
| | Unpaid loss
  and loss expenses             |  |      | (78,831  | )   |   | (1,376  | ) |       | (21,293 | ) |   | (101,500 | )
| | Reinsurance
  balances payable              |  |      |         |     |   |        |   |       |        |   |   |         |  

20

---



XL Financial Assurance Ltd.Notes to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004(U.S. dollars in thousands, except share amounts)


|   |                                                                                                                                  
|-- | ---------------------------------------------------------------------------------------------------------------------------------
|8. | Deferred Acquisition Costs                                                                                                       
|   |                                                                                                                                  
|   | Acquisition
  costs deferred for amortization against future income and related amortization
  charged to expense are as follows:

| |                                 |  |      |         |      |   |         |  
| | ------------------------------- |  | ---- | ------- | ---- | - | ------- | -
| |                                 |  | 2006 |         | 2005 |  
| |                                 |  |      |         |      |  
| |                                 |  |      |         |      |   |         |  
| | Balance, beginning of year      |  | $    | 100,784 |      | $ | 83,868  |  
| | Costs deferred during the year: |  |      |         |      |   |         |  
| | Assumed commission expense      |  |      | 47,162  |      |   | 35,543  |  
| | Ceding commission income        |  |      | (7,013  | )    |   | (4,243  | )
| |                                 |  |      |         |      |   |         |  
| |                                 |  |      |         |      |   |         |  
| | Total                           |  | $    | 40,149  |      | $ | 31,300  |  
| | Costs amortized during the year |  |      | 4,996   |      |   | (14,384 | )
| |                                 |  |      |         |      |   |         |  
| |                                 |  |      |         |      |   |         |  
| | Balance end of year             |  | $    | 145,929 |      | $ | 100,784 |  
| |                                 |  |      |         |      |   |         |  

|   |                                                                                                                                                                                                                                                                                                                                                                                                   | 
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|9. | Outstanding Exposure and Collateral                                                                                                                                                                                                                                                                                                                                                              
|  
|   | The Companys
  policies reinsure the scheduled payments of principal and interest on
  asset-backed and municipal obligations.
  The following tables reflect the insured exposures in categories based
  on the Companys underwriting and surveillance structure.  The principal amount reinsured (in
  millions) as of December 31, 2006 and 2005 and the terms to maturity are as
  follows:

| |                      |  |                  |        |                      |   |                  |  |                      |        |              |   |            |  |              |        |            |   |        |  |   |        |  |   |        | 
| | -------------------- |  | ---------------- | ------ | -------------------- | - | ---------------- |  | -------------------- | ------ | ------------ | - | ---------- |  | ------------ | ------ | ---------- | - | ------ |  | - | ------ |  | - | ------ | 
| |                      |  | 2006             |        | 2005                 |  
| |                      |  | Public
  Finance |        | Non Public
  Finance |   | Public
  Finance |  | Non Public
  Finance |       
| |                      |  |                  |        |                      |   |                  |  |                      |       
| | Terms to Maturity    |  | GrossPar O/S     |        | NetPar O/S           |   | GrossPar O/S     |  | NetPar O/S           |        | GrossPar O/S |   | NetPar O/S |  | GrossPar O/S |        | NetPar O/S |  
| |                      |  |                  |        |                      |   |                  |  |                      |        |              |   |            |  |              |        |            |  
|
| | 0 to 5 Years         |  | $                | 1,139  |                      | $ | 1,135            |  | $                    | 8,934  |              | $ | 8,224      |  | $            | 996    |            | $ | 968    |  | $ | 11,133 |  | $ | 9,543  | 
| | 5 to 10
  Years      |  |                  | 2,855  |                      |   | 2,790            |  |                      | 12,363 |              |   | 11,679     |  |              | 2,854  |            |   | 2,630  |  |   | 11,156 |  |   | 10,076 | 
| | 10 to 15
  Years     |  |                  | 5,816  |                      |   | 5,645            |  |                      | 9,320  |              |   | 8,766      |  |              | 4,300  |            |   | 3,867  |  |   | 5,411  |  |   | 5,204  | 
| | 15 to 20
  Years     |  |                  | 10,308 |                      |   | 9,737            |  |                      | 3,393  |              |   | 3,305      |  |              | 7,316  |            |   | 6,398  |  |   | 2,303  |  |   | 2,182  | 
| | 20 Years and
  Above |  |                  | 23,947 |                      |   | 22,679           |  |                      | 30,593 |              |   | 28,896     |  |              | 17,707 |            |   | 16,014 |  |   | 17,856 |  |   | 16,646 | 
| |                      |  |                  |        |                      |   |                  |  |                      |        |              |   |            |  |              |        |            |   |        |  |   |        |  |   |        | 
|
| | Total                |  | $                | 44,065 |                      | $ | 41,986           |  | $                    | 64,603 |              | $ | 60,870     |  | $            | 33,173 |            | $ | 29,877 |  | $ | 47,859 |  | $ | 43,651 | 
| |                      |  |                  |        |                      |   |                  |  |                      |        |              |   |            |  |              |        |            |   |        |  |   |        |  |   |        | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                | 
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | The Company
  limits its exposure to losses from writing financial guarantees by
  underwriting investment-grade obligations and diversifying its portfolio and
  maintaining rigorous collateral requirements on asset-backed obligations. The
  gross principal amounts of reinsured obligations in the asset-backed
  reinsured portfolio are backed by the following types of collateral as of
  December 31, 2006 and 2005 (in millions):

21

---



XL Financial Assurance Ltd.
  Notes to Financial StatementsFor the years ended December 31, 2006, 2005 and 2004(U.S. dollars in thousands, except share amounts)  2006

2005Types of Collateral

Gross

Net

Gross

NetCollateralized
  debt

$
21,365

$
20,882

$
12,608

$
12,608Corporate
  assets


3,645


3,284


3,444


2,997Consumer
  assets


9,945


9,148


9,552


8,470Pre-Insured


122


122


142


142Total asset-backed
  obligations

$
35,077

$
33,436

$
25,746

$
24,217 In
its asset-backed business, the Company considers its overall geographic
concentration as a factor in underwriting reinsurance covering securitizations
of pools of such assets as residential mortgages or consumer receivables. In
writing reinsurance for other types of asset-backed obligations, such as
securities primarily backed by government or corporate debt, geographic
concentration is not deemed by the Company to be significant, given other more
relevant measures of diversification, such as issuer or industry. The
Company seeks to maintain a diversified portfolio of reinsured municipal
obligations designed to spread its risk across a number of geographic areas.
The following table sets forth, by state and territory of the United States,
those states and territories in which municipalities located therein issued an
aggregate of 2% or more of the Companys par amount outstanding of reinsured
municipal securities as of December 31, 2006 and 2005 (in millions): 2006

2005Par
  amount outstanding

Par
  amount outstandingState/territory

Gross

Net

% of net

Gross

Net

% of netCalifornia

$
9,766

$
9,018


21.5
%
$
7,516

$
6,620


22.2
%New York


4,706


4,622


11.0


4,228


3,292


11.0Texas


2,603


2,410


5.7


1,796


1,657


5.5Illinois


2,169


2,094


5.0


1,677


1,602


5.4Alabama


1,812


1,538


3.7


1,315


926


3.1Pennsylvania


1,786


1,786


4.3


1,010


1,010


3.4New Jersey


1,789


1,714


4.1


1,668


1,306


4.4Massachusetts


1,539


1,488


3.5


1,465


1,414


4.7Wisconsin


1,544


1,289


3.1


1,437


1,166


3.9Colorado


1,307


1,266


3.0


1,177


1,107


3.7Michigan


1,154


1,134


2.7


1,024


1,005


3.4Florida


1,218


1,210


2.9


924


916


3.1Puerto Rico


1,031


1,031


2.5


852


852


2.9Georgia


911


911


2.2


755


755


2.5Other U.S.
  states


10,208


9,953


23.6


5,611


5,562


18.5Nationally
  diversified


522


522


1.2


718


687


2.3Total

$
44,065

$
41,986


100.0
%
$
33,173

$
29,877


100.0
% As
of December 31, 2006 and 2005, the insured portfolio was diversified by type of
insured obligation as shown in the following table (in millions): 22


---



XL Financial Assurance Ltd.
  Notes to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004(U.S. dollars in thousands, except share amounts)  2006

2005Par
  amount outstanding

Par
  amount outstandingPublic Finance

Gross

Net

% of net

Gross

Net

% of netGeneral Obligation & appropriation

$
19,272

$
18,715


18.2
%
$
15,222

$
13,178


17.9
%Utility


8,459


7,907


7.7


6,623


6,006


8.2Transportation


5,772


5,466


5.3


3,426


3,394


4.6Non Ad Valorem


4,996


4,448


4.3


3,555


3,087


4.2Higher Education


4,548


4,473


4.4


3,481


3,416


4.6Pre-Insured


657


657


0.6


536


536


0.7Revenue Secured


330


289


0.3


330


260


0.4Healthcare


31


31











Total Public Finance

$
44,065

$
41,986


40.8
%
$
33,173

$
29,877


40.6
%  Structured
  Finance

Gross

Net

% of net

Gross

Net

% of netPooled Debt Obligations

$
20,445

$
19,969


19.4
%
$
12,288

$
12,288


16.7
%Consumer ABS


9,518


8,740


8.5


9,488


8,406


11.4Financial Products


5,696


5,303


5.2


5,360


4,835


6.5Power & Utility


4,797


4,471


4.4


3,811


3,659


5.0Commercial ABS


2,570


2,285


2.2


2,154


1,818


2.5Transportation


787


546


0.5


400


262


0.4Pre-Insured


785


766


0.7


590


590


0.8Housing & Public Building


677


677


0.7


599


599


0.8Specialized Risk  Other


516


516


0.5


865


705


1.0Specialized Risk


455


413


0.4








Total Structured Finance

$
46,246

$
43,686


42.5
%
$
35,555

$
33,162


45.1
%  International
  Finance

Gross

Net

% of net

Gross

Net

% of netPower & Utility

$
4,601

$
4,324


4.2
%
$
3,084

$
2,673


3.6
%Infrastructure


3,787


3,436


3.3


1,214


1,120


1.5Transportation


2,784


2,580


2.5


1,766


1,698


2.3Future Flow


1,673


1,546


1.5


2,935


1,848


2.5Pooled Debt Obligations


1,486


1,479


1.4


946


946


1.3Pre-Insured


998


985


1.0








Financial Products


889


889


0.9


842


842


1.2Sovereign


556


456


0.5


106


106


0.2General Obligation & Appropriation


429


429


0.4


425


425


0.6Consumer ABS


427


408


0.4


355


334


0.5Whole Business Securitization


341


288


0.3


365


231


0.3Commercial ABS


222


200


0.2


102


102


0.1Specialized Risk  Other


150


150


0.1


150


150


0.2Non Ad Valorem


14


14





14


14


Total International Finance

$
18,357

$
17,184


16.7
%
$
12,304

$
10,489


14.3
%Total

$
108,668

$
102,856


100.0
%
$
81,032

$
73,528


100.0
% 23


---



XL Financial Assurance Ltd.Notes to Financial StatementsFor the years ended December 31, 2006, 2005 and 2004(U.S. dollars in thousands, except share
  amounts)


|    |                                                                                                                                                                                                                                                                                                                                  
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | Gross
  financial guarantees in-force (principal and interest), was $169,545 million
  and $120,768 million as of December 31, 2006 and 2005, respectively. Net
  financial guarantees in-force (after giving effect to reinsurance), was $160,213
  million and $109,538 million as of December 31, 2006 and 2005, respectively.
|    |                                                                                                                                                                                                                                                                                                                                  
|10. | Unpaid Losses and Loss Expenses                                                                                                                                                                                                                                                                                                  
|    |                                                                                                                                                                                                                                                                                                                                  
|    | The
  Companys liability for losses and loss 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 December 31, |        
|                                                                                                  |  |                    |        
|                                                                                                  |  | 2006               |         | 2005                    |   | 2004            |  
|                                                                                                  |  |                    |         |                         |   |                 |  
|                                                                                                  |  | Case
  Reserves    |         | Unallocated 
  Reserves |   | Case
  Reserves |   | Unallocated 
  Reserves |         | Case 
  Reserves |   | Unallocated 
  Reserves |  
|                                                                                                  |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |  
|Unpaid losses and loss
  expenses at beginning of year                                            |  | $                  | 64,747  |                         | $ | 69,297          |   | $                       | 50,810  |                  | $ | 58,341                  |   | $ | 4,108  |   | $ | 31,791 |  
|                                                                                                  |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |   |   |        |   |   |        |  
|Unpaid losses and loss
  expenses recoverable                                                     |  |                    | (52,317 | )                       |   | (14,077         | ) |                         | (42,150 | )                |   | (13,291                 | ) |   |       |   |   | (7,745 | )
|                                                                                                  |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |   |   |        |   |   |        |  
|Net unpaid losses and loss
  expense at beginning of year                                         |  |                    | 12,430  |                         |   | 55,220          |   |                         | 8,660   |                  |   | 45,050                  |   |   | 4,108  |   |   | 24,046 |  
|                                                                                                  |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |   |   |        |   |   |        |  
|Increase (decrease) in net
  losses and loss expenses incurred in respect of losses occurring in: |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |   |   |        |   |   |        |  
|                                                                                                  |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |   |   |        |   |   |        |  
|Current year                                                                                      |  |                    |         |                         |   | 12,585          |   |                         | 11      |                  |   | 10,170                  |   |   | 6,069  |   |   | 15,024 |  
|                                                                                                  |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |   |   |        |   |   |        |  
|Prior years                                                                                       |  |                    | 1,474   |                         |   |                |   |                         | 6,671   |                  |   |                        |   |   |       |   |   |       |  
|                                                                                                  |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |   |   |        |   |   |        |  
|Less net losses and loss
  expenses (paid) received & other relating to prior years               |  |                    | (3,206  | )                       |   |                |   |                         | (2,912  | )                |   |                        |   |   | (1,517 | ) |   | 5,980  |  
|                                                                                                  |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |   |   |        |   |   |        |  
|Net unpaid losses and loss
  expenses at end of year                                              |  |                    | 10,698  |                         |   | 67,805          |   |                         | 12,430  |                  |   | 55,220                  |   |   | 8,660  |   |   | 45,050 |  
|                                                                                                  |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |   |   |        |   |   |        |  
|Unpaid losses and loss
  expenses recoverable                                                     |  |                    | 64,359  |                         |   | 13,871          |   |                         | 52,317  |                  |   | 14,077                  |   |   | 42,150 |   |   | 13,291 |  
|                                                                                                  |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |   |   |        |   |   |        |  
|Unpaid losses and loss
  expenses at end of year                                                  |  | $                  | 75,057  |                         | $ | 81,676          |   | $                       | 64,747  |                  | $ | 69,297                  |   | $ | 50,810 |   | $ | 58,341 |  
|                                                                                                  |  |                    |         |                         |   |                 |   |                         |         |                  |   |                         |   |   |        |   |   |        |  

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                                                                                                                                                                           
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Case Basis Reserves for Losses
  and Loss 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 reinsured transaction described under (a) below by XLI in
  connection with SCAs IPO.  As a
  result of such indemnification, all adverse loss development on such reinsured
  transaction subsequent to the effective date of the IPO, which is in excess
  of the Companys carried reserve for such transaction at the date of the IPO,
  will be indemnified by XLI.  Such
  protection does not relieve the Company of its obligations under the
  aforementioned reinsurance transaction.
  Accordingly, the Company is still liable under the reinsurance
  transaction in the event that XLI does not meet its obligations under the
  indemnification.  For further
  information with respect to the indemnification see Note 6.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | a.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | During the
  year ended December 31, 2004, the Company recorded a provision for losses of
  approximately $42.1 million representing the present value of losses expected
  to be incurred in the future with respect to a

24

---



XL Financial
  Assurance Ltd.Notes
  to Financial Statements 
  For the years ended December 31, 2006, 2005 and 2004(U.S.
  dollars in thousands, except share amounts)


reinsured
  project financing. As this loss represented a full limit loss to the subordinated
  tranche of the reinsured transaction, the remaining unearned premium
  pertaining to such tranche, which aggregated approximately $23.3 million, was
  fully earned resulting in an impact on the Companys results of operations,
  before reinsurance, of approximately $18.8 million. The portion of the
  reinsured exposure to which this loss relates was fully retroceded to XLI
  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 $13.5 million
  ($5.6 million after retrocession to XLI), on a net present value basis to
  reflect certain adverse developments. During 2006, the Company recorded
  an additional provision for loss relating to this transaction of $13.8
  million which after retrocession to XLI was fully covered under the
  indemnification discussed above and in Note 6. Accordingly, there was no net
  impact on the Companys results of operations in 2006. The total remaining
  par reinsured by the Company in connection with this transaction aggregated
  approximately $287.0 million ($5.9 million net of retrocession to XLI, but
  before considering XLI indemnification) at December 31, 2006, and amortizes
  over many years into the future. The estimate of loss was 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 if
  necessary, as new information becomes available.b.
In December
  2005, certain notes collateralized by loans to medical providers that were
  insured by XLCA (the Insured Notes) and reinsured by the Company defaulted
  upon their maturity. In satisfaction of the resulting claim, XLCA purchased
  the Insured Notes for $20.2 million, which represented the remaining
  outstanding principal and accrued interest on the Insured Notes. In
  connection therewith, the Company recorded a loss of $0.6 million
  representing its share under the aforementioned reinsurance agreement of the
  difference between the estimated fair value of the Insured Notes at the date
  they were acquired by XLCA and the consideration paid by XLCA to acquire the
  Insured Notes. In addition, the Company paid XLCA its share of the cost of
  the Insured Notes and recorded such payment as funds withheld. At December
  31, 2005, the carrying amount of the Companys funds withheld relating to
  this transaction was $15.9 million. During 2006, the Company recognized a
  charge of $12.6 million relating to the impairment of the Insured Notes and
  reduced it funds withheld by a corresponding amount. In addition, during 2006
  the balance of its funds withheld was returned by XLCA to the Company.c.
During the
  year ended December 31, 2005, the Company recorded a provision for loss of
  $4.3 million ($2.5 million net of a retrocession) representing the Companys
  share under its reinsurance agreement with XLCA of the present value loss
  expected to be incurred in the future by XLCA with respect to two related
  insured residential mortgage securitizations.During 2006,
  the reinsurance of the aforementioned two transactions was cancelled in
  settlement of a dispute with the reinsurer. As a result of the cancellation,
  all retroceded premium (which was on an installment basis and consequently
  fully earned) aggregating $0.4 million (net of ceding commission), was
  returned to the Company and the Companys net reserve increased by
  approximately $1.8 million. Also, during 2006, one of the insured debt
  obligations was retired early as a result of the exercise of a clean-up call
  by the entity which transferred the underlying mortgages to the special
  purpose issuer. As a result of the aforementioned retirement, the Company
  reduced the related case reserve by approximately $1.7 million. The Companys
  earnings for 2006 were increased by approximately $0.3 million as a result of
  the aforementioned returned premium, cancellation, and early retirement. At
  December 31, 2006, the carrying amount of the Companys case reserve with
  respect to the remaining outstanding insured transaction was $2.7 million on
  a gross and net basis. There continues to be no payment default with respect
  to this transaction and management continues to monitor the exposure and will
  revise its loss estimate if necessary, as new information becomes available.




25

---



XL Financial
  Assurance Ltd.Notes
  to Financial Statements
  For the years ended December 31, 2006, 2005 and 2004(U.S.
  dollars in thousands, except share amounts)


| |    |                                                                                                                                                                                                                                                                                                                       
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | d. | The Company
  maintains a provision of $1.6 million in respect of reinsurance provided to a
  primary for a cash flow collateralized borrowing obligation. The estimate of
  loss is based on current assumptions, although no claim is expected to be
  paid until the legal maturity of principal in 2011 if at all.

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | Unallocated Reserves                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | During
  2004 the Company adjusted its initial expected loss ratio to 20% from 25%,
  which was utilized since the adoption of its unallocated reserve methodology
  in recognition of the cumulative experience of its business to that point in
  time, as well as the increasing percentage of its in-force business from
  public finance insurance. This change resulted in approximately a $13.5 million
  decrease in unallocated loss reserves, which decrease was substantially
  offset by a change in the estimated expected loss emergence pattern of the
  Companys 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s updated analyses in 2005 and 2006 indicated
  that no change was necessary in the Companys expected loss ratio of 20%
  from that in 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                       
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|11. | Derivative Instruments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | Credit
  derivatives issued by the Company meet the definition of a derivative under
  FAS 133. The Company has recorded these products at fair value, modeled on
  prevailing market conditions and certain other factors relating to the
  structure of the transaction. The Company considers credit derivatives to be
  financial guarantee contracts, in substance, as the Company intends to hold
  them to maturity. The Company determines fair value using a model which
  calculates the difference between the actual remaining present value of
  installment premiums and an estimated remaining present value of installment
  premiums under current market conditions. In essence, the model estimates the
  cost of an offsetting position to the original credit derivatives from other
  comparable counterparties under the current market environment. The model is
  dependent upon a number of factors including changes in credit spreads,
  changes in credit quality, foreign exchange and other market factors.                                                                                                                                                                                                                                                                                                   
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | The
  Companys credit derivatives portfolio generally requires the Company to meet
  payment obligations for referenced credits within the portfolio in the event
  of specific credit events after erosion or exhaustion of various first loss
  protection levels. These credit events are contract specific, but generally
  cover bankruptcy, failure to pay and repudiation. The notional exposure of
  the credit derivatives portfolio as of December 31, 2006 was $19.9 billion.
  At December 31, 2006, approximately 98% of the portfolio was rated AAA with
  the remainder being BBB. The weighted average term of the contracts in force
  was 11.6 years at December 31, 2006.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | The
  net fair value adjustment for the years ended December 31, 2006, 2005 and
  2004 was a realized and unrealized gain (loss) of ($5,025), ($4,084) and
  $11,959, respectively. At December 31, 2006 and 2005, the Company had a net
  credit derivatives asset of $6,592 and $11,618, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | In
  2005, the Company amended the presentation of credit derivatives transactions
  in the Statements of Income to include certain components of the transactions
  in gross premiums written, net premiums earned, net losses and loss
  expense incurred and fee and other income, and certain components of the
  change in fair value in unpaid loss and loss expenses. Previously
  components on the transactions and the change in fair value were reflected in
  one line item under Net realized and unrealized gains and losses on
  derivative instruments, and the fair value had been reflected in Derivative
  assets and Derivative liabilities. There was no effect on net income as a
  result of this change and prior period results have been reclassified to
  reflect this presentation. This change in presentation is applicable only to
  credit default swaps assumed by the Company that are investment grade and
  that the Company intends and has the ability to hold to maturity and is
  consistent with practices in the financial guarantee insurance industry for
  reporting the results of such instruments. Results of the prior period
  presented have been reclassified to conform to the current period
  presentation. The effect of the reclassification is outlined as follows:

26

---



| |                                                       
| | ------------------------------------------------------
| | XL Financial
  Assurance Ltd.                         
| | Notes
  to Financial Statements                       
| | For
  the years ended December 31, 2006, 2005 and 2004
| |                                                       
| | (U.S.
  dollars in thousands, except share amounts)   

| |                                                                    |  |   |                     |   |   |        |   |   |        | 
| | ------------------------------------------------------------------ |  | - | ------------------- | - | - | ------ | - | - | ------ | 
| |                                                                    |  |   | For the years ended |  
| |                                                                    |  |   |                     |   |   |        |   |   |        | 
| |                                                                    |  |   | 2006                |   |   | 2005   |   |   | 2004   | 
| |                                                                    |  |   |                     |   |   |        |  
| | Income Statement                                                   |  |   |                     |   |   |        |   |   |        | 
| | Net earned premiums                                                |  | $ | 21,140              |   | $ | 15,961 |   | $ | 19,757 | 
| | Net losses and loss
  expense                                      |  |   | 1,615               |   |   | 391    |   |   | 4,939  | 
| | Net realized and
  unrealized gains (losses) on credit derivatives |  |   | (5,025              | ) |   | (4,084 | ) |   | 11,959 | 

| |                                |  |  |  |  |                    |        |  |   |        | 
| | ------------------------------ |  |  |  |  | ------------------ | ------ |  | - | ------ | 
| |                                |  |  |  |  | As of December 31, |       
| |                                |  |  |  |  |                    |       
| |                                |  |  |  |  |                    | 2006   |  |   | 2005   | 
| |                                |  |  |  |  |                    |        |  |  
| |                                |  |  |  |  |                    |        |  |   |        | 
| | Assets                         |  |  |  |  |                    |        |  |   |        | 
| | Derivative Assets              |  |  |  |  | $                  | 11,148 |  | $ | 13,482 | 
| |                                |  |  |  |  |                    |        |  |   |        | 
| | Liabilities                    |  |  |  |  |                    |        |  |   |        | 
| | Net losses and loss
  expenses |  |  |  |  |                    | 12,083 |  |   | 10,468 | 
| | Derivative liabilities         |  |  |  |  |                    | 4,685  |  |   | 1,864  | 

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | The
  Company reinsures interest rate swaps indirectly as part of financial
  guarantee reinsurance of XLCA. The swap portion of these insurance contracts
  is required to be measured and recorded at fair value. The valuation
  methodology comprises of a mark to model approach that measures the change in
  expected loss. The expected loss is driven by the valuation of the underlying
  derivative; the default probability of the underlying obligor and the expected
  recovery rate on the underlying asset class.                                                                                                                                                                                                                                             
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|12. | Variable Interest Entities                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|    | The
  Company primarily provides financial guarantee reinsurance or enters into a
  credit derivative on the senior interests, which would otherwise be rated
  investment grade. The obligations related to these transactions are often
  securitized through variable interest entities. The Company does not hold any
  equity positions or subordinated debt in these arrangements. The Company does
  not have a significant variable interest in these entities and, therefore,
  these entities are not consolidated.                                                                                                                                                                                                                                                 
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|13. | Letters of Credit                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|    | Under
  certain of the Companys reinsurance treaties, primary insurers may require
  collateral or letters of credit so they can receive reinsurance credit under
  certain U.S. state laws. Beginning in September 2006, such letters of
  credit are issued on behalf of the Company under a letter of credit facility
  established by SCA. Prior thereto, such letters of credit were issued on
  behalf of the Company under XL Capitals letter of credit facility. For
  the years ended December 31, 2006, 2005 and 2004, the Company incurred expenses
  of $0.7 million, $1.6 million, and $2.4 million related to letters of credit.
  Substantially all of such costs in 2006 related to letters of credit issued
  under XL Capitals letter of credit facility.

27

---



| |                                                       
| | ------------------------------------------------------
| | XL Financial
  Assurance Ltd.                         
| | Notes
  to Financial Statements                       
| | For
  the years ended December 31, 2006, 2005 and 2004
| |                                                       
| | (U.S.
  dollars in thousands, except share amounts)   

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|14. | Regulation 114 Trust                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|    | Effective
  December 1, 2004 the Company established a trust account in accordance with
  Regulation 114 of the New York Insurance Department for the benefit of XLCA
  to secure the obligations of the Company to XLCA under the Treaty. This trust
  account is required for XLCA to take financial credit for statutory reporting
  purposes for the reinsurance cessions by XLCA to the Company under the
  Treaty, since the Company is not a licensed insurer or reinsurer in any state
  of the United States of America. At December 31, 2006, investments at an
  amortized cost of $1,703.5 million were on deposit in the trust account.
  Included in this amount were $75.1 million of cash and cash equivalent instruments.
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|15. | Taxation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|    | Bermuda
  presently imposes no income tax, withholding tax or capital gains taxes and
  the Company is exempted until March 2016 from any such future taxes pursuant
  to the Bermuda Exempted Undertakings Tax Protection Act 1966, and Amended Act
  1987.                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|16. | Statutory Financial Data                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|    | Under
  the Bermuda Insurance Act 1978, amendments thereto and related regulations (“The Act”) the Company is required to prepare Statutory Financial Statements
  and to file a Statutory Financial Return. The Act also requires the Company
  to meet certain minimum capital and surplus requirements. To satisfy these
  requirements, the Company was required to maintain a minimum level of
  statutory capital and surplus of $53.0 million, $33.6 million and $36.0
  million as of December 31, 2006, 2005 and 2004, respectively.                                                                                                                                                                                             
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|    | The following
  summarizes the significant differences between statutory accounting practices
  and generally accepted accounting principles (GAAP).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

| |  |                                                                                                        |  |   |           |   |   |          |   |   |          |  
| |  | ------------------------------------------------------------------------------------------------------ |  | - | --------- | - | - | -------- | - | - | -------- | -
| |  |                                                                                                        |  |   | 2006      |   |   | 2005     |   |   | 2004     |  
| |  |                                                                                                        |  |   |           |   |   |          |   |   |          |  
|
| |  | GAAP net income                                                                                        |  | $ | 132,958   |   | $ | 98,389   |   | $ | 76,252   |  
| |  | Deferred acquisition costs                                                                             |  |   | (38,579   | ) |   | (19,775  | ) |   | (25,931  | )
| |  | Net realized and unrealized losses (gains)
  on credit derivatives, interest rate swaps and put option |  |   | 5,029     |   |   | 4,109    |   |   | (11,939  | )
| |  |                                                                                                        |  |   |           |   |   |          |   |   |          |  
|
| |  | Statutory net income                                                                                   |  | $ | 99,408    |   | $ | 82,723   |   | $ | 38,382   |  
| |  |                                                                                                        |  |   |           |   |   |          |   |   |          |  
| |  |                                                                                                        |  |   |           |   |   |          |   |   |          |  
| |  | GAAP shareholders equity and Series A
  redeemable  preferred shares                                  |  | $ | 1,133,367 |   | $ | 690,074  |   | $ | 614,795  |  
| |  | Non-admitted assets                                                                                    |  |   | (171,561  | ) |   | (138,137 | ) |   | (122,472 | )
| |  |                                                                                                        |  |   |           |   |   |          |   |   |          |  
| |  |                                                                                                        |  |   |           |   |   |          |   |   |          |  
| |  | Statutory shareholders equity                                                                         |  | $ | 961,806   |   | $ | 551,937  |   | $ | 492,323  |  
| |  |                                                                                                        |  |   |           |   |   |          |   |   |          |  

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The
  Company is also required to maintain a minimum liquidity ratio whereby the
  value of its relevant assets is not less than 75% of the amount of its
  relevant liabilities. As of December 31, 2006 and 2005, the Company was
  required to maintain relevant assets of at least $576.3 million and $449.9
  million, respectively. At those dates relevant assets were
  approximately $1,729.7 million and $1,110.2 million,
  respectively, and the minimum liquidity ratio was therefore met.

28

---



| |                                                       
| | ------------------------------------------------------
| |                                                       
| | XL Financial
  Assurance Ltd.                         
| | Notes
  to Financial Statements                       
| | For
  the years ended December 31, 2006, 2005 and 2004
| |                                                       
| | (U.S.
  dollars in thousands, except share amounts)   

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|17. | Disclosures about Fair Value of Financial
  Instruments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    | For
  financial instruments other than derivative instruments (see note 11),
  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 following estimated fair
  value amounts.       
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    | Debt Security Investments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    | The carrying
  amount represents fair value, which is based primarily on quoted market
  prices received from an internationally recognized pricing service or dealer
  quotes.                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    | Short-term investments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    | The
  carrying amount represents fair value, which approximates cost due to the
  short maturity of these instruments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    | Cash and cash equivalents                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    | The
  carrying amount is a reasonable estimate of approximate fair value because of
  the short maturity term 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 reinsurance contract. The fair value of deferred premium revenue, net 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 reinsurance
  contract.     
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    | Unpaid losses and loss expenses, net of
  reinsurance balances recoverable                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    | The
    carrying amount is fair value, which is the present value of the expected
    cash flows for specifically identified claims and potential losses in the
    Companys
  reinsured portfolio.                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    | 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
  reinsurance contract. The fair value is derived by calculating the present
  value of the estimated future cash flow stream (net of premium and ceding
  commissions) discounted at 4.80% and 4.20% at December 31, 2006 and 2005,
  respectively.

29

---



XL
  Financial Assurance Ltd.Notes to
  Financial StatementsFor the years
  ended December 31, 2006, 2005 and 2004(U.S. dollars in thousands, except share amounts)


|                                                                                            |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|------------------------------------------------------------------------------------------- |  | ----------------- | --------- | ---------------------- | - | ----------------- |  | ---------------------- | --------- |  | - | --------- | 
|                                                                                            |  | 2006              |           | 2005                   |  
|                                                                                            |  |                   |           |                        |  
|                                                                                            |  | Carrying
  Amount |           | Estimated
  Fair Value |   | Carrying
  Amount |  | Estimated
  Fair Value |          
|                                                                                            |  |                   |           |                        |   |                   |  |                        |          
|Assets:                                                                                     |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|                                                                                            |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Debt securities                                                                             |  | $                 | 1,404,197 |                        | $ | 1,404,197         |  | $                      | 1,036,606 |  | $ | 1,036,606 | 
|                                                                                            |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Short-term investments                                                                      |  |                   | 206,923   |                        |   | 206,923           |  |                        | 23,569    |  |   | 23,569    | 
|                                                                                            |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Cash and cash equivalents                                                                   |  |                   | 86,528    |                        |   | 86,528            |  |                        | 22,256    |  |   | 22,256    | 
|                                                                                            |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Liabilities:                                                                                |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|                                                                                            |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Deferred premium revenue, net of prepaid
  reinsurance premiums                             |  |                   | 657,349   |                        |   | 460,144           |  |                        | 472,078   |  |   | 330,455   | 
|                                                                                            |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Unpaid loss and loss adjustment expenses,
  net of reinsurance recoverable on unpaid losses |  |                   | 78,503    |                        |   | 78,503            |  |                        | 67,650    |  |   | 67,650    | 
|                                                                                            |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Off-Balance sheet Instruments:                                                              |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|                                                                                            |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Installment premiums, net of ceding
  commissions                                           |  |                   |          |                        |   | 376,516           |  |                        |          |  |   | 234,765   | 

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|18. | Contingencies and Commitments                                                                                                                                                                                                                                                                                                                                                                                                      
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                    
|    | 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 as a co-guarantor along with SCA US Holdings Inc., a wholly-owned
      subsidiary of SCA, is jointly and severally liable for the performance
      of all obligations and duties, and the payment of all amounts, due to certain
      SCA executives in accordance with the provisions of their respective employment
      contracts.                                                                        
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                    
|19. | Unaudited Quarterly Financial
  Information                                                                                                                                                                                                                                                                                                                                                                                        
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                    
|    | The
  following is a summary of the unaudited quarterly financial data for 2006 and
  2005.                                                                                                                                                                                                                                                                                                                                        

|                         |  |                 |        |                  |   |                 |  |                  |        |  |   |         | 
|------------------------ |  | --------------- | ------ | ---------------- | - | --------------- |  | ---------------- | ------ |  | - | ------- | 
|2006                     |  | First
  Quarter |        | Second
  Quarter |   | Third
  Quarter |  | Fourth
  Quarter |       
|                         |  |                 |        |                  |   |                 |  |                  |        |  |   |         | 
|Gross
  premiums written |  | $               | 73,820 |                  | $ | 96,636          |  | $                | 72,014 |  | $ | 107,302 | 
|Net premiums
  written   |  |                 | 67,240 |                  |   | 91,263          |  |                  | 95,426 |  |   | 97,619  | 
|Net premiums
  earned    |  |                 | 35,454 |                  |   | 49,659          |  |                  | 41,534 |  |   | 40,024  | 
|Net
  investment income  |  |                 | 11,347 |                  |   | 12,426          |  |                  | 16,292 |  |   | 18,912  | 
|Loss and
  loss expenses |  |                 | 3,684  |                  |   | 2,470           |  |                  | 4,497  |  |   | 3,408   | 
|Net income               |  |                 | 24,083 |                  |   | 34,346          |  |                  | 33,860 |  |   | 40,669  | 

30

---



XL
  Financial Assurance Ltd.Notes to
  Financial StatementsFor the years
  ended December 31, 2006, 2005 and 2004(U.S. dollars in thousands, except share amounts)


|                         |  |                 |        |                  |   |                 |  |                  |        |  |   |        | 
|------------------------ |  | --------------- | ------ | ---------------- | - | --------------- |  | ---------------- | ------ |  | - | ------ | 
|2005                     |  | First
  Quarter |        | Second
  Quarter |   | Third
  Quarter |  | Fourth
  Quarter |       
|                         |  |                 |        |                  |   |                 |  |                  |        |  |   |        | 
|Gross
  premiums written |  | $               | 43,053 |                  | $ | 75,958          |  | $                | 71,651 |  | $ | 64,962 | 
|Net premiums
  written   |  |                 | 33,471 |                  |   | 68,592          |  |                  | 64,057 |  |   | 55,726 | 
|Net premiums
  earned    |  |                 | 28,460 |                  |   | 29,687          |  |                  | 35,317 |  |   | 41,472 | 
|Net
  investment income  |  |                 | 8,274  |                  |   | 9,096           |  |                  | 9,858  |  |   | 10,885 | 
|Loss and
  loss expenses |  |                 | 556    |                  |   | 10,782          |  |                  | 1,056  |  |   | 4,448  | 
|Net income               |  |                 | 27,226 |                  |   | 12,063          |  |                  | 28,840 |  |   | 30,260 | 

31

---