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UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington,
D.C. 20549



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FORM
10-K



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

For the fiscal year ended December 31, 2006

OR

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

For the transition period from _____ to _____Commission file
number 001-32950



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SECURITY
CAPITAL ASSURANCE LTD

(Exact name of registrant as specified in its charter)



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|                                  |                      
|--------------------------------- | ---------------------
|BERMUDA                           | NOT
  APPLICABLE     
|(State
  or other jurisdiction of | (I.R.S.
  Employer   
|incorporation
  or organization)  | Identification
  No.)

One Bermudiana Road, Hamilton, Bermuda HM 11
(Address of principal executive offices and zip code)

(441) 294-7448
(Registrants telephone number, including area code)

Indicate
by check mark whether the registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes
 xNoo

Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of accelerated
filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check
one): Large accelerated filer o Accelerated filer o Non-accelerated
filer x

Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes
 oNo x

As
of March 13, 2007, there were 64,136,364 outstanding Common Shares, $0.01 par
value per share, of the registrant.

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SECURITY CAPITAL ASSURANCE LTD

TABLE OF CONTENTS

|         |  |                                                                                                                  |  |        
|-------- |  | ---------------------------------------------------------------------------------------------------------------- |  | -------
|         |  |                                                                                                                  |  | Page No
|         |  |                                                                                                                  |  |        
|         |  | PART I                                                                                                           |  |        
|         |  |                                                                                                                  |  |        
|Item 1.  |  | Business                                                                                                         |  | 3      
|         |  |                                                                                                                  |  |        
|Item 1A. |  | Risk
  Factors                                                                                                   |  | 31     
|         |  |                                                                                                                  |  |        
|Item 1B. |  | Unresolved
  Staff Comments                                                                                      |  | 47     
|         |  |                                                                                                                  |  |        
|Item 2.  |  | Properties                                                                                                       |  | 47     
|         |  |                                                                                                                  |  |        
|Item 3.  |  | Legal
  Proceedings                                                                                              |  | 48     
|         |  |                                                                                                                  |  |        
|Item 4.  |  | Submission
  of Matters to a Vote of Security Holders                                                            |  | 48     
|         |  |                                                                                                                  |  |        
|         |  |                                                                                                                  |  |        
|         |  | PART II                                                                                                          |  |        
|         |  |                                                                                                                  |  |        
|Item 5.  |  | Market for
  Registrants Common Equity, Related Stockholder Matters and Issuer Purchases
  of Equity Securities |  | 49     
|         |  |                                                                                                                  |  |        
|Item 6.  |  | Selected
  Financial Data                                                                                        |  | 51     
|         |  |                                                                                                                  |  |        
|Item 7.  |  | Managements
  Discussion and Analysis of Financial Condition and Results of Operations                          |  | 53     
|         |  |                                                                                                                  |  |        
|Item 7A. |  | Quantitative
  and Qualitative Disclosures About Market Risk                                                     |  | 87     
|         |  |                                                                                                                  |  |        
|Item 8.  |  | Financial
  Statements and Supplementary Data                                                                    |  | 90     
|         |  |                                                                                                                  |  |        
|Item 9.  |  | Changes in
  and Disagreements with Accountants on Accounting and Financial Disclosure                           |  | 133    
|         |  |                                                                                                                  |  |        
|Item 9A. |  | Controls
  and Procedures                                                                                        |  | 133    
|         |  |                                                                                                                  |  |        
|Item 9B. |  | Other
  Information                                                                                              |  | 133    
|         |  |                                                                                                                  |  |        
|         |  | PART III                                                                                                         |  |        
|         |  |                                                                                                                  |  |        
|Item 10. |  | Directors,
  Executive Officers and Corporate Governance                                                         |  | 134    
|         |  |                                                                                                                  |  |        
|Item 11. |  | Executive
  Compensation                                                                                         |  | 134    
|         |  |                                                                                                                  |  |        
|Item 12. |  | Security
  Ownership of Certain Beneficial Owners and Management and Related Stockholder
  Matters               |  | 134    
|         |  |                                                                                                                  |  |        
|Item 13. |  | Certain
  Relationships and Related Transactions, and Director Independence                                      |  | 134    
|         |  |                                                                                                                  |  |        
|Item 14. |  | Principal
  Accounting Fees and Services                                                                         |  | 134    
|         |  |                                                                                                                  |  |        
|         |  | PART IV                                                                                                          |  |        
|         |  |                                                                                                                  |  |        
|Item 15. |  | Exhibits
  and Financial Statement Schedules                                                                     |  | 134    

This Annual Report on Form 10-K contains “Forward-Looking Statements” as defined in the Private Securities Litigation Reform Act of 1995. A non-exclusive list of the important factors that could cause actual results to differ materially from those in such Forward-Looking Statements is set forth herein under the caption “Management's Discussion and Analysis of Financial Condition and Results of Operations — Cautionary Note Regarding Forward-Looking Statements.”

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PART
I

All amounts presented in this part are in U.S. dollars except as otherwise noted.

ITEM 1. BUSINESS

Overview

We are a
Bermuda-domiciled holding company whose operating subsidiaries provide
financial guaranty insurance, reinsurance, and other credit enhancement
products to the public finance and structured finance markets throughout the
United States and internationally. We were formed on March 17, 2006 by XL
Capital Ltd (XL Capital) in anticipation of contributing its ownership
interests in its financial guarantee insurance and financial guarantee
reinsurance operating businesses to us and selling an interest in us to the
public through an initial public offering of our common shares (the IPO). The
contribution of the businesses from XL Capital to us occurred on July 1, 2006
and the IPO was consummated on August 4, 2006. The aforementioned operating
businesses consisted of: (i) XL Capital Assurance Inc. (XLCA) and its
wholly-owned subsidiary, XL Capital Assurance (U.K.) Limited (XLCA-UK) and
(ii) XL Financial Assurance Ltd. (XLFA). Prior to the IPO, XLCA was an indirect
wholly owned subsidiary of XL Capital and substantially all of XLFA was
indirectly owned by XL Capital, except for a $54.0 million preferred stock
interest which is owned by Financial Security Assurance Holdings Ltd. (FSAH).
See Note 5 to our Consolidated Financial Statements elsewhere herein for
additional information.

XL Capital
is a public company whose shares are listed on the New York Stock Exchange
under the symbol XL. XL Capital, through its operating subsidiaries, is a leading provider of insurance and reinsurance coverages and financial products and
services to industrial, commercial and professional service firms, insurance
companies and other enterprises on a worldwide basis.

XLCA is an
insurance company domiciled in the State of New York and is licensed to conduct
financial guarantee insurance business throughout all 50 of the United States,
as well as in the Commonwealth of Puerto Rico, the District of Columbia and the
U.S. Virgin Islands. In addition, XLCA through its wholly owned subsidiary,
XLCA-UK, which is an insurance company organized under the laws of England, is
permitted to conduct business in England, Ireland, Spain, France, Portugal,
Italy, The Netherlands, Greece, Norway, and Germany. To facilitate distribution
of their products, XLCA maintains a branch office abroad in Singapore and
XLCA-UK maintains a branch office in Madrid. In addition, XLCA has an office in
California. XLCA and XLCA-UK are primarily engaged in providing credit
protection through the issuance of financial guarantee insurance policies and
credit default swaps. XLCA began writing direct financial guarantee insurance
in 2000.

XLFA is
incorporated in Bermuda and is registered as a Class 3 insurer under The
Insurance Act of 1978. XLFA is primarily engaged in the business of providing
reinsurance of financial guarantee insurance policies and credit default swaps
issued by XLCA, subsidiaries of FSAH (see Note 5 to the Consolidated Financial
Statements elsewhere herein), and, on a limited basis, certain other
non-affiliated triple-A-rated financial guarantee primary insurance companies.
XLFA began providing financial guarantee reinsurance in 1999.

XLCA,
XLCA-UK, and XLFA are rated Aaa by Moodys Investors Service, Inc., which we refer
to as Moodys, AAA by Standard & Poors Ratings Services, a division of
the McGraw-Hill Companies, Inc., which we refer to as S&P, and AAA by
Fitch, Inc., which we refer to as Fitch. Each of these ratings is the highest
applicable rating available from that agency. Ratings are a measure of our
subsidiaries ability to meet obligations to their policyholders. See Business
 Ratings elsewhere herein for further information in regard to ratings.

In
connection with our IPO, we issued 18,009,119 common shares at $20.50 per
share. Net proceeds to us from the IPO aggregated $341.3 million after
underwriting expenses and other issuance costs. After the IPO, a secondary
offering of SCA common stock by XL Capital of 4,438,609 common shares, the
exercise of the underwriters over-allotment option from shares owned by XL
Capital of 992,165 common shares and 500,428 restricted share awards to
management of SCA, XL Capitals ownership of our outstanding common shares
aggregated 40,696,471 shares or approximately a 63 percent economic interest.
However, as a result of limitations on XL Capitals voting power contained in
our 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.

Description of Financial Guarantee Insurance
and Credit Default Swaps

Financial
guarantee insurance provides an unconditional and irrevocable guarantee to the
holder of a financial obligation of full and timely payment of the principal
and interest thereon when due. Financial guarantee insurance enhances the
credit quality of a financial obligation by adding another potential source of
repayment of principal and

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interest for an investor, namely the credit quality of the financial
guarantor. In addition to enhancing the credit quality of a financial
obligation, financial guarantee insurance may also enhance the liquidity of the
financial obligation and may reduce the price volatility of such a financial
obligation for those investors that mark their portfolio to market. From an
issuer perspective, all of these benefits can reduce the cost of debt issuance,
as the cost of debt in the capital markets, all else being equal, is generally
lower for higher credit quality, more liquid and lower price volatility debt
instruments.

Generally,
in the event of any default on an insured financial guarantee obligation,
payments made pursuant to the applicable insurance policy may not be accelerated
by the holder of the insured obligation without the approval of the insurer.
While the holder of such an insured obligation continues to receive payments of
principal and interest on schedule, as if no default had occurred, and each
subsequent purchaser of the obligation generally receives the benefit of such
guarantee, the insurer normally retains the option to pay the obligation in
full at any time. Also, the insurer generally has recourse against the issuer
of the defaulted obligation and/or any related collateral for amounts paid
under the terms of the insurance policy as well as pursuant to general rights
of subrogation.

The
    issuer of an insured obligation generally pays the premium for financial
    guarantee insurance, either in full at the inception of the policy, as is
    the case in most public finance transactions, or in periodic installments
    funded by the cash flow generated by related pledged collateral, as is the
    case in most asset-backed, structured single risk and pooled debt (CDOs) transactions.
    Typically, premium rates paid by an issuer at the inception of a policy are
    stated as a percentage of the total principal and interest of the insured
    obligation. Premium rates paid by an issuer in periodic installments are
    typically stated as a percentage of the total principal of the insured obligation.

The
establishment of a premium rate for a financial guarantee insurance policy for
a transaction is determined by some or all of the following factors. Premiums
are almost always non-refundable and are invested upon receipt.

| |   |                                                                                                                                                                                                                                                                             
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | issuer-related
  factors, such as the credit strength of the issuer and its sources of income;                                                                                                                                                                              
| |   |                                                                                                                                                                                                                                                                             
| |  | obligation-related
  factors, such as the type of an issue, the type and amount of collateral pledged,
  applicable revenue sources and amounts therefrom, governing restrictive
  covenants, rating agency capital charges and maturity; and                               
| |   |                                                                                                                                                                                                                                                                             
| |  | insurer and
  market-related factors, such as competition, if any, from other credit
  enhancement providers, investor demand for a certain bond insurers
  guarantee, investor demand for bond insurance and the credit spreads in the
  market available to pay premiums.

In
    addition to financial guarantee insurance products, monoline financial guarantee
    insurance companies typically also provide customers credit enhancement products
    in derivative form known as credit default swaps. Credit default
    swaps provide credit protection relating to a particular security or pools
    of specified securities. Under the terms of a credit default swap, the seller
    of credit protection makes a specified payment to the buyer of credit protection
    upon the occurrence of one or more specified credit events with respect to
    a referenced security. Credit derivatives typically provide protection to
    one beneficiary rather than a class of investors.

Description of
Financial Guarantee Reinsurance

Financial
guarantee reinsurance indemnifies a primary insurance company against part or
all of the loss that it may sustain under a policy that it has issued. A
financial guarantee reinsurer may itself purchase reinsurance, referred to as
retrocessions, from other reinsurers, thereby syndicating its exposure to
risks that have been ceded to it.

Reinsurance
provides an important benefit to ceding companies by, among other benefits,
allowing such companies to write greater single risks and greater aggregate
risks than would otherwise be permitted under the risk limits and capital
requirements applicable to the ceding company, including state insurance laws
and rating agency guidelines. U.S. state insurance regulators generally allow
ceding companies to record a credit for reinsurance as an asset or as a
reduction from liabilities to the extent that they obtain such reinsurance from
licensed reinsurers or, subject to certain requirements (including the
provision of letters of credit or other security) from unlicensed reinsurers.
Similarly, rating agencies generally take into account liability ceded under
reinsurance agreements when calculating an insurers exposure, with the amount
of credit accorded to such reinsurance based on the financial strength rating
and, in the case of S&P, the financial enhancement rating, of the relevant
reinsurer.

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Financial
Guarantee Insurance Markets

Financial
guarantee insurance products are sold in three principal markets: the U.S.
public finance market, the structured finance market in the U. S. and the
international finance market.

U.S. Public
Finance

U.S. public
finance obligations consist primarily of debt obligations issued by or on
behalf of states or their political subdivisions (counties, cities, towns and
villages, utility districts, public universities and hospitals, public housing
and transportation authorities), other public and quasi-public entities
(including non-U.S. sovereigns and subdivisions thereof), private universities
and hospitals. These obligations generally are
supported by the taxing authority of the issuer, the issuers or underlying
obligors ability to collect fees or assessments for certain projects or public
services or revenues from operations. This market also includes project finance
obligations, as well as other structured obligations supporting infrastructure
and other public works projects, where the underlying credit obligation is from
a public source, such as a government or agency. See also Business Financial
Guarantee In-Force Business for additional information regarding the nature of
debt obligations comprising the U.S. public finance market.

The
following table sets forth the reported volume of new issues of long-term
(longer than 12 months) municipal bonds and the volume of new issues of insured
long-term municipal bonds over the past six years in the United States:

U.S. Municipal Long-Term Bond
Market

|                                    |  |                           |   |               |  |                   |  |                                     |       |                     |  |                                          |   |       |  |  |      |   |  |  |   |       |  |  |      |   | 
|----------------------------------- |  | ------------------------- | - | ------------- |  | ----------------- |  | ----------------------------------- | ----- | ------------------- |  | ---------------------------------------- | - | ----- |  |  | ---- | - |  |  | - | ----- |  |  | ---- | - | 
|(in
  billions, except percentages) |  | New Money
  Financings(1) |   | Refundings(2) |  | Total
  Volume(2) |  | Refundings
  as % of Total
  Volume |       | Insured
  Volume(2) |  | Insured
  Bonds as %
  of Total
  Volume |  
|                                    |  |                           |   |               |  |                   |  |                                     |       |                     |  |                                          |  
|2000                                |  |                           | $ | 181.3         |  |                   |  | $                                   | 19.6  |                     |  |                                          | $ | 200.9 |  |  | 9.8  | % |  |  | $ | 79.3  |  |  | 39.5 | % | 
|2001                                |  |                           |   | 223.4         |  |                   |  |                                     | 64.7  |                     |  |                                          |   | 288.1 |  |  | 22.5 | % |  |  |   | 134.3 |  |  | 46.6 | % | 
|2002                                |  |                           |   | 266.3         |  |                   |  |                                     | 92.3  |                     |  |                                          |   | 358.6 |  |  | 25.7 | % |  |  |   | 178.9 |  |  | 49.9 | % | 
|2003                                |  |                           |   | 288.4         |  |                   |  |                                     | 95.2  |                     |  |                                          |   | 383.6 |  |  | 24.8 | % |  |  |   | 190.5 |  |  | 49.7 | % | 
|2004                                |  |                           |   | 271.4         |  |                   |  |                                     | 88.3  |                     |  |                                          |   | 359.7 |  |  | 24.5 | % |  |  |   | 194.9 |  |  | 54.2 | % | 
|2005                                |  |                           |   | 277.6         |  |                   |  |                                     | 130.7 |                     |  |                                          |   | 408.3 |  |  | 32.0 | % |  |  |   | 233.0 |  |  | 57.1 | % | 
|2006                                |  |                           |   | 308.7         |  |                   |  |                                     | 79.0  |                     |  |                                          |   | 387.7 |  |  | 20.4 | % |  |  |   | 190.6 |  |  | 49.2 | % | 

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|    |                                                                                             
|--- | --------------------------------------------------------------------------------------------
|(1) | New money
  financings is equal to reported total volume issued minus reported
  refundings.
|    |                                                                                             
|(2) | Source: Thomson
  Financial.                                                                

The
percentage of municipal long-term bonds that are insured varies from period to
period for several reasons, including the mix of credit ratings of the issuers,
interest rates and market credit spreads, financial guarantee price competition
and investor demand for insured versus uninsured obligations.

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U.S. Structured Finance

U.S.
structured finance obligations consist of all obligations issued in the U.S.
which are not public finance obligations. See also Business Financial
Guarantee In-Force Business for additional information regarding the nature of
debt obligations comprising the U.S. structured finance market.

The
structured finance market for financial guarantors includes collateralized debt
obligations (CDOs), which are largely non-public transactions; financings for
investor-owned utilities; financings for privately owned or leased
infrastructure; asset-backed securities (ABS), which constitute the largest
market of publicly offered (including Rule 144a) structured finance obligations
and various other types of structured transactions.

ABS are
generally backed by pools of assets, such as residential mortgage loans,
consumer or trade receivables, securities or other assets having an
ascertainable cash flow or market value, which are generally held by a special
purpose issuing entity. ABS and CDO obligations can be funded or synthetic.
Funded structured finance obligations generally have the benefit of one or more
forms of credit enhancement, such as over-collateralization and excess cash
flow, to cover credit risks associated with the related assets. Financial
guarantors participation in synthetic structured finance obligations generally
take the form of credit derivatives or credit-linked notes that reference a
pool of assets, securities or loans, with a defined deductible to cover credit
risks associated with the referenced assets, securities or loans. Because
synthetic transactions are private transactions, estimating market size is
inherently uncertain.

The
following table sets forth the par value of reported U.S. ABS new issuance volume
    and the par amount of U.S. ABS insured during
    the years indicated. This table describes only U.S. ABS issuance and excludes
    certain private ABS, CDOs, private sector project finance, and certain
    other U.S. structured financings:

U.S. Asset-Backed Market

|              |  |              |  |             |       |            |        | Insured ABS
|------------- |  | ------------ |  | ----------- | ----- | ---------- | ------ | -----------
|              |  | Total ABS    |  |             |       |            | as a %
|              |  | New Issuance |  | Insured ABS |       | of Total  
|(in billions) |  | Volume(1)    |  | Obligations |       | ABS Volume
|              |  |              |  |             |       |           
|              |  |              |  |             |       |            |        |            
|2000          |  | 341.3        |  |             | 71.0  |            |        | 20.8%      
|2001          |  | 471.3        |  |             | 89.6  |            |        | 19.0%      
|2002          |  | 627.1        |  |             | 107.3 |            |        | 17.1%      
|2003          |  | 801.1        |  |             | 60.2  |            |        | 7.5%       
|2004          |  | 1,018.9      |  |             | 95.1  |            |        | 9.3%       
|2005          |  | 1,415.7      |  |             | 88.3  |            |        | 6.2%       
|2006          |  | 1,480.2      |  |             | 80.8  |            |        | 5.5%       

---

|    |                              
|--- | -----------------------------
|(1) | Source:
  Asset-Backed Alert.
|    |                              

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International

Over
approximately the last ten years, non-U.S. or international opportunities in
the financial guarantee industry have increased. These opportunities
principally are: (i) international public finance and structured securities,
including ABS and CDOs (both funded and synthetic) (ii) investor-owned
utilities in areas where the regulatory framework is supportive and (iii)
public/private partnership transactions as described below.

A number of
countries have established, or are expected to establish, regulatory regimes
for the sale of public assets to the private sector. These programs are known
generally as public/private partnerships, which we refer to as PPPs, and
provide a mechanism for funding major capital investments in public
infrastructure. The U.K.-based Private Finance Initiative, which we refer to as
the PFI, is widely viewed to be the first example of a broad, government
supported PPP program. PFI-type programs are expected to support the sale of
government-owned assets in other European countries. A PPP program will
typically provide for a government entity to pay fees to the concessionaire in consideration
for operating and maintaining the infrastructure asset.

The
financing of infrastructure utility, and transportation assets in Europe and
    other countries has provided, and is expected to continue to provide, growth
    opportunities for the bond insurance industry.

Our Products

We offer
our clients a full range of financial guarantee products through our financial
guarantee insurance and financial guarantee reinsurance operating segments. Our
financial guarantee insurance segment offers financial guarantee insurance
policies and credit default swaps. Our financial guarantee reinsurance segment
reinsures financial guarantee policies and credit default swaps issued by other
monoline financial guarantee insurance companies.

The
following sets forth certain information about the business we write in our
operating segments:

Information About Our Operating Segments

For
management and reporting purposes, the Companys business is organized in two
operating segments: financial guarantee insurance and financial guarantee
reinsurance. Our financial guarantee insurance segment reflects the results of
all direct business produced by us net of any ceded reinsurance relating to
such business. Our financial guarantee reinsurance segment reflects the results
of all business assumed by us from affiliates of FSAH and third-party insurers,
as well as any ceded reinsurance relating to such business. Further information
about our operating segments is discussed below. See also Managements
Discussion and Analysis of Financial Condition and Results of Operations and
Note 4 to the Consolidated Financial Statements elsewhere herein for additional
information with regard to our operating segments.

Financial
Guarantee Insurance Segment

U.S. Public Finance We
participate in
most segments of the public finance market. As of December 31, 2006, $46.1
billion or 42% of our consolidated net par outstanding represented insurance of
public finance obligations.

U.S. Structured Finance We are
an active
participant in the U.S. structured finance market, particularly in ABS and
CDOs. As of December 31, 2006, $12.9 billion or 10.9% of our consolidated net
par outstanding represented insurance of ABS (largely securities backed by
pools of mortgages and auto loans) and $23.5 billion or 19.9% of our
consolidated net par outstanding represented insurance of CDOs. We also provide
guarantees on a variety of other synthetic and funded obligations in the U.S.
structured finance market, most notably guarantees of debt of investor owned
utilities, structured life insurance obligations, debt of privately owned or
leased infrastructure assets and, through our bank deposit program, excess
deposit insurance for the obligations of certain rated U.S, banks.

International Finance The most
significant portion of our international business is guaranteeing the debt of
essential public infrastructure and transportation projects, often under PPP
programs, as well as debt of utilities located in jurisdictions with strong
regulatory regimes, such as the U.K., Australia and New Zealand. We are also
active in guaranteeing both synthetic and funded CDOs and ABS. We insure
international public finance obligations, which are often structured
transactions, as well as future flow securities, which are funded transactions
generally in emerging market

7

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countries structured to minimize the related sovereign
    risk by utilizing cash flows generated from outside the relevant country
    to repay the debt we guarantee. As of December 31,
2006, $6.8 billion or 5.8% of our consolidated net par outstanding represented
insurance of debt backed by essential public infrastructure and transportation
projects located outside the U.S.; $4.7 billion or 4.0% represented insurance
of debt of utilities outside of the U.S.; and $7.4 billion or 6.3% of our
consolidated net par represented insurance of other obligations originated
either completely or predominately outside of the U.S.  Our international business
    comprises $18.9 billion or 16.0% of our net par insured debt outstanding,
    with the largest concentration in the U.K with $7.6 billion or 6.4% of our
    net par insured debt outstanding. See  Consolidated Financial
    Guarantee In-Force Business by Geographic Area for a breakdown
    of our international exposures.

The following
sets forth certain information with respect to business production in our
financial guarantee insurance segment:

Management uses Adjusted Gross Premiums (which equals, for any period,
the sum of: (i) upfront premiums written in such period, (ii) current
installment premiums due on business written in such period and (iii) expected
future installment premiums on contracts written during such period that remain
in-force and for which there is a binding obligation on the part of the insured
to pay the future installment premiums, discounted at 7%) to evaluate new
business production for our financial guarantee insurance business. Adjusted
Gross Premium is a measure that is not in accordance with generally accepted
accounting principles (GAAP).  Such
measures are known as non-GAAP measures.
For a reconciliation of Adjusted Gross Premiums to total premiums
written, as reported in our consolidated financial statements prepared in
accordance with GAAP presented elsewhere herein, see Managements Discussion
and Analysis of Financial Condition and Results of Operations  Other Measures
Used by Management to Evaluate Operating Performance. The following table sets
forth this measure by product line for each of the periods presented:

Adjusted Gross Premiums

|                          |  |                           |         |      |   |         |  |   |         | 
|------------------------- |  | ------------------------- | ------- | ---- | - | ------- |  | - | ------- | 
|                          |  | Year
  Ended December 31, |        
|                          |  |                           |        
|(in millions)             |  | 2006                      |         | 2005 |   | 2004    | 
|                          |  |                           |         |      |   |         | 
|U.S. Public
  finance     |  | $                         | 140,276 |      | $ | 92,042  |  | $ | 84,799  | 
|U.S. Structured
  finance |  |                           | 206,842 |      |   | 104,063 |  |   | 116,311 | 
|International
  finance   |  |                           | 167,027 |      |   | 145,865 |  |   | 65,560  | 
|                          |  |                           |         |      |   |         |  |   |         | 
|Total                     |  | $                         | 514,145 |      | $ | 341,970 |  | $ | 266,670 | 
|                          |  |                           |         |      |   |         |  |   |         | 

Adjusted
Gross Premiums in our financial guarantee insurance segment increased between
2004 and 2005, and between 2005 and 2006, across most of our product lines
notwithstanding a continued tight credit spread environment. This increase was
a result of increased market penetration, as well as a lengthening in the
average maturity of new business written. All other factors remaining constant,
an increase in the maturity of business written will increase Adjusted Gross
Premiums because a given level of premiums is received for a longer duration.

Financial
Guarantee Reinsurance Segment

Within the
financial guarantee reinsurance segment, we provide reinsurance for both
affiliated and unaffiliated financial guarantee insurance companies, which we
refer to as primary companies, for the same range of obligations for which we
provide insurance through our financial guarantee insurance segment. Rating
agency constraints restrict XLFA from providing reinsurance to non-affiliated
third-party companies to an aggregate of 5% of XLFAs total reinsured par
outstanding. In addition to these rating agency restrictions on non-affiliated
third-party reinsurance, we believe that our third-party reinsurance underwriting
policies are more restrictive than those of the financial guarantee industry
generally. As of December 31, 2006, $8.4 billion or 92% of our assumed net par
outstanding represented reinsurance provided to FSA and unaffiliated primary
companies.

Management
also uses Adjusted Gross Premiums, as defined above, to evaluate new business
production for our financial guarantee reinsurance business. The following
table sets forth Adjusted Gross Premiums in our financial guarantee reinsurance
segment by product line for each of the periods presented:

8

---



|                          |  |                           |        |      |   |        |  |   |        | 
|------------------------- |  | ------------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                          |  | Year
  Ended December 31, |       
|                          |  |                           |       
|(in millions)             |  | 2006                      |        | 2005 |   | 2004   | 
|                          |  |                           |        |      |   |        | 
|U.S. Public
  finance     |  | $                         | 1,914  |      | $ | 1,134  |  | $ | 3,218  | 
|U.S. Structured
  finance |  |                           | 1,200  |      |   | 25,819 |  |   | 6,999  | 
|International
  finance   |  |                           | 38,802 |      |   | 26,898 |  |   | 18,088 | 
|                          |  |                           |        |      |   |        |  |   |        | 
|Total                     |  | $                         | 41,916 |      | $ | 53,851 |  | $ | 28,305 | 
|                          |  |                           |        |      |   |        |  |   |        | 

Adjusted
Gross Premiums in our financial guarantee reinsurance segment decreased 22.2%
in 2006 as compared to 2005, primarily as a result of  a large structured finance transaction that closed in 2005.  Large
transactions are part of our
reinsurance business and consequently new business opportunities will vary
between periods.

Adjusted
Gross Premiums in our financial guarantee reinsurance segment were $53.9
million in 2005, an increase of 90.5% as compared to 2004, primarily the result
of a large structured single risk transaction underwritten in 2005, increased
asset-backed business from one third-party primary insurer, and cessions from
    a new relationship with a triple-A-rated primary insurer that started in
2005.

The following table sets forth our financial guarantee reinsurance
segment net reinsured par outstanding by source as of each of the dates
presented below:

|                                    |  |                |       |      |  |       |   |   |       |  |  |       |   |   |       |  |  |       |  
|----------------------------------- |  | -------------- | ----- | ---- |  | ----- | - | - | ----- |  |  | ----- | - | - | ----- |  |  | ----- | -
|                                    |  | December
  31, |      
|                                    |  |                |      
|(in millions, except
  percentages) |  | 2006           |       | 2005 |  | 2004  |  
|                                    |  |                |       |      |  |       |  
|FSA                                 |  | $              | 6,545 |      |  | 71.5  | % | $ | 5,520 |  |  | 69.3  | % | $ | 5,821 |  |  | 75.0  | %
|Other
  triple-A-rated primaries    |  |                | 1,873 |      |  | 20.5  | % |   | 1,661 |  |  | 20.8  | % |   | 905   |  |  | 11.7  | %
|XLI(1)                              |  |                | 730   |      |  | 8.0   | % |   | 792   |  |  | 9.9   | % |   | 1,035 |  |  | 13.3  | %
|                                    |  |                |       |      |  |       |   |   |       |  |  |       |   |   |       |  |  |       |  
|Total                               |  | $              | 9,148 |      |  | 100.0 | % | $ | 7,973 |  |  | 100.0 | % | $ | 7,761 |  |  | 100.0 | %
|                                    |  |                |       |      |  |       |   |   |       |  |  |       |   |   |       |  |  |       |  

---

|                                                                                                                                                                                                                                                                                                                                                                                           | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | 
|(1) Includes transactions where we
  guarantee obligations of XL Insurance (Bermuda) Ltd (XLI), a wholly owned
  subsidiary of XL Capital to a client of XLI that requires a triple-A-rated
  guarantee in addition to the A+ or Aa3-rated guarantee provided by XLI
  and transactions entered into by XLI prior to XLCAs entry into the financial
  guarantee insurance industry.

Except for
the reinsurance that we provide to XLI, we generally only reinsure
triple-A-rated financial guarantee primary monoline insurance companies. We
believe that such firms maintain higher underwriting and surveillance standards
than double-A financial guarantee companies or multi-line insurers that only
intermittently insure credit risks. However, as previously discussed, we are
limited by the rating agencies in the amount of reinsurance that we can provide
to non-affiliated third-party companies and, consequently, the growth rate we
can achieve in our non-affiliated third-party reinsurance business is limited.

Financial Guarantee In-Force Business

Set forth
below is certain information with regard to our insured and reinsured in-force
business.

Consolidated
financial guarantee portfolio by operating segment

The
following table sets forth our net insured and reinsured par outstanding by
operating segment:

|                                    |  |                |         |      |  |       |   |   |        |  |  |       |   |   |        |  |  |       |  
|----------------------------------- |  | -------------- | ------- | ---- |  | ----- | - | - | ------ |  |  | ----- | - | - | ------ |  |  | ----- | -
|                                    |  | December
  31, |        
|                                    |  |                |        
|(in millions, except
  percentages) |  | 2006           |         | 2005 |  | 2004  |  
|                                    |  |                |         |      |  |       |  
|Financial
  Guarantee Insurance     |  | $              | 108,864 |      |  | 92.2  | % | $ | 73,918 |  |  | 90.3  | % | $ | 59,173 |  |  | 88.4  | %
|Financial
  Guarantee Reinsurance   |  |                | 9,148   |      |  | 7.8   | % |   | 7,973  |  |  | 9.7   | % |   | 7,761  |  |  | 11.6  | %
|                                    |  |                |         |      |  |       |   |   |        |  |  |       |   |   |        |  |  |       |  
|Total                               |  | $              | 118,012 |      |  | 100.0 | % | $ | 81,891 |  |  | 100.0 | % | $ | 66,934 |  |  | 100.0 | %
|                                    |  |                |         |      |  |       |   |   |        |  |  |       |   |   |        |  |  |       |  

Consolidated
financial guarantee portfolio by product line

The
following table sets forth our net insured and reinsured par outstanding by
product line as of December 31 for the years presented:

9

---



|                            |  |                    |         |      |   |        |  |   |        | 
|--------------------------- |  | ------------------ | ------- | ---- | - | ------ |  | - | ------ | 
|                            |  | As of December 31, |        
|                            |  |                    |        
|(in millions)               |  | 2006               |         | 2005 |   | 2004   | 
|                            |  |                    |         |      |   |        | 
|U.S.
  Public Finance       |  |                    |         |      |   |        |  |   |        | 
|Direct                      |  | $                  | 46,106  |      | $ | 31,300 |  | $ | 21,153 | 
|Reinsurance                 |  |                    | 2,140   |      |   | 2,370  |  |   | 2,356  | 
|                            |  |                    |         |      |   |        |  |   |        | 
|Total Public Finance        |  |                    | 48,246  |      |   | 33,670 |  |   | 23,509 | 
|U.S.
  Structured Finance   |  |                    |         |      |   |        |  |   |        | 
|Direct                      |  |                    | 48,905  |      |   | 34,503 |  |   | 33,153 | 
|Reinsurance                 |  |                    | 2,003   |      |   | 2,323  |  |   | 2,350  | 
|                            |  |                    |         |      |   |        |  |   |        | 
|Total Structured Finance    |  |                    | 50,908  |      |   | 36,826 |  |   | 35,503 | 
|International
  Finance     |  |                    |         |      |   |        |  |   |        | 
|Direct                      |  |                    | 13,853  |      |   | 8,116  |  |   | 4,867  | 
|Reinsurance                 |  |                    | 5,005   |      |   | 3,279  |  |   | 3,055  | 
|                            |  |                    |         |      |   |        |  |   |        | 
|Total International Finance |  |                    | 18,858  |      |   | 11,395 |  |   | 7,922  | 
|                            |  |                    |         |      |   |        |  |   |        | 
|Total net par
  outstanding |  | $                  | 118,012 |      | $ | 81,891 |  | $ | 66,934 | 
|                            |  |                    |         |      |   |        |  |   |        | 

Consolidated
financial guarantee portfolio by size of underlying policies and contracts

The
following table sets forth our insured and reinsured net par outstanding as of
December 31, 2006 by size of underlying policies and contracts (multiple policies
written for the same issuer have not been aggregated):

|                                               |  |                       |       |                  |  |       |  
|---------------------------------------------- |  | --------------------- | ----- | ---------------- |  | ----- | -
|(in millions, except policies and percentages) |  | Number 
  of Policies |       | Percent of Total | 
|                                               |  |                       |       |                  | 
|Net
  Par Exposure:                            |  |                       |       |                  |  |       |  
|$0 - $24                                       |  |                       | 3,059 |                  |  | 77.3  | %
|$25 - $49                                      |  |                       | 319   |                  |  | 8.1   | %
|$50 - $74                                      |  |                       | 166   |                  |  | 4.2   | %
|$75 - $99                                      |  |                       | 106   |                  |  | 2.7   | %
|$100 - $199                                    |  |                       | 192   |                  |  | 4.8   | %
|$200 - $299                                    |  |                       | 61    |                  |  | 1.5   | %
|$300 - $399                                    |  |                       | 21    |                  |  | 0.5   | %
|$400 - $499                                    |  |                       | 18    |                  |  | 0.5   | %
|$500 - $599                                    |  |                       | 5     |                  |  | 0.1   | %
|$600 - $699                                    |  |                       | 3     |                  |  | 0.1   | %
|$700 - $799                                    |  |                       | 3     |                  |  | 0.1   | %
|$800 - $899                                    |  |                       | 1     |                  |  | 0.0   | %
|$900 - $999                                    |  |                       | 1     |                  |  | 0.0   | %
|3 $1,000                                       |  |                       | 3     |                  |  | 0.1   | %
|                                               |  |                       |       |                  |  |       |  
|Total                                          |  |                       | 3,958 |                  |  | 100.0 | %
|                                               |  |                       |       |                  |  |       |  

| | >                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------
| | Consolidated financial guarantee portfolio
  by type of insured obligation and information regarding concentrations of
  exposure

U.S.
Public finance obligations.We provide guarantees of the payment of principal and
interest on a number of different types of public finance obligations. As of
December 31, 2006, U.S. public finance obligations made up 41% of our total net
par outstanding. These obligations include the following:

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | General
  obligation & appropriation General obligation bonds are supported by the
  full faith and credit of the obligated government entity and legally require
  taxes or other revenues to be raised as needed to repay debt. Also included
  are certain lease revenue bonds that are general fund obligations of a
  municipality or other governmental authority, which are subject to annual
  appropriation or abatement. Projects that are financed by such bonds
  ordinarily include real estate or equipment serving an essential public
  purpose. Bonds in this category also include moral obligation bonds issued by
  municipalities or governmental authorities, which are backed by the pledge,
  as opposed to the legal obligation, of a state government to appropriate funds
  in the event of a default thereunder.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | UtilitiesThese
include the obligations of
  every type of municipal utility and include electric, water and sewer
  utilities and resource recovery revenue bonds. Issuing utilities may be
  organized in various forms, including municipal enterprise systems,
  authorities or joint-action agencies.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | TransportationThese include obligations
  relating to airports, bridges, parking, mass transit systems and ports as
  well as publicly owned toll roads located in the United States and related
  revenue bonds.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

10

---



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Non-ad
  valoremThese are obligations that are backed by specific revenue streams,
  such as those provided by receipts of sales tax, gas and motor vehicle
  registration tax, excise tax, hotel/motel tax or other types of taxes.                                                                                                                                                                                                                                                                                                 
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | Higher
  educationThese are obligations ofprivateinstitutions
of higher education.                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | OtherThese
obligations include
  pre-insured public finance bonds involving double trigger transactions in
  which the underlying obligation is already guaranteed by another financial
  guarantee primary insurer, obligations that provide funding for public
  housing, certain privatized residential and office properties that involve
  public sector tenants or are otherwise wholly or partially supported by
  public funding, including by the issuance of tax-exempt debt, and other forms
  of revenue secured bonds.

The
following table sets forth our U.S. public finance insured and reinsured net
par outstanding by type of obligation as of the dates indicated:

|                                     |  |              |        |      |   |        |  |   |        | 
|------------------------------------ |  | ------------ | ------ | ---- | - | ------ |  | - | ------ | 
|                                     |  | December 31, |       
|                                     |  |              |       
|(in millions)                        |  | 2006         |        | 2005 |   | 2004   | 
|                                     |  |              |        |      |   |        | 
|General obligation
  & appropriation |  | $            | 21,161 |      | $ | 14,710 |  | $ | 9,215  | 
|Utilities                            |  |              | 9,232  |      |   | 6,896  |  |   | 5,221  | 
|Transportation                       |  |              | 6,330  |      |   | 3,891  |  |   | 3,391  | 
|Non-ad valorem                       |  |              | 5,349  |      |   | 3,512  |  |   | 2,348  | 
|Higher education                     |  |              | 5,071  |      |   | 3,769  |  |   | 2,142  | 
|Other                                |  |              | 1,103  |      |   | 892    |  |   | 1,192  | 
|                                     |  |              |        |      |   |        |  |   |        | 
|Total net par outstanding            |  | $            | 48,246 |      | $ | 33,670 |  | $ | 23,509 | 
|                                     |  |              |        |      |   |        |  |   |        | 

The table
below sets forth our five largest financial guarantee U.S. public finance
insurance and reinsurance exposures by type and by net par outstanding as a percentage of
our total net par outstanding as of December 31, 2006:

|                                      |  |                        |       |                                        |  |               |   |  |        | 
|------------------------------------- |  | ---------------------- | ----- | -------------------------------------- |  | ------------- | - |  | ------ | 
|(in millions, except percentages)     |  | Net Par 
  Outstanding |       | Percent ofTotal Net Par 
  Outstanding |  | S&P Rating(1) |  
|                                      |  |                        |       |                                        |  |               |  
|General obligation                    |  | $                      | 1,198 |                                        |  | 1.0           | % |  | AA-(2) | 
|General obligation                    |  |                        | 968   |                                        |  | 0.8           | % |  | A+(3)  | 
|General obligation
  & Non-ad valorem |  |                        | 906   |                                        |  | 0.8           | % |  | AA-(4) | 
|Utilities                             |  |                        | 814   |                                        |  | 0.7           | % |  | A      | 
|Transportation                        |  |                        | 720   |                                        |  | 0.6           | % |  | A      | 
|                                      |  |                        |       |                                        |  |               |   |  |        | 
|Total of five largest
exposures       |  | $                      | 4,606 |                                        |  | 3.9           | % |  |        | 
|                                      |  |                        |       |                                        |  |               |   |  |        | 

|                                                                                                                                                           |                                                                                                                                                                                | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | 
|                                                                                                                                                           |                                                                                                                                                                               
|(1)                                                                                                                                                        | See Ratings.                                                                                                                                                               
|                                                                                                                                                           |                                                                                                                                                                               
|(2)                                                                                                                                                        | $35 million of
  this exposure is rated BBB, $15 million of this exposure is rated A+, $26
  million of this exposure is rated AA.                                            
|                                                                                                                                                           |                                                                                                                                                                               
|(3)                                                                                                                                                        | $5 million of this exposure is rated BBB+, $10
  million of this exposure is rated BBB, $554 million of this exposure is rated
  A, $47 million of this exposure is rated AAA.
|                                                                                                                                                           |                                                                                                                                                                               
|(4)                                                                                                                                                        | $67 million of
  this exposure is rated BBB, $214 million of this exposure is rated A+, $0.2
  million of this exposure is rated A                                            
|                                                                                                                                                           |                                                                                                                                                                               
|The
  following table sets forth our ten largest state insurance and reinsurance
  exposures for U.S. public finance transactions as of December 31, 2006:

|                                     |  |                                                 |        |                                                         |  |      |  
|------------------------------------ |  | ----------------------------------------------- | ------ | ------------------------------------------------------- |  | ---- | -
|(in
  millions, except percentages)  |  | Net Par
  Outstanding as of
  December 31, 2006 |        | Percent of Total
  Public Finance Net
  Par Outstanding | 
|                                     |  |                                                 |        |                                                         | 
|California                           |  | $                                               | 10,171 |                                                         |  | 21.1 | %
|New York                             |  |                                                 | 5,156  |                                                         |  | 10.7 | %
|Texas                                |  |                                                 | 2,762  |                                                         |  | 5.7  | %
|Illinois                             |  |                                                 | 2,362  |                                                         |  | 4.9  | %
|Pennsylvania                         |  |                                                 | 2,042  |                                                         |  | 4.2  | %
|Florida                              |  |                                                 | 1,964  |                                                         |  | 4.1  | %
|New Jersey                           |  |                                                 | 1,892  |                                                         |  | 3.9  | %
|Alabama                              |  |                                                 | 1,782  |                                                         |  | 3.7  | %
|Massachusetts                        |  |                                                 | 1,678  |                                                         |  | 3.5  | %
|Wisconsin                            |  |                                                 | 1,470  |                                                         |  | 3.0  | %
|                                     |  |                                                 |        |                                                         |  |      |  
|Total of ten largest state
exposures |  | $                                               | 31,279 |                                                         |  | 64.8 | %
|                                     |  |                                                 |        |                                                         |  |      |  

11

---



U.S. Structured finance obligations.We provide guarantees of the payment
of principal and interest on a number of different types of structured finance
obligations. As of December 31, 2006, U.S. structured finance obligations made
up 43% of our total net par outstanding.We originate both U.S. structured finance transactions and
international transactions through one or more of our six product groups: 
CDOs, Consumer ABS, Commercial ABS, Power & Utilities, Global
Infrastructure and Specialized Risk.  For U.S.
Structured Finance, these obligations are divided into Pooled Debt
Obligations which are generally originated by the CDO group, Consumer ABS,
Financial Products generally originated by the Specialized Risk group, Power
& Utility, Commercial ABS, and Other, which constitute U.S. transactions
that are non-public finance transactions and which do not fall into one of the
other U.S. structured finance categories listed above.

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Pooled
  debt obligationsThese include both
  synthetic and funded collateralized debt obligations (CDOs), including
  collateralized bond obligations (CBOs), collateralized loan obligations
  (CLOs) and collateralized fund obligations (CFOs).  The collateral is
  generally pooled and held by a special purpose entity which then issues multiple
  tranches of debt. These tranches of debt have ratings ranging from triple-A
  and higher down to layers of risk that are rated triple-B and lower.  We
  generally guarantee the most senior, or risk remote, tranches of debt, in most
  cases rated at least triple-A or
  super-senior, meaning having collateral backing the tranche of
  debt in excess of the amount needed to obtain a triple-A rating.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | Consumer
  ABS- These include the following obligations: Consumer mortgages, Automotive
  loans and leases, and credit cards.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | Consumer
  mortgagesThese include obligations backed by prime and sub-prime first and
  second lien home mortgages and home equity loans and lines of credit. Credit
  support is provided by the cash flows generated by the underlying
  obligations, as well as by the value of the property being financed, and in
  certain cases, reserve funds.                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | Automotive
  loansThese
  include obligations backed by prime, near-prime and sub-prime pools of
  consumer auto loans. Credit support is generally provided by the cash flows
  generated by the underlying obligations, as well as by the value of the
  automobiles being financed, and in certain cases, reserve funds.                                                                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | Credit
  cardsThese
  include obligations backed by prime and non-prime consumer credit card
  programs. Credit support is provided by the cash flows generated by the
  underlying obligations, and in certain cases, reserve funds.                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | Financial
  Product- These include the following obligations: Financial
  Product/Insurance, Bank deposit insurance and Guaranteed Investment
  Contracts.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | Financial/insuranceThese primarily involve closed
  block and embedded value life insurance transactions, as well as certain
  other structured transactions where the ultimate risk is to a financing or
  insurance company but is not a Consumer ABS or Commercial ABS transaction.                                                                                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | Bank
  deposit insuranceThese include bank deposits with maturities of
  generally less than one year. The primary purpose of these obligations is to
  provide bank deposit insurance to municipal customers and other customers
  who, by law or regulation, cannot maintain deposits at deposit taking financial
  institutions unless separate insurance is arranged for deposit amounts in
  excess of the $100,000 insured by the Federal Deposit Insurance Corporation.                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | Guaranteed
  investment contractsThese include municipal guaranteed investment contracts,
  which we refer to as GICs, and non-municipal GICs. We entered into a
  program agreement with an affiliate, XL Asset Funding I LLC (XLAF),
  pursuant to which we agree to guarantee the municipal GICs issued by XL Asset
  Funding I LLC. Under this program, XLAF is restricted to investing the
  proceeds from GICs that it issues in certain eligible investments which must
  comply with certain portfolio maturity, credit, diversification, and
  marketability guidelines.  At December
  31, 2006, the total gross par value of municipal GICs that we guaranteed was
  $3.9 billion.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | Power
  & UtilitiesThese include obligations backed by investor-owned
  electrical and gas utilities, oil and gas pipelines and gas distribution
  systems. This category also includes structured transactions involving the
  electric and gas utility industry, including project financings.                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

12

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | 
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | Commercial
  ABSThese
  include obligations backed by a variety of commercial exposures, including
  dealer floor plan financing, intellectual property, franchises and small
  business loans.Commercial ABS obligations also include debt backed
  by fleets of rental cars, which are often, but not always, supported by
  buy-back guarantees from the relevant car manufacturers.Credit support is provided by the cash flows
  generated by the underlying obligations, as well as by the value of the
  property or equipment being financed and, in certain cases, reserve funds.                                 
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | 
| | Other
  structured financeOther structured finance exposures in our portfolio
  include bonds or other securities backed by assets that generally do not fall
  into one of the five categories described above, including equipment loans
  and leases, enhanced equipment trust certificates, trade receivables and
  asset-backed pre-insured obligations involving double trigger transactions
  in which the underlying obligation is already guaranteed by another financial
  guarantee primary insurer.  This
  category also includes debt of privately owned or leased infrastructure
  located within the U.S.

The
following table sets forth our U.S. structured finance insurance and
reinsurance net par outstanding by type as of the dates indicated:

|                          |  |              |        |      |   |        |  |   |        | 
|------------------------- |  | ------------ | ------ | ---- | - | ------ |  | - | ------ | 
|                          |  | December 31, |       
|                          |  |              |       
|(in millions)             |  | 2006         |        | 2005 |   | 2004   | 
|                          |  |              |        |      |   |        | 
|Pooled Debt Obigations    |  | $            | 23,480 |      | $ | 13,631 |  | $ | 9,109  | 
|Consumer ABS              |  |              | 10,240 |      |   | 9,398  |  |   | 14,065 | 
|Financial Product         |  |              | 6,070  |      |   | 5,374  |  |   | 3,732  | 
|Power &
  Utilities       |  |              | 5,184  |      |   | 4,113  |  |   | 3,736  | 
|Commercial ABS            |  |              | 2,674  |      |   | 2,034  |  |   | 3,843  | 
|Other                     |  |              | 3,260  |      |   | 2,276  |  |   | 1,018  | 
|                          |  |              |        |      |   |        |  |   |        | 
|Total net par outstanding |  | $            | 50,908 |      | $ | 36,826 |  | $ | 35,503 | 
|                          |  |              |        |      |   |        |  |   |        | 

The table
below sets forth our five largest financial guarantee U.S. structured finance
insurance and reinsurance exposures by net par outstanding as a percentage of
our total net par outstanding as of December 31, 2006:

|                                  |  |                        |       |                                       |  |               |   |  |     | 
|--------------------------------- |  | ---------------------- | ----- | ------------------------------------- |  | ------------- | - |  | --- | 
|(in millions, except percentages) |  | Net Par 
  Outstanding |       | Percent of
  Total Net ParOutstanding |  | S&P Rating(1) |  
|                                  |  |                        |       |                                       |  |               |  
|Pooled Debt Obligation            |  | $                      | 1,261 |                                       |  | 1.1           | % |  | AA  | 
|Pooled Debt Obligation            |  |                        | 1,234 |                                       |  | 1.0           | % |  | AAA | 
|Pooled Debt Obligation            |  |                        | 1,076 |                                       |  | 0.9           | % |  | AAA | 
|Pooled Debt Obligation            |  |                        | 1,059 |                                       |  | 0.9           | % |  | AAA | 
|Consumer ABS                      |  |                        | 1,054 |                                       |  | 0.9           | % |  | BBB | 
|                                  |  |                        |       |                                       |  |               |   |  |     | 
|Total of five largest
exposures   |  | $                      | 5,684 |                                       |  | 4.8           | % |  |     | 
|                                  |  |                        |       |                                       |  |               |   |  |     | 

|    |                 | 
|--- | --------------- | 
|    |                
|(1) | See Ratings.

The following table sets forth our five largest aggregate ABS seller
servicer insurance and reinsurance concentrations by net par outstanding as of
December 31, 2006:

|                                         |  |                        |       |                                          |  |               |   |  |      | 
|---------------------------------------- |  | ---------------------- | ----- | ---------------------------------------- |  | ------------- | - |  | ---- | 
|(in millions, except percentages)        |  | Net Par 
  Outstanding |       | Percent of
  Total Net Par
  Outstanding |  | S&P Rating(1) |  
|                                         |  |                        |       |                                          |  |               |  
|Seller servicer #1                       |  | $                      | 4,319 |                                          |  | 3.6           | % |  | A    | 
|Seller servicer #2                       |  |                        | 1,386 |                                          |  | 1.2           | % |  | BBB+ | 
|Seller servicer #3                       |  |                        | 1,142 |                                          |  | 1.0           | % |  | BBB  | 
|Seller servicer #4                       |  |                        | 676   |                                          |  | 0.6           | % |  | BBB- | 
|Seller servicer #5                       |  |                        | 525   |                                          |  | 0.4           | % |  | B+   | 
|                                         |  |                        |       |                                          |  |               |   |  |      | 
|Total of five
  largest seller servicers |  | $                      | 8,048 |                                          |  | 6.8           | % |  |      | 
|                                         |  |                        |       |                                          |  |               |   |  |      | 

|    |                                                                     | 
|--- | ------------------------------------------------------------------- | 
|    |                                                                    
|(1) | S&P Rating of
  ultimate parent of seller servicer. See Ratings.

13

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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|International
  FinanceWe provide guarantees of the payment of principal and interest on a
  number of different types of international finance obligations. As of
  December 31, 2006, international finance obligations made up 16% of our total
  net par outstanding.Our international transactions are divided into
  eight categories: Power & Utility, originated by the Power & Utility
  group; Infrastructure, originated by the Global Infrastructure group;
  Transportation, originated by the Global Infrastructure group; Pooled Debt
  Obligations, originated by the CDO group; Future Flow, originated by the
  Specialized Risk group; Financial Products, generally originated by the
  Specialized Risk group; Consumer ABS, originated by the Consumer ABS group;
  and Other, which may be originated by any of the six product groups.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | Power
  & Utilities These generally are
  obligations of privately and publicly owned regulated water, gas and electric
  utilities located outside of the U.S., primarily in the U.K., Australia and
  New Zealand. This also includes structured transactions involving power and
  energy.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | InfrastructureThese
  consist of essential public infrastructure such as schools, hospitals and
  government buildings which in most cases are being designed, built, operated
  and financed under a PPP project finance scheme. The majority of our
  infrastructure guarantees are of obligations originated in the U.K., though
  we have guaranteed Infrastructure projects in Canada, Australia and Spain.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | TransportationThese are generally international
  obligations relating to toll roads, airports, bridges, mass transit and
  parking facilities.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | Pooled
  debt obligationsThese consist of CDOs, in
  synthetic or funded form, where the collateral is primarily or substantially
  originated outside of the U.S. The liabilities for international Pooled Debt
  Obligations guaranteed by XLCA are generally denominated in currencies other
  than U.S. Dollars.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | Future
  flowThese
  are obligations backed by hard currency funds, usually generated by overseas
  entities that flow through offshore trust accounts to service the debt of
  companies located in emerging markets. These hard currency funds relate to
  the sale of certain commodity products, such as oil or iron ore, or hard
  currency credit card remittances or bank wire transfer payments. The funds
  backing the guaranteed future flow transaction are remitted directly to the
  offshore trust account instead of to the emerging market company which has
  sold the relevant goods or services for which hard currency payment is being
  made. With the support of liquidity facilities, debt service reserves and other
  forms of credit support, these transactions are often able to pierce
  the sovereign ceiling such that a particular obligation can obtain a
  higher rating than that assigned to the foreign debt obligations of the country
  in which an emerging market company resides.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | Financial
  productsThese consist of other financial products, such as
  Financial/Insurance, Bank deposit insurance and GICs, all as described in U.S. Structured finance
obligations,
  where the underlying assets are located substantially outside of the U.S. or
  where the obligation guaranteed is denominated in a currency other than U.S.
  Dollars.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | OtherOther
international finance
  exposures in our portfolio include bonds or other securities backed by assets
  that generally do not fall into one of the six categories described above,
  including pre-insured obligations involving double trigger transactions in
  which the underlying obligation is already guaranteed by another financial
  insurer and other types of generally international obligations, including
  international public finance transactions.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

14

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The
following table sets forth our international finance insurance and reinsurance net par outstanding by type as of
the dates indicated:

|                          |  |              |        |      |   |        |  |   |       | 
|------------------------- |  | ------------ | ------ | ---- | - | ------ |  | - | ----- | 
|                          |  | December 31, |       
|                          |  |              |       
|(in
  millions)           |  | 2006         |        | 2005 |   | 2004   | 
|                          |  |              |        |      |   |        | 
|Power &
  Utilities       |  | $            | 4,664  |      | $ | 2,893  |  | $ | 1,406 | 
|Infrastructure            |  |              | 3,905  |      |   | 1,205  |  |   | 284   | 
|Transportation            |  |              | 2,876  |      |   | 1,838  |  |   | 1,312 | 
|Pooled Debt
  Obligations |  |              | 1,714  |      |   | 1,048  |  |   | 1,202 | 
|Future Flow               |  |              | 1,672  |      |   | 2,131  |  |   | 1,212 | 
|Financial Products        |  |              | 890    |      |   | 842    |  |   | 893   | 
|Consumer ABS              |  |              | 475    |      |   | 371    |  |   | 594   | 
|Other                     |  |              | 2,662  |      |   | 1,067  |  |   | 1,019 | 
|                          |  |              |        |      |   |        |  |   |       | 
|Total net par outstanding |  | $            | 18,858 |      | $ | 11,395 |  | $ | 7,922 | 
|                          |  |              |        |      |   |        |  |   |       | 

The table
below shows our five largest international finance insurance and reinsurance
exposures by type and by net par outstanding as a percentage of our total net par
outstanding as of December 31, 2006:

|                                    |  |                       |       |                                          |  |               |   |     |     | 
|----------------------------------- |  | --------------------- | ----- | ---------------------------------------- |  | ------------- | - | --- | --- | 
|(in
  millions, except percentages) |  | Net Par
  Outstanding |       | Percent of
  Total Net Par
  Outstanding |  | S&P Rating(1) |  
|                                    |  |                       |       |                                          |  |               |  
|Power & Utilities                   |  | $                     | 1,021 |                                          |  | 0.9           | % | BBB |     | 
|Infrastructure                      |  |                       | 690   |                                          |  | 0.6           | % | BBB | -   | 
|Infrastructure                      |  |                       | 665   |                                          |  | 0.5           | % | BBB | (2) | 
|Infrastructure                      |  |                       | 540   |                                          |  | 0.5           | % | BBB | -   | 
|Pre-insured                         |  |                       | 485   |                                          |  | 0.4           | % | AAA |     | 
|                                    |  |                       |       |                                          |  |               |   |     |     | 
|Total of five largest
exposures     |  | $                     | 3,401 |                                          |  | 2.9           | % |     |     | 
|                                    |  |                       |       |                                          |  |               |   |     |     | 

|    |                                                                                           
|--- | ------------------------------------------------------------------------------------------
|   
|(1) | See Ratings.                                                                           
|    |                                                                                           
|(2) | $40 million of
  this exposure is rated BBB- and $625 million of this exposure is rated A-

Consolidated
Financial
Guarantee In-Force Business by S&P Rating

The
following table sets forth our financial guarantee insurance and reinsurance
portfolio as of the dates indicated by S&P rating category:

|                                    |  |                                           |         |                                          |  |                                            |   |                                           |        |  |  |       |  
|----------------------------------- |  | ----------------------------------------- | ------- | ---------------------------------------- |  | ------------------------------------------ | - | ----------------------------------------- | ------ |  |  | ----- | -
|(in
  millions, except percentages) |  | Net Par
  Outstanding
  December 31, 2006 |         | Percent of
  Total Net Par
  Outstanding |  | Net Par 
  Outstanding
  December 31, 2005 |   | Percent of 
  Total Net Par
  Outstanding |       
|                                    |  |                                           |         |                                          |  |                                            |   |                                           |       
|S&P
  Rating Category(1):           |  |                                           |         |                                          |  |                                            |   |                                           |        |  |  |       |  
|AAA                                 |  | $                                         | 34,559  |                                          |  | 29.3                                       | % | $                                         | 22,697 |  |  | 27.7  | %
|AA                                  |  |                                           | 17,846  |                                          |  | 15.1                                       | % |                                           | 10,640 |  |  | 13.0  | %
|A                                   |  |                                           | 35,226  |                                          |  | 29.9                                       | % |                                           | 27,185 |  |  | 33.2  | %
|BBB                                 |  |                                           | 29,889  |                                          |  | 25.3                                       | % |                                           | 20,962 |  |  | 25.6  | %
|Below investment
  grade            |  |                                           | 492     |                                          |  | 0.4                                        | % |                                           | 407    |  |  | 0.5   | %
|                                    |  |                                           |         |                                          |  |                                            |   |                                           |        |  |  |       |  
|Total                               |  | $                                         | 118,012 |                                          |  | 100.0                                      | % | $                                         | 81,891 |  |  | 100.0 | %
|                                    |  |                                           |         |                                          |  |                                            |   |                                           |        |  |  |       |  

|    |                                                                                                                                                                                                                                                                                                                                
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | If unrated by
  S&P, an internal assessment of underlying credit quality is used to
  assign a rating category for purposes of this table and calculation of the
  weighted average S&P rating. See Ratings. At December 31, 2006, the
  weighted average S&P credit rating of the obligations that we guarantee
  was A+.

15

---



Consolidated
Financial Guarantee In-Force Business by Geographic Area

The
following table sets forth the geographic distribution of our consolidated net
par insurance and reinsurance exposure as of the dates indicated by country:

|                                    |  |                                           |         |                                          |  |                                           |   |                                          |        |  |  |       |  
|----------------------------------- |  | ----------------------------------------- | ------- | ---------------------------------------- |  | ----------------------------------------- | - | ---------------------------------------- | ------ |  |  | ----- | -
|(in
  millions, except percentages) |  | Net Par
  Outstanding
  December 31, 2006 |         | Percent of
  Total Net Par
  Outstanding |  | Net Par
  Outstanding
  December 31, 2005 |   | Percent of
  Total Net Par
  Outstanding |       
|                                    |  |                                           |         |                                          |  |                                           |   |                                          |       
|S&P
  Rating Category(1):           |  |                                           |         |                                          |  |                                           |   |                                          |        |  |  |       |  
|United States(2)                    |  | $                                         | 99,155  |                                          |  | 84.0                                      | % | $                                        | 70,560 |  |  | 86.1  | %
|United Kingdom                      |  |                                           | 7,644   |                                          |  | 6.5                                       | % |                                          | 3,537  |  |  | 4.3   | %
|Australia                           |  |                                           | 1,936   |                                          |  | 1.7                                       | % |                                          | 803    |  |  | 1.0   | %
|Multi-jurisdictional(1)             |  |                                           | 1,671   |                                          |  | 1.4                                       | % |                                          | 1,414  |  |  | 1.6   | %
|Spain                               |  |                                           | 858     |                                          |  | 0.7                                       | % |                                          | 601    |  |  | 0.7   | %
|Canada                              |  |                                           | 838     |                                          |  | 0.7                                       | % |                                          | 555    |  |  | 0.7   | %
|Chile                               |  |                                           | 831     |                                          |  | 0.7                                       | % |                                          | 459    |  |  | 0.6   | %
|New Zealand                         |  |                                           | 726     |                                          |  | 0.6                                       | % |                                          | 558    |  |  | 0.7   | %
|Turkey                              |  |                                           | 693     |                                          |  | 0.6                                       | % |                                          | 670    |  |  | 0.8   | %
|Mexico                              |  |                                           | 599     |                                          |  | 0.5                                       | % |                                          | 640    |  |  | 0.8   | %
|Norway                              |  |                                           | 491     |                                          |  | 0.4                                       | % |                                          | 56     |  |  | 0.1   | %
|Italy                               |  |                                           | 461     |                                          |  | 0.4                                       | % |                                          | 74     |  |  | 0.1   | %
|France                              |  |                                           | 450     |                                          |  | 0.4                                       | % |                                          | 430    |  |  | 0.5   | %
|Japan                               |  |                                           | 423     |                                          |  | 0.4                                       | % |                                          | 303    |  |  | 0.4   | %
|Brazil                              |  |                                           | 335     |                                          |  | 0.3                                       | % |                                          | 253    |  |  | 0.3   | %
|Portugal                            |  |                                           | 269     |                                          |  | 0.2                                       | % |                                          | 252    |  |  | 0.3   | %
|Egypt                               |  |                                           | 189     |                                          |  | 0.2                                       | % |                                          | 143    |  |  | 0.2   | %
|Ireland                             |  |                                           | 162     |                                          |  | 0.1                                       | % |                                          |       |  |  | 0.0   | %
|Guatemala                           |  |                                           | 125     |                                          |  | 0.1                                       | % |                                          | 125    |  |  | 0.2   | %
|El Salvador                         |  |                                           | 96      |                                          |  | 0.1                                       | % |                                          | 161    |  |  | 0.2   | %
|Panama                              |  |                                           | 35      |                                          |  | 0.0                                       | % |                                          | 51     |  |  | 0.1   | %
|Costa Rica                          |  |                                           | 15      |                                          |  | 0.0                                       | % |                                          | 169    |  |  | 0.2   | %
|Luxembourg                          |  |                                           | 10      |                                          |  | 0.0                                       | % |                                          |       |  |  | 0.0   | %
|Jamaica                             |  |                                           |        |                                          |  | 0.0                                       | % |                                          | 72     |  |  | 0.1   | %
|Korea, Republic of                  |  |                                           |        |                                          |  | 0.0                                       | % |                                          | 5      |  |  | 0.0   | %
|Germany                             |  |                                           |        |                                          |  | 0.0                                       | % |                                          |       |  |  | 0.0   | %
|                                    |  |                                           |         |                                          |  |                                           |   |                                          |        |  |  |       |  
|Total(2)                            |  | $                                         | 118,012 |                                          |  | 100.0                                     | % | $                                        | 81,891 |  |  | 100.0 | %
|                                    |  |                                           |         |                                          |  |                                           |   |                                          |        |  |  |       |  

|    |                                                                                                                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(1) | Involves exposure
  to at least two international jurisdictions.                                                                                                                                                              
|    |                                                                                                                                                                                                                               
|(2) | At December 31,
  2006 and 2005, $1.1 and $0.9 million respectively, represented exposures in
  the Commonwealth of Puerto Rico, which constitutes less than 1.3% of each of
  United States and total exposure at such dates.

Historically,
our country limits have been set together with the XL Capital group global
limitations for exposure among the entire XL Capital group of companies using a
value at risk approach based on the internal or rating agency rating of a
country and the type of transaction involved. We manage our exposure within
these limits using retrocessions to XLI and to third parties where possible.

Information with
Regard to Business Conducted in Non-U.S. Dollar Denominated Currencies

We
primarily conduct our business in the United States, however, some of our
clients are companies located in Europe, including the United Kingdom, as well
as Latin America, Australia and New Zealand. For the years ended December 31,
2006, 2005 and 2004, gross premiums written in currencies other than U.S.
dollars were $7.3 million, $40.1 million and $15.8 million, respectively. For
the years ended December 31, 2006, 2005 and 2004, reinsurance premiums assumed
in currencies other than U.S. dollars was $2.1 million, $8.5 million and $1.5
million, respectively. As of December 31, 2006, the aggregate net par
outstanding of all exposures not denominated in U.S. dollars was less than 0.7%
of our total net par outstanding. See Managements Discussion and Analysis of
Financial Condition and Results of OperationsQuantitative and Qualitative
Disclosures About Market RiskForeign Currency Fluctuation.

16

---



Underwriting Procedures

The
underwriting, operations and risk management guidelines, policies and
procedures of our insurance and reinsurance subsidiaries are tailored to their
respective businesses, providing multiple levels of credit review and analysis.
Our strategy is to provide financial guarantee insurance and reinsurance only
for credit risks that we deem to be investment grade. Generally, we receive a
confirmation from Moodys and S&P that each obligation we guarantee is
investment grade. We have developed underwriting procedures that enable us to
conduct our own, independent assessment of risk for each obligation that we
guarantee. Exposure limits and underwriting criteria are established, as
appropriate, for sectors and asset classes.

Each
transaction passing an initial underwriting review, intended to test the
desirability of the proposed exposure, is assigned to a team including relevant
underwriting and legal personnel. Each transaction is further screened for
characteristics that require an accounting review. In such cases, finance
personnel review the proposed exposure for compliance with applicable
accounting standards and investment guidelines. The underwriting team reviews
the structure of the transaction, and the underwriter reviews credit issues
pertinent to the particular line of business. In our financial guarantee line,
particularly for ABS, CDO and other transactions dependent on structured cash
flows for repayment of debt, underwriters generally apply computer-based models
to stress test cash flows in their assessment of the risk inherent in a
particular transaction. For reinsurance transactions, stress model results may
be provided by the primary insurer. Stress models may also be developed
internally by our underwriting department and reflect both empirical research
as well as information gathered from third parties, such as rating agencies,
investment banks or servicers. The structure of a transaction is also
scrutinized from a legal perspective by in-house and, where appropriate,
external counsel, and specialty legal expertise is consulted when our legal
staff deems it appropriate.

Upon
completion of underwriting analysis, the underwriter prepares a formal credit
report that is submitted to an underwriting committee for review. We will not
commit to assume any risk until the risk has been approved by the appropriate
underwriting committee, or subcommittee to which authority has been delegated
by the main underwriting committee.

Our
reinsurance business is underwritten separately from our primary insurance
business. Our reinsurance underwriting policy is to keep primary insurer
information confidential, including from other primary insurers, whether a
third-party or not, as is consistent with industry practice and our reinsurance
transactions are underwritten by our Bermuda staff. Surveillance of reinsurance
transactions is also separate from our primary insurance operation. These
separate underwriting, separate surveillance and general confidentiality
policies are intended to address concerns of current and potential clients.

XLCA
insures obligations both in the U.S. and internationally within three major
categories: U.S. public finance, U.S. structured finance and international. The
following is a summary of each category and notes the major risk factors. Each
risk is addressed through our underwriting process prior to offering insurance
on a transaction. We limit our par exposure to each obligor based on its credit
rating and type of asset.

Public Finance

Public
finance obligations generally fall into two major categories: general
obligation bonds and revenue bonds. General obligation bonds are supported by
the full faith and credit of the obligated government entity and legally
require taxes or other revenues to be raised as needed to repay debt. Credit
quality depends on the strength and diversity of the underlying economy. Risks
include economic decline, natural disasters and political changes that could
reduce revenue collections. Historical financial performance, debt and reserve
levels, specific legal restrictions and quality of management are also factors
that determine credit quality. Revenue bonds comprise a wide spectrum of
obligations issued by governmental entities or non-profit organizations that
are payable from a specified revenue source, including most obligations
categorized as utilities, transportation, non-ad valorem, higher education and
other. Examples are bonds backed by sales, gas or other special taxes and
obligations issued by airports, toll roads, utilities and universities. Levels
of required debt service coverage are dependent upon the historic performance
of revenues, whether the entity has rate setting flexibility and expectations
of future performance. Risks include the factors cited for general obligation
debt but may, in addition, include risks such as operating costs, utilization
rates and competitive pressures.

Structured
Finance

Included
within this category are U.S. transactions underwritten by XLCAs non-public
finance business production groups: Commercial ABS, Consumer ABS, CDOs, Power
and Utilities, Global Infrastructure and Specialized Risks.

17

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Asset-Backed
Securities

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | ABS,
  underwritten by XLCAs Commercial ABS and Consumer ABS groups in conjunction
  with appropriate officers of the underwriting department, generally encompass
  three types of risk: (1) asset quality, or the underlying performance of the
  assets; (2) structure, or the legal safeguards that protect against loss; and
  (3) operational risk, or the performance of a servicer that affects cash
  flow. Typical assets for Consumer ABS transactions are mortgages, auto loans
  and credit cards. Typical assets for Commercial ABS transactions are commercial
  assets such as rental cars, equipment leases and a variety of receivables.
  Generally, the amount of credit protection required with respect to a
  particular asset-backed security depends on the historical performance of the
  asset class and the assets actually included in the proposed transaction.
  Future performance expectations are determined from historical performance as
  well as the social, political and economic factors affecting the underlying
  assets and the asset class. In order to protect the insurer from poor asset
  performance and asset volatility, appropriate credit enhancement levels are
  required based on a multiple of expected performance. In addition,
  asset-backed securities are usually designed to protect the insurer from the
  potential bankruptcy risk of the seller/servicer.                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | Pooled
  debt obligationsinclude CDOs, CLOs, or collateralized loan obligations, and
  collateralized fund obligations, which we refer to as CFOs. Pooled debt
  obligations are underwritten by XLCAs CDO group, in conjunction with
  appropriate underwriting department officers including, in most instances,
  specialized personnel focusing on quantitative analysis. There are generally
  five distinct forms of risks associated with these obligations: (1) default
  risk of the underlying assets; (2) structural risk pertaining to asset
  investment guidelines and to cash flow priorities for the different classes
  of debt; (3) asset manager risk, related to the performance by an asset
  manager during the reinvestment period; (4) interest rate risk, due to its
  potential effect on excess spread; and (5) market risk, due to risks stemming
  from exposure to diversified equity, debt, currency and interest rate markets
  over an extended period. Generally, the default risk is assessed by the
  historic performance of the assets underlying the transaction. Adequacy of
  the structural enhancements and subordination is determined from the ability
  of the transaction to withstand projections of stressed default and recovery
  rates as well as market risks such as adverse interest rate movements. The
  asset managers expertise and past performance are important considerations
  in the underwriting process. Conclusions are then drawn about the amount of
  over-collateralization or other structural enhancement necessary in a
  particular transaction in order to protect the investors (and therefore the
  guarantor) against poor asset performance. In addition, structured investment
  products are designed to protect investors from the bankruptcy or insolvency
  of the manager of the underlying assets.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | Power & Utilities:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | Obligations
  guaranteed in this sector include secured and unsecured debt of investor
  owned electric, gas and water utilities, though the majority of exposure is
  to electric utilities. In addition, structured transactions involving project
  finance structures for electric and gas utilities are also included in this
    sector. As well as evaluating the adequacy of cash flows and collateral in
    a wide variety of stress situations, underwriting in this sector focuses
    on the strength, adequacy and consistency of the relevant regulatory environment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | Financial Products:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | These
  include Financial/Insurance, the bank deposit program and GICs.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | Financial/Insurance
  transactions, generally involving the securitization of current and sometimes
  future life insurance policies, have three fundamental risks which are
  evaluated in a wide variety of projected stress scenarios: mortality risk, or
  the risk that the level of payout on the policies being securitized is higher
  than anticipated; lapse risk, or the risk that insureds will choose not to
  renew their policies and thus not pay their premiums; and investment risk, or
  the risk that the insurance premium proceeds will generate less investment
  income than anticipated. The underwriting team on Financial/Insurance
  transactions, which is headed by members of the Specialized Risk group,
  includes consultants with a life actuarial background. In underwriting
  Financial/Insurance transactions, the team analyses mortality, lapse and
  investment risks to determine the appropriateness of the transaction for
  XLCA.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | Underwriting
  for our bank deposit program focuses on the credit-worthiness of the banks
  whose deposits are proposed for insurance. The underwriting team, headed by
  members of our Specialized Risk group and including credit officers with
  extensive experience in bank and financial institution credit analysis,
  focuses on the financial strength of a proposed bank and in particular the
  probability of it remaining solvent over the full tenor of the obligations to
  be insured, which in most cases is one year or less. Because XLCA retains the
  right to cancel its insurance at any time for any reason on short notice,
  generally 30 days or less, analysis focuses on the probability of a proposed
  bank remaining solvent over the longest maturing deposit being insured.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | XLCAs
  GIC program is currently limited to insuring
  GICs provided by XL Asset Funding (XLAF), which generally has focused on
  providing GICs to municipal and other public finance funders. Pursuant to a
  program agreement between XLCA and XLAF, each guarantee issued by XLCA is
  secured by the proceeds held by XLAF in exchange for the issuance of the
  related GIC. XLAF, under the terms of the program                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

18

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | agreement, is restricted to
  investing the proceeds from the sale of the relevant GIC, insured by XLCA, in
  certain eligible investments which must comply with certain portfolio
  maturity, credit, diversification and marketability guidelines.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | Other:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | This
  includes infrastructure transactions, described below in --International,
  as well as transactions not included in the categories set forth above, such as
  whole business securitizations and other financings that do not fall within
  the major categories of Structured Finance. Underwriting for these
  transactions uses the same general principles, namely a focus on the adequacy
  of cash flows and collateral in a variety of stress conditions. In addition,
  for each transaction the responsible product origination group works closely
  with the relevant underwriting department officers to identify unique or
  unusual risks which need to be analysed fully before a proposed obligation is
  insured.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | International                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

International
credits will generally present the same risks as above with the additional
focus on specific local laws and regulations as well as the financial and
political risks related to the sovereign entity. Currency exposure, if any, is
generally guaranteed by or transferred to another entity through hedging or a
currency swap. For each of Pooled Debt Obligations, Power &
Utilities, Consumer ABS, and Financial Products, the descriptions of the underwriting
procedures set forth above in --Structured Finance apply to
International as well, except that these categories in an international context
require analysis of local law and regulation as well as any financial or political
risks relating to the relevant sovereign entity or entities, as the case may
be.

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Infrastructure and
  Transportation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | These obligations are generally
  those of a private non-governmental entity and are funded on a project
  finance basis. They include PPP and PFI financings, as described in -- International
  Finance -- Infrastructure as well as other financings for
  essential public infrastructure facilities such toll roads, airports,
  government buildings, schools and housing. Risks to infrastructure and
  transportation projects can include construction, demand, concession
  restrictions, performance of private parties responsible for operating the
  financed project asset, competition from other related facilities and, in
  general, costs as compared to revenues. Underwriting of infrastructure and
  transportation projects, whether or not part of an overall PPP or PFI plan,
  focuses on the adequacy of projected cash flow coverage, revenue flexibility
  and the reasonableness of the expectations of future performance.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | Future Flow:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | These transactions, as described
  in  -- International
  Finance -- Future Flow, are structured to allow an issuer to
  pierce the sovereign ceiling of the country in which the company benefiting
  from the financing is located. This means in most cases that a given transaction
  will obtain a rating higher than the foreign currency rating of the related
  sovereign. In addition to evaluating the adequacy of projected cash flows to
  service the guaranteed obligation in a variety of stressed situations, the
  underwriting teams analyse the strength of the related sovereign and attempt
  to determine its financial, political and ratings stability over the life of
  the proposed future flow transaction.                                                                                                                                                                                                                 
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | Other:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | This includes international
  transactions which are not within the Power & Utilities, Infrastructure,
  Transportation, Pooled Debt Obligations, Future Flow or Financial Products
  categories. For example, all asset-backed deals originated by the Commercial
  ABS groups that involve sponsors or issuers outside of the U.S. are within
  this category.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

Pricing

We
    use an internally-developed pricing model on a deal-by-deal basis to evaluate
    the return on equity implied by quoting a given premium rate. As one input,
    the pricing model requires a capital charge, which is an estimate of a deals worst
    case loss severity provided to us by S&P. This capital charge, together
    with the exposure and maturity characteristics of the deal, an allocated
    expense load and the quoted premium rate, is used to derive an estimate of
    required allocated capital and an implied return on that capital. We review
    the assumptions used by our pricing model periodically and make adjustments
    as are deemed appropriate.

We use our
pricing model as one basis for assessing the adequacy of pricing, but our
pricing decisions are also influenced by the value we believe our guarantee
provides to the issuer, our expectations of competitive behavior and other
market factors.

19

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Risk Management

Our risk
management personnel are responsible for transactional and treaty surveillance,
insured portfolio management, risk syndication and claims administration. Risk
management, in consultation with the chief underwriting officer, sets risk
limits for each line of business and designates those risks which are to be
excluded from our reinsurance treaty assumptions. Tailored surveillance
strategies have been developed for each type of exposure, depending upon the
credit risk inherent in the exposure, with a view to determining credit trends
in the insured book and making recommendations on portfolio management and risk
mitigation strategies, to the extent appropriate.

We may also
seek to mitigate the risk inherent in our exposures through the purchase of
third-party reinsurance or retrocessions, and also periodically purchase
derivative contracts to alleviate all or a portion of this risk.

Direct
Businesses

We conduct
surveillance procedures to closely track risk aggregations and monitor
performance of each risk. For municipal risk, we have review schedules for each
credit dependent on the underlying rating of the credit and the revenue type.
Credits perceived to have greater risk profiles are reviewed more frequently
than other credits or classes of credits which historically have had few
defaults. In the event of credit deterioration of a particular exposure, we
review the credit more frequently and take remedial action as permitted by the
terms of the transaction.

For
structured securities, we generally collect data, often monthly or quarterly,
and compare actual default and delinquency statistics to those generated by our
models. To the extent that a transaction is performing materially below
expectations, we seek to take steps to mitigate the potential for loss. Such
steps may include meetings with servicers, re-evaluation of loan files and, in
the most extreme cases, removal of the servicer.

We have
created computerized models to track performance of certain other large direct
business lines including CDOs and credit derivatives on corporate debt. These
systems incorporate risk tracking tools such as credit spreads and ratings
which are obtained from third parties and incorporated into computerized risk
tracking systems.

Reinsurance
Businesses

Our risk
management personnel take steps to help ensure that the primary insurer is
managing risk pursuant to the terms of the applicable reinsurance agreement. To
this end, we conduct periodic audits of ceding companies. We may conduct
additional surveillance audits during the year, at which time underwriting,
surveillance and claim files of the ceding company are reviewed.

Credit Monitoring

Our
surveillance department is responsible for monitoring the performance of our
in-force portfolio. They maintain a list of credits that they have determined
need to be closely monitored and, for certain of those credits, they undertake
remediation activities they determine to be appropriate in order to mitigate
the likelihood and/or amount of any loss that we could incur with respect to
such credits.

Our
surveillance department focuses its review on monitoring the lower rated bond
sectors. It tracks performance monthly to try to ensure that covenants have not
been breached. Once a covenant is breached we may have the right to put the
transaction into rapid amortization so that all cash flow generated from that
transaction is used to pay down principal and stay current with interest.
Typically, we review periodically servicing and trustee reports to help track
coverage levels, enhancement levels, delinquency levels, loss frequency, loss
severity and total losses and compare these performance metrics with the
metrics that were made available at the time the transaction was closed. If
losses are above projections we will analyze the reasons for the deviation. In
some cases it may be an indication of servicing problems where loans are
delinquent and are not put into foreclosure in time to maximize recovery.
Typically, once per year we audit servicers of loans and other assets
supporting our insured obligations to better understand their servicing
practices and to identify potential servicing problems, if any. Management
believes that this is an important safeguard, as servicers are required to
indemnify us against failure to adhere to the servicing standards set forth in
the servicing agreements.

Our
surveillance department also analyzes whether a claim on our policy is
probable. In some cases, we will engage an outside consultant with appropriate
expertise in the underlying collateral assets and respective industries to
assist management in examining the underlying collateral and determining the
projected loss frequency and loss severity. In such case, we will use that
information to run a cash flow model which includes enhancement levels and debt
service to determine whether a claim is probable, possible or not likely.

20

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The
activities of our surveillance department are integral to the identification
    of specific credits that have experienced deterioration in credit quality
    and the assessment of whether losses on such credits are probable, as well
    as any estimation of the amount of loss expected to be incurred with respect
    to such credits. Closely monitored credits are divided into four categories:
    (i) Special Monitoring Listinvestment grade credits where a covenant
    or trigger may be breached or is close to being breached and warrants closer
    monitoring; (ii) Yellow Flag Listcredits that we determine to be non-investment
    grade but a loss or claim is unlikely; (iii) Red Flag Listcredits where
    we do not expect an ultimate loss but a claim is possible but not probable;
    and (iv) Loss Listcredits where we have either paid a loss or expect
    to suffer a loss and have recorded a case reserve. Out of over 2,500 credits
    in our in-force portfolio only 17 credits are in one of the four above categories.
    Credits that are not closely monitored credits are considered to be fundamentally
    sound, normal risk. Our management establishes reserves for losses and loss
    adjustment expenses following consultation with our Loss Reserve Committee,
    which is comprised of senior members of management, including senior management
    of our surveillance department. See Risk Management for
    further definition and discussion of credits designated as closely monitored
    credits. 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. See Managements Discussion
    and Analysis of Financial Condition and Results of Operations  Critical
    Accounting Policies for further information regarding
our reserves for losses and loss adjustment expenses.

The
following table presents our consolidated financial guarantee insurance and
reinsurance net par outstanding by internal credit monitoring category as of
December 31, 2006 and December 31, 2005.

|                                  |  |                           |         |                                    |  |                       |   |                                    |        |  |  |       |  
|--------------------------------- |  | ------------------------- | ------- | ---------------------------------- |  | --------------------- | - | ---------------------------------- | ------ |  |  | ----- | -
|                                  |  | As of December
  31, 2006 |         | As of December 31, 2005            | 
|                                  |  |                           |         |                                    | 
|(in millions, except percentages) |  | Net Par
  Outstanding     |         | Percent of
  Net Par
  Outstanding |  | Net Par
  Outstanding |   | Percent of
  Net Par
  Outstanding |       
|                                  |  |                           |         |                                    |  |                       |   |                                    |       
|Fundamentally sound, normal risk  |  | $                         | 117,318 |                                    |  | 99.4                  | % | $                                  | 80,573 |  |  | 98.4  | %
|Closely monitored credits:        |  |                           |         |                                    |  |                       |   |                                    |        |  |  |       |  
|Special monitoring                |  |                           | 558     |                                    |  | 0.5                   | % |                                    | 692    |  |  | 0.8   | %
|Yellow flag                       |  |                           | 3       |                                    |  | 0.0                   | % |                                    | 229    |  |  | 0.3   | %
|Red flag                          |  |                           | 37      |                                    |  | 0.0                   | % |                                    | 58     |  |  | 0.1   | %
|Loss list(1)                      |  |                           | 96      |                                    |  | 0.1                   | % |                                    | 339    |  |  | 0.4   | %
|                                  |  |                           |         |                                    |  |                       |   |                                    |        |  |  |       |  
|Subtotal                          |  |                           | 694     |                                    |  | 0.6                   | % |                                    | 1,318  |  |  | 1.6   | %
|                                  |  |                           |         |                                    |  |                       |   |                                    |        |  |  |       |  
|Total                             |  | $                         | 118,012 |                                    |  | 100.0                 | % | $                                  | 81,891 |  |  | 100.0 | %
|                                  |  |                           |         |                                    |  |                       |   |                                    |        |  |  |       |  

---

(1)The change in
net par outstanding on the loss list from December 31, 2005 to December 31,
2006 was primarily due to: (i) an indemnification provided to us by XL Capital
in connection with our IPO of an insured project financing, and (ii) the early
retirement of a mortgage securitization  See Notes 13(a) and 13(c) to the
Consolidated Financial Statements for a more detailed
explanation.


Investments

See
Managements Discussion and Analysis of Financial Condition and Results of
Operations  Critical Accounting Policies and Managements Discussion and
Analysis of Financial Condition and Results of Operations  Investments for
further information regarding our investments.

Ratings

As of
December 31, 2006, our insurance and reinsurance subsidiaries have been
assigned the following insurance financial strength ratings (which are the
highest ratings used by each respective rating agency):

| |      |  |         |  |     |  |       | 
| | ---- |  | ------- |  | --- |  | ----- | 
| |      |  | Moodys |  | S&P |  | Fitch | 
| |      |  |         |  |     |  |       | 
| | XLCA |  | Aaa     |  | AAA |  | AAA   | 
| | XLFA |  | Aaa     |  | AAA |  | AAA   | 

These
ratings reflect only the views of the respective rating agencies and are
subject to revision or withdrawal at any time. A financial strength rating is
an opinion regarding the financial security characteristics of an insurance or
reinsurance organization with respect to an insurers ability to pay under its
insurance policies and contracts in accordance with their terms. The opinion is
not specific to any particular policy or contract. Financial strength ratings
do not refer to an insurers ability to meet non-insurance or non-reinsurance
obligations and are not a recommendation to purchase or discontinue any policy
or contract issued by an insurer or to buy, hold, or sell any security issued
by an insurer or any parent company of any insurer or reinsurer.

21

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The major
rating agencies have developed and published rating guidelines for rating
financial guarantee insurers and reinsurers. The financial strength ratings
assigned by S&P, Moodys and Fitch are based upon factors relevant to
policyholders and are not directed toward the protection of investors in our
common shares. The rating criteria used by the rating agencies in establishing
these ratings include consideration of the sufficiency of capital resources to
meet projected growth (as well as access to such additional capital as may be
necessary to continue to meet applicable capital adequacy standards), a
companys overall financial strength, business plan and strategy, and
demonstrated management expertise in financial guarantee and traditional reinsurance,
credit analysis, systems development, marketing, capital markets and investment
operations.

For
example, S&P considers an AAA rating to be Extremely Strong, an AA rating
to be High-Grade, High Credit Quality, A+ and A ratings to be Upper-Medium
Grade, a BBB rating to be Medium Grade, a BBB rating to be Lower Medium
Grade and a BB+ rating to be Low Grade, Speculative. The AAA, AA, A+, A,
BBB, BBB and BB+ ratings are the first, third, fifth, sixth, ninth, tenth and
eleventh highest of S&Ps 20 ratings categories, respectively.

22

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Business Locations

We conduct
our European business through XLCA-UK, a wholly-owned subsidiary of XLCA that
is licensed to write financial guarantee insurance in the U.K. XLCA-UK operates
a branch office in Madrid, Spain. In addition, XLCA has a branch office in
Singapore and we may establish offices in additional countries in the future.

We
coordinate strategy for and underwrite all of our primary business on a global
basis, with our key business managers and credit risk officers based in New
York. We believe this global approach results in a consistent approach to
underwriting and credit risk management wherever we conduct business.

Competition

Our
principal competitors in the market for financial guarantees are Ambac
Financial Group, Inc., (Ambac), FGIC Corporation (FGIC), Financial Security
Assurance Inc., (FSA) and MBIA Inc., (MBIA), which are larger than we are,
as well as recent entrants CIFG and Assured Guaranty, each of which has AAA
and Aaa ratings from S&P and Moodys (except for Assured Guaranty, which
has a Aa1 rating from Moodys). Banks, hedge funds, smaller and lower-rated
financial guarantee insurance companies and multiline insurers and reinsurers
also participate in the broader credit enhancement market. The principal
competitive factors are: (1) premium rates; (2) conditions precedent to the
issuance of a policy related to the structure and security features of a
proposed bond issue; (3) the financial strength ratings of the guarantor; and
(4) the quality of service and execution provided to issuers, investors and
other clients of the issuer. Financial guarantee insurance also competes
domestically and internationally with other forms of credit enhancement,
including the use of senior and subordinated tranches of a proposed structured
finance obligation and/or over-collateralization or cash collateral accounts,
as well as more traditional forms of credit support.

Our
competitors in the market for reinsurance of financial guarantees include
Assured Guaranty Re Ltd., RAM Reinsurance Company Ltd., Channel Reinsurance
Ltd., BluePoint Re Limited and Radian Asset Assurance Inc., as well as several
multiline insurance companies. We also compete directly and indirectly with
providers of certain credit default swaps and other alternative transaction
structures that may be a more attractive alternative to traditional financial
guarantee reinsurance. Primary financial guarantee companies choose reinsurance
providers based upon several factors, including overall financial strength,
financial strength ratings by the major rating agencies, financial enhancement
rating (which determines capital relief under the S&P capital model),
single risk capacity, level of service quality and in some cases whether or not
the reinsurer or its affiliate competes with the primary company. In addition,
issuers may choose to divide large transactions among several primary insurers,
reducing or eliminating the need for reinsurance. Primary insurers may also
choose to reinsure transactions with other primary insurers directly, also
reducing or eliminating the need for reinsurance. We are currently the only
financial guarantee reinsurer with triple-A ratings from each of Moodys,
S&P & Fitch.

Regulation

General

The
business of insurance and reinsurance is regulated in most countries, although
the degree and type of regulation varies significantly from one jurisdiction to
another. Reinsurers are generally subject to less direct regulation than
primary insurers. XLCA is primarily subject to New York insurance regulations.
As a Bermuda reinsurer, XLFA operates under a relatively less intensive
regulatory regime than certain of its competitors that are located elsewhere.

United States

XLCA is a
monoline financial guarantee insurance company with a Triple-A financial
strength rating and is incorporated under the laws of the State of New York.
XLCA currently is licensed to write insurance business in, and is subject to
the insurance regulation of and supervision by, all 50 states, the District of
Columbia, Puerto Rico, the U.S. Virgin Islands and Singapore. XLCA-UK is a
wholly-owned subsidiary of XLCA.

Article 69 of the New York Insurance
Law. XLCA
is licensed to provide financial guarantee insurance under Article 69 of the
New York Insurance Law. Article 69 defines financial guarantee insurance to
include any guarantee under which loss is payable upon proof of occurrence of
financial loss to an insured as a result of certain events. These events
include the failure of any obligor on or any issuer of any debt instrument or
other monetary obligation to pay principal, interest, premium, dividend or
purchase price of or on such instrument or obligation when due. Article 69
limits both the aggregate and individual risks that XLCA may insure on a net
basis based on the type of obligations insured. Under Article 69, XLCA is
permitted to transact financial guarantee insurance, surety insurance and credit
insurance and such other kinds of business to the extent necessarily or
properly incidental to the kinds of insurance which XLCA is authorized to
transact. In addition, XLCA is empowered to assume or reinsure the kinds of
insurance described above.

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Insurance Holding Company
Regulation. XLCA
is subject to the insurance holding company laws of New York. These laws
require XLCA to register with the New York Insurance Department and to furnish
annually financial and other information about the operations of companies
within its holding company system. Generally, all transactions among companies
in the holding company system to which any insurance company subsidiary is a
party (including sales, loans, reinsurance agreements and service agreements)
must be fair and, if material or of a specified category, such as service
agreements, require prior notice and approval or non-disapproval by the
insurance department where the applicable subsidiary is domiciled.

Change of Control. Before a person can
acquire control of a U.S. domestic insurance company, prior written approval
must be obtained from the insurance commissioner of the state where the
domestic insurer is domiciled. Generally, state statutes provide that control
over a domestic insurer is presumed to exist if any person, directly or
indirectly, owns, controls, holds with the power to vote, or holds proxies
representing, 10% or more of the voting securities of the domestic insurer.
Prior to granting approval of an application to acquire control of a domestic
insurer, the state insurance commissioner will consider such factors as the
financial strength of the applicant, the integrity of the applicants board of
directors and executive officers, the applicants plans for the management of
the domestic insurer, the applicants plans for the future operations of the
domestic insurer and any anti-competitive results that may arise from the
consummation of the acquisition of control. These laws may discourage potential
acquisition proposals and may delay, deter or prevent a change of control
involving us that some or all of our stockholders might consider to be
desirable, including in particular unsolicited transactions.

State Insurance Regulation. State
insurance authorities have broad regulatory powers with respect to various
aspects of the business of U.S. insurance companies, including licensing these
companies to transact business, accrediting reinsurers, admitting assets to
statutory surplus, regulating unfair trade and claims practices, establishing
reserve requirements and solvency standards, regulating investments and
dividends, and, in certain instances, approving policy forms and related
materials and approving premium rates. State insurance laws and regulations
require XLCA to file financial statements with insurance departments everywhere
it is licensed, authorized or accredited to conduct insurance business, and its
operations are subject to examination by those departments at any time. XLCA
prepares statutory financial statements in accordance with Statutory Accounting
Practices, or SAP, and procedures prescribed or permitted by these departments.
State insurance departments also conduct periodic examinations of the books and
records, financial reporting, policy filings and market conduct of insurance
companies domiciled in their state, generally once every three to five years.
Market-conduct examinations generally are carried out in cooperation with the
insurance departments of other states under guidelines promulgated by the
National Association of Insurance Commissioners.

Financial
examinations are conducted by the state of domicile of the insurer. The New
York Insurance Department, the regulatory authority of the domiciliary
jurisdiction of XLCA, conducts a periodic examination of insurance companies
domiciled in New York at least once every five years. During 2003, the New York
Insurance Department completed its examination of XLCA for the period from
January 1, 1999 though December 31, 2002. The report on the examination does
not contain any materially adverse findings.

The terms
and conditions of reinsurance agreements generally are not subject to
regulation by any U.S. state insurance department with respect to rates. As a
practical matter, however, the rates charged by primary insurers do have an
effect on the rates that can be charged by reinsurers.

New York State Dividend
 Limitations. Under
New York Insurance Law, a New York-domiciled insurer may not declare or
distribute shareholder dividends during any 12-month period that would exceed
the lesser of (a) 10% of policyholders surplus, as shown by the most recent
statutory financial statement on file with the New York Superintendent or (b)
100% of adjusted net investment income for such 12-month period (the net
investment income for such 12-month period plus the excess, if any, of net
investment income over dividends declared or distributed during the two-year
period preceding such 12-month period), unless the New York Superintendent approves
a greater dividend based upon a finding that the insurer will retain sufficient
surplus to support its obligations and writings. Moreover, a New York-domiciled
insurer may not declare or distribute any dividends except out of earned
surplus. Currently, XLCA has negative earned surplus and is unable to declare
or distribute dividends. In connection with our IPO, XLCA and XLFA have each
agreed with certain of the rating agencies that, until the second anniversary
of the IPO each will not declare or grant dividends on its common stock without
the prior written consent of those ratings agencies, other than to fund certain
parent holding company operating expenses and debt service requirements and to
fund dividends on our preferred stock and nominal dividends on our common
stock.

Contingency Reserves. Under New York
Insurance Law, XLCA must establish and maintain a contingency reserve to
protect policyholders against the effects of excessive losses occurring during
adverse economic cycles. This reserve is established by quarterly contributions
of unassigned surplus and is reflected in XLCAs statutory financial
statements. The total reserve required is calculated as the greater of 50% of
premiums written or a specified percentage

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applied to the insured outstanding principal, net of collateral and
reinsurance. Such specified percentage varies by the type of outstanding
principal. Contributions to the contingency reserve may be released after such
reserve has been in existence for forty quarters unless an earlier withdrawal
is approved by the Superintendent of Insurance pursuant to the New York
Insurance Law.

Investments. XLCA is subject to laws and
regulations that require diversification of its investment portfolio and limit
the amount of investments in certain asset categories, such as below investment
grade debt securities, equity real estate, other equity investments and
derivatives. Failure to comply with these laws and regulations would cause
investments exceeding regulatory limitations to be treated as non-admitted
assets for purposes of measuring surplus, and, in some instances, would require
divestiture of such non-qualifying investments. We believe that the investments
made by XLCA complied with such regulations as of December 31, 2006. In
addition, any investment must be approved by the insurance companys board of
directors or a committee thereof that is responsible for supervising or making
such investment.

Operations of Our Non-U.S. Insurance
Subsidiaries. The
insurance laws of each state of the United States and of many other countries
regulate or prohibit the sale of insurance and reinsurance within their
jurisdictions by unlicensed or non-accredited insurers and reinsurers. XLCA-UK
is not admitted to do business in the United States. We do not intend that
XLCA-UK will maintain offices or solicit, advertise, settle claims or conduct
other insurance activities in any jurisdiction in the United States where the
conduct of such activities would require it to be admitted or authorized.

In addition
to the regulatory requirements imposed by the jurisdictions in which they are
licensed, reinsurers business operations are affected by regulatory
requirements in various states of the United States governing credit for
reinsurance which are imposed on their ceding companies. In general, a ceding
company which obtains reinsurance from a reinsurer that is licensed, accredited
or approved by the ceding companys state of domicile is permitted to reflect
in its statutory financial statements a credit in an aggregate amount equal to
the ceding companys liability for unearned premiums (which are that portion of
premiums written which applies to the unexpired portion of the policy period),
loss reserves and loss expense reserves ceded to the reinsurer. The great
majority of states, however, permit a credit on the statutory financial
statement of a ceding insurer for reinsurance obtained from a non-licensed or
non-accredited reinsurer to the extent that the reinsurer secures its
reinsurance obligations to the ceding insurer by providing a letter of credit,
trust fund or other acceptable security arrangement. A few states do not allow
credit for reinsurance ceded to non-licensed reinsurers except in certain
limited circumstances, and others impose additional requirements that make it
difficult to become accredited.

Bermuda

Bermuda Insurance
RegulationThe Insurance Act 1978 and Related Regulations. Bermudas
Insurance Act 1978, as amended, and related regulations, which we refer to as
the Insurance Act, which regulates the insurance business of XLFA, provides
that no person shall carry on an insurance business in or from within Bermuda
unless registered as an insurer under the Insurance Act by the Bermuda Monetary
Authority (BMA). The BMA, in deciding whether to grant registration, has
broad discretion to act as it thinks fit in the public interest. It is required
by the Insurance Act to determine whether the applicant is a fit and proper
body to be engaged in the insurance business and, in particular, whether it
has, or has available to it, adequate knowledge and expertise. The registration
of an applicant as an insurer is subject to its complying with the terms of its
registration and such other conditions as the BMA may impose at any time.

The
Insurance Act also grants to the BMA powers to supervise, investigate and
intervene in the affairs of insurance companies.

An
Insurance Advisory Committee appointed by the Bermuda Minister of Finance advises
the BMA on matters connected with the discharge of the BMAs functions, and
subcommittees thereof supervise, investigate and review the law and practice of
insurance in Bermuda, including reviews of accounting and administrative
procedures.

The
Insurance Act imposes on Bermuda insurance companies solvency and liquidity
standards, as well as auditing and reporting requirements. Certain significant
aspects of the Bermuda insurance regulatory framework are set forth below.

Classification of Insurers. The
Insurance
Act distinguishes between insurers carrying on long-term business and insurers
carrying on general business. There are four classifications of insurers
carrying on general business, with Class 4 insurers subject to the strictest
regulation and Class 3 insurers subject to the next strictest regulation. As
XLFA has been incorporated to conduct financial guarantee insurance and
reinsurance, it has been registered as a Class 3 insurer in Bermuda and will be
regulated as such under the Insurance Act.

Principal Representative. An insurer is
required to maintain a principal office in Bermuda and to appoint and maintain
a principal representative in Bermuda. Without a reason acceptable to the BMA,
an insurer may not terminate the appointment of its principal representative,
and the principal representative may not cease to act as such, unless 30

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days notice in writing to the BMA is given of the intention to do so.
It is the duty of the principal representative upon reaching the view that
there is a likelihood of the insurer (for which the principal representative
acts) becoming insolvent or that a reportable event has, to the principal
representatives knowledge, occurred or is believed to have occurred, to
immediately notify the BMA and to make a report in writing to the BMA within 14
days setting out all the particulars of the case that are available to the
principal representative. Examples of such a reportable event include failure
by the insurer to comply substantially with a condition imposed upon the
insurer by the BMA relating to a solvency margin or other ratio.

Cancellation of Insurers
Registration. The
BMA, on certain grounds specified in the Insurance Act, including failure of
the insurer to comply with its obligations under the Insurance Act or a belief
on the part of the BMA that the insurer has not been carrying on business in
accordance with sound insurance principles, may cancel an insurers
registration.

Independent Approved Auditor. Every
registered insurer must appoint an independent auditor who will annually audit
and report on the statutory financial statements and the statutory financial
return of the insurer. These statements must be filed annually with the BMA.
The independent auditor of the insurer must be approved by the BMA and may be
the same person or firm that audits the insurers financial statements and
reports for presentation to its shareholders.

Loss Reserve Specialist. As a Class 3
insurer, XLFA is required to submit an opinion of its approved loss reserve
specialist with its statutory financial return in respect of its loss and loss
expense provisions. The loss reserve specialist will normally be a qualified
casualty actuary and must be approved by the BMA.

Annual Statutory Financial
Statements. An
insurer must prepare annual statutory financial statements. The Insurance Act
prescribes rules for the preparation and substance of such statutory financial
statements, which include, in statutory form, a balance sheet, income
statement, a statement of capital and surplus, and notes thereto. The insurer
is required to give detailed information and analysis regarding premiums,
claims, reinsurance and investments. The statutory financial statements are not
prepared in accordance with GAAP and are distinct from the financial statements
prepared for presentation to the insurers shareholders under the Companies
Act, which may be prepared in accordance with GAAP. An insurer is required to
submit the annual statutory financial statements as part of the annual
statutory financial return. The statutory financial statements and the
statutory financial return do not form part of the public records maintained by
the BMA or the Registrar of Companies.

Annual Statutory Financial Return. XLFA
is
required to file with the BMA a statutory financial return no later than four
months after its financial year end, unless specifically extended. The
statutory financial return includes, among other things, a report of the
approved independent auditor on the statutory financial statements of the
insurer, a general business solvency certificate, the statutory financial
statements themselves and the opinion of the loss reserve specialist. The
principal representative and at least two directors of the insurer must sign
the solvency certificate. The directors are required to certify whether the
minimum solvency margin has been met, and the independent approved auditor is
required to state whether in its opinion it was reasonable for the directors to
so certify. Where an insurers accounts have been audited for any purpose other
than compliance with the Insurance Act, a statement to that effect must be
filed with the statutory financial return.

Minimum Solvency Margin and Restrictions on
Dividends
and Distributions. The Insurance Act provides that the statutory
assets of an insurer must exceed its statutory liabilities by an amount greater
than the prescribed minimum solvency margin.

XLFA is
registered as a Class 3 insurer under the Insurance Act and, as such:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------
| |  | XLFA is required,
  with respect to its general business, to maintain a minimum solvency margin
  equal to the greatest of:                                                                                                                                                                                                                                                                                                                                                                                                                    
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                       
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | $1,000,000,                                                                                           
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                       
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | 20% of net
  premiums written up to $6,000,000 plus 15% of net premiums written over
  $6,000,000, and
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                       
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | 15% of loss and
  other insurance reserves;                                                           
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                       
| |  | XLFA is prohibited
  from declaring or paying any dividends during any financial year if it is in
  breach of its minimum solvency margin or minimum liquidity ratio, or if the
  declaration or payment of such dividends would cause it to fail to meet such
  margin or ratio. If XLFA has failed to meet its minimum solvency margin or
  minimum liquidity ratio on the last day of any financial year, it will be
  prohibited, without the approval of the BMA, from declaring or paying any
  dividends during the next financial year;
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                       
| |  | XLFA is
  prohibited, without the approval of the BMA, from reducing by 15% or more its
  total statutory capital as set out in its previous years financial
  statements.                                                                                                                                                                                                                                                                                                                                                                    

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Minimum Liquidity Ratio. The Insurance
Act
provides a minimum liquidity ratio for general business. An insurer engaged in
general business is required to maintain the value of its relevant assets at
not less than 75% of the amount of its relevant liabilities. Relevant assets
include cash and time deposits, quoted investments, unquoted bonds and
debentures, first liens on real estate, investment income due and accrued,
accounts and premiums receivable, and reinsurance balances receivable.

There are
certain categories of assets, which, unless specifically permitted by the BMA,
do not qualify as relevant assets, such as unquoted equity securities,
investments in and advances to affiliates, and real estate and collateral
loans.

The
relevant liabilities are total general business insurance reserves and total
other liabilities less deferred income tax and sundry liabilities (by
interpretation, those not specifically defined).

Supervision, Investigation and
Intervention. The
BMA may appoint an inspector with extensive powers to investigate the affairs
of an insurer if the BMA believes that an investigation is required in the
interest of the insurers policyholders or potential policyholders. In order to
verify or supplement information otherwise provided to the inspector, the BMA
may direct an insurer to produce documents or information relating to matters
connected with the insurers business.

If it
appears to the BMA that there is a risk of the insurer becoming insolvent, or
that it is in breach of the Insurance Act or any conditions imposed upon its
registration, the BMA may direct the insurer: (1) not to take on any new
insurance business, (2) not to vary any insurance contract if the effect would
be to increase the insurers liabilities, (3) not to make certain investments,
(4) to realize certain investments, (5) to maintain, or transfer to the custody
of a specified bank, certain assets, (6) not to declare or pay any dividends or
other distributions or to restrict the making of such payments, and/or (7) to
limit its premium income.

Disclosure of Information. In addition
to
powers under the Insurance Act to investigate the affairs of an insurer, the
BMA may require certain information from an insurer (or certain other persons)
to be produced to the inspector. Further, the BMA has been given powers to
assist other regulatory authorities with their investigations involving
insurance and reinsurance companies in Bermuda but subject to restrictions. For
example, the BMA must be satisfied that the assistance being requested is in
connection with the discharge of regulatory responsibilities of the foreign
regulatory authority. Further, the BMA must consider whether co-operation is in
the public interest. The grounds for disclosure are limited and the Insurance
Act provides sanctions for breach of the statutory duty of confidentiality.

Bermuda Companies Act. Under the
Companies
Act, a Bermuda company may not declare and pay a dividend or make a
distribution out of contributed surplus, defined under the Companies Act, if
there are reasonable grounds for believing that such company is, and after the
payment will be, unable to pay its liabilities as they become due or that the
realizable value of such companys assets would thereby be less than the
aggregate of its liabilities and its issued share capital and share premium
accounts. The Companies Act also regulates and restricts the reduction and
return of capital and paid-in share premium, including repurchase and
redemption of shares, and imposes minimum issued and outstanding share capital
requirements. In addition, XLFA has undertaken not to declare or grant
dividends on its common shares without the prior written consent of each of the
ratings agencies until the earlier of December 31, 2006 and the date on which
all of these rating agencies cease to provide a AAA rating to XLFA.
 XLFA has agreed with certain of the rating agencies that, until the second
anniversary of the IPO that it will not declare or grant dividends on its
common stock without the prior written consent of those ratings agencies,
other than to fund certain parent holding company operating expenses and
debt service requirements and to fund nominal dividends on our common stock.

Certain other Bermuda law
considerations. Although
XLFA is incorporated in Bermuda, it is classified as a non-resident of Bermuda
for exchange control purposes by the BMA. Pursuant to its non-resident status,
XLFA may engage in transactions in currencies other than Bermuda dollars and there
are no restrictions on its ability to transfer funds, other than funds
denominated in Bermuda dollars, inside and outside of Bermuda or to pay
dividends to U.S. residents that are holders of our common shares.

Under
Bermuda law, exempted companies, meaning companies that are exempted from
certain provisions of Bermuda law that stipulate that at least 60% of a
particular companys equity must be beneficially owned by Bermudians, are
companies formed for the purpose of conducting business outside Bermuda from a
principal place of business in Bermuda. As an exempted company, XLFA may not,
except pursuant to a license or consent granted by the Minister of Finance,
participate in certain business or other transactions, including: (1) the acquisition
or holding of land in Bermuda, except for land that is held by way of lease or
tenancy agreement, is required for its business and is held for a term not
exceeding 50 years, or that is used to provide accommodation or recreational
facilities for XLFAs officers and employees and held with the consent of the
Bermuda Minister of Finance for a term not exceeding 21 years, (2) the taking
of mortgages on land in Bermuda to secure a principal amount in excess of
$50,000, unless the Minister of Finance consents to such higher amount, and (3)
the carrying on of business of any kind or type for which XLFA is not duly

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licensed in Bermuda, except in certain limited circumstances, such as
doing business with another exempted undertaking in furtherance of XLFAs
business carried on outside Bermuda.

XLFA is not
currently subject to taxes computed on profits or income or computed on any
capital asset, gain or appreciation. Bermuda companies pay, as applicable,
annual government fees, business fees, payroll tax and other taxes and duties.
See Certain Tax ConsiderationsTaxation of SCA and SubsidiariesBermuda.

Special
considerations apply to our Bermuda operations. Under Bermuda law,
non-Bermudians, other than spouses of Bermudians and individuals holding
permanent resident certificates or working resident certificates, are not
permitted to engage in any gainful occupation in Bermuda without a work permit
issued by the Bermuda government. A work permit is granted or extended only if
an employer can show that, after a proper public advertisement, no Bermudian,
spouse of a Bermudian or individual holding a permanent resident certificate is
available who meets the minimum standards for the relevant position. The
Bermuda government has announced a policy that places a six-year term limit on
individuals with work permits, subject to specified exemptions for persons
deemed key employees. Currently, all of our Bermuda-based professional
employees who require work permits have been granted permits by the Bermuda
government.

United Kingdom

General.Since
December 1, 2001, the regulation of the financial services industry in the
United Kingdom has been consolidated under the Financial Services Authority,
which we refer to as FSA UK. In addition, the regulatory regime in the United
Kingdom must comply with certain European Union, which we refer to as EU, directives
binding on all EU member states.

The FSA UK
is the single statutory regulator responsible for regulating the financial
services industry in the U.K., and has the authority to oversee the carrying on
of regulated activities (including deposit taking, insurance and reinsurance,
investment management and most other financial services), with the purpose of
maintaining confidence in the U.K. financial system, providing public
understanding of the system, securing the proper degree of protection for
consumers and helping to reduce financial crime. It is a criminal offense for
any person to carry on a regulated activity in the U.K. unless that person is
authorized by the FSA UK and has been granted permission to carry on that
regulated activity, or otherwise falls under an exemption to such regulation.

The
insurance business in the United Kingdom falls into two main categories:
long-term insurance (which is primarily investment-related) and general
insurance. It is not possible for an insurance company to be authorized in both
long-term and general insurance business. These two categories are both divided
into classes (for example: permanent health and pension fund management are
two classes of long-term insurance; damage to property and motor vehicle
liability are two classes of general insurance). Under the Financial Services
and Markets Act 2000, which we refer to as FSMA, effecting or carrying out
contracts of insurance, within a class of general or long-term insurance, by
way of business in the U.K., constitutes a regulated activity requiring
authorization. An authorized insurance company must have permission for each
class of insurance business it intends to write.

XLCA-UK has
obtained authorization from the FSA to effect and carry out certain classes of
non-life insurance, specifically: classes 14 (credit), 15 (suretyship) and 16
(miscellaneous financial loss). This scope of permission is sufficient to
enable XLCA-UK to effect and carry out financial guarantee insurance and
reinsurance.

XLCA-UK
insurance business is subject to close supervision by the FSA UK. The FSA UK
currently is seeking to strengthen its requirements for senior management
arrangements, systems and controls of insurance and reinsurance companies under
its jurisdiction and intends to place an increased emphasis on risk
identification and management in relation to the prudential regulation of
insurance and reinsurance business in the United Kingdom. There are a number of
proposed changes to the FSA UKs rules that will affect insurance and
reinsurance companies authorized in the U.K. For example, the FSA UK currently
is in consultation on a number of proposals, including the regulation of the
sale of general insurance, insurance mediation, capital adequacy and proposals
aimed at ensuring adequate diversification of an insurers or reinsurers
exposures to any credit risks of its reinsurers. Changes in the scope of the
FSA UKs regulation may have an adverse impact on the potential business operations
of XLCA-UK.

Supervision.The
FSA UK carries out the prudential supervision of insurance companies through a
variety of methods, including the collection of information from statistical
returns, review of accountants reports, visits to insurance companies and
regular formal interviews.

The FSA UK
has adopted a risk-based approach to the supervision of insurance companies.
Under this approach, the FSA UK periodically performs a formal risk assessment
of insurance companies or groups carrying on business in the U.K. which varies
in scope according to the risk profile of the insurer. The FSA UK performs its
risk assessment by analyzing information which it receives during the normal
course of its supervision, such as regular prudential returns on the financial
position of the insurance company, or which it acquires through a series of
meetings with senior management

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of the insurance company. After each risk assessment, the FSA UK will
inform the insurer of its views on the insurers risk profile. This will
include details of any remedial action that the FSA UK requires and the likely
consequences if this action is not taken.

Solvency
Requirements.The Interim Prudential Sourcebook for Insurers requires that insurance
companies maintain a margin of solvency at all times in respect of any general
insurance undertaken by the insurance company, the calculation of which depends
on the type and amount of insurance business a company writes. The method of
calculation of the solvency margin is set out in the Interim Prudential
Sourcebook for Insurers, and for these purposes, all of the insurers assets
and liabilities are subject to specified valuation rules. Failure to maintain
the required solvency margin is one of the grounds on which the wide powers of
intervention conferred upon the FSA UK may be exercised.

To the
extent that the amount of premiums for such classes exceeds certain specified
minimum thresholds, each insurance company writing property, credit and other
specified categories of insurance or reinsurance business is required by the
Interim Prudential Sourcebook for Insurers to maintain an equalization reserve
for the financial years ending on or after December 23, 1996 calculated in
accordance with the provisions of the Interim Prudential Sourcebook for
Insurers.

These
solvency requirements have recently been amended in order to implement the EUs
Solvency I directives. These new rules came into effect on January 1, 2004.

In
addition, an insurer (other than a company conducting only reinsurance
business) is required to perform and submit to the FSA UK a solvency margin
calculation return in respect of its ultimate parent. This return is not part
of an insurers own solvency return and hence will not be publicly available.
Although there is no requirement that the parent solvency calculation show a
positive result, the FSA UK is required to take action where it considers that
the solvency of the insurance company is or may be jeopardized due to the group
solvency position. Further, an insurer is required to report in its annual
returns to the FSA UK all material related party transactions (for example,
intragroup reinsurance, whose value is more than 5% of the insurers general
insurance business amount). However, the FSA UK has published proposals for the
implementation of the EUs Financial Groups Directive, which includes a
requirement for insurance groups to hold an amount of capital indicated in the
calculation of the parent companys solvency margin at the European Economic
Area parent level for the financial years beginning in 2005. The purpose of
these proposals is to prevent leveraging of capital arising from involvements
in other group insurance firms. The FSA UK has stated that it will phase in
these proposals. Given the current structure of the group of which XLCA-UK is a
member, regulatory obligation does not apply to XLCA-UKs parent, because it is
incorporated in New York.

Restrictions
on Dividend Payments.U.K. company law prohibits XLCA-UK from declaring a
dividend to its shareholders unless it has profits available for
distribution. The determination of whether a company has profits available for
distribution is based on its accumulated realized profits less its accumulated
realized losses. While the U.K. insurance regulatory laws impose no statutory
restrictions on a general insurers ability to declare a dividend, the FSA UK
requires the maintenance of each insurance companys solvency margin within its
jurisdiction. The FSA UKs rules require XLCA-UK to notify the FSA UK of any
proposed or actual payment of a dividend that is greater than forecast in the
business plans submitted with their respective applications for authorization.
Any such payment or proposal could result in regulatory intervention. In
addition, the FSA UK requires authorized insurance companies to notify it in
advance of any significant dividend payment.

Reporting
Requirements.U.K. insurance companies must prepare their financial statements under
the Companies Act of 1985, as amended, which requires the filing with Companies
House of audited financial statements and related reports. In addition, U.K.
insurance companies are required to file regulatory returns with the FSA UK,
which include a revenue account, a profit and loss account and a balance sheet
in prescribed forms. Under the Interim Prudential Sourcebook for Insurers,
audited regulatory returns must be filed with the FSA UK within two months and
15 days of the financial year end (or three months where the delivery of the
return is made electronically).

Supervision
of Management.The FSA UK closely supervises the management of
insurance companies through the approved persons regime, by which any
appointment of persons to perform certain specified controlled functions
within a regulated entity must be approved by the FSA UK.

Change
of Control.FSMA regulates the acquisition of control of any U.K. insurance
company authorized under FSMA. Any company or individual that (together with
its or his or her associates) directly or indirectly acquires 10% or more of
the shares in a U.K.-authorized insurance company or its parent company, or is
entitled to exercise or control the exercise of 10% or more of the voting power
in such authorized insurance company or its parent company, would be considered
to have acquired control for the purposes of the relevant legislation, as
would a person who had significant influence over the management of such
authorized insurance company or its parent company by virtue of his or her
shareholding or voting power in either.

Under FSMA,
any person proposing to acquire control of a U.K. authorized insurance
company must give prior notification to the FSA UK of its intention to do so.
The FSA UK then has three months to consider that persons

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application to acquire control. In considering whether to approve
such application, the FSA UK must be satisfied that the acquirer is a fit and
proper person to have control and that the interests of consumers would not
be threatened by such acquisition of control. Consumers in this context
includes all persons who may use the services of the authorized insurance
company. Failure to make the relevant prior application could result in action
being taken by the FSA UK.

Intervention
and Enforcement.The FSA UK has extensive powers to intervene in the
affairs of an authorized person, culminating in the ultimate sanction of the
removal of authorization to carry on a regulated activity. FSMA imposes on the
FSA UK statutory obligations to monitor compliance with the requirements
imposed by FSMA, and to enforce the provisions of FSMA-related rules made by
the FSA UK. The FSA UK has power, among other things, to enforce and take
disciplinary measures in respect of breaches of both the Interim Prudential
Sourcebook for Insurers and breaches of the conduct of business rules generally
applicable to authorized persons.

The FSA UK
also has the power to prosecute criminal offenses arising under FSMA, and to
prosecute insider dealing under Part V of the Criminal Justice Act of 1993, and
breaches of money laundering regulations. The FSA UKs stated policy is to
pursue criminal prosecution in all appropriate cases.

Passporting.EU
directives allow XLCA-UK to conduct business in EU states other than the United
Kingdom in compliance with the scope of permission granted these companies by
FSA UK without the necessity of additional licensing or authorization in other
EU jurisdictions. This ability to operate in other jurisdictions of the EU on
the basis of home state authorization and supervision is sometimes referred to
as passporting. Insurers may operate outside their home member state either
on a services basis or on an establishment basis. Operating on a services
basis means that a company conducts permitted businesses in the host state
without having a physical presence there, while operating on an establishment
basis means that a company has a branch or physical presence in the host state.
In both cases, a company remains subject to regulation by its home regulator,
and not by local regulatory authorities, although such company nonetheless may
have to comply with certain local rules. In addition to EU member states,
Norway, Iceland and Liechtenstein (members of the broader European Economic
Area) are jurisdictions in which this passporting framework applies. XLCA-UK
intends to operate on a passport basis throughout the EU.

Fees
and Levies.XLCA-UK is subject to FSA UK fees and levies based on XLCA-UKs gross
premiums written. The FSA UK also requires authorized insurers to participate
in an investors protection fund, known as the Financial Services Compensation
Scheme, which we refer to as the FSCS. The FSCS was established to compensate
consumers of financial services, including the buyers of insurance, against
failures in the financial services industry. Individual policyholders and small
businesses may be compensated by the FSCS when an authorized insurer is unable,
or likely to be unable, to satisfy policyholder claims. XLCA-UK has not and
does not expect to write any insurance business that is protected by the FSCS.

Employees

As
of December 31, 2006, we had approximately 160 employees. None of our employees
is subject to a collective bargaining agreement.

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ITEM 1A. RISK FACTORS

Risks Related to Our Company

A downgrade of our financial
strength or financial enhancement ratings from triple-A would materially
adversely affect our business and, consequently, our results of operations and
financial condition.

The
maintenance of our triple-A ratings is essential for us to continue to operate
in the triple-A financial guarantee insurance and reinsurance markets. As of
December 31, 2006, our financial guarantee insurance and reinsurance
subsidiaries have been assigned a AAA (Extremely Strong) financial strength
rating from S&P, a Aaa (Exceptional) financial strength rating from Moodys
and a AAA (Exceptionally Strong) financial strength rating from Fitch, the
highest rating categories used by each of these rating agencies. A financial
strength rating is an opinion regarding the financial security characteristics
of an insurance or reinsurance organization with respect to its ability to pay
under its insurance and reinsurance policies and contracts in accordance with
their terms. The opinion is not specific to any particular policy or contract.
Financial strength ratings do not refer to the ability of an insurer or
reinsurer to meet non-insurance or non-reinsurance obligations and are not a
recommendation to purchase or discontinue any policy or contract issued by an
insurer or reinsurer or to buy, hold or sell any security issued by an insurer
or reinsurer or any parent company of any insurer or reinsurer.

S&P
also assigns financial enhancement ratings, which provide investors with a
specific opinion regarding the willingness of an insurance or reinsurance
company to pay financial guarantee claims on a timely basis. Our financial
guarantee insurance and reinsurance companies carry a financial enhancement
rating from S&P of AAA (Extremely Strong), the highest rating category
used by S&P.

The ratings
assigned to us by S&P, Moodys and Fitch are subject to periodic review and
may be downgraded by one or more of these rating agencies as a result of
changes in their views regarding the financial guarantee insurance and
reinsurance industry, adverse developments in our financial condition or
results of operations due to underwriting or investment losses or other
factors, including changes in applicable rating agency criteria. In addition,
one or more of the rating agencies may change the methodologies they use to
rate financial guarantee insurers or reinsurers and no assurances can be given
as to the effect on us (or other members of our industry) of any such change.

See also
Risks Related to Our Historical Ownership by XL Capital as well as our
continuing relationship with XL CapitalOur financial strength or financial
enhancement ratings may be negatively impacted by XL Capitals ratings.

Any
decrease in the ratings of any of our insurance or reinsurance subsidiaries
below current levels by any of the rating agencies would have a material
adverse effect on our ability to compete with other large monoline financial
guarantee companies, which are our principal competitors, all of which
currently have triple-A ratings from S&P, Moodys and Fitch. Also, certain
of the reinsurance agreements pursuant to which we reinsure financial guarantee
insurance written by other insurers contain provisions that allow the ceding
primary insurer to terminate the agreement on a run-off basis or, in some
cases, a cut-off basis in the event of a downgrade in our credit ratings or
other event that would result in the reinsurance credit provided by us to the
ceding primary insurer being diminished. In order to maintain our credit
ratings we may be required to raise additional capital, reduce the amount or
change the type of insurance that we write, increase the amount of insurance
that we cede to reinsurers, or take a combination of these or other actions not
currently contemplated by us.

Increased rating agency capital charges may
adversely affect us.

Individual
obligations that we guarantee are assessed a rating agency capital charge
based on a variety of factors including the nature of the credits, their
underlying ratings and their expected and actual performance. In the event of
an actual or perceived deterioration in creditworthiness, a reduction in the
underlying rating or a change in the rating agency capital methodology, we may
be required to hold more capital in reserve against obligations in our insured portfolio,
regardless of whether losses actually occur, or against potential new business.
There can be no assurance that our capital position will be adequate to meet
such increased reserve requirements or that we will be able to secure
additional capital if so needed to maintain our ratings.

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A downgrade of the financial strength or
financial enhancement ratings of any of our reinsurers, or a change in the
treatment by the rating agencies of the reinsurance provided to us by subsidiaries of XL Capital would impact the
value of the reinsurance that any such reinsurer provides to us and, therefore,
could adversely affect us.

A downgrade
of the ratings of any of our reinsurers would reduce the value of the outwards,
or ceded, reinsurance that such reinsurer provides to us by affecting the
amount of reinsurance credit that we receive for risks that we have ceded to
such reinsurer in the rating agency models that are used to determine our
ratings. Triple-A-rated reinsurance is necessary to qualify for a 100%
reinsurance credit in the rating agencies capital adequacy models.
Consequently, a downgrade in the ratings of any of our reinsurers could affect
the amount of capital the rating agencies require us to maintain in order to
keep our triple-A ratings. Based upon publicly available information, we are
aware that one of our third-party reinsurers, representing 24.3% of our ceded
par exposure as of December 31, 2006 is under negative outlook for below
average earnings from Standard and Poors.
A different third-party reinsurer representing 12.1% of our ceded par
exposure as of December 31, 2006 is also on negative outlook by Fitch
Ratings.  We also depend upon subsidiaries of XL Capital, including XLI, for
21.6% of our retrocessions as at December 31, 2006.  This is a reduction
from in excess of one third of our retrocessions as at December 31, 2005. XLI
does not currently have a bond insurance financial enhancement rating from S&P, which normally determines the amount of credit
that S&P gives to reinsurance cessions. However, because of the
relationship between us and XLI, S&P uses XLIs financial strength rating
to determine the amount of credit we receive for reinsurance provided to us by
XLI. If the financial strength rating of XLI changes, or the relationship
between us and XLI changes, there is a risk that S&P will change its
determination as to the amount of such credit, or revoke its decision to use
XLIs financial strength rating, which would result in us receiving a reduced
amount or no credit for XLIs reinsurance.

In the
event of any such downgrade, or a change in the treatment by the rating
agencies of the reinsurance provided to us by XLI or other subsidiaries of XL
Capital, we cannot assure you that we will be able to find other reinsurers
that can provide us with the reinsurance capacity currently provided to us by
our existing reinsurers. Even if reinsurance is generally available, we may not
be able to negotiate terms comparable to the terms of our current policies, or
that we deem appropriate or acceptable, or to obtain coverage from entities
with satisfactory financial resources. Such a result, or a reduction in the
amount of business that we are able to retrocede to XLI or other subsidiaries
of XL Capital, could put us at a competitive disadvantage with respect to
larger monoline financial guarantee companies, principally by affecting our
ability to underwrite larger single-name risks, including risks for certain
public finance obligors, or increasing the amount of capital that the rating
agencies require us to maintain in order to write such larger risks or to keep
our triple-A ratings. XLI and other subsidiaries of XL Capital may also decide
at any time to reduce or eliminate the amount of retrocessional coverage it
provides to us.

The size of our capital base may adversely
affect our ability to grow our business and execute our business strategy.

We
currently have a significantly smaller capital base (meaning our shareholders
equity) than most of our direct competitors, which may effectively reduce our
ability to compete with them. Larger competitors have several advantages over
us because of their size, including being able to offer larger single risk
limits, having greater economies of scale and having more diverse product
lines, as well as having greater market acceptance. At December 31, 2006, our
capital base was approximately $1.4 billion.

We may require additional capital or liquidity
in the future, which may not be available or may be available only on
unfavorable terms.

Our ongoing
capital requirements depend on many factors, including our in-force book of
business and regulatory and rating agency capital requirements. To the extent
that our existing capital is insufficient to meet these requirements or cover
losses, we may need to raise additional funds through financings or curtail our
growth and reduce our insured exposure. Any equity or debt financing, if
available at all, may be on terms that are not favorable to us. If we cannot
obtain adequate capital on favorable terms or at all, our business, operating
results and financial condition could be adversely affected.

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In
addition, as an offshore reinsurer, XLFA is required to post collateral
security with respect to any reinsurance liabilities that it assumes from
ceding insurers domiciled in the United States in order for U.S. ceding
companies to obtain full statutory and regulatory credit for XLFAs reinsurance.
Under applicable statutory provisions, these security arrangements may be in
the form of letters of credit, reinsurance trusts maintained by trustees or
funds-withheld arrangements where assets are held by the ceding company. We
currently satisfy such statutory requirements by providing to primary insurers
letters of credit issued under our credit facility  See Managements
Discussion and Analysis of Financial Condition and Results of Operations 
Liquidity and Capital Resources for further information. To the extent that we
are required to post additional security in the future, we may require
additional letter of credit capacity and we cannot assure you that we will be
able to obtain such additional capacity or arrange for other types of security
on commercially acceptable terms. Our inability to provide collateral
satisfying the statutory and regulatory guidelines applicable to financial
guarantee primary insurers would have a material adverse effect on our ability
to provide reinsurance to third parties and negatively affect our financial
position and results of operations.

Some of our
direct financial guarantee products may be riskier than traditional financial
guarantee insurance, principally because these less traditional products may
require us to make payments of the full guaranteed amount earlier than, or upon
the occurrence of events not covered by, traditional products.

Some
    of our financial guarantee direct exposures have been written as credit derivatives
rather than financial guarantee insurance policies. Traditional financial
guarantee insurance provides an unconditional and irrevocable guarantee that
protects the holder of a municipal finance or structured finance obligation
against non-payment of principal and interest. In contrast, credit derivatives
provide protection from the occurrence of specified credit events, which
usually include non-payment of principal and interest, but may also include
other events, such as certain types of restructurings, that would not typically
trigger a payment obligation under traditional products. Credit derivative
products may also provide for settlement of an entire exposure, rather than a
missed payment obligation as in traditional financial guarantee insurance, upon
the occurrence of a credit event, which could require us to sell assets or
otherwise generate liquidity in advance of any potential recoveries. Our net
earned premium on credit default swaps was $23.7 million, $16.5 million, and
$22.3 million for the years ended December 31, 2006, 2005 and 2004,
respectively, which represented 12.9%, 10.9% and 19.2% of total net earned
premium for such years, respectively. These amounts of net earned premium
represented 9.9%, 8.5% and 13.5% of total revenue for the period ended December
31, 2006, 2005, and 2004, respectively. Our
notional exposure, net of reinsurance, from the issuance of credit default swap
policies was $24.6 billion and $14.0 billion at December 31, 2006 and 2005,
respectively, which represented 20.8% and 17.1% of our total net par
outstanding at these dates.

Our insurance and reinsurance portfolio and
financial guarantee products expose us to concentrations of risks, and a
material adverse event or series of events with respect to one or more of these
risks could result in significant losses to our business.

The breadth
of our business exposes us to potential losses in a variety of our products,
which may be correlated as to credit risk. For example, we could be exposed to
a corporate credit risk with respect to a companys securities that are
contained in a portfolio of collateralized debt obligations, which we refer to
as CDOs, that we insure and could also be exposed to the same corporate
credit risk if such company is also the originator or servicer of loans or other
assets backing structured securities that we insure. While we track our
aggregate exposure to credit problems at a single issuer or servicer, which we
refer to as single name exposure, of asset-backed securities, which we refer
to as ABS, and have established underwriting criteria to manage risk
aggregations, there can be no assurance that an event with respect to a single
name will not cause a significant loss across a number of transactions that we
have guaranteed. In addition, we have a number of individual large exposures to
single obligors in our public finance portfolio, concentrations of risk in
infrastructure sectors, such as water and sewer utilities and transportation,
and concentrations of risk in certain geographic areas. While the risk of a
complete loss on such public finance obligations, where we are required to pay
the entire principal amount of an issue of bonds and interest thereon with no
recovery, is generally lower than for single corporate credits as most
municipal bonds are backed by tax or other revenues, there can be no assurance
that a single default by a municipality or public authority would not have a
material adverse effect on our results of operations or financial condition.

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Rules relating to certain accounting practices
in the financial guarantee insurance and reinsurance industry are currently
being reviewed by applicable regulatory bodies and any changes required by that
review could have a material adverse effect on the reported operating results
and financial condition of the industry or particular market participants,
including us.

In June
2005, at the request of the Securities and Exchange Commission, the Financial
Accounting Standards Board, which we refer to as 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.  When the FASB
reaches a conclusion on these issues, we and the rest of the financial
guarantee industry may be required to change aspects of certain accounting
policies, which could have a material effect on our reported or ongoing results
to the extent that our current policies differ significantly from the policies
promulgated by the FASB.

Our ability to implement, for the fiscal year
ended December 31, 2007, the requirements of Section 404 of the Sarbanes-Oxley
Act of 2002 in a timely and satisfactory manner could cause the price of our
common shares to fall.

We are
presently evaluating our existing internal controls with respect to the
standards adopted by the Public Company Accounting Oversight Board. While we
are not presently aware of any circumstances that would prohibit us from
successfully completing the procedures, certification and attestation
requirements of Section 404 of the Sarbanes-Oxley Act of 2002 by the time that
we are required to file our Annual Report on Form 10-K for the year ended December
31, 2007 (which is the first time that our management and our outside auditors
will be required to deliver reports on our internal controls and procedures in
accordance with the Sarbanes-Oxley Act of 2002), no assurances can be given
that we will be able to successfully complete those procedures by that time.
Uncertainty as to our ability to comply with such requirements or any material
weaknesses uncovered as a result of such procedures could have a material
adverse effect on the trading price of our common shares. In addition, we will
incur increased costs associated with such procedures or a diversion of
internal resources necessary to prepare for or comply with such requirements.

We face significant competition in our
business and our revenues and profitability could decline as a result.

The
financial guarantee industry is highly competitive. The principal sources of
direct and indirect competition are other financial guarantee insurance
companies, most of which have significantly greater financial resources than we
do and have been in the industry for longer than we have. Four companies, Ambac
Financial Group, Inc., which we refer to as Ambac, FGIC Corporation, which we
refer to as FGIC, Financial Security Assurance Inc., which we refer to as
FSA, and MBIA Inc., which we refer to as MBIA, accounted for the vast
majority of the gross premiums written for the entire financial guarantee
industry in 2006. In addition, growing interest from banks in assuming
structured finance risk has also increased competition. We also face
competition from other forms of credit enhancement, including structural
enhancements such as senior/subordinated tranching structures incorporated in
structured and other obligations, and from letters of credit, guarantees and
credit derivatives provided by foreign and domestic banks and other financial
institutions, some of which are governmental enterprises, by hedge funds,
structured derivatives product companies and others.

Demand for
financial guarantee insurance changes and is dependent upon a number of
factors, including changes in interest rates, credit spreads, regulatory
requirements, its cost relative to uninsured financing alternatives, risk
appetite in debt capital markets generally and supply of new bond issues. Our
ability to compete with other financial guarantors is affected by the fact that
our guaranteed bonds in certain product lines generally have not traded at
parity, and in the future may not trade at parity, with those of our principal
competitors in these lines of business. In particular, our guaranteed bonds in
certain markets, in particular the fixed rate municipal market, trade at a
small discount to those of our principal competitors. We believe that this
trading differential has been caused by our short operating track record and
small size compared to that of our competitors, as well as a perception among
some investors of a ratings linkage between us and XL Capital. Failure on our
part to achieve trading parity with more established financial guarantors with
respect to our guaranteed bonds in any particular market could make our
guarantees in such market somewhat less attractive and place us at a
competitive disadvantage.

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There are
also a relatively limited number of financial guarantee reinsurance companies.
As a result, the industry is particularly vulnerable to swings in capacity
based on the entry or exit of one or a small number of financial guarantee
reinsurers. Developments over the past several years that have either increased
reinsurance capacity or reduced the demand for reinsurance include: the
formation of a new captive Bermuda-based triple-A-rated financial guarantee
reinsurer, Channel Reinsurance Ltd.; the formation of a new Bermuda-based
double-A-rated financial guarantee reinsurer, Blue Point Re Limited; the use by
certain primary insurers of their excess capacity to provide reinsurance to
other primary insurers; and rising interest rates and a general trend toward
narrowing credit spreads, which have resulted in lower business production for
primary insurers and have reduced the need for reinsurance. New entrants into
the financial guarantee industry could have an adverse effect on our prospects
either by further increasing competition with respect to terms or pricing or by
reducing the aggregate demand for our reinsurance as a result of additional
insurance capacity.

A substantial majority of our third-party
reinsurance business consists of reinsuring risks from 
FSA and our ability to expand our third-party reinsurance business is
constrained by rating agency restrictions.

For the
years ended December 31, 2006, 2005 and 2004, FSA accounted for 69.7%, 65.7%
and 73.0%, respectively, of our gross reinsurance premiums written. While we
provide reinsurance to insurers other than FSA, our ability to increase the
amount of reinsurance that we provide to third parties other than FSA is
restricted by rating agency constraints, which have traditionally limited such
amount to approximately 5% of XLFAs total net par outstanding. Because FSA
holds a preferred share investment in XLFA, the rating agencies have, to date,
generally exempted FSA from the limitations on the amount of third-party
reinsurance business that we may write. These constraints significantly limit
the amount of reinsurance business that we may write from sources other than
FSA in the future. These constraints would also limit the amount of business
that we obtain from FSA in the future if any of the rating agencies begin to
consider FSA business to be third-party business. In addition, should FSA
reduce or eliminate its preferred share investment in XLFA, the rating agencies
may no longer exempt business ceded to XLFA by FSA from their constraints on
third-party business. Similarly, we believe that XLFAs historical status as a
venture between XL Capital and FSAH, accords XLFA better standing as a
potential reinsurer for FSA than it would otherwise have and FSA retains the
right under its reinsurance agreements with us to terminate such agreements
upon the occurrence of certain events, including if XLFA comes under the
control of any other insurance company or organization. Because the reinsurance
agreements that we have in place with FSA and its affiliates do not require it
or them to cede business to us, we can give no assurances as to the amount
and/or profitability of business that we may receive from it or them in the
future.

Consequently,
if FSA were to reduce or eliminate its ownership interest in XLFA, or if we
come under the control of any other insurance company or organization, FSA
could choose to significantly reduce the amount of reinsurance business that it
conducts with XLFA or to reassume business it had previously ceded to us, which
would have a material adverse effect on our business.

General economic factors, including
fluctuations in interest rates, as well as terrorist acts or natural or other
catastrophes, may adversely affect our loss experience or the demand for our
products.

Our loss
experience could be materially adversely affected by extended national or
regional economic recessions, business failures, rising unemployment rates,
terrorist attacks, natural or other catastrophic events such as hurricanes and
earthquakes, acts of war, or combinations of such factors. In addition to
exposure to general economic factors, we are exposed to the specific risks
faced by the particular businesses, municipalities or pools of assets covered
by our financial guarantee products. For example, catastrophic events or
terrorist acts could adversely affect the ability of public sector issuers to
meet their obligations with respect to securities insured by us and we may
incur material losses due to these exposures if the economic stress caused by
these events is more severe than we currently foresee.

Other
events, such as interest rate changes or volatility, could materially decrease
demand for financial guarantee insurance or the demand for financial guarantee
reinsurance. For example, higher interest rates may result in declines in new
issues and refunding volume, which may reduce demand for our financial
guarantee insurance and reinsurance products. Lower interest rates generally
are accompanied by narrower interest rate spreads between insured and uninsured
obligations. The purchase of insurance during periods of narrower interest rate
spreads generally will provide lower cost savings to the issuer than during
periods of wider spreads. These lower cost savings could be accompanied by a
corresponding decrease in demand for financial guarantee insurance.

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If claims
exceed our loss reserves, our financial position and results of operations
could be materially adversely affected.

Our results
of operations and financial condition depend upon our ability to assess
accurately and manage the potential loss associated with the risks that we
insure and reinsure. We establish loss and loss adjustment expense reserves
based on estimates of the ultimate settlement and administration costs of
claims on the policies we write using actuarial and statistical
techniques.  Estimates of loss and loss
adjustment expenses are subject to large potential errors of estimation, due to
the fact that the ultimate dispositions of claims incurred prior to a financial
statement date, whether reported or not, are subject to the outcome of events
that have not yet occurred. If our loss reserves are at any time determined to
be inadequate, we will be required to increase our loss reserves at the time of
such determination. Such an increase would cause a corresponding increase in
our liabilities and a reduction in our profitability, which could have a
material adverse effect on our business.

If the counterparties to our reinsurance
arrangements default on their obligations to us, we may be exposed to risks we
had sought to mitigate, which could adversely affect our financial condition
and results of operations.

We use
reinsurance to mitigate our risks in various circumstances. Reinsurance does
not relieve us of our direct liability to our policyholders, even when the
reinsurer is liable to us. Accordingly, we bear credit risk with respect to our
reinsurers. We cannot assure you that our reinsurers will pay the reinsurance
recoverables owed to us now or in the future or that they will pay these
recoverables on a timely basis. A reinsurers insolvency or inability or
unwillingness to make payments under the terms of its reinsurance agreement
with us could have a material adverse effect on our financial condition and
results of operations.

Our net income may be volatile because a
significant portion of the credit risk we assume must be accounted for as
credit derivatives under FAS 133, as amended by FAS 149, which requires that
these instruments be marked to market quarterly.

Any event
causing credit spreads on an underlying security referenced in a credit
derivative in our portfolio to either widen or tighten will affect the fair
value of the credit derivative and may increase the volatility of our earnings.
Derivatives must be accounted for either as assets or liabilities on the
balance sheet and measured at fair value pursuant to the guidance of Statement
of Financial Accounting Standards No. 133. Although there is no cash flow
effect from this marking to market, net changes in the fair value of the
derivative are reported in our statement of operations and therefore will
affect our reported earnings. See Managements Discussion and Analysis of
Financial Condition and Results of OperationsCritical Accounting Policies and
EstimatesValuation of Credit Default Swaps.

Common
events that may cause credit spreads on an underlying municipal bond or pool of
corporate securities referenced in a credit derivative to fluctuate include
changes in the state of national or regional economic conditions, industry
cyclicality, changes to a companys competitive position within an industry,
management changes, changes in the ratings of the underlying security,
movements in interest rates, default or failure to pay interest or any other
factor leading investors to revise expectations about the issuers ability to
pay principal and interest on its debt obligations. Similarly, common events
that may cause credit spreads on an underlying structured security referenced
in a credit derivative to fluctuate may include the occurrence and severity of
collateral defaults, rating changes, changes in interest rates or underlying
cash flows or any other factor leading investors to revise expectations about
the sufficiency of the applicable collateral or the ability of the servicer to
collect payments on the underlying assets sufficient to pay principal and
interest when due.

Net
unrealized and realized gains (losses) from credit derivatives was $(8.4)
million, $(6.7) million, and $12.7 million for the years ended December 31,
2006, 2005, and 2004, respectively, which represented (7.2)%, (8.3)%, and 21.6%
of net income reported in such years, respectively.

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Because our
financial guarantee insurance and reinsurance policies are unconditional and
irrevocable, we may incur losses from fraudulent conduct relating to the
securities that we insure or reinsure.

Issuers of
obligations that we insure or reinsure may default on those obligations because
of fraudulent or other intentional misconduct on the part of such issuers,
their officers, directors, employees, agents or outside advisers or, in the
case of public finance obligations, public officials. Financial guarantee
insurance and reinsurance provided by us is unconditional and does not provide
for any exclusion of liability based on fraud or other misconduct. Despite any
risk analysis conducted by us or by the financial guarantors whose policies we
reinsure, it is impossible to predict which, if any, of the obligations insured
or reinsured by us will result in claims against us because of fraudulent or
other intentional misconduct involving the issuer or whether or to what extent
we will have any remedy available to us against any party in connection with
such conduct. Any such claims against us could have a material adverse effect
on our financial condition and results of operations.

Legislative and regulatory changes and
interpretations could harm our business.

The
financial guarantee industry is subject to extensive regulation. Changes in
laws and regulations affecting insurance companies, the municipal and
structured securities markets, the financial guarantee insurance and
reinsurance markets and the credit derivatives markets, as well as other
governmental regulations, may subject us to additional legal liability or
affect the demand for the products that we provide, The tax treatment of
non-U.S. insurance companies and their U.S. insurance subsidiaries has been the
subject of Congressional discussion and legislative proposals. While no
proposals are currently pending, we cannot assure you that future legislative
action will not materially adversely affect our financial condition.

Risks Related to Our Historical Ownership by
XL Capital As Well As Our Continuing Relationships with XL Capital

Our historical consolidated financial
information is not necessarily representative of the results we would have
achieved as a stand-alone, public company and may not be a reliable indicator
of our future results.

Prior to
our IPO, all of the common shares of our subsidiaries were owned by XL Capital.
Our historical consolidated financial information does not necessarily reflect
the financial condition, results of operations or cash flows we would have
achieved as a stand-alone public company during the periods presented in our
historical financial statements or those that we will achieve in the future.
This is primarily a result of the following factors:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Our historical
  consolidated financial results reflect allocations of corporate expenses from
  XL Capital for services provided on our behalf and included: information
  technology, legal, human resources, facilities, taxation, treasury,
  actuarial, corporate finance and other expenses. Those allocations may be different
  from the comparable expenses that we would have incurred had we operated as a
  stand-alone company. Although as a stand-alone company our cost structure may
  have been different due to reduced economies of scale with respect to certain
  services, we believe that, had we been a stand-alone company, we would have
  derived other efficiencies. The result is that we do not believe the
  difference between the previously allocated costs and costs we would have
  incurred as a stand-alone company for those periods would, in the aggregate,
  be material;
|
| |  | Significant
  changes may occur in our cost structure, management, financing and business
  operations as a result of our being a stand-alone, public company. These
  changes could result in increased costs associated with reduced economies of
  scale, including costs related to information technology; stand-alone costs
  for services currently provided by XL Capital; marketing and legal entity
  transition expenses related to building a company brand identity separate
  from XL Capital; the need for additional personnel to perform services
  currently provided by XL Capital; and the legal, accounting, compliance and
  other costs associated with being a public company with listed equity;                                                                                                                                                                                           
|
| |  | Some of the agreements pursuant to which we provide reinsurance to
  third-party ceding companies have change of control provisions that may be
  triggered if an unaffiliated entity acquires more than a specified percentage
  of our voting securities or if we come under control of any other insurance company
  or organization. In addition, certain other of our third-party reinsurance
  agreements have change of control provisions that may be triggered if XL
  Capitals ownership of our company decreases to less than 50% of our
  outstanding common shares. If any of our clients wish to exercise their
  rights under any such provision, then we may be required to terminate or
  modify the relevant agreement or seek alternative arrangements, which could
  result in reduced premiums, increased costs or other disruptions to our
  business;                                       

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The terms of our current services, leasing,
reinsurance, and other arrangements with XL Capital may be more or less
favorable to us than we will be able to obtain in the future from an
unaffiliated third-party.

Effective
upon our IPO, we and XL Capital entered into a series of service agreements
pursuant to which XL Capital provides us, for a period of up to two years,
transitional services, including treasury, payroll and other financial
services, human resources and employee benefit services, legal services,
information systems and network services, tax and treasury services, investment
management and procurement and sourcing support. We also entered into a
transition agreement with XL Capital, which governs the relationship between us
and XL Capital and reinsurance agreements with subsidiaries of XL Capital.

We
negotiated these arrangements with XL Capital in the context of a
parent-subsidiary relationship and, although XL Capital is contractually
obligated to provide us with services during the terms of the master services
agreements, we cannot assure you that these services will be sustained at the
same level after the expiration of such agreements, or that we will be able to
replace these services in a timely manner or on comparable terms. Our costs of
procuring those services from unaffiliated third parties may, therefore,
increase as a result of our transition into a stand-alone company, which could
have a material adverse effect on our financial condition and results of
operations.

XL Capital owns approximately 63% of our
outstanding common shares and will retain the ability to exert significant
influence over us.

XL Capital
has a significant economic and voting interest in us and, therefore, is able to
exercise significant influence over us. This is primarily a result of the
following factors:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | XL Capital
  beneficially owns approximately 63% of our outstanding common shares;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|
| |  | Three of the
  members of our Board of Directors are directors or officers of XL Capital;
  and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| |  | Until XL Capitals
  ownership of our then-outstanding common shares is first reduced to 35% or
  less, XL Capital has the right, pursuant to the transition agreement, to
  nominate such number of nominees for director as would equal one nominee less
  than a majority of the total number of directors constituting our full board
  (currently four out of nine persons). Such nominees are allocated among the
  classes of our Board of Directors as follows: (i) two nominees to Class I,
  whose term will expire at our annual general meeting in 2007, (ii) one
  nominee to Class II, whose term will expire at our annual general meeting in
  2008, and (iii) one nominee to Class III, whose term will expire at our
  annual general meeting in 2009.

XL Capital
may therefore exert significant influence over, among other things, election of
our directors and determination of our business strategies, risk profile and
underwriting limits.

We cannot
assure you that the resolution of any matter that may involve the interests of
both us and XL Capital will be resolved in what investors would consider to be
in our or their best interests. In addition, our Bye-laws contain provisions
providing indemnification, exculpation and other protections to our directors,
officers and employees with respect to such matters.

Initially, XL Capitals voting percentage for
election of directors and on all other matters will be limited to 50.1% and
47.5%, respectively, of the aggregate voting power of all common shares
entitled to vote on such matters in order for the rating of our financial
guarantee insurance and reinsurance subsidiaries to not be linked directly to
those of XL Capital and its subsidiaries. If our rating agencies would permit
XL Capitals voting rights to be commensurate with its economic interest in us
(without adversely affecting our ratings), 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 other shareholders.

Pursuant to
our Bye-laws, the votes conferred by the common shares owned by XL Capital may
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. Either or both of such
limitations on XL Capital, which were established in order for the rating of
our financial guarantee insurance and reinsurance subsidiaries to not be linked
directly to those of XL Capital and its subsidiaries, shall cease to apply, or
may be adjusted upwards, upon our receipt of written confirmation from each
nationally recognized rating agency then providing a financial strength rating
for us and/or our subsidiaries that such financial strength rating is or will
be determined without reference to the ratings of XL Capital or that the then
financial strength rating issued by it will not at the time of such
confirmation be adversely affected by the elimination or adjustment of such
limitation, and, in the

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case of any adjustment (as opposed to elimination), the applicable
percentages set forth above shall automatically be adjusted to those
percentages as so determined by the foregoing; If such an event should occur,
the voting power of all other shareholders in the aggregate would
correspondingly decrease, thereby eliminating preferential voting rights of all
other shareholders.

Our financial strength or financial
enhancement ratings may be negatively affected by a downgrade in XL Capitals
ratings.

Rating
agencies examine a number of analytical, regulatory and legal factors to assess
the relationship between related entities and, therefore, whether (and to what
extent) the ratings of related entities should be linked and whether declines
in the ratings of one related entity should affect adversely the ratings of
another related entity. The ratings
of our financial guarantee insurance and reinsurance subsidiaries are not
linked directly to those of XL Capital and its subsidiaries; however, a
downgrade of the current ratings of XL Capital or its major subsidiaries by
three or more notches could subject our ratings to downward pressure unless XL
Capital significantly reduced its ownership in and degree of influence over us.

If XL Capital engages in the same type of
business we conduct, our ability to successfully operate and expand our
business may be hampered.

Our
Bye-laws provide that neither XL Capital nor any person controlled by XL
Capital will have any obligation to refrain from:

| |   |                                                                                     
| | - | ------------------------------------------------------------------------------------
| |  | engaging in the
  same or similar business activities or lines of business as us; or
|
| |  | doing business
  with any of our clients, competitors or vendors.                   

XL Capital
is a global insurance, reinsurance and financial risk specialist with
significant financial services businesses. In particular, XL Financial
Solutions Ltd, which we refer to as XLFS, a wholly-owned subsidiary of XL
Capital, currently arranges double-A-rated structured single obligor credit wraps,
which may be executed as credit default swaps or as financial guarantees. XL
Capital also has a significant equity ownership interest in Primus Guaranty
Ltd., a Bermuda company that, through its subsidiaries, is a triple-A-rated
provider of credit default swaps with respect to both corporate and sovereign
entities. Because of XL Capitals significant financial resources, XL Capital
could have a significant competitive advantage over us should it decide to
engage in businesses that compete directly with any of the businesses we
conduct.

Conflicts may arise between us and XL Capital
that could be resolved in a manner unfavorable to us or investors in our
securities.

Questions
relating to conflicts of interest may arise between us and XL Capital in a
number of areas. Three of our directors, each of whom was nominated to our
Board of Directors by XL Capital, are officers or directors of XL Capital,
including the chairman of our Board of Directors, who is also the chairman of
the board of directors of each of XL Capital and Primus Guaranty Ltd. Until XL
Capitals ownership of our then-outstanding common shares is first reduced to
35% or less, XL Capital will have the right, pursuant to the transition
agreement, to nominate such number of nominees for director as would equal one
nominee less than a majority of the nominees for director. Cetain of these
directors own significant numbers of XL Capital ordinary shares, and options to
purchase XL Capital ordinary shares, and all of them participate in XL Capital
pension plans. Ownership interests of our directors or officers in XL Capital
ordinary shares and participation in XL Capital pension plans, or service as a
director or officer of both our company and XL Capital, could give rise to
potential conflicts of interest when a director or officer is faced with a
decision that could have different implications for the two companies. These
potential conflicts could arise, for example, over matters such as the
desirability of an acquisition opportunity, employee retention or recruiting,
capital raising activities or our dividend policy. We cannot assure you that
any conflicts will be resolved in a manner that is in our or your best
interests, if at all.

Our
Bye-laws contain provisions relating to potential conflicts of interest and
allocation of corporate opportunities between our company, on the one hand, and
XL Capital and those of its officers, directors and employees who are also
officers, directors or employees of our company, on the other hand. These
provisions, in effect, provide that: (i) XL Capital (but only to the fullest
extent permitted by applicable law) will have no obligation to refrain from
competing with us or doing business with any of our clients, competitors or
vendors and (ii) each of our directors, officers or employees who is also a
director, officer or employee of XL Capital will have satisfied (but only to
the fullest extent permitted by applicable law) any fiduciary duties to us and
our shareholders with respect to corporate opportunities if such director,
officer or employee acts in good faith in a manner consistent with those
policies that are set forth in our Bye-laws.

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Risks Related to Taxation

U.S. taxation
of XLFA could materially adversely affect our financial condition and results
of operations.

We intend
to take the position that XLFA is not subject to U.S. tax (other than U.S.
excise tax on insurance and reinsurance premiums and withholding tax on
specified investment income from U.S. sources), because XLFA does not engage in
business in the United States through a permanent establishment in the United
States. However, because the U.S. Internal Revenue Code of 1986, as amended,
which we refer to as the Code, regulations promulgated under the Code, administrative
rulings or pronouncements, judicial decisions and treaties provide very limited
guidance (and no definitive guidance) on whether any particular set of facts
will constitute being engaged in a trade or business in the United States (or
give rise to a permanent establishment) it is unclear whether the U.S. Internal
Revenue Service, which we refer to as the IRS, could successfully challenge
our position on this issue.

If XLFA
were engaged in a trade or business in the United States and did not qualify
for benefits under the income tax treaty between Bermuda and the United States,
which we refer to as the Bermuda Treaty, XLFA would be subject to U.S. tax at
regular corporate rates on its income that is effectively connected with its
U.S. business plus an additional 30% branch profits tax on its income
remaining after the regular tax that is deemed to be distributed as a dividend.
If XLFA were to qualify for benefits under the Bermuda Treaty, it would be
subject to U.S. tax in this manner with respect to income protected by the
Bermuda Treaty only if it were engaged in a trade or business in the United
States and that trade or business were conducted though a permanent
establishment in the United States. The Bermuda Treaty clearly applies to
premium income but it is unclear whether the treaty applies to other income
such as investment income. If XLFA were found to be engaged in a trade or
business in the United States and were entitled to the benefits of the Bermuda
Treaty in general, but the Bermuda Treaty were found not to protect investment
income, a portion of XLFAs investment income could be subject to U.S. income
tax.

Any
taxation of the kind described above could materially adversely affect our
financial condition and results of operations.

Our U.S. subsidiary may be subject to
additional taxes.

Our U.S.
subsidiary, XLCA, conducts business in the United States and currently expects
to reinsure a majority of its future business with XLFA. While we believe that
this reinsurance is written on arms-length terms, we cannot assure you that
(1) the IRS will not assert that the reinsurance is not on arms-length terms
or (2) any such assertion by the IRS will not be successful. If such an
assertion were successful, XLCA would be treated as having additional income
that is subject to additional U.S. tax, and possibly associated interest and
penalties. The IRS might also treat this additional income as having been
distributed as dividends to XLCAs parent, SCA, in which case this deemed
dividend would also be subject to a withholding tax of 30%. A similar analysis
(and similar tax risks) may also apply to other intercompany income and expense
items between XLCA and its non-U.S. affiliates, such as ceding commissions,
other intercompany fees and allocation of corporate overhead. If any of these
circumstances were to occur, our financial condition and results of operations
could be materially adversely affected.

Our U.K. subsidiary may be subject to
additional taxes.

Our U.K.
subsidiary, XL Capital Assurance (U.K.) Limited, which we refer to as
XLCA-UK, conducts business in the United Kingdom and currently expects to
reinsure a majority of its future business via a quota share reinsurance treaty
with XLCA. While we believe that this reinsurance is written on arms-length
terms, we cannot assure you that (1) the U.K. fiscal authority, which we refer
to as HMRC, will not assert that the reinsurance is not on arms-length terms
or (2) any such assertion by HMRC will not be successful. If such an assertion
were successful, our U.K. subsidiary would be treated as having additional
income that is subject to additional U.K. tax, and possibly associated interest
and penalties.

XLCA-UK has
also entered into an excess of loss reinsurance agreement with XLCA whereby it
cedes 100% of net incurred losses in excess of 10% of XLCA-UKs capital and
surplus, up to an aggregate limit of $50 million. While we believe that this
reinsurance is written on arms-length terms, we cannot assure you that (1)
HMRC will not assert that the reinsurance is not on arms-length terms or (2)
any such assertion by HMRC will not be successful. If such an assertion were
successful, our U.K. subsidiary would be treated as having additional income that is subject to additional U.K. tax, and
possibly associated interest and penalties.

If
any of these circumstances were to occur, our financial condition and results
of operations could be materially adversely affected.

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There is U.S. income tax risk associated with
reinsurance between U.S. insurance companies and their Bermuda affiliates.

Congress
has periodically considered legislation intended to eliminate certain perceived
tax advantages of Bermuda insurance companies and U.S. insurance companies
having Bermuda affiliates, including perceived tax benefits resulting
principally from reinsurance between or among U.S. insurance companies and
their Bermuda affiliates. In this regard, Section 845 of the Code was amended
in 2004 to permit the IRS to reallocate, recharacterize or adjust items of
income, deduction or certain other items related to a reinsurance agreement
between related parties to reflect the proper source, character and amount
for each item (in contrast to prior law, which only covered source and
character). If the IRS were to successfully challenge our reinsurance
arrangements under Section 845, our financial condition and results of
operations could be materially adversely affected.

There are U.S. income tax risks associated
with the controlled foreign corporation rules under the U.S. Internal Revenue
Code.

Each
United States shareholder of a non-U.S. corporation that is a controlled
foreign corporation, which we refer to as a CFC, for an uninterrupted period
of 30 days or more during a tax year and that owns shares in the CFC on the
last day of the non-U.S. corporations taxable year on which it is a CFC must
include in its gross income for U.S. federal income tax purposes its ratable
share of the CFCs subpart F income, even if the subpart F income is not
distributed. Subpart F income of a non-U.S. insurance corporation typically
includes foreign personal holding company income (such as interest, dividends
and other types of passive income), as well as insurance and reinsurance income
(including underwriting and investment income) attributable to the insurance of
risks situated outside the CFCs country of incorporation. In general, any U.S.
person who owns, directly or indirectly through non-U.S. persons, or is
considered to own under applicable constructive ownership rules of the Code,
10% or more of the total combined voting power of all classes of stock of a
non-U.S. corporation will be considered to be a United States shareholder. In
general, a non-U.S. insurance company (such as XLFA) will be treated as a CFC
if United States shareholders collectively own (directly, indirectly or
constructively) more than 25% of the total combined voting power or total value
of its stock on any day during its tax year. More expansive definitions of
United States shareholder and CFC may apply with respect to RPII (as
defined below).

Although we
may be or become a CFC, we believe that, because of the dispersion of our share
ownership among holders other than XL Capital and the fact that our Bye-laws
provide that no single holder (other than XL Capital or its consolidated
subsidiaries or, in certain circumstances, up to three transferees thereof) is
permitted to exercise more than 9.5% of the total combined voting power of our
company, investors in our common shares should not be subject to treatment as
United States shareholders of a CFC (except to the extent that special
provisions governing RPII (as defined below) apply). However, because of legal
and factual uncertainties, it is unclear whether the CFC rules may apply to
holders of our common shares. Accordingly, U.S. persons should consider the
possible application of the CFC rules.

There are U.S. income tax risks associated
with the related person insurance income of our non-U.S. insurance
subsidiaries.

If (i) the
related person insurance income, which we refer to as RPII, of any one of our
non-U.S. insurance subsidiaries were to equal or exceed 20% of that subsidiarys
gross insurance income in any taxable year and (ii) U.S. persons were treated
as owning 25% or more of the subsidiarys stock (by vote or value), a U.S.
person who owns any common shares, directly or indirectly, on the last day of
such taxable year on which the 25% threshold is met would be required to
include in its income for U.S. federal income tax purposes that persons
ratable share of that subsidiarys RPII for the taxable year, determined as if
that RPII were distributed proportionately only to U.S. holders at that date,
regardless of whether that income is distributed. The amount of RPII earned by
a subsidiary (generally, premium and related investment income from the direct
or indirect insurance or reinsurance of any direct or indirect U.S. holder of
shares of that subsidiary or any person related to that holder) will depend on
a number of factors, including the identity of persons directly or indirectly
insured or reinsured by that subsidiary. Although we do not believe that the
20% threshold will be met in respect of any of our non-U.S. insurance
subsidiaries, some of the factors that may affect the result in any period may
be beyond our control. Consequently, we cannot assure you that we will not
exceed the RPII threshold in any taxable year.

The RPII
rules provide that if a holder who is a U.S. person disposes of shares in a
non-U.S. insurance corporation that had RPII (even if the 20% threshold was not
met) and met the 25% threshold at any time during the five-year period ending
on the date of disposition, and the holder owned any stock at such time, any
gain from the disposition will generally be treated as a dividend to the extent
of the holders share (taking into account certain rules

41

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for determining a U.S. holders share of RPII) of the corporations
undistributed earnings and profits that were accumulated during the period that
the holder owned the shares (possibly whether or not those earnings and profits
are attributable to RPII). In addition, such a shareholder will be required to
comply with specified reporting requirements, regardless of the amount of
shares owned. We believe that these rules should not apply to dispositions of
our common shares because SCA is not itself directly engaged in the insurance
business. We cannot assure you, however, that the IRS will not successfully
assert that these rules apply to dispositions of our common shares.

U.S. holders who hold our common shares will
be subject to adverse tax consequences if we are considered to be a passive
foreign investment company for U.S. federal income tax purposes.

If we are
considered to be a passive foreign investment company, which we refer to as a
PFIC, for U.S. federal income tax purposes, a U.S. holder who owns any of our
common shares will be subject to adverse tax consequences, including a greater
tax liability than might otherwise apply and an interest charge on certain
taxes that are deferred by virtue of our non-U.S. status. In addition, if we
were considered a PFIC, upon the death of any U.S. individual owning our common
shares, such individuals heirs or estate would not be entitled to a step-up
in the basis of such common shares, which might otherwise be available under
U.S. federal income tax laws. We currently do not expect to be a PFIC for U.S.
federal income tax purposes in 2006 or in the foreseeable future. We cannot
assure you, however, that we will not be deemed a PFIC by the IRS. There are
currently no regulations regarding the application of the PFIC provisions to
an insurance company. New regulations or pronouncements interpreting or clarifying
such provisions may be forthcoming. We cannot predict what impact, if any, such
guidance would have on an investor that is subject to U.S. federal income
taxation.

U.S. tax-exempt entities may recognize
unrelated business taxable income.

If any
non-U.S. insurance subsidiary owned by us is considered a CFC in general (or
with respect to RPII), tax-exempt entities
that are considered United States shareholders of such non-U.S. insurance
subsidiary (or with respect to RPII, U.S. persons that hold any of our
common shares) will be required to treat their proportionate share of all of
such subsidiarys insurance and reinsurance income (or all of such subsidiarys
RPII) as unrelated business taxable income that generally is subject to tax,
whether or not such income is currently distributed.

Changes in U.S. tax law might adversely
affect an investment in our shares.

The tax
treatment of non-U.S. companies and their U.S. and non-U.S. insurance
subsidiaries has been the subject of Congressional discussion and legislative
proposals. For example, one legislative proposal would impose additional limits
on the deductibility of interest by foreign-owned U.S. corporations. Another
legislative proposal would treat a non-U.S. corporation as a U.S. corporation
for U.S. federal income tax purposes if it were considered to be primarily
managed and controlled in the U.S. We cannot assure you that future legislative
action will not increase the amount of U.S. tax payable by us. If this happens,
our financial condition and results of operations could be materially adversely
affected.

Additionally,
the U.S. federal income tax laws and interpretations, including those regarding
whether a company is engaged in a trade or business (or has a permanent
establishment) within the United States or is a PFIC, or whether U.S. holders
would be required to include in their gross income subpart F income or the
RPII of a CFC, are subject to change, possibly on a retroactive basis. There
are currently no regulations regarding the application of the PFIC rules to
insurance companies and the regulations regarding RPII are still in proposed
form. New regulations or pronouncements interpreting or clarifying such rules
may be forthcoming. We cannot be certain if, when or in what form such
regulations or pronouncements may be provided and whether such guidance will
have a retroactive effect.

Bermuda and the Organisation for Economic
Co-operation and Development are considering measures that might change the
manner in which we are taxed.

The
Organisation for Economic Co-operation and Development, which we refer to as
OECD, has published reports and launched a global dialogue among member and
non-member countries on measures to limit harmful tax competition. These
measures are largely directed at counteracting the effects of tax havens and
preferential tax regimes in countries around the world. In OECDs report of
April 18, 2002, as updated as of June 2004, Bermuda was not listed as an
uncooperative tax haven jurisdiction because it had previously committed to
eliminate harmful tax practices and to embrace international tax standards for
transparency, exchange of information and the elimination of any aspects of the
regimes for financial and other services that attract business with no
substantial domestic activity. We are not able to predict what changes will
arise from this commitment or whether such changes will subject us to additional
taxes.

42

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In
addition, on June 27, 2005, OECD issued a discussion draft, Attribution
of Profits to a Permanent EstablishmentRelease of Discussion Draft of Part IV
(Insurance), which we refer to as the Draft, which constitutes
the fourth and final part of the report on OECDs project to establish a broad
consensus regarding the interpretation and practical application of Article 7
of the OECD Model Tax Convention on Income and on Capital, which we refer to as
Article 7. Article 7 sets forth international tax principles for attributing
profits to a permanent establishment and forms the basis of an extensive
network of bilateral income tax treaties between OECD member countries and
between many OECD member and non-member countries. Once finalized, the
conclusions of Parts I-IV of the report will be implemented through revision of
the Commentary on Article 7 and/or Article 7 itself. Section C of the Draft
discusses the application of the 1995 OECD Transfer Pricing Guidelines to
insurance business conducted between associated enterprises and, if adopted in
its current form, might change the manner in which we are taxed and could
therefore impact our future after-tax profitability. We cannot predict the
effect of any such changes.

Risks Related to Ownership of Our Common
Shares

Because we are a holding company and
substantially all of our operations are conducted by our subsidiaries, our
ability to meet any ongoing cash requirements, including any debt service
payments or other expenses, and to pay dividends on our common shares in the
future will depend on our ability to obtain cash dividends or other cash
payments or obtain loans from our subsidiaries, which are regulated insurance
companies that depend upon ratings from independent rating agencies. Our
subsidiaries ability to pay dividends, or make loans, to us is consequently
limited by regulatory and rating agency constraints.

We conduct
substantially all of our operations through our subsidiaries and our
subsidiaries generate substantially all of our operating income and cash flow.
Our ability to meet our ongoing cash requirements, including any debt service
payments or other expenses, and pay dividends on our common shares in the
future will depend on our ability to obtain cash dividends or other cash
payments or obtain loans from our subsidiaries and will also depend on the
financial condition of our subsidiaries. Our subsidiaries are separate and
distinct legal entities that will have no obligation to pay any dividends or to
lend or advance us funds and may be restricted from doing so by contract,
including other financing arrangements, charter provisions or applicable legal,
regulatory requirements of the various countries that they operate in,
including Bermuda, the United States and the U.K., or rating agency
constraints.

In
connection with our IPO, XLCA and XLFA have each agreed with certain of the
rating agencies that, until the second anniversary of the IPO each will not
declare or grant dividends on its common stock without the prior written
consent of those ratings agencies, other than to fund certain parent holding
company operating expenses and debt service requirements and to fund dividends
on our preferred stock and nominal dividends on our common stock.

Under New
York Insurance Law, XLCA may pay a shareholder dividend only if it files notice
of its intention to declare such dividend and the amount thereof with the New
York Superintendent of Insurance, which we refer to as the New York
Superintendent, and the New York Superintendent does not disapprove such
dividend. In addition, New York Insurance law contains a test governing the
amount of dividends that XLCA can pay in any year and, as a result of the
application of such test, XLCA cannot currently pay dividends, without notice
to, and prior approval from, the New York Superintendent. We cannot assure you
that XLCA will have statutory earnings to support the payment of dividends to
us in an amount sufficient to fund our cash requirements and pay cash dividends
or that the New York Superintendent will not disapprove, or will approve, as
applicable, any dividends that XLCA may seek to pay to us.

XLFA
    is subject to Bermuda regulatory constraints that will affect its ability
    to pay dividends on its common shares and to make other payments to us. Under
Bermudas Insurance Act 1978, as amended, and related regulations, which
we refer to as the Insurance Act, XLFA is required to maintain a
minimum solvency margin and minimum liquidity ratio and is prohibited from declaring
or paying dividends if such payment would result in its non-compliance with these
requirements. In addition, under the Companies Act 1981 of Bermuda, as amended,
which we refer to as the Companies Act, XLFA may not declare or pay
a dividend, or make a distribution out of its contributed surplus, if there are
reasonable grounds for believing that (1) it is, or would after the payment be,
unable to pay its liabilities as they become due; or (2) the realizable value
of its assets would thereby be less than the aggregate of its liabilities and
its issued share capital and share premium accounts (as such terms are defined
in the Companies Act). Furthermore, in order to reduce its total statutory
capital by 15% or more, XLFA would require the prior approval of the BMA.

XLCA-UK is
also subject to significant regulatory restrictions limiting its ability to
declare and pay dividends. See BusinessRegulation.

43

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The
inability of our subsidiaries to pay dividends in an amount sufficient to
enable us to meet our cash requirements could have a material adverse effect on
us and the value of our common shares.

Our subsidiaries ratings are not evaluations
directed to the protection of investors in our common shares.

The ratings
of our insurance and reinsurance subsidiaries, as described under
BusinessRatings and elsewhere in this document, reflect each rating agencys
current opinion of these subsidiaries respective financial strength, operating
performance and ability to meet obligations to policyholders and contract
holders. These factors are of concern to policyholders, contract holders and
lenders. Ratings are not evaluations directed to the protection of investors in
our common shares. They are not ratings of our common shares and should not be
relied upon when making a decision to buy, hold or sell our common shares or
any other security. In addition, the standards used by rating agencies in
determining financial strength are different from capital requirements set by
state insurance regulators. We may need to take actions in response to changing
standards set by any of the rating agencies, as well as statutory capital
requirements, which could adversely affect the market price of our common
shares.

Future sales of our common shares may
adversely affect the market price of our common shares.

As of
December 31, 2006, we have 64,136,364 common shares outstanding (not
including approximately 497,928 restricted common shares issued to our
management), of which 40,696,471 shares, or approximately 63%, are owned by
XLI. These shares owned by XLI are restricted securities subject to the
volume limitations and other conditions of Rule 144 under the Securities Act of
1933, as amended, which we refer to as the Securities Act. Furthermore, XLI
and its transferees have the right to require us to register these common
shares under the Securities Act for sale to the public. Following any
registration of this type, the common shares to which the registration relates
will be freely transferable. In addition, we have registered on Form S-8 under
the Securities Act common shares under the Security Capital Assurance Ltd 2006
Long-Term Incentive and Share Award Plan. We cannot predict what effect, if
any, future sales of our common shares, or the availability of common shares
for future sale, will have on the market price of our common shares. Sales of
substantial amounts of our common shares in the public market, or the
perception that sales of this type could occur, could depress the market price
of our common shares and may make it more difficult for you to sell your common
shares at a time and price that you deem appropriate.

There are provisions in our Bye-laws that,
subject to certain exceptions, reduce the voting rights of common shares that
are held by a person or group to the extent that such person or group holds
more than 9.5% of the aggregate voting power of all common shares entitled to
vote on a matter.

In general,
and except as provided below, shareholders have one vote for each common share
held by them and are entitled to vote at all meetings of shareholders. However,
if, and for so long as (and whenever), the common shares of a shareholder,
including any votes conferred by controlled shares (as defined in our
Bye-laws), would otherwise represent more than 9.5% of the aggregate voting
power of all common shares entitled to vote on a matter, including an election
of directors, the votes conferred by such shares will be reduced by whatever
amount is necessary such that, after giving effect to any such reduction (and
any other reductions in voting power required by our Bye-laws), the votes
conferred by such shares represent 9.5% of the aggregate voting power of all
common shares entitled to vote on such matter, provided that the foregoing
restrictions do not apply to common shares held by XL Capital or its
consolidated subsidiaries or, in certain circumstances, up to three transferees
thereof. Controlled shares include, among other things, all shares of SCA
that a person is deemed to own directly, indirectly (applying the provisions of
section 958(a)(2) of the Code) or constructively (applying the provisions of
section 318(a) of the Code, as modified by the rules of section 958(b)(1)
through (4) of the Code), or, as a result of such person being a member of a
group under applicable SEC rules. At December 31, 2006, there were 64,136,364
common shares outstanding (not including 497,928 shares issued to our
management), of which approximately 6,092,954 common shares would confer votes
that represent 9.5% of the aggregate voting power of all common shares entitled
to vote generally at an election of directors, assuming that all shares have
one vote, or approximately 4,462,505 common shares would confer votes that
represent 9.5% of the aggregate voting power of all common shares entitled to
vote generally at an election of directors as a result of limitation on XL
Capitals voting power contained in our Bye-laws. An investor who does not
hold, and is not deemed under the provisions of our Bye-laws to own, any of our
common shares may therefore purchase up to 4,273,616
common shares without being subject to voting cutback provisions in our
Bye-laws.

44

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There are provisions in our Bye-laws which
may limit a shareholders voting rights if our Board of Directors determines to
do so to avoid certain material adverse legal, tax or regulatory consequences.

Our
Board of Directors may limit a shareholders voting rights where it deems it
appropriate to do so to avoid certain material adverse tax, legal or regulatory
consequences to us or any of our subsidiaries or any shareholder or its
affiliates. These consequences may include subjecting us or our subsidiaries to
insurance regulatory requirements in jurisdictions in which we would not
otherwise be subject or subjecting us, or our subsidiaries or shareholders to
adverse tax consequences due to a particular persons ownership of our shares.
See Certain Tax Considerations. We also
have the authority under our Bye-laws to request information from any
shareholder for the purpose of determining ownership of controlled shares by
such shareholder. It is expected that our Board of Directors would
provide, to the extent they deem appropriate and without subjecting us or our
shareholders to such material adverse consequences, appropriate notification to
the applicable shareholder and an opportunity to make an appropriate
presentation to our management or Board prior to so limiting any shareholders
voting rights.

There are provisions in our Bye-laws that may
restrict shareholders ability to transfer common shares and, therefore, may
affect the liquidity of common shares.

Our Board
of Directors may decline to approve or register a transfer of any common shares
(1) if it appears to the Board of Directors, after taking into account the
limitations on voting rights contained in our Bye-laws, that any adverse tax,
regulatory or legal consequences to us, any of our subsidiaries or any of our
shareholders or their respective affiliates would result from such transfer
(other than such as our Board of Directors considers to bede minimis), (2) if the
Board of Directors does not receive a written opinion from counsel supporting
the legality of the transaction under U.S. securities laws and approval from
appropriate governmental authorities if any such approval is required, provided
that no such opinion shall be required if it is inconsistent with the
applicable requirements of any applicable stock exchange or (3) if the
transferee has not been approved by applicable governmental authorities (if
such approval is required) or if the transfer is not in compliance with applicable
consent, authorization or permission of any governmental body or agency in
Bermuda. These restrictions in our Bye-laws could adversely affect the
liquidity of the common shares that you own.

Bermuda Law and our Bye-laws provide broad
indemnity and exculpation protections for the benefit of our officers,
directors and employees.

Under
Bermuda law and our Bye-laws, we will indemnify our officers, directors and
employees to the full extent permitted by Bermuda law and none of our officers,
directors or employees would be personally liable to us or our shareholders,
unless in any such case such officer, director or employee is found, by a court
of competent jurisdiction in a final judgment or decree not subject to appeal,
guilty of any fraud or dishonesty in relation to our company.

Provisions in our Bye-laws could impede an
attempt to replace or remove our directors or change the direction or policies
of our company, which could diminish the value of our common shares.

Our
Bye-laws contain provisions that may make it more difficult for shareholders to
replace directors, or effect a change in corporate policy or direction, even if
the shareholders consider it beneficial to do so. In addition, these provisions
could delay or prevent a change of control that a shareholder might consider
favorable. For example, these provisions may prevent a shareholder from
receiving the benefit from any premium over the market price of our common
shares offered by a bidder in a potential takeover. Even in the absence of an
attempt to effect a change in management or a takeover attempt, these
provisions may adversely affect the prevailing market price of our common
shares if they are viewed as discouraging takeover attempts in the future.

For
example, our Bye-laws contain the following provisions that could have such an
effect:

| |   |                                                                                                                                                                                                                           
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | election of our
  directors is staggered, meaning that the members of only one of three classes
  of our directors are elected each year;                                                                                 
| |   |                                                                                                                                                                                                                           
| |  | shareholders may
  not remove directors except for cause (as defined in our Bye-laws) and only
  by the affirmative vote of at least 66-2/3% of the votes cast at a general
  meeting;                                    
| |   |                                                                                                                                                                                                                           
| |  | our Bye-laws
  recognize the right of XL Capital, pursuant to the transition agreement, to
  nominate such number of nominees for director as would equal one nominee less
  than a majority of the nominees for director;

45

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | if the controlled
  shares (as defined in our Bye-laws) of any person (other than XL Capital or
  its consolidated subsidiaries or, in certain circumstances, up to three
  transferees thereof) confer votes representing more than 9.5% of the
  aggregate voting power of all common shares entitled to vote on a matter,
  including an election of directors, the number of such votes shall be reduced
  by whatever amount is necessary such that, after giving effect to any such
  reduction (and any other reductions in voting power required by our
  Bye-laws), votes conferred by such shares represent 9.5% of the aggregate
  voting power of all common shares entitled to vote on such matter;                                                                                                                                                                                                                  
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |  | our Board of
  Directors may decline to approve or register the transfer of any common
  shares on our share register if it appears to the Board of Directors, after
  taking into account the limitations on voting rights contained in our
  Bye-laws, that any adverse tax, regulatory or legal consequences to us, any
  of our subsidiaries or any of our shareholders or their respective affiliates
  would result from such transfer (other than such as our Board of Directors
  considers to be de minimis) or, if the Board of Directors does not
  receive: (i) a written opinion from counsel supporting the legality of the
  transaction under U.S. securities laws, provided that no such opinion will be
  required if it is inconsistent with the applicable requirements of any
  applicable stock exchange and (ii) approval from appropriate governmental
  authorities if any such approval is required; and
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |  | shareholders may
  not pass a written resolution with respect to any matter unless such
  resolution is signed by all of the shareholders who at the date of such
  resolution would otherwise be entitled to attend a meeting and vote on such
  resolution.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

There are
regulatory limitations on the ownership and transfer of our common shares.

The BMA must
approve all issuances and transfers of securities of a Bermuda exempted company
like us. We have received permission from the BMA to issue our common shares,
and for the free transferability of our common shares as long as the shares are
listed on the New York Stock Exchange or other appointed exchange, to and among
persons who are non-residents of Bermuda for exchange control purposes and up
to 20% of the common shares to and among persons who are residents of Bermuda
for exchange control purposes. Any other transfers remain subject to approval
by the BMA.

Shareholders of our company may have greater
difficulties in protecting their interests than as a shareholder of a U.S.
corporation.

The
Companies Act, which applies to our company, differs in material respects from
laws generally applicable to U.S. corporations and their shareholders. Taken
together with the provisions of our Bye-laws, some of these differences may
result in your having greater difficulties in protecting your interests as a
shareholder of our company than you would have as a shareholder of a U.S.
corporation. This affects, among other things, the circumstances under which
transactions involving an interested director are voidable, whether an
interested director can be held accountable for any benefit realized in a
transaction with our company, what approvals are required for business
combinations by our company with a large shareholder or a wholly-owned
subsidiary, what rights you may have as a shareholder to enforce specified
provisions of the Companies Act or our Bye-laws, and the circumstances under
which we may indemnify our directors and officers.

We are a Bermuda company and it may be
difficult for our shareholders to enforce judgments against us or against our
directors and executive officers.

We were
incorporated under the laws of Bermuda and our business is based in Bermuda. In
addition, certain of our directors and officers reside outside the United
States, and a portion of our assets and the assets of such persons may be
located in jurisdictions outside the United States. As such, it may be
difficult or impossible to effect service of process within the United States
upon us or those persons, or to recover against us or them on judgments of U.S.
courts, including judgments predicated upon the civil liability provisions of
the U.S. federal securities laws. Further, no claim may be brought in Bermuda
against us or our directors and officers in the first instance for violation of
U.S. federal securities laws because these laws have no extraterritorial
application under Bermuda law and do not have force of law in Bermuda; however,
a Bermuda court may impose civil liability, including the possibility of
monetary damages, on us or our directors and officers if the facts alleged in a
complaint constitute or give rise to a cause of action under Bermuda law.

46

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We have
been advised by Bermuda counsel, that there is doubt as to whether the courts
of Bermuda would enforce judgments of U.S. courts obtained in actions against
us or our directors and officers predicated upon the civil liability provisions
of the U.S. federal securities laws, or original actions brought in Bermuda
against us or such persons predicated solely upon U.S. federal securities laws.
Further, we have been advised by Bermuda counsel that there is no treaty in
effect between the United States and Bermuda providing for the enforcement of
judgments of U.S. courts in civil and commercial matters, and there are grounds
upon which Bermuda courts may decline to enforce the judgments of U.S. courts.
Some remedies available under the laws of U.S. jurisdictions, including some
remedies available under the U.S. federal securities laws, may not be allowed
in Bermuda courts as contrary to public policy in Bermuda. Because judgments of
U.S. courts are not automatically enforceable in Bermuda, it may be difficult
for you to recover against us based upon such judgments.

ITEM 1B. UNRESOLVED
STAFF COMMENTS

None

ITEM 2. PROPERTIES

We
and our subsidiaries currently lease office space in Bermuda; New York, New York;
Norwalk, Connecticut; Walnut Creek, California; London; Madrid and Singapore.

47

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ITEM 3. LEGAL PROCEEDINGS

In the
ordinary course of business, we are 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.

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

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF
SECURITY HOLDERS

No matters
were submitted to a vote of ordinary shareholders during the fourth quarter of
the fiscal year covered by this report.

Executive Officers of the Company

The
following table provides information regarding our executive officers and key
employees as of December 31, 2006:

|                        |  |     |  |                                                                                   
|----------------------- |  | --- |  | ----------------------------------------------------------------------------------
|Name                    |  | Age |  | Position(s)                                                                       
|Paul S. Giordano        |  | 44  |  | President and
  Chief Executive Officer; Director                                 
|David P. Shea           |  | 51  |  | Executive Vice
  President and Chief Financial Officer                            
|Edward B. Hubbard       |  | 47  |  | Executive Vice
  President and Chief Operating Officer                            
|Michael E. Rego         |  | 46  |  | Executive Vice
  PresidentFinancial Guarantee Reinsurance                        
|Richard P.
  Heberton   |  | 48  |  | Senior Managing
  Director and Chief Credit Officer of XLCA                       
|Thomas W. Currie,
  CFA |  | 47  |  | Senior Vice
  President and Chief Risk Officer; Chief Underwriting Officer of XLFA
|T. Wynne Morriss,
  Jr. |  | 45  |  | Head of
  Origination, XLCA                                                       
|Claude L. LeBlanc       |  | 41  |  | Executive Vice President
  Corporate Development & Strategy                      
|Orlando Rivera          |  | 45  |  | Head of Human Resources                                                           

Paul
S. Giordanohas been President, Chief Executive Officer and a director of SCA since
its formation and Chairman and Chief Executive Officer of XLCA since March 2005
and March 2006, respectively. Mr. Giordano has recently served as Executive
Vice President and Chief Executive of Financial Products and Services
Operations for XL Capital. Mr. Giordano previously served as General Counsel of
XL Capital from January 1997 to November 2004. Mr. Giordano has also been a
director of Primus Guaranty Ltd. since May 2005. Mr. Giordano was associated
with Cleary, Gottlieb, Steen & Hamilton and Clifford Chance in New York and
London prior to joining XL Capital.

David
P. Sheahas been Executive Vice President and Chief Financial Officer of SCA since its
formation. From March 2003 to August 2006, Mr. Shea served as Chief Financial
& Administrative Officer of Financial Products and Services Operations for
XL Capital. Prior to joining XL Capital, Mr. Shea held various senior
management positions during his 17-year career at General Electric Company,
most recently as Chief Financial Officer and Treasurer at Financial Guaranty
Insurance Company from April 2001 to March 2003.

Edward
B. Hubbardhas been Executive Vice President-Financial Guarantee Insurance of SCA
since its formation. Mr. Hubbard has served as President and Chief Operating
Officer of XLCA since June 2004 and previously served as Chief Financial
Officer and Chief Administrative Officer of XLCA from February 2000 to June
2004. Prior to joining XLCA, Mr. Hubbard was a Managing Director at MBIA
Insurance Corporation from February 1998 to February 2000. Mr. Hubbard worked
in a variety of positions, including Senior Vice President and Treasurer, at
Capital Markets Assurance Corporation from April 1990 to February 1998, when
MBIA Inc. acquired Capital Markets Assurance Corporation.

48

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Michael
E. Regohas been Executive Vice PresidentFinancial Guarantee Reinsurance of SCA since
its formation. Mr. Rego has served as Executive Vice President and Chief
Operating Officer of XLFA since July 2004 and previously served as Chief
Operating Officer of XLCA-UK from May 2002 to July 2004 and as Vice President
of XLI from December 1997 to July 2000. Prior to joining XLI, Mr. Rego worked
at the Bank of Bermuda Ltd from September 1982 to November 1997.

Richard
P. Hebertonhas been Senior Managing Director and Chief Credit Officer of XLCA
since April 2005. Mr. Heberton previously served as Head of Surveillance of
XLCA from February 2000 to April 2005. Prior to joining XLCA, Mr. Heberton was
a director and a manager in the Insured Portfolio Management department at MBIA
Insurance Corporation.

Thomas
W. Currie, CFAhas been Senior Vice President and Chief Risk Officer of SCA since its
formation. Mr. Currie has served as Chief Underwriting Officer of XLFA since
February 2002. Prior to joining XLFA, Mr. Currie was a structured finance bond
analyst in the new assets group at Standard & Poors, a division of The
McGraw-Hill Companies, Inc.

T.
Wynne Morriss, Jr.has been Head of Origination at XLCA since October
2006. Mr. Morriss previously led XLCAs public finance, global infrastructure,
power & utilities, and specialized risk product groups. He has been at XLCA
and its predecessor companies since March 1999, and has served in a number of
other capacities, including as XLCAs General Counsel. Prior to joining XLCA,
Mr. Morriss served as associate general counsel at CapMAC Holdings, Inc. and
subsequently at MBIA Insurance Corporation when it acquired CapMAC in 1998. Mr.
Morriss practiced law for seven years with Sidley & Austin and Skadden, Arps,
Slate, Meagher & Flom.

Claude L
LeBlancjoined SCA in November 2006 as Executive Vice
PresidentCorporate Development and Strategy. Mr. LeBlanc previously served as
Senior Vice PresidentCorporate Development for XL Capital Ltd from April 2002
to November 2006. Prior to joining XL Capital Ltd, Mr. LeBlanc served in a
variety of senior financial and operating roles, including Chief Operating
Officer for TransWorld Network International and Vice President Financial
Advisory Services for PricewaterhouseCoopers where he advised on mergers and
acquisition, due diligence, financing and transaction structuring.

Orlando Riverahas been Head of Human Resources of SCA since its formation. Prior to being appointed to this role, Orlando served as Human Resources Global Generalist for XL Capital's Financial Products & Services segment from October 2003 to August 2006. Before joining XL Capital, he was head of Human Resources for Gen Re Securities’ U.S. business and has more than 20 years professional experience in human resources positions in the financial services industry.

PART II

All amounts presented in this part are in U.S. dollars except as otherwise noted.

ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY,
RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The
Companys common shares, $0.01 par value, are listed on the New York Stock
Exchange under the symbol SCA.

The
following table sets forth the high, low and closing sales prices per share, as
reported on the New York Stock Exchange Composite Tape, of the Companys common
shares per fiscal quarter commencing from the Companys initial public offering
on August 4, 2006.

|            |   |      |       |     |  |       |   |  |       | 
|----------- | - | ---- | ----- | --- |  | ----- | - |  | ----- | 
|            |   | High |       | Low |  | Close |  
|            |   |      |       |     |  |       |  
|2006:       |   |      |       |     |  |       |  
|3rd Quarter | $ |      | 24.50 | $   |  | 20.50 | $ |  | 23.95 | 
|4th Quarter | $ |      | 28.16 | $   |  | 22.92 | $ |  | 27.83 | 

49

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Each
common share has one vote. However, 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.

There
were approximately 2,900 record holders of our common shares as of December 31,
2006. This figure does not represent the actual number of beneficial owners of
the our Class A ordinary shares because such shares are frequently held in
street name by securities dealers and others for the benefit of individual
owners who may vote the shares.

The
declaration and payment of future dividends by us will be at the discretion of
the Board of Directors and will depend upon many factors, including the
Companys earnings, financial condition, business needs, capital and surplus
requirements of the Companys operating subsidiaries and regulatory and
contractual restrictions.

As a
holding company, SCAs ability to meet its cash requirements (including any
dividends on its common shares, if and when declared) depends upon the receipt
of dividends from its operating subsidiaries, if declared and paid, and
investment income on assets held by it from the proceeds of the IPO, offset by
expenses incurred for employee compensation and other expenses incurred as a
stand-alone public company. The payment of dividends from our operating
subsidiaries is subject to regulatory and other restrictions. In 2006, one
quarterly dividend was paid by SCA in the amount of $0.02 per share to all
common shareholders of record as of December 11, 2006. Also, on February 27,
2007, our board of directors declared a dividend of $.02 per common share,
which is payable on March 30, 2007 to shareholders of record on March 15, 2007.
For further information see Managements Discussion and Analysis of Financial
Condition and Results of Operations  Liquidity and Capital Resources.

Information
concerning securities authorized for issuance under equity compensation plans
appears in Part III, Item 12, Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters.

Common Share Performance Graph

Set
    forth below is a line graph comparing the monthly dollar change in the cumulative
    total shareholder return from the effective date of our IPO through December
    31, 2006 as compared to the cumulative total return during such period of
    the Standard & Poors 500 Stock Index and the cumulative total return
    of the Standard & Poors 500 Financial Stock Index. This graph assumes
    an equal measurement point of $100 of invested value on August 1, 2006, with
all dividends reinvested.



Purchases of Equity Securities by the Issuer and Affiliate Purchases

None

50

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ITEM 6. SELECTED FINANCIAL INFORMATION

The
following table presents our selected consolidated financial and operating
data. The financial data set forth below for the years ended December 31, 2006,
2005, 2004, 2003 and 2002 are derived from our consolidated financial
statements. The financial data as at December 31, 2006 and 2005 and for the
years ended December 31, 2006, 2005, and 2004 have been audited. The
information set forth below should be read together with Managements Discussion
and Analysis of Financial Condition and Results of Operations and our
consolidated financial statements and related notes included in Item 8.

|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|------------------------------------------------------------------ |  | ----------------------- | ------- | - | - | ------- | - | - | ------- | - | - | ------- | - | - | ------- | -
|                                                                   |  | Year Ended December 31, |        
|                                                                   |  |                         |        
|(in
  thousands,
  except per share amounts)                       |  |                         | 2006    |   |   | 2005    |   |   | 2004    |   |   | 2003    |   |   | 2002    |  
|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Statement of operations data:                                      |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Gross premiums written                                             |  | $                       | 353,728 |   | $ | 233,269 |   | $ | 232,541 |   | $ | 260,321 |   | $ | 161,108 |  
|Reinsurance premiums assumed                                       |  |                         | 55,271  |   |   | 52,170  |   |   | 44,021  |   |   | 59,131  |   |   | 36,899  |  
|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Total premiums written                                             |  |                         | 408,999 |   |   | 285,439 |   |   | 276,562 |   |   | 319,452 |   |   | 198,007 |  
|Ceded premiums                                                     |  |                         | (13,067 | ) |   | (40,527 | ) |   | (8,123  | ) |   | (67,414 | ) |   | (87,903 | )
|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Net premiums written                                               |  |                         | 395,932 |   |   | 244,912 |   |   | 268,439 |   |   | 252,038 |   |   | 110,104 |  
|Net premiums earned                                                |  |                         | 183,115 |   |   | 151,839 |   |   | 116,281 |   |   | 103,072 |   |   | 57,585  |  
|Net investment income                                              |  |                         | 77,724  |   |   | 51,160  |   |   | 35,746  |   |   | 22,754  |   |   | 25,962  |  
|Net realized (losses) gains on investments                         |  |                         | (16,180 | ) |   | (3,221  | ) |   | (178    | ) |   | 3,621   |   |   | 15,896  |  
|Net realized and unrealized (losses) gains
  on credit derivatives |  |                         | (8,385  | ) |   | (6,681  | ) |   | 12,687  |   |   | 15,606  |   |   | 6,066   |  
|Fee income and other                                               |  |                         | 2,365   |   |   | 750     |   |   | 100     |   |   | 3,321   |   |   | 174     |  
|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Total revenues                                                     |  |                         | 238,639 |   |   | 193,847 |   |   | 164,636 |   |   | 148,374 |   |   | 105,683 |  
|Net losses and loss adjustment expenses                            |  |                         | 14,958  |   |   | 26,021  |   |   | 21,274  |   |   | 20,038  |   |   | 4,584   |  
|Acquisition costs, net                                             |  |                         | 16,240  |   |   | 12,231  |   |   | 8,259   |   |   | 6,776   |   |   | 1,136   |  
|Operating expenses                                                 |  |                         | 78,999  |   |   | 67,621  |   |   | 58,395  |   |   | 51,719  |   |   | 35,565  |  
|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Total expenses                                                     |  |                         | 110,197 |   |   | 105,873 |   |   | 87,928  |   |   | 78,533  |   |   | 41,285  |  
|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Income before income taxand
minority interest                      |  |                         | 128,442 |   |   | 87,974  |   |   | 76,708  |   |   | 69,841  |   |   | 64,398  |  
|Income tax expense (benefit)                                       |  |                         | 3,133   |   |   | (1,277  | ) |   | 1,920   |   |   | (955    | ) |   | (246    | )
|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Income before minority interest                                    |  |                         | 125,309 |   |   | 89,251  |   |   | 74,788  |   |   | 70,796  |   |   | 64,644  |  
|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Minority interest  dividends on redeemable
  preferred shares     |  |                         | 7,954   |   |   | 8,805   |   |   | 15,934  |   |   | 9,491   |   |   | 8,866   |  
|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Net income                                                         |  | $                       | 117,355 |   | $ | 80,446  |   | $ | 58,854  |   | $ | 61,305  |   | $ | 55,778  |  
|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Per Share Data (1):                                                |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Earnings per share:                                                |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Basic                                                              |  | $                       | 2.19    |   | $ | 1.74    |   | $ | 1.28    |   | $ | 1.33    |   | $ | 1.21    |  
|Diluted                                                            |  | $                       | 2.18    |   | $ | 1.74    |   | $ | 1.28    |   | $ | 1.33    |   | $ | 1.21    |  
|                                                                   |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  
|Dividends (2)                                                      |  |                         |         |   |   |         |   |   |         |   |   |         |   |   |         |  



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | 2002  2005 based
  on 46,127,245 shares outstanding immediately prior to the initial public
  offering of our common stock. See note 20 to our consolidated financial statements
  for additional information.                                                                                                                                                                                                                                                                                                                       
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|(2) | On October 31, 2006 the Board of Directors of the Company declared a cash dividend on our common shares of $0.02 per share, aggregating $1.3 million. The dividend was paid on December 29, 2006 to shareholders of record
  on December 11, 2006. Also, on February 27, 2007, our board of directors
  declared a dividend of $.02 per common share, which is payable on March 30,
  2007 to shareholders of record on March 15, 2007. Any future dividends will be subject to the discretion and approval of the Board of Directors.

51

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|                                                    |  |                    |           |   |   |           |   |   |           |   |   |           |  |   |         | 
|--------------------------------------------------- |  | ------------------ | --------- | - | - | --------- | - | - | --------- | - | - | --------- |  | - | ------- | 
|                                                    |  | As of December 31, |          
|                                                    |  |                    |          
|                                                   
|(in
  thousands, except per share amounts)          |  |                    | 2006      |   |   | 2005      |   |   | 2004      |   |   | 2003      |  |   | 2002    | 
|                                                    |  |                    |           |   |   |           |   |   |           |   |   |           |  |   |         | 
|Balance sheet data:                                 |  |                    |           |   |   |           |   |   |           |   |   |           |  |   |         | 
|Investments, cash and cash equivalents              |  | $                  | 2,160,911 |   | $ | 1,419,054 |   | $ | 1,228,452 |   | $ | 935,703   |  | $ | 660,990 | 
|Prepaid reinsurance premiums                        |  |                    | 59,983    |   |   | 69,873    |   |   | 57,454    |   |   | 108,475   |  |   | 78,713  | 
|Deferred acquisition costs                          |  |                    | 93,809    |   |   | 59,592    |   |   | 44,599    |   |   | 17,739    |  |   | 7,670   | 
|Reinsurance balances recoverable on unpaid
  losses |  |                    | 88,616    |   |   | 69,217    |   |   | 60,914    |   |   | 11,400    |  |   | 5,979   | 
|Total assets                                        |  |                    | 2,496,814 |   |   | 1,684,315 |   |   | 1,472,193 |   |   | 1,137,631 |  |   | 786,437 | 
|Unpaid losses and loss adjustment expenses          |  |                    | 178,517   |   |   | 147,368   |   |   | 115,734   |   |   | 47,195    |  |   | 21,735  | 
|Deferred premium revenue                            |  |                    | 795,906   |   |   | 592,585   |   |   | 487,093   |   |   | 385,956   |  |   | 207,228 | 
|Total liabilities                                   |  |                    | 1,076,278 |   |   | 765,983   |   |   | 618,774   |   |   | 469,213   |  |   | 277,365 | 
|Accumulated other comprehensive income              |  |                    | (19,705   | ) |   | (20,307   | ) |   | (241      | ) |   | 2,501     |  |   | 8,907   | 
|Shareholders equity                                |  |                    | 1,366,520 |   |   | 867,814   |   |   | 804,730   |   |   | 621,563   |  |   | 465,066 | 
|Per
      Share Data:                               |  |                    |           |   |   |           |   |   |           |   |   |           |  |   |         | 
|Book value per share                                |  | $                  | 21.31     |   | $ | 18.81     |   | $ | 17.45     |   | $ | 13.47     |  | $ | 10.08   | 



---

52

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ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our consolidated financial
statements and the related notes which appear in Item 8. This
discussion and analysis contains forward-looking statements that involve risks
and uncertainties. Our actual results could differ materially from those
anticipated in these forward-looking statements as a result of various factors,
including those discussed below and under the headings Risk Factors and
Cautionary Note Regarding Forward-Looking Statements.

Overview

General

We are a
Bermuda-domiciled holding company whose operating subsidiaries provide credit
enhancement and protection products to the public finance and structured
finance markets throughout the United States and internationally.

We provide
credit enhancement and protection through the issuance of financial guarantee
insurance policies and credit default swaps, as well as the reinsurance of
financial guarantee insurance and credit default products written by other
insurers. Financial guarantee insurance provides an unconditional and
irrevocable guarantee to the holder of a debt obligation of full and timely payment
of principal and interest. In the event of a default under the obligation, the
insurer has recourse against the issuer and/or any related collateral (which is
more common in the case of insured asset-backed obligations or other
non-municipal debt) for amounts paid under the terms of the policy. Credit
default swaps are derivative contracts that offer credit protection relating to
a particular security or pools of specified securities. Under the terms of a
credit default swap, the seller of credit protection makes a specified payment
to the buyer of credit protection upon the occurrence of one or more specified
credit events with respect to a referenced security. Our financial guarantee
reinsurance provides a means by which financial guarantee insurance companies
can manage and mitigate risks in their in-force business and/or increase their
capacity to write such business.

Initial Public
Offering

On August
4, 2006, we completed the sale of 18,009,119 of our common shares through an
initial public offering (the IPO) at $20.50 per share for aggregate
consideration of $369.2 million. Underwriting expenses were $22.2 million and
other issuance costs were $5.7 million resulting in net proceeds of
approximately $341.3 million. In addition, XL Capital sold 4,438,609 of its
common share holdings in SCA directly to the public in a secondary offering
concurrent with our IPO and another 992,165 common shares of SCA pursuant to
the exercise of the underwriters over-allotment option. As a result, after the
IPO, the aforementioned secondary offering, 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 in SCA. As a result of limitations on XL
Capitals voting power contained in our 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. See
Liquidity and Capital Resources for further details regarding the use of
proceeds.

Formation
Transactions

Concurrent
with the IPO, we entered into arrangements with affiliates of XL Capital to:
(i) provide us with protection with respect to adverse development on certain
transactions, (ii) have exposures transferred to us or re-assume exposures
under certain financial guarantee policies that were originally reinsured to,
or written on our behalf by, XLI, due principally to single risk constraints
and rating agency capital adequacy requirements applicable to us at the time
that business was first written, (iii) cancel our reinsurance of certain
non-financial guarantee business ceded to us by XLI, (iv) govern certain
aspects of our relationship with XL Capital after the IPO, including a series
of service agreements under which subsidiaries of XL Capital provide certain
services to us or receive certain services from us for a period of time after
the IPO, (v) contribute to us the proceeds from the redemption of an investment
related to our financial guarantee business which aggregated $15.0 million
(this contribution was made on the effective date of the IPO), and (vi) fund a
portion of long-term compensation awarded by XL Capital to our employees prior
to the IPO. In this regard, in December 2006 XL Capital contributed $6.2
million to us to fund the aforementioned long-term compensation awards of SCA
employees which were voluntarily or involuntarily converted from XL Capital
long-term incentive plans to our long-

53

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term
incentive plans and will make periodic contributions in the future for such
awards that were not so converted. Such future contributions are not expected
to exceed $1.6 million in the aggregate.

Certain of
the aforementioned arrangements are discussed in more detail below. See also
Note 7 to our Consolidated Financial Statements elsewhere herein for further
information in regard to the Formation Transactions.

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Effective August
  4, 2006, certain subsidiaries of XL Capital indemnified us for all losses and
  loss adjustment expenses incurred in excess of our retained reserves at the
  effective date of the agreement relating to an insured project financing. In
  consideration for the aforementioned indemnifications we are obligated to pay
  such affiliates an aggregate amount of approximately $9.8 million on an
  installment basis over the life of the aformentioned project financing. See
  Note 13 (a) to our Consolidated Financial Statements elsewhere herein for
  further information.                                                                                     
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | Effective August
  4, 2006, XLA indemnified us for any dimunition in value below their carrying
  value at June 30, 2006 of certain investments which were acquired in
  connection with the satisfaction of a claim under a financial guarantee
  insurance policy issued by XLCA. In addition, pursuant to the aforementioned
  indemnity, XLA agreed to indemnify us for any costs arising out of any
  litigation or future claim in connection with the aforementioned insurance
  policy. See Note 13 (b) to our Consolidated Financial Statements elsewhere
  herein for further information.                                                                                         
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | On August 4, 2006,
  we terminated a facultative quota share reinsurance treaty with XLI that had
  been effective since 2001. As a result of the termination, XLI returned $26.5
  million of premiums to us, we returned ceding commissions of $7.8 million to
  XLI, and XLI paid us $18.7 million.                                                                                                                                                                                                                                                                                                                                                                                       
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | On August 4, 2006,
  we and XLI agreed to cancel from inception the reinsurance of certain
  business ceded under a facultative quota share reinsurance treaty that was
  effective since 1999. As a result of this cancellation, we paid XLI $0.2
  million, XLI assumed our obligation for $1.2 million of reserves for losses
  and loss adjustment expenses, and we recorded a capital contribution of $1.0
  million. In addition, on such date, we assumed certain business from XLI. As
  a result thereof, we 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.

Key Factors
Affecting Profitability

We believe
that the financial guarantee business is significantly affected by economic
cycles. For example, a robust economy featuring a good or improving credit
environment is beneficial to the in-force portfolios of financial guarantee
insurers and reinsurers. Historically, however, when such conditions have
existed for an extended period, credit spreads tend to narrow and pricing and
demand for financial guarantee insurance and reinsurance tend to decline. A
deteriorating economic and credit environment, in contrast, is typically marked
by widening credit spreads and increasing pricing for financial guarantee
products. However, a prolonged period of weak or declining economic activity
could stress in-force financial guarantee insured portfolios and result in claims
or could adversely impact capital adequacy due to deterioration in the credit
quality of in-force insured portfolios. During the past several years, economic
conditions and the credit environment have been strong and, as a result, credit
spreads have generally narrowed and new aggregate business production of
primary insurers has generally slowed.

We derive
our revenues principally from: (i) premiums from our insurance and reinsurance
businesses, (ii) net investment income and net realized gains and losses from
our investment portfolio supporting these businesses and (iii) realized and
unrealized gains and losses on credit derivatives.

Our
premiums are a function of the amount of par or notional amount of debt
obligations that we guarantee, market prices and the type of debt obligation
guaranteed. We receive premiums either on an upfront basis when the policy is
issued or the contract is executed or on an installment basis over the life of
the applicable transaction.

Premiums
are accounted for as written when due; therefore when we enter into policies
that provide for upfront premium, all of the premium on the policy is accounted
for as written generally when the policy commences. The portion of the upfront
premium that has been written but has not yet been earned is carried on our
balance sheet as deferred premium revenue. When we enter into policies that
provide for installment premium, only that installment of the premium that is
then due (generally the current monthly, quarterly or semiannual installment)
is accounted for as written. Future premium installments during the remainder
of the life of the installment-based policy are not reflected on our balance
sheet. Therefore, the amount of total premiums written that we report for any
period will be affected by the mix of policies that we wrote in that period on
an upfront and, in that period and prior periods, on an installment basis.
Generally, a

54

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financial guarantee insurance company with a growing in-force book of
business should recognize an increasing amount of net earned premium from
policies written in prior reporting periods, whether premiums are received on
an upfront or installment basis. Future installments of premium on business
written in a year are sometimes reported by financial guarantors as a component
of adjusted gross premiums (AGP), a non-GAAP financial measure See
Business-Financial
Guarantee Insurance Segment. The amount of installment premiums
actually realized by us in the future (and that would be otherwise reflected in
revenue) could be reduced due to factors such as early termination of insurance
contracts or accelerated prepayments of underlying obligations. See Critical
Accounting Policies and Estimates below for a description of how such premiums
are earned.

Our
investment income is a function of the amount of our invested assets and the
yield that we earn on those assets. The investment yield will be a function of
market interest rates at the time of investment, as well as the type, credit
quality and duration of our invested assets. In addition, we could realize
gains or losses on the sale of securities in our investment portfolio or
recognize an other-than-temporary impairment as a result of changing market
conditions, including changes in market interest rates, and changes in the
credit quality of our invested assets.

Unrealized
gains and losses on credit derivatives and insurance policies that we account
for as derivative contracts are a function of changes in the estimated fair
value of those contracts. We expect these unrealized gains and losses to
fluctuate primarily based on changes in credit spreads and the credit quality
of the referenced securities. We generally hold these derivative contracts to
maturity. When we hold a derivative contract to maturity, the cumulative
unrealized gains and losses will net to zero if we incur no credit losses on
that contract. In certain circumstances, we may choose to terminate a credit
derivative prior to its maturity (for example, upon deterioration in underlying
credit quality).

Our
expenses primarily consist of losses and loss adjustment expenses, acquisition
costs, operating expenses, and income taxes. Losses and loss adjustment
expenses are a function of the quality, amount and type of business we
guarantee and are based upon estimates. The risks inherent in our credit
enhancement businesses have a low expected frequency of loss and, at the time
we accept such risk, generally will be of investment-grade quality without the
benefit of credit enhancement provided by us through the issuance of our
insurance policies and credit default swaps. Acquisition costs are related to
the production of new business and are generally deferred and recognized over
the period in which the related premiums are earned. See Critical Accounting
Policies and EstimatesDeferred Acquisition Costs and Deferred Ceding
Commissions. Operating expenses consist primarily of costs relating to
compensation of our employees, information technology, office premises and
professional fees. Income taxes are a function of our profitability and the
applicable tax rate in the various jurisdictions in which we do business.

Other Measures Used by Management to
Evaluate
Operating Performance

The
following are certain financial measures management considers important in
evaluating the Companys operating performance:

We review
our periodic sales performance by reviewing a non-GAAP measure known as
adjusted gross premiums. Adjusted gross premiums for any period equals the
sum of: (i) upfront premiums written in such period, (ii) current installment
premiums on business written in such period and (iii) expected future
installment premiums on contracts written during such period that remain in
force and for which there is a binding obligation on the part of the insured to
pay the future installment premiums, discounted at 7%, which we refer to as the
present value of future installment premiums, or PVFIP, on business written
during such period. The 7% discount rate was established when our subsidiaries
first started reporting adjusted gross premiums based upon the view that 7% was
the appropriate discount for these future premiums and that rate has not been
changed in order to preserve comparability among periods. This measure adjusts
for the fact, as described above, that upfront premiums are recorded in full as
total premiums written at inception of the contract but future installment
premiums are not, even though the volume of insured business we are writing is
essentially the same. PVFIP is not reflected on our consolidated balance sheet.
PVFIP can be negatively affected by prepayments and refundings, early
terminations, credit losses or other factors impacting our in-force book of
business.

The
following is a reconciliation of total premiums written to adjusted gross
premiums. Total premiums written is the most directly comparable GAAP financial
measure.

|                                                                                                                                         |  |                            |       |      |   |       |  |   |       | 
|---------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ----- | ---- | - | ----- |  | - | ----- | 
|                                                                                                                                         |  | Years Ended
  December 31, |      
|                                                                                                                                         |  |                            |       |      |   |       |  |   |       | 
|(in millions)                                                                                                                            |  | 2006                       |       | 2005 |   | 2004  | 
|                                                                                                                                         |  |                            |       |      |   |       |  |   |       | 
|Total upfront premiums written                                                                                                           |  | $                          | 278.3 |      | $ | 163.8 |  | $ | 166.4 | 
|Total installment premiums written                                                                                                       |  |                            | 130.7 |      |   | 121.6 |  |   | 110.2 | 
|                                                                                                                                         |  |                            |       |      |   |       |  |   |       | 
|Total premiums written                                                                                                                   |  |                            | 409.0 |      |   | 285.4 |  |   | 276.6 | 
|Present value of estimated future installment premiums
  written and assumed on contracts issued in the current period, discounted at 7% |  |                            | 147.1 |      |   | 110.4 |  |   | 18.4  | 
|                                                                                                                                         |  |                            |       |      |   |       |  |   |       | 
|Adjusted gross premiums                                                                                                                  |  | $                          | 556.1 |      | $ | 395.8 |  | $ | 295.0 | 
|                                                                                                                                         |  |                            |       |      |   |       |  |   |       | 

55

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We also
measure our performance by excluding from net income: (i) net realized gains
(losses) on investments and credit derivatives and (ii) earned premiums from
refundings. Management believes that net income adjusted to exclude the
aforementioned items provides a better measure of the operating performance of
its business, as such items are largely not subject to management discretion or
control.

We also
view the Companys book value per share as an additional measure of the
Companys performance. Book value per share is calculated by dividing
shareholders equity by the number of outstanding common shares at any period
end. Book value per share is affected primarily by the Companys net income and
also by any changes in the net unrealized gains and losses on its investment
portfolio. Book value per share was $21.31 at December 31, 2006, as compared to
$18.81 at December 31, 2005. The increase in book value was primarily
attributable to net income, partially offset by an increase in unrealized
losses on our investment portfolio, which was principally attributable to
rising interest rates.

Segments

Our
businesses are organized and managed in two operating segments: financial
guarantee insurance and financial guarantee reinsurance. Our financial
guarantee insurance segment offers financial guarantee insurance policies and
credit default swaps. Our financial guarantee reinsurance segment reinsures
financial guarantee policies and credit default swaps issued by other monoline
financial guarantee insurance companies. We evaluate the performance of each
operating segment based upon underwriting profit or loss before income taxes,
nonrecurring items (for example, items of an unusual or infrequent nature) and
inter-segment transactions. Certain costs and operating expenses are allocated
to each of the segments based upon: (i) a review of the nature of such costs
and (ii) time studies analyzing the amount of employee compensation costs
incurred by each segment. Except for the foregoing allocations, the accounting
policies of the segments are the same as those described in the summary of
significant accounting policies in our consolidated financial statements
presented elsewhere in Item 8.

Critical
Accounting Policies and Estimates

The
discussion and analysis of our financial condition and results of operations
are based on our consolidated financial statements, which have been prepared in
accordance with GAAP. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities as of the date
of the financial statements and the reported amounts of revenues and expenses
during the periods presented. Actual results could differ from those estimates,
and those differences may be material.

Critical
accounting policies and estimates are defined as those that require management
to make significant judgments, as well as those where results therefrom may be
materially different under different assumptions and conditions. We have
identified the accounting for: losses and loss adjustment expenses, the
valuation of credit default swaps and investments, premium revenue recognition,
deferred acquisition costs, and deferred income taxes, as critical accounting
policies.

An
understanding of our accounting policies for these items is of critical
importance to understanding our consolidated financial statements. The
following discussion provides more information regarding the estimates and
assumptions used for these items and should be read in conjunction with the
notes to our consolidated financial statements.

Reserves for
Losses and Loss Adjustment Expenses

Our
financial guarantees insure scheduled payments of principal and interest due on
various types of financial obligations against payment default by the issuers
of such obligations. We establish reserves for losses and loss adjustment
expenses on such business based on our best estimate of the ultimate expected
incurred losses. Our estimated ultimate expected incurred losses are comprised
of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative
paid losses to date. Establishment of such reserves requires the use and
exercise of significant judgment by management, including estimates regarding
the occurrence and amount of a loss on an insured obligation. Estimates of
losses may differ from actual results and such difference may be material, due
to the fact that the ultimate dispositions of claims are subject to the outcome
of events that have not yet occurred. Examples of these events include changes
in the

56

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level of interest rates, credit deterioration of insured obligations,
and changes in the value of specific assets supporting insured obligations.
Both qualitative and quantitative factors are used in establishing such
reserves. In determining the reserves, management considers all factors in the
aggregate, and does not attribute the reserve provisions or any portion thereof
to any specific factor. Any estimate of future costs is subject to the inherent
limitation on our 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
following tables summarize our gross reserves (before the effect of reinsurance
ceded) for losses and loss adjustment expenses by segment and by type of
reserve as of the dates presented. For an explanation of changes in these
reserves see Consolidated Results of Operations.

|                                                        |  |                                   |         |                                     |   |        |  |   |         | 
|------------------------------------------------------- |  | --------------------------------- | ------- | ----------------------------------- | - | ------ |  | - | ------- | 
|                                                        |  | As of December 31, 2006           |        
|                                                        |  |                                   |        
|(in
  thousands)                                        |  | Financial
  Guarantee
  Insurance |         | Financial
  Guarantee
  Reinsurance |   | Total  | 
|                                                        |  |                                   |         |                                     |   |        |  |   |         | 
|Gross case basis reserve for losses                     |  | $                                 | 82,304  |                                     | $ | 1,568  |  | $ | 83,872  | 
|Gross case basis reserve for loss
  adjustment expenses |  |                                   | 1,479   |                                     |   |       |  |   | 1,479   | 
|Gross unallocated reserves                              |  |                                   | 76,407  |                                     |   | 16,759 |  |   | 93,166  | 
|                                                        |  |                                   |         |                                     |   |        |  |   |         | 
|Total                                                   |  | $                                 | 160,190 |                                     | $ | 18,327 |  | $ | 178,517 | 
|                                                        |  |                                   |         |                                     |   |        |  |   |         | 

|                                                        |  |                                   |         |                                     |   |        |  |   |         | 
|------------------------------------------------------- |  | --------------------------------- | ------- | ----------------------------------- | - | ------ |  | - | ------- | 
|                                                        |  | As of December 31, 2005           |        
|                                                        |  |                                   |        
|(in thousands)                                          |  | Financial
  Guarantee
  Insurance |         | Financial
  Guarantee
  Reinsurance |   | Total  | 
|                                                        |  |                                   |         |                                     |   |        | 
|Gross case basis reserve for losses                     |  | $                                 | 64,057  |                                     | $ | 1,269  |  | $ | 65,326  | 
|Gross case basis reserve for loss
  adjustment expenses |  |                                   | 2,880   |                                     |   | 1,176  |  |   | 4,056   | 
|Gross unallocated reserves                              |  |                                   | 63,091  |                                     |   | 14,895 |  |   | 77,986  | 
|                                                        |  |                                   |         |                                     |   |        |  |   |         | 
|Total                                                   |  | $                                 | 130,028 |                                     | $ | 17,340 |  | $ | 147,368 | 
|                                                        |  |                                   |         |                                     |   |        |  |   |         | 

Case basis
reserves on financial guarantee insurance business written are established by
us with respect to a specific policy or contract upon receipt of a claim notice
or when management determines that (i) a claim is probable in the future based
on specific credit events that have occurred and (ii) the amount of the
ultimate loss that we will incur can be reasonably estimated. As specific case
basis reserves are established we consider whether any changes are required to
the assumptions underlying the calculation of unallocated reserves (which are
discussed below) as a result of such activity. As case basis reserve activity
to date has been limited, we have not adjusted our unallocated reserves
assumptions due to such activity. The amount of the case basis reserve is based
on the net present value of the expected ultimate loss and loss adjustment
expense payments that we expect to make, net of expected recoveries under
salvage and subrogation rights. Case basis reserves are determined using cash
flow or similar models to estimate the net present value of the anticipated
shortfall between (i) scheduled payments on the insured obligation plus
anticipated loss adjustment expenses and (ii) anticipated cash flow from the
proceeds to be received on sales of any collateral supporting the obligation
and other anticipated recoveries. A number of quantitative and qualitative
factors are considered when determining or assessing, in managements judgment,
the need for a case basis reserve. These factors may include the
creditworthiness of the underlying issuer of the insured obligation, whether
the obligation is secured or unsecured, the projected cash flow or market value
of any assets that collateralize or secure the insured obligation, and the
historical and projected loss rates on such assets. Other factors that may affect
the actual ultimate loss include the state of the economy, changes in interest
rates, rates of inflation and the salvage values of specific collateral. Case
basis reserves are generally discounted at a rate reflecting the yield on our
investment portfolio during the period the case basis reserve is established.
We believe this yield is an appropriate rate to discount our reserves because
it reflects the rate of return on the assets supporting such business. When a
case basis reserve is established for a guaranteed obligation whose premium is
paid on an upfront basis, we continue to record premium earnings on such policy
over its remaining life, unless we have recorded a full limit loss with respect
to such policy, in which case the remaining deferred premium revenue relating
thereto is immediately reflected in earnings. When a case basis reserve is
established for a guaranteed obligation whose premium is paid on an installment
basis, those premiums, if expected to be received prospectively, are considered
a form of recovery and are no longer earned as premium revenue.

Case basis
reserves on financial guarantee reinsurance assumed are generally established
by us upon notification from ceding companies. Based on our evaluation of the
loss activity reported to us from our ceding companies, as well as the results
from our periodic reviews of our ceding companies underwriting and
surveillance procedures, we may, in managements judgment, establish case
reserves greater than those reported by the ceding companies. Our

57

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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 on the ceding companies
equivalent of our list of closely monitored credits as discussed below. This
information is recorded into our records upon receipt of the monthly
statements. Due to the timing of the receipts of such statements from our
ceding companies, we record 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 1 of the prior calendar year
through November 30 of the reporting year. Because such activity principally
consists of premium and related activity, we believe that reporting such
activity on a one-month lag allows us to record more accurate information than
if we were to estimate such activity for one month, and we compare our calendar
year results to our results recorded on a one-month lag for reasonableness.
Further, because only a small percentage of premiums 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.

In
assessing whether a loss is probable, management considers all available
qualitative and quantitative evidence. Qualitative evidence may take various
forms and the nature of such evidence will depend upon the type of insured
obligation and the nature and sources of cash flows to fund the insured
obligations debt service. For example, such evidence with respect to an
insured special revenue obligation, such as an obligation supported by cash
flows from a toll road, would consider traffic statistics such as highway
volume and related demographic information, whereas an insured mortgage backed
securitization would consider the quality of the mortgage loans supporting the
insured obligation including delinquency and foreclosure rates, loan to value
statistics, market valuation of the mortgaged properties and other pertinent
information. In addition, management will make qualitative judgments with
respect to the amount by which certain other structural protections built into
the transaction are expected to limit our loss exposure. Examples of such
structural protections may include: (i) rate covenants, which generally
stipulate that issuers (i.e. public finance issuers) set rates for services at
certain pre-determined levels (i.e. water and sewer rates which support debt
obligations supported by such revenues), (ii) springing liens, which generally
require the issuer to provide additional collateral upon the breach of a
covenant or trigger incorporated into the terms of the transaction, (iii)
consultant call-in rights, which provide, under certain circumstances, for a
consultant to be engaged to make certain binding recommendations, such as
raising rates or reducing expenses, (iv) the ability to transfer servicing of
collateral assets to another party, and (v) other legal rights and remedies
pursuant to representations and warranties made by the issuer and written into
the terms of such transactions. Quantitative information may take the form of
cash flow projections of the assets supporting the insured debt obligation
(which may include, in addition to collateral assets supporting the obligation,
structural protections subordinate to the attachment point of our risk, such as
cash reserve accounts and letters of credit), as well as (to the extent
applicable) other metrics indicative of the performance of such assets and the
trends therein. Managements ability to make a reasonable estimate of its
expected loss depends upon its evaluation of the totality of both the available
quantitative and qualitative evidence, and no one quantitative or qualitative
factor is dispositive.

In addition
to case basis reserves, we maintain an unallocated loss reserve for expected
losses inherent in our in-force business (consisting of both financial
guarantee insurance and reinsurance business) that we expect to emerge in the
future. Our unallocated loss reserves represent our estimated ultimate
liability from claims expected to be incurred in the future under our in-force
insured and reinsured policies less outstanding case basis reserves and
cumulative paid claims to date on such policies. Our unallocated reserves are
estimated by management based upon an actuarial reserving analysis. The
actuarial methodology applied by us is in accordance with Actuarial Standards
of Practice No. 36, Determination of
Reasonable Provision. The methodology applied 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 and reinsured in-force policies). Salvage and subrogation recoveries
are implicit in our 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 our
selected expected ultimate loss ratio is consistent with managements explicit
consideration of collateral support in the establishment of its case basis
reserves.

We update
our estimates of losses and loss adjustment expense reserves quarterly and any
resulting changes in reserves are recorded as a charge or credit to earnings in
the period such estimates are changed. In connection therewith, our unallocated
reserves are adjusted each period to reflect (i) revisions to managements
estimate of expected ultimate losses, if any, and (ii) the underlying par risk
amortization of the related insured and reinsured in-force business (i.e., loss
emergence pattern). As stated above, our 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 our
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 our case basis reserve and unallocated reserve activity to date
to warrant a reduction of our 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

58

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thereof represents managements best estimate of the ultimate losses it
expects to incur on our 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 our initial expected loss ratio is based on an analysis, which we
update annually, of the historic earned premium and ultimate losses of the
financial guaranty industry. The analysis utilizes loss and premium data filed
by the three largest companies in the financial guaranty 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. The mean ten-year
observed historic industry loss ratio resulting from our initial analysis in
2001 (which was conducted when we first adopted our unallocated reserve
methodology) encompassing years 1991 through 2000 was 13%. Later analyses
performed in 2005 (encompassing years 1995 through 2004) and 2006 (encompassing
years 1996 through 2005) indicated that the average industry loss ratio was
16%.

Management
further reviewed the individual loss years and, where possible, the events
underlying the average composite industry loss ratios in 2005 and 2006.
Management noted that 1998 and 2002 were particularly adverse for the financial
guaranty industry due to credit events following the stock market decline in
1997 and the Enron collapse in 2001 as well as that certain individual losses
were in bond sectors in which we do not actively participate. Accordingly, in
the judgment of management the increase in the industry loss ratio compared to
the 2001 analysis was not indicative of an overall deterioration in our
expected loss activity.

Our initial
selection of an initial expected loss ratio (and subsequent periodic updates
thereof) is based on managements judgment and considered: (i) the
characteristics of our in-force financial guarantee insurance and reinsurance
business (e.g., principally the mix of our in-force financial guarantee
insurance and reinsurance business between public finance and structured
finance business; however, we also considered the various bond sectors
comprising our insured and reinsured in-force business which are discussed in
detail in Note 13 to our consolidated financial statements included elsewhere
herein, as well as the credit profile of our insured and reinsured portfolio of
business), (ii) our actual loss experience, (iii) the characteristics, as
discussed above in relation to our in-force financial guarantee insurance and
reinsurance 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 our analysis referred to above. Other
factors impacting market default levels and the assumptions important to our
reserving methodology are implicit in our 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, we adjust our expected loss ratio, as we consider necessary,
to ensure that such ratio continues to be appropriate for the risks inherent in
our in-force business.

When we
adopted our current unallocated reserve methodology in 2001 we selected an
initial expected loss ratio of 25%. Our selection was based on the following
qualitative factors, which involved the exercise of managements judgment: (i)
the low-frequency/high-severity nature of the business which resulted in
considerable volatility in the loss ratios by year and by company reflected in
the analysis discussed above, (ii) our limited loss experience reflecting the
fact that we commenced operations in 1999, and (iii) the fact that the sample
loss ratio data in the analysis was drawn from industry data which reflect a
balanced mix of public and structured finance business during a robust growth
economy, whereas our in-force insurance business was more heavily weighted
toward structured finance business. Accordingly, the ultimate loss ratios from
the industry data were lower than that expected for our in-force business.

Our
methodology applies the initial expected loss ratio to earned premium during
the period from our entire in-force book of business (after exclusion of the
effect on earned premium of refunding and full limit losses because no more
risk exists on these related policies). Significant changes to any variables on
which our initial expected loss ratio is based, over an extended period of
time, will likely result in an increase or decrease in such ratio. For example,
a shift in business written for sectors with high default rates would likely
increase our expected loss ratio, while a shift for sectors with low default
rates would likely decrease our expected loss ratio. Additionally, increases in
default rates relative to our insured portfolio and in our actual loss
experience or decreases in statistical recovery rates and in our actual
recovery experience would increase our expected loss ratio, while the inverse
would likely decrease our expected loss ratio.

During 2004
we adjusted our initial expected loss ratio to 20% from 25%, which was utilized
since the adoption of our unallocated reserve methodology in recognition of the
cumulative experience of our business to that point in time, as well as the
increasing percentage of our in-force business from public finance insurance.
This change resulted in approximately a $15.0 million decrease in unallocated
loss reserves, which decrease was substantially offset by a change in the
estimated expected loss emergence pattern of our in-force business due to the
availability of more detailed information as a result of the implementation in
2004 of a new automated information system. Management also

59

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considered its industry studies described above as supportive of
managements change in the initial expected loss ratio in 2004, for the reasons
described above. Our updated analyses in 2005 and 2006 indicated that no change
was necessary in our expected loss ratio of 20% from that in 2004.

Our
expected loss emergence pattern is determined by underwriting year based on the
par amortization schedules of the underlying insured and reinsured debt
obligations comprising our in-force business. We adjust or realign the expected
loss emergence pattern each quarter to reflect the underlying changes in our
in-force business (for example, changes in the average life of in-force
business resulting from changes in the mix of business and risk or par
expiration). Analysis of the risk demographic by underwriting year demonstrates
that, while the proportionate mix of municipal versus structured finance
business may fluctuate from year to year, the average outstanding life
parameter within each product type remains fairly stable between underwriting
years. Structured finance business will typically have an aggregate average
life of 5 to 10 years and municipal finance business will typically have an
aggregate average life of 15 to 20 years. In addition, management believes that
loss emergence for structured finance business tends to be front-loaded. For
example, underperformance in the early periods of a consumer-asset-backed
security is generally of particular concern from the standpoint of potential
loss manifestation. However, early underperformance does not necessarily
predict that an incurred loss will result and, in certain instances, a
restructuring of the transaction can mitigate a loss event. Conversely, if
structured finance deals perform more or less as expected in the early stages,
collateral protection multiples usually increase with time and, accordingly,
the loss propensity decreases. Similarly, municipal default statistics
demonstrate a propensity toward increased relative defaults in the early years
and less in the later years. Once a municipality has established its revenue
flows to meet its debt borrowing obligations and these are performing as
expected, it becomes increasingly unlikely that the existing debt burden cannot
be adequately serviced in the future from the same revenue base. Management
believes it is reasonable to estimate the loss emergence pattern by reflecting
the proportionate mix of municipal versus structured finance.

Our
unallocated loss reserve is established on an undiscounted basis and represents
managements best estimate of losses that we will incur in the future as a
result of credit deterioration in our in-force business but which have not yet
been specifically identified. We do not attempt to apportion unallocated
reserves by type of product.

The
following example illustrates our method for calculating unallocated reserves
over the life of a financial guarantee contract.

For the
purposes of the following example, we assume a 15-year financial guarantee
contract with a $1,000 upfront premium that is earned in proportion to the
expiration of related risk, as described in Critical Accounting Policies and
EstimatesPremium Revenue Recognition. The example below assumes the guarantee
contract was written in 2005 and shows how premiums would earn, as well as how
unallocated reserves are calculated and amortized over the loss emergence
pattern. The application of the methodology set forth in this example is
indicative of how this methodology applies to our entire in-force business. The
assumed loss emergence pattern represented by the Fraction of Loss Exposure
Exhausted (column (3) and the selected initial expected loss ratio of 20%, is
shown in the calculation in column (4). For purposes of this example we applied
the selected initial expected loss ratio of 20% on a policy level; however, we
apply in practice the selected initial expected loss ratio on a portfolio-wide
basis to earned premium during the period from our entire in-force book of
business. The first table below illustrates the establishment of the
unallocated reserve and run-off of such reserve as the par at risk of the
insured obligation in the example amortizes. The second table below is the same
as the first table except that a column is added to illustrate the periods in
which the model assumes case reserve and paid loss activity to occur and the
related amounts. In accordance with our methodology, 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. We
have described above the interrelationship of unallocated reserves, case basis
reserves and cumulative paid losses to date as well as the methodology for
selecting our initial loss ratio. As previously stated, 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 third
table below illustrates by an example the impact of actual loss experience
different from that assumed in the second table.

60

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|     |  |                                               |       |                                                               |  |                                                                               |  |                                            |   |    |  |  |      |   | 
|---- |  | --------------------------------------------- | ----- | ------------------------------------------------------------- |  | ----------------------------------------------------------------------------- |  | ------------------------------------------ | - | -- |  |  | ---- | - | 
|Year |  | Inception-to-Date (ITD)
  Earned Premium(1) |       | ITD (Cumulative)
  Fraction of
  Loss Exposure
  Exhausted(2) |  | Selected
  Unallocated
  Reserve As of
  December 31 of
  the Applicable Year |  | Booked
  Unallocated Ratio
  on ITD Earned |  
|     |  |                                               |       |                                                               |  |                                                                               |  |                                            |  
|(1)  |  | (2)                                           |       | (3)                                                           |  | (4) = (2) * 20% * (1 - (3))                                                   |  | (5) = (4) ÷ (2)                            |  
|     |  |                                               |       |                                                               |  |                                                                               |  |                                            |   |    |  |  |      |  
|2005 |  | $                                             | 221   |                                                               |  | 0.075                                                                         |  |                                            | $ | 41 |  |  | 18.5 | % | 
|2006 |  | $                                             | 376   |                                                               |  | 0.422                                                                         |  |                                            | $ | 43 |  |  | 11.6 | % | 
|2007 |  | $                                             | 497   |                                                               |  | 0.685                                                                         |  |                                            | $ | 31 |  |  | 6.3  | % | 
|2008 |  | $                                             | 596   |                                                               |  | 0.817                                                                         |  |                                            | $ | 22 |  |  | 3.7  | % | 
|2009 |  | $                                             | 678   |                                                               |  | 0.885                                                                         |  |                                            | $ | 16 |  |  | 2.3  | % | 
|2010 |  | $                                             | 747   |                                                               |  | 0.924                                                                         |  |                                            | $ | 11 |  |  | 1.5  | % | 
|2011 |  | $                                             | 805   |                                                               |  | 0.947                                                                         |  |                                            | $ | 8  |  |  | 1.1  | % | 
|2012 |  | $                                             | 854   |                                                               |  | 0.963                                                                         |  |                                            | $ | 6  |  |  | 0.7  | % | 
|2013 |  | $                                             | 894   |                                                               |  | 0.974                                                                         |  |                                            | $ | 5  |  |  | 0.5  | % | 
|2014 |  | $                                             | 926   |                                                               |  | 0.981                                                                         |  |                                            | $ | 3  |  |  | 0.4  | % | 
|2015 |  | $                                             | 952   |                                                               |  | 0.987                                                                         |  |                                            | $ | 2  |  |  | 0.3  | % | 
|2016 |  | $                                             | 972   |                                                               |  | 0.992                                                                         |  |                                            | $ | 2  |  |  | 0.2  | % | 
|2017 |  | $                                             | 986   |                                                               |  | 0.995                                                                         |  |                                            | $ | 1  |  |  | 0.1  | % | 
|2018 |  | $                                             | 996   |                                                               |  | 0.998                                                                         |  |                                            | $ | 0  |  |  | 0.0  | % | 
|2019 |  | $                                             | 1,000 |                                                               |  | 0.998                                                                         |  |                                            | $ | 0  |  |  | 0.0  | % | 



---

|    |                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------
|(1) | Earned Premium is
  after giving effect to considerations for refundings and full limit losses.                          
|    |                                                                                                                          
|(2) | Fraction of Loss
  Exposure Exhausted represents the percentage of insured par (risk exposure)
  that has been amortized.

Implicit in this technique is an assumption with respect to the timing
of reported losses. Since our initial expected loss ratio is 20%, the assumed
reported losses are the amounts needed to achieve a 20% ITD ultimate expected
loss ratio on the business. (These estimated cumulative reported losses are in
column (4) below.) The table below adds the implicit assumptions to the table
above, and then shows the total expected incurred losses at successive
year-ends.

|     |  |                           |       |                                                                               |  |                                                                                       |    |                                                  |  |   |     |  |  |   |     |  | 
|---- |  | ------------------------- | ----- | ----------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------- | -- | ------------------------------------------------ |  | - | --- |  |  | - | --- |  | 
|Year |  | ITD
  Earned
  Premium(1) |       | Selected
  Unallocated
  Reserve As of
  December 31 of
  the Applicable Year |  | Estimated
  Cumulative
  Reported Losses
  As of December 31
  of the Applicable Year |    | Cumulative
  Total
  Estimated
  Incurred Losses | 
|     |  |                           |       |                                                                               |  |                                                                                       |    |                                                  | 
|(1)  |  | (2)                       |       | (3)                                                                           |  | (4) = (2)*20% - (3)                                                                   |    | (5) = (3) + (4)                                  | 
|     |  |                           |       |                                                                               |  |                                                                                       |    |                                                  |  |   |     |  |  |  
|2005 |  | $                         | 221   |                                                                               |  | $                                                                                     | 41 |                                                  |  | $ | 3   |  |  | $ | 44  |  | 
|2006 |  | $                         | 376   |                                                                               |  | $                                                                                     | 43 |                                                  |  | $ | 32  |  |  | $ | 75  |  | 
|2007 |  | $                         | 497   |                                                                               |  | $                                                                                     | 31 |                                                  |  | $ | 68  |  |  | $ | 99  |  | 
|2008 |  | $                         | 596   |                                                                               |  | $                                                                                     | 22 |                                                  |  | $ | 97  |  |  | $ | 119 |  | 
|2009 |  | $                         | 678   |                                                                               |  | $                                                                                     | 16 |                                                  |  | $ | 120 |  |  | $ | 136 |  | 
|2010 |  | $                         | 747   |                                                                               |  | $                                                                                     | 11 |                                                  |  | $ | 138 |  |  | $ | 149 |  | 
|2011 |  | $                         | 805   |                                                                               |  | $                                                                                     | 8  |                                                  |  | $ | 153 |  |  | $ | 161 |  | 
|2012 |  | $                         | 854   |                                                                               |  | $                                                                                     | 6  |                                                  |  | $ | 164 |  |  | $ | 171 |  | 
|2013 |  | $                         | 894   |                                                                               |  | $                                                                                     | 5  |                                                  |  | $ | 174 |  |  | $ | 179 |  | 
|2014 |  | $                         | 926   |                                                                               |  | $                                                                                     | 3  |                                                  |  | $ | 182 |  |  | $ | 185 |  | 
|2015 |  | $                         | 952   |                                                                               |  | $                                                                                     | 2  |                                                  |  | $ | 188 |  |  | $ | 190 |  | 
|2016 |  | $                         | 972   |                                                                               |  | $                                                                                     | 2  |                                                  |  | $ | 193 |  |  | $ | 194 |  | 
|2017 |  | $                         | 986   |                                                                               |  | $                                                                                     | 1  |                                                  |  | $ | 196 |  |  | $ | 197 |  | 
|2018 |  | $                         | 996   |                                                                               |  | $                                                                                     | 0  |                                                  |  | $ | 199 |  |  | $ | 199 |  | 
|2019 |  | $                         | 1,000 |                                                                               |  | $                                                                                     | 0  |                                                  |  | $ | 200 |  |  | $ | 200 |  | 



---

|    |                                                                                                
|--- | -----------------------------------------------------------------------------------------------
|(1) | Earned Premium is
  after giving effect to considerations for refundings and full limit losses.

61

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Actual losses will not be reported in accordance with expectation, and
the ultimate loss ratio will likely be different than that expected. A
substitution of an alternative reporting pattern than expected, as compared to
that set forth in the previous table, demonstrates the effect thereof. In the
table that follows, we assume that over time, our sample guarantee contract
generates $170 in losses, yielding a 17% actual ultimate loss ratio.

|     |  |                           |       |                                                                               |  |                                                                                         |    |                                                  |  |   |     |  |  |   |     |  | 
|---- |  | ------------------------- | ----- | ----------------------------------------------------------------------------- |  | --------------------------------------------------------------------------------------- | -- | ------------------------------------------------ |  | - | --- |  |  | - | --- |  | 
|Year |  | ITD
  Earned
  Premium(1) |       | Selected
  Unallocated
  Reserve As of
  December 31 of
  the Applicable Year |  | Alternative
  Cumulative
  Reported Losses
  As of December 31
  of the Applicable Year |    | Cumulative
  Total
  Estimated
  Incurred Losses | 
|     |  |                           |       |                                                                               |  |                                                                                         |    |                                                  | 
|(1)  |  | (2)                       |       | (3)                                                                           |  | (4)                                                                                     |    | (5) = (3) + (4)                                  | 
|     |  |                           |       |                                                                               |  |                                                                                         |    |                                                  |  |   |     |  |  |  
|2005 |  | $                         | 221   |                                                                               |  | $                                                                                       | 41 |                                                  |  | $ | 0   |  |  | $ | 41  |  | 
|2006 |  | $                         | 376   |                                                                               |  | $                                                                                       | 43 |                                                  |  | $ | 0   |  |  | $ | 43  |  | 
|2007 |  | $                         | 497   |                                                                               |  | $                                                                                       | 31 |                                                  |  | $ | 40  |  |  | $ | 71  |  | 
|2008 |  | $                         | 596   |                                                                               |  | $                                                                                       | 22 |                                                  |  | $ | 130 |  |  | $ | 152 |  | 
|2009 |  | $                         | 678   |                                                                               |  | $                                                                                       | 16 |                                                  |  | $ | 130 |  |  | $ | 146 |  | 
|2010 |  | $                         | 747   |                                                                               |  | $                                                                                       | 11 |                                                  |  | $ | 130 |  |  | $ | 141 |  | 
|2011 |  | $                         | 805   |                                                                               |  | $                                                                                       | 8  |                                                  |  | $ | 145 |  |  | $ | 153 |  | 
|2012 |  | $                         | 854   |                                                                               |  | $                                                                                       | 6  |                                                  |  | $ | 145 |  |  | $ | 151 |  | 
|2013 |  | $                         | 894   |                                                                               |  | $                                                                                       | 5  |                                                  |  | $ | 145 |  |  | $ | 150 |  | 
|2014 |  | $                         | 926   |                                                                               |  | $                                                                                       | 3  |                                                  |  | $ | 170 |  |  | $ | 173 |  | 
|2015 |  | $                         | 952   |                                                                               |  | $                                                                                       | 2  |                                                  |  | $ | 170 |  |  | $ | 172 |  | 
|2016 |  | $                         | 972   |                                                                               |  | $                                                                                       | 2  |                                                  |  | $ | 170 |  |  | $ | 172 |  | 
|2017 |  | $                         | 986   |                                                                               |  | $                                                                                       | 1  |                                                  |  | $ | 170 |  |  | $ | 171 |  | 
|2018 |  | $                         | 996   |                                                                               |  | $                                                                                       | 0  |                                                  |  | $ | 170 |  |  | $ | 170 |  | 
|2019 |  | $                         | 1,000 |                                                                               |  | $                                                                                       | 0  |                                                  |  | $ | 170 |  |  | $ | 170 |  | 



---

|    |                                                                                                
|--- | -----------------------------------------------------------------------------------------------
|(1) | Earned Premium is
  after giving effect to considerations for refundings and full limit losses.

Our total
reserves for losses and loss adjustment expenses represent a small fraction of
our insured and reinsured in-force par outstanding, which reflects the nature
of the business we underwrite and the loss experience of the industry. We
believe that our reserves are adequate to cover our 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 our consolidated financial statements, and the differences may be
material. Differences exist within the financial guarantee industry with regard
to the methodology and measurement of such reserves. While we believe that the
principles we apply are the most appropriate for our business and have applied
them consistently within the periods presented, alternate methods may produce different
estimates as compared to the current methodology we use. See Risk
FactorsRisks Related to Our CompanyRules relating to certain accounting
practices in the financial guarantee insurance and reinsurance industry are
currently being reviewed by applicable regulatory bodies and any changes
required by that review could have a material effect on the reported operating
results and financial condition of the industry or particular market
participants, including us, depending on the extent to which current policies
differ from those promulgated by such regulatory bodies.

Our
surveillance department is responsible for monitoring the performance of our
in-force portfolio. They maintain a list of credits that they have determined
need to be closely monitored and, for certain of those credits, they undertake
remediation activities they determine to be appropriate in order to mitigate
the likelihood and/or amount of any loss that we could incur with respect to
such credits.

Our
surveillance department focuses its review on monitoring the lower-rated bond
sectors. It tracks performance monthly to try to ensure that covenants have not
been breached. Once a covenant is breached we may have the right to put the
transaction into rapid amortization so that all cash flow generated from that
transaction is used to pay down principal and stay current with interest.
Typically, we review periodically servicing and trustee reports to help track
coverage levels, enhancement levels, delinquency levels, loss frequency, loss
severity and total losses and compare these performance metrics with the
metrics that were made available at the time the transaction was closed. If
losses are above projections we will analyze the reasons for the deviation. In
some cases it may be an indication of servicing problems where loans are
delinquent and are not put into foreclosure in time to maximize recovery.
Typically, once to twice per year we audit servicers of loans and other assets
supporting our insured obligations to better understand their servicing
practices and to identify potential servicing problems, if any. Management
believes that this is an important safeguard, as servicers are required to
indemnify us against failure to adhere to the servicing standards set forth in
the servicing agreements.

62

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Our
surveillance department also analyzes whether a claim on our policy is
probable. In some cases, we will engage an outside consultant with appropriate
expertise in the underlying collateral assets and respective industries to
assist management in examining the underlying collateral and determining the
projected loss frequency and loss severity. In such case, we will use that
information to run a cash flow model, which includes enhancement levels and
debt service to determine whether a claim is probable, possible or not likely.

The
activities of our surveillance department are integral to the identification
    of specific credits that have experienced deterioration in credit quality
    and to the assessment of whether losses on such credits are probable, as
    well as any estimation of the amount of loss expected to be incurred with
    respect to such credits. Closely monitored credits are divided into four
    categories: (i) Special Monitoring Listinvestment grade credits where
    a covenant or trigger may be breached or is close to being breached and warrants
    closer monitoring; (ii) Yellow Flag Listcredits that we determine to
    be non-investment grade but a loss or claim is unlikely; (iii) Red Flag Listcredits
    where we do not expect an ultimate loss but a claim is possible but not probable;
    and (iv) Loss Listcredits where we have either paid a loss or expect
    to suffer a loss and have recorded a case reserve. Out of over 2,500 credits
    in our in-force portfolio only 17 credits are in one of the four above categories.
    Credits that are not closely monitored credits are considered fundamentally
    sound, normal risk.

Our
management establishes reserves for losses and loss adjustment expenses
following consultation with our Loss Reserve Committee, which is comprised of
senior members of management, including senior management of our surveillance
department. See BusinessRisk Management for further definition and
discussion of credits designated as closely monitored credits. 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.

The
following table presents our consolidated in-force financial guarantee net par
outstanding at December 31, 2006 and 2005 by category of closely monitored
credit:

|                                  |  |                         |         |                            |  |                       |   |                            |        |  |  |       |  
|--------------------------------- |  | ----------------------- | ------- | -------------------------- |  | --------------------- | - | -------------------------- | ------ |  |  | ----- | -
|                                  |  | As of December 31, 2006 |         | As of December 31, 2005    | 
|                                  |  |                         |         |                            | 
|(in millions, except percentages) |  | Net Par
  Outstanding   |         | % of Net Par
  Outstanding |  | Net Par
  Outstanding |   | % of Net Par
  Outstanding |       
|                                  |  |                         |         |                            |  |                       |   |                            |       
|Fundamentally
  sound normal risk |  | $                       | 117,318 |                            |  | 99.4                  | % | $                          | 80,573 |  |  | 98.4  | %
|Closely monitored
  credits(1):   |  |                         |         |                            |  |                       |   |                            |        |  |  |       |  
|Special monitoring                |  |                         | 558     |                            |  | 0.5                   | % |                            | 692    |  |  | 0.8   | %
|Yellow flag                       |  |                         | 3       |                            |  | 0.0                   | % |                            | 229    |  |  | 0.3   | %
|Red flag                          |  |                         | 37      |                            |  | 0.0                   | % |                            | 58     |  |  | 0.1   | %
|Loss list(2)                      |  |                         | 96      |                            |  | 0.1                   | % |                            | 339    |  |  | 0.4   | %
|                                  |  |                         |         |                            |  |                       |   |                            |        |  |  |       |  
|Sub Total                         |  |                         | 694     |                            |  | 0.6                   | % |                            | 1,318  |  |  | 1.6   | %
|                                  |  |                         |         |                            |  |                       |   |                            |        |  |  |       |  
|Total                             |  | $                       | 118,012 |                            |  | 100.0                 | % | $                          | 81,891 |  |  | 100.0 | %
|                                  |  |                         |         |                            |  |                       |   |                            |        |  |  |       |  



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Protection with
  respect to loss development relating to the two closely monitored credits
  described in this section was provided by affiliates of XL Capital in
  connection with the IPO. See  Formation Transactions.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|(2) | At December 31,
  2006 and 2005, the loss list consisted of four and five guarantee contracts,
  respectively, with remaining net par outstanding of $95.8 million and $338.9
  million, respectively, against which net reserves of $13.6 million and $13.4
  million have been established.  The
  decrease in net par outstanding on the loss list at December 31, 2006, as
  compared to December 31, 2005 resulted primarily from the indemnification
  provided by XL Capital relating to an insured project financing (see
  Formation Transactions and Note 13 of the Consolidated Financial Statements
  elsewhere herein for further information), as well as the early retirement of
  an insured obligation (see Note 13 (c) of the Consolidated Financial
  Statements for further information).

The
following table sets forth our consolidated in-force financial guarantee net
par outstanding as of the dates indicated by S&P rating category.

|                                  |  |                                             |         |                                          |  |                                             |   |                                          |        |  |  |       |  
|--------------------------------- |  | ------------------------------------------- | ------- | ---------------------------------------- |  | ------------------------------------------- | - | ---------------------------------------- | ------ |  |  | ----- | -
|(in millions, except percentages) |  | Net Par
  Outstanding
  December 31,
  2006 |         | Percent of
  Total Net Par
  Outstanding |  | Net Par
  Outstanding
  December 31,
  2005 |   | Percent of
  Total Net Par
  Outstanding |       
|                                  |  |                                             |         |                                          |  |                                             |   |                                          |       
|S&P
  Rating Category(1):         |  |                                             |         |                                          |  |                                             |   |                                          |        |  |  |       |  
|AAA                               |  | $                                           | 34,559  |                                          |  | 29.3                                        | % | $                                        | 22,697 |  |  | 27.7  | %
|AA                                |  |                                             | 17,846  |                                          |  | 15.1                                        | % |                                          | 10,640 |  |  | 13.0  | %
|A                                 |  |                                             | 35,226  |                                          |  | 29.9                                        | % |                                          | 27,185 |  |  | 33.2  | %
|BBB                               |  |                                             | 29,889  |                                          |  | 25.3                                        | % |                                          | 20,962 |  |  | 25.6  | %
|Below investment
  grade          |  |                                             | 492     |                                          |  | 0.4                                         | % |                                          | 407    |  |  | 0.5   | %
|                                  |  |                                             |         |                                          |  |                                             |   |                                          |        |  |  |       |  
|Total                             |  | $                                           | 118,012 |                                          |  | 100.0                                       | % | $                                        | 81,891 |  |  | 100.0 | %
|                                  |  |                                             |         |                                          |  |                                             |   |                                          |        |  |  |       |  



---

|    |                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------
|(1) | If unrated by
  S&P, an internal assessment of underlying credit quality is used to
  calculate a rating. See Ratings.

63

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As
discussed above, the initial expected loss ratio selected by management to
determine our unallocated reserves is based on historical financial guarantee
insurance industry loss experience, based on managements judgment, adjusted
for the risk inherent in our in-force business, as compared to that of the
industry, and our actual loss experience. Based upon the actual historical
industry loss experience considered in establishing our unallocated reserves,
we believe it is reasonably likely that the industry loss ratio could vary
within a range of plus or minus 5 percentage points of its current mean. However,
determining the variability in managements initial expected loss ratio that
could be considered to be reasonably likely requires the application of further
management judgment. In this regard, after considering the variability of
industry loss experience that would be reasonably likely, management applied
its judgment to consider whether its own experience and the composition of our
in-force business would suggest that another range of variability would be more
appropriate for measuring the reasonably likely variability of our unallocated
reserves. In addition, management considered the change in our unallocated
reserves, implied by our selection of a reasonably likely range of variability,
relative to the insured risks on our flag lists noted above. Based on the
convergence of the mix of our in force business with that of the industry, our
cumulative experience to date, and the insured risks on our flag lists compared
to our selected range, management concluded that the selected industry
historical range of loss reserve variability would also represent an
appropriate range around our current initial expected loss ratio. Accordingly,
increasing our initial expected loss ratio by 5 percentage points, which would
be indicative of a deteriorating economic and credit environment, would
increase our net unallocated reserves by approximately $16.7 million or 22.1%
more than that recorded at December 31, 2006. Similarly, decreasing our initial
expected loss ratio by 5 percentage points, which would be indicative of a
robust economy would decrease our net unallocated reserves by $15.8 million or
21.0% less than that recorded at December 31, 2006. Please see Key Factors
Affecting Profitability.

At December
31, 2006, the loss list consisted of 4 credits, 3 of which had case reserves.
Gross case basis reserves at December 31, 2006 were $83.9 million (or $13.6
million net of ceded reinsurance). One credit did not have a case reserve
because it had been fully paid and it remains on the loss list to monitor
certain ongoing related litigation. One other credit, aggregating at December
31, 2006, has $1.6 million of case reserves and $2.8 million of par outstanding
is not viewed by us as significant. The remaining two insured transactions, of
which one was a single-structured risk project financing and the other was a
mortgage-backed securitization are discussed in Note 13 (a) and 13 (c) to the
Consolidated Financial Statements elsewhere herein. We have not received a
claim on any of these credits that have case reserves.

Case basis
reserve established represents a point estimate reflecting managements best
estimate, in its judgment, of the ultimate loss expected to be incurred on the
policies. Managements estimate was based on projections of cash flows expected
from the assets supporting the insured obligations debt service requirements,
as well as qualitative factors considered by management.

See Note 13
in our Consolidated Financial Statements for a discussion of
the significant activity in our reserves for losses and loss adjustment
expenses including both current and prior year development.

Industry
Methodology

We are
aware that there are certain differences regarding the measurement of
unallocated reserves for losses and loss adjustment expenses among companies in
the financial guarantee industry. In January and February 2005, the SEC staff
had discussions concerning these differences with a number of industry
participants. Based on those discussions, in June 2005, the FASB staff decided
additional guidance is necessary. The FASB arrived at tentative decisions
during the Board meetings held in the third quarter which will form the basis
of a forthcoming Exposure Draft.  When
the FASB staff reaches a conclusion on this issue we (and the rest of the
financial guarantee industry) may be required to change our loss reserving
policies as well as other accounting policies. We cannot currently assess how
the FASB or SEC staffs ultimate resolution of this issue will impact us or
other members of our industry. However, any changes required by the FASB as a
result its deliberations on this matter could have a material effect on the
reported operating results and financial condition of the industry or
particular market participants, including us, depending on the extent to which
current policies differ from those promulgated by such regulatory bodies.

64

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Valuation of
Credit Default Swaps

We write
and reinsure credit default swaps, which are derivative financial instruments.
While we view the credit default swaps that we write or reinsure as, in
substance, an extension of our financial guarantee business, they do not
qualify for the financial guarantee insurance scope exception under FAS 133
and, therefore, are reported at fair value, with changes in fair value included
in our earnings.

Because we
view these derivative contracts as an extension of our financial guarantee
business, we believe that the most meaningful presentation of these derivatives
is to reflect: (i) fees that we receive from the issuance of such contracts in
the line item captions in the statement of operations entitled gross premiums
written, reinsurance premium assumed, net premiums written and net
premiums earned, as appropriate, (ii) losses from actual and expected payments
to counterparties under such contracts in the line item caption in the
statement of operations entitled net losses and loss adjustment expenses and
(iii) changes in the fair value of such instruments which are attributable to
market factors, as discussed below, in the line item caption in the statement
of operations entitled net realized and unrealized gains (losses) on credit
derivatives.

We
generally hold credit default swaps that we issue to maturity. However, in
certain circumstances, such as for risk management purposes, we may decide to
terminate a derivative contract prior to maturity. When we hold a derivative to
maturity, the cumulative unrealized gains and losses will net to zero if we
incur no credit losses on that contract. However, in the event that we
terminate a derivative contract prior to maturity the unrealized gain or loss
would be realized through premiums earned and losses incurred.

We
determine the fair value of our issued in-force credit default swaps using a
model we have developed. This model utilizes observable market data where
available and is dependent upon a number of factors including changes in
interest rates, credit spreads, changes in credit quality, expected recovery
rates and other market factors. The change in fair value resulting from
movements in these factors is unrealized as the credit default swaps are not
traded to realize this value. Because the valuation of our credit default swaps
requires management to make certain assumptions and estimates, actual
experience may differ from the estimates reflected in our consolidated
financial statements, and the differences may be material. This model and the
related assumptions are periodically reevaluated by management and enhanced, as
appropriate, based upon improvements in modeling techniques and availability of
more timely market information. While limited in volume, transactions where we
reinsure a derivative instrument are also reported at fair value using
information from the primary insurer. A decrease in interest rates of 1% would
have decreased the value of the net derivative asset at December 31, 2006 by
$6.5 million. There would not have been a significant impact on the value of
our credit default swaps as a result of a 10% increase in default rates or a
10% decrease in recovery rates.

Valuation of
Investments

All of our
investments in debt securities and short-term investments are considered
available-for-sale and accordingly are carried at fair value. As of December
31, 2006 and 2005, the carrying value of such investments was $2.0 billion and
$1.3 billion, respectively. The fair values of our investments are based upon
quoted market prices from nationally recognized pricing services or, in the
absence of quoted market prices, on dealer quotes.

As
    of December 31, 2006, based on fair value, approximately 89% of our investments
were long-term debt securities, and our portfolio had an average duration of
3.1 years, compared with 96% and 3.5 years as of December 31, 2005. Changes in
interest rates affect the value of our investment portfolio. As interest rates
fall, the fair value of debt securities increases, and as interest rates rise,
the fair value of debt securities decreases. The following table summarizes the
estimated change in fair value net of related income taxes of our investments
in debt securities and short-term investments as of December 31, 2006 based
upon an assumed parallel shift in interest rates across the entire yield curve:

|                            |  |                                              |        |  
|--------------------------- |  | -------------------------------------------- | ------ | -
|(in millions)               |  | Estimated Increase(Decrease in
  Fair Value) |       
|                            |  |                                              |       
|Change
  in interest rates: |  |                                              |        |  
|300 basis point rise        |  | $                                            | (199.6 | )
|200 basis point rise        |  |                                              | (133.1 | )
|100 basis point rise        |  |                                              | (66.5  | )
|100 basis point decrease    |  |                                              | 66.5   |  
|200 basis point decrease    |  |                                              | 133.1  |  
|300 basis point decrease    |  |                                              | 199.6  |  

Our process
for identifying declines in the fair value of investments that are
other-than-temporary involves consideration of several factors. These factors
include (i) the time period during which there has been a significant decline
in value, (ii) an analysis of the liquidity, business prospects and 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) our intent and ability to hold the
investment for a sufficient period of time for the value to recover. Where our
analysis of the above factors results in the conclusion that declines in fair
values are other-than-temporary, the cost of the security would be written down
to fair value and such write down is reflected as a realized loss in the period
that such determination is made.

65

---



We
    did not record any other-than-temporary declines in the fair value of debt
    securities or short-term investments for the years ended December 31, 2006,
2005 or 2004.

The
following table summarizes the unrealized losses on debt securities and
short-term investments in our investment portfolio by type of security and the
length of time such securities have been in a continuous unrealized loss
position as of the dates indicated:

|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   |     |   |           |  |   |        | 
|-------------------------------------------------- |  | ------------------- | ------- | ----------------- | - | ---------- |  | ----------------- | ------- | ---------- | - | ----------------- | --- | - | --------- |  | - | ------ | 
|                                                   |  |                     |         | December 31, 2006 |   |            | 
|                                                   |  |                     |         |                   |   |            | 
|                                                   |  | Less than 12 months |         | 12 months or more |   | Total      | 
|                                                   |  |                     |         |                   |   |            | 
|(in thousands)                                     |  | Fair Value          |         | Unrealized
  Loss |   | Fair Value |  | Unrealized
  Loss |         | Fair Value |   | Unrealized
  Loss |    
|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   |    
|Description of securities                          |  |                     |         |                   |   |            |  |                   |         |            |   |                   |     |   |           |  |   |        | 
|Mortgage and asset-backed securities               |  | $                   | 220,065 |                   | $ | 931        |  | $                 | 371,675 |            | $ | 10,504            |     | $ | 591,740   |  | $ | 11,435 | 
|U.S. Government and government agencies            |  |                     | 60,713  |                   |   | 575        |  |                   | 361,831 |            |   | 7,571             |     |   | 422,544   |  |   | 8,146  | 
|Corporate                                          |  |                     | 46,444  |                   |   | 204        |  |                   | 211,228 |            |   | 5,913             |     |   | 257,672   |  |   | 6,117  | 
|U.S. states and political subdivisions             |  |                     |        |                   |   |           |  |                   | 2,227   |            |   | 27                |     |   | 2,227     |  |   | 27     | 
|Non-U.S. sovereign government                      |  |                     | 503     |                   |   |           |  |                   | 8,424   |            |   | 201               |     |   | 8,927     |  |   | 201    | 
|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   |     |   |           |  |   |        | 
|Total debt securities and
  short-term investments |  | $                   | 327,725 |                   | $ | 1,710      |  | $                 | 955,385 |            | $ | 24,216            | (1) | $ | 1,283,110 |  | $ | 25,926 | 
|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   |     |   |           |  |   |        | 

|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   |  |   |           |  |   |        | 
|-------------------------------------------------- |  | ------------------- | ------- | ----------------- | - | ---------- |  | ----------------- | ------- | ---------- | - | ----------------- |  | - | --------- |  | - | ------ | 
|                                                   |  |                     |         |                   |   |            |  | December 31, 2005 |         |            |   |                   |  |   |          
|                                                   |  |                     |         |                   |   |            | 
|                                                   |  | Less than 12 months |         | 12 months or more |   | Total      | 
|                                                   |  |                     |         |                   |   |            | 
|(in thousands)                                     |  | Fair Value          |         | Unrealized
  Loss |   | Fair Value |  | Unrealized
  Loss |         | Fair Value |   | Unrealized
  Loss | 
|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   | 
|Description of securities                          |  |                     |         |                   |   |            |  |                   |         |            |   |                   |  |   |           |  |   |        | 
|Mortgage and asset-backed securities               |  | $                   | 225,179 |                   | $ | 3,846      |  | $                 | 244,632 |            | $ | 7,841             |  | $ | 469,811   |  | $ | 11,687 | 
|U.S. Government and government agencies            |  |                     | 352,657 |                   |   | 4,456      |  |                   | 82,271  |            |   | 2,210             |  |   | 434,928   |  |   | 6,666  | 
|Corporate                                          |  |                     | 139,192 |                   |   | 2,032      |  |                   | 91,972  |            |   | 3,355             |  |   | 231,164   |  |   | 5,387  | 
|U.S. states and political subdivisions             |  |                     | 410     |                   |   |           |  |                   | 1,804   |            |   | 45                |  |   | 2,214     |  |   | 45     | 
|Non-U.S. sovereign government                      |  |                     |        |                   |   |           |  |                   | 8,445   |            |   | 234               |  |   | 8,445     |  |   | 234    | 
|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   |  |   |           |  |   |        | 
|Total debt securities and
  short-term investments |  | $                   | 717,438 |                   | $ | 10,334     |  | $                 | 429,124 |            | $ | 13,685            |  | $ | 1,146,562 |  | $ | 24,019 | 
|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   |  |   |           |  |   |        | 



---

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | 
|(1)Securities in a continuous
  unrealized loss position for 12 months or more consist of U.S. Government and
  Agency securities aggregating $7.6 million and corporate bonds,
  mortgage-backed, and asset-backed securities (non-government securities)
  aggregating $16.4 million.  Of the
  non-government securities 59.2%, 74.7%, and 100% are rated AAA, AA- or
  better, and A- or better, respectively, by S&P as of December 31,
  2006.  In addition, of the
  non-government securities in a continuous unrealized loss position of 12
  months or more, securities aggregating 87% of the total unrealized loss in
  such category have a price decline of less than 6% from their cost and 13%
  have a price decline between 6% and 9% of their cost as of December 31, 2006.

Premium Revenue Recognition

Premiums
charged by us in connection with the issuance of our guarantees are received
either upfront or in installments. Such premiums are recognized as written when
due. Installment premiums written are earned ratably over the installment
period, generally one to three months, which is consistent with the expiration
of the underlying risk or amortization of the underlying insured par. Upfront
premiums written are also earned in proportion to the expiration of the related
risk. However, the methodology employed to earn upfront premiums requires that
such premiums be apportioned to individual scheduled principal payments of a
bond issue according to the bond issues amortization schedule. The
apportionment is based on the ratio of the principal amount of each scheduled
principal payment to the total principal amount of the bond issue. After the
premium is allocated to each scheduled principal payment, such allocated
premium is earned on a straight-line basis over the period of that scheduled
principal payment. As a result, for upfront premiums on amortizing insured
obligations, premium revenue recognition will tend to be greater in the earlier
periods of the transaction when there is a higher amount of risk or principal
outstanding. The effect of our upfront premium earnings policy is that we

66

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recognize greater levels of upfront premiums in earlier years of each
amortizing insured obligation. Recognizing premium revenue on a straight line
basis over the life of each amortizing insured obligation without allocating
premiums to the scheduled principal payments would materially change the amount
of premium we recognize in a particular financial reporting period, but not
over the life of the applicable policy. For upfront premiums on non-amortizing
bullet maturity debt obligations, premium revenue recognition is recognized on
a straight-line basis over the life of the underlying insured obligation.
Deferred premium revenue represents the portion of premiums written that is
applicable to the unexpired risk or principal of insured obligations. In
addition, when an insured issue is retired early, is called by the issuer or is
in substance paid in advance through a refunding accomplished by placing U.S.
Government securities in escrow, the remaining deferred premium revenue is
earned at that time. Premiums earned for the years ended December 31, 2006,
2005 and 2004 include $27.4 million, $14.7 million, and $6.0 million,
respectively, related to refunded and called bonds.

While
premium earnings would be ratably recorded as revenue throughout the period of
risk, application of a straight-line method to amortizing obligations would not
appropriately match premiums earned to our exposure to underlying risk.
Therefore, we believe our upfront premium earnings methodology is the most
appropriate methodology for us to utilize.

For the
years ended December 31, 2006, 2005 and 2004, approximately 69%, 57% and 63%,
respectively, of our gross premiums written were received upfront, and 31%, 43%
and 37%, respectively, were received in installments. For the years ended
December 31, 2006, 2005 and 2004  approximately
65%, 59% and 45%, respectively, of our reinsurance premiums assumed were
received upfront, and 35%, 41% and 55%, respectively, were received in
installments.

Our
accounting policies for the recognition of ceded premiums, ceding commissions
and ceded losses and loss adjustment expenses under our ceded reinsurance
contracts mirror the policies described under our critical accounting policy
discussion above for premium revenue recognition, deferred ceding commissions,
and reserves for losses and loss adjustment expenses. See Critical Accounting
Policies and Estimates.

We describe
our premium revenue recognition for reinsurance contracts under Reserves for
Losses and Loss Adjustment Expenses and with regard to ceded reinsurance under
Liquidity and Capital ResourcesCeded Reinsurance Recoverables.

Deferred
Acquisition Costs and Deferred Ceding Commissions

Acquisition
costs incurred that vary with and are directly related to the production of new
insurance and reinsurance business are deferred and amortized to expense in
relation to earned premiums. These costs include direct and indirect expenses
such as compensation costs of underwriting and marketing personnel and ceding
commissions paid on assumed business. As of December 31, 2006 and 2005, we had
deferred acquisition costs of $93.8 million and $59.6 million, respectively.
Management uses its judgment in determining the amount of costs that should be
deferred. Each year we conduct a study to determine the amount of operating
costs that vary with, and are directly related to, the acquisition of new
business and therefore qualify for deferral. The amount of expenses that
qualify for deferral is dependent on the level of new business production, the
level of ceding commissions negotiated with primary insurers, managements
judgment as to what costs and the percentages thereof that are deferrable.
Ceding commissions received on premiums we cede to other reinsurers reduce
acquisition costs. Such costs are earned in relation to earned premium. In
determining the recoverability of our deferred acquisition costs we consider
expected losses and loss adjustment expenses, maintenance costs, unearned
premiums, the anticipated present value of future premiums under installment contracts
written, and anticipated investment income. Acquisition costs associated with
credit derivative products are expensed as incurred. For policies reinsured
with third parties we receive ceding commissions to compensate for acquisition
costs incurred. We net ceding commissions received against deferred acquisition
costs and earn these ceding commissions over the period in which the related
premiums are earned.

67

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Deferred Income
Taxes

Deferred
income tax assets and liabilities are established for the temporary differences
between the financial statement carrying amounts and tax bases of assets and
liabilities using enacted rates in effect for the year in which the differences
are expected to reverse. Such temporary differences relate principally to
deferred ceding commissions, reserves for losses and loss adjustment expenses,
deferred premium revenue, realized and unrealized gains and losses on
investments and derivative financial instruments and statutory contingency
reserves. A valuation allowance is recorded to reduce a deferred tax asset to
the amount that is estimated to be more likely than not to be realized.

As
    of December 31, 2006 and 2005, our consolidated financial statements reflect
    a deferred federal income tax asset of $18.2 million, and $17.6 million,
respectively, resulting from the operations of the SCA Holdings U.S. Inc. group
which are subject to U.S. federal income taxes. Such deferred tax assets are
net of a valuation allowance of $1.9 million and $0.9 million as of December
31, 2006 and 2005, respectively. The valuation allowance relates to net
unrealized capital losses and a net realized capital loss carry forward that
may not be realized within a reasonable period.  At December 31, 2006, the Company
    has net unrealized capital losses and a net realized capital loss carry forward
    of approximately $3.2 million and $2.2 million respectively, against which
    a valuation allowance has been established. The net realized capital
loss carry forward will expire in 2011.

Management believes it is more likely than not that the tax benefit
relating to the Companys deferred tax assets, net of the valuation allowance
discussed above, will be realized.

Consolidated Results of Operations

The
following table presents summary consolidated statement of operations data for
the years ended December 31,2006, 2005 and 2004:

|                                                                                      |  |      |          |      |   |         |   |   |          |  
|------------------------------------------------------------------------------------- |  | ---- | -------- | ---- | - | ------- | - | - | -------- | -
|(in thousands, except
  per share amounts)                                            |  | 2006 |          | 2005 |   | 2004    |  
|                                                                                      |  |      |          |      |   |         |  
|Revenues                                                                              |  |      |          |      |   |         |   |   |          |  
|Gross premiums written                                                                |  | $    | 353,728  |      | $ | 233,269 |   | $ | 232,541  |  
|Reinsurance premiums assumed                                                          |  |      | 55,271   |      |   | 52,170  |   |   | 44,021   |  
|                                                                                      |  |      |          |      |   |         |   |   |          |  
|Total premiums written                                                                |  |      | 408,999  |      |   | 285,439 |   |   | 276,562  |  
|Ceded premiums written                                                                |  |      | (13,067  | )    |   | (40,527 | ) |   | (8,123   | )
|                                                                                      |  |      |          |      |   |         |   |   |          |  
|Net premiums written                                                                  |  |      | 395,932  |      |   | 244,912 |   |   | 268,439  |  
|Change in net deferred premium revenue                                                |  |      | (212,817 | )    |   | (93,073 | ) |   | (152,158 | )
|                                                                                      |  |      |          |      |   |         |   |   |          |  
|Net premiums earned (net of ceded premiums
  earned of $22,957; $28,107; and $59,144) |  |      | 183,115  |      |   | 151,839 |   |   | 116,281  |  
|Net investment income                                                                 |  |      | 77,724   |      |   | 51,160  |   |   | 35,746   |  
|Net realized losses on investments                                                    |  |      | (16,180  | )    |   | (3,221  | ) |   | (178     | )
|Net realized and unrealized (losses) gains
  on credit derivatives                    |  |      | (8,385   | )    |   | (6,681  | ) |   | 12,687   |  
|Fee income and other                                                                  |  |      | 2,365    |      |   | 750     |   |   | 100      |  
|                                                                                      |  |      |          |      |   |         |   |   |          |  
|Total revenues                                                                        |  |      | 238,639  |      |   | 193,847 |   |   | 164,636  |  
|                                                                                      |  |      |          |      |   |         |   |   |          |  
|Expenses                                                                              |  |      |          |      |   |         |   |   |          |  
|Net losses and loss adjustment expenses                                               |  |      | 14,958   |      |   | 26,021  |   |   | 21,274   |  
|Acquisition costs, net                                                                |  |      | 16,240   |      |   | 12,231  |   |   | 8,259    |  
|Operating expenses                                                                    |  |      | 78,999   |      |   | 67,621  |   |   | 58,395   |  
|                                                                                      |  |      |          |      |   |         |   |   |          |  
|Total expenses                                                                        |  |      | 110,197  |      |   | 105,873 |   |   | 87,928   |  
|                                                                                      |  |      |          |      |   |         |   |   |          |  
|Income before income tax and
  minority interest                                      |  |      | 128,442  |      |   | 87,974  |   |   | 76,708   |  
|Income tax expense (benefit)                                                          |  |      | 3,133    |      |   | (1,277  | ) |   | 1,920    |  
|                                                                                      |  |      |          |      |   |         |   |   |          |  
|Income before minority interest                                                       |  |      | 125,309  |      |   | 89,251  |   |   | 74,788   |  
|Minority interest - dividends on redeemable
  preferred shares                        |  |      | 7,954    |      |   | 8,805   |   |   | 15,934   |  
|                                                                                      |  |      |          |      |   |         |   |   |          |  
|Net income                                                                            |  | $    | 117,355  |      | $ | 80,446  |   | $ | 58,854   |  
|                                                                                      |  |      |          |      |   |         |   |   |          |  

68

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Segment Results of Operations

The following table presents summary statement of operations data for
our operating segments for the years ended December 31, 2006, 2005 and 2004:

|                                                                   |  |                          |          |      |   |         |   |   |          |  
|------------------------------------------------------------------ |  | ------------------------ | -------- | ---- | - | ------- | - | - | -------- | -
|                                                                   |  | Years ended December 31, |         
|                                                                   |  |                          |         
|(in thousands)                                                     |  | 2006                     |          | 2005 |   | 2004    |  
|                                                                   |  |                          |          |      |   |         |  
|Financial guarantee insurance
  segment:                           |  |                          |          |      |   |         |   |   |          |  
|Gross premiums written                                             |  | $                        | 353,728  |      | $ | 233,269 |   | $ | 232,541  |  
|Ceded premiums                                                     |  |                          | (13,067  | )    |   | (40,527 | ) |   | (8,123   | )
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net premiums written                                               |  |                          | 340,661  |      |   | 192,742 |   |   | 224,418  |  
|Change in net deferred premium revenue                             |  |                          | (185,098 | )    |   | (72,159 | ) |   | (138,977 | )
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net premiums earned                                                |  |                          | 155,563  |      |   | 120,583 |   |   | 85,441   |  
|Fee and other income                                               |  |                          | 2,365    |      |   | 750     |   |   | 100      |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Total underwriting revenues                                        |  |                          | 157,928  |      |   | 121,333 |   |   | 85,541   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net losses and loss adjustment expenses                            |  |                          | 12,639   |      |   | 25,369  |   |   | 17,099   |  
|Acquisition costs, net                                             |  |                          | 10,537   |      |   | 4,664   |   |   | 1,932    |  
|Operating expenses                                                 |  |                          | 62,592   |      |   | 59,434  |   |   | 48,071   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Total underwriting expenses                                        |  |                          | 85,768   |      |   | 89,467  |   |   | 67,102   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Financial guarantee insurance underwriting
  profit                |  |                          | 72,160   |      |   | 31,866  |   |   | 18,439   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Financial guarantee reinsurance
  segment:                         |  |                          |          |      |   |         |   |   |          |  
|Reinsurance premiums assumed                                       |  |                          | 55,271   |      |   | 52,170  |   |   | 44,021   |  
|Change in net deferred premium revenue                             |  |                          | (27,719  | )    |   | (20,914 | ) |   | (13,181  | )
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net premiums earned and total underwriting
  revenues              |  |                          | 27,552   |      |   | 31,256  |   |   | 30,840   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net losses and loss adjustment expenses                            |  |                          | 2,319    |      |   | 652     |   |   | 4,175    |  
|Acquisition costs, net                                             |  |                          | 5,703    |      |   | 7,567   |   |   | 6,327    |  
|Operating expenses                                                 |  |                          | 10,055   |      |   | 8,187   |   |   | 10,324   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Total underwriting expenses                                        |  |                          | 18,077   |      |   | 16,406  |   |   | 20,826   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Financial guarantee reinsurance
  underwriting profit              |  |                          | 9,475    |      |   | 14,850  |   |   | 10,014   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Total segment underwriting profit                                  |  |                          | 81,635   |      |   | 46,716  |   |   | 28,453   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Corporate and other:                                               |  |                          |          |      |   |         |   |   |          |  
|Net investment income                                              |  |                          | 77,724   |      |   | 51,160  |   |   | 35,746   |  
|Net realized losses on investments                                 |  |                          | (16,180  | )    |   | (3,221  | ) |   | (178     | )
|Net realized and unrealized (losses) gains
  on credit derivatives |  |                          | (8,385   | )    |   | (6,681  | ) |   | 12,687   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Subtotal                                                           |  |                          | 134,794  |      |   | 87,974  |   |   | 76,708   |  
|Corporate operating expenses                                       |  |                          | 6,352    |      |   |        |   |   |         |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Income before income tax and
  minority interest                   |  |                          | 128,442  |      |   | 87,974  |   |   | 76,708   |  
|Income tax expense (benefit)                                       |  |                          | 3,133    |      |   | (1,277  | ) |   | 1,920    |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Income before minority interest                                    |  |                          | 125,309  |      |   | 89,251  |   |   | 74,788   |  
|Minority interest - dividends on redeemable
  preferred shares     |  |                          | 7,954    |      |   | 8,805   |   |   | 15,934   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net income                                                         |  | $                        | 117,355  |      | $ | 80,446  |   | $ | 58,854   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  

69

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Discussion of Consolidated and Segment
Results of Operations for the Fiscal Years 2006, 2005 and 2004

Net Income

Comparison of Year Ended December 31, 2006 to
Year Ended December 31, 2005.Net income
for the year ended December 31, 2006 was $117.4 million, an increase of $36.9
million from that reported in 2005. Net income for the year ended December 31,
2006 included $16.2 million of net realized losses on investments, as compared
to net realized losses of $3.2 million in 2005. In addition, also included in
net income in 2006 was approximately $8.4 million of net realized and
unrealized losses on credit derivatives, as compared to net realized and
unrealized losses on credit derivatives of $6.7 million in 2005.

The
increase in our net income of $36.9 million for the year ended December 31,
2006, as compared to 2005, was primarily driven by: (i) significant growth in
net premiums earned of $31.3 million, which was largely due to refunding
activity, the effect of the transfer of certain business to XLFA from an
affiliate in connection with our IPO See Formation Transactions,
and the growth of our insured in force business, (ii) an increase in investment
income of $26.6 million reflecting an increase in average invested assets and
higher yields on new money investments, and (iii) lower net losses and loss adjustment
expenses of $11.1 million, offset in part by (iv) higher net realized losses
on investments of $13.0 million which primarily resulted from a $15.1 million
impairment charge recorded during 2006 on investments acquired in satisfaction
of a claim, (v) higher net realized and unrealized losses on credit derivatives
of $1.7 million due primarily to higher mark to market losses on insured interest
rate swaps resulting from lower long-term interest rates and the addition of
interest rate swaps to the portfolio, (vi) higher net acquisition costs of $4.0
million primarily reflecting the effect of the aforementioned refunding
activity and growth in our in force business, (vii) an increase in operating
expenses of $11.4 million, which resulted primarily from an increase in
compensation costs associated with certain employees whose compensation prior
to the IPO was partially charged to other affiliates of XL Capital, as well as
certain expenses associated with SCA being a standalone public company, which
prior to the IPO we did not incur, and (viii) an increase in income tax expense
of $4.4 million resulting from higher profitability in the Companys operations
in the United States.

Set
forth below is additional information with respect to certain of the items
discussed above, as well as other elements of our earnings for the year ended December 31, 2006, as compared to
2005:

Net
premiums earned for the year ended December 31, 2006 were $183.1 million and
included $27.4 million of earnings from the early retirement of certain
guaranteed obligations (refundings) (or $25.1 million, net of accelerated
amortization of deferred acquisition costs related to the earnings from such
refundings).  For the year ended
December 31, 2005, net earned premiums were $151.8 million and included $14.7
million of refundings (or $13.2 million, net of accelerated amortization of
deferred acquisition costs related to the earnings from such refundings).  The year over year increase in earned
premiums (excluding earned premiums from refundings) resulted from the effect of the transfer of
certain business to us from XLI in connection with our IPO See Formation
Transactions, andthe continued growth in our in force book of
business.  Our business production as
measured by AGP (which includes upfront premiums written in the period, current
installment premiums due on business written in the period and expected future
installment premiums on business written during the period discounted at 7.0%)
totaled $556.1 million for the year ended December 31, 2006, a 40.5% increase
over $395.8 million in 2005. For a reconciliation of AGP to premiums written
see Other Measures Used by Management to Evaluate Operating Performance.

Investment
income totaled $77.7 million for the year ended December 31, 2006, a $26.5
million increase from $51.2 million reported in 2005.  The favorable variance was driven by an increase in average
investment balances period over period and an increase in new money
yields.  The weighted average invested
assets for the year ended December 31, 2006 was $1.7 billion, as compared to
$1.3 billion during 2005.  The increase
in average invested assets resulted primarily from: (i) operating cash flows of
$392.9 million during 2006, (ii) net proceeds from SCAs IPO of $342.3 million,
(iii) capital contributions in cash of $21.2 million, (iv) a $2.5 million
reimbursement of compensation expense recognized during 2006 relating to awards
exchanged under SCAs Offer to Exchange originally filed on Schedule TO with
the Securities and Exchange Commission on November 13, 2006, (v) approximately
$22.0 million in cash received in connection with business transferred from XLI
in connection with the IPO, offset in part by, (vi) SCAs dividend payout, (vii)
the dividend payout on XLFAs preferred shares, and (viii) the acceleration of
SCAs deferred Bonus awards, all of which payments aggregated approximately $8.0
million.  Weighted average yield
increased to 4.6% in 2006 from 3.9% in 2005.

For
the year ended December 31, 2006, we recorded a provision for net losses and
loss adjustment expenses of $15.0 million, a decrease of $11.0 million, or
42.3%, from the $26.0 million recorded in 2005. The decrease resulted from
lower provisions for case basis reserves after reinsurance, offset in part by
    a nominal increase in the provision for unallocated reserves, as compared
    to 2005. During the year ended December 31, 2006 there were nominal net provisions
    for case

70

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basis
reserves, whereas such activity for 2005 included a provision for case basis
reserves of $12.2 million, of which $12.1 million related to two insured
obligations See Note 13 (a) and 13 (b) to the Consolidated Financial
Statements elsewhere herein for details.

Comparison
of Year Ended December 31, 2005 to Year Ended December 31, 2004.We reported net income for 2005 of
$80.4 million, a 36.5% increase over $58.9 million in 2004. The increase in our
2005 earnings was driven by significant growth in net premiums earned,
reflecting new business written in 2005 as well as the cumulative benefit of
business written in prior years, and a 43.4% increase in investment income as
our growing investment portfolio was invested at higher yields in the
increasing interest rate environment. The increase in our investment portfolio
primarily resulted from new business production and a capital contribution of
$125 million in December 2004. Market conditions in 2005 continued to reflect
tight credit spreads and increasing financial guarantee insurance competition.
However, the volume of new securities issued in our principal target markets
increased over 2004 and we were able to increase our production of new business
written across all business lines, other than asset-backed obligations, while
still maintaining price and underwriting discipline. Our business production in
any period, as measured by AGP (which includes upfront premiums written in such
period, current installment premiums due on business written in such period and
expected future installment premiums discounted at 7% on business written
during such period) totaled $395.8 million in 2005, a 34.2% increase over
$295.0 million in 2004.For a
reconciliation of AGP to premiums written see Other Measures Used by
Management to Evaluate Operating Performance.

Our
provision for net losses and loss adjustment expenses grew modestly in 2005 as
compared to 2004, reflecting both an increase in unallocated reserves
reflecting the growth in our in-force book of business and an increase in case
basis reserves relating to certain insured credits. In addition, our operating
expenses increased by 15.8% as we continued the build-out of our information
technology infrastructure and added resources needed to support the planned
growth of our business. We recorded a net unrealized loss on credit derivatives
of $6.7 million in 2005 as compared to a net unrealized gain of $12.7 million
during the prior year, primarily as a result of a slight widening of credit
spreads, partially offset by the improved credit quality of underlying
obligations for which we wrote credit default swaps.

Dividends
on the Series A preferred shares of XLFA decreased by 44.7% in 2005 as compared
to 2004. The dividend on the XLFA Series A preferred shares varied from period
to period, prior to December 31, 2005, because it was based in part on the
average dividend rate paid by a select group of financial guarantee companies.
Effective January 1, 2006, the dividend rate on the Series A preferred shares
was changed to a fixed rate of 81⁄4% per year. See Note 5 to our consolidated
financial statements for details.

Gross Premiums
Written

All our
gross premiums written are from our financial guarantee insurance segment.
Gross premiums written during the period include: (i) premiums received upfront
on policies or contracts written during the period, (ii) installment premiums
received during the period on in-force policies or contracts that were written
prior to the period, and (iii) installment premiums received during the period
on policies and contracts written during the period. Gross premiums written
during the period do not include installment premiums due in future periods. Accordingly,
our premiums written during any period are a function of the type of contracts
we write (upfront versus installment), as well as prevailing market prices.
Factors affecting market prices include credit spreads, interest rates,
competition and new issuance and refunding volume. Generally, financial
guarantee insurers are able to charge higher premiums when credit spreads
widen. The following table presents, for the periods indicated, the amount of
gross premiums written attributable to upfront and installment policies and
contracts.

|                               |  |                                 |         |      |   |         |  |   |         | 
|------------------------------ |  | ------------------------------- | ------- | ---- | - | ------- |  | - | ------- | 
|                               |  | For the Year Ended December 31, |        
|                               |  |                                 |        
|(in thousands)                 |  | 2006                            |         | 2005 |   | 2004    | 
|                               |  |                                 |         |      |   |         | 
|Gross premiums
  written:      |  |                                 |         |      |   |         |  |   |         | 
|Upfront policies/contracts     |  | $                               | 242,397 |      | $ | 133,100 |  | $ | 146,475 | 
|Installment policies/contracts |  |                                 | 111,331 |      |   | 100,169 |  |   | 86,066  | 
|                               |  |                                 |         |      |   |         |  |   |         | 
|                               |  | $                               | 353,728 |      | $ | 233,269 |  | $ | 232,541 | 
|                               |  |                                 |         |      |   |         |  |   |         | 

Gross
premiums written were $353.7 million in 2006, an increase of $120.4 million or
51.6%, from $233.3 million recorded in 2005. The
increase was primarily due to a $109.3 million increase in upfront premiums
written resulting from growth in premiums written in the public finance
infrastructure and utilities sectors, and an $11.1 million increase in
installment premiums written resulting from growth in the CDO and the
infrastructure financing portfolios partially offset by the decrease in
installment premiums written in the asset backed securities sector. See Managements Discussion and
Analysis of Financial Condition and Results of Operations Key Factors
Affecting Profitability for a discussion of the accounting for installment
premium business and the reason why installment premium reported in any period
is not

71

---



indicative of new installment business production, and Managements
Discussion and Analysis of Financial Condition and Results of Operations Other
Measures Used by Management to Evaluate Operating Performance for information
management reviews to evaluate new business production.

Gross
premiums written were $233.3 million in 2005, an increase of $0.8 million or
0.3%, from $232.5 million recorded in 2004. Gross premiums written remained
relatively flat in 2005 as compared to 2004, primarily as a result of a decline
in upfront premiums written offset by an increase in installment premiums
written. Upfront premiums declined due to tighter credit spreads and increased
market competition across our all our principal markets. The
increase in our installment premiums reflected the growth of our in-force book
of installment business.

The
following table presents, for the periods indicated, the amount of gross
premiums written by principal market:

|                         |  |                                 |         |      |   |         |  |   |         | 
|------------------------ |  | ------------------------------- | ------- | ---- | - | ------- |  | - | ------- | 
|                         |  | For the Year Ended December 31, |        
|                         |  |                                 |        
|(in thousands)           |  | 2006                            |         | 2005 |   | 2004    | 
|                         |  |                                 |         |      |   |         | 
|Gross premiums
  written |  |                                 |         |      |   |         |  |   |         | 
|U.S. Public finance      |  | $                               | 133,257 |      | $ | 93,820  |  | $ | 88,408  | 
|U.S. Structured finance  |  |                                 | 101,284 |      |   | 67,864  |  |   | 90,763  | 
|International finance    |  |                                 | 119,187 |      |   | 71,585  |  |   | 53,370  | 
|                         |  |                                 |         |      |   |         |  |   |         | 
|                         |  | $                               | 353,728 |      | $ | 233,269 |  | $ | 232,541 | 
|                         |  |                                 |         |      |   |         |  |   |         | 

See
Managements Discussion and Analysis of Financial Condition and Results of
Operations Other Measures Used by Management to Evaluate Operating
Performance for information management reviews to evaluate new business
production.

Reinsurance
Premiums Assumed

All our
reinsurance premiums assumed are from our financial guarantee reinsurance
segment. The majority of our financial guarantee reinsurance business is
assumed from affiliates of FSA.

The following
table presents, for the periods indicated, the amount of reinsurance premiums
assumed from affiliates of FSA, XLI, and other third-party primary companies:

|                                |  |                                 |        |      |   |        |  |   |        | 
|------------------------------- |  | ------------------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                |  | For the Year Ended December 31, |       
|                                |  |                                 |       
|(in thousands)                  |  | 2006                            |        | 2005 |   | 2004   | 
|                                |  |                                 |        |      |   |        | 
|Affiliates of FSA               |  | $                               | 38,513 |      | $ | 34,274 |  | $ | 32,131 | 
|XLI                             |  |                                 | 9,162  |      |   | 2,874  |  |   | 1,264  | 
|Third-party
  primary companies |  |                                 | 7,596  |      |   | 15,022 |  |   | 10,626 | 
|                                |  |                                 |        |      |   |        |  |   |        | 
|Total                           |  | $                               | 55,271 |      | $ | 52,170 |  | $ | 44,021 | 
|                                |  |                                 |        |      |   |        |  |   |        | 

Reinsurance
premiums assumed in 2006 were $55.3 million, an increase of $3.1 million or
5.9%, as compared to $52.2 million recorded in 2005. The increase resulted
primarily from premiums assumed in connection with the transfer of business
from XLI (see Managements Discussion and Analysis of Financial Condition and
Results of Operations Formation Transactions.  The amount of reinsurance ceded to us from year to year by
affiliates of FSA and other third-party primary companies depends upon the type
and amount of insurance that they write, their capital needs and other
factors.

Reinsurance
premiums assumed in 2005 were $52.2 million, an increase of $8.2 million or
18.6%, as compared to $44.0 million recorded in 2004. The increase was largely
due to a new reinsurance arrangement with a large third-party financial
guarantee primary company, which generated $7.0 million of assumed premiums.

The
following table presents, for the periods indicated, the amount of reinsurance
premiums assumed attributable to upfront and installment policies and
contracts:

|                                |  |                                 |        |      |   |        |  |   |        | 
|------------------------------- |  | ------------------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                |  | For the Year Ended December 31, |       
|                                |  |                                 |       
|(in thousands)                  |  | 2006                            |        | 2005 |   | 2004   | 
|                                |  |                                 |        |      |   |        | 
|Reinsurance
  premiums assumed: |  |                                 |        |      |   |        |  |   |        | 
|Upfront policies/contracts      |  | $                               | 35,860 |      | $ | 30,820 |  | $ | 19,947 | 
|Installment policies/contracts  |  |                                 | 19,411 |      |   | 21,350 |  |   | 24,074 | 
|                                |  |                                 |        |      |   |        |  |   |        | 
|                                |  | $                               | 55,271 |      | $ | 52,170 |  | $ | 44,021 | 
|                                |  |                                 |        |      |   |        |  |   |        | 

The
following table presents, for the periods indicated, the amount of gross
reinsurance premiums assumed by principal market:

72

---



|                                      |  |                                 |        |      |   |        |  |   |        | 
|------------------------------------- |  | ------------------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                      |  | For the Year Ended December 31, |       
|                                      |  |                                 |       
|(in thousands)                        |  | 2006                            |        | 2005 |   | 2004   | 
|                                      |  |                                 |        |      |   |        | 
|Gross reinsurance
  premiums assumed: |  |                                 |        |      |   |        |  |   |        | 
|U.S. Public finance                   |  | $                               | 1,095  |      | $ | 2,327  |  | $ | 17,603 | 
|U.S. Structured finance               |  |                                 | 7,925  |      |   | 23,536 |  |   | 409    | 
|International finance                 |  |                                 | 46,251 |      |   | 26,307 |  |   | 26,009 | 
|                                      |  |                                 |        |      |   |        |  |   |        | 
|                                      |  | $                               | 55,271 |      | $ | 52,170 |  | $ | 44,021 | 
|                                      |  |                                 |        |      |   |        |  |   |        | 

Ceded Premiums

We
    manage our in-force business based on single-risk limits to avoid concentration
    in single names and to mitigate event risk. For transactions that exceed
    these limits, we cede the excess to subsidiaries of XL Capital or third-party
    reinsurers. Through these cessions, we gain greater flexibility to manage
    large single risks and reduce concentration in specific bond sectors and
    geographic regions. Part of our long-term strategy is to reduce reinsurance
    to XLI and increase our third-party reinsurance relationships. To the extent
    that we cede a portion of our exposure to one or more reinsurance companies,
    we can reduce our concentration to particular issuers and help to control
    the diversification of our in-force business. In addition, use of reinsurance
    can increase our capacity to write new business and strengthen our financial
    ratios.

The
following table presents, for the periods indicated, the amount of premiums
ceded to XLI, XL Reinsurance America Inc., which we refer to as XL RE AM, a
wholly-owned subsidiary of XL Capital, and other third-party reinsurers:

|                               |  |                                 |         |      |   |         |   |   |         |  
|------------------------------ |  | ------------------------------- | ------- | ---- | - | ------- | - | - | ------- | -
|                               |  | For the Year Ended December 31, |        
|                               |  |                                 |        
|(in thousands)                 |  | 2006                            |         | 2005 |   | 2004    |  
|                               |  |                                 |         |      |   |         |  
|XLI                            |  | $                               | 18,298  |      | $ | (21,388 | ) | $ | 4,130   |  
|XL RE AM                       |  |                                 | (12,721 | )    |   | (2,449  | ) |   | 5,931   |  
|Other third-party
  reinsurers |  |                                 | (18,644 | )    |   | (16,690 | ) |   | (18,184 | )
|                               |  |                                 |         |      |   |         |   |   |         |  
|Total                          |  | $                               | (13,067 | )    | $ | (40,527 | ) | $ | (8,123  | )
|                               |  |                                 |         |      |   |         |   |   |         |  



---

All
    our ceded premiums are from our financial guarantee insurance segment. Ceded
premiums in 2006 were $13.1 million, a decrease of $27.4 million, or 67.7% as
compared to $40.5 million in 2005.  The
decrease was largely attributable to the transfer of certain business back to
XLFA from XLI in connection with our IPO, offset in part by an increase in
cessions to XL RE AM in connection with the management of XLCAs single risk
limits.  As a result of a capital
contribution to XLFA from the net proceeds of our IPO, XLFA had additional
capacity to retain risk and, accordingly, canceled reinsurance of certain
policies with XLI (see Managements Discussion and Analysis of Financial
Condition and Results of Operations Formation Transactions for further
details).  On July 1, 2006 XLCA and XLFA
amended their quota share reinsurance arrangement to reduce the maximum
percentage amount of any policy or contract that XLCA could reinsure with XLFA
from 90% to 75%.  As a result thereof,
XLCA was required to cede more business to XL RE AM in 2006, as compared to
2005, due to its need to comply with its single risk limits.


Ceded
premiums in 2005 were $40.5 million, an increase of $32.4 million as compared
to $8.1 million recorded in 2004. The increase in ceded premiums largely
resulted from the cancellation and commutation at the end of 2004 of
reinsurance provided to XLFA by XLI on 129 transactions, which reduced ceded
premiums in 2004 by approximately $35.2 million. As a result of a capital
contribution to XLFA at the end of 2004 of approximately $125 million, XLFA had
additional capacity to retain risk and, accordingly, canceled its reinsurance
with XLI on the aforementioned transactions. The commutation was accounted for
by XLFA at fair value. Fair value approximated carrying value due to no change
in the ratings on the underlying reinsured transactions. Accordingly, no gain
or loss was recognized by XLFA as a result of the commutation. Additionally,
XLCA commuted a reinsurance arrangement with XL RE AM effective January 1,
2004, which reduced ceded premiums in 2004 by approximately $6.0 million. XLCA
received a $100 million capital contribution in December of 2003 and for the
same reason XLFA commuted its reinsurance with XLI, XLCA commuted its
reinsurance arrangement with XL RE AM. Like XLFA, XLCA accounted for the
commutation at fair value and recognized no gain or loss.

Net Premiums
Earned

Financial
guarantee upfront premiums are earned in proportion to the expiration of the
related risk and financial guarantee installment premiums are earned ratably
over the installment period, generally one to three months. In addition, when
an insured issue is retired early, is called by the issuer or is in substance
paid in advance through a refunding accomplished by placing U.S. Government
securities in escrow, the remaining deferred premium revenue is earned at

73

---



that time. While reinsurance premiums assumed are earned based on
reports from the reinsured companies, we believe that the underlying reinsured
companies generally follow the revenue recognition policies and practices
discussed above. See Critical Accounting Policies and EstimatesPremium
Revenue Recognition.

The
following table presents, for the periods indicated, the amount of earned
premiums attributable to upfront and installment policies:

|                               |  |                                 |         |      |   |         |  |   |         | 
|------------------------------ |  | ------------------------------- | ------- | ---- | - | ------- |  | - | ------- | 
|                               |  | For the Year Ended December 31, |        
|                               |  |                                 |        
|(in thousands)                 |  | 2006                            |         | 2005 |   | 2004    | 
|                               |  |                                 |         |      |   |         | 
|Earned premium                 |  |                                 |         |      |   |         |  |   |         | 
|Upfront policies/contracts     |  | $                               | 70,645  |      | $ | 56,049  |  | $ | 31,469  | 
|Installment policies/contracts |  |                                 | 112,470 |      |   | 95,790  |  |   | 84,812  | 
|                               |  |                                 |         |      |   |         |  |   |         | 
|                               |  | $                               | 183,115 |      | $ | 151,839 |  | $ | 116,281 | 
|                               |  |                                 |         |      |   |         |  |   |         | 

Net
premiums earned in 2006 were $183.1 million, an increase of $31.3 million or
20.6%, as compared to $151.8 million in 2006. The increase in earned premiums
in 2006, as compared to 2005, was primarily attributable to higher earned
premiums in the financial guarantee insurance segment of $35.0 million,
partially offset by lower earned premiums in the financial guarantee reinsurance
segment of $3.7 million. Higher earned premiums in the financial guarantee
insurance segment in 2006 are primarily due to the effect of the transfer of
certain business to us from XLI in connection with our IPO See Formation
Transactions, the growth of our in-force business (in particular, our book of
installment premium business written in prior periods) and earned premiums from
the early retirement or refunding of insured securities of $26.6 million in
2006, as compared to $12.9 million in 2005. The $3.7 million decrease in earned
premiums in our financial guarantee reinsurance segment was primarily due to a
decrease of $3.4 million assumed from affiliates of FSA. Earned premiums from
the refunding of insured securities in the financial guarantee reinsurance
segment were $1.2 million in 2006, as compared to $1.9 million in 2005.

Net
premiums earned in 2005 were $151.8 million, an increase of $35.5 million or
30.5%, as compared to $116.3 million in 2004. The increase in earned premiums
in 2005, as compared to 2004, was primarily attributable to higher earned
premiums in the financial guarantee insurance segment of $35.1 million, and
higher earned premiums in the financial guarantee reinsurance segment of $0.4
million. Higher earned premiums in the financial guarantee insurance segment
    in 2005 are primarily due to the growth of our in-force business (in particular,
our book of installment premium business written in prior periods) and earned
premiums from the early retirement or refunding of insured securities of $12.9
million in 2005, as compared to $3.8 million in 2004. The $0.4 million increase
in earned premiums in our financial guarantee reinsurance segment was primarily
due to an increase in earned premium of $2.3 million relating to business
assumed from third-party primary companies, partially offset by a decrease of
$1.8 million in earned premium assumed from affiliates of FSA. Earned premiums
from the refunding of insured securities in the financial guarantee reinsurance
segment were $1.8 million in 2005, as compared to $2.2 million in 2004.

Net Investment
Income

Net
investment income was $77.7 million in 2006, an increase of $26.5 million or
51.8% as compared to $51.2 million in 2005. The increase in net investment income
was due primarily to higher average invested assets and higher new money
yields.  The increase in our average
invested assets in 2006, as compared to 2005, was primarily attributable to the
net proceeds from our IPO and the net cash inflows from our operations.  Net
    investment income of $51.2 million in 2005, increased $15.5 million, or 43.4%,
    as compared to $35.7 million in 2004. The increase in net investment income
    in 2005, as compared to 2004, was similarly due to higher average invested
    assets and higher new money yields. The increase in our average
invested assets in 2005, as compared to 2004, resulted primarily from net cash
inflows from our operations and a $125.0 million capital infusion during the
fourth quarter of 2004.

The following
tables present net investment income, average invested assets, and the
effective yield on our average invested assets for the years ended December 31,
2006, 2005, and 2004, and the average duration of our invested assets as of
December 31, 2005 and 2006:

|                                   |  |                                 |           |      |   |           |   |   |           |  
|---------------------------------- |  | ------------------------------- | --------- | ---- | - | --------- | - | - | --------- | -
|                                   |  | For the Year Ended December 31, |          
|                                   |  |                                 |          
|(in thousands, except percentages) |  | 2006                            |           | 2005 |   | 2004      |  
|                                   |  |                                 |           |      |   |           |  
|Net investment
  income            |  | $                               | 77,724    |      | $ | 51,160    |   | $ | 35,746    |  
|Average invested
  assets(1)       |  |                                 | 1,672,602 |      |   | 1,319,178 |   |   | 1,009,857 |  
|Yield(2)                           |  |                                 | 4.6       | %    |   | 3.9       | % |   | 3.5       | %



---

|    |                                                                                                                                                                
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Represents the
  quarterly average of the amortized cost of debt securities, short-term
  investments and cash and cash equivalents for the respective periods.

74

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|    |                                                                                                                                                                                                                                          
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | Effective yield
  represents net investment income as a percentage of average invested assets.
  The increase in the effective yield was due to the turnover in our investment
  portfolios capturing the trend of rising interest rates.

|                      |  |                    |     |      |  |     | 
|--------------------- |  | ------------------ | --- | ---- |  | --- | 
|                      |  | As of December 31, |    
|                      |  |                    |    
|                      |  | 2006               |     | 2005 | 
|                      |  |                    |     |      | 
|Duration (in
  years) |  |                    | 3.1 |      |  | 3.5 | 

Net Realized
(Losses) Gains on Investments

Net
realized losses on investments were $(16.2) million, $(3.2) million, and $(0.2)
million in 2006, 2005 and 2004, respectively. Net realized losses in 2006 were
primarily due to an impairment charge of $15.1 million relating to notes
acquired in satisfaction of a claim (see Note 13 (b) to the Consolidated
Financial Statements for a more detailed discussion).  Net realized losses in 2005 and 2004 were
primarily attributable to portfolio management actions relating to the
management of duration, yield and exposure to certain credit risks.

Net Realized
and Unrealized Gains (Losses) on Credit Derivatives

Changes in
the fair value of credit default swaps attributable to earnings from premiums
received by us from the issuance of such contracts are recorded in net premiums
earned in the consolidated statement of operations. In addition, changes in the
fair value of credit default swaps attributable to losses from actual and
expected payments to counterparties under such contracts are recorded in losses
and loss adjustment expense in the consolidated statement of operations, and
the remaining components of the change in fair value of credit default swaps,
which are attributable to changes in interest rates, credit spreads, credit
quality, expected recovery rates and other market factors, are recorded in net
realized and unrealized gains (losses) on credit derivatives. See Critical
Accounting Policies and EstimatesValuation of Credit Default Swaps.

Net
realized and unrealized gains (losses) on credit derivatives were $(8.4)
million, $(6.7) million and $12.7 million for the years ended December 31,
2006, 2005 and 2004, respectively. The losses in 2006 and 2005 were primarily
attributable to insured interest rate swaps, which are accounted for at fair
value.  Volatility in long term interest
rates resulted in an increase in the derivative liability of these contracts.  The gains in 2004 were driven by tightening
credit spreads that increased the value of our credit default swaps. In 2005
credit spreads widened slightly, but did not move significantly in relation to
2004. Contributing to the realized and unrealized losses in 2006 and 2005 were
premium payments associated with an embedded derivative within XLFAs soft
capital facility. See Liquidity and Capital Resources.

Net Losses and
Loss Adjustment Expenses

Net losses
and loss expenses include current year net losses incurred and adverse or favorable
development of prior year net loss and loss expenses reserves. See Critical
Accounting Policies and EstimatesReserves for Losses and Loss Adjustment
Expenses.

The
following table presents, for the periods indicated, the activity in our
reserves for losses and loss adjustment expenses, net of reinsurance:

|                                                  |  |                                   |        |                                     |   |                      |   |   |        |  
|------------------------------------------------- |  | --------------------------------- | ------ | ----------------------------------- | - | -------------------- | - | - | ------ | -
|(in thousands)                                    |  | Financial
  Guarantee
  Insurance |        | Financial
  Guarantee
  Reinsurance |   | Consolidated
  Total |  
|                                                  |  |                                   |        |                                     |   |                      |  
|Net Beginning
  balance, January 1, 2004          |  | $                                 | 22,544 |                                     | $ | 13,251               |   | $ | 35,795 |  
|Case reserve provision                            |  |                                   |       |                                     |   | 562                  |   |   | 562    |  
|Loss adjustment expense reserve provision         |  |                                   | 4,391  |                                     |   |                     |   |   | 4,391  |  
|Unallocated reserve provision                     |  |                                   | 12,708 |                                     |   | 3,613                |   |   | 16,321 |  
|                                                  |  |                                   |        |                                     |   |                      |   |   |        |  
|Net losses and loss adjustment expenses           |  |                                   | 17,099 |                                     |   | 4,175                |   |   | 21,274 |  
|Paid loss and loss adjustment expenses            |  |                                   | (2,249 | )                                   |   |                     |   |   | (2,249 | )
|                                                  |  |                                   |        |                                     |   |                      |   |   |        |  
|Net Ending
  balance, December 31, 2004           |  |                                   | 37,394 |                                     |   | 17,426               |   |   | 54,820 |  
|                                                  |  |                                   |        |                                     |   |                      |   |   |        |  
|Case reserve provision                            |  |                                   | 12,905 |                                     |   | (3,953               | ) |   | 8,952  |  
|Loss adjustment expense reserve provision         |  |                                   | 1,527  |                                     |   | 1,913                |   |   | 3,440  |  
|Unallocated reserve provision                     |  |                                   | 10,937 |                                     |   | 2,692                |   |   | 13,629 |  
|                                                  |  |                                   |        |                                     |   |                      |   |   |        |  
|Net losses and loss adjustment expenses           |  |                                   | 25,369 |                                     |   | 652                  |   |   | 26,021 |  
|Paid loss and loss expenses                       |  |                                   | (1,952 | )                                   |   | (738                 | ) |   | (2,690 | )
|                                                  |  |                                   |        |                                     |   |                      |   |   |        |  
|Net Ending
  balance, December 31, 2005           |  |                                   | 60,811 |                                     |   | 17,340               |   |   | 78,151 |  
|                                                  |  |                                   |        |                                     |   |                      |   |   |        |  
|Case reserve provision                            |  |                                   | (136   | )                                   |   | 298                  |   |   | 162    |  
|Loss adjustment expense reserve provision         |  |                                   | 334    |                                     |   | 155                  |   |   | 489    |  
|Unallocated reserve provision                     |  |                                   | 12,441 |                                     |   | 1,866                |   |   | 14,307 |  
|                                                  |  |                                   |        |                                     |   |                      |   |   |        |  
|Net losses and loss adjustment expenses           |  |                                   | 12,639 |                                     |   | 2,319                |   |   | 14,958 |  
|Cancellation of contract assumed from
  affiliate |  |                                   |       |                                     |   | (1,177               | ) |   | (1,177 | )
|Paid loss and loss adjustment expenses            |  |                                   | (1,876 | )                                   |   | (155                 | ) |   | (2,031 | )
|                                                  |  |                                   |        |                                     |   |                      |   |   |        |  
|Net Ending balance,
  December 31, 2006           |  | $                                 | 71,754 |                                     | $ | 18,327               |   | $ | 89,901 |  
|                                                  |  |                                   |        |                                     |   |                      |   |   |        |  

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Net losses
and loss adjustment expenses in 2006 were $15.0 million, a decrease of $11.0
million or 42.3%, as compared to $26.0 million recorded in 2005. The decrease
in net losses and loss adjustment expenses was primarily attributable to lower
net losses and loss adjustment expenses in the financial guarantee insurance
segment of $12.7 million, offset in part by higher net losses and loss
adjustment expenses in the financial guarantee reinsurance segment of $1.7
million.  Lower net losses and loss
adjustment expenses in the financial guarantee insurance segment resulted from
lower case reserves of $14.2 million, offset in part by a higher provision for
unallocated reserves of $1.5 million.
During 2006 there was a nominal case reserve provision for losses and
loss adjustment expenses, whereas 2005 included case basis reserve provisions
aggregating $12.2 million, of which $12.1 million related to two insured
obligations See Note 13 (a) and 13 (b) to the Consolidated Financial
Statements elsewhere herein for details.
Higher
net losses and loss adjustment expenses in the financial guarantee reinsurance
segment was primarily attributable to a net increase in the net case reserve
provision of $0.5 million in 2006 as compared to a net decrease in the case
reserve provision for losses and loss adjustment expenses in 2005 of $2.0
million..  The net decrease in the 2005
provision was primarily related to the reduction in certain case reserves on
transactions assumed from FSA, offset in part by an increase in the case
provision of loss adjustment expenses in 2005 relating to certain business
which we reinsured from XLI and which was cancelled in 2006 in connection with
our IPO (see Managements Discussion and Analysis of Financial Condition and
Results of Operations Formation Transactions for further details).

Also,
during 2006 we recorded a $15.2 million increase in our gross case reserve
relating to an insured project financing, as well as a $5.0 million gross case
reserve in connection with an insured transaction supported by loans to medical
providers (see Note 13 (a) and 13 (b) of our Consolidated Financial Statements,
respectively, included elsewhere herein for further details of the
aforementioned two insurance transactions).
These increases in case reserves in 2006 had no effect on our results of
operations due to reinsurance and indemnities provided to us by XL Capital in
connection with our IPO. See Managements Discussion and
Analysis of Financial Condition and Results of Operations Formation
Transactions for further details.In addition, during 2006 one of the two
insured transactions discussed in Note 13 (c) to our Consolidated Financial
Statements included elsewhere herein was retired pursuant to rights exercised
by the sponsor of the obligation.  As a
result thereof, we recorded a reduction in our net case reserves of $1.1
million in the financial guarantee insurance segment.  This reduction was offset by a $1.3 million increase in case
reserves relating to the other insured transaction discussed in Note 13 (c) to the Consolidated Financial Statements
resulting from the cancellation of reinsurance protection on the transaction
which we had purchased from a third-party financial guarantee company.

Losses and
loss adjustment expenses in 2005 were $26.0 million, net of reinsurance of
$11.1 million, an increase of $4.7 million or 22.1%, as compared to $21.3
million, net of reinsurance of $49.5 million, recorded in 2004. The increase in
net losses and loss adjustment expenses in 2005, as compared to 2004, was
primarily attributable to lower net losses and loss adjustment expenses in the
financial guarantee reinsurance segment of $3.5 million offset by higher net
losses and loss adjustment expenses in the financial guarantee insurance
segment of $8.3 million. Higher net losses and loss adjustment expenses in the
financial guarantee insurance segment resulted from losses related to three
insured structured finance transactions, partially offset by net favorable
development of our unallocated loss reserves and a lower provision for loss
adjustment expenses. The favorable loss reserve development was due to changes
in our in-force book of business during the year which resulted in slightly faster
expiration of our in-force par. During 2004, we decreased our expected loss
ratio by approximately five percentage points, primarily as a result of an
expanding proportion of public finance exposure in the guaranteed portfolio.
The impact of this change was offset by a change in the expected pattern of the
expiration of risk on in-force policies which was determined to be longer than
initially estimated. Lower net losses and loss adjustment expenses in the
financial guarantee reinsurance segment consisted of favorable case reserve
development on two transactions assumed from FSA.

Acquisition
Costs, Net

The
following table presents the components of acquisition costs, net, during the
periods indicated:

|                                                                    |  |                         |        |      |   |        |   |   |         |  
|------------------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ | - | - | ------- | -
|                                                                    |  | Year Ended December 31, |       
|                                                                    |  |                         |       
|(in thousands)                                                      |  | 2006                    |        | 2005 |   | 2004   |  
|                                                                    |  |                         |        |      |   |        |  
|Amortization of deferred
  acquisition costs and ceding commissions |  |                         |        |      |   |        |   |   |         |  
|Financial Guarantee Insurance:                                      |  |                         |        |      |   |        |   |   |         |  
|Acquisition costs                                                   |  | $                       | 16,719 |      | $ | 12,370 |   | $ | 12,062  |  
|Ceding commissions                                                  |  |                         | (6,182 | )    |   | (7,706 | ) |   | (10,130 | )
|                                                                    |  |                         |        |      |   |        |   |   |         |  
|Net acquisition costs                                               |  |                         | 10,537 |      |   | 4,664  |   |   | 1,932   |  
|Financial Guarantee Reinsurance:                                    |  |                         |        |      |   |        |   |   |         |  
|Acquisition costs                                                   |  |                         | 5,703  |      |   | 7,567  |   |   | 6,327   |  
|                                                                    |  |                         |        |      |   |        |   |   |         |  
|Acquisition costs, net                                              |  | $                       | 16,240 |      | $ | 12,231 |   | $ | 8,259   |  
|                                                                    |  |                         |        |      |   |        |   |   |         |  

76

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Capitalized
acquisition costs in the financial guarantee insurance segment consist of a
portion of compensation, travel and entertainment and marketing costs; as well
as premium and excise taxes, rating agency fees and legal costs associated with
the production of new business. Such capitalized acquisition costs are reduced
by ceding commission income on premiums ceded to reinsurers.

Amortization
of acquisition costs in the financial guarantee insurance segment was $16.7 million
for the year ended December 31, 2006, an increase of $4.3 million, as compared
to $12.4 million in 2005 (which included $2.1 million and 1.1 million,
respectively, of accelerated amortization of deferred acquisition costs due to
refundings in  2006 and 2005). Excluding
the impact of refundings, the increase of $3.3 million primarily reflects
higher acquisition costs resulting from the growth in our in-force business.

Amortization
of deferred ceding commission revenue in the financial guarantee insurance
segment for the year ended December 31, 2006 was lower by $1.5 million, as
compared to 2005, due to a commutation of business previously ceded to an
affiliate that resulted in the company retaining more business written.

Acquisition
costs in the financial guarantee reinsurance segment represent commissions paid
to acquire assumed business, as well as fees for letters of credit to secure
our obligations to primary companies so that they can take credit for our
reinsurance in filings with their insurance regulators. Amortization of
acquisition costs in the financial guarantee reinsurance segment was $5.7
million for the year ended December 31, 2006, a decrease of $1.9 million, as
compared to $7.6 million in 2005. The decrease was primarily the result of a
decrease in net premiums earned in the financial guarantee reinsurance segment
and a decrease in letter of credit fees of $0.9 million.

Amortization
of acquisition costs in the financial guarantee insurance segment was $12.4 million
in 2005, an increase of $0.3 million or 2.5% as compared to $12.1 million in
2004 (which included $1.1 million and $0.4 million, respectively, of
accelerated amortization of deferred acquisition costs due to refundings in
2005 and 2004.). The increase primarily reflects the growth in our in-force
business offset by a shift in business mix to more installment-based policies,
resulting in lower deferred costs associated with premium and excise taxes.
Amortization of deferred ceding commission revenue in the financial guarantee
insurance segment was $7.7 million in 2005, a decrease of $2.4 million or 23.8%
as compared to $10.1 million in 2004.

Amortization
of deferred ceding commission revenue from third party reinsurers increased
$1.1 million from 2004 to 2005 due to higher cessions of installment business,
while amortization of deferred ceding commission revenue from XLI and XL RE AM
decreased $3.5 million from 2004 to 2005 primarily as a result of lower
cessions of installment business.

Amortization
of acquisition costs in the financial guarantee reinsurance segment was $7.6
million in 2005, an increase of $1.3 million or 20.6% as compared to $6.3
million in 2004. The increase was primarily due to an increase in letter of
credit fees consistent with growth in our in-force reinsurance book of
business.

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Operating
Expenses

Operating
expenses were $79.0 million in 2006, an increase of $11.4 million or 16.8% as
compared to $67.6 million in 2005. The increase in operating expenses in 2006,
as compared to 2005, was primarily attributable to corporate expenses we
incurred as a public company in 2006 of $6.4 million that we did not incur
prior to our IPO, higher operating expenses in the financial guarantee
insurance segment of $3.2 million, and higher operating expenses in the
financial guarantee reinsurance segment of $1.9 million. The increase in
operating expenses was primarily due to higher compensation costs associated
with certain employees whose compensation prior to the IPO was partially
charged to other affiliates of XL Capital, as well as certain expenses
associated with SCA being a standalone public company, which prior to the IPO
we did not incur.

Operating
expenses were $67.6 million in 2005, an increase of $9.2 million or 15.8% as
compared to $58.4 million in 2004. The increase in operating expenses in 2005,
as compared to 2004, was primarily attributable to higher operating expenses in
the financial guarantee insurance segment of $11.3 million, partially offset by
lower operating expenses in the financial guarantee reinsurance segment of $2.1
million. The increase in operating expenses in the financial guarantee
insurance segment was primarily due to higher information technology and other
miscellaneous expenses related to the continued build-out of the infrastructure
for our financial guarantee insurance business. The decrease in operating
expenses in the financial guarantee reinsurance segment was primarily due to
non-recurring costs incurred in 2004 in connection with the establishment of
XLFAs soft capital facility. See Liquidity and Capital Resources for
additional information regarding XLFAs soft capital facility.

Liquidity and Capital Resources

Liquidity
Resources

We define
liquidity resources to include: our total investments in debt securities, short-term
investments, cash and cash equivalents, accrued investment income, the capacity
for revolving credit loans under our Letter of Credit and Liquidity Facility
(seeLetter of Credit and Liquidity Facility below for details), and with
respect to XLFA, our soft capital credit facility (seeXLFA Soft Capital
Facility below for details). At December 31, 2006 and 2005 our total liquidity
resources on a consolidated basis were $2.6 billion and $1.6 billion,
respectively.

Our
    total consolidated net cash inflows for the year ended December 31, 2006
    were $762.5 million, which consisted of $392.9 million in net cash flow generated
    by operations, $342.3 million generated from our IPO ($341.3 million excluding
certain offering costs not yet paid), and $28.5 million from capital
contributions from XL Capital (which includes cash held by a contributed
subsidiary). Of these cash flows $608.6 million was used for net purchases of
new investments, and $7.2 million was used to pay dividends to holders of our
    common stock and the redeemable preferred shares of our subsidiary. The balance
    of cash inflows increased cash and cash equivalents by $148.0 million which
    are primarily invested in high yielding, high quality commercial paper of
    less than a 90 day maturity. Cash inflows from operations were driven by
new business written and investment income.

Capital
Resources

We manage
our capital resources to maintain appropriate claims-paying resources to
sustain the Triple-A claims-paying ratings of our insurance subsidiaries, while
minimizing our cost of capital. To the extent that the existing capital
resources of our operating subsidiaries are insufficient to meet regulatory or
rating agency requirements or cover losses, we may need to raise additional
funds through financings or curtail our insurance subsidiaries growth and
reduce their insured exposure. In addition, any equity or debt financing, if
available, may be on terms that are not favorable to us. If we cannot obtain
adequate capital on favorable terms or at all, our business, operating results,
and financial condition could be adversely affected.

As a result
of significant business production by our operating subsidiaries in 2006 and
anticipated future business growth, management is exploring raising additional
capital in the form of preferred securities or debt and, in addition,
increasing the use of third-party reinsurance. Any such transaction in this
regard will be subject to market, regulatory and other considerations.

SCA Liquidity

Our
cash flow consists of dividends from our insurance subsidiaries (XLCA and
XLFA), if declared and paid, and investment income on assets held by us from
the proceeds of our IPO, offset by expenses incurred for employee compensation
and other expenses incurred as a stand-alone public company, including: board
of directors fees, directors and officers liability insurance, independent
auditor fees, stock registrar and listing fees, legal fees, and annual report
and proxy production and distribution costs. Of the net proceeds from our IPO
of $341.3 million, we contributed $298.1 million

78

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to XLFA and $25.0 million to XLCA to support their business operations
and retained $19.3 million for general corporate purposes. On October 31, 2006 the Board of Directors of the Company declared a cash dividend on our common shares of $0.02 per share, aggregating $1.3 million. The dividend was paid on December 29, 2006 to shareholders of
record on December 11, 2006. Also, on February 27, 2007, our board of directors
declared a dividend of $.02 per common share, which is payable on March 30,
2007 to shareholders of record on March 15, 2007. Any future dividends will be subject to the discretion and approval of the Board of Directors.

As a
holding company, our ability to meet our cash requirements (including any
dividends on our common shares, if and when declared) depends, in part, upon
dividends or advances from our insurance subsidiaries. The payment of dividends
or advances from our insurance subsidiaries is subject to regulatory
restrictions (see Note 17 to our Consolidated Financial Statements elsewhere
herein). In addition, the ability of our insurance subsidiaries to conduct
business depends upon ratings from independent rating agencies and,
consequently, they are subject to rating agency imposed restrictions which also
may affect their ability to pay dividends or make advances. As a result of the
aforementioned regulatory and rating agency restrictions, there can be no
assurance that our insurance subsidiaries will be able to pay dividends or make
advances, or that any dividends or advances paid by our insurance subsidiaries
will be sufficient to fund our cash requirements or that we will not be
required to seek external debt or equity financing to meet our operating
expenses.

In the
ordinary course of business, we evaluate our liquidity resource needs in light
of our expenses, our dividend policy, and the dividend paying ability of our
insurance subsidiaries. Based on our liquidity resources (see definition above)
at December 31, 2006, which aggregated $279.6 million and the income we expect
to receive from such liquidity resources, we believe that our holding company
will have sufficient liquidity to pay its operating expenses and planned
dividends over the next twelve months.

In
connection with our IPO, our operating subsidiaries have each agreed that,
until the second anniversary of the IPO each will not declare or pay dividends
on its common stock other than to fund certain parent holding company operating
expenses and debt service requirements and to fund nominal dividends on our
common stock. In addition, New York Insurance law contains a test governing the
amount of dividends that XLCA can pay in any year and, as a result of the
application of such test, XLCA cannot currently pay dividends, without notice
to, and prior approval from, the New York Superintendent. As a U.S. company
paying dividends to a Bermuda holding company, XLCAs dividends are subject to
a 30% withholding tax rate.

Operating
Subsidiaries Liquidity

Liquidity
resources at our operating subsidiaries are primarily used to pay their
operating expenses, claims, payment obligations with respect to credit derivatives,
reinsurance premiums, support in force business, and pay dividends to us, as
well as in the case of XLCA to make investments from time to time in its
subsidiary, XLCA-UK. Our operating subsidiaries principal sources of liquidity
resources are their portfolio of liquid assets and their net operating cash
flow, as well as, in the case of XLFA, the soft capital facility described
under XLFA Soft Capital Facility below. Liquidity resources can be affected
by changes in interest rates and the amount and timing of loss payments as well
as the other factors described under Managements Discussion and Analysis of
Financial Condition and Results of OperationsKey Factors Affecting
Profitability.

We believe
that our operating subsidiaries have sufficient liquidity resources to meet
their obligations as of December 31, 2006 See also Capital Resources above.
Their liquidity resources are subject to market conditions, regulation and
rating agency requirements and we cannot guarantee that they will have
sufficient liquidity resources in the future or that they will not have to seek
alternative sources of liquidity resources, which may be more expensive than
their current liquidity resource options.

Cash
Flows.Net
cash provided by operating activities was $392.9 million in 2006 compared to
$226.7 million in 2005. Net cash provided by operating activities increased by
$166.2 million, driven by new business written and investment income. Net cash
provided by operating activities was $226.7 million in 2005 compared to $190.5
million in 2004. Net cash provided by operating activities increased by $36.2
million, consistent with the slight increase in net income.

Net
    cash provided by (used in) financing activities was $363.7 million, $(7.5)
    million, and $(13.2) million for the years ended December 31, 2006, 2005
    and 2004, respectively. We received proceeds, net of underwriting fees and
    issuance costs paid, of $342.3 million from our initial public offering in
    August of 2006. We received additional cash capital contributions from XL
    Capital Ltd of $28.5 million coincident with certain transactions described
    under Formation
Transactions. Cash outflows from financing activities relate to dividends paid
to holders of the redeemable preferred shares of our subsidiary and, in the
current year, holders of our common stock.

Net cash
used in investing activities was $608.6 million, $235.9 million and $209.3
million for the years ended December 31, 2006, 2005 and 2004, respectively.
Cash used in investing activities is primarily a result of investing cash

79

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received from premiums and investment income. The increase in cash used
for investing activities from 2006 to 2005 is due to the investment of the net
proceeds received from our initial public offering.

Our
operating subsidiaries liquid assets include substantial U.S. Treasury
holdings, short-term investments and readily marketable debt securities. We
believe that the operating subsidiaries sources of liquidity are adequate to
meet their anticipated needs. As of December 31, 2006 and 2005, the operating
subsidiaries on a consolidated basis had readily marketable debt securities and
short-term investments with a carrying value of $2.0 billion and $1.3 billion,
respectively. At those dates, approximately 99.9% of our operating
subsidiaries consolidated fixed income portfolio was rated A or higher. See
Managements Discussion and Analysis of Financial Condition and Results of
Operations  Investments for further details.

Letter of
Credit and Liquidity Facility

On August
4, 2006, we and certain of our subsidiaries entered into an aggregate $500.0
million, five-year letter of credit and revolving credit facility (the $500.0
million credit facility) with a syndicate of banks, for which Citibank N.A. is
the administrative agent. The letter of credit and liquidity facility provides
for letters of credit of up to $250 million and up to $250 million of revolving
credit loans with the aggregate amount of outstanding letters of credit and
revolving credit loans thereunder not to exceed $500 million.

Interest
and fees payable under the letter of credit and liquidity facility shall be
determined based upon certain spreads over defined benchmarks, principally
LIBOR. The commitments under the letter of credit and liquidity facility will
expire on, and amounts borrowed under the letter of credit and liquidity
facility may be borrowed, repaid and reborrowed from time to time until, the
earlier of (i) the date that is five years after the closing date of the letter
of credit and liquidity facility and (ii) the date of termination in whole of
the commitments upon an optional termination or reduction of the commitments by
the Account Parties or upon an event of default.

The credit
and liquidity facility contains financial covenants that require that SCA at
any time (a) prior to August 4, 2008, maintain a minimum net worth of $857.4
million, (b) after August 4, 2008, maintain a minimum net worth equal to the
greater of (1) $857.4 million (our net worth, defined as total shareholders
equity before accumulated other comprehensive income, was approximately
$1,386.2 million at December 31, 2006) or (2) an amount equal to 65% of the
consolidated net worth as of the end of the then most recent fiscal year or
fiscal quarter of SCA for which financial statements shall have been delivered,
and (c) maintain a maximum total funded debt-to-total capitalization ratio of
30% (at December 31, 2006, we had no debt outstanding). The letter of credit
and liquidity facility also contains certain covenants, including restrictions
on mergers, acquisitions and other business consolidations; the sale of assets;
incurrence of indebtedness; liens on our assets; and transactions with
affiliates. In addition, the letter of credit and liquidity facility contains
certain customary provisions regarding events of default, including payment
defaults, breaches of representations and warranties, covenant defaults,
cross-default and cross-acceleration to certain other indebtedness, certain
events of bankruptcy and insolvency, material judgments, certain events under
the Employee Retirement Income Security Act of 1974, as amended, and changes of
control.

As
of December 31, 2006, the Company had letters of credit outstanding under the
Facility of $171.9 million, which were established for the benefit of primary
insurance companies reinsured by the Company, as explained below. No revolving
loans have been drawn by the Company under the Facility since its inception.
For the period from August 4, 2006 through December 31, 2006, the Company
incurred expenses of $0.2
million under the Facility. Prior to August 4, 2006, XL Capital had drawn
letters of credit under its credit facility with a syndicate of commercial
banks for the benefit of primary companies reinsured by the Company. For the
period from January 1, 2006 through August 3, 2006 and the years ended December
31, 2005 and 2004, the Company incurred expenses of $0.3 million, $1.6 million,
and $0.5 million, respectively, related to letters of credit drawn by XL Capital
for the benefit of primary companies reinsured by the Company.

Primary
insurers may require collateral or letters of credit so that they can receive
reinsurance credit under certain U.S. state laws. In addition, under certain of
the Companys reinsurance treaties, the Company may be required to provide
collateral or letters of credit in favor of its ceding insurers in the event of
a downgrade of the Companys credit ratings or other event which would diminish
the credit provided by the Companys reinsurance to such ceding insurers.

Ceded
Reinsurance Recoverables

We manage
our in-force portfolio of guaranteed obligations based on, and to comply with,
regulatory and rating agency single-risk limits and internal credit guidelines.
Single-risk limits are designed to avoid concentration in single names and to
mitigate event risk and are calculated as a percentage of capital. For
transactions that exceed these limits or guidelines, we will cede the excess to
XLI or other third-party reinsurers. Generally, all such reinsurance is
structured as facultative quota share reinsurance in which the reinsurer is
liable to us for its quota share of the applicable policies

80

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that we issue, regardless of when the loss occurs. Accordingly, related
loss reserves, including unallocated loss reserves, are ceded in accordance
with such contracts. Through these facultative cessions, we gain greater
flexibility to manage large single risks and reduce concentration in specific
bond sectors and geographic regions. Part of our strategy is to reduce
reinsurance to XLI and increase our third-party reinsurance relationships. To
the extent that we cede a portion of our exposure to one or more reinsurance
companies, we can reduce our concentration to particular issuers and help to
control the diversification of our credit portfolio. In addition, use of
reinsurance can increase our capacity to write new business and strengthen our
capital adequacy ratios.

As of
December 31, 2006 and December 31, 2005, we had $70.8 million and $52.3
million, respectively, in reinsurance recoverables from our reinsurers relating
to specific case reserves. The following table presents, by reinsurer, the
amount of our in-force principal exposure ceded to reinsurers as of December
31, 2006 and 2005:

|                                    |  |                         |     |                          |  |                         |   |                          |     |  |  |     |  
|----------------------------------- |  | ----------------------- | --- | ------------------------ |  | ----------------------- | - | ------------------------ | --- |  |  | --- | -
|                                    |  | As of December 31, 2006 |     | As of December 31, 2005  | 
|                                    |  |                         |     |                          | 
|(in
  billions, except percentages) |  | Ceded Par
  Outstanding |     | % Of Gross
  Outstanding |  | Ceded Par
  Outstanding |   | % Of Gross
  Outstanding |    
|                                    |  |                         |     |                          |  |                         |   |                          |    
|XL RE AM                            |  | $                       | 0.9 |                          |  | 0.7                     | % | $                        | 0.3 |  |  | 0.3 | %
|XLI(1)                              |  |                         | 0.7 |                          |  | 0.5                     | % |                          | 4.0 |  |  | 4.4 | %
|AAA Companies(2)                    |  |                         | 2.5 |                          |  | 2.0                     | % |                          | 2.0 |  |  | 2.2 | %
|AA Companies &
  others(3)          |  |                         | 3.2 |                          |  | 2.5                     | % |                          | 2.5 |  |  | 2.8 | %
|                                    |  |                         |     |                          |  |                         |   |                          |     |  |  |     |  
|Total                               |  | $                       | 7.3 |                          |  | 5.7                     | % | $                        | 8.8 |  |  | 9.7 | %
|                                    |  |                         |     |                          |  |                         |   |                          |     |  |  |     |  



---

|    |                                                                                                                                                                                                                                                               
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In connection with
  the transfer of business from XLI to us as described under Formation
  Transactions the amount of our in-force principal exposure ceded to XLI was
  reduced by approximately $3.9 billion.                                            
|    |                                                                                                                                                                                                                                                               
|(2) | AAA Companies
  means those firms that have both an AAA rating from S&P and an Aaa
  rating from Moodys.                                                                                                                                               
|    |                                                                                                                                                                                                                                                               
|(3) | AA Companies and
  others means those firms (other than XLI) that have either an AA category
  rating from S&P and/or an Aa category rating from Moodys or have an
  investment grade rating but do not have a financial enhancement rating from
  S&P.

XLFA Soft
Capital Facility

In December
2004, XLFA 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 XLFA with
the irrevocable right to require the Asset Trust at any time and from time to
time to purchase XLFAs non-cumulative perpetual Series B preferred shares with
an aggregate liquidation preference of up to $200 million. There is no limit to
the number of times that XLFA may exercise the put option, redeem the Series B
preferred shares from the Asset Trust and exercise the put option again. XLFA
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 XLFA pursuant to the asset trust expense
reimbursement agreement. The put option agreement is perpetual but would
terminate on delivery of notice by XLFA on or after December 9, 2009, or under
certain defined circumstances, such as the failure of XLFA to pay the put
option premium when due or bankruptcy. The premium payable by XLFA is the sum
of certain trustee and investment managers expenses, the distribution of income
paid to holders of the pass-through trust securities, less the investment yield
on the eligible assets purchased using the proceeds originally raised from the
issuance of the pass-through securities. The eligible securities (which are
generally high-grade investment securities) are effectively held in trust to be
used to fund the purchase of any Series B preferred shares upon exercise of the
put. The put option has not been exercised since the inception of the facility.

XLFA Preferred
Share Dividend Requirements

Pursuant to
an agreement with FSAH in April 2006, XLFA restructured the terms of its Series
A Redeemable Preferred Shares and changed its bye-laws accordingly. In
accordance with the agreement, the participating dividend provision of the preference shares was eliminated, the stated value of the
preference shares held by FSAH were increased to $54.0 million, and the fixed
dividend rate was increased from 5% to 8.25%. For the year ended December 31,
2006 and 2005, XLFA paid total dividends to the holders of its redeemable
preferred shares of $5.9 million and $7.5 million, respectively.

On
    February 27, 2007, the board of directors of XLFA 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. Payment of the extraordinary
    dividend and the reduction in the stated value of the Series A Redeemable
    Preferred Shares are expected to be made in March 2007. As a result of the
    decrease in stated value, the Companys annual fixed dividend requirement
    on the Series A Redeemable Preferred Shares will be reduced from $4.5 million
    to $3.2 million.

81

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Long-Term Contractual Obligations

The
    following table presents our long-term contractual obligations and related
    payments as at December 31, 2006, due by period:

|                                                              |  |       |       |                          |   |              |  |              |      |                           |   |      |  |   |       | 
|------------------------------------------------------------- |  | ----- | ----- | ------------------------ | - | ------------ |  | ------------ | ---- | ------------------------- | - | ---- |  | - | ----- | 
|(in millions)                                                 |  | Total |       | Less than
        1 year |   | 1 to 3 years |  | 3 to 5 years |      | More than
        5 years |  
|                                                              |  |       |       |                          |   |              |  |              |      |                           |  
|Contractual
          Obligations:                            |  |       |       |                          |   |              |  |              |      |                           |   |      |  |   |       | 
|Operating
          lease obligations                         |  | $     | 113.1 |                          | $ | 7.4          |  | $            | 15.4 |                           | $ | 15.3 |  | $ | 75.0  | 
|Other
          contractual obligations (1)                   |  |       | 20.0  |                          |   | 4.0          |  |              | 8.0  |                           |   | 8.0  |  |   |      | 
|Reserves
          for losses and loss adjustment expenses(2) |  |       | 178.5 |                          |   | 6.5          |  |              |     |                           |   | 33.2 |  |   | 138.8 | 
|                                                              |  |       |       |                          |   |              |  |              |      |                           |   |      |  |   |       | 
|Total(3)                                                      |  | $     | 311.6 |                          | $ | 17.9         |  | $            | 23.4 |                           | $ | 56.5 |  | $ | 213.8 | 
|                                                              |  |       |       |                          |   |              |  |              |      |                           |   |      |  |   |       | 



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The Company is liable under an information technology
          outsourcing agreement that it entered into with International Business
          Machines Corporation (IBM) on October 1, 2006. Pursuant
          to the agreement IBM will: (i) provide the Company with all its information
          technology hardware, (ii) provide all support services to maintain
          such hardware and provide for efficient disaster recovery, (iii) develop
          a transition plan for the Companys systems from its existing
          hardware to new hardware, and (iv) maintain the Companys technology
          at a level that allows the Company to take advantage of technological
          advances. In consideration for these services the Company is obligated
          to pay IBM approximately $4.0 million per annum for the five year term
          of the contract. No expense was incurred by the Company under this
          agreement during 2006.
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|(2) | The timing and amounts of actual claims payments
          related to these reserves vary based on many factors. The ultimate
          amount of the claims payments could differ materially from our estimated
          amounts. For information regarding the estimates for unpaid loss and
          loss expenses as well as factors affecting potential payment patterns
          of reserves for actual and potential claims related to our different
          lines of business see Critical Accounting Policies and
          Estimates above.                                                                                                                                                                                                                                                                                                                                                                                                                          
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|(3) | Does not include contractual payments required
          under: (i) preferred shares issued by XLFA, and (ii) XLFAs soft
          capital facility  see details above and in notes to our Consolidated
          Financial Statements included elsewhere herein.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

Off-Balance Sheet Arrangements

As
    of December 31, 2006 and 2005, we did not have any significant off-balance
    sheet arrangements that were not accounted for or disclosed in the Consolidated
    Financial Statements. See Liquidity and Capital ResourcesXLFA
    Soft Capital Facility above and Notes 6 and 12 to our Consolidated
    Financial Statements.

Recent Accounting Pronouncements

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 us, have evolved over time and incorporate the
concepts of both short-duration and long-duration contract accounting under the
provisions of SFAS 60 and SFAS 97, as well as other accounting literature, such
as FASB Statement of Financial Accounting Standards No. 5, Accounting for
Contingencies (SFAS No. 5) and Emerging Issues Task Force (EITF) Issue No.
85-20, Recognition of Fees for Guaranteeing a Loan. An exposure draft is
expected to be issued by the FASB during the first quarter of 2007. We will
continue to apply the accounting policies described in Managements Discussion
and Analysis of Financial Condition and Results of Operations  Critical
Accounting Policies and our Consolidated Financial Statements elsewhere herein
until further guidance is provided by the FASB.

In
February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid
Financial Instruments (SFAS 155), which amends SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities (SFAS 133) and SFAS No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities (SFAS 140), and addresses issues raised in SFAS 133
Implementation Issue No. D1, Application of Statement 133 to Beneficial
Interests in Securitized Financial Assets. The primary objectives of SFAS 155
are: (i) with respect to SFAS 133, to address the accounting for beneficial
interests in securitized financial assets and (ii) with respect to SFAS 140, to
eliminate a restriction on the passive derivative instruments that a qualifying
special purpose entity may hold. SFAS 155 is effective for all financial
instruments acquired or issued after the beginning of an entitys first fiscal
year that begins after September 15, 2006. We will adopt SFAS 155 on
January 1, 2007 and are currently evaluating the implications of SFAS No.
155 to our financial statements.

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. We adopted the
guidance in this FSP as of July 1, 2006 and it did not have any material effect
on our financial statements.

82

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In
    July 2006, the FASB issued FASB Interpretation No. 48, Accounting for
    Uncertainty in Income Taxes  an interpretation of FASB Statement No.
    109 (FIN 48). FIN 48 prescribes a recognition threshold
    and measurement attribute for financial statement recognition and measurement
    of a tax position taken or expected to be taken in a tax return, and also
    provides guidance on de-recognition, classification, interest and penalties,
    accounting in interim periods, disclosure, and transition. FIN 48 is applicable
    for fiscal years beginning after December 15, 2006. We will adopt FIN 48
    on January 1, 2007 and are currently evaluating the effect of this Interpretation
on our financial statements.

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 accordance with GAAP, 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 these fiscal years. We are currently evaluating the
    effect of SFAS 157 on our financial statements.

In
    February 2007, the FASB issued SFAS 159, The Fair Value Option for
    Financial Assets and Financial Liabilities. SFAS 159 provides us 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. We are currently
    evaluating the effect of SFAS 159 on our financial statements.

Investments

The
financial risk and oversight committee of our Board of Directors approves our
general investment objectives, policies, and guidelines. Independent investment
managers manage all of our consolidated investment portfolios.

Our primary
investment objective is the preservation of capital, subject to an appropriate
degree of liquidity, and a steady stream of investment income. A secondary
objective is to optimize long-term returns.

We select
our investment managers on the basis of various criteria, including investment
style, historical performance, internal controls, operational risk, and the
ability to contribute to the diversification of our portfolio.

Because of
the structure of our investment portfolio, our earnings are directly affected
by changes in the valuations of the securities and investments held in the
investment portfolio. These valuation changes reflect changes in interest rates
(for example, changes in the level, slope and curvature of yield curves,
volatility of interest rates, mortgage prepayment speeds and credit spreads)
and credit quality. Market risk therefore arises due to the uncertainty
surrounding the future valuations of these different assets, the factors that
impact their values and the impact that this could have on our earnings.

We seek to
manage the risks of our investment portfolio through a combination of asset
class, industry and security level diversification. In addition, individual
security and issuer exposures are controlled and monitored at the investment
portfolio level via specific investment constraints outlined in our investment
guidelines and agreed with the external investment professionals. Additional
constraints are generally agreed upon with the external investment
professionals and may address exposures to eligible securities, prohibited
investments/transactions, credit quality and concentrations limits. We also
have a policy not to invest in any securities that we guarantee.

83

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At December
31, 2006, our consolidated fixed-income portfolio consisted of debt securities,
short-term investments and cash and cash equivalents with a carrying value of
$1.7 billion, $0.2 million and $0.2 million, respectively. Our debt securities
are designated as available for sale in accordance with SFAS 115, Accounting
for Certain Investments in Debt and Equity Securities. The fixed-income
portfolio is reported at fair value in accordance with SFAS 115, and the change
in fair value is reported as part of accumulated other comprehensive income.
Short-term investments consist of securities with maturities equal to or
greater than 90 days but less than one year at time of purchase.

The average
duration of our investment portfolio was 3.1 years at December 31, 2006.

Our
fixed-income portfolio is exposed to credit and interest rate risk. At December
31, 2006, the fair value of our fixed-income portfolio was approximately $2.1
billion, as compared to approximately $1.4 billion as at December 31, 2005.

The table
below shows the percentage of our fixed-income portfolio by credit rating
(excluding cash and cash equivalents) at December 31, 2006:

|                    |  |       |       |  
|------------------- |  | ----- | ----- | -
|                    |  | Total |      
|                    |  |       |      
|Credit
  Rating(1): |  |       |       |  
|AAA                 |  |       | 80.4  | %
|AA                  |  |       | 6.8   | %
|A                   |  |       | 12.8  | %
|                    |  |       |       |  
|Total               |  |       | 100.0 | %
|                    |  |       |       |  



---

|    |                                                                                                             
|--- | ------------------------------------------------------------------------------------------------------------
|(1) | Ratings represent
  S&P classifications. If S&P classifications are unavailable, Moodys
  ratings are used.

As at
December 31, 2006, the top 10 corporate holdings, which exclude government
guaranteed and government sponsored enterprises, represented approximately 6.7%
of the total fixed-income portfolio and approximately 42.7% of all corporate
holdings. At December 31, 2006, none of our corporate holdings exceeded 1.5% of
our total fixed-income portfolio (including debt securities, short-term
investments, cash and cash equivalents and net payable for investments
purchased).

Our
fixed-income portfolio is exposed to interest rate risk. Interest rate risk is
the price sensitivity of a fixed-income security to changes in interest rates.
We manage interest rate risk by setting duration targets for our investment
portfolio, thus mitigating the overall economic effect of interest rate risk.
We remain nevertheless exposed to interest rate risk since the assets are
marked-to-market, thus subject to market conditions, while liabilities are
accrued at a static rate. The hypothetical case of an immediate 100 basis point
adverse parallel shift in global bond curves at December 31, 2006 would have
decreased the fair value of our fixed-income portfolio by approximately 3.1%,
or $66.5 million.

The
following table summarizes our consolidated investment portfolio at December
31, 2006:

|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|------------------------------------------------------ |  | -------------------------- | --------- | -------------------------- | - | --------------------------- |  | ---------- | ------- | - | - | --------- | 
|                                                       |  | December 31, 2006          |          
|                                                       |  |                            |          
|(in thousands)                                         |  | Cost or
  Amortized
  Cost |           | Gross
  Unrealized
  Gains |   | Gross
  Unrealized
  Losses |  | Fair Value |        
|                                                       |  |                            |           |                            |   |                             |  |            |        
|Debt securities                                        |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Mortgage and asset-backed
securities                   |  | $                          | 1,077,846 |                            | $ | 3,850                       |  | $          | (11,435 | ) | $ | 1,070,261 | 
|U.S. Government and government
agencies                |  |                            | 323,638   |                            |   | 990                         |  |            | (7,074  | ) |   | 317,554   | 
|Corporate                                              |  |                            | 343,199   |                            |   | 1,164                       |  |            | (6,111  | ) |   | 338,252   | 
|Non-U.S. sovereign government                          |  |                            | 10,126    |                            |   | 93                          |  |            | (202    | ) |   | 10,017    | 
|U.S. states and political subdivisions of
  the states |  |                            | 375       |                            |   | 3                           |  |            |        |   |   | 378       | 
|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Total debt securities                                  |  | $                          | 1,755,184 |                            | $ | 6,100                       |  | $          | (24,822 | ) | $ | 1,736,462 | 
|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Short-term investments                                 |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Total short-term investments                           |  | $                          | 222,930   |                            | $ | 75                          |  | $          | (1,104  | ) | $ | 221,901   | 
|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 

The
amortized cost and estimated fair value of debt securities available for sale
as of December 31, 2006, by contractual maturity, are presented below. Expected
maturities will differ from contractual maturities because borrowers may have
the right to call or prepay obligations with or without call or prepayment
penalties. See Note 3 of the notes to our Consolidated Financial Statements for
additional information regarding our debt securities available for sale as of
December 31, 2006 and 2005.

84

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|                                       |  |                   |           |            |   |           | 
|-------------------------------------- |  | ----------------- | --------- | ---------- | - | --------- | 
|                                       |  | December 31, 2006 |          
|                                       |  |                   |          
|(in
  thousands)                       |  | Amortized Cost    |           | Fair Value |  
|                                       |  |                   |           |            |  
|Due after one
  through five years     |  | $                 | 333,340   |            | $ | 327,943   | 
|Due after five
  through ten years     |  |                   | 301,642   |            |   | 295,850   | 
|Due after ten
  years                  |  |                   | 42,356    |            |   | 42,408    | 
|                                       |  |                   |           |            |   |           | 
|                                       |  |                   |           |            |   |           | 
|Mortgage and
  asset-backed securities |  |                   | 1,077,846 |            |   | 1,070,261 | 
|                                       |  |                   |           |            |   |           | 
|Total                                  |  | $                 | 1,755,184 |            | $ | 1,736,462 | 
|                                       |  |                   |           |            |   |           | 

85

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Cautionary
Note Regarding Forward-Looking Statements

The Private
Securities Litigation Reform Act of 1995 (PSLRA) provides a safe harbor for
forward-looking statements. Any prospectus, prospectus supplement, our annual
report to ordinary shareholders, any proxy statement, any other Form 10-K, Form
10Q, or Form 8-K of ours, or any other written or oral statements made by or on
behalf of us may include forward-looking statements that reflect our current
views with respect to future events and financial performance. Statements that
include the words expect, intend, plan, believe, project,
anticipate, will, may and similar statements of a future or
forward-looking nature identify forward-looking statements. All forward-looking
statements address matters that involve risks and uncertainties. Accordingly,
there are or will be important factors that could cause actual results to
differ materially from those indicated in such statements.

We believe that these factors include, but are not limited to, the
following:

|  |                                                                                                                                                                                                                                                        
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | changes in rating
  agency policies or practices, including adverse changes to the financial
  strength or financial enhancement ratings of any or all of our operating
  subsidiaries;                                                                
|  |                                                                                                                                                                                                                                                        
| | ineffectiveness or
  obsolescence of our business strategy, due to changes in current or future
  market conditions or other factors;                                                                                                                  
|  |                                                                                                                                                                                                                                                        
| | the performance of
  our invested assets or losses on credit derivatives;                                                                                                                                                                              
|  |                                                                                                                                                                                                                                                        
| | availability of
  capital (whether in the form of debt or equity) and liquidity (including
  letter of credit facilities);                                                                                                                             
|  |                                                                                                                                                                                                                                                        
| | the timing of
  claims payments being faster or the receipt of reinsurance recoverables being
  slower than anticipated by us;                                                                                                                         
|  |                                                                                                                                                                                                                                                        
| | increased
  competition on the basis of pricing, capacity, terms or other factors;                                                                                                                                                                     
|  |                                                                                                                                                                                                                                                        
| | greater frequency
  or severity of claims and loss activity, including as a result of natural or
  man-made catastrophic events, than our underwriting, reserving or investment
  practices anticipate based on historical experience or industry data;
|  |                                                                                                                                                                                                                                                        
| | developments in
  the worlds financial and capital markets that adversely affect the
  performance of our investments and our access to such markets;                                                                                                 
|  |                                                                                                                                                                                                                                                        
| | changes in, or
  termination of, our ongoing reinsurance agreements with XL Capital or FSA;                                                                                                                                                            
|  |                                                                                                                                                                                                                                                        
| | changes in
  regulation or tax laws applicable to us or our customers or suppliers such as
  our reinsurers;                                                                                                                                           
|  |                                                                                                                                                                                                                                                        
| | changes in the
  rating agencies views on third-party inward reinsurance;                                                                                                                                                                             
|  |                                                                                                                                                                                                                                                        
| | changes in the
  availability, cost or quality of reinsurance or retrocessions, including a
  material adverse change in the ratings of our reinsurers or
  retrocessionaires;                                                                         
|  |                                                                                                                                                                                                                                                        
| | changes with
  respect to XL Capital (including changes in its ownership percentage in us)
  or our relationship with XL Capital;                                                                                                                      
|  |                                                                                                                                                                                                                                                        
| | changes that may
  occur in our operations as we begin operations as a public company;                                                                                                                                                                 
|  |                                                                                                                                                                                                                                                        
| | changes in
  accounting policies or practices or the application thereof;                                                                                                                                                                              
|  |                                                                                                                                                                                                                                                        
| | changes in the
  officers of our company or our subsidiaries;                                                                                                                                                                                          
|  |                                                                                                                                                                                                                                                        
| | legislative or
  regulatory developments;                                                                                                                                                                                                              
|  |                                                                                                                                                                                                                                                        
| | changes in general
  economic conditions, including inflation, interest rates, foreign currency
  exchange rates and other factors; and                                                                                                                
|  |                                                                                                                                                                                                                                                        
| | the effects of
  business disruption or economic contraction due to war, terrorism or natural
  or other catastrophic events.                                                                                                                          

The foregoing review of important factors should not be construed as
exhaustive and should be read in conjunction with the other cautionary
statements that are included herein or elsewhere. We undertake no obligation to
update publicly or revise any forward-looking statement, whether as a result of
new information, future developments or otherwise.

86

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ITEM 7A. QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK

Set forth
below is a discussion regarding our market risk and how it is managed. This
discussion and the estimated amounts generated from the sensitivity and
value-at-risk, which we refer to as VaR, analyses presented in this document
are forward-looking statements of market risk assuming certain adverse market
conditions occur. Actual results in the future may differ materially from these
estimated results due to, among other things, actual developments in the global
financial markets. The results of analysis used by us to assess and mitigate
risk should not be considered projections of future events or losses. See
Cautionary Note Regarding Forward-Looking Statements.

Credit
Derivative Risk

Credit
default swaps that we write or reinsure are generally written on International
Swaps and Derivatives Association, which we refer to as ISDA, forms. The fair
value of such instruments is determined using models developed by us, which are
dependent upon a number of factors, including changes in interest rates, future
default rates, credit spreads, changes in credit quality, future expected
recovery rates and other market factors. Other elements of the change in fair value
are based upon pricing established at the inception of the contract. The
following table summarizes the estimated change in fair value as a result of an
assumed shift in the following factors:

|                                       |  |                                                 |      |   | 
|-------------------------------------- |  | ----------------------------------------------- | ---- | - | 
|(in
  millions)                        |  | Estimated Increase
  (Decrease) in Fair
  Value |     
|                                       |  |                                                 |     
|Change
  in interest rates:            |  |                                                 |      |   | 
|10% increase in recovery rate          |  | $                                               | 1.5  |   | 
|10% decrease in recovery rate          |  |                                                 | (2.1 | ) | 
|10% increase in default rate           |  |                                                 | (0.7 | ) | 
|10% decrease in default rate           |  |                                                 | 0.5  |   | 
|1% increase in benchmark interest
rate |  |                                                 | 3.4  |   | 
|1% decrease in benchmark interest
rate |  |                                                 | (6.5 | ) | 

Investment
Market Risk

We have
engaged BlackRock, Inc. and Evergreen Investment Management Company, LLC and/or
their respective affiliates as our principal investment managers.

We select
external investment managers on the basis of various criteria, including
investment style, historical performance, internal controls, operational risk,
and the ability to contribute to the diversification of our portfolio. The
investment portfolio is managed in accordance with detailed investment
guidelines determined by us. Our investment managers are well established,
large institutional investment professionals.

Our
investment portfolio consists of fixed-income debt securities, short-term
investments, and cash and cash equivalents. These investments are principally
denominated in U.S. dollars.

Our
earnings and book value are directly affected by changes in the valuation of
the securities in our fixed-income portfolio. These valuation changes reflect
changes in interest rates (for example, changes in the level, slope and
curvature of yield curves, volatility of interest rates, mortgage prepayment
speeds and credit spreads) and credit quality (for example, changes in prices
and volatilities of individual securities). Market risk therefore arises due to
the uncertainty surrounding the future valuations of these different assets and
the factors that impact their values.

We seek to
manage the risks of our fixed-income portfolio through a combination of
industry and security level diversification. These allocation decisions are
made relative to our capital and with an emphasis on high quality securities as
is appropriate for the financial guarantee business. We establish specific
investment guidelines for our external investment professionals within the
general investment objectives, policies, and guidelines approved by the
financial risk and oversight committee of our Board of Directors. Additional
constraints are generally agreed with the external investment professionals,
which may address exposures to eligible securities, prohibited
investments/transactions, credit quality and general concentrations limits.

Investment
Value-at-Risk

VaR is a
statistical risk measure, calculating the level of potential losses that could
be expected to be exceeded, over a specified holding period and at a given
level of confidence, in normal market conditions, due to adverse movements in
the valuation of the securities comprising our total investment portfolio. The
total investment portfolio includes debt securities, short-term investments,
and cash and cash equivalents.

87

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We
calculate the VaR of our total investment portfolio using a one-month time
horizon and a 95% level of confidence. This means that, on average, we could
expect losses greater than predicted by the VaR results 5% of the time, or once
every 20 months. The calculation of VaR is performed quarterly using a full
valuation based on the Monte Carlo modeling approach and it is expressed both
in terms of U.S. dollars and as a percentage of our total investment portfolio.

The
modeling of the risk of any portfolio, as measured by VaR, involves a number of
assumptions and approximations. While we believe that our assumptions and
approximations are appropriate, there is no uniform industry methodology for
calculating VaR. We are aware that different VaR results can be produced for
the same portfolio depending on the approach used, as well as the assumptions
employed when implementing the approach. The VaR approach uses historical data
to determine the sensitivity of each of the underlying securities to the risk
factors incorporated into the models that are employed in the Monte Carlo
simulations. In calculating these sensitivities, greater importance is placed
on the more recent data points and information. Since the VaR approach is based
on historical positions and market data, VaR results should not be viewed as an
absolute and predictive gauge of future financial performance or as a way for
us to predict the magnitude of risk to which we are exposed. There is no
assurance that our actual future losses will not exceed the VaR. Also, risks
associated with abnormal market events can be significantly different from the
VaR results and these are by definition not reflected or assessed in the VaR
analysis.

The VaR of
our total investment portfolio at December 31, 2006 was approximately $21.2
million.

In
instances where the data or time series are insufficient to determine the risk
factor sensitivities, the VaR approach uses proxy time series data available
for similar instruments. At December 31, 2006, approximately $1.1 billion (51%
of our total investment portfolio at market value) used proxy time series data
related to various total investment portfolios. We review the proxies to ensure
that an appropriate data and time series is being used in the calculations and
that the proxies used are conservative.

The
following two tables show our average, minimum and maximum VaR in percentage
and dollar terms for our total investment portfolio during 2006, based upon the
VaR at month-end dates. The two tables also include our VaR in percentage and
dollar terms, respectively, for our total investment portfolio at December 31,
2006. Our total investment portfolio VaR at December 31, 2006 is not
necessarily indicative of future VaR levels:

|                                    |  |                        |     |                        |  |                        |     |                                   |  |  |     |   |  |  |     |   | 
|----------------------------------- |  | ---------------------- | --- | ---------------------- |  | ---------------------- | --- | --------------------------------- |  |  | --- | - |  |  | --- | - | 
|                                    |  | Average VaR
  % VaR(1) |     | Minimum VaR
  % VaR(1) |  | Maximum VaR
  % VaR(1) |     | At
  December 31, 2006
  % VaR(1) | 
|                                    |  |                        |     |                        |  |                        |     |                                   | 
|Total Investment
  Portfolio VaR(2) |  |                        | 1.0 | %                      |  |                        | 0.8 | %                                 |  |  | 1.1 | % |  |  | 1.0 | % | 

|                                    |  |                                    |  |                                    |  |                                    |  |                                        |  |  |  |  |  |  |  |  | 
|----------------------------------- |  | ---------------------------------- |  | ---------------------------------- |  | ---------------------------------- |  | -------------------------------------- |  |  |  |  |  |  |  |  | 
|(in
  millions)                     |  | Average VaR
  during 2006
  VaR(3) |  | Minimum VaR
  during 2006
  VaR(3) |  | Maximum VaR
  during 2006
  VaR(3) |  | VaR as at
  December 31, 2006
  VaR(3) | 
|                                    |  |                                    |  |                                    |  |                                    |  |                                        | 
|Total Investment
  Portfolio VaR(2) |  | $ 16.2                             |  | $ 12.0                             |  | $ 21.2                             |  | $ 21.2                                 | 



---

|    |                                                                                                                                                                                                                                                                 
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Based on a 95%
  confidence level with a one-month holding period and expressed as a
  percentage of our total investment portfolio.                                                                                                                            
|    |                                                                                                                                                                                                                                                                 
|(2) | Total Investment
  Portfolio VaR is our VaR based on the prescribed methodology that explicitly
  accounts for the diversification benefits that occur when each of the
  allocations to the individual asset classes is included in the investment
  portfolio.
|    |                                                                                                                                                                                                                                                                 
|(3) | Based on a 95%
  confidence level with a one-month holding period.                                                                                                                                                                                              

Our total
investment portfolio VaR is driven by: the size of the overall investment
portfolio; the size of the allocations to the different asset classes and
securities in the asset classes; the risks associated with each of the asset
classes and securities; and the correlations and diversification benefits
between each of the asset classes and securities. Changes in any of these
variables will have a direct impact on our VaR.

Stress Testing

VaR does
not provide the means to estimate the magnitude of the loss in the 5% of
occurrences by which we expect the VaR level to be exceeded. To complement the
VaR analysis based on normal market environments, we consider the impact on the
investment portfolio in several different historical stress periods to analyze
the effect of unusual market conditions. We establish certain historical stress
test scenarios that are applied to our total investment portfolio. As these
stress tests and estimated gains and losses are based on historical events,
they will not necessarily reflect future

88

---



stress events or gains and losses from such events. The results of the
stress test scenarios are reviewed on a regular basis to ensure they are
appropriate, based on current shareholders equity, market conditions and our
total risk tolerance.

The table
below shows the maximum impact on our total investment portfolio if all events
stress tested were to repeat themselves, given the actual portfolios allocations
at quarter end dates during 2006. We assume that no action is taken during the
stress period to either liquidate or rebalance the portfolio. We believe that
this fairly reflects the potential decreased liquidity that is often associated
with stressed market environments.

|                                   |  |                  |      |                 |  |                      |      |                     |  |  |      |    |  |  |      |    | 
|---------------------------------- |  | ---------------- | ---- | --------------- |  | -------------------- | ---- | ------------------- |  |  | ---- | -- |  |  | ---- | -- | 
|                                   |  | March 31,
  2006 |      | June 30,
  2006 |  | September 30,
  2006 |      | December 31,
  2006 | 
|                                   |  |                  |      |                 |  |                      |      |                     | 
|Stress
  Test:                     |  |                  |      |                 |  |                      |      |                     |  |  |      |    |  |  |      |    | 
|Maximum loss
  impact on portfolio |  |                  | (5.1 | %)              |  |                      | (5.0 | %)                  |  |  | (4.8 | %) |  |  | (4.8 | %) | 
|Maximum gain impact
  on portfolio |  |                  | 15.7 | %               |  |                      | 16.0 | %                   |  |  | 14.0 | %  |  |  | 13.4 | %  | 

From the
different scenarios that we analyze, the largest downside event risk exposure
during 2006 was (5.1%), based on the investment portfolio at March 31, 2006.
The largest upside risk exposure during 2006 was 16.0% at June 30, 2006.

Given our
total investment portfolio allocations at December 31, 2006, we would expect to
lose approximately (4.8%) of the portfolio value if the most damaging event
stress tested was repeated, all other things held equal, and we would expect to
gain approximately 13.4% of the portfolio value if the most favorable event
stress tested was repeated, all other things held equal.

Foreign Currency Fluctuation

We are
exposed to foreign currency fluctuation risk primarily as it relates to
potential losses on policies not denominated in U.S. dollars and on non-U.S.
dollar installment premiums expected to be collected in the future. As of
December 31, 2006, the aggregate net par outstanding of all exposures not
denominated in U.S. dollars was less than 15% of our total net par outstanding.
We do not currently hold individual currency portfolios to support the
potential liabilities for each currency. To mitigate the risk of foreign
currency fluctuations on the non-U.S. dollar installment premiums, we forecast
non-U.S. dollar installment premiums to be collected and non-U.S. dollar
expenses on a quarterly basis to determine if any foreign currency hedging
activities are prudent. No such hedging activities have been executed to date.

89

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ITEM 8. FINANCIAL STATEMENTS

INDEX TO FINANCIAL STATEMENTS

|                                                                                                                      |  |     
|--------------------------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                                      |  | Page
|                                                                                                                      |  |     
|                                                                                                                     
|Report of Independent Registered Public
  Accounting Firm                                                             |  | 91  
|                                                                                                                      |  |     
|Consolidated Balance Sheets at December
  31, 2006 and 2005                                                           |  | 92  
|                                                                                                                      |  |     
|Consolidated Statements of Operations and
  Comprehensive Income for the years ended December 31, 2006, 2005 and 2004 |  | 93  
|                                                                                                                      |  |     
|Consolidated Statements of Changes in
  Shareholders Equity for the years ended December 31, 2006, 2005 and 2004     |  | 94  
|                                                                                                                      |  |     
|Consolidated Statements of Cash Flows for
  the years ended December 31, 2006, 2005 and 2004                          |  | 95  
|                                                                                                                      |  |     
|Notes to Consolidated Financial
Statements                                                                            |  | 96  

90

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Report of Independent Registered Public Accounting Firm

To
the Board of Directors and Shareholders of Security Capital Assurance Ltd:

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

PricewaterhouseCoopers
LLP
New York, New York

March 14,
2007

91

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SECURITY CAPITAL ASSURANCE LTD CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2006 AND 2005

|                                                                                                                                                 |  |      |           |      |   |           |  
|------------------------------------------------------------------------------------------------------------------------------------------------ |  | ---- | --------- | ---- | - | --------- | -
|(U.S. Dollars in thousands, except per share
amounts)                                                                                            |  | 2006 |           | 2005 |  
|                                                                                                                                                 |  |      |           |      |  
|Assets                                                                                                                                           |  |      |           |      |   |           |  
|Investments                                                                                                                                      |  |      |           |      |   |           |  
|Debt securities available for sale, at
fair
  value (amortized cost: 2006$1,755,184; 2005$1,336,075)                                           |  | $    | 1,736,462 |      | $ | 1,316,029 |  
|Short-term investments, at fair value
  (amortized cost: 2006$222,930; 2005$31,015)                                                            |  |      | 221,901   |      |   | 30,811    |  
|Other invested assets                                                                                                                            |  |      |          |      |   | 17,621    |  
|                                                                                                                                                 |  |      |           |      |   |           |  
|Total investments                                                                                                                                |  |      | 1,958,363 |      |   | 1,364,461 |  
|Cash and cash equivalents                                                                                                                        |  |      | 202,548   |      |   | 54,593    |  
|Accrued investment income                                                                                                                        |  |      | 16,515    |      |   | 11,847    |  
|Deferred acquisition costs                                                                                                                       |  |      | 93,809    |      |   | 59,592    |  
|Prepaid reinsurance premiums                                                                                                                     |  |      | 59,983    |      |   | 69,873    |  
|Premiums receivable                                                                                                                              |  |      | 12,936    |      |   | 7,770     |  
|Reinsurance balances recoverable on
unpaid
  losses                                                                                              |  |      | 88,616    |      |   | 69,217    |  
|Intangible assetsacquired
licenses                                                                                                              |  |      | 11,529    |      |   | 11,529    |  
|Deferred income tax asset                                                                                                                        |  |      | 18,182    |      |   | 17,569    |  
|Other assets                                                                                                                                     |  |      | 34,333    |      |   | 17,864    |  
|                                                                                                                                                 |  |      |           |      |   |           |  
|Total assets                                                                                                                                     |  | $    | 2,496,814 |      | $ | 1,684,315 |  
|                                                                                                                                                 |  |      |           |      |   |           |  
|Liabilities, Minority Interest and
  Shareholders Equity                                                                                        |  |      |           |      |   |           |  
|Liabilities                                                                                                                                      |  |      |           |      |   |           |  
|Unpaid losses and loss adjustment
expenses                                                                                                       |  | $    | 178,517   |      | $ | 147,368   |  
|Deferred premium revenue                                                                                                                         |  |      | 795,906   |      |   | 592,585   |  
|Reinsurance premiums payable                                                                                                                     |  |      | 13,952    |      |   | 310       |  
|Net payable for investments
purchased                                                                                                            |  |      | 5,435     |      |   |          |  
|Accounts payable, accrued expenses and
  other liabilities                                                                                       |  |      | 82,468    |      |   | 25,720    |  
|                                                                                                                                                 |  |      |           |      |   |           |  
|Total liabilities                                                                                                                                |  |      | 1,076,278 |      |   | 765,983   |  
|                                                                                                                                                 |  |      |           |      |   |           |  
|Commitments and
      Contingencies (Note 15)                                                                                                    |  |      |           |      |   |           |  
|                                                                                                                                                 |  |      |           |      |   |           |  
|Minority interest  redeemable preferred
  shares of subsidiary                                                                                  |  |      | 54,016    |      |   | 50,518    |  
|                                                                                                                                                 |  |      |           |      |   |           |  
|Shareholders Equity                                                                                                                             |  |      |           |      |   |           |  
|Common stock (par value $0.01 per share;
  500,000,000 shares authorized; shares issued and outstanding: 2006 
  64,136,364; 2005  46,127,245) |  |      | 641       |      |   | 461       |  
|Additional paid-in capital                                                                                                                       |  |      | 987,803   |      |   | 605,951   |  
|Retained earnings                                                                                                                                |  |      | 397,781   |      |   | 281,709   |  
|Accumulated other comprehensive
loss                                                                                                             |  |      | (19,705   | )    |   | (20,307   | )
|                                                                                                                                                 |  |      |           |      |   |           |  
|Total shareholders
equity                                                                                                                       |  |      | 1,366,520 |      |   | 867,814   |  
|                                                                                                                                                 |  |      |           |      |   |           |  
|Total liabilities, minority interest and
  shareholders equity                                                                                  |  | $    | 2,496,814 |      | $ | 1,684,315 |  
|                                                                                                                                                 |  |      |           |      |   |           |  

See accompanying notes to consolidated financial
statements.

92

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SECURITY CAPITAL ASSURANCE LTD CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | -------- | ---- | - | ------- | - | - | -------- | -
|(U.S. Dollars in thousands, except
  per share amounts)                                                                                                     |  | 2006 |          | 2005 |   | 2004    |  
|                                                                                                                                                            |  |      |          |      |   |         |  
|Revenues                                                                                                                                                    |  |      |          |      |   |         |   |   |          |  
|Gross premiums written                                                                                                                                      |  | $    | 353,728  |      | $ | 233,269 |   | $ | 232,541  |  
|Reinsurance premiums assumed                                                                                                                                |  |      | 55,271   |      |   | 52,170  |   |   | 44,021   |  
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|Total premiums written                                                                                                                                      |  |      | 408,999  |      |   | 285,439 |   |   | 276,562  |  
|Ceded premiums written                                                                                                                                      |  |      | (13,067  | )    |   | (40,527 | ) |   | (8,123   | )
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|Net premiums written                                                                                                                                        |  |      | 395,932  |      |   | 244,912 |   |   | 268,439  |  
|Change in net deferred premium
revenue                                                                                                                      |  |      | (212,817 | )    |   | (93,073 | ) |   | (152,158 | )
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|Net premiums earned (net of ceded
premiums
  earned of $22,957; $28,107; and $59,144)                                                                       |  |      | 183,115  |      |   | 151,839 |   |   | 116,281  |  
|Net investment income                                                                                                                                       |  |      | 77,724   |      |   | 51,160  |   |   | 35,746   |  
|Net realized losses on
investments                                                                                                                          |  |      | (16,180  | )    |   | (3,221  | ) |   | (178     | )
|Net realized and unrealized (losses)
gains
  on credit derivatives                                                                                          |  |      | (8,385   | )    |   | (6,681  | ) |   | 12,687   |  
|Fee income and other                                                                                                                                        |  |      | 2,365    |      |   | 750     |   |   | 100      |  
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|Total revenues                                                                                                                                              |  |      | 238,639  |      |   | 193,847 |   |   | 164,636  |  
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|Expenses                                                                                                                                                    |  |      |          |      |   |         |   |   |          |  
|Net losses and loss adjustment
expenses                                                                                                                     |  |      | 14,958   |      |   | 26,021  |   |   | 21,274   |  
|Acquisition costs, net                                                                                                                                      |  |      | 16,240   |      |   | 12,231  |   |   | 8,259    |  
|Operating expenses                                                                                                                                          |  |      | 78,999   |      |   | 67,621  |   |   | 58,395   |  
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|Total expenses                                                                                                                                              |  |      | 110,197  |      |   | 105,873 |   |   | 87,928   |  
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|Income before income tax and minority
  interest                                                                                                            |  |      | 128,442  |      |   | 87,974  |   |   | 76,708   |  
|Income tax expense (benefit)                                                                                                                                |  |      | 3,133    |      |   | (1,277  | ) |   | 1,920    |  
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|Income before minority interest                                                                                                                             |  |      | 125,309  |      |   | 89,251  |   |   | 74,788   |  
|Minority interest - dividends on
redeemable
  preferred shares                                                                                              |  |      | 7,954    |      |   | 8,805   |   |   | 15,934   |  
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|Net income                                                                                                                                                  |  | $    | 117,355  |      | $ | 80,446  |   | $ | 58,854   |  
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|Net Income per share:                                                                                                                                       |  |      |          |      |   |         |   |   |          |  
|Basic                                                                                                                                                       |  | $    | 2.19     |      | $ | 1.74    |   | $ | 1.28     |  
|Diluted                                                                                                                                                     |  | $    | 2.18     |      | $ | 1.74    |   | $ | 1.28     |  
|Weighted-average shares outstanding:                                                                                                                        |  |      |          |      |   |         |   |   |          |  
|(Shares in thousands)                                                                                                                                       |  |      |          |      |   |         |   |   |          |  
|Basic                                                                                                                                                       |  |      | 53,676   |      |   | 46,127  |   |   | 46,127   |  
|Diluted                                                                                                                                                     |  |      | 53,718   |      |   | 46,127  |   |   | 46,127   |  
|Comprehensive income                                                                                                                                        |  |      |          |      |   |         |   |   |          |  
|Net income                                                                                                                                                  |  | $    | 117,355  |      | $ | 80,446  |   | $ | 58,854   |  
|Change in unrealized appreciation
  (depreciation) of investments, net of deferred tax benefit (expense) of $102
  in 2006, $792 in 2005 and ($135) in 2004 |  |      | 602      |      |   | (20,066 | ) |   | (2,742   | )
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  
|Total comprehensive income                                                                                                                                  |  | $    | 117,957  |      | $ | 60,380  |   | $ | 56,112   |  
|                                                                                                                                                            |  |      |          |      |   |         |   |   |          |  

See accompanying notes to consolidated
financial statements.

93

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SECURITY CAPITAL ASSURANCE LTDCONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY
YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

|                                                                        |  |      |           |      |   |         |   |   |         |  
|----------------------------------------------------------------------- |  | ---- | --------- | ---- | - | ------- | - | - | ------- | -
|(U.S. Dollars in thousands, except
  per share amounts)                 |  | 2006 |           | 2005 |   | 2004    |  
|                                                                        |  |      |           |      |   |         |  
|Common stock                                                            |  |      |           |      |   |         |   |   |         |  
|Balancebeginning of year                                               |  | $    | 461       |      | $ | 461     |   | $ | 461     |  
|Issuance of common stock                                                |  |      | 180       |      |   |         |   |   |         |  
|                                                                        |  |      |           |      |   |         |   |   |         |  
|Balanceend of year                                                     |  |      | 641       |      |   | 461     |   |   | 461     |  
|                                                                        |  |      |           |      |   |         |   |   |         |  
|Additional paid-in capital                                              |  |      |           |      |   |         |   |   |         |  
|Balancebeginning of year                                               |  |      | 605,951   |      |   | 603,247 |   |   | 476,192 |  
|Issuance of common stock, net of
  underwriting fees and issuance costs |  |      | 341,082   |      |   |         |   |   |         |  
|Capital contributions                                                   |  |      | 40,770    |      |   | 2,704   |   |   | 127,055 |  
|                                                                        |  |      |           |      |   |         |   |   |         |  
|Balanceend of year                                                     |  |      | 987,803   |      |   | 605,951 |   |   | 603,247 |  
|                                                                        |  |      |           |      |   |         |   |   |         |  
|Retained Earnings                                                       |  |      |           |      |   |         |   |   |         |  
|Balancebeginning of year                                               |  |      | 281,709   |      |   | 201,263 |   |   | 142,409 |  
|Net income                                                              |  |      | 117,355   |      |   | 80,446  |   |   | 58,854  |  
|Dividends on common shares                                              |  |      | (1,283    | )    |   |         |   |   |         |  
|                                                                        |  |      |           |      |   |         |   |   |         |  
|Balanceend of year                                                     |  |      | 397,781   |      |   | 281,709 |   |   | 201,263 |  
|                                                                        |  |      |           |      |   |         |   |   |         |  
|Accumulated other comprehensive income                                  |  |      |           |      |   |         |   |   |         |  
|Balancebeginning of year                                               |  |      | (20,307   | )    |   | (241    | ) |   | 2,501   |  
|Net change in unrealized appreciation
  (depreciation) of investments   |  |      | 602       |      |   | (20,066 | ) |   | (2,742  | )
|                                                                        |  |      |           |      |   |         |   |   |         |  
|Balanceend of year                                                     |  |      | (19,705   | )    |   | (20,307 | ) |   | (241    | )
|                                                                        |  |      |           |      |   |         |   |   |         |  
|Total shareholders
equity                                              |  | $    | 1,366,520 |      | $ | 867,814 |   | $ | 804,730 |  
|                                                                        |  |      |           |      |   |         |   |   |         |  

See accompanying notes to consolidated
financial statements.

94

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SECURITY CAPITAL ASSURANCE LTDCONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

|                                                                                              |  |      |          |      |   |          |   |   |            |  
|--------------------------------------------------------------------------------------------- |  | ---- | -------- | ---- | - | -------- | - | - | ---------- | -
|(U.S. Dollars in thousands)                                                                   |  | 2006 |          | 2005 |   | 2004     |  
|                                                                                              |  |      |          |      |   |          |  
|Cash provided by operating activities:                                                        |  |      |          |      |   |          |   |   |            |  
|Net income                                                                                    |  | $    | 117,355  |      | $ | 80,446   |   | $ | 58,854     |  
|Adjustments to reconcile net income to
net
  cash provided by operating activities            |  |      |          |      |   |          |   |   |            |  
|Net realized losses on sale of
investments                                                    |  |      | 16,180   |      |   | 3,221    |   |   | 178        |  
|Net realized and unrealized losses
(gains)
  on credit derivatives                            |  |      | 8,385    |      |   | 6,681    |   |   | (12,687    | )
|Amortization of premium on
bonds                                                              |  |      | 3,396    |      |   | 4,299    |   |   | 5,672      |  
|Minority interest  dividends on
redeemable
  preferred shares                                |  |      | 7,954    |      |   | 8,805    |   |   | 15,934     |  
|Deferred tax benefit                                                                          |  |      | (434     | )    |   | (916     | ) |   | (3,834     | )
|Increase (decrease) in accrued investment
  income                                            |  |      | (4,643   | )    |   | (2,519   | ) |   | 416        |  
|(Increase) in deferred acquisition
costs                                                      |  |      | (34,217  | )    |   | (14,993  | ) |   | (26,860    | )
|Decrease (increase) in prepaid
reinsurance
  premiums                                         |  |      | 9,890    |      |   | (12,419  | ) |   | 51,021     |  
|(Increase) decrease in premiums
receivable                                                    |  |      | (5,166   | )    |   | 14,448   |   |   | (17,506    | )
|(Increase) in reinsurance balances
  recoverable on unpaid losses                             |  |      | (19,399  | )    |   | (8,303   | ) |   | (49,514    | )
|Increase in unpaid losses and loss
  adjustment expenses                                      |  |      | 31,149   |      |   | 31,634   |   |   | 68,539     |  
|Increase in deferred premium
revenue                                                          |  |      | 203,321  |      |   | 105,492  |   |   | 101,137    |  
|Increase (decrease) in reinsurance
premiums
  payable                                         |  |      | 13,642   |      |   | (3,975   | ) |   | (4,133     | )
|Other, net                                                                                    |  |      | 45,532   |      |   | 14,845   |   |   | 3,317      |  
|                                                                                              |  |      |          |      |   |          |   |   |            |  
|Total adjustments                                                                             |  |      | 275,590  |      |   | 146,300  |   |   | 131,680    |  
|                                                                                              |  |      |          |      |   |          |   |   |            |  
|Net cash provided by operating
activities                                                     |  |      | 392,945  |      |   | 226,746  |   |   | 190,534    |  
|                                                                                              |  |      |          |      |   |          |   |   |            |  
|Cash flows from investing activities:                                                         |  |      |          |      |   |          |   |   |            |  
|Proceeds from sale of debt
securities                                                         |  |      | 384,451  |      |   | 589,013  |   |   | 2,009,239  |  
|Purchase of debt securities                                                                   |  |      | (994,454 | )    |   | (922,522 | ) |   | (2,314,521 | )
|Net (purchases) sales of short-term
  investments                                             |  |      | (45,714  | )    |   | 20,373   |   |   | (449,367   | )
|Proceeds from maturity of debt securities
  and short-term investments                        |  |      | 47,074   |      |   | 77,217   |   |   | 545,389    |  
|                                                                                              |  |      |          |      |   |          |   |   |            |  
|Net cash used in investing
activities                                                         |  |      | (608,643 | )    |   | (235,919 | ) |   | (209,260   | )
|                                                                                              |  |      |          |      |   |          |   |   |            |  
|Cash flows from financing activities:                                                         |  |      |          |      |   |          |   |   |            |  
|Proceeds from issuance of common stock
less
  underwriters allowance and issuance costs paid |  |      | 342,341  |      |   |         |   |   |           |  
|Cash from contributed
subsidiary                                                              |  |      | 7,304    |      |   |         |   |   |           |  
|Cash contributions from XL
Capital                                                            |  |      | 21,229   |      |   |         |   |   | 876        |  
|Dividends on common shares                                                                    |  |      | (1,283   | )    |   |         |   |   |           |  
|Dividends on redeemable preferred
shares                                                      |  |      | (5,938   | )    |   | (7,481   | ) |   | (14,103    | )
|                                                                                              |  |      |          |      |   |          |   |   |            |  
|Net cash provided by (used in) financing
  activities                                         |  |      | 363,653  |      |   | (7,481   | ) |   | (13,227    | )
|                                                                                              |  |      |          |      |   |          |   |   |            |  
|Increase (decrease) in cash and cash
  equivalents                                            |  |      | 147,955  |      |   | (16,654  | ) |   | (31,953    | )
|Cash and cash equivalentsbeginning of
year                                                   |  |      | 54,593   |      |   | 71,247   |   |   | 103,200    |  
|                                                                                              |  |      |          |      |   |          |   |   |            |  
|Cash and cash equivalentsend of year                                                         |  | $    | 202,548  |      | $ | 54,593   |   | $ | 71,247     |  
|                                                                                              |  |      |          |      |   |          |   |   |            |  
|                                                                                              |  |      |          |      |   |          |   |   |            |  
|Non-cash capital contributions                                                                |  | $    | 19,541   |      | $ | 2,704    |   | $ | 127,055    |  
|Taxes (received) paid under tax sharing
  agreement                                           |  | $    | (508     | )    | $ | 2,485    |   | $ | 8,639      |  

See accompanying notes to consolidated
financial statements.

95

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

1. Organization and Business

On
    March 17, 2006, XL Capital Ltd (XL Capital) formed Security
    Capital Assurance Ltd (SCA), a Bermuda based holding company,
    in anticipation of contributing its ownership interests in its financial
    guarantee insurance and financial guarantee reinsurance operating businesses
    to SCA and selling an interest therein to the public through an initial public
    offering of SCA common shares (the IPO). The contribution of
    the businesses to SCA occurred on July 1, 2006 and the IPO was consummated
    on August 4, 2006  see Initial Public Offering
below for further information. The aforementioned operating businesses
contributed to SCA by XL Capital consisted of: (i) XL Capital Assurance Inc.
(XLCA) and its wholly-owned subsidiary, XL Capital Assurance (U.K.)
Limited (XLCA-UK) and (ii) XL Financial Assurance Ltd. (XLFA).
In addition, on July 1, 2006, XL Capital contributed all its ownership interest
in XL Financial Administrative Services Inc. (XLFAS) to SCA. XLFAS
employs personnel whom provide services exclusively to SCA and its subsidiaries. Prior
to the IPO, XLCA and XLFAS were indirect wholly owned subsidiaries of XL Capital
and substantially all of XLFA was owned by XL Capital, except for a $54.0 million
preferred stock interest which is owned by Financial Security Assurance Holdings
Ltd. (FSAH)
 see Note 5.

XL Capital
is a public company whose shares are listed on the New York Stock Exchange
under the symbol XL. XL Capital, through its operating subsidiaries, provides
a wide range of insurance and reinsurance coverage and financial products and
services to industrial, commercial and professional service firms, insurance
companies and other enterprises worldwide.

XLCA is an
insurance company domiciled in the State of New York and is licensed to conduct
financial guarantee insurance business throughout all 50 of the United States,
as well as in the Commonwealth of Puerto Rico, the District of Columbia and the
U.S. Virgin Islands. In addition, XLCA through its wholly owned subsidiary,
XLCA-UK, which is an insurance company organized under the laws of England, is
permitted to conduct business in England, Ireland, Spain, France, Portugal,
Italy, The Netherlands, Greece, Norway and Germany. To facilitate distribution
of their products, XLCA maintains a branch office abroad in Singapore and
XLCA-UK maintains a branch office in Madrid. In addition, XLCA has an office in
California.

XLCA and
XLCA-UK are primarily engaged in providing credit protection through the
issuance of financial guarantee insurance policies and credit default swaps.
Financial guarantee insurance provides an unconditional and irrevocable
guarantee to the holder of a debt obligation of full and timely payment of
principal and interest. In the event of a default under the obligation, the
insurer has recourse against the issuer and/or any related collateral (which is
more common in the case of insured asset-backed obligations or other
non-municipal debt) for amounts paid under the terms of the policy. Credit
default swaps are derivative contracts which offer credit protection relating
to a particular security or pools of specified securities. Under the terms of a
credit default swap, the seller of credit protection makes a specified payment
to the buyer of credit protection upon the occurrence of one or more specified
credit events with respect to a referenced security. Credit derivatives
typically provide protection to a buyer rather than credit enhancement of an
issue as in traditional financial guarantee insurance. The companies
underwriting policies limit the companies to providing credit protection only
on obligations or referenced securities that it determines would be of
investment-grade quality without the benefit of credit enhancement provided by
the companies through their issuance of insurance policies and credit default
swaps.

XLFA is
primarily engaged in the business of providing reinsurance of financial
guarantee insurance policies and credit default swaps issued by XLCA,
subsidiaries of FSAH (see Note 5), and certain other non-affiliated
triple-A-rated financial guarantee primary insurance companies.

XLCA,
XLCA-UK, and XLFA all have triple-A financial strength ratings from Standard
& Poors Ratings Services, Moodys Investors Service, Inc. and Fitch Inc.
SCA, XLCA, XLFA, XLFAS and all other subsidiaries of SCA are hereafter
collectively referred to as the Company.

Initial Public Offering

In
the IPO SCA issued 18,009,119 common shares at $20.50 per share for aggregate
consideration of $369.2 million. Underwriting expenses were $22.2 million and
other issuance costs were approximately $5.7 million resulting in net proceeds
of approximately $341.3 million. After the IPO, a secondary offering of SCA common
stock 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 represented approximately a 63 percent economic
interest in SCA. 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. Either or both of such limitations
on XL Capital shall cease to apply, or may be adjusted upwards, upon our receipt
of written confirmation from each nationally recognized rating agency then providing a financial
strength rating for us and/or our subsidiaries that such financial strength rating is
or will be determined without reference to the ratings of XL Capital or that the
then financial strength rating issued by it will not at the time of such confirmation be adversely
affected by the elimination or adjustment of such limitation, and, in the case of any adjustment
(as opposed to elimination), the applicable percentages set forth above shall automatically be
adjusted to those percentages

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

as so determined by the foregoing; provided, however, that, in the event that such written confirmation
shall later be rescinded, such limitation shall be reinstated at a percentage equal to the lesser of
(i) such percentage as is required by the rescinding rating agency and (ii) the percentage set forth
above originally applicable to such limitation.

2. Summary of Significant Accounting Policies

Basis of
Presentation

The
accompanying consolidated financial statements present the historical
consolidated financial position, results of operations and cash flows of the
Company. These consolidated financial statements have been prepared in
conformity with accounting principles generally accepted in the United States
of America (GAAP), which requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and disclosure
of contingent assets and liabilities as of the date of the financial statements
and the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. Accounting policies requiring
significant estimates relate to deferred acquisition costs, investments and
reserves, as discussed in this note. Certain amounts in 2005 and 2004 have been
reclassified to conform to the current year presentation.

Prior to
the IPO, certain expenses reflected in the financial statements include
allocations of corporate expenses incurred by XL Capital related to general and
administrative services provided to the Company. These expenses were allocated
based on estimates of the cost incurred by XL Capital to provide these services
to the Company. Management believes that the methods used to estimate the costs
allocated to the company are reasonable. All intercompany accounts and
transactions have been eliminated in consolidation. However, these results do
not necessarily represent what the historical consolidated financial position,
results of operations and cash flows of the Company would have been if the
Company had been a separate and stand-alone entity during the periods
presented.

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 a nationally recognized pricing service
or, in the absence of quoted market prices, on dealer quotes. The net
unrealized appreciation or depreciation on investments, net of deferred income
taxes, 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 pre-refunded bonds, the
remaining term is determined based on the contractual refunding date. 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. Cash equivalents include
fixed-interest and money market fund deposits with a maturity of less than 90
days when purchased.

97

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

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 average 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 the Companys investment portfolio of
December 31, 2006 or 2005.

Other Invested
Assets

Other
invested assets consisted of certain notes acquired in connection with the
satisfaction of a claim resulting from the default of an insured obligationsee
Note 13. Income on such notes was recognized based on the effective yield
method. Under the effective yield method, the excess of all cash flows expected
from the notes at acquisition over the Companys initial investment in the
notes was recognized as interest income on a level-yield basis over the
expected life of the notes. Subsequent increases in cash flows expected to be
collected were recognized prospectively through adjustment of the notes yield
over its expected remaining life. Decreases in cash flows expected to be
collected were recognized as impairments and are reflected in the accompanying
consolidated statement of operations under the caption Net realized losses on
investments.

Premium Revenue
Recognition

Premiums
charged in connection with the issuance of the Companys guarantees are
received either upfront or in installments. Such premiums are recognized as
written when due. Installment premiums written are earned ratably over the
installment period, generally one to three months, which is consistent with the
expiration of the underlying risk or amortization of the underlying insured
par. Upfront premiums written are earned in proportion to the expiration of the
related risk. The methodology employed to earn upfront premiums requires that
such premiums be apportioned to individual sinking fund payments of a bond
issue according to the bond issues amortization schedule. The apportionment is
based on the ratio of the principal amount of each sinking fund payment to the
total principal amount of the bond issue. After the premium is allocated to
each scheduled sinking fund payment, such allocated premium is earned on a
straight-line basis over the period of that sinking fund payment. As a result,
for upfront premiums on amortizing insured obligations, premium revenue
recognition will tend to be greater in the earlier periods of the transaction
when there is a higher amount of risk or principal outstanding. The effect of
the Companys upfront premium earnings policy is that the Company recognizes
greater levels of upfront premiums in earlier years of each amortizing insured
obligation. Recognizing premium revenue on a straight-line basis over the life
of each amortizing insured obligation without allocating premiums to the
scheduled principal payments would materially change the amount of premium the
Company recognizes in a particular financial reporting period, but not over the
life of the applicable policy. For upfront premiums on non-amortizing bullet
maturity debt obligations, premium revenue recognition is recognized on a
straight-line basis over the life of the underlying insured obligation.
Deferred premium revenue represents the portion of premiums written that is
applicable to the unexpired risk or principal of insured obligations. For both
upfront and installment policies, ceded premium expense is recognized in
earnings in proportion to and at the same time the related premium revenue is
recognized.

The
Companys accounting policies for the recognition of ceded premiums, ceding
commissions and ceded losses and loss adjustment expenses under its ceded
reinsurance contracts mirror the policies described herein for premium revenue
recognition, deferred ceding commissions, and reserves for losses and loss
adjustment expenses.

In
addition, when an insured issue is retired early, is called by the issuer or
    is in substance paid in advance through a refunding accomplished by placing
    U.S. government securities in escrow, the remaining deferred premium revenue
    is earned at that time since there is no longer risk to the Company. Premiums
earned for the years ended December 31, 2006, 2005, and 2004 include $27.4
million, $14.7 million and $6.0 million, respectively, related to refunded and
called bonds.

Fee Income and
Other

The Company
collects advisory and structuring fees in connection with certain transactions.
Depending upon the type of fee received, the fee is either earned when services
are rendered 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 Income and Other. Structuring,
waiver and consent, and commitment fees are included in the accompanying
consolidated statements of operations as premiums and earned on a straight-line
basis over the life of the related transaction.

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

Losses and Loss
Adjustment Expenses

The
financial guarantees that the Company issues insure scheduled payments of
principal and interest due on various types of financial obligations against
default by the issuers of such obligations. The Company establishes reserves
for losses and loss adjustment expenses on such business based on its best
estimate of the ultimate expected incurred losses. The Companys estimated
ultimate expected incurred losses are comprised of: (i) case basis reserves,
(ii) unallocated reserves, and (iii) cumulative paid losses to date.
Establishment of such reserves requires the use and exercise of significant
judgment by management, including with respect to estimates regarding the
occurrence and amount of a loss on an insured obligation. Estimates of losses
may differ from actual results and such difference may be material due to the
fact that the ultimate dispositions of claims are subject to the outcome of
events that have not yet occurred. Examples of these events include changes in
the level of interest rates, credit deterioration of insured obligations, and
changes in the value of specific assets supporting insured obligations. Both
qualitative and quantitative factors are used in establishing such reserves. In
determining the reserves, management considers all factors in the aggregate,
and does not attribute the reserve provisions or any portion thereof to any
specific factor. Any estimate of future costs is subject to the inherent
limitation on the Companys ability to predict the aggregate course of future
events. It should therefore be expected that the actual emergence of losses and
loss adjustment expenses will vary, perhaps materially, from any estimate.

Case basis
reserves on financial guarantee insurance business written are established by
the Company with respect to a specific policy or contract upon receipt of a
claim notice or when management determines that: (i) a claim is probable in the
future based on specific credit events that have occurred and (ii) the amount
of the ultimate loss that the Company will incur can be reasonably estimated.
As specific case basis reserves are established the Company considers whether
any changes are required to the assumptions underlying the calculation of
unallocated reserves (which are discussed below) as a result of such activity.
As case basis reserve activity to date has been limited, the Company has not,
to date, adjusted its unallocated reserves to reflect such case basis reserve
activity. See Note 13 to the Consolidated Financial Statements for a discussion
of case reserve activity to date. The amount of the case basis reserve is based
on the net present value of the expected ultimate loss and loss adjustment
expense payments that the Company expects to make, net of expected recoveries
under salvage and subrogation rights. Case basis reserves are determined using
cash flow or similar models to estimate the net present value of the
anticipated shortfall between (i) scheduled payments on the insured obligation
plus anticipated loss adjustment expenses and (ii) anticipated cash flow from
the proceeds to be received on sales of any collateral supporting the
obligation and other anticipated recoveries. A number of quantitative and
qualitative factors are considered when determining or assessing, in
managements judgment, the need for a case basis reserve. These variables may
include the creditworthiness of the underlying issuer of the insured
obligation, whether the obligation is secured or unsecured, the projected cash
flow or market value of any assets that collateralize or secure the insured
obligation, and the historical and projected loss rates on such assets. Other
factors that may affect the actual ultimate loss include the state of the
economy, changes in interest rates, rates of inflation and the salvage values
of specific collateral. Case basis reserves are generally discounted at a rate
reflecting the yield on our investment portfolio during the period the case
basis reserve is established. The Company believes this yield is an appropriate
rate to discount its reserves because it reflects the rate of return on the
assets supporting such business. When a case basis reserve is established for a
guaranteed obligation whose premium is paid on an upfront basis, the Company
continues to record premium earnings on such policy over its remaining life,
unless the Company has recorded a full limit loss with respect to such policy,
in which case the remaining deferred premium revenue relating thereto is
immediately reflected in earnings. When a case basis reserve is established for
a guaranteed obligation whose premium is paid on an installment basis, those
premiums, if expected to be received prospectively, are considered a form of
recovery and are no longer earned as premium revenue.

Case basis
reserves on financial guarantee reinsurance assumed are generally established
upon notification from ceding companies. Case basis reserves are established by
the Companys ceding companies and our proportionate share of these reserves
are reported to us on a monthly basis. Based on the Companys evaluation of the
loss activity reported to it on a monthly basis, as well as the results from
our periodic reviews of our ceding companies underwriting and surveillance
procedures, the Company may, in managements judgment, establish case reserves
greater 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 on the ceding companies equivalent of the Companys
list of closely monitored credits as discussed below. 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

99

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

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. Further, 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.

In assessing
whether a loss is probable, the Company considers all available qualitative and
quantitative evidence. Qualitative evidence may take various forms and the
nature of such evidence will depend upon the type of insured obligation and the
nature and sources of cash flows to fund the insured obligations debt service.
For example, such evidence with respect to an insured special revenue
obligation such as an obligation supported by cash flows from a toll road would
consider traffic statistics such as highway volume and related demographic
information, whereas an insured mortgage backed securitization would consider
the quality of the mortgage loans supporting the insured obligation including
delinquency and foreclosure rates, loan to value statistics, market valuation
of the mortgaged properties and other pertinent information. In addition, the
Company will make qualitative judgments with respect to the amount by which
certain other structural protections built into the transaction are expected to
limit the Companys loss exposure. Examples of such structural protections may
include: (i) rate covenants, which generally stipulate that issuers (i.e.
public finance issuers) set rates for services at certain pre-determined levels
(i.e. water and sewer rates which support debt obligations supported by such
revenues), (ii) springing liens, which generally require the issuer to provide
additional collateral upon the breach of a covenant or trigger incorporated
into the terms of the transaction, (iii) consultant call-in rights, which
provide, under certain circumstances, for a consultant to be engaged to make
certain binding recommendations, such as raising rates or reducing expenses,
(iv) the ability to transfer servicing of collateral assets to another party,
and (v) other legal rights and remedies pursuant to representations and
warranties made by the issuer and written into the terms of such transactions.
Quantitative information may take the form of cash flow projections of the
assets supporting the insured debt obligation (which may include, in addition
to collateral assets supporting the obligation, structural protections
subordinate to the attachment point of our risk, such as cash reserve accounts
and letters of credit), as well as (to the extent applicable) other metrics
indicative of the performance of such assets and the trends therein. The
Companys ability to make a reasonable estimate of its expected loss depends
upon its evaluation of the totality of both the available quantitative and
qualitative evidence, and no one quantitative or qualitative factor is
dispositive.

In addition
to case basis reserves, the Company maintains an unallocated loss reserve for
expected losses inherent in its in-force business (consisting of both financial
guarantee insurance and reinsurance business) that it expects to emerge in the
future. The Companys unallocated loss reserves represent its estimated
ultimate liability from claims expected to be incurred in the future under its
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 us is in accordance with
Actuarial Standards of Practice No. 36, Determination
of Reasonable Provision.The methodology applied 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 and reinsured in-force policies). Salvage and subrogation recoveries
are implicit in the Company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 the Companys selected expected ultimate loss ratio is consistent
with the Companys explicit consideration of collateral support in the
establishment of its case basis reserves.

The Company
updates its estimates of losses and loss adjustment expense reserves quarterly
and any resulting changes in reserves are recorded as a charge or credit to
earnings in the period such estimates are changed. In connection therewith, the
Companys unallocated reserves are adjusted each period to reflect (i) any
revisions to managements estimate of expected ultimate losses, if any, and
(ii) the underlying par risk amortization (or loss development) of the
related insured and reinsured in-force business (i.e., loss emergence pattern).
As stated above, the Companys estimated ultimate expected incurred losses are
comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii)
cumulative paid losses to date. As the Company 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 the Company may, based on its judgment, reduce unallocated
reserves in response to significant case basis reserve and/or paid loss
activity. The Company would only expect such reductions to occur in limited
instances, such as economic events generating significant loss activity. The
Company has not viewed its case basis reserve and unallocated reserve activity
to date to warrant a reduction of its unallocated reserves. Each quarterly
period there is an interplay between case basis

100

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

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 to incur on the Companys in-force business. The
Companys initial selection of an initial expected loss ratio (and subsequent
periodic updates thereof) was based on managements judgment and considered the
characteristics of its in-force financial guarantee insurance and reinsurance
business (e.g. principally the mix of the Companys in-force financial
guarantee insurance and reinsurance business between public finance and
structured finance business; however, the Company also considered the various
bond sectors comprising the Companys insured and reinsured in-force business
which are discussed in detail in Note 12 to the Consolidated Financial Statements,
as well as the credit profile of the Companys insured and reinsured portfolio
of business), as well as the Companys actual loss experience, the
characteristics of the insured in-force business of companies comprising the
financial guarantee industry and the actual loss experience of companies
comprising the industry from the Companys analysis referred to above. Other
factors impacting market default levels and the assumptions important to the
Companys reserving methodology are implicit in our 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, the Company adjusts its expected loss
ratio as considered necessary to ensure that such ratio continues to be
appropriate for the risks inherent in the Companys in-force business.

The
Companys unallocated loss reserve is established on an undiscounted basis and
represents managements best estimate of losses that the Company will incur in
the future as a result of credit deterioration in the Companys in-force
business but which have not yet been specifically identified. The Company does
not attempt to apportion unallocated reserves by type of product.

The
Companys total reserves for losses and loss adjustment expenses represent a
small fraction of the Companys insured and reinsured in-force par outstanding,
which reflects the nature of the business the Company underwrites, which is
consistent with that of the financial guarantee insurance industry and the loss
experience of the industry. The Company believes that its reserves are adequate
to cover its expected ultimate losses. However, due to the inherent
uncertainties of estimating reserves for losses and loss adjustment expenses,
actual experience may differ from the estimates reflected in the Companys
consolidated financial statements, and the differences may be material. While
the Company believes that the underlying principles applied to loss reserving
are consistent across the financial guarantee industry, differences may exist
with regard to the methodology and measurement of such reserves. While the
Company believes that the principles it applies are the most appropriate for
the Companys business and have been applied consistently within the periods
presented, alternate methods may produce different estimates as compared to the
current methodology used by the Company.

The
Companys loss reserving policy, described above, is based on guidance provided
in SFAS 60, Accounting and Reporting by Insurance Enterprises, SFAS 5,
Accounting for Contingencies and analogies to Emerging Issues Task Force
(EITF) 85-20, Recognition of Fees for Guaranteeing a Loan. SFAS 60 requires that,
for short-duration contracts, a liability for unpaid claim costs relating to
insurance contracts, including estimates of costs relating to incurred but not
reported claims, be accrued when insured events occur. Additionally, SFAS 5,
requires that a loss be recognized when it is probable that one or more future
events will occur confirming that a liability has been incurred at the date of
the financial statements and the amount of loss can be reasonably estimated.

Although
SFAS 60 provides guidance to insurance enterprises, the Company does not
believe SFAS 60 comprehensively addresses the unique attributes of financial
guarantee insurance contracts, as the standard was developed prior to the
maturity of the financial guarantee industry. SFAS 60 provides guidance with
respect to insurance contracts that are either short-duration or long-duration
in nature. Financial guarantee contracts typically have attributes of both and,
therefore, are difficult to classify as either. For instance, financial
guarantee contracts are reported for regulatory purposes as property and
liability insurance, normally considered short-duration, but have elements of
long-duration contracts in that they are irrevocable and extend over a period
that may be in excess of 30 years.

The Company
believes its loss reserving policy reflects the requirements of applicable
accounting literature, as well as the fact that financial guarantee losses
occur over time as a result of credit deterioration, operational difficulties
of the insured obligor or fraud, which may not be specifically detected when
they occur but which can be generally estimated across a portfolio of insured
obligations based on the credit quality and nature of the portfolio and
historical default data. The Company does, however, recognize premium revenue
and policy acquisition costs in a manner consistent with the 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

101

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

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.

In June
2005, at the request of the Securities and Exchange Commission, the Financial
Accounting Standards Board (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.
The Company will continue to apply the accounting policies noted herein until
further guidance is provided by the FASB. See Recent Accounting Pronouncements
for further information.

Deferred
Acquisition Costs (DAC) and Deferred Ceding Commission

Policy
acquisition costs include those expenses that primarily relate to, and vary
with, the production of new business. The Company periodically conducts a study
to estimate the amount of operating costs that are acquisition costs. These
costs include direct and indirect expenses related to underwriting, marketing
and policy issuance, rating agency fees and premium taxes, and are reduced by
ceding commission income on premiums ceded to reinsurers. Policy acquisition
costs are deferred and amortized over the period in which the related premiums
are earned.

The Company
will recognize a premium deficiency if the sum of expected losses and loss
adjustment expenses, maintenance costs and unamortized policy acquisition costs
exceed the related unearned premiums, the anticipated present value of future
premiums under installment contracts written, and anticipated investment
income. If the Company was to have a premium deficiency that is greater than
unamortized acquisition costs, the unamortized acquisition costs would be
reduced by a charge to expense, and a liability (if necessary) would be
established for any remaining deficiency. There have been no premium
deficiencies recorded by the Company since its inception. For policies
reinsured with third parties the Company receives ceding commissions to
compensate for acquisition costs incurred. The Company nets ceding commissions
received against deferred acquisition costs and earns these ceding commissions
over the period in which the related premiums are earned.

If an
insured issue is retired or defeased prior to the end of the expected period of
coverage, the remaining net amount of DAC with respect to such insured issue is
recognized at such time.

Reinsurance

In the
normal course of business, the Company purchases reinsurance coverage
principally to increase aggregate capacity, manage its risk guidelines and to
reduce the risk of loss on its in-force business. Reinsurance premiums ceded
are earned over the period the reinsurance coverage is provided. Prepaid
reinsurance premiums represent the portion of premiums ceded which is
applicable to the unexpired term of reinsured policies in-force. Amounts
recoverable from reinsurers are estimated in a manner consistent with the claim
liability associated with the reinsured policy. Provision is made for any
estimated uncollectible reinsurance.

Intangible
AssetsAcquired Licenses

Intangible
assets are comprised of licenses to conduct financial guarantee insurance
business in 45 states of the United States. The recoverability of the carrying
value of these intangible assets are evaluated annually for impairment. The
Company has not recorded any adjustments to the carrying value of its
intangible assets since its their acquisition.

Income Taxes

The Company
utilizes the asset and liability method of accounting for income taxes.
Deferred federal income taxes are provided for temporary differences between
the tax and financial reporting basis of assets and liabilities that will
result in deductible or taxable amounts in future years when the reported
amounts of the assets or liabilities are recovered or settled. A valuation
allowance is recorded if it is more likely than not that all, or some portion,
of the benefits related to deferred tax assets will not be realized.

Derivative
Instruments

Credit
default swaps issued by the Company meet the definition of a derivative under
FASB Statement of Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities (SFAS 133), as amended by SFAS No. 149.
Credit default swaps are recognized at fair value and recorded in either assets
or liabilities in the accompanying consolidated balance sheet. The Company
intends to hold these derivative instruments until maturity.

102

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SECURITY CAPITAL ASSURANCE LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

The
fair value of credit default swaps is determined using a model developed by the
Company, the results of which are dependent upon a number of factors including
changes in interest rates, credit spreads, changes in credit quality, expected
recovery rates and other market factors. The change in fair value during the
period resulting from movements in these factors is unrealized as the credit
default swaps are not traded to realize this value. Other elements of the
change in fair value are based upon pricing established at the inception of the
contract, as well as events triggering loss payments under the contracts by the
Company.

Changes
in the fair value of credit default swaps attributable to earnings from
premiums received by the Company from the issuance of such contracts are
recorded in each of the line items within the subtotal net premiums earned  in
the accompanying consolidated statement of operations. In addition, changes in
the fair value of credit default swaps attributable to losses from actual and
expected payments to counterparties under such contracts are recorded in the
line item caption entitled net losses and loss adjustment expenses in
the accompanying consolidated statement of operations, and the remaining components
of the change in fair value of credit defaults swaps, which are attributable
to the market and other factors discussed above, are recorded in the line item
caption entitled net realized and unrealized gains (losses) on credit derivatives in
the accompanying consolidated statement of operations. This presentation is
applicable only to credit default swaps issued by the Company that it has the
intent and ability to hold to maturity and is consistent with practices in the
financial guarantee insurance industry for reporting the results of such
instruments.

Variable Interest
Entities

The
Company insures obligations issued by variable interest entities (VIEs) in
the ordinary course of the Companys business. The Company provides financial
guarantee insurance of structured transactions backed by pools of assets of
specified types, municipal obligations supported by the issuers ability to
charge fees for specified services or projects, and corporate risk obligations
including essential infrastructure projects and obligations backed by
receivables from future sales of commodities and other specified services. The
obligations related to these transactions are often securitized through VIEs.
In synthetic transactions, the Company guarantees payment obligations of
counterparties, including VIEs, through credit default swaps referencing asset
portfolios. The Company only provides financial guarantee insurance of these
VIEs for premiums at market rates but does not hold any equity positions or
subordinated debt in these off-balance sheet arrangements. These financial
guarantee contracts represent variable interests held by the Company in VIEs.

In
underwriting financial guarantees, the Company generally requires that
guaranteed obligations be investment-grade prior to the provision of credit
enhancement. Typically, in the case of asset-backed securities and other
structured obligations, such investment grade ratings are based upon
subordination, cash reserves and other structural protections. Consequently,
the Company has determined that it is not the primary beneficiary of any VIEs
in which it holds a variable interest. Accordingly, these VIEs are not
consolidated by the Company.

Earnings Per Share

Basic
earnings per share amounts are calculated by dividing net income by the
weighted average number of common shares outstanding during the year. Diluted
earnings per share amounts are calculated by dividing net income by the sum of
the weighted average number of common shares outstanding during the year plus
additional shares from all potential dilutive securities. The Companys
dilutive securities consist of stock option and restricted stock awards
outstanding. The additional shares included in the denominator when calculating
diluted earnings per share is calculated in accordance with the treasury stock
method. The treasury stock method assumes that a company uses the proceeds from
the exercise of awards to repurchase common stock at the average market price
during the period. The assumed proceeds under the treasury stock method
include: (i) the purchase price that the grantee will pay in the future, if any
(e.g., the exercise price of a stock option); (ii) compensation cost for future
service that the company has not yet recognized; and (iii) certain tax benefits
when the award generates a tax deduction.

103

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SECURITY CAPITAL ASSURANCE LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

Recent Accounting
Pronouncements

In
June 2005, at the request of the Securities and Exchange Commission, the FASB
added a project to their agenda to review and provide guidance for the
accounting for financial guarantee insurance contracts under which it will
consider claims liability recognition, premium recognition, and the related
amortization of deferred policy acquisition costs. Current accounting
literature, specifically FASB Statement of Financial Accounting Standards No.
60, Accounting and Reporting by Insurance Enterprises (SFAS 60), and FASB
Statement of Financial Accounting Standards No. 97, Accounting and Reporting
by Insurance Enterprises for Certain Long-Duration Contracts and for Realized
Gains and Losses from the Sale of Investments (SFAS 97), does not
specifically address the unique characteristics of accounting for financial
guarantee insurance contracts. Consequently, the accounting principles applied
by the industry, as well as the Company, have evolved over time and incorporate
the concepts of both short-duration and long-duration contract accounting under
the provisions of SFAS 60 and SFAS 97, as well as other accounting literature,
such as FASB Statement of Financial Accounting Standards No. 5, Accounting for
Contingencies (SFAS No. 5) and Emerging Issues Task Force (EITF) Issue No.
85-20, Recognition of Fees for Guaranteeing a Loan. An exposure draft is
expected to be issued by the FASB during the first quarter of 2007. The Company
will continue to apply the accounting policies described herein until further
guidance is provided by the FASB.

In
February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid
Financial Instruments (SFAS 155), which amends SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities (SFAS 133) and SFAS No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities (SFAS 140), and addresses issues raised in SFAS 133
Implementation Issue No. D1, Application of Statement 133 to Beneficial
Interests in Securitized Financial Assets. The primary objectives of SFAS 155
are: (i) with respect to SFAS 133, to address the accounting for beneficial
interests in securitized financial assets and (ii) with respect to SFAS 140, to
eliminate a restriction on the passive derivative instruments that a qualifying
special purpose entity may hold. SFAS 155 is effective for all financial
instruments acquired or issued after the beginning of an entitys first fiscal year
that begins after September 15, 2006. The Company will adopt SFAS 155 on
January 1, 2007 and is currently evaluating the effect of SFAS No. 155 on
its financial statements.

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 any
material effect on the Companys financial statements.

In
July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in
Income Taxes (FIN 48), which clarifies the accounting for uncertainty in
income taxes recognized in an enterprises financial statements in accordance
with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in
a tax return. FIN 48 also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure, and
transition. FIN 48 is applicable for fiscal years beginning after December 15,
2006. The Company will adopt FIN 48 on January 1, 2007 and is currently
evaluating the effect of this Interpretation on its financial statements.

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 these fiscal years. The Company is currently evaluating
the effect of SFAS 157 on its financial statements

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

104

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SECURITY CAPITAL ASSURANCE LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

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

The
Companys primary investment objective is the preservation of capital through
maintenance of high-quality investments with adequate liquidity. A secondary
objective is optimizing long-term, after-tax returns.

The
amortized cost and fair value of investments as of December 31, 2006 and 2005
are as follows:

|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|------------------------------------------------------ |  | -------------------------- | --------- | -------------------------- | - | --------------------------- |  | ---------- | ------- | - | - | --------- | 
|                                                       |  | December 31, 2006          |          
|                                                       |  |                            |          
|(U.S. Dollars in thousands)                            |  | Cost or
  Amortized
  Cost |           | Gross
  Unrealized
  Gains |   | Gross
  Unrealized
  Losses |  | Fair Value |        
|                                                       |  |                            |           |                            |   |                             |  |            |        
|Debt securities                                        |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Mortgage and asset-backed securities                   |  | $                          | 1,077,846 |                            | $ | 3,850                       |  | $          | (11,435 | ) | $ | 1,070,261 | 
|U.S. Government and government agencies                |  |                            | 323,638   |                            |   | 990                         |  |            | (7,074  | ) |   | 317,554   | 
|Corporate                                              |  |                            | 343,199   |                            |   | 1,164                       |  |            | (6,111  | ) |   | 338,252   | 
|Non-U.S. sovereign government                          |  |                            | 10,126    |                            |   | 93                          |  |            | (202    | ) |   | 10,017    | 
|U.S. states and political subdivisions of
  the states |  |                            | 375       |                            |   | 3                           |  |            |        |   |   | 378       | 
|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Total debt securities                                  |  | $                          | 1,755,184 |                            | $ | 6,100                       |  | $          | (24,822 | ) | $ | 1,736,462 | 
|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Short-term investments                                 |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Total short-term investments                           |  | $                          | 222,930   |                            | $ | 75                          |  | $          | (1,104  | ) | $ | 221,901   | 
|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 

|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|------------------------------------------------------ |  | -------------------------- | --------- | -------------------------- | - | --------------------------- |  | ---------- | ------- | - | - | --------- | 
|                                                       |  | December 31, 2005          |          
|                                                       |  |                            |          
|(U.S. Dollars in thousands)                            |  | Cost or
  Amortized
  Cost |           | Gross
  Unrealized
  Gains |   | Gross
  Unrealized
  Losses |  | Fair Value |        
|                                                       |  |                            |           |                            |   |                             |  |            |        
|Debt securities                                        |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Mortgage and asset-backed securities                   |  | $                          | 585,998   |                            | $ | 709                         |  | $          | (11,678 | ) | $ | 575,029   | 
|U.S. Government and government agencies                |  |                            | 469,053   |                            |   | 1,438                       |  |            | (6,538  | ) |   | 463,953   | 
|Corporate                                              |  |                            | 268,708   |                            |   | 1,455                       |  |            | (5,307  | ) |   | 264,856   | 
|Non-U.S. sovereign government                          |  |                            | 9,678     |                            |   | 154                         |  |            | (234    | ) |   | 9,598     | 
|U.S. states and political subdivisions of
  the states |  |                            | 2,638     |                            |   | 1                           |  |            | (46     | ) |   | 2,593     | 
|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Total debt securities                                  |  | $                          | 1,336,075 |                            | $ | 3,757                       |  | $          | (23,803 | ) | $ | 1,316,029 | 
|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Short-term investments                                 |  |                            |           |                            |   |                             |  |            |         |   |   |           | 
|Total short-term investments                           |  | $                          | 31,015    |                            | $ | 12                          |  | $          | (216    | ) | $ | 30,811    | 
|                                                       |  |                            |           |                            |   |                             |  |            |         |   |   |           | 

The change in
net unrealized gains (losses) consists of:

|                                        |  |                          |       |      |   |         |   |   |        |  
|--------------------------------------- |  | ------------------------ | ----- | ---- | - | ------- | - | - | ------ | -
|                                        |  | Years Ended December 31, |      
|                                        |  |                          |      
|(U.S. Dollars in thousands)             |  | 2006                     |       | 2005 |   | 2004    |  
|                                        |  |                          |       |      |   |         |  
|Debt
  securities                       |  | $                        | 1,324 |      | $ | (21,001 | ) | $ | (2,233 | )
|Short-term
  investments                |  |                          | (824  | )    |   | 143     |   |   | (375   | )
|                                        |  |                          |       |      |   |         |   |   |        |  
|Change in net unrealized gains (losses) |  | $                        | 500   |      | $ | (20,858 | ) | $ | (2,608 | )
|                                        |  |                          |       |      |   |         |   |   |        |  

Proceeds
from sales of debt securities for the years ended December
31, 2006, 2005 and 2004 were $384.5 million, $589.0 million and $2,009.2
million, respectively.

105

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SECURITY CAPITAL ASSURANCE LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

The
amortized cost and fair value of bonds at December 31, 2006 and 2005 by
contractual maturity are shown below. Actual maturity may differ from
contractual maturity because issuers may have the right to call or prepay
obligations with or without call or prepayment penalties.

|                                       |  |                   |           |            |   |           | 
|-------------------------------------- |  | ----------------- | --------- | ---------- | - | --------- | 
|                                       |  | December 31, 2006 |          
|                                       |  |                   |          
|(U.S. Dollars in thousands)            |  | Amortized Cost    |           | Fair Value |  
|                                       |  |                   |           |            |  
|Due after
  one through five years     |  | $                 | 333,340   |            | $ | 327,943   | 
|Due after
  five through ten years     |  |                   | 301,642   |            |   | 295,850   | 
|Due after
  ten years                  |  |                   | 42,356    |            |   | 42,408    | 
|                                       |  |                   |           |            |   |           | 
|Subtotal                               |  |                   | 677,338   |            |   | 666,201   | 
|Mortgage and
  asset-backed securities |  |                   | 1,077,846 |            |   | 1,070,261 | 
|                                       |  |                   |           |            |   |           | 
|Total                                  |  | $                 | 1,755,184 |            | $ | 1,736,462 | 
|                                       |  |                   |           |            |   |           | 

|                                       |  |                   |           |            |   |           | 
|-------------------------------------- |  | ----------------- | --------- | ---------- | - | --------- | 
|                                       |  | December 31, 2005 |          
|                                       |  |                   |          
|(U.S. Dollars in thousands)            |  | Amortized Cost    |           | Fair Value |  
|                                       |  |                   |           |            |  
|Due after
  one through five years     |  | $                 | 479,956   |            | $ | 472,033   | 
|Due after
  five through ten years     |  |                   | 235,540   |            |   | 232,401   | 
|Due after
  ten years                  |  |                   | 34,581    |            |   | 36,566    | 
|                                       |  |                   |           |            |   |           | 
|Subtotal                               |  |                   | 750,077   |            |   | 741,000   | 
|Mortgage and
  asset-backed securities |  |                   | 585,998   |            |   | 575,029   | 
|                                       |  |                   |           |            |   |           | 
|Total                                  |  | $                 | 1,336,075 |            | $ | 1,316,029 | 
|                                       |  |                   |           |            |   |           | 

Net
investment income is derived from the following sources:

|                                                               |  |      |        |      |   |        |   |   |        |  
|-------------------------------------------------------------- |  | ---- | ------ | ---- | - | ------ | - | - | ------ | -
|(U.S. Dollars in thousands)                                    |  | 2006 |        | 2005 |   | 2004   |  
|                                                               |  |      |        |      |   |        |  
|Debt
  securities, short-term investments and cash equivalents |  | $    | 79,996 |      | $ | 52,781 |   | $ | 37,183 |  
|Less:
  Investment expenses                                    |  |      | (2,272 | )    |   | (1,621 | ) |   | (1,437 | )
|                                                               |  |      |        |      |   |        |   |   |        |  
|Net investment income                                          |  | $    | 77,724 |      | $ | 51,160 |   | $ | 35,746 |  
|                                                               |  |      |        |      |   |        |   |   |        |  

The
gross realized gains and gross realized losses for the years ended December 31,
2006, 2005 and 2004 were $1.9 million, ($18.1) million; $2.0 million and ($5.2)
million; and $9.4 million and ($9.6) million, respectively. The Company has
gross unrealized losses on securities which it considers to be temporary
impairments. Such individual security positions have been evaluated by
management, based on specific criteria, to determine if these impairments
should be considered other-than-temporary. These criteria include 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 following tables present
the aggregate gross unrealized losses and fair value by investment category and
length of time that individual securities have been in a continuous unrealized
loss position at December 31, 2006 and 2005, respectively:

|                                                 |  |                     |         |                   |   |            |  |                   |         |            |   |                   |     |   |           |  |   |        | 
|------------------------------------------------ |  | ------------------- | ------- | ----------------- | - | ---------- |  | ----------------- | ------- | ---------- | - | ----------------- | --- | - | --------- |  | - | ------ | 
|                                                 |  | December 31, 2006   |        
|                                                 |  |                     |        
|                                                 |  | Less than 12 months |         | 12 months or more |   | Total      | 
|                                                 |  |                     |         |                   |   |            | 
|(U.S. Dollars in thousands)                      |  | Fair Value          |         | Unrealized
  Loss |   | Fair Value |  | Unrealized
  Loss |         | Fair Value |   | Unrealized
  Loss |    
|                                                 |  |                     |         |                   |   |            |  |                   |         |            |   |                   |    
|Description of securities                        |  |                     |         |                   |   |            |  |                   |         |            |   |                   |     |   |           |  |   |        | 
|Mortgage and asset-backed securities             |  | $                   | 220,065 |                   | $ | 931        |  | $                 | 371,675 |            | $ | 10,504            |     | $ | 591,740   |  | $ | 11,435 | 
|U.S. Government and government agencies          |  |                     | 60,713  |                   |   | 575        |  |                   | 361,831 |            |   | 7,571             |     |   | 422,544   |  |   | 8,146  | 
|Corporate                                        |  |                     | 46,444  |                   |   | 204        |  |                   | 211,228 |            |   | 5,913             |     |   | 257,672   |  |   | 6,117  | 
|U.S. states and political subdivisions           |  |                     |        |                   |   |           |  |                   | 2,227   |            |   | 27                |     |   | 2,227     |  |   | 27     | 
|Non-U.S. sovereign government                    |  |                     | 503     |                   |   |           |  |                   | 8,424   |            |   | 201               |     |   | 8,927     |  |   | 201    | 
|                                                 |  |                     |         |                   |   |            |  |                   |         |            |   |                   |     |   |           |  |   |        | 
|Total debt securities and short-term
investments |  | $                   | 327,725 |                   | $ | 1,710      |  | $                 | 955,385 |            | $ | 24,216            | (1) | $ | 1,283,110 |  | $ | 25,926 | 
|                                                 |  |                     |         |                   |   |            |  |                   |         |            |   |                   |     |   |           |  |   |        | 

106

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   |  |   |           |  |   |        | 
|-------------------------------------------------- |  | ------------------- | ------- | ----------------- | - | ---------- |  | ----------------- | ------- | ---------- | - | ----------------- |  | - | --------- |  | - | ------ | 
|                                                   |  | December 31, 2005   |        
|                                                   |  |                     |        
|                                                   |  | Less than 12 months |         | 12 months or more |   | Total      | 
|                                                   |  |                     |         |                   |   |            | 
|(U.S. Dollars in
  thousands)                      |  | Fair Value          |         | Unrealized
  Loss |   | Fair Value |  | Unrealized
  Loss |         | Fair Value |   | Unrealized
  Loss | 
|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   | 
|Description of securities                          |  |                     |         |                   |   |            |  |                   |         |            |   |                   |  |   |           |  |   |        | 
|Mortgage and asset-backed securities               |  | $                   | 225,179 |                   | $ | 3,846      |  | $                 | 244,632 |            | $ | 7,841             |  | $ | 469,811   |  | $ | 11,687 | 
|U.S. Government and government agencies            |  |                     | 352,657 |                   |   | 4,456      |  |                   | 82,271  |            |   | 2,210             |  |   | 434,928   |  |   | 6,666  | 
|Corporate                                          |  |                     | 139,192 |                   |   | 2,032      |  |                   | 91,972  |            |   | 3,355             |  |   | 231,164   |  |   | 5,387  | 
|U.S. states and political subdivisions             |  |                     | 410     |                   |   |           |  |                   | 1,804   |            |   | 45                |  |   | 2,214     |  |   | 45     | 
|Non-U.S. sovereign government                      |  |                     |        |                   |   |           |  |                   | 8,445   |            |   | 234               |  |   | 8,445     |  |   | 234    | 
|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   |  |   |           |  |   |        | 
|Total debt securities and
  short-term investments |  | $                   | 717,438 |                   | $ | 10,334     |  | $                 | 429,124 |            | $ | 13,685            |  | $ | 1,146,562 |  | $ | 24,019 | 
|                                                   |  |                     |         |                   |   |            |  |                   |         |            |   |                   |  |   |           |  |   |        | 

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Securities in a continuous unrealized
        loss position for 12 months or more consist of U.S. Government and Agency
        securities aggregating $7.6 million and corporate bonds, mortgage-backed,
        and asset-backed securities (non-government securities) aggregating
        $16.4 million. Of the non-government securities 59.2%, 74.7%, and 100%
        are rated AAA, AA- or better, and A- or
        better, respectively, by S&P as of December 31, 2006. In addition,
        of the non-government securities in a continuous unrealized loss position
        of 12 months or more, securities aggregating 87% of the total unrealized
        loss in such category have a price decline of less than 6% from their
        cost and 13% have a price decline between 6% and 9% of their cost as
    of December 31, 2006.

Debt
  securities with an amortized cost and fair value of $6.6 million and $6.6
  million and $6.9 million and $7.0 million at December 31, 2006 and 2005,
  respectively, were on deposit with various regulatory authorities as required
  by insurance laws.

4. Segments

The Companys
business activities are organized and managed in two operating segments:
financial guarantee insurance and financial guarantee reinsurance. These
segments are managed separately because they provide different products or
services to different customers, are subject to different regulation, require
different strategies and have different technology requirements.  Products comprising the financial guarantee
insurance segment primarily include financial guarantee insurance of public
finance and structured finance debt securities and credit default swaps.
Products comprising the reinsurance segment primarily include reinsurance of
financial guarantee insurance products issued by financial guarantee insurance
companies. Refer to Note 1 and Note 12 for additional information with regard
to the products offered by the Companys operating segments.

Set forth
in the table below is certain financial information with respect to the
Companys operating segments as of and for the years ended December 31, 2006,
2005 and 2004. Except for various allocations discussed below, the accounting
policies of the segments are the same as those described in the summary of
significant accounting policies. The Company evaluates the performance of each
operating segment based on underwriting profit or loss before income taxes,
nonrecurring items (e.g. items of an unusual or infrequent nature), and
inter-segment transactions. Certain costs and operating expenses are allocated
to each of the segments based on: (i) a review of the nature of such costs, and
(ii) time studies analyzing the amount of employee compensation costs incurred
by each segment.

107

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

|                                                                   |  |                          |          |      |   |         |   |   |          |  
|------------------------------------------------------------------ |  | ------------------------ | -------- | ---- | - | ------- | - | - | -------- | -
|                                                                   |  | Years ended December 31, |         
|                                                                   |  |                          |         
|(U.S.
  Dollars in thousands)                                      |  | 2006                     |          | 2005 |   | 2004    |  
|                                                                   |  |                          |          |      |   |         |  
|Financial guarantee insurance
  segment:                           |  |                          |          |      |   |         |   |   |          |  
|Gross premiums written                                             |  | $                        | 353,728  |      | $ | 233,269 |   | $ | 232,541  |  
|Ceded premiums                                                     |  |                          | (13,067  | )    |   | (40,527 | ) |   | (8,123   | )
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net premiums written                                               |  |                          | 340,661  |      |   | 192,742 |   |   | 224,418  |  
|Change in net deferred premium revenue                             |  |                          | (185,098 | )    |   | (72,159 | ) |   | (138,977 | )
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net premiums earned                                                |  |                          | 155,563  |      |   | 120,583 |   |   | 85,441   |  
|Fee and other income                                               |  |                          | 2,365    |      |   | 750     |   |   | 100      |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Total underwriting revenues                                        |  |                          | 157,928  |      |   | 121,333 |   |   | 85,541   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net losses and loss adjustment expenses                            |  |                          | 12,639   |      |   | 25,369  |   |   | 17,099   |  
|Acquisition costs, net                                             |  |                          | 10,537   |      |   | 4,664   |   |   | 1,932    |  
|Operating expenses                                                 |  |                          | 62,592   |      |   | 59,434  |   |   | 48,071   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Total underwriting expenses                                        |  |                          | 85,768   |      |   | 89,467  |   |   | 67,102   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Financial guarantee insurance underwriting
  profit                |  |                          | 72,160   |      |   | 31,866  |   |   | 18,439   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Financial guarantee reinsurance
  segment:                         |  |                          |          |      |   |         |   |   |          |  
|Reinsurance premiums assumed                                       |  |                          | 55,271   |      |   | 52,170  |   |   | 44,021   |  
|Change in net deferred premium revenue                             |  |                          | (27,719  | )    |   | (20,914 | ) |   | (13,181  | )
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net premiums earned and total underwriting
  revenues              |  |                          | 27,552   |      |   | 31,256  |   |   | 30,840   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net losses and loss adjustment expenses                            |  |                          | 2,319    |      |   | 652     |   |   | 4,175    |  
|Acquisition costs, net                                             |  |                          | 5,703    |      |   | 7,567   |   |   | 6,327    |  
|Operating expenses                                                 |  |                          | 10,055   |      |   | 8,187   |   |   | 10,324   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Total underwriting expenses                                        |  |                          | 18,077   |      |   | 16,406  |   |   | 20,826   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Financial guarantee reinsurance
  underwriting profit              |  |                          | 9,475    |      |   | 14,850  |   |   | 10,014   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Total segment underwriting profit                                  |  |                          | 81,635   |      |   | 46,716  |   |   | 28,453   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Corporate and other:                                               |  |                          |          |      |   |         |   |   |          |  
|Net investment income                                              |  |                          | 77,724   |      |   | 51,160  |   |   | 35,746   |  
|Net realized losses on investments                                 |  |                          | (16,180  | )    |   | (3,221  | ) |   | (178     | )
|Net realized and unrealized (losses) gains
  on credit derivatives |  |                          | (8,385   | )    |   | (6,681  | ) |   | 12,687   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Subtotal                                                           |  |                          | 134,794  |      |   | 87,974  |   |   | 76,708   |  
|Corporate operating expenses                                       |  |                          | 6,352    |      |   |        |   |   |         |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Income before income tax and
  minority interest                   |  |                          | 128,442  |      |   | 87,974  |   |   | 76,708   |  
|Income tax expense (benefit)                                       |  |                          | 3,133    |      |   | (1,277  | ) |   | 1,920    |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Income before minority interest                                    |  |                          | 125,309  |      |   | 89,251  |   |   | 74,788   |  
|Minority interest - dividends on redeemable
  preferred shares     |  |                          | 7,954    |      |   | 8,805   |   |   | 15,934   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  
|Net income                                                         |  | $                        | 117,355  |      | $ | 80,446  |   | $ | 58,854   |  
|                                                                   |  |                          |          |      |   |         |   |   |          |  

5. Minority Interest  Redeemable Preferred
Shares of Subsidiary

XLFA
    was originally formed in 1998 as part of an investment venture between XL
    Capital and FSAH and was initially capitalized through a series of transactions
resulting in the issuance by XLFA of 2,057 common shares to XL Insurance
(Bermuda) Ltd (XLI), an indirect wholly owned subsidiary of XL Capital,
for consideration of $221.0 million and the issuance by XLFA of 363 shares
of Series A Redeemable Preferred Shares to FSAH and its subsidiaries for
consideration of $39 million. FSAH is a holding company whose primary operating
subsidiary, Financial Security Assurance Inc. (FSA), is a monoline
financial guarantee insurance company. On
December 7, 2004, XLFA issued an additional 392 common shares to XLI in
exchange for $125 million and on July 1, 2006 all of XL Capitals direct
and indirect ownership interest in XLFA 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 XLFA from the net proceeds of its
IPO. There were no common or other shares of equity capital issued by XLFA to
SCA in exchange for such contributions.
Pursuant to XLFAs corporate by-laws each share of common stock of XLFA
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 XLFAs Series
A Redeemable Preferred Shares as a group had approximately a 5% voting interest
in XLFA, respectively, whereas holders of XLFAs common shares had an
approximate 95% voting interest, respectively.

Under
XLFAs corporate by-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 company industry average for dividends paid,
and (iii) a payment upon redemption. Under XLFAs amended corporate
by-laws the Series A Preferred shares may be redeemed by XLFA: (i)


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

Prior to April, 2006 the redemption price of the Series A
Preferred Shares was estimated at the end of each reporting period and changes in
the redemption value were accreted over the period from the date of issuance to the earliest
redemption date using the interest method.

Pursuant
    to resolution of XLFAs shareholders on April 2006, XLFA restructured
    the terms of its Series A Redeemable Preferred Shares and changed its bye-laws
    accordingly. In accordance with the resolution, the participating dividend

108

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

of the preference shares was eliminated, the
stated value of the preferred shares held by FSAH and its subsidiaries was increased
    to $54.0 million, and the fixed dividend rate was increased from 5% to 8.25%.

For the
year ended December 31, 2006, the Company recorded $8.0 million of minority
interest  dividends on redeemable preferred shares representing the effect of
the restructured terms of the Series A Preferred Shares referred to above.  For the years ended December 31, 2005 and
2004, the Company recorded $8.8 million and $15.9 million of fixed and participating
dividends and accreted redemption value, respectively.

On
    February 27, 2007, the board of directors of XLFA 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. Payment
    of the extraordinary dividend and the reduction in the stated value of the
    Series A Redeemable Preferred Shares are expected to be made 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.

6. XLFA Capital Facility

In
    December 2004, XLFA 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 XLFA 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. XLFA 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 XLFA pursuant to the Asset Trust Expense
Reimbursement Agreement. The put option agreement is perpetual but would terminate
on delivery of notice by XLFA on or after December 10, 2009, or under certain
defined circumstances, such as the failure of XLFA 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 credit derivatives. The effect 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.

XLFA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 XLFAs common and Series A Redeemable Preferred
Shares (see Note 5) and have a liquidation preference of $100,000 each. In the
event that XLFA 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 XLFAs common and
Series A Redeemable Preferred Shares, cash dividends at a percentage rate per
Series B Preferred Share as follows:

| |     |                                                                                                                                                 
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------
| | (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 XLFA and their consent will not be required for taking any
corporate action. Subject to certain requirements, the Series B Preferred
Shares may be redeemed, in whole or in part, at the option of XLFA at any time
or from time to time after December 9, 2009 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.

7. Related Party Transactions

Concurrent
with the IPO, the Company entered into arrangements with affiliates of XL
Capital: (i) to provide it protection with respect to adverse development on
certain transactions, (ii) have exposures transferred to it or re-assume
exposures under certain financial guarantee policies that were originally
reinsured to, or written on behalf of, the Company by XLI, due principally to
single risk constraints and rating agency capital adequacy requirements applicable
to the Company at the time that business was first written, (iii) cancel the
Companys reinsurance of certain non-financial guarantee business ceded to it
by XLI, and (iv) to govern certain aspects of Companys relationship with XL
Capital after the IPO, including a series of service agreements under which
subsidiaries of XL Capital will provide certain services to

109

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

the
Company or receive certain services from the Company for a period of time after
the IPO.  The aforementioned
arrangements are discussed in detail below.
In addition, in connection with the IPO, XL Capital agreed to:

|     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(i)  | contribute to SCA the proceeds
  from the redemption of an investment related to its financial guarantee
  reinsurance business which aggregated $15.0 million.  This contribution was made on the
  effective date of the IPO.                                                                                                                                                                                                                                                                                                                                                               
|     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|(ii) | to fund a portion of long-term
  compensation awarded by XL Capital to employees of SCA prior to the IPO.  In this regard, in December 2006 XL
  Capital contributed $6.2 million to SCA to fund the aforementioned long-term
  compensation awards of SCA employees which were voluntarily or involuntarily
  converted from XL Capital long-term incentive plans to SCA long-term
  incentive plans and will make periodic contributions in the future for such
  awards that were not so converted.
  Such future contributions are not expected to exceed $1.6 million in
  the aggregate.

Services
Agreements with Affiliates

Prior to the IPO, the Company purchased
various services from affiliates of XL Capital under various agreements and
continues to purchase such services under new agreements that became effective
at the date of the IPO.  Such services
principally include: (i) information technology support, (ii) reinsurance and
retrocessional consulting and management services, (iii) actuarial, finance,
legal, internal audit services and certain investment management services.  For the years ended December 31, 2006, 2005,
and 2004, the Company incurred costs under the aforementioned agreements
aggregating $58.7 million, $63.7 million, and $70.1 million, respectively,
which are reflected in operating expenses in the accompanying consolidated
statements of operations.

Employee
Benefit Plans

Prior to
the IPO, XL America, Inc (XLA) maintained a qualified defined contribution
pension plan for the benefit of all eligible employees and a non-qualified
deferred compensation plan for the benefit of certain employees (collectively,
the Plans). Discretionary contributions to both Plans were based on a fixed
percentage of employee contributions and compensation as defined by the Plans.
Such plans were converted to the Companys plans on the effective date of the
IPO.  The terms and provisions of the
Companys plans are substantially the same as the aforementioned plans of
XLA.  For the years ended December 31,
2006, 2005, and 2004, the Company incurred costs under the aforementioned plans
aggregating $2.7 million, $2.2 million, and $2.1 million, respectively, which
are reflected in operating expenses in the accompanying consolidated
statements of operations.

Reinsurance
Agreements With Affiliates and Other Guarantees

The Company
has the following reinsurance agreements with affiliates.  Certain of the agreements discussed below
may be terminated under certain conditions, as defined in the agreements.

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Effective August
  4, 2006, certain subsidiaries of XL Capital indemnified the Company for all
  losses and loss adjustment expenses incurred in excess of its retained
  reserves at the effective date of the agreement relating to an insured
  project financing described in Note 13 (a). In consideration for the
  aforementioned indemnifications the Company is obligated to pay such
  affiliates approximately $9.8 million on an installment basis over the life
  of the aformentioned project financing. As this premium is due irrespective
  of any early termination of the underlying insurance transaction, the Company
  recorded a liability of approximately $7.0 million at the effective date of
  the indemnifications (representing the present value of the obligation
  discounted at 5.0%, which reflects the rate on treasury obligations with a
  term to maturity commensurate with that of the liability) and a corresponding
  deferred cost, which are reflected in the accompanying consolidated balance
  sheet in reinsurance premiums payable and prepaid reinsurance premiums,
  respectively. For the year ended December 31, 2006, the Company incurred
  costs under the aforementioned agreements aggregating approximately $0.4
  million.

110

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Effective August
  4, 2006, XLA has undertaken to indemnify the Company for any dimunition in
  value below their carrying value at June 30, 2006 of the notes and preferred
  shares described in Note 13 (b), which notes and preferred shares were
  acquired in connection with the satisfaction of a claim under a financial
  guarantee insurance policy issued by XLCA. In addition, pursuant to the
  aforementioned indemnity, XLA agreed to indemnify the Company for any costs
  arising out of any litigation or future claim in connection with the
  aforementioned insurance policy. See Note 13 (b) for further information
  regarding amounts recovered or recoverable by SCA under the indemnity.                                                                                                                                                                 
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | On August 4, 2006,
  XLFA terminated a faculatative quota share reinsurance treaty with XLI that
  had been effective since 2001. As a result of the termination, XLI returned
  $26.5 million of premiums to XLFA, XLFA returned ceding commissions of $7.8
  million to XLI, and XLI paid XLFA $18.7 million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | On August 4, 2006,
  XLFA and XLI agreed to cancel from inception the reinsurance of certain
  business ceded under a facultative quota share reinsurance treaty that was
  effective since 1999. As a result of this cancellation, XLFA paid XLI $0.2
  million, XLI assumed XLFAs obligation for $1.2 million of reserves for
  losses and loss adjustment expenses, and XLFA recorded a capital contribution
  of $1.0 million. In addition, on such date, XLFA assumed certain business
  from XLI pursuant to the aforementioned reinsurance treaty. As a result
  thereof, XLFA 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.                                                                                                                       
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | Effective October
  1, 2001, XLFA entered into an excess of loss reinsurance agreement with XLI.
  This agreement covers a portion of XLFAs liability arising as a result of
  losses on policies written by XLFA 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,
  and excludes coverage for liabilities arising other than pursuant to the
  terms of an underlying policy. The Company incurred expense under this
  agreement of approximately $0.5 million for each of the years ended December
  31, 2006, 2005 and 2004.                                                                                                                   
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | Effective November
  1, 2002, XLCA entered into a facultative reinsurance arrangement (the XL Re
  Treaty) with XL RE AM. Under the terms of the XL Re Treaty, XL RE AM agrees to
  reinsure risks insured by XLCA under financial guarantee insurance policies
  up to the amount necessary for XLCA to comply with single risk limitations
  set forth in Section 6904(d) of the New York Insurance Laws. Such reinsurance
  was on an automatic basis prior to the effective date of the IPO and is on a
  facultative basis on and after the effective date of the IPO. The reinsurance
  provided by XL RE AM may be on an excess of loss or quota share basis. The
  Company is allowed up to a 30% ceding commission (or such other percentage on
  an arms-length basis) on ceded premiums written under the terms of this
  agreement.                                   
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|  | Effective January 1, 2004, XLCA
  commuted all the reinsurance ceded under the XL RE Treaty through December
  31, 2003. As a result of the commutation, XL RE AMreturned
  $6.0 million of premiums to XLCA, XLCA returned ceding commissions of $1.8
  million to XL RE AM, and XL RE AM paid XLCA $4.2 million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | Since it commenced
  operations, XLFA has entered into several reinsurance arrangements with
  subsidiaries and affiliates of FSAH (hereafter referred to as FSA) to
  reinsure certain policies issued by FSA which guarantee the timely payment of
  the principal of and interest on various types of debt obligations. XLFAs
  obligations under certain of these arrangements are guaranteed by XLI.
  Effective upon the IPO, the guarantee was terminated with respect to all new
  business assumed by XLFA under such arrangement, but the guarantee remains in
  effect with respect to cessions under the agreement prior to the IPO.
  Premiums assumed by XLFA under its reinsurance arrangements with FSA
  represented 70%, 66%, and 73% of the Companys total reinsurance premiums
  assumed for the years ended December 31, 2006, 2005, and 2004. respectively.

111

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | XLFA has
  guaranteed 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 XLFA does
  not have to pay a claim unless both the underlying transaction and XLI
  default. For each of these transactions, XLFA has entered into a
  reimbursement agreement with XLI, pursuant to which XLI pays XLFA a fee for
  providing its guarantee and XLI grants XLFA a security interest in a portion
  of the payments received by it from its client. As of December 31, 2006 and
  2005, XLFAs aggregate net par outstanding relating to such guarantees was
  $522.8 million and $526.8 million, respectively.                                                                                                                                                                 
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Effective May 1,
  2004, XLI entered into an agreement with XLCA which unconditionally and
  irrevocably guarantees to XLCA the full and complete payment when due of all
  of XLFAs obligations under its facultative quota share reinsurance agreement
  with XLCA, under which agreement XLFA has assumed business from XLCA since
  December 19, 2000. The par value of business guaranteed by XLI under this
  agreement was approximately $83.1 billion and $72.6 billion as of December
  31, 2006 and 2005, respectively. The XLI guarantee agreement terminated with
  respect to any new business produced by XLCA and ceded to XLFA pursuant to
  the faculative quota share reinsurance agreement after the effective date of
  the IPO, but the guarantee remains in effect with respect to cessions under
  the such agreement prior to the IPO.                                                                  
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | The Company
  provides financial guarantee insurance policies insuring timely payment of
  investment agreements issued by XL Asset Funding Company I LLC (XLAF), an
  affiliate of the Company. As of December 31, 2006 and 2005, the aggregate
  face amount of such investment agreements insured by the Company was $3.9
  billion ($554.8 million net of reinsurance) and $3.7 billion ($366.7 million
  net of reinsurance), respectively. In addition, the Company insures XLAFs
  obligations under certain derivative contracts issued and purchased by XLAF.
  As of December 31, 2006 and 2005, the total notional value of such contracts
  insured was $179.1 million and $167.8 million, respectively. For the years
  ended December 31, 2006, 2005, and 2004, the Company recorded earned premiums
  of $3.8 million, $3.0 million and $2.0 million, respectively, relating to the
  aforementioned contracts.

The
following table summarizes the non-affiliated and affiliated components of each
line item in the consolidated statements of operations where applicable:

|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|------------------------------------------------------------------ |  | ---------------------------------- | -------- | ---- | - | ------- | - | - | ------- | -
|                                                                   |  | For the
  Years Ended December 31, |         
|                                                                   |  |                                    |         
|(U.S. Dollars in thousands)                                        |  | 2006                               |          | 2005 |   | 2004    |  
|                                                                   |  |                                    |          |      |   |         |  
|Net premiums earned                                                |  |                                    |          |      |   |         |   |   |         |  
|Non-affiliated:                                                    |  |                                    |          |      |   |         |   |   |         |  
|Total premiums written                                             |  | $                                  | 359,411  |      | $ | 245,272 |   | $ | 239,038 |  
|Ceded premiums written                                             |  |                                    | (18,665  | )    |   | (16,690 | ) |   | (18,184 | )
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Net premiums written                                               |  |                                    | 340,746  |      |   | 228,582 |   |   | 220,854 |  
|Change in net deferred premium revenue                             |  |                                    | (166,484 | )    |   | (82,590 | ) |   | (77,521 | )
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Non-affiliated net premiums
  earned                               |  |                                    | 174,262  |      |   | 145,992 |   |   | 143,333 |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Affiliated:                                                        |  |                                    |          |      |   |         |   |   |         |  
|Total premiums written                                             |  |                                    | 49,588   |      |   | 40,167  |   |   | 37,524  |  
|Ceded premiums written                                             |  |                                    | 5,598    |      |   | (23,837 | ) |   | 10,061  |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Net premiums written                                               |  |                                    | 55,186   |      |   | 16,330  |   |   | 47,585  |  
|Change in net deferred premium revenue                             |  |                                    | (46,333  | )    |   | (10,483 | ) |   | (74,637 | )
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Affiliated net premiums earned                                     |  |                                    | 8,853    |      |   | 5,847   |   |   | (27,052 | )
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Total net premiums earned                                          |  |                                    | 183,115  |      |   | 151,839 |   |   | 116,281 |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Net investment income                                              |  |                                    | 77,724   |      |   | 51,160  |   |   | 35,746  |  
|Net realized losses on
  investments                               |  |                                    | (16,180  | )    |   | (3,221  | ) |   | (178    | )
|Net realized and unrealized
  (losses) gains on credit derivatives |  |                                    | (8,385   | )    |   | (6,681  | ) |   | 12,687  |  
|Fee and other income                                               |  |                                    | 2,365    |      |   | 750     |   |   | 100     |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|                                                                   |  |                                    | 55,524   |      |   | 42,008  |   |   | 48,355  |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Total revenues                                                     |  |                                    | 238,639  |      |   | 193,847 |   |   | 164,636 |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Losses and loss adjustment
  expenses                              |  |                                    |          |      |   |         |   |   |         |  
|Non-affiliated                                                     |  |                                    | 29,137   |      |   | 30,707  |   |   | 70,506  |  
|Affiliated                                                         |  |                                    | (14,179  | )    |   | (4,686  | ) |   | (49,232 | )
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Total losses and loss
  adjustment expenses                        |  |                                    | 14,958   |      |   | 26,021  |   |   | 21,274  |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Acquisition costs, net                                             |  |                                    |          |      |   |         |   |   |         |  
|Non-affiliated                                                     |  |                                    | 14,452   |      |   | 11,639  |   |   | 11,285  |  
|Affiliated                                                         |  |                                    | 1,788    |      |   | 592     |   |   | (3,026  | )
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Total acquisition costs, net                                       |  |                                    | 16,240   |      |   | 12,231  |   |   | 8,259   |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Operating expenses                                                 |  |                                    | 78,999   |      |   | 67,621  |   |   | 58,395  |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Total expenses                                                     |  |                                    | 110,197  |      |   | 105,873 |   |   | 87,928  |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Income before income tax and
  minority interest                   |  |                                    | 128,442  |      |   | 87,974  |   |   | 76,708  |  
|Income tax expense (benefit)                                       |  |                                    | 3,133    |      |   | (1,277  | ) |   | 1,920   |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Income before minority interest                                    |  |                                    | 125,309  |      |   | 89,251  |   |   | 74,788  |  
|Minority interest - dividends on redeemable
  preferred shares     |  |                                    | 7,954    |      |   | 8,805   |   |   | 15,934  |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  
|Net income                                                         |  | $                                  | 117,355  |      | $ | 80,446  |   | $ | 58,854  |  
|                                                                   |  |                                    |          |      |   |         |   |   |         |  

112

---



SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

The
following table summarizes the affiliated components of each line item in the
consolidated balance sheets where applicable:

|                                                                |  |                    |           |      |   |           | 
|--------------------------------------------------------------- |  | ------------------ | --------- | ---- | - | --------- | 
|                                                                |  | As of December 31, |          
|                                                                |  |                    |          
|(U.S. Dollars in thousands)                                     |  | 2006               |           | 2005 |  
|                                                                |  |                    |           |      |  
|Assets                                                          |  |                    |           |      |   |           | 
|Deferred acquisition costs                                      |  | $                  | 16,125    |      | $ | 1,509     | 
|Prepaid reinsurance premiums                                    |  |                    | 24,236    |      |   | 40,479    | 
|Premiums receivable                                             |  |                    | 4,366     |      |   | 2,374     | 
|Reinsurance balances recoverable on unpaid
  losses             |  |                    | 79,460    |      |   | 64,476    | 
|Other assets                                                    |  |                    | 679       |      |   | 3,519     | 
|                                                                |  |                    |           |      |   |           | 
|Total affiliated assets                                         |  |                    | 124,866   |      |   | 112,357   | 
|Non-affiliated assets                                           |  |                    | 2,371,948 |      |   | 1,571,958 | 
|                                                                |  |                    |           |      |   |           | 
|Total assets                                                    |  | $                  | 2,496,814 |      | $ | 1,684,315 | 
|                                                                |  |                    |           |      |   |           | 
|Liabilities and shareholders
  equity                          |  |                    |           |      |   |           | 
|Liabilities                                                     |  |                    |           |      |   |           | 
|Unpaid loss and loss adjustment expenses                        |  | $                  | 13,388    |      | $ | 14,419    | 
|Deferred premium revenue                                        |  |                    | 113,108   |      |   | 83,055    | 
|Reinsurance premiums payable                                    |  |                    | 10,984    |      |   | 6,703     | 
|Accounts payable, accrued expenses and
  other liabilities      |  |                    |          |      |   | 1,445     | 
|                                                                |  |                    |           |      |   |           | 
|Total affiliated liabilities                                    |  |                    | 137,480   |      |   | 105,622   | 
|Non-affiliated liabilities                                      |  |                    | 938,798   |      |   | 660,361   | 
|                                                                |  |                    |           |      |   |           | 
|Total Liabilities                                               |  |                    | 1,076,278 |      |   | 765,983   | 
|Minority interest -  redeemable preferred shares (affiliate)    |  |                    | 54,016    |      |   | 50,518    | 
|Total shareholders equity                                      |  |                    | 1,366,520 |      |   | 867,814   | 
|                                                                |  |                    |           |      |   |           | 
|Total liabilities, minority
  interest and shareholders equity |  | $                  | 2,496,814 |      | $ | 1,684,315 | 
|                                                                |  |                    |           |      |   |           | 

8. Net Premiums Earned

Net premiums earned are comprised of:

|                                           |  |                         |          |      |   |         |   |   |         |  
|------------------------------------------ |  | ----------------------- | -------- | ---- | - | ------- | - | - | ------- | -
|                                           |  | Year ended December 31, |         
|                                           |  |                         |         
|(U.S. Dollars in thousands)                |  | 2006                    |          | 2005 |   | 2004    |  
|                                           |  |                         |          |      |   |         |  
|Gross premiums written                     |  | $                       | 353,728  |      | $ | 233,269 |   | $ | 232,541 |  
|Reinsurance premiums assumed               |  |                         | 55,271   |      |   | 52,170  |   |   | 44,021  |  
|                                           |  |                         |          |      |   |         |   |   |         |  
|Total premiums written                     |  |                         | 408,999  |      |   | 285,439 |   |   | 276,562 |  
|Change in direct deferred premium revenue  |  |                         | (175,208 | )    |   | (82,688 | ) |   | (87,670 | )
|Change in assumed deferred premium revenue |  |                         | (27,719  | )    |   | (22,805 | ) |   | (13,467 | )
|                                           |  |                         |          |      |   |         |   |   |         |  
|Gross premiums earned                      |  |                         | 206,072  |      |   | 179,946 |   |   | 175,425 |  
|                                           |  |                         |          |      |   |         |   |   |         |  
|                                           |  |                         |          |      |   |         |   |   |         |  
|Reinsurance premiums ceded                 |  |                         | (13,067  | )    |   | (40,527 | ) |   | (8,123  | )
|Change in prepaid reinsurance premiums     |  |                         | (9,890   | )    |   | 12,420  |   |   | (51,021 | )
|                                           |  |                         |          |      |   |         |   |   |         |  
|Ceded premiums earned                      |  |                         | (22,957  | )    |   | (28,107 | ) |   | (59,144 | )
|                                           |  |                         |          |      |   |         |   |   |         |  
|                                           |  |                         |          |      |   |         |   |   |         |  
|Net premiums earned                        |  | $                       | 183,115  |      | $ | 151,839 |   | $ | 116,281 |  
|                                           |  |                         |          |      |   |         |   |   |         |  

113

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

9. Deferred Acquisition Costs and Deferred
Ceding Commissions

Deferred
acquisition costs, net of deferred ceding commission revenue, as well as
related amortization, as of and for the years ended December 31, 2006, 2005 and
2004 are as follows:

|                                                             |  |                         |         |      |   |         |   |   |         |  
|------------------------------------------------------------ |  | ----------------------- | ------- | ---- | - | ------- | - | - | ------- | -
|                                                             |  |                         |        
|                                                             |  | Year Ended December 31, |        
|                                                             |  |                         |        
|(U.S. Dollars in thousands)                                  |  | 2006                    |         | 2005 |   | 2004    |  
|                                                             |  |                         |         |      |   |         |  
|                                                             |  |                         |         |      |   |         |   |   |         |  
|Deferred acquisition costs, net- beginning of year           |  | $                       | 59,592  |      | $ | 44,599  |   | $ | 17,739  |  
|                                                             |  |                         |         |      |   |         |   |   |         |  
|Costs and revenues deferred:                                 |  |                         |         |      |   |         |   |   |         |  
|Acquisition costs deferred during the year                   |  |                         | 51,214  |      |   | 38,508  |   |   | 37,259  |  
|Ceding commission revenue deferred during
  the year         |  |                         | (8,566  | )    |   | (11,284 | ) |   | (2,140  | )
|                                                             |  |                         |         |      |   |         |   |   |         |  
|Net costs and revenues deferred                              |  |                         | 42,648  |      |   | 27,224  |   |   | 35,119  |  
|                                                             |  |                         |         |      |   |         |   |   |         |  
|Commutation with affiliate                                   |  |                         | 7,809   |      |   |        |   |   |        |  
|                                                             |  |                         |         |      |   |         |   |   |         |  
|Acquisition costs and ceding
  commission revenue amortized: |  |                         |         |      |   |         |   |   |         |  
|Acquisition costs amortized                                  |  |                         | (22,422 | )    |   | (19,937 | ) |   | (18,389 | )
|Ceding commission revenue amortized                          |  |                         | 6,182   |      |   | 7,706   |   |   | 10,130  |  
|                                                             |  |                         |         |      |   |         |   |   |         |  
|Net
    acquisition costs amortized                          |  |                         | (16,240 | )    |   | (12,231 | ) |   | (8,259  | )
|                                                             |  |                         |         |      |   |         |   |   |         |  
|                                                             |  |                         |         |      |   |         |   |   |         |  
|Deferred acquisition costs, net- end of year                 |  | $                       | 93,809  |      | $ | 59,592  |   | $ | 44,599  |  
|                                                             |  |                         |         |      |   |         |   |   |         |  

10. Reinsurance

The Company
enters into ceded reinsurance arrangements principally to increase aggregate
capacity, manage its risk guidelines and to reduce the risk of loss on business
written or assumed. This reinsurance includes the reinsurance arrangements with
affiliates that are discussed in Note 7, as well as reinsurance arrangements
with non-affiliated reinsurers. Reinsurance does not relieve the Company of its
obligations under its guarantees. Accordingly, the Company is still liable
under its guarantees in the event reinsuring companies do not meet their
obligations to the Company under reinsurance agreements. The Company regularly
monitors the financial condition of its reinsurers. For the years ended
December 31, 2006, 2005, and 2004 there were no amounts provided by the Company
for uncollectible reinsurance recoverable. The following tables set forth
certain amounts ceded to affiliate and non-affiliate reinsurers as of and for
the years ended December 31, 2006, 2005, and 2004. The affiliated amounts
presented for 2004 do not include the effect of the commutation with XL RE AM
discussed in Note 7.

114

---



SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

|                                                    |  |           |           |               |   |           |  |   |           | 
|--------------------------------------------------- |  | --------- | --------- | ------------- | - | --------- |  | - | --------- | 
|                                                    |  | 2006      |          
|                                                    |  |           |          
|(U.S. Dollars in thousands)                         |  | Affiliate |           | Non-Affiliate |   | Total     | 
|                                                    |  |           |           |               |   |           | 
|Year Ended December 31                              |  |           |           |               |   |           |  |   |           | 
|Ceded premiums written                              |  | $         | (5,577    | )             | $ | 18,644    |  | $ | 13,067    | 
|Ceded premiums earned                               |  |           | 10,666    |               |   | 12,291    |  |   | 22,957    | 
|Ceding commission revenue                           |  |           | 2,809     |               |   | 3,373     |  |   | 6,182     | 
|Ceded losses and loss adjustment expenses           |  |           | 14,647    |               |   | 487       |  |   | 15,134    | 
|At December 31                                      |  |           |           |               |   |           |  |   |           | 
|Par exposure ceded                                  |  | $         | 1,581,107 |               | $ | 5,745,370 |  | $ | 7,326,477 | 
|Reinsurance balances recoverable on unpaid
  losses |  |           | 79,615    |               |   | 9,001     |  |   | 88,616    | 

115

---



SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

|                                                    |  |           |           |               |   |           |  |   |           | 
|--------------------------------------------------- |  | --------- | --------- | ------------- | - | --------- |  | - | --------- | 
|                                                    |  | 2005      |          
|                                                    |  |           |          
|(U.S. Dollars in thousands)                         |  | Affiliate |           | Non-Affiliate |   | Total     | 
|                                                    |  |           |           |               |   |           | 
|Year
  Ended December 31                            |  |           |           |               |   |           |  |   |           | 
|Ceded premiums
  written                            |  | $         | 23,837    |               | $ | 16,690    |  | $ | 40,527    | 
|Ceded premiums
  earned                             |  |           | 16,894    |               |   | 11,213    |  |   | 28,107    | 
|Ceding commission
  revenue                         |  |           | 4,895     |               |   | 2,811     |  |   | 7,706     | 
|Ceded losses and
  loss adjustment expenses         |  |           | 7,761     |               |   | 3,491     |  |   | 11,252    | 
|At
  December 31                                    |  |           |           |               |   |           |  |   |           | 
|Par exposure ceded                                  |  | $         | 4,405,870 |               | $ | 4,428,175 |  | $ | 8,834,045 | 
|Reinsurance
  balances recoverable on unpaid losses |  |           | 64,476    |               |   | 4,741     |  |   | 69,217    | 
|                                                    |  |           |           |               |   |           |  |   |           | 
|                                                    |  | 2004      |          
|                                                    |  |           |          
|(U.S.
  Dollars in thousands)                       |  | Affiliate |           | Non-Affiliate |   | Total     | 
|                                                    |  |           |           |               |   |           | 
|Year
  Ended December 31                            |  |           |           |               |   |           |  |   |           | 
|Ceded premiums
  written                            |  | $         | (10,061   | )             | $ | 18,184    |  | $ | 8,123     | 
|Ceded premiums
  earned                             |  |           | 51,357    |               |   | 7,787     |  |   | 59,144    | 
|Ceding commission
  revenue                         |  |           | 8,420     |               |   | 1,710     |  |   | 10,130    | 
|Ceded losses and
  loss adjustment expenses         |  |           | 50,034    |               |   | 1,412     |  |   | 51,446    | 
|At
  December 31                                    |  |           |           |               |   |           |  |   |           | 
|Par exposure ceded                                  |  | $         | 3,012,944 |               | $ | 4,076,577 |  | $ | 7,089,521 | 
|Reinsurance
  balances recoverable on unpaid losses |  |           | 58,167    |               |   | 2,747     |  |   | 60,914    | 

11. Letter of Credit and Liquidity Facility

On
August 4, 2006, the Company entered into an aggregate $500.0 million, five-year
letter of credit and revolving credit facility (the Facility) with a
syndicate of banks, for which Citibank N.A. is the administrative agent. The
Facility enables the Company to draw letters of credit of up to $250.0 million
and revolving credit loans of up to $250.0 million with the aggregate amount of
outstanding letters of credit and revolving credit loans thereunder not to
exceed $500.0 million.  Commitments
under the Facility expire on, and amounts borrowed under the letter of credit
and liquidity facility may be borrowed, repaid and re-borrowed from time to
time until, the earlier of (i) the date that is five years after the closing
date of the Facility and (ii) the date of termination in whole of the
commitments upon an optional termination or reduction of the commitments or
upon an event of default.

The
Facility contains financial covenants that require that SCA at any time (a)
prior to August 4, 2008, maintain a minimum net worth (defined as total
shareholders equity before accumulated other comprehensive income) of $857.4
million, (b) after August 4, 2008, maintain a minimum net worth equal to the
greater of (1) $857.4 million or (2) an amount equal to 65% of the consolidated
net worth as of the end of the then most recent fiscal year or fiscal quarter
of SCA for which financial statements shall have been delivered, and (c)
maintain a maximum total funded debt-to-total capitalization ratio of 30%. The
letter of credit and liquidity facility also contains certain covenants,
including restrictions on mergers, acquisitions and other business
consolidations; the sale of assets; incurrence of indebtedness; liens on our
assets; and transactions with affiliates. In addition, the letter of credit and
liquidity facility contains certain customary provisions regarding events of
default, including payment defaults, breaches of representations and
warranties, covenant defaults, cross-default and cross-acceleration to certain
other indebtedness, certain events of bankruptcy and insolvency, material
judgments, certain events under the Employee Retirement Income Security Act of
1974, as amended, and changes of control.

As
of December 31, 2006, the Company had letters of credit outstanding under the
Facility of $171.9 million, which were established for the benefit of primary
insurance companies reinsured by the Company, as explained below.  No revolving
    loans have been drawn by the Company under the Facility since its inception.
    For the period from August 4, 2006 through December 31, 2006, the Company
    incurred expenses of $0.2 million under the Facility. Prior to August 4,
2006, XL Capital had drawn letters of credit under its credit facility with a
syndicate of commercial banks for the benefit of primary companies reinsured
    by the Company. For the period from
January 1, 2006 through August 3, 2006 and the years ended December 31, 2005
and 2004, the Company incurred expenses of $0.3 million, $1.6 million, and $0.5
million, respectively, related to letters of credit drawn by XL Capital for the
benefit of primary companies reinsured by the Company.

116

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

Primary insurers may require collateral or letters of credit so that
they can receive reinsurance credit under certain U.S. state laws. In addition,
under certain of the Companys reinsurance treaties, the Company may be
required to provide collateral or letters of credit in favor of its ceding
insurers in the event of a downgrade of the Companys credit ratings or other
event which would diminish the credit provided by the Companys reinsurance to
such ceding insurers.

12. Outstanding Exposure and Collateral

Financial
guarantee insurance policies issued by the Company and assumed pursuant to
reinsurance arrangements guarantee the timely payment of principal and interest
on insured obligations. Credit default swaps issued by the Company guarantee
the payment of the notional amounts of referenced securities. The net exposure
retained on any risk guaranteed or reinsured by the Company is subject to the
Companys underwriting guidelines and regulatory risk limitations. The
Companys in-force business is diversified both domestically and
internationally, across multiple industries and by type of obligations
guaranteed. The Companys total exposure, before reinsurance, to principal (or
par) amounts insured and notional amounts guaranteed as of December 31, 2006
and 2005 was $125.3 billion and $90.7 billion, respectively. The Companys
total exposure, before reinsurance, to principal and interest amounts insured
and notional amounts guaranteed as of December 31, 2006 and 2005 was $195.4
billion and $135.3 billion, respectively.

The
following tables present certain information with respect to the par amounts
insured and notional amounts guaranteed by the Company at December 31, 2006 and
2005, before and after reinsurance (or on a gross and net basis,
respectively):

|                           |  |       |       |      |  |            |  |       |       |     |   |           |  |   |      |  |  |       |  
|-------------------------- |  | ----- | ----- | ---- |  | ---------- |  | ----- | ----- | --- | - | --------- |  | - | ---- |  |  | ----- | -
|                           |  | 2006  |       | 2005 | 
|                           |  |       |       |      | 
|(U.S. Dollars in billions) |  | Gross |       | Net  |  | % of
  Net |  | Gross |       | Net |   | %of
  Net | 
|                           |  |       |       |      |  |            |  |       |       |     |   |           | 
|Risk ClassesPar Exposure  |  |       |       |      |  |            |  |       |       |     |   |           |  |   |      |  |  |       |  
|U.S. Public finance        |  | $     | 50.6  |      |  | 48.2       |  |       | 40.9  | %   | $ | 37.3      |  | $ | 33.7 |  |  | 41.2  | %
|Non-U.S. Public finance:   |  |       |       |      |  |            |  |       |       |     |   |           |  |   |      |  |  |       |  
|U.S Structured finance     |  |       | 54.0  |      |  | 50.9       |  |       | 43.1  | %   |   | 39.8      |  |   | 36.8 |  |  | 44.9  | %
|International finance      |  |       | 20.7  |      |  | 18.9       |  |       | 16.0  | %   |   | 13.6      |  |   | 11.4 |  |  | 13.9  | %
|                           |  |       |       |      |  |            |  |       |       |     |   |           |  |   |      |  |  |       |  
|Total                      |  | $     | 125.3 |      |  | 118.0      |  |       | 100.0 | %   | $ | 90.7      |  | $ | 81.9 |  |  | 100.0 | %
|                           |  |       |       |      |  |            |  |       |       |     |   |           |  |   |      |  |  |       |  

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

|                               |  |                     |      |                         |   |       |  |     |      |  |   |      | 
|------------------------------ |  | ------------------- | ---- | ----------------------- | - | ----- |  | --- | ---- |  | - | ---- | 
|                               |  | 2006                |     
|                               |  |                     |     
|                               |  | U.S. Public Finance |      | Non-U.S. Public Finance |  
|                               |  |                     |      |                         |  
|(U.S.
  Dollars in billions)   |  | Gross               |      | Net                     |   | Gross |  | Net |     
|                               |  |                     |      |                         |   |       |  |     |     
|Years to MaturityPar Exposure |  |                     |      |                         |   |       |  |     |      |  |   |      | 
|0 to 5 years                   |  | $                   | 1.3  |                         |   | 1.2   |  |     | 10.0 |  |   | 9.1  | 
|5 to 10 years                  |  |                     | 3.2  |                         |   | 3.1   |  |     | 14.1 |  |   | 13.1 | 
|10 to 15 years                 |  |                     | 6.5  |                         |   | 6.4   |  |     | 10.7 |  |   | 10.1 | 
|15 to 20 years                 |  |                     | 11.7 |                         |   | 11.2  |  |     | 3.8  |  |   | 3.7  | 
|20 years and beyond            |  |                     | 27.9 |                         |   | 26.3  |  |     | 36.1 |  |   | 33.8 | 
|                               |  |                     |      |                         |   |       |  |     |      |  |   |      | 
|Total                          |  | $                   | 50.6 |                         |   | 48.2  |  |     | 74.7 |  |   | 69.8 | 
|                               |  |                     |      |                         |   |       |  |     |      |  |   |      | 
|                               |  |                     |      |                         |   |       |  |     |      |  |   |      | 
|                               |  | 2005                |     
|                               |  |                     |     
|                               |  | U.S. Public Finance |      | Non-U.S. Public Finance |  
|                               |  |                     |      |                         |  
|(U.S.
  Dollars in billions)   |  | Gross               |      | Net                     |   | Gross |  | Net |     
|                               |  |                     |      |                         |   |       |  |     |     
|Years to MaturityPar Exposure |  |                     |      |                         |   |       |  |     |      |  |   |      | 
|0 to 5 years                   |  | $                   | 1.1  |                         | $ | 1.1   |  | $   | 12.4 |  | $ | 10.6 | 
|5 to 10 years                  |  |                     | 3.1  |                         |   | 2.9   |  |     | 12.5 |  |   | 11.2 | 
|10 to 15 years                 |  |                     | 4.7  |                         |   | 4.3   |  |     | 6.0  |  |   | 5.8  | 
|15 to 20 years                 |  |                     | 8.1  |                         |   | 7.2   |  |     | 2.5  |  |   | 2.3  | 
|20 years and beyond            |  |                     | 20.3 |                         |   | 18.2  |  |     | 20.0 |  |   | 18.3 | 
|                               |  |                     |      |                         |   |       |  |     |      |  |   |      | 
|Total                          |  | $                   | 37.3 |                         | $ | 33.7  |  | $   | 53.4 |  | $ | 48.2 | 
|                               |  |                     |      |                         |   |       |  |     |      |  |   |      | 

The Company
seeks to limit its exposure to losses from writing financial guarantees through
its credit approval process and by maintaining a surveillance function which
monitors such transactions throughout their lives. Additionally,

117

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

the Company seeks to mitigate credit risk by only underwriting
investment-grade transactions, diversifying its portfolio and maintaining
collateral requirements on asset-backed obligations, as well as through
reinsurance.

As of
December 31, 2006 and 2005, par and notional amounts of the Companys guaranteed
asset-backed obligations were supported by the following types of collateral:

|                                            |  |       |      |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|------------------------------------------- |  | ----- | ---- | ---- |  | ---------- |  | ----- | ----- | --- | - | ---------- |  | - | ---- |  |  | ----- | -
|                                            |  | 2006  |      | 2005 | 
|                                            |  |       |      |      | 
|(U.S.
  Dollars in billions)                |  | Gross |      | Net  |  | % of
  Net |  | Gross |       | Net |   | % of
  Net | 
|                                            |  |       |      |      |  |            |  |       |       |     |   |            | 
|Asset-Backed Collateral TypePar
  Exposure |  |       |      |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|Consumer ABS                                |  | $     | 11.7 |      |  | 10.7       |  |       | 78.7  | %   | $ | 11.3       |  | $ | 9.8  |  |  | 80.3  | %
|Commercial ABS                              |  |       | 3.2  |      |  | 2.9        |  |       | 21.3  | %   |   | 2.9        |  |   | 2.4  |  |  | 19.7  | %
|                                            |  |       |      |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|Total                                       |  | $     | 14.9 |      |  | 13.6       |  |       | 100.0 | %   | $ | 14.2       |  | $ | 12.2 |  |  | 100.0 | %
|                                            |  |       |      |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  

As of
December 31, 2006 and 2005, the Companys in-force portfolio of guaranteed
risks was diversified by type of obligation as shown in the following table:

|                                          |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|----------------------------------------- |  | ----- | ----- | ---- |  | ---------- |  | ----- | ----- | --- | - | ---------- |  | - | ---- |  |  | ----- | -
|                                          |  | 2006  |       | 2005 | 
|                                          |  |       |       |      | 
|(U.S.
  Dollars in billions)              |  | Gross |       | Net  |  | % of
  Net |  | Gross |       | Net |   | % of
  Net | 
|                                          |  |       |       |      |  |            |  |       |       |     |   |            | 
|Type
  of Insured ObligationPar Exposure |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|Pooled Debt
  Obligation                  |  | $     | 25.8  |      |  | 25.2       |  |       | 21.3  | %   | $ | 14.7       |  | $ | 14.7 |  |  | 17.9  | %
|General Obligation                        |  |       | 22.2  |      |  | 21.6       |  |       | 18.3  | %   |   | 17.2       |  |   | 15.2 |  |  | 18.5  | %
|Consumer ABS                              |  |       | 11.7  |      |  | 10.7       |  |       | 9.1   | %   |   | 11.2       |  |   | 9.8  |  |  | 11.9  | %
|Power &
  Utilities                       |  |       | 10.7  |      |  | 9.8        |  |       | 8.3   | %   |   | 7.7        |  |   | 7.0  |  |  | 8.6   | %
|Transportation                            |  |       | 10.7  |      |  | 9.9        |  |       | 8.4   | %   |   | 6.3        |  |   | 6.0  |  |  | 7.3   | %
|Utilities                                 |  |       | 10.0  |      |  | 9.2        |  |       | 7.8   | %   |   | 7.8        |  |   | 6.9  |  |  | 8.4   | %
|Financial Product                         |  |       | 7.5   |      |  | 7.0        |  |       | 5.9   | %   |   | 6.9        |  |   | 6.2  |  |  | 7.6   | %
|Non-Ad Valorem                            |  |       | 5.9   |      |  | 5.4        |  |       | 4.6   | %   |   | 4.0        |  |   | 3.5  |  |  | 4.3   | %
|Higher Education                          |  |       | 5.2   |      |  | 5.1        |  |       | 4.3   | %   |   | 3.9        |  |   | 3.8  |  |  | 4.6   | %
|Infrastructure                            |  |       | 4.3   |      |  | 3.9        |  |       | 3.3   | %   |   | 1.3        |  |   | 1.2  |  |  | 1.5   | %
|Commercial ABS                            |  |       | 3.2   |      |  | 2.9        |  |       | 2.5   | %   |   | 2.5        |  |   | 2.1  |  |  | 2.6   | %
|Pre-Insured                               |  |       | 2.7   |      |  | 2.6        |  |       | 2.2   | %   |   | 1.2        |  |   | 1.2  |  |  | 1.5   | %
|Future Flow                               |  |       | 2.0   |      |  | 1.7        |  |       | 1.4   | %   |   | 3.4        |  |   | 2.1  |  |  | 2.6   | %
|Housing and Public
  Buildings            |  |       | 0.8   |      |  | 0.8        |  |       | 0.7   | %   |   | 0.7        |  |   | 0.7  |  |  | 0.8   | %
|Sovereign                                 |  |       | 0.7   |      |  | 0.5        |  |       | 0.4   | %   |   | 0.1        |  |   | 0.1  |  |  | 0.1   | %
|Specialized Risk                          |  |       | 0.7   |      |  | 0.6        |  |       | 0.5   | %   |   |           |  |   | 0.0  |  |  | 0.0   | %
|Specialized Risk-
  Other                 |  |       | 0.5   |      |  | 0.5        |  |       | 0.4   | %   |   | 1.0        |  |   | 0.9  |  |  | 1.1   | %
|Revenue Secured                           |  |       | 0.4   |      |  | 0.3        |  |       | 0.3   | %   |   | 0.4        |  |   | 0.3  |  |  | 0.4   | %
|Whole Business
  Secured                  |  |       | 0.3   |      |  | 0.3        |  |       | 0.3   | %   |   | 0.4        |  |   | 0.2  |  |  | 0.3   | %
|                                          |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|Total                                     |  | $     | 125.3 |      |  | 118.0      |  |       | 100.0 | %   | $ | 90.7       |  | $ | 81.9 |  |  | 100.0 | %
|                                          |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  

118

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

In addition, the Company seeks to maintain a diversified portfolio of guaranteed
obligations designed to spread its risk across a number of geographic areas.
Set forth below is the distribution of the Companys par and notional exposures
by geographic location as of December 31, 2006 and 2005:

|                                       |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|-------------------------------------- |  | ----- | ----- | ---- |  | ---------- |  | ----- | ----- | --- | - | ---------- |  | - | ---- |  |  | ----- | -
|                                       |  | 2006  |       | 2005 | 
|                                       |  |       |       |      | 
|(U.S.
  Dollars in billions)           |  | Gross |       | Net  |  | % of
  Net |  | Gross |       | Net |   | % of
  Net | 
|                                       |  |       |       |      |  |            |  |       |       |     |   |            | 
|Geographic DistributionPar
  Exposure |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|California                             |  | $     | 12.9  |      |  | 12.1       |  |       | 10.2  | %   | $ | 9.8        |  | $ | 8.7  |  |  | 10.7  | %
|New York                               |  |       | 9.2   |      |  | 8.8        |  |       | 7.5   | %   |   | 5.9        |  |   | 4.8  |  |  | 5.9   | %
|Illinois                               |  |       | 3.2   |      |  | 3.1        |  |       | 2.6   | %   |   | 3.0        |  |   | 2.8  |  |  | 3.4   | %
|Delaware                               |  |       | 3.2   |      |  | 2.8        |  |       | 2.4   | %   |   | 1.7        |  |   | 1.1  |  |  | 1.3   | %
|Texas                                  |  |       | 2.9   |      |  | 2.7        |  |       | 2.4   | %   |   | 2.2        |  |   | 2.0  |  |  | 2.4   | %
|Alabama                                |  |       | 3.0   |      |  | 2.3        |  |       | 2.0   | %   |   | 1.7        |  |   | 1.2  |  |  | 1.5   | %
|Florida                                |  |       | 2.6   |      |  | 2.5        |  |       | 2.1   | %   |   | 1.9        |  |   | 1.8  |  |  | 2.2   | %
|New Jersey                             |  |       | 2.5   |      |  | 2.4        |  |       | 2.0   | %   |   | 2.4        |  |   | 2.1  |  |  | 2.6   | %
|Massachusetts                          |  |       | 2.3   |      |  | 2.3        |  |       | 1.9   | %   |   | 2.3        |  |   | 2.2  |  |  | 2.7   | %
|Pennsylvania                           |  |       | 2.2   |      |  | 2.2        |  |       | 1.9   | %   |   | 1.4        |  |   | 1.4  |  |  | 1.7   | %
|Wisconsin                              |  |       | 1.9   |      |  | 1.7        |  |       | 1.4   | %   |   | 1.8        |  |   | 1.5  |  |  | 1.8   | %
|Michigan                               |  |       | 1.7   |      |  | 1.7        |  |       | 1.4   | %   |   | 1.5        |  |   | 1.5  |  |  | 1.8   | %
|Colorado                               |  |       | 1.5   |      |  | 1.4        |  |       | 1.2   | %   |   | 1.3        |  |   | 1.3  |  |  | 1.5   | %
|Georgia                                |  |       | 1.4   |      |  | 1.4        |  |       | 1.2   | %   |   | 1.1        |  |   | 1.1  |  |  | 1.2   | %
|District of Columbia                   |  |       | 1.2   |      |  | 1.2        |  |       | 1.0   | %   |   | 0.9        |  |   | 0.9  |  |  | 1.1   | %
|Other U.S. Jurisdictions               |  |       | 16.3  |      |  | 15.7       |  |       | 13.3  | %   |   | 10.2       |  |   | 9.8  |  |  | 12.0  | %
|U.S. Diversified                       |  |       | 36.6  |      |  | 34.8       |  |       | 29.5  | %   |   | 28.0       |  |   | 26.5 |  |  | 32.3  | %
|International                          |  |       | 20.7  |      |  | 18.9       |  |       | 16.0  | %   |   | 13.6       |  |   | 11.2 |  |  | 13.9  | %
|                                       |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|Total                                  |  | $     | 125.3 |      |  | 118.0      |  |       | 100.0 | %   | $ | 90.7       |  | $ | 81.9 |  |  | 100.0 | %
|                                       |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  

In its
asset-backed business, the Company considers geographic concentration as a
factor in its underwriting process. However, the existence of first-loss
protection in a typical asset-backed securitization, in addition to other
factors, makes it difficult to attribute geographic exposure to deals
collateralized by diversified pools of obligations. For asset-backed
transactions, the Company considers the seller/servicer, industry and type of
collateral to be more relevant measures of diversification.

Set forth
below is the Companys par exposure from the issuance of financial guarantee
insurance policies and its notional exposure from the issuance of credit
default swaps as of December 31, 2006 and 2005:

|                                       |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|-------------------------------------- |  | ----- | ----- | ---- |  | ---------- |  | ----- | ----- | --- | - | ---------- |  | - | ---- |  |  | ----- | -
|                                       |  | 2006  |       | 2005 | 
|                                       |  |       |       |      | 
|(U.S.
  Dollars in billions)           |  | Gross |       | Net  |  | % of
  Net |  | Gross |       | Net |   | % of
  Net | 
|                                       |  |       |       |      |  |            |  |       |       |     |   |            | 
|Credit
  EnhancementPar Exposure      |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|Financial
  guarantee insurance policy |  | $     | 100.1 |      |  | 93.4       |  |       | 79.2  | %   | $ | 76.7       |  | $ | 67.9 |  |  | 82.9  | %
|Credit default
  swap                  |  |       | 25.2  |      |  | 24.6       |  |       | 20.8  | %   |   | 14.0       |  |   | 14.0 |  |  | 17.1  | %
|                                       |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  
|Total                                  |  | $     | 125.3 |      |  | 118.0      |  |       | 100.0 | %   | $ | 90.7       |  | $ | 81.9 |  |  | 100.0 | %
|                                       |  |       |       |      |  |            |  |       |       |     |   |            |  |   |      |  |  |       |  

119

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

13. Liability for Losses and Loss Adjustment
Expenses

The
Companys liability for losses and loss adjustment expenses consists of case
basis reserves and unallocated reserves. The provision for losses and loss
adjustment expenses represents the expense recorded to establish the total
reserve (case basis and unallocated reserves) at a level determined by
management to be adequate for losses inherent in the financial guarantee
portfolio as of the reporting date. Activity in the liability for losses and
loss adjustment expenses is summarized as follows:

|                                                                                                 |  |                         |         |                        |   |                 |   |                        |         |                 |   |                        |   |   |        |   |   |         |  
|------------------------------------------------------------------------------------------------ |  | ----------------------- | ------- | ---------------------- | - | --------------- | - | ---------------------- | ------- | --------------- | - | ---------------------- | - | - | ------ | - | - | ------- | -
|                                                                                                 |  | Year Ended December 31, |        
|                                                                                                 |  |                         |        
|                                                                                                 |  | 2006                    |         | 2005                   |   | 2004            |  
|                                                                                                 |  |                         |         |                        |   |                 |  
|(U.S.
  dollars in thousands)                                                                    |  | Case
  Reserves         |         | Unallocated
  Reserves |   | Case
  Reserves |   | Unallocated
  Reserves |         | Case
  Reserves |   | Unallocated
  Reserves |  
|                                                                                                 |  |                         |         |                        |   |                 |   |                        |         |                 |   |                        |  
|Gross unpaid losses and loss expenses at
  beginning of year                                     |  | $                       | 69,382  |                        | $ | 77,986          |   | $                      | 50,771  |                 | $ | 64,963                 |   | $ | 4,660  |   | $ | 42,535  |  
|Unpaid losses and loss expenses recoverable                                                      |  |                         | (52,316 | )                      |   | (16,901         | ) |                        | (43,407 | )               |   | (17,507                | ) |   |       |   |   | (11,400 | )
|                                                                                                 |  |                         |         |                        |   |                 |   |                        |         |                 |   |                        |   |   |        |   |   |         |  
|Net unpaid losses and loss expenses at
  beginning of year                                       |  |                         | 17,066  |                        |   | 61,085          |   |                        | 7,364   |                 |   | 47,456                 |   |   | 4,660  |   |   | 31,135  |  
|Increase (decrease) in net losses and loss
  expenses incurred in respect of losses occurring in |  |                         |         |                        |   |                 |   |                        |         |                 |   |                        |   |   |        |   |   |         |  
|Current year                                                                                     |  |                         |        |                        |   | 14,307          |   |                        | 4,789   |                 |   | 13,629                 |   |   | 4,391  |   |   | 16,321  |  
|Prior years                                                                                      |  |                         | 651     |                        |   |                |   |                        | 7,603   |                 |   |                       |   |   | 562    |   |   |        |  
|Cancellation of contract assumed from
  affiliate                                                |  |                         | (1,177  | )                      |   |                |   |                        |        |                 |   |                       |   |   |       |   |   |        |  
|Less net losses and loss expenses paid                                                           |  |                         | (2,031  | )                      |   |                 |   |                        | (2,690  | )               |   |                       |   |   | (2,249 | ) |   |        |  
|                                                                                                 |  |                         |         |                        |   |                 |   |                        |         |                 |   |                        |   |   |        |   |   |         |  
|Net unpaid losses and loss expenses at end
  of year                                             |  |                         | 14,509  |                        |   | 75,392          |   |                        | 17,066  |                 |   | 61,085                 |   |   | 7,364  |   |   | 47,456  |  
|Unpaid losses and loss expenses recoverable                                                      |  |                         | 70,842  |                        |   | 17,774          |   |                        | 52,316  |                 |   | 16,901                 |   |   | 43,407 |   |   | 17,507  |  
|                                                                                                 |  |                         |         |                        |   |                 |   |                        |         |                 |   |                        |   |   |        |   |   |         |  
|Gross unpaid losses and loss
  expenses at end of year                                           |  | $                       | 85,351  |                        | $ | 93,166          |   | $                      | 69,382  |                 | $ | 77,986                 |   | $ | 50,771 |   | $ | 64,963  |  
|                                                                                                 |  |                         |         |                        |   |                 |   |                        |         |                 |   |                        |   |   |        |   |   |         |  

Case Basis Reserves for Losses and Loss Adjustment
Expenses

Set
forth below is a discussion of certain case basis reserves established by the
Company. The Company has been indemnified with respect to loss development
relating to the insurance transactions described under (a) and (b) below by
affiliates of XL Capital in connection with SCAs IPO.  As a result of such indemnifications, all
adverse loss development on such insurance transactions subsequent to the
effective date of the IPO, which is in excess of the Companys carried reserves
for such transactions at the date of the IPO, will be absorbed by the
aforementioned affiliates of XL Capital.
Such protection does not relieve the Company of its obligations under
the aforementioned insurance transactions.
Accordingly, the Company is still liable under the insurance
transactions in the event that the affiliates of XL Capital do not meet their
obligations under the indemnifications.
For further information with respect to the indemnifications see Note 7.

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) | During the year
  ended December 31, 2004, the Company recorded a provision for losses of
  approximately $42.1 million, representing the present value loss expected to
  be incurred in the future with respect to an insured project financing.
  Because this loss represented a full limit loss to the subordinated tranche
  of the insured transaction, the remaining deferred premium revenue pertaining
  to such tranche, which aggregated approximately $23.3 million, was fully
  earned resulting in a net loss, before reinsurance, of approximately $18.8
  million. The portion of the insured exposure to which this loss relates was
  fully reinsured on a first-loss basis by XLI and, accordingly, there was no
  net

120

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | impact on the
  Companys results of operations from this loss provision. During 2005, the
  Company recorded an additional provision for loss relating to this
  transaction of $16.7 million ($8.7 million after reinsurance to affiliates),
  on a present value basis, to reflect certain adverse developments. During
  2006, the Company again recorded an additional provision for loss relating to
  the transaction of $15.2 million, which was fully covered under an
  indemnification discussed above and in Note 7 and, accordingly, resulted in
  no net impact on the Companys results of operations in 2006. The total
  remaining par insured by the Company in connection with this transaction (net
  of applicable carried case reserves before reinsurance), which amortizes over
  the next 12 years, aggregated approximately $215.8 million at December 31,
  2006. 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 that were insured by the Company and collateralized by loans to
  medical providers (the Insured Notes) defaulted upon their maturity. In
  satisfaction of the resulting claim, the Company purchased the Insured Notes
  for $20.2 million, which represented the remaining outstanding principal and
  accrued interest on the Insured Notes. The Insured Notes were recorded as an
  investment at their estimated fair value of $19.5 million at the date of
  acquisition and were reflected in the accompanying consolidated balance sheet
  at December 31, 2005 under the caption, Other invested assets. The
  difference between the estimated fair value of the Insured Notes at the date
  they were acquired and the consideration paid to acquire the notes was
  recorded as a paid loss of $0.7 million. The estimate of fair value of the
  Insured Notes was based on the Companys estimate of the fair value of the
  underlying collateral. During 2006, the Company recognized an impairment
  charge of $15.1 million relating to the Insured Notes and the balance of the
  Insured Notes was paid down. In addition, during 2006 the Company recorded a
  charge for $5.0 million relating to other exposures under this transaction.
  With respect to the aforementioned charges, the Company was indemnified for
  $6.1 million by XLA pursuant to an indemnification discussed above and in
  Note 7.
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|(c) | During the year
  ended December 31, 2005, the Company recorded a provision for loss of $5.2
  million ($3.4 million after reinsurance) representing the present value of
  the loss expected to be incurred in the future with respect to two related
  insured residential mortgage securitizations. The total remaining par insured
  by the Company in connection at December 31, 2006. There has been no payment
  default with respect to these transactions. The estimate of loss reflects
  management best estimate of loss that will ultimately be incurred on these
  transactions and was based on assumptions and estimates extending over many
  years into the future.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

During 2006, the reinsurance of the aforementioned two residential
mortgage transactions was cancelled in settlement of a dispute with the
reinsurer. As a result of the cancellation, all ceded premium (which was on an
installment basis and consequently fully earned) aggregating $0.4 million, was
returned to the Company and the Companys net reserve increased by
approximately $1.7 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 $1.9 million. The Companys earnings for
2006 were increased by approximately $0.6 million as a result of the
aforementioned returned premium, cancellation, and early retirement. At
December 31, 2006, the carrying amount of the case reserve with respect to the
remaining outstanding insured transaction was $3.3 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.

The
financing vehicles through which the insured exposures referred to above were
issued are variable interest entities, as defined under FASB Interpretation
46/46R, Consolidation of Variable Interest Entities, however, the Company is
not the primary beneficiary of such entities. If the transactions are
restructured or if the Company exercises its contractual rights under such
transactions in the event of a default, the primary beneficiary in such
transactions may have to be reconsidered. If such events occur, the Company may
be required to consolidate the financing vehicles.

Unallocated
Reserves

In
accordance with the Companys accounting policy discussed in Note 2, the
Companys net provision for unallocated reserves is a function of applying the
initial expected loss ratio to earned premium each period (after exclusion of
the effect on earned premium of refunding and full limit losses because no more
risk exists on those related policies) and the expected loss emergence pattern.
For the years ended December 31, 2006, 2005, and 2004, the Company recorded a
net provision for unallocated reserves of $14.3 million, $13.6 million and
$16.3 million, respectively. During 2004, the Company changed its initial
expected loss ratio from 25 percent of earned premium to 20 percent of

121

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

earned premium to reflect the changing risk profile of its in-force
business. This change resulted in approximately a $15.0 million decrease in
unallocated loss reserves which decrease was substantially offset by a change
in the estimated expected loss emergence pattern of our in-force business due
to the availability of more detailed information as a result of the
implementation in 2004 of a new automated information system. 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.

14. Income Taxes

XLFA is not
subject to any taxes in Bermuda on either income or capital gains under current
Bermuda law. In the event that there is a change such that these taxes are
imposed, XLFA would be exempted from any such tax until March 2016 pursuant to
the Bermuda Exempted Undertakings Tax Protection Act of 1966, and Amended Act
of 1987.

XLCA is
subject to federal, state and local corporate income taxes and other taxes
applicable to U.S. corporations. The U.S. federal income tax liability is
determined in accordance with the principles of the consolidated tax provisions
of the Internal Revenue Code and Regulations. XLCA has operations in subsidiary
and branch form in certain international jurisdictions that are subject to
relevant taxes in those jurisdictions. As a wholly owned subsidiary of XL RE AM
through June 30, 2006, XLCA was consolidated with XLA for purposes of
determining its U.S. federal income tax liability at, and prior to, such date.
As a result of the transfer of ownership of XLCA to SCA (see Note 1), XLCA will
be required to file its own federal income tax return and will no longer
qualify to be consolidated with the XLA tax group subsequent to June 30, 2006.

XLCA will
file two separate short period U.S. income tax returns for 2006, one will
include the pre-ownership change period and the second will include the
post-ownership change period. For the pre-ownership change period, XLCAs
income tax return will be consolidated with XLA and its subsidiaries. For the
post-ownership change period, XLCA will file a consolidated tax return with SCA
Holdings U.S. Inc (the new U.S. common parent of the SCA group) and its
subsidiaries (which consists of XLCA and SCAs other U.S. based subsidiaries).
For the pre-ownership change period filing, XLA maintains a tax sharing
agreement with its subsidiaries, whereby the consolidated income tax liability
is allocated among affiliates in the ratio that each affiliates separate
return liability bears to the sum of the separate return liabilities of all
affiliates that are members of the consolidated group. In addition, a
complementary method is used which results in reimbursement by profitable
affiliates to loss affiliates for tax benefits generated by loss affiliates.

At December
31, 2006 and 2005 XLCA had a federal income tax payable of $5.3 million and
$1.0 million respectively. For the post-ownership change period, XLCA will
maintain a similar tax sharing agreement with U.S. affiliates that are a member
of the SCA Holdings U.S. Inc. consolidated tax filing. In addition, a
complementary method is used which results in reimbursement by profitable
affiliates to loss affiliates for tax benefits generated by loss affiliates.

The
Companys income tax provisions for the years ended December 31, 2006, 2005,
and 2004 are as follows:

|                                |  |                         |        |      |   |        |   |   |        |  
|------------------------------- |  | ----------------------- | ------ | ---- | - | ------ | - | - | ------ | -
|                                |  | Year Ended December 31, |       
|                                |  |                         |       
|(U.S.
  dollars in thousands)   |  | 2006                    |        | 2005 |   | 2004   |  
|                                |  |                         |        |      |   |        |  
|Current Expense
  (Benefit):    |  |                         |        |      |   |        |   |   |        |  
|U.S.                            |  | $                       | 3,567  |      | $ | (361   | ) | $ | 5,754  |  
|Non-U.S.                        |  |                         |       |      |   |       |   |   |       |  
|                                |  |                         |        |      |   |        |   |   |        |  
|Total current expense
(benefit) |  | $                       | 3,567  |      | $ | (361   | ) | $ | 5,754  |  
|                               
|Deferred Expense
  (Benefit):   |  |                         |        |      |   |        |   |   |        |  
|U.S.                            |  | $                       | 1,083  |      | $ | (102   | ) | $ | (2,910 | )
|Non-U.S.                        |  |                         | (1,517 | )    |   | (814   | ) |   | (924   | )
|                                |  |                         |        |      |   |        |   |   |        |  
|Total deferred benefit          |  |                         | (434   | )    |   | (916   | ) |   | (3,834 | )
|Total tax expense (benefit)     |  | $                       | 3,133  |      | $ | (1,277 | ) | $ | 1,920  |  
|                                |  |                         |        |      |   |        |   |   |        |  

122

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

Reconciliation
of the difference between the provision for income taxes and the expected tax
provision at the weighted average tax rate for the years ended December 31,
2006, 2005, and 2004 is provided below:

|                                 |  |                         |       |      |   |        |   |   |       |  
|-------------------------------- |  | ----------------------- | ----- | ---- | - | ------ | - | - | ----- | -
|                                 |  | Year Ended December 31, |      
|                                 |  |                         |      
|(U.S.
  dollars in thousands)    |  | 2006                    |       | 2005 |   | 2004   |  
|                                 |  |                         |       |      |   |        |  
|Expected tax
  expense (benefit) |  | $                       | 984   |      | $ | (2,146 | ) | $ | 79    |  
|Adjustments                      |  |                         |       |      |   |        |   |   |       |  
|Transfer pricing adjustments     |  |                         | 528   |      |   | 700    |   |   | 1,485 |  
|Prior year adjustments           |  |                         | 568   |      |   | 20     |   |   | 326   |  
|Valuation allowance              |  |                         | 700   |      |   | 85     |   |   |      |  
|Non deductible expenses          |  |                         | 263   |      |   | 68     |   |   | 58    |  
|Foreign taxes                    |  |                         | 65    |      |   |       |   |   |      |  
|Other                            |  |                         | 25    |      |   | (4     | ) |   | (28   | )
|                                 |  |                         |       |      |   |        |   |   |       |  
|Income tax expense (benefit)     |  | $                       | 3,133 |      | $ | (1,277 | ) | $ | 1,920 |  
|                                 |  |                         |       |      |   |        |   |   |       |  

The weighted
average expected tax provision or benefit has been calculated using the pre-tax
accounting income or loss in each jurisdiction multiplied by that
jurisdictions applicable statutory tax rate. The expected and actual tax
benefit or expense for each of the years ending December 31, is primarily
attributable to the taxable income or loss in the United States. XLCA has a
facultative quota share reinsurance treaty with XLFA. Under the terms of this
treaty, XLFA agrees to reinsure up to 75% of the guaranty business written by
the Company. Prior to July 1, 2006, the treaty provided for XLFA to reinsure up
to 90% of such business.

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

|                                         |  |      |        |      |   |        |  
|---------------------------------------- |  | ---- | ------ | ---- | - | ------ | -
|(U.S.
  dollars in thousands)            |  | 2006 |        | 2005 |  
|                                         |  |      |       
|Deferred
  tax assets                    |  |      |        |      |   |        |  
|Deferred ceding
  commissions, net       |  | $    | 14,519 |      | $ | 14,895 |  
|Unpaid loss
  reserve discount, net      |  |      | 480    |      |   | 486    |  
|Deferred premium
  revenue               |  |      | 2,928  |      |   | 2,088  |  
|Foreign losses                           |  |      | 741    |      |   | 153    |  
|Unrealized
  depreciation on investments |  |      | 1,136  |      |   | 803    |  
|Capital loss carry
  forward             |  |      | 786    |      |   | 86     |  
|Valuation
  allowance                    |  |      | (1,921 | )    |   | (888   | )
|Othernet                                |  |      |       |      |   | 142    |  
|                                         |  |      |        |      |   |        |  
|Total deferred tax assets                |  | $    | 18,669 |      | $ | 17,765 |  
|                                        
|Deferred
  tax liabilities               |  |      |        |      |   |        |  
|Accretion of
  discount on investments   |  | $    | 272    |      | $ | 196    |  
|Other- net                               |  |      | 215    |      |   |       |  
|                                         |  |      |        |      |   |        |  
|Total deferred tax liabilities           |  |      | 487    |      |   | 196    |  
|                                         |  |      |        |      |   |        |  
|Net deferred federal income tax
asset    |  | $    | 18,182 |      | $ | 17,569 |  
|                                         |  |      |        |      |   |        |  

The
valuation allowance at December 31, 2006 and 2005 relates to net unrealized
capital losses and realized capital loss carry forwards in the U.S. that may
not be realized within a reasonable period. As of December 31, 2006, the
Company has net unrealized depreciation on investments and realized capital
loss carry forwards in the U.S of approximately $3.2 million and $2.2 million,
respectively, against which a valuation allowance of $1.9 million has been
established. As of December 31, 2005, the Company has net unrealized capital
losses and realized capital loss carry forwards of approximately $2.3 million
and $0.2 million, respectively, in the U.S., against which a valuation
allowance of $0.9 million had been established. Management has concluded that
the remaining deferred tax assets are more likely than not to be realized.
Management will continue to evaluate income generated in future periods in
determining the reasonableness of its position. If management determines that
future income generated is insufficient to cause the realization of the
deferred tax assets within a reasonable period, a valuation allowance would be
required.

123

---



SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

15. Commitments and Contingencies

a.
Litigation

In the
ordinary course of business, the Company is subject to litigation or other
legal proceedings. It is the opinion of the Companys 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 the Companys financial
position, results of operations or liquidity.

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

b.
Tax Matters

SCA is a
Bermuda corporation and, except as described below, neither it nor its
non-United States subsidiaries have paid United States corporate income taxes
on the basis that they are not engaged in a trade or business or otherwise
subject to taxation in the U.S. However, because definitive identification of
activities which constitute being engaged in a trade or business in the United
States is not provided by the Internal Revenue Code of 1986, regulations or
court decisions, there could be no assurance that the Internal Revenue Service
will not contend that the Company or its non-United States subsidiaries are
engaged in a trade or business or otherwise subject to taxation in the U.S. If
the Company or its non-United States subsidiaries were considered to be engaged
in a trade or business in the United States (and, if the Company or such
subsidiaries were to qualify for the benefits under the income tax treaty
between the United States and Bermuda and other countries in which the Company
operates, such business were attributable to a permanent establishment in the
U.S.), the Company or such subsidiaries could be subject to United States tax
at regular tax rates on its taxable income that is effectively connected with
its United States trade or business plus an additional 30% branch profits tax
on such income remaining after the regular tax, in which case there could be a
significant adverse effect on the Companys results of operations and financial
condition.

c.
Lease and Other Commitments

The
Companys lease commitments are comprised primarily of office premise leases at
1221 Avenue of the Americas, New York, New York, 25 Copthall Ave  London,
Merrit 7 Corporate park, Connecticut and office space lease commitments it
assumed from an affiliate, Global Credit Analytics, Inc. (GCA), with respect
to office space at 250 Park Avenue, New York, New York. In addition, the
Company is liable under an information technology outsourcing agreement that it
entered into with International Business Machines Corporation (IBM) on
October 1, 2006. Pursuant to the agreement IBM will: (i) provide the Company
with all its information technology hardware, (ii) provide all support services
to maintain such hardware and provide for efficient disaster recovery, (iii)
develop a transition plan for the Companys systems from its existing hardware
to new hardware, and (iv) maintain the Companys technology at a level that
allows the Company to take advantage of technological advances. In
consideration for these services the Company is obligated to pay IBM approximately
$4.0 million per annum for the five year term of the contract. No expense was
incurred by the Company under this agreement during 2006.

The table
below presents the Companys minimum lease payment obligations under the
aforementioned lease commitments and outsourcing agreement, as well as
estimated sub-lease income from the sub-lease of space at the aforementioned
locations.

|                              |  |                          |         |                    |   |       | 
|----------------------------- |  | ------------------------ | ------- | ------------------ | - | ----- | 
|(U.S.
  Dollars in thousands) |  | Minimum Lease
  Payments |         | Sub-lease
  Income |  
|                              |  |                          |         |                    |  
|2007                          |  | $                        | 11,423  |                    | $ | 904   | 
|2008                          |  |                          | 11,693  |                    |   | 778   | 
|2009                          |  |                          | 11,714  |                    |   | 791   | 
|2010                          |  |                          | 11,743  |                    |   | 795   | 
|2011                          |  |                          | 11,589  |                    |   | 795   | 
|Later years                   |  |                          | 75,022  |                    |   | 2,172 | 
|                              |  |                          |         |                    |   |       | 
|Total                         |  | $                        | 133,184 |                    | $ | 6,235 | 
|                              |  |                          |         |                    |   |       | 

124

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

Net rent
expense was $6.2 million, $5.0 million and $5.1 million for the years ended
December 31, 2006, 2005, and 2004, respectively.

16. Disclosures About Fair Values of
Financial Instruments

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

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

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

Deferred
premium revenue, net of prepaid reinsurance premiums:The carrying amount of deferred
premium revenue, net of prepaid reinsurance premiums, represents the Companys
future premium revenue, net of reinsurance, on policies where the premium was
received at the inception of the insurance contract. The fair value of deferred
premium revenue, net of prepaid reinsurance premiums, is an estimate of the
premiums that would be paid under a reinsurance agreement with a third party to
transfer the Companys financial guarantee risk, net of that portion of the
premiums retained by the Company to compensate it for originating and servicing
the insurance contract.

Losses
and loss expenses, net of reinsurance balances recoverable:The carrying value is assumed to be
fair value, because the provision is established for non-specific expected
levels of losses resulting from credit failures.

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

|                                                                                     |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|------------------------------------------------------------------------------------ |  | ----------------- | --------- | ---------------------- | - | ----------------- |  | ---------------------- | --------- |  | - | --------- | 
|                                                                                     |  | 2006              |           | 2005                   |  
|                                                                                     |  |                   |           |                        |  
|(U.S. Dollars in thousands)                                                          |  | Carrying
  Amount |           | Estimated
  Fair Value |   | Carrying
  Amount |  | Estimated
  Fair Value |          
|                                                                                     |  |                   |           |                        |   |                   |  |                        |          
|Assets                                                                               |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Debt securities and short-term investments                                           |  | $                 | 1,958,363 |                        | $ | 1,958,363         |  | $                      | 1,346,840 |  | $ | 1,346,840 | 
|Cash and cash equivalents                                                            |  |                   | 202,548   |                        |   | 202,548           |  |                        | 54,593    |  |   | 54,593    | 
|                                                                                     |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Liabilities                                                                          |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Deferred premium revenue, net of prepaid
  reinsurance premiums                      |  |                   | 735,923   |                        |   | 518,404           |  |                        | 522,712   |  |   | 369,572   | 
|Loss and loss adjustment expenses, net of
  reinsurance recoverable on unpaid losses |  |                   | 89,901    |                        |   | 89,901            |  |                        | 78,151    |  |   | 78,151    | 
|                                                                                     |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Off-Balance Sheet Instruments                                                        |  |                   |           |                        |   |                   |  |                        |           |  |   |           | 
|Installment premiums                                                                 |  |                   |          |                        |   | 622,293           |  |                        |          |  |   | 340,863   | 

17. Dividend Restrictions

XLCA

The ability
of XLCA to declare and pay SCA a dividend is governed by the Insurance Law of
the State of New York (the Insurance Law). Under the Insurance Law XLCA is
permitted to pay dividends each calendar year, without the prior approval of
the superintendent of the insurance department, in an amount equal to the
lesser of ten percent of its policyholders surplus as of the end of the
preceding calendar year or its net investment income for the preceding calendar
year, as determined in accordance with Statutory Accounting Practices
prescribed or permitted by the Insurance

125

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

Department of the State of New York. The law also provides that XLCA
may distribute dividends to its shareholders in excess of the aforementioned
amount only upon giving notice of its intention to declare such dividend, and
the amount thereof, to the New York Superintendent. The New York Superintendent
may disapprove such distribution if he finds that the financial condition of XLCA
does not warrant such distribution.

For the
years ended December 31, 2006, 2005, and 2004, XLCA reported statutory-basis
net income (loss) of $0.1 million, $(0.4) million, and $(5.7) million,
respectively, and statutory-basis capital and surplus of $207.0 million and
$188.8 million as of December 31, 2006 and 2005, respectively.

In
addition, in connection with the IPO, XLCA has agreed with certain of the
rating agencies that, until the second anniversary of the effective date of the
IPO it will not declare or grant dividends on its common stock without the
prior consent of those rating agencies, other than to fund certain parent
holding company operating expenses and debt service requirements and to fund
dividends on our preferred stock and nominal dividends on our common stock.

XLFA

XLFA is subject to
     Bermuda regulatory constraints that will affect its ability to pay
dividends on its common shares and to make other payments to us. Under
Bermudas Insurance Act 1978, as amended, and related regulations, which we
refer to as the Insurance Act, XLFA is required to maintain a
minimum solvency margin and minimum liquidity ratio and is prohibited from
declaring or paying dividends if such payment would result in its non-compliance
with these requirements. In addition, under the Companies Act 1981 of Bermuda,
as amended, which we refer to as the Companies Act, XLFA may not
declare or pay a dividend, or make a distribution out of its contributed
surplus, if there are reasonable grounds for believing that (1) it is, or would
after the payment be, unable to pay its liabilities as they become due; or (2)
the realizable value of its assets would thereby be less than the aggregate of
its liabilities and its issued share capital and share premium accounts (as such
terms are defined in the Companies Act). Furthermore, in order to reduce its
total statutory capital by 15% or more, XLFA would require the prior approval of
the BMA.

In
addition, in connection with the IPO, XLFA has agreed with certain of the
rating agencies that, until the second anniversary of the effective date of the
IPO it will not declare or grant dividends on its common stock without the
prior consent of those rating agencies, other than to fund certain parent
holding company operating expenses and debt service requirements and nominal dividends on SCAs common stock.

18. Credit Default Swaps

Credit
default swaps insured by the Company meet the definition of a derivative under
SFAS No. 133. The Company has recorded these products at fair value, modeled on
prevailing market conditions and certain other factors relating to the
structure and credit quality of the transaction. The Company considers credit
default swaps to be, in substance, financial guarantee contracts as the Company
intends to hold them to maturity. See Note 2 for information regarding the
Companys accounting policy for credit default swaps.

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

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

The Companys
credit default swap portfolio generally requires the Company to meet payment
obligations for referenced credits within the portfolio in the event of
specific credit events after exhaustion of various first loss protection
levels. These credit events are contract-specific, but generally cover
bankruptcy and failure to pay and repudiation. The credit default swap
portfolio consists of structured pools of corporate obligations that were
awarded investment-grade ratings at the deals inception. On a net par basis,
approximately 98.3% of the portfolio is rated AAA with the remaining

126

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

1.73% allocated to other investment-grade ratings.
    The weighted average term of the contracts in-force was 11.52 years. The
    following tables present the amounts related to credit default swaps reflected
    in our financial statements as of and for the periods indicated:

|                                                                   |  |                         |        |      |   |        |   |   |        | 
|------------------------------------------------------------------ |  | ----------------------- | ------ | ---- | - | ------ | - | - | ------ | 
|                                                                   |  | Year Ended December 31, |       
|                                                                   |  |                         |       
|(U.S. dollars in thousands)                                        |  | 2006                    |        | 2005 |   | 2004   |  
|                                                                   |  |                         |        |      |   |        |  
|Statement
  of Income:                                             |  |                         |        |      |   |        |   |   |        | 
|Net earned
  premiums                                              |  | $                       | 23,674 |      | $ | 16,527 |   | $ | 22,267 | 
|Net losses and
  loss expenses                                     |  |                         | 2,068  |      |   | 415    |   |   | 4,448  | 
|Net realized and
  unrealized gains (losses) on credit derivatives |  |                         | (8,385 | )    |   | (6,681 | ) |   | 12,687 | 

|                                              |  |  |  |  |                    |       
|--------------------------------------------- |  |  |  |  | ------------------ | ------
|                                              |  |  |  |  | As at December 31, |       
|                                              |  |  |  |  |                    |       
|                                              |  |  |  |  | 2006               |       
|                                              |  |  |  |  |                    |       
|Balance
  sheet:                              |  |  |  |  |                    |       
|Unpaid losses and
  loss expenses recoverable |  |  |  |  | $                  | 1,111 
|Other assets                                  |  |  |  |  |                    | 11,976
|Unpaid losses and
  loss expenses             |  |  |  |  |                    | 14,283
|Deferred premium
  revenue                    |  |  |  |  |                    | 137   
|Other liabilities                             |  |  |  |  |                    | 5,117 

19. Stock-Based and Long-Term Compensation
Plans

Prior to
the IPO, certain employees of the Company participated under XL Capitals stock-based
and long-term compensation plans and expense relating thereto was reflected in
the Companys results of operations.
Subsequent to the IPO, SCA adopted its own stock-based and long-term
incentive plan and certain awards to employees of the Company under XL
Capitals stock-based compensation and long-term incentive plans were converted
to SCAs plans.  Expense relating to
awards to employees of the Company under XL Capital plans that were not so
converted and remain outstanding continues to be recognized in the Companys
financial statements.  See also Note 7.

Set forth
below is: (i) a description of the stock-based and long-term compensation plans
of SCA, as well as those plans of XL Capital in which employees of the Company
participated, (ii) the awards made under the aforementioned plans, (iii)
information concerning awards to employees of the Company under XL Capitals
plans that were converted to SCA plans, as well as those awards under XL
Capitals plans that were not converted and remain outstanding, and (iv)
certain other information.

SCA Long-Term Incentive Plan 

Effective
August 4, 2006 the Board of Directors of the Company adopted the 2006 Long-Term
Incentive and Share Award Plan (the Plan). The Plan provides for grants to
eligible employees, consultants and directors of stock options, share
appreciation rights, which we refer to as SARs, restricted shares, restricted
share units, performance shares, performance units, dividend equivalents, and
other share based and non-share based awards, which collectively, we refer to
as the Awards. An aggregate of 3,848,182 common shares has been reserved for
issuance under the Plan, subject to anti-dilution adjustments in the event of
certain changes in our capital structure. Shares issued pursuant to the Plan
will be either authorized but unissued shares or treasury shares.

The Plan is
administered by the Compensation Committee or such other Board committee (or
the entire Board) as may be designated by the Board, which we refer to as the
Committee. The Committee will determine which eligible employees, consultants
and directors receive Awards, the types of Awards to be received and the terms
and conditions thereof. However, the exercise price of options and SARs will
not be less than the fair market value of the shares on the date of grant, and
the term will not be longer than ten years from the date of grant.

In
the event of a change in control (as defined in the Plan), all awards granted
under the Plan then outstanding but not then exercisable (or subject to
restrictions) shall become immediately exercisable, all restrictions shall
lapse, and any performance criteria shall be deemed satisfied, unless otherwise
provided in the applicable Award agreement.

127

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

Stock-Based Compensation Plans

Effective
January 1, 2006, the Company adopted Statement of Financial Accounting
Standards No. 123 (Revised) Share-Based Payments (SFAS 123R). As there was
no stock based compensation issued by the Company prior to the effective date
of the IPO, the Company is utilizing the modified prospective transition
method. Under the modified prospective transition method, compensation cost
recognized relates to the estimated fair value at the grant date of stock based
compensation granted subsequent to January 1, 2006 in accordance with SFAS
123R.

At
the effective date of the IPO the Company awarded employees 447,963 shares
under the Plan in the form of stock options and 500,428 shares under the Plan
in the form of restricted stock. In addition, the Company awarded 200,000
shares under the plan in the form of stock options to directors, of which
50,000 relate to directors who, as officers of XL Capital, pledged such options
to XL Capital. The Awards vest as set forth in the applicable Award agreements,
and the requisite service period is equivalent to the vesting period. The
Awards contain certain restrictions, prior to vesting, relating to, among other
things, forfeiture in the event of termination of employment and
transferability.

The
stock options awarded under the Plan had a weighted average grant-date fair
value of $6.06 and the restricted stock had a weighted average grant-date fair
value of $20.50.

During
the year ended December 31, 2006, the Company recognized approximately $0.7
million of compensation expense, net of tax, related to its stock option
Awards.

The
fair value of each option Award is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions:

|                        |  |                                |           |  
|----------------------- |  | ------------------------------ | --------- | -
|                        |  | Year Ended
  December 31, 2006 |           |  
|                        |  |                                |           |  
|Expected dividends      |  |                                | 0.0       | %
|Risk free interest rate |  |                                | 5.0       | %
|Expected volatility     |  |                                | 25.0      | %
|Expected life           |  |                                | 5.5 years |  

The
risk free interest rate is based on U.S. Treasury rates. The expected lives are
estimated using the exercise behavior of grant recipients.

The
following is a summary of stock options as of December 31, 2006, and related
activity for the year then ended:

|                                  |  |                    |           |                                         |   |                                                         |  |                             |           |  |   |           | 
|--------------------------------- |  | ------------------ | --------- | --------------------------------------- | - | ------------------------------------------------------- |  | --------------------------- | --------- |  | - | --------- | 
|                                  |  | Number of
  Shares |           | Weighted 
  Average 
  Exercise
  Price |   | Weighted 
  Average 
  Remaining 
  Contractual 
  Term |  | Aggregate 
  IntrinsicValue |          
|                                  |  |                    |           |                                         |   |                                                         |  |                             |          
|Outstanding  beginning of period |  |                    | 0         |                                         |   |                                                         |  |                             |           |  |   |           | 
|Granted                           |  |                    | 647,963   |                                         | $ | 20.50                                                   |  |                             |           |  |   |           | 
|Exercised                         |  |                    | 0         |                                         |   |                                                         |  |                             |           |  |   |           | 
|Cancelled                         |  |                    | 0         |                                         |   |                                                         |  |                             |           |  |   |           | 
|                                 
|                                  |  |                    |           |                                         |   |                                                         |  |                             |          
|Outstanding  end of period       |  |                    | 647,963   |                                         | $ | 20.50                                                   |  |                             | 3.6 years |  | $ | 4,749,569 | 
|                                  |  |                    |           |                                         |   |                                                         |  |                             |           |  |   |           | 
|                                 
|Options available for grant *     |  |                    | 2,702,291 |                                         |   |                                                         |  |                             |           |  |   |           | 
|                                  |  |                    |           |                                         |   |                                                         |  |                             |           |  |   |           | 



---

*
Available for grant December 31, 2006 irrespective of the form of the Award
(e.g. SARs, restricted shares, restricted share units, performance shares,
performance units, dividend equivalents, and other share-based awards).


The
aggregate intrinsic value in the table above represents the total pre-tax
intrinsic value (the difference between the Companys closing stock price on
the last trading day of the year ended December 31, 2006 and the exercise price,
multiplied by the number of in-the-money-options) that would have been received
by the option holders had all option holders exercised their options on
December 31, 2006. Total unrecognized stock based compensation expense related
to

128

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

non-vested
stock options was approximately $3.1 million as of December 31, 2006, related
to 647,963 options, which is expected to be recognized over a weighted-average
period of 3.6 years.

Awards
of restricted stock at the effective date of the SCA IPO had a weighted average
grant date fair value of $20.50. During the year ended December 31, 2006, SCA
recognized approximately $1.2 million of compensation expense related to its
restricted stock awards. There were 2,500 shares of restricted stock forfeited
and no shares vested during the year ended December 31, 2006.

Total
unrecognized stock based compensation expense related to non-vested restricted
stock was approximately $9.0 million at December 31, 2006, which is expected
to be recognized over a weighted-average period of 4.5 years.

Long-Term
Compensation Plans

a.
Deferred Cash and Deferred Bonus Awards

Effective
August 4, 2006, all outstanding and unvested awards to employees of the Company
under XL Capital plans, known as deferred cash and deferred bonus awards,
were involuntarily converted to awards under SCAs plan. All the terms,
conditions and values of the awards made under SCAs plan pursuant to such
conversion were structured to mirror the terms of the awards made under XL
Capitals plan. The Awards vest as set forth in the applicable Award
agreements, and the requisite service period is equivalent to the vesting
period. The Awards contain certain restrictions, prior to vesting, relating to,
among other things, forfeiture in the event of termination of employment and
transferability.

Deferred
cash and deferred bonus awards at the effective date of the SCA IPO were valued
at $15.8 million and $0.8 million, respectively. For the period from August 4,
2006 through December 31, 2006, SCA recognized approximately $2.1 million and
$0.8 million of compensation expense related to such Awards, respectively.
Total unrecognized compensation expense related to non-vested deferred cash
awards was approximately $13.7 million at December 31, 2006. There was no
unrecognized compensation expense related to deferred bonus awards at December
31, 2006. The non-vested unrecognized compensation expense relating to the
deferred cash awards are expected to be recognized over a weighted-average
period of 2.0 years.

b. Long
Term Incentive Plan Awards

In
connection with the IPO, XL Capital and the Company offered eligible employees
of the Company the opportunity to exchange all of their outstanding unvested
restricted Class A Ordinary Shares of XL Capital and options to purchase Class
A Ordinary Shares of XL Capital, which were awarded to such employees under XL Capital
Plans prior to the IPO, for a long term incentive plan award (the LTIP Award)
from SCA to be granted under SCAs Plan (the Exchange Offer).

An LTIP
Award is the right to receive a cash payment, or base amount, from SCA of no less than 75% of the
target amount  indicated in each
offerees award letter. Such target amount will be adjusted higher or lower
(but in no event lower than the base amount) based on the performance of SCA
pursuant to the terms and conditions specified in the Award. The Awards
vest as set forth in the applicable Award agreements, and the requisite service
period is equivalent to the vesting period. The Awards contain certain
restrictions, prior to vesting, relating to, among other things, forfeiture in
the event of termination of employment and transferability.

Elections
under the Exchange Offer became effective on December 12, 2006; 443,532
eligible options and 97,119 shares of eligible restricted stock of XL Capital
were exchanged under the Exchange Offer and SCA issued LTIP Awards with an
aggregate target amount of $11.4 million. Approximately $4.1 million of
eligible outstanding unvested restricted Class A Ordinary Shares of XL Capital
and options to purchase Class A Ordinary Shares of XL Capital were not
exchanged under the Exchange Offer and remain outstanding under XL Capital
plans. See Note 7.

Apart
from the Exchange Offer, other long-term compensation awards under XL Capital
plans to certain senior executives and officers of the Company were
involuntarily converted to LTIP Awards at the IPO date. This aggregate base
amount of such awards was $1.5 million.

For
the year ended December 31, 2006 the Company recognized compensation expense
relating to its LTIP Awards of approximately $0.3 million. Total unrecognized
compensation expense related to non-vested LTIP Awards was approximately $11.4
million at December 31, 2006. The non-vested unrecognized compensation expense
relating to LTIP Awards are expected to be recognized over a weighted-average
period of 2.0 years.

129

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

XL Capital Long-Term Incentive
Plans 

Stock-Based
Compensation Plans

Prior
to August 4, 2006, employees of the Company were eligible to receive awards
under XL
Capitals 1991 Performance Incentive Program which governs XL Capitals
grants of non-qualified or incentive stock options, restricted stock,
restricted stock units, performance shares, performance units and stock
appreciation rights (SARs). The plan is administered by XL CapitalsBoardof Directors and the Compensation
Committee of the Board of Directors. Stock options may be granted with or
without SARs. No SARs have been granted to date. Grant prices are established
at the fair market value of XL Capitals common stock at the date of grant.
Options and SARs have a life of not longer than ten years and vest as set forth
at the time of grant. Options currently vest annually over four years from date
of grant.

Restricted
stock awards issued under the 1991 Performance Incentive Program vest as set
forth in the applicable award agreements. These shares contained certain
restrictions, prior to vesting, relating to, among other things, forfeiture in
the event of termination of employment and transferability. Restricted stock
issued to employees of the Company under the plan totaled 0 shares, 113,850
shares, and 66,675 shares in 2006, 2005, and 2004, respectively.

Under
    XL Capitals 1999 Performance Incentive Plan, 1,250,000 options were
    available for issuance to employees who were not directors or executive officers
    of the Company.

The fair
value of each optiongrant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions:

|                          |  |      |           |      |  |           |   |  |           |  
|------------------------- |  | ---- | --------- | ---- |  | --------- | - |  | --------- | -
|                          |  | 2006 |           | 2005 |  | 2004      |  
|                          |  |      |           |      |  |           |  
|Dividend yield            |  |      | 2.10      | %    |  | 2.60      | % |  | 2.54      | %
|Risk free interest
  rate |  |      | 4.70      | %    |  | 4.00      | % |  | 3.00      | %
|Expected
  volatility     |  |      | 25.0      | %    |  | 25.0      | % |  | 27.0      | %
|Expected lives            |  |      | 5.5 years |      |  | 5.5 years |   |  | 6.0 years |  

Total
expense recognized by the Company with respect to awards to employees of the
Company of XL Capital restricted stock was $2.1 million, $2.4 million and $4.1
million in 2006, 2005 and 2004, respectively.

Following
is a summary of stock option awards to employees of the Company under XL
Capital Plans and related activity. There were no awards of stock options to
employees of the Company in 2006.

|                                |  |                    |   |                                       |       |                    |           |                                       |   |                    |  |                                       |   |   |       | 
|------------------------------- |  | ------------------ | - | ------------------------------------- | ----- | ------------------ | --------- | ------------------------------------- | - | ------------------ |  | ------------------------------------- | - | - | ----- | 
|                                |  | 2006               |   | 2005                                  |       | 2004               |          
|                                |  |                    |   |                                       |       |                    |          
|                                |  | Number
  of Shares |   | Weighted
  Average
  Exercise
  Price |       | Number
  of Shares |           | Weighted
  Average
  Exercise
  Price |   | Number
  of Shares |  | Weighted
  Average
  Exercise
  Price |  
|                                |  |                    |   |                                       |       |                    |           |                                       |   |                    |  |                                       |  
|Outstandingbeginning
  of year |  | 1,084,118          |   | $                                     | 77.65 |                    | 1,345,201 |                                       | $ | 75.62              |  | 1,299,950                             |   | $ | 75.53 | 
|Granted                         |  |                    |   | $                                     | —     |                    | 205,000   |                                       | $ | 75.65              |  | 199,200                               |   | $ | 77.10 | 
|Exercised                       |  | (92,570            | ) | $                                     | 52.23 |                    | (253,750  | )                                     | $ | 60.10              |  | (40,083                               | ) | $ | 60.42 | 
|Cancelled                       |  | (823,532           | ) | $                                     | 79.23 |                    | (212,333  | )                                     | $ | 83.84              |  | (113,866                              | ) | $ | 82.50 | 
|                                |  |                    |   |                                       |       |                    |           |                                       |   |                    |  |                                       |   |   |       | 
|Outstandingend of
  year       |  | 168,016            |   | $                                     | 81.78 |                    | 1,084,118 |                                       | $ | 77.65              |  | 1,345,201                             |   | $ | 75.62 | 
|                                |  |                    |   |                                       |       |                    |           |                                       |   |                    |  |                                       |   |   |       | 
|Options
  exercisable           |  | 166,200            |   |                                       |       |                    | 730,093   |                                       |   |                    |  | 932,058                               |   |   |       | 
|                                |  |                    |   |                                       |       |                    |           |                                       |   |                    |  |                                       |   |   |       | 

The
exercise price of theoptions granted is the market price of XL Capitals
Class A ordinary shares on the grant date.

At December 31, 2006 outstanding stock option awards under XL Capital Plans held by employees of the Company had a range of exercise prices of $50.00 to $94.62 per share, respectively, and a weighted average exercise price, in the aggregate, of $81.78 per share. In addition, the average remaining contractual life of such options was 5.7 years.

130

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SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

Long-Term
Compensation Plans

a.
Deferred Cash and Deferred Bonus Awards

In
addition, prior to August 4, 2006, employees of the Company were eligible to
receive awards from XL Capital, known as deferred cash and deferred bonus
awards. Such awards were converted at the effective date of the IPO to SCA
awards with identical terms and conditions. The awards vest as set forth in the
applicable award agreements, and the requisite service period is equivalent to
the vesting period. The awards contain certain restrictions, prior to vesting,
relating to, among other things, forfeiture in the event of termination of
employment and transferability.

For
the years ended December 31, 2006, 2005 and 2004, the Company recognized
approximately $2.5 million, $2.7 million, and $4.3 million of
compensation expense related to such Awards, respectively. There was no unrecognized
compensation expense at December 31, 2006 related to the aforementioned deferred
cash and deferred bonus awards as a result of the involuntary conversion of such
Awards to SCA plans as discussed above.

20. Earnings Per Share

The following table sets forth the computation of basic and diluted
earnings per share:

|                                                    |  |                         |         |      |   |        |  |   |        | 
|--------------------------------------------------- |  | ----------------------- | ------- | ---- | - | ------ |  | - | ------ | 
|                                                    |  | Year ended December 31, |        
|                                                    |  |                         |        
|(U.S. dollars in thousands, except
  share amounts) |  | 2006                    |         | 2005 |   | 2004   | 
|                                                   
|Net income                                          |  | $                       | 117,355 |      | $ | 80,446 |  | $ | 58,854 | 
|                                                    |  |                         |         |      |   |        |  |   |        | 
|Basic shares
  (000s) (1)                          |  |                         | 53,676  |      |   | 46,127 |  |   | 46,127 | 
|Common stock
  equivalents (000s)                  |  |                         | 42      |      |   |       |  |   |       | 
|Diluted shares
  (000s) (1)                        |  |                         | 53,718  |      |   | 46,127 |  |   | 46,127 | 
|                                                    |  |                         |         |      |   |        |  |   |        | 
|Net income:                                         |  |                         |         |      |   |        |  |   |        | 
|Basic EPS                                           |  | $                       | 2.19    |      | $ | 1.74   |  | $ | 1.28   | 
|Diluted EPS                                         |  | $                       | 2.18    |      | $ | 1.74   |  | $ | 1.28   | 

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | For the years ended December 31,
  2005 and 2004, based on 46,127,245 shares outstanding immediately prior to
  the IPO. In July 2006, a stock split of the Companys outstanding common
  shares was effected. As a result, there were 46,127,245 shares of the
  Companys common stock issued and outstanding just prior to the offering. The
  accompanying financial statements and share amounts have been retroactively
  adjusted for the effects of such stock split.

131

---



SECURITY CAPITAL ASSURANCE LTDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2006, 2005 AND 2004

21. Quarterly Financial Information
      (Unaudited)

|                                                 |  |       |        |        |   |         |  |        |         |  |   |         | 
|------------------------------------------------ |  | ----- | ------ | ------ | - | ------- |  | ------ | ------- |  | - | ------- | 
|                                                 |  | 2006  |       
|                                                 |  |       |       
|(U.S. Dollars in thousands)                      |  | First |        | Second |   | Third   |  | Fourth |        
|                                                 |  |       |        |        |   |         |  |        |        
|Total premiums written                           |  | $     | 82,183 |        | $ | 107,643 |  | $      | 85,570  |  | $ | 133,603 | 
|Net premiums
  written                           |  |       | 74,591 |        |   | 101,483 |  |        | 100,478 |  |   | 119,380 | 
|Net premiums
  earned                            |  |       | 37,813 |        |   | 55,541  |  |        | 45,455  |  |   | 44,306  | 
|Net investment
  income                          |  |       | 15,062 |        |   | 16,129  |  |        | 21,835  |  |   | 24,698  | 
|Net losses and
  loss adjustment expenses        |  |       | 3,449  |        |   | 2,880   |  |        | 4,994   |  |   | 3,635   | 
|Income before
  income tax and minority interest |  |       | 21,376 |        |   | 37,311  |  |        | 32,298  |  |   | 37,457  | 
|Net income                                       |  |       | 16,749 |        |   | 36,388  |  |        | 28,412  |  |   | 35,806  | 
|                                                 |  |       |        |        |   |         |  |        |         |  |   |         | 
|Basic earnings per
  share                       |  | $     | 0.36   |        | $ | 0.79    |  | $      | 0.49    |  | $ | 0.56    | 
|Diluted earnings
  per share                     |  | $     | 0.36   |        | $ | 0.79    |  | $      | 0.49    |  | $ | 0.56    | 
|                                                 |  |       |        |        |   |         |  |        |         |  |   |         | 
|                                                 |  | 2005  |       
|                                                 |  |       |       
|(U.S.
  Dollars in thousands)                    |  | First |        | Second |   | Third   |  | Fourth |        
|                                                 |  |       |        |        |   |         |  |        |        
|Total premiums written                           |  | $     | 51,737 |        | $ | 82,169  |  | $      | 82,979  |  | $ | 68,554  | 
|Net premiums
  written                           |  |       | 40,044 |        |   | 73,961  |  |        | 73,544  |  |   | 57,363  | 
|Net premiums
  earned                            |  |       | 32,640 |        |   | 33,055  |  |        | 41,136  |  |   | 45,008  | 
|Net investment
  income                          |  |       | 11,308 |        |   | 12,262  |  |        | 13,259  |  |   | 14,331  | 
|Net losses and
  loss adjustment expenses        |  |       | 2,206  |        |   | 16,743  |  |        | 1,095   |  |   | 5,977   | 
|Income before
  income tax and minority interest |  |       | 25,536 |        |   | 2,451   |  |        | 30,691  |  |   | 29,296  | 
|Net income                                       |  |       | 21,984 |        |   | 74      |  |        | 31,373  |  |   | 27,015  | 
|                                                 |  |       |        |        |   |         |  |        |         |  |   |         | 
|Basic earnings per
  share                       |  | $     | 0.48   |        | $ | 0.00    |  | $      | 0.68    |  | $ | 0.59    | 
|Diluted earnings
  per share                     |  | $     | 0.48   |        | $ | 0.00    |  | $      | 0.68    |  | $ | 0.59    | 

132

---



ITEM 9. CHANGES IN AND DISAGREEMENTS WITH
ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

Conclusion
Regarding the Effectiveness of Disclosure Controls and Procedures

The Company
carried out an evaluation, under the supervision and with the participation of
the Companys management, including the Chief Executive Officer and Chief
Financial Officer, of the effectiveness of disclosure controls and procedures
pursuant to Rules 13a-15 and 15d-15 promulgated under the Securities Exchange
Act of 1934, as amended, as of the end of the period covered by this report.
Based on that evaluation, the Chief Executive Officer and Chief Financial
Officer concluded that the disclosure controls and procedures are effective to
provide reasonable assurance that all material information relating to the
Company required to be filed in this report has been made known to them in a
timely fashion.

Managements
Report on Internal Control Over Financial Reporting

This annual report does not include a report of management’s assessment regarding internal control over financial reporting or an attestation report of the company’s registered public accounting firm due to a transition period established by rules of the Securities and Exchange Commission for newly public companies.

Changes in
Internal Control Over Financial Reporting

There have
been no changes in internal control over financial reporting identified in
connection with the Companys evaluation required pursuant to Rules 13a-15 and
15d-15 promulgated under the Securities Exchange Act of 1934, as amended, that
occurred during the most recent fiscal quarter that have materially affected,
or are reasonably likely to materially affect, the Companys internal control
over financial reporting.

ITEM 9B. OTHER INFORMATION

None.

133

---



PART
III

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
GOVERNANCE

Certain of
the information required by this item relating to the executive officers of the
Company may be found under Item 4, Submission of Matters to a Vote of Security
Holders  Executive Officers of the Company. The balance of the information
required by this item is omitted because a definitive proxy statement that
involves the election of directors will be filed with the Securities and
Exchange Commission not later than 120 days after the close of the fiscal year
pursuant to Regulation 14A, which proxy statement is incorporated by reference.

ITEM 11. EXECUTIVE COMPENSATION

This item
is omitted because a definitive proxy statement that involves the election of
directors will be filed with the Securities and Exchange Commission not later
than 120 days after the close of the fiscal year pursuant to Regulation 14A,
which proxy statement is incorporated by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The following table summarizes the Companys equity compensation plan information as of December 31, 2006:

|                |  |                   |  |                   |                      |     | Number of           |    
|--------------- |  | ----------------- |  | ----------------- | -------------------- | --- | ------------------- | ---
|                |  |                   |  |                   |                      |     | securities          |    
|                |  | Number of         |  |                   |                      |     | remaining available |    
|                |  | securities to be  |  |                   |                      |     | for future issuance |    
|                |  | iissued upon      |  | Weighted-average  | under equity         |    
|                |  | exercise of       |  | exercise price of | compensation         |    
|                |  | outstanding       |  | outstanding       | plans (excluding     |    
|                |  | options, warrants |  | options, warrants | securities reflected |    
|                |  | and rights        |  | and rights        | in column a)         |    
|               
|Plan Category   |  | (a)               |  | (b)               |                      | (c) |                    
|               
|Equity          |  |                   |  |                   |                      |     |                     |    
|compensation    |  |                   |  |                   |                      |     |                     |    
|plans approved  |  |                   |  |                   |                      |     |                     |    
|by security     |  |                   |  |                   |                      |     |                     |    
|holders         |  |                   |  |                   |                      |     |                     |    
|               
|Equity          |  |                   |  |                   |                      |     |                     |    
|compensation    |  |                   |  |                   |                      |     |                     |    
|plans not       |  |                   |  |                   |                      |     |                     |    
|approved by     |  |                   |  |                   |                      |     |                     |    
|security        |  |                   |  |                   |                      |     |                     |    
|holders (1) (2) |  | 647,963           |  | $                 | 20.50                |     | 2,702,291           | (3)
|               
|Total           |  | 647,963           |  | $                 | 20.50                |     | 2,702,291           |    

| | (1) | See Note 19 to the Consolidated Financial Statements for a description of the Companys equity compensation plan.                 
| | --- | ----------------------------------------------------------------------------------------------------------------------------------
| | (2) | The Plan is being submitted for approval by our shareholders at our annual general meeting of shareholders to be held May 4, 2007.
| | (3) | The securities available to be issued under the Plan may be in any form provided for under the Plan.                              

The remaining information required by this Item is omitted because a definitive proxy statement that involves the election of directors will be filed with the Securities and Exchange Commission not
later than 120 days after the close of the fiscal year pursuant to Regulation 14A, which information is incorporated by reference.

ITEM 13. CERTAIN
RELATIONSHIPS
AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

This item
is omitted because a definitive proxy statement that involves the election of
directors will be filed the Securities and Exchange Commission not later than
120 days after the close of the fiscal year pursuant to Regulation 14A, which
proxy statement is incorporated by reference.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND
SERVICES

This item
is omitted because a definitive proxy statement that involves the election of
directors will be filed the Securities and Exchange Commission not later than
120 days after the close of the fiscal year pursuant to Regulation 14A, which
proxy statement is incorporated by reference.

PART
IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT
SCHEDULES

Financial Statements, Financial Statement Schedules and Exhibits.

|                                                                                                                            |  |          |  |     
|--------------------------------------------------------------------------------------------------------------------------- |  | -------- |  | ----
|                                                                                                                           
|1. Financial Statements                                                                                                     |  |          |  |     
|                                                                                                                            |  |          |  |     
|Included in Part II  See Item 8 of this
  report.                                                                          |  |          |  |     
|                                                                                                                            |  |          |  |     
|2. Financial Statement
  Schedules                                                                                          |  |          |  |     
|                                                                                                                            |  |          |  |     
|Included in Part IV of this report:                                                                                         |  |          |  |     
|                                                                                                                            |  |          |  |     
|                                                                                                                            |  | Schedule |  |     
|                                                                                                                            |  | Number   |  | Page
|                                                                                                                            |  |          |  |     
|                                                                                                                            |  |          |  |     
|Condensed
      Financial Information of Registrant, as of December 31, 2006 and for the
      year ended December 31, 2006 |  | II       |  | 135 
|                                                                                                                            |  |          |  |     
|Other Schedules have been omitted as they
  are not applicable to the Company                                               |  |          |  |     

134

---



SECURITY CAPITAL
ASSURANCE LTD SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONDENSED BALANCE SHEET- PARENT COMPANY ONLY
DECEMBER 31, 2006

|                                                           |  |      |           |  
|---------------------------------------------------------- |  | ---- | --------- | -
|(U.S. Dollars in thousands, except per
  share amounts)    |  | 2006 |          
|                                                           |  |      |          
|Assets                                                     |  |      |           |  
|Cash and cash equivalents                                  |  |      | 29,568    |  
|Accrued investment income                                  |  |      | 39        |  
|Investment in subsidiaries                                 |  |      | 1,346,647 |  
|Other assets                                               |  |      | 1,172     |  
|                                                           |  |      |           |  
|Total assets                                               |  | $    | 1,377,426 |  
|                                                           |  |      |           |  
|Liabilities and Shareholders
  Equity                     |  |      |           |  
|Liabilities                                                |  |      |           |  
|Accounts payable, accrued expenses and
  other liabilities |  |      | 10,906    |  
|                                                           |  |      |           |  
|Total liabilities                                          |  |      | 10,906    |  
|                                                           |  |      |           |  
|Shareholders Equity                                       |  |      |           |  
|Common stock                                               |  |      | 641       |  
|Additional paid-in capital                                 |  |      | 987,803   |  
|Retained earnings                                          |  |      | 397,781   |  
|Accumulated other comprehensive
loss                       |  |      | (19,705   | )
|                                                           |  |      |           |  
|Total shareholders
equity                                 |  |      | 1,366,520 |  
|                                                           |  |      |           |  
|Total liabilities and
shareholders equity                 |  | $    | 1,377,426 |  
|                                                           |  |      |           |  

135

---



SECURITY CAPITAL ASSURANCE LTD SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTD) STATEMENT OF OPERATIONS
AND COMPREHENSIVE INCOME- PARENT COMPANY ONLY
YEAR ENDED DECEMBER 31, 2006

|                                       |  |      |         | 
|-------------------------------------- |  | ---- | ------- | 
|(U.S. Dollars in thousands)            |  | 2006 |        
|                                       |  |      |        
|Revenues                               |  |      |         | 
|Net investment income                  |  | $    | 1,976   | 
|Net realized gains on
investments      |  |      | 837     | 
|Equity in net earnings of
subsidiaries |  |      | 121,419 | 
|                                       |  |      |         | 
|Total revenues                         |  |      | 124,232 | 
|                                       |  |      |         | 
|Expenses                               |  |      |         | 
|Operating expenses                     |  |      | 6,877   | 
|                                       |  |      |         | 
|Net income                             |  | $    | 117,355 | 
|                                       |  |      |         | 

136

---



SECURITY CAPITAL ASSURANCE LTD SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTD)
STATEMENT OF CASH FLOWS- PARENT COMPANY ONLY
YEAR ENDED DECEMBER 31, 2006

|                                                                                              |  |      |          |  
|--------------------------------------------------------------------------------------------- |  | ---- | -------- | -
|(U.S. Dollars in thousands)                                                                   |  | 2006 |         
|                                                                                              |  |      |         
|Cash provided by operating
  activities:                                                      |  |      |          |  
|Net income                                                                                    |  | $    | 117,355  |  
|Adjustments to reconcile net income to
net
  cash provided by operating activities            |  |      |          |  
|Equity in net earnings of
subsidiaries                                                        |  |      | (121,419 | )
|Net realized gains on sale of
investments                                                     |  |      | (837     | )
|Other, net                                                                                    |  |      | 9,411    |  
|                                                                                              |  |      |          |  
|Total adjustments                                                                             |  |      | (112,845 | )
|                                                                                              |  |      |          |  
|Net cash provided by operating
activities                                                     |  |      | 4,510    |  
|                                                                                              |  |      |          |  
|Cash flows from investing
  activities:                                                       |  |      |          |  
|Proceeds
    from sale of debt securities                                                     |  |      | 39,305   |  
|Purchase
    of debt securities                                                               |  |      | (161,506 | )
|Cash contributed to
subsidiaries                                                              |  |      | (215,028 | )
|                                                                                              |  |      |          |  
|Net cash used in investing
activities                                                         |  |      | (337,229 | )
|                                                                                              |  |      |          |  
|Cash flows from financing
  activities:                                                       |  |      |          |  
|Proceeds from issuance of common stock
less
  underwriters allowance and issuance costs paid |  |      | 342,341  |  
|Cash contributions from XL
Capital                                                            |  |      | 21,229   |  
|Dividends on common shares                                                                    |  |      | (1,283   | )
|                                                                                              |  |      |          |  
|Net cash provided by financing
activities                                                     |  |      | 362,287  |  
|                                                                                              |  |      |          |  
|Increase (decrease) in cash and cash
  equivalents                                            |  |      | 29,568   |  
|Cash and cash equivalentsbeginning of
year                                                   |  |      |         |  
|                                                                                              |  |      |          |  
|Cash and cash equivalentsend of year                                                         |  | $    | 29,568   |  
|                                                                                              |  |      |          |  
|Non-cash capital contribution to subsidiary-debt
      securities at fair value               |  | $    | 123,076  |  

137

---



3. EXHIBITS

|EXHIBIT |                                                                                                                                                                                                                                                                                                                           
|------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NUMBER  | DESCRIPTION
    OF DOCUMENT                                                                                                                                                                                                                                                                                               
|       
|3.1     | Memorandum of Association of CA Holdings
        Ltd, incorporated by reference to Exhibit 3.1 to the Companys Registration
    Statement on Form S-1 (File No. 333-133066)                                                                                                                                              
|3.2     | Amended and Restated Bye-laws of Security
        Capital Assurance Ltd, incorporated by reference to Exhibit 3.2 to the
        Security Capital Assurance Ltd Registration Statement on Form S-1 (File
    No. 333-133066)                                                                                              
|10.1    | Transition Agreement, dated as of August
        4, 2006, among XL Capital Ltd, XL Insurance (Bermuda) Ltd, X.L. America,
        Inc. and Security Capital Assurance Ltd, incorporated by reference to
        Exhibit 10.1 to Security Capital Assurance Ltd Quarterly Report on Form
    10-Q dated June 30, 2006.     
|10.2    | Tax Indemnity Agreement, dated as of August
        4, 2006, among XL Capital Ltd, X.L. America, Inc. and Security Capital
        Assurance Ltd, incorporated by reference to Exhibit 10.2 to Security
        Capital Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                  
|10.3    | Employment Agreement with Paul S. Giordano
        dated as of August 2, 2006, incorporated by reference to Exhibit 10.3
        to Security Capital Assurance Ltd Quarterly Report on Form 10-Q dated
    June 30, 2006.                                                                                                 
|10.4**  | Employment Agreement with David P. Shea dated
        as of January 23, 2007.                                                                                                                                                                                                                                             
|10.5**  | Employment Agreement with Edward B. Hubbard
        dated as of December 21, 2007.                                                                                                                                                                                                                                        
|10.6**  | Employment Agreement with Claude L. LeBlanc
    dated as of November 14, 2006.                                                                                                                                                                                                                                            
|10.7    | Letter Agreement Regarding Stock Options,
        Restricted Shares and Long-Term Incentive Award between XL Capital Ltd
        and Paul Giordano, dated as of August 2, 2006, incorporated by reference
        to Exhibit 10.4 to Security Capital Assurance Ltd Quarterly Report on
    Form 10-Q dated June 30, 2006.
|10.8    | Security Capital Assurance Ltd 2006 Long-Term
        Incentive and Share Award Plan, incorporated by reference to Exhibit
        10.5 to Security Capital Assurance Ltd Quarterly Report on Form 10-Q
    dated June 30, 2006.                                                                                          
|10.9**  | Amendment to Security Capital Assurance Ltd
        2006 Long-Term Incentive and Share Award Plan effective December 29,
    2006.                                                                                                                                                                                        
|10.10   | Security Capital Assurance Ltd Annual Incentive
        Compensation Plan, incorporated by reference to Exhibit 10.6 to Security
    Capital Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                                                                             
|10.11   | SCA Holdings US Inc. Deferred Compensation
        Program, incorporated by reference to Exhibit 10.7 to Security Capital
    Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                                                                                            
|10.12   | Master Services Agreement, dated as of August
        4, 2006, between XL Global Services, Inc. and XL Financial Administrative
        Services Inc., incorporated by reference to Exhibit 10.8 to Security
        Capital Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                             
|10.13   | Master Services Agreement, dated as of August
        4, 2006, between XL Services (Bermuda) Ltd and SCA Bermuda Administrative
        Ltd, incorporated by reference to Exhibit 10.9 to Security Capital Assurance
    Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                           
|10.14   | Master Services Agreement, dated as of August
        4, 2006, between XL Capital Ltd and SCA Bermuda Administrative Ltd,
        incorporated by reference to Exhibit 10.10 to Security Capital Assurance
    Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                     
|10.15   | Master Services Agreement, dated as of August
        4, 2006, between XL Services UK Limited and XL Capital Assurance (U.K.)
        Limited, incorporated by reference to Exhibit 10.11 to Security Capital
    Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                        

138

---



|10.16 | Master Services Agreement, dated as of August
        4, 2006, between XL Services UK Limited, in respect of its Spanish branch
        and XL Capital Assurance (U.K.) Limited, in respect of its Spanish branch,
        incorporated by reference to Exhibit 10.12 to Security Capital Assurance
    Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                                     
|----- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.17 | Master Services Agreement, dated as of August
        4, 2006, between X.L. America, Inc. and XL Financial Administrative
        Services Inc., incorporated by reference to Exhibit 10.13 to Security
        Capital Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                                                                                                           
|10.18 | General Services Agreement, dated as of August
        4, 2006, between XL Financial Administrative Services Inc. and XL Insurance
        (Bermuda) Ltd, incorporated by reference to Exhibit 10.14 to Security
        Capital Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                                                                                                  
|10.19 | General Services Agreement, dated as of August
        4, 2006, between XL Financial Assurance Ltd. and XL Insurance (Bermuda) Ltd, incorporated by reference to Exhibit 10.15 to Security Capital
    Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                                                                                                                            
|10.20 | General Services Agreement, dated as of August
        4, 2006, between XL Capital Assurance Inc. and XL Global Services, Inc.,
        incorporated by reference to Exhibit 10.16 to Security Capital Assurance
    Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                                                                                                                        
|10.21 | Assignment and Assumption of Lease between
        Global Credit Analytics, Inc. and XL Capital Assurance Inc., dated as
        of August 4, 2006, incorporated by reference to Exhibit 10.17 to Security
    Capital Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                                                                                                            
|10.22 | Amendment No. 1 to Facultative Quota Share
        Reinsurance Agreement between XL Financial Assurance Ltd. and XL Insurance
        (Bermuda) Ltd, dated as of August 4, 2006, incorporated by reference
        to Exhibit 10.18 to Security Capital Assurance Ltd Quarterly Report on
    Form 10-Q dated June 30, 2006.                                                                                                       
|10.23 | Amendment No. 1 to Excess of Loss Reinsurance
        Agreement between XL Financial Assurance Ltd. and XL Insurance (Bermuda)
        Ltd, dated as of August 4, 2006, incorporated by reference to Exhibit
        10.19 to Security Capital Assurance Ltd Quarterly Report on Form 10-Q
    dated June 30, 2006.                                                                                                                
|10.24 | Third Amended and Restated Facultative Quota
        Share Reinsurance Treaty between XL Financial Assurance Ltd. and XL Capital
        Assurance Inc., dated as of August 4, 2006, incorporated by reference
        to Exhibit 10.20 to Security Capital Assurance Ltd Quarterly Report on
    Form 10-Q dated June 30, 2006.                                                                                                   
|10.25 | Amendment and Termination of Reinsurance
        Guarantee Agreement between XL Insurance (Bermuda) Ltd, XL Capital
        Assurance Inc. and XL Financial Assurance Ltd., dated as of August 4,
        2006, incorporated by reference to Exhibit 10.21 to Security Capital
    Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                                                
|10.26 | First Amended and Restated Facultative Master
        Certificate issued by XL Reinsurance America Inc. to XL Capital Assurance
        Inc., dated as of August 4, 2006, incorporated by reference to Exhibit
        10.22 to Security Capital Assurance Ltd Quarterly Report on Form 10-Q
    dated June 30, 2006.                                                                                                              
|10.27 | Credit Agreement between Security Capital
        Assurance Ltd, XL Capital Assurance Inc. and XL Financial Assurance Ltd.
        and the Lenders party thereto and Citibank, N.A., Citigroup Global Markets
        Inc. and J.P. Morgan Securities Inc., dated as of August 1, 2006, incorporated
        by reference to Exhibit 10.23 to Security Capital Assurance Ltd Quarterly
    Report on Form 10-Q dated June 30, 2006.
|10.28 | Amendment No. 1 to Agency Agreement between
        XL Financial Solutions Ltd, XL Re Ltd, XL Insurance (Bermuda) Ltd and
        XL Financial Assurance Ltd., dated as of August 4, 2006, incorporated
        by reference to Exhibit 10.23 to Security Capital Assurance Ltd Quarterly
    Report on Form 10-Q dated June 30, 2006.                                                                                             
|10.29 | Security Capital Assurance Ltd Deferred Cash
        Program Guidelines, incorporated by reference to Exhibit 10.39 to the
        Security Capital Assurance Ltd Registration Statement on Form S-1 (File
    No. 333-133066)                                                                                                                                                                                                     

139

---



|10.30  | XL Financial Assurance Ltd. Second
        Amended and Restated Shareholders Agreement, dated as of July 21, 2006,
        incorporated by reference to Exhibit 10.40 to the Security Capital Assurance
    Ltd Registration Statement on Form S-1 (File No. 333-133066)                                                                                                                                       
|------ | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.31  | Amended and Restated General
        Services Agreement, dated as of August 4, 2006, between XL Capital Assurance
        Inc. and XL Financial Administrative Services Inc., incorporated by reference
        to Exhibit 10.27 to Security Capital Assurance Ltd Quarterly Report on
    Form 10-Q dated June 30, 2006.                                                                                      
|10.32* | Indemnification Agreement, dated
        as of August 4, 2006, between XL Financial Assurance Ltd. and XL Insurance
        (Bermuda) Ltd, incorporated by reference to Exhibit 10.28 to Security
        Capital Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                                                                                             
|10.33* | Indemnification Agreement, dated
        as of August 4, 2006, between XL Capital Assurance Inc. and X.L. America,
        Inc., incorporated by reference to Exhibit 10.29 to Security Capital
    Assurance Ltd Quarterly Report on Form 10-Q dated June 30, 2006.                                                                                                                                           
|10.34* | Adverse Development Reinsurance
        Agreement, dated as of August 4, 2006, between XL Capital Assurance
        Inc. and XL Reinsurance America Inc., incorporated by reference to Exhibit
        10.30 to Security Capital Assurance Ltd Quarterly Report on Form 10-Q
    dated June 30, 2006.                                                                                                          
|10.35  | Information Technology outsourcing
        agreement dated as of October 1, 2006 between Security Capital Assurance
        Ltd and affiliates thereof and International Business Machines Corporation
        and affiliates thereof dated September 30, 2006, incorporated by reference
        to Exhibit 10.1 to Security Capital Assurance Ltd Quarterly Report on
    Form 10-Q dated September 30, 2006.
|31**   | Rule 13a-14(a)/15d-14(a) Certifications                                                                                                                                                                                                                                                                                                                                                                        
|       |                                                                                                                                                                                                                                                                                                                                                                                                                
|32**   | Section 1350 Certification                                                                                                                                                                                                                                                                                                                                                                                     
|       |                                                                                                                                                                                                                                                                                                                                                                                                                
|99.1** | XL Capital Assurance Inc. and
        Subsidiary consolidated financial statements as of December 31, 2006
    and 2005 and for the years ended December 31, 2006, 2005, and 2004                                                                                                                                                                                                                              
|       |                                                                                                                                                                                                                                                                                                                                                                                                                
|99.2** | XL Financial Assurance Ltd. financial
        statements as of December 31, 2006 and 2005 and for the years ended December
    31, 2006, 2005, and 2004                                                                                                                                                                                                                                                        

*       Omits information for which confidential
  treatment has been requested.
**      Filed herewith.

140

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Date: March 14, 2007



| | SECURITY CAPITAL ASSURANCE LTD
| | ------------------------------
| | (Registrant)                  
| |                               
| |                               
| |                               
| | By:                           
| |                               
| |                               



141

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POWER OF ATTORNEY

We, the undersigned directors and executive officers of Security Capital Assurance Ltd, hereby severally constitute Michael P. Esposito, Jr., Paul S. Giordano, Brian M. OHara and Kirstin Romann Gould, and each of them
singly, our true and lawful attorneys with full power to them and each of them to sign for us, and in our names in the capacities indicated below, any and all amendments to the Annual Report on Form 10-K filed with the Securities and Exchange
Commission, hereby ratifying and confirming our signatures as they may be signed by our said attorneys to any and all amendments to said Annual Report on Form 10-K.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

|Signature                    |  | Title                                        |  | Date          
|---------------------------- |  | -------------------------------------------- |  | --------------
|                             |  |                                              |  |               
|/s/ Paul S. Giordano         |  |                                              |  |               
|Paul S. Giordano             |  | President, Chief Executive Officer and       |  |               
|                             |  | Director (Principal Executive Officer)       |  | March 14, 2007
|                             |  |                                              |  |               
|/s/ David P. Shea            |  |                                              |  |               
|David P. Shea                |  | Executive Vice President and Chief Financial |  |               
|                             |  | Officer (Principal Financial Officer and     |  |               
|                             |  | Principal Accounting Officer)                |  | March 14, 2007
|                             |  |                                              |  |               
|/s/ Michael P. Esposito, Jr. |  |                                              |  |               
|Michael P. Esposito, Jr.     |  | Director and Chairman of the Board of        |  |               
|                             |  | Directors                                    |  | March 14, 2007
|                             |  |                                              |  |               
|/s/ Brian M. OHara          |  |                                              |  |               
|Brian M. OHara              |  | Director                                     |  | March 14, 2007
|                             |  |                                              |  |               
|/s/ E. Grant Gibbons         |  |                                              |  |               
|E. Grant Gibbons             |  | Director                                     |  | March 14, 2007
|                             |  |                                              |  |               
|/s/ Bruce G. Hannon          |  |                                              |  |               
|Bruce G. Hannon              |  | Director                                     |  | March 14, 2007
|                             |  |                                              |  |               
|/s/ Mary R. Hennessy         |  |                                              |  |               
|Mary R. Hennessy             |  | Director                                     |  | March 14, 2007
|                             |  |                                              |  |               
|/s/ Robert M. Licthen        |  |                                              |  |               
|Robert M. Licthen            |  | Director                                     |  | March 14, 2007
|                             |  |                                              |  |               
|/s/ Coleman D. Ross          |  |                                              |  |               
|Coleman D. Ross              |  | Director                                     |  | March 14, 2007
|                             |  |                                              |  |               
|/s/ Alan Z. Senter           |  |                                              |  |               
|Alan Z. Senter               |  | Director                                     |  | March 14, 2007

142

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