---

---

|                                                                                            
|--------------------------------------------------------------------------------------------
|UNITED STATES
  SECURITIES AND EXCHANGE COMMISSION                                          
|Washington, D.C. 20549                                                                      
|                                                                                            
|                                                                                            
|                                                                                            
|FORM 10-Q                                                                                   
|                                                                                            
|                                                                                            
|x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
  THE SECURITIES EXCHANGE ACT OF 1934 
|                                                                                            
|For the quarterly period ended September 30, 2006                                           
|                                                                                            
|OR                                                                                          
|                                                                                            
|o TRANSITION 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               
|                                                                                            
|                                                                                            
|                                                                                            
|SECURITY CAPITAL ASSURANCE LTD                                                              
|                                                                                            
|(Exact name of registrant as specified in its charter)                                      
|                                                                                            
|                                                                                            

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

|                                                                                                    
|----------------------------------------------------------------------------------------------------
|One Bermudiana Road, Hamilton, Bermuda HM 11
  (Address of principal executive offices and zip code)
|                                                                                                    
|(441) 292-8515 
  (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 x No o

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 o No x

As
of November 14, 2006, there were 64,136,364 outstanding Common Shares, $0.01 par
value per share, of the registrant.

---

---



|                              
|------------------------------
|                              
|SECURITY CAPITAL ASSURANCE LTD

INDEX TO FORM 10-Q

|         |                                                                                                                                                                                                                   |  |        
|-------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------
|         |                                                                                                                                                                                                                   |  | Page No
|         |                                                                                                                                                                                                                   |  |        
|         | PART I. FINANCIAL INFORMATION                                                                                                                                                                                     |  |        
|         |                                                                                                                                                                                                                   |  |        
|Item 1.  | Financial Statements:                                                                                                                                                                                             |  |        
|         |                                                                                                                                                                                                                   |  |        
|         | Interim Consolidated Balance Sheets as of
  September 30, 2006 (Unaudited) and December 31, 2005                                                                                                                  |  | 3      
|         |                                                                                                                                                                                                                   |  |        
|         | Interim Consolidated Statements of
  Operations and Comprehensive Income for the Three Months Ended September 30,
  2006 and 2005 (Unaudited) and the Nine Months Ended September 30, 2006 and
  2005 (Unaudited) |  | 4      
|         |                                                                                                                                                                                                                   |  |        
|         | Interim Consolidated Statements of
  Shareholders Equity for the Nine Months Ended September 30, 2006 (Unaudited)
  and the Year Ended December 31, 2005                                                         |  | 5      
|         |                                                                                                                                                                                                                   |  |        
|         | Interim Consolidated Statements of Cash
  Flows for the Nine Months Ended September 30, 2006 and 2005 (Unaudited)                                                                                                 |  | 6      
|         |                                                                                                                                                                                                                   |  |        
|         | Notes to Unaudited Interim Consolidated
  Financial Statements                                                                                                                                                    |  | 7      
|         |                                                                                                                                                                                                                   |  |        
|Item 2.  | Managements Discussion and Analysis of
Financial
  Condition and Results of Operations                                                                                                                           |  | 26     
|         |                                                                                                                                                                                                                   |  |        
|Item 3.  | Quantitative and Qualitative Disclosures About Market
  Risk                                                                                                                                                      |  | 70     
|         |                                                                                                                                                                                                                   |  |        
|Item 4.  | Controls and Procedures                                                                                                                                                                                           |  | 70     
|         |                                                                                                                                                                                                                   |  |        
|         | PART II. OTHER INFORMATION                                                                                                                                                                                        |  |        
|         |                                                                                                                                                                                                                   |  |        
|Item 1.  | Legal Proceedings                                                                                                                                                                                                 |  | 71     
|         |                                                                                                                                                                                                                   |  |        
|Item 1A. | Risk Factors                                                                                                                                                                                                      |  | 71     
|         |                                                                                                                                                                                                                   |  |        
|Item 6.  | Exhibits                                                                                                                                                                                                          |  | 71     
|         |                                                                                                                                                                                                                   |  |        
|         | Signatures                                                                                                                                                                                                        |  | 72     

---



PART I  FINANCIAL
INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SECURITY CAPITAL ASSURANCE LTD INTERIM CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share amounts)

|                                                                                                                                                 |  |                                            |           |                             |   |           |  
|------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------------------------------ | --------- | --------------------------- | - | --------- | -
|                                                                                                                                                 |  | (Unaudited)
  As of
  September 30,
  2006 |           | As of
  December 31,
  2005 |  
|                                                                                                                                                 |  |                                            |           |                             |   |           |  
|ASSETS                                                                                                                                           |  |                                            |           |                             |   |           |  
|Investments                                                                                                                                      |  |                                            |           |                             |   |           |  
|Debt securities available for sale, at fair value (amortized cost:
  2006 - $1,693,212; 2005 - $1,336,075)                                       |  | $                                          | 1,676,940 |                             | $ | 1,316,029 |  
|Short-term investments, at fair value (amortized cost: 2006 -
  $194,580; 2005 - $31,015)                                                        |  |                                            | 193,196   |                             |   | 30,811    |  
|Other invested assets                                                                                                                            |  |                                            |          |                             |   | 17,621    |  
|                                                                                                                                                 |  |                                            |           |                             |   |           |  
|Total investments                                                                                                                                |  |                                            | 1,870,136 |                             |   | 1,364,461 |  
|                                                                                                                                                 |  |                                            |           |                             |   |           |  
|Cash and cash equivalents                                                                                                                        |  |                                            | 218,317   |                             |   | 54,593    |  
|Accrued investment income                                                                                                                        |  |                                            | 13,477    |                             |   | 11,847    |  
|Deferred acquisition costs                                                                                                                       |  |                                            | 85,606    |                             |   | 59,592    |  
|Prepaid reinsurance premiums                                                                                                                     |  |                                            | 48,917    |                             |   | 69,873    |  
|Premiums receivable                                                                                                                              |  |                                            | 15,224    |                             |   | 7,770     |  
|Reinsurance balances recoverable on unpaid losses                                                                                                |  |                                            | 70,310    |                             |   | 69,217    |  
|Intangible assets  acquired licenses                                                                                                            |  |                                            | 11,529    |                             |   | 11,529    |  
|Deferred income tax asset                                                                                                                        |  |                                            | 18,059    |                             |   | 18,845    |  
|Other assets                                                                                                                                     |  |                                            | 23,381    |                             |   | 16,588    |  
|                                                                                                                                                 |  |                                            |           |                             |   |           |  
|Total assets                                                                                                                                     |  | $                                          | 2,374,956 |                             | $ | 1,684,315 |  
|                                                                                                                                                 |  |                                            |           |                             |   |           |  
|                                                                                                                                                 |  |                                            |           |                             |   |           |  
|LIABILITIES,
  MINORITY INTEREST AND SHAREHOLDERS EQUITY                                                                                        |  |                                            |           |                             |   |           |  
|Liabilities                                                                                                                                      |  |                                            |           |                             |   |           |  
|Unpaid losses and loss adjustment expenses                                                                                                       |  | $                                          | 156,650   |                             | $ | 147,368   |  
|Deferred premium revenue                                                                                                                         |  |                                            | 709,447   |                             |   | 592,585   |  
|Reinsurance premiums payable                                                                                                                     |  |                                            | 9,526     |                             |   | 310       |  
|Payable for investments purchased                                                                                                                |  |                                            | 66,452    |                             |   |          |  
|Accounts payable, accrued expenses and other liabilities                                                                                         |  |                                            | 47,708    |                             |   | 23,252    |  
|Dividend payable                                                                                                                                 |  |                                            | 1,139     |                             |   | 1,445     |  
|Current income tax payable                                                                                                                       |  |                                            | 2,609     |                             |   | 1,023     |  
|                                                                                                                                                 |  |                                            |           |                             |   |           |  
|Total liabilities                                                                                                                                |  |                                            | 993,531   |                             |   | 765,983   |  
|                                                                                                                                                 |  |                                            |           |                             |   |           |  
|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                                                                                                                       |  |                                            | 981,165   |                             |   | 605,951   |  
|Retained earnings                                                                                                                                |  |                                            | 363,258   |                             |   | 281,709   |  
|Accumulated other comprehensive loss                                                                                                             |  |                                            | (17,655   | )                           |   | (20,307   | )
|                                                                                                                                                 |  |                                            |           |                             |   |           |  
|Total shareholders equity                                                                                                                       |  |                                            | 1,327,409 |                             |   | 867,814   |  
|                                                                                                                                                 |  |                                            |           |                             |   |           |  
|Total liabilities, minority interest and shareholders
equity                                                                                    |  | $                                          | 2,374,956 |                             | $ | 1,684,315 |  
|                                                                                                                                                 |  |                                            |           |                             |   |           |  

See accompanying Notes to Unaudited Interim Consolidated
Financial Statements

3

---



SECURITY CAPITAL ASSURANCE LTD INTERIM CONSOLIDATED STATEMENTS OF
OPERATIONS AND COMPREHENSIVE INCOME 
(U.S. dollars in thousands, except per share amounts)

|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|------------------------------------------------------------------------------------------- |  | ------------------------------------------------ | ------- | ----------------------------------------------- | - | ------- | - | ---- | -------- | - | - | ------- | -
|                                                                                            |  | (Unaudited)
  Three Months Ended
  September 30, |         | (Unaudited)
  Nine Months Ended
  September 30, |  
|                                                                                            |  |                                                  |         |                                                 |  
|                                                                                            |  | 2006                                             |         | 2005                                            |   | 2006    |   | 2005 |         
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |         
|Revenues                                                                                    |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Gross premiums written                                                                      |  | $                                                | 65,081  |                                                 | $ | 63,757  |   | $    | 235,212  |   | $ | 179,812 |  
|Reinsurance premiums assumed                                                                |  |                                                  | 20,489  |                                                 |   | 19,222  |   |      | 40,184   |   |   | 37,073  |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Total premiums written                                                                      |  |                                                  | 85,570  |                                                 |   | 82,979  |   |      | 275,396  |   |   | 216,885 |  
|Ceded premiums                                                                              |  |                                                  | 14,908  |                                                 |   | (9,435  | ) |      | 1,156    |   |   | (29,336 | )
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Net premiums written                                                                        |  |                                                  | 100,478 |                                                 |   | 73,544  |   |      | 276,552  |   |   | 187,549 |  
|Change in net deferred premium revenue                                                      |  |                                                  | (55,023 | )                                               |   | (32,408 | ) |      | (137,743 | ) |   | (80,718 | )
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Net premiums earned (net of ceded premiums earned of $1,576,
  $6,875, $19,800 and $21,367) |  |                                                  | 45,455  |                                                 |   | 41,136  |   |      | 138,809  |   |   | 106,831 |  
|Net investment income                                                                       |  |                                                  | 21,835  |                                                 |   | 13,259  |   |      | 53,026   |   |   | 36,829  |  
|Net realized losses on investments                                                          |  |                                                  | (156    | )                                               |   | (768    | ) |      | (16,556  | ) |   | (2,139  | )
|Net realized and unrealized losses on credit derivatives                                    |  |                                                  | (3,216  | )                                               |   | (1,919  | ) |      | (6,765   | ) |   | (4,214  | )
|Fee income and other                                                                        |  |                                                  | 59      |                                                 |   |        |   |      | 2,290    |   |   | 750     |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Total revenues                                                                              |  |                                                  | 63,977  |                                                 |   | 51,708  |   |      | 170,804  |   |   | 138,057 |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Expenses                                                                                    |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Net losses and loss adjustment expenses                                                     |  |                                                  | 4,994   |                                                 |   | 1,095   |   |      | 11,323   |   |   | 20,044  |  
|Acquisition costs, net                                                                      |  |                                                  | 5,824   |                                                 |   | 3,235   |   |      | 13,048   |   |   | 9,320   |  
|Operating expenses                                                                          |  |                                                  | 20,861  |                                                 |   | 16,686  |   |      | 55,448   |   |   | 50,015  |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Total expenses                                                                              |  |                                                  | 31,679  |                                                 |   | 21,016  |   |      | 79,819   |   |   | 79,379  |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Income before
  income tax and minority interest                                            |  |                                                  | 32,298  |                                                 |   | 30,692  |   |      | 90,985   |   |   | 58,678  |  
|Income tax expense (benefit)                                                                |  |                                                  | 2,747   |                                                 |   | (632    | ) |      | 2,559    |   |   | (1,655  | )
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Income
  before minority interest                                                           |  |                                                  | 29,551  |                                                 |   | 31,324  |   |      | 88,426   |   |   | 60,333  |  
|Minority interest  dividends on redeemable preferred
shares                                |  |                                                  | 1,139   |                                                 |   | (49     | ) |      | 6,877    |   |   | 6,902   |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Net
  income                                                                                |  | $                                                | 28,412  |                                                 | $ | 31,373  |   | $    | 81,549   |   | $ | 53,431  |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Net
  income per share:                                                                     |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Basic                                                                                       |  | $                                                | 0.49    |                                                 | $ | 0.68    |   | $    | 1.63     |   | $ | 1.16    |  
|Diluted                                                                                     |  | $                                                | 0.49    |                                                 | $ | 0.68    |   | $    | 1.63     |   | $ | 1.16    |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Weighted-average
  shares outstanding:                                                      |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|(Shares in thousands)                                                                       |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Basic                                                                                       |  |                                                  | 58,068  |                                                 |   | 46,127  |   |      | 50,151   |   |   | 46,127  |  
|Diluted                                                                                     |  |                                                  | 58,095  |                                                 |   | 46,127  |   |      | 50,160   |   |   | 46,127  |  
|Comprehensive
  income                                                                      |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Net income                                                                                  |  | $                                                | 28,412  |                                                 | $ | 31,373  |   | $    | 81,549   |   | $ | 53,431  |  
|Change in unrealized appreciation (depreciation) of
investments                             |  |                                                  | 31,991  |                                                 |   | (22,610 | ) |      | 2,652    |   |   | (20,066 | )
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  
|Total
  comprehensive income                                                                |  | $                                                | 60,403  |                                                 | $ | 8,763   |   | $    | 84,201   |   | $ | 33,365  |  
|                                                                                            |  |                                                  |         |                                                 |   |         |   |      |          |   |   |         |  

See accompanying Notes to Unaudited Interim Consolidated
Financial Statements

4

---



SECURITY CAPITAL ASSURANCE LTDINTERIM CONSOLIDATED
STATEMENTS OF SHAREHOLDERS EQUITY
(U.S. dollars in thousands)

|                                                                                                                                    |  |                                                        |           |                                  |   |         |  
|----------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------------ | --------- | -------------------------------- | - | ------- | -
|                                                                                                                                    |  | (Unaudited)
  Nine Months
  Ended September 30,
  2006 |           | Year Ended
  December 31,
  2005 |  
|                                                                                                                                    |  |                                                        |           |                                  |  
|Common stock                                                                                                                        |  |                                                        |           |                                  |   |         |  
|Balance  beginning of year                                                                                                         |  | $                                                      | 461       |                                  | $ | 461     |  
|Issuance of common stock                                                                                                            |  |                                                        | 180       |                                  |   |        |  
|                                                                                                                                    |  |                                                        |           |                                  |   |         |  
|Balance  end of period                                                                                                             |  |                                                        | 641       |                                  |   | 461     |  
|                                                                                                                                    |  |                                                        |           |                                  |   |         |  
|Additional paid-In Capital                                                                                                          |  |                                                        |           |                                  |   |         |  
|Balance  beginning of year                                                                                                         |  |                                                        | 605,951   |                                  |   | 603,247 |  
|Issuance of common stock                                                                                                            |  |                                                        | 340,982   |                                  |   |        |  
|Capital contributions                                                                                                               |  |                                                        | 34,232    |                                  |   | 2,704   |  
|                                                                                                                                    |  |                                                        |           |                                  |   |         |  
|Balance  end of period                                                                                                             |  |                                                        | 981,165   |                                  |   | 605,951 |  
|                                                                                                                                    |  |                                                        |           |                                  |   |         |  
|Retained Earnings                                                                                                                   |  |                                                        |           |                                  |   |         |  
|Balance  beginning of year                                                                                                         |  |                                                        | 281,709   |                                  |   | 201,263 |  
|Net income                                                                                                                          |  |                                                        | 81,549    |                                  |   | 80,446  |  
|                                                                                                                                    |  |                                                        |           |                                  |   |         |  
|Balance  end of period                                                                                                             |  |                                                        | 363,258   |                                  |   | 281,709 |  
|                                                                                                                                    |  |                                                        |           |                                  |   |         |  
|Accumulated Other Comprehensive Loss                                                                                                |  |                                                        |           |                                  |   |         |  
|Balance  beginning of year                                                                                                         |  |                                                        | (20,307   | )                                |   | (241    | )
|Net change in unrealized appreciation (depreciation)
 of investments, net of deferred
  tax benefit of $57 in 2006 and $792 in 2005 |  |                                                        | 2,652     |                                  |   | (20,066 | )
|                                                                                                                                    |  |                                                        |           |                                  |   |         |  
|Balance  end of period                                                                                                             |  |                                                        | (17,655   | )                                |   | (20,307 | )
|                                                                                                                                    |  |                                                        |           |                                  |   |         |  
|Total shareholders equity                                                                                                          |  | $                                                      | 1,327,409 |                                  | $ | 867,814 |  
|                                                                                                                                    |  |                                                        |           |                                  |   |         |  

See accompanying Notes to Unaudited Interim Consolidated
Financial Statements

5

---



SECURITY CAPITAL ASSURANCE LTDINTERIM CONSOLIDATED
STATEMENTS OF CASH FLOWS
(U.S. dollars in thousands)

|                                                                                              |  |                                           |          |      |   |          |  
|--------------------------------------------------------------------------------------------- |  | ----------------------------------------- | -------- | ---- | - | -------- | -
|                                                                                              |  | (Unaudited)Nine Months EndedSeptember 30, |         
|                                                                                              |  |                                           |         
|                                                                                              |  | 2006                                      |          | 2005 |  
|                                                                                              |  |                                           |          |      |  
|Cash provided by operating activities:                                                        |  |                                           |          |      |   |          |  
|Net income                                                                                    |  | $                                         | 81,549   |      | $ | 53,431   |  
|                                                                                              |  |                                           |          |      |   |          |  
|Adjustments to reconcile net income to net cash
provided by operating
  activities            |  |                                           |          |      |   |          |  
|Net realized losses on investments                                                            |  |                                           | 16,556   |      |   | 2,139    |  
|Net realized and unrealized losses on credit
derivatives                                      |  |                                           | 6,765    |      |   | 4,214    |  
|Amortization of premium on bonds                                                              |  |                                           | 2,721    |      |   | 3,191    |  
|Minority interest  dividends on redeemable
preferred shares                                  |  |                                           | 6,877    |      |   | 6,902    |  
|(Increase) in accrued investment income                                                       |  |                                           | (1,605   | )    |   | (801     | )
|(Increase) in deferred acquisition costs                                                      |  |                                           | (26,014  | )    |   | (11,505  | )
|Decrease (increase) prepaid reinsurance
premiums                                              |  |                                           | 20,956   |      |   | (7,991   | )
|(Increase) decrease in premiums
receivable                                                    |  |                                           | (7,454   | )    |   | 5,917    |  
|(Increase) in reinsurance balances recoverable on
unpaid losses                               |  |                                           | (1,093   | )    |   | (8,875   | )
|Increase in unpaid losses and loss adjustment
expenses                                        |  |                                           | 9,282    |      |   | 27,914   |  
|Increase in deferred premium revenue                                                          |  |                                           | 116,862  |      |   | 88,709   |  
|Increase in reinsurance premiums payable                                                      |  |                                           | 9,216    |      |   | 5,268    |  
|Other, net                                                                                    |  |                                           | 24,984   |      |   | (4,029   | )
|                                                                                              |  |                                           |          |      |   |          |  
|Total adjustments                                                                             |  |                                           | 178,053  |      |   | 111,053  |  
|                                                                                              |  |                                           |          |      |   |          |  
|Net cash provided by operating activities                                                     |  |                                           | 259,602  |      |   | 164,484  |  
|                                                                                              |  |                                           |          |      |   |          |  
|Cash flows from investing activities:                                                         |  |                                           |          |      |   |          |  
|Proceeds from sale of debt securities and short
term investments                              |  |                                           | 287,226  |      |   | 720,139  |  
|Proceeds from maturity of debt securities and short
term investments                          |  |                                           | 45,103   |      |   | 45,012   |  
|Purchase of debt securities and short term
investments                                        |  |                                           | (791,029 | )    |   | (943,051 | )
|                                                                                              |  |                                           |          |      |   |          |  
|Net cash used in investing activities                                                         |  |                                           | (458,700 | )    |   | (177,900 | )
|                                                                                              |  |                                           |          |      |   |          |  
|Cash flows from financing activities:                                                         |  |                                           |          |      |   |          |  
|Proceeds from issuance of common stock less
underwriters allowance
  and issuance costs paid |  |                                           | 344,175  |      |   |         |  
|Cash from contributed subsidiary                                                              |  |                                           | 7,304    |      |   |         |  
|Cash contributions from XL Capital Ltd                                                        |  |                                           | 15,028   |      |   |         |  
|Dividends on redeemable preferred shares                                                      |  |                                           | (3,685   | )    |   | (7,481   | )
|                                                                                              |  |                                           |          |      |   |          |  
|Net cash provided by (used in) financing
activities                                           |  |                                           | 362,822  |      |   | (7,481   | )
|                                                                                              |  |                                           |          |      |   |          |  
|Increase (decrease) in cash and cash
equivalents                                              |  |                                           | 163,724  |      |   | (20,897  | )
|                                                                                              |  |                                           |          |      |   |          |  
|Cash and cash equivalents-beginning of
year                                                   |  |                                           | 54,593   |      |   | 71,247   |  
|                                                                                              |  |                                           |          |      |   |          |  
|Cash and cash equivalents-end of period                                                       |  | $                                         | 218,317  |      | $ | 50,350   |  
|                                                                                              |  |                                           |          |      |   |          |  
|                                                                                              |  |                                           |          |      |   |          |  
|Supplemental Cash Flow Disclosure                                                             |  |                                           |          |      |   |          |  
|Tax refund received under tax sharing agreement                                               |  | $                                         | 759      |      | $ |         |  

See accompanying Notes to Unaudited Interim Consolidated
Financial Statements

6

---



SECURITY CAPITAL ASSURANCE LTD NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL
STATEMENTS

1. Organization and Ownership

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 guaranty insurance and financial
guaranty reinsurance operating businesses to SCA and selling an interest
therein to the public through an initial public offering of SCA common shares
(the IPO). The contribution of such businesses to SCA occurred on July 1,
2006 and the IPO was consummated on August 4, 2006  see Note 12. 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). Prior to the IPO, XLCA was an indirect wholly owned subsidiary
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). After the IPO, a secondary offering by XL
Capital, the exercise of the underwriters over-allotment option and restricted
share awards to management of SCA, XL Capitals ownership of SCAs outstanding
common shares represents approximately a 63% economic interest. As a
result of limitations on XL Capitals voting power contained in SCAs 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.  SCA,
XLCA, XLFA and all other subsidiaries of SCA (see Note 12) are hereafter
collectively referred to as the Company.

2. Basis of Presentation and Consolidation

The
unaudited interim consolidated financial statements have been
prepared in conformity with accounting principles generally accepted in the
United States of America (GAAP) and, in the opinion of management, reflect
all adjustments, consisting of normally recurring adjustments, necessary for a
fair presentation of the Companys financial condition, results of operations
and cash flows for the periods presented. These financial statements do not
include all of the information and footnotes required by GAAP for complete
financial statements. These consolidated interim financial statements of the
Company should be read in conjunction with the audited historical financial
statements of the Company as of December 31, 2005 and 2004 and for the years
ended December 31, 2005, 2004, and 2003 included in our Registration Statement
on Form S-1 (SEC File No. 333-133066).

For
all periods presented, certain expenses reflected in the financial statements
include allocations of expenses 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. 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 stand-alone entity during the periods presented.

The
results of operations for the interim period are not necessarily indicative of
the results that may be expected for the year ended December 31, 2006, as
interim results may be affected by several factors including, but not limited
to, changes in the economic environment. The preparation of financial
statements in conformity with GAAP requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities 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.

7

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

3. Credit Default Swaps

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

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

Changes
in the fair value of credit default swaps attributable to earnings from
premiums received by the Company from the issuance of such contracts are
recorded in the line item caption entitled 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 default 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 guaranty insurance industry for reporting the
results of such instruments.

The
Companys credit default swap portfolio generally requires the Company to meet
payment obligations for referenced credits within the portfolio in the event of
specific credit events after exhaustion of various first-loss protection
levels. These credit events are contract-specific, but generally cover
bankruptcy, failure to pay and repudiation. The Companys credit default swap portfolio
consists of structured pools of corporate obligations that were awarded
investment-grade ratings at the deals inception. At September 30, 2006, on a
net par basis, approximately 97.7% of the portfolio was rated AAA with the
remaining 2.3% rated at or above investment-grade and the weighted average term of
the contracts in-force was 12.7 years.

The
following tables present the amounts related to credit default swaps reflected
in our financial statements as of and for the periods indicated:

|                                                           |  |                      |        |                      |   |                      |   |                      |        |   |   |        |  
|---------------------------------------------------------- |  | -------------------- | ------ | -------------------- | - | -------------------- | - | -------------------- | ------ | - | - | ------ | -
|                                                           |  | Three Months Ended   |        | Nine Months Ended    |  
|                                                           |  |                      |        |                      |  
|(U.S. dollars
  in thousands)                              |  | September 30,
  2006 |        | September 30,
  2005 |   | September 30,
  2006 |   | September 30,
  2005 |       
|                                                           |  |                      |        |                      |   |                      |   |                      |       
|Statement
  of Operations:                                 |  |                      |        |                      |   |                      |   |                      |        |   |   |        |  
|Net premiums earned                                        |  | $                    | 6,309  |                      | $ | 5,132                |   | $                    | 17,029 |   | $ | 12,678 |  
|Net losses and loss
  adjustment expenses                  |  |                      | 513    |                      |   | 236                  |   |                      | 1,787  |   |   | 414    |  
|Net realized and
  unrealized losses on credit derivatives |  |                      | (3,216 | )                    |   | (1,919               | ) |                      | (6,765 | ) |   | (4,214 | )

8

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

|                                                         |  |                              |        |                             |   |        | 
|-------------------------------------------------------- |  | ---------------------------- | ------ | --------------------------- | - | ------ | 
|                                                         |  | As at
  September 30,
  2006 |        | As at
  December 31,
  2005 |  
|                                                         |  |                              |        |                             |  
|Balance
  sheet:                                         |  |                              |        |                             |  
|Reinsurance balances recoverable on unpaid losses        |  | $                            | 1,007  |                             | $ | 787    | 
|Other assets                                             |  |                              | 11,068 |                             |   | 14,605 | 
|Unpaid losses and loss adjustment expenses               |  |                              | 13,898 |                             |   | 11,890 | 
|Deferred premium revenue                                 |  |                              | 154    |                             |   | 205    | 
|Accounts payable, accrued expenses and other liabilities |  |                              | 2,876  |                             |   | 2,071  | 

4. 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 guaranty 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. The FASB arrived at a tentative decision during
the third quarter of 2006 which will form the basis of the forthcoming Exposure
Draft.  The Company will continue to
apply the accounting policies as disclosed in its audited historical consolidated
financial statements as of December 31, 2005 and 2004 and for the years ended
December 31, 2005, 2004, and 2003 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 implications of SFAS 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 a
material effect on the Companys financial condition or results of
operations.

9

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

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 effective for fiscal years
beginning after December 15, 2006. The adoption of FIN 48 is not expected to
have a material effect on the Companys financial condition or results of
operations.

In
September 2006, the FASB issued proposed FSP FAS 123(R)-e, Amendment of FASB
Staff Position FAS 123(R)-1, which addresses whether the modification of an
instrument in connection with an equity restructuring or a business combination
should be considered a modification for purposes of applying FSP FAS 123(R)-1,
Classification and Measurement of Freestanding Financial Instruments
Originally Issued in Exchange for Employee Services under FASB Statement No.
123(R).  The FASB staff has taken the
position that for instruments that were originally issued as employee
compensation and then exchanged or changed, where the only change is a change
to the terms of an award to reflect an equity restructuring or a business
combination that occurs when the holders are no longer employees, then no
change in the recognition and measurement (due to a change in classification)
of these instruments will result if, there is (i) no increase in value to the
holders of the instrument or (ii) the exchange or change in the terms of the
award is not made in contemplation of an equity restructuring or a business
combination and (iii) all holders of the same class of equity instruments (for
example, stock options) are treated in a similar manner.  These provisions must be applied in the
first reporting period beginning after the date the final FSP is posted to the
FASBs website.  This guidance is not
expected to have a significant impact on the Companys financial condition or
results of operations.

In
September 2006, the Securities and Exchange Commission (the SEC) issued Staff
Accounting Bulletin No.  108 (SAB
108), Considering the Effects of Prior Year Misstatements when Qualifying
Misstatements in Current Year Financial Statements, which provides
interpretive guidance on the consideration of the effects of prior year
misstatements in quantifying current year misstatements for the purpose of a
materiality assessment.  SAB 108 is
effective for companies with fiscal years ending after November 15, 2006 and is
required to be adopted by the Company in its fiscal year ending December 31,
2006.  However, early application is
encouraged in any report for an interim period filed after the publication of
this guidance.  The Company is currently
assessing the impact of the adoption of SAB 108.  The guidance is not expected to have a significant impact on the Companys financial condition or results of operations.

In September 2006, the FASB issued SFAS No.
157, Fair Value Measurements (SFAS 157) which defines fair value,
establishes a framework in generally accepted
accounting principles for measuring fair value, 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 will be effective for interim
and annual financial statements issued after January 1, 2008.  The Company is currently assessing the
impact of the adoption of SFAS 157.

5. Premiums Earned from Refunded and Called Bonds

Premiums earned include $0.4 million and $25.6 million for the three and nine months ended September 30, 2006, respectively, and $4.1 million and $4.3 million for the three and nine months ended September 30, 2005, respectively, related to refunded and called bonds.

10

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

6. Related Party Transactions

Services
Agreements with Affiliates

Prior
to the IPO, substantially all of the Companys personnel services were provided
by employees of affiliates of XL Capital.
In connection with the IPO, such employees have become employees of the
Company.  In addition, the Company
purchased various services from affiliates of XL Capital prior to the IPO 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 and certain investment management
services, and (iv) certain advertising services. For the three and nine months ended September 30, 2006,
the Company incurred costs under the aforementioned agreements aggregating
$15.6 million and $42.8 million, respectively, compared to $8.5 million and $46.6 million for the three and nine months ended September 30, 2005,
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 three and nine months
ended September 30, 2006, the Company incurred costs under the
aforementioned plans aggregating $0.7 million and $2.0 million, respectively, compared to $0.4 million and $1.7 million for the three and nine months ended September 30, 2005, respectively, which are reflected in operating
expenses in the accompanying consolidated statements of operations.

Reinsurance
Agreements With Affiliates and Other Guaranties

The
Company has the following reinsurance and other 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 9 (a). In consideration for the aforementioned indemnifications the
  Company is obligated to pay 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 three and nine
  months ended September 30, 2006, the Company incurred costs under the
  aforementioned agreements aggregating approximately $0.2 million.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |  | 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 9 (b), which notes and preferred shares were acquired in
  connection with the satisfaction of a claim under a financial guaranty
  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.
  The aforementioned notes and preferred shares are reflected in the
  accompanying consolidated balance sheets in other
  invested assets. This indemnity was provided by XLA at no cost to XLCA.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

11

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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 automatically reinsure risks insured by XLCA under financial guaranty
  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.
  The reinsurance provided by XL RE AM may be on an excess of loss or quota
  share basis. 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 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.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |  | XLFA has entered into the
  following reinsurance agreements with XLI:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |   | (a)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | 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 reinsured by XLFA that are in excess of certain limits and are not
  covered by retrocessional 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. For the three and nine month periods ended September
  30, 2006, the Company incurred expense under this agreement of
  approximately $0.1 million and $0.4 million, respectively, compared to approximately $0.1 million and $0.4 million for the three and nine month periods ended September 30, 2005, respectively.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |   | (b)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | Effective August 17, 2001,
  XLFA entered into a facultative quota share reinsurance treaty with XLI. This
  treaty allows XLFA to propose to cede to XLI a portion of a risk, which risk
  XLI may then accept or reject in its sole discretion. Under this treaty, XLI
  pays XLFA a ceding commission of 30% on the premiums ceded under this treaty
  unless otherwise specified.  On August
  4, 2006, XLFA and XLI terminated certain reinsurance cessions ceded under
  this agreement to XLI.  As a result of
  the termination of certain of these cessions, 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.                                                                                                                                                                                                                   
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |   | (c)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | Effective December 31,
  1999, XLFA entered into a facultative quota share reinsurance treaty with
  XLI. This treaty allows XLI to propose to cede to XLFA a portion of a risk it
  insured, which risk XLFA may then accept or reject in its sole discretion.
  Under this treaty, XLFA pays XLI a ceding commission of 12% on the premiums
  ceded under this treaty unless otherwise specified.  On August 4, 2006, XLFA and XLI agreed to cancel from inception
  the reinsurance of certain business ceded under this arrangement.  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 August 4,
  2006, XLFA entered into certain reinsurance cessions  with XLI pursuant to the aforementioned
  facultative quota share reinsurance treaty.
  As a result of these cessions, 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |  | XLFA has entered into the
  following reinsurance agreements with certain subsidiaries and affiliates of
  FSAH (hereafter referred to as FSA). Premiums assumed from FSA represented
  55.2% and 52.0% of the Companys total reinsurance premiums assumed for the
  three and nine month periods ended September 30, 2006, respectively, as
  compared to 82.4% and 77.7% for the comparable periods in 2005. All of the
  agreements discussed below may be terminated under certain conditions, as
  defined in the agreements:                                                                                                                                                                                                                                                                                                                          

12

---



SECURITY CAPITAL ASSURANCE LTD 
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | (a)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | Effective November 3,
  1998, XLFA entered into a master facultative reinsurance agreement with FSA.
  This agreement allows FSA to propose to cede a portion of a risk insured by
  it to XLFA, which risk XLFA may then accept or reject solely in its
  discretion. The ceding commission that XLFA pays FSA on the premiums ceded
  under this agreement is determined on a case-by-case basis. XLFAs
  obligations under this agreement are guarantied by XLI.  Effective upon our IPO, this guaranty is
  terminated with respect to all new business assumed by XLFA under this
  agreement, but the guaranty remains in effect with respect to cessions
  under the agreement prior to the IPO.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |   | (b)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | Effective January 1, 2004,
  XLFA entered into a reinsurance treaty with FSA to reinsure certain policies
  FSA issued insuring the timely payment of the principal of and interest on
  certain asset-backed securities and pools of consumer debt obligations.                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |   | (c)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | Effective January 1, 2004,
  XLFA entered into a reinsurance treaty with FSA to reinsure certain policies
  FSA issued insuring the timely payment of the principal and interest on securities
  and obligations that provide financing for governmental or public purpose
  infrastructure projects located outside of the United States and its
  territories, excluding certain countries.                                                                                                                                                                                                                                                                                                           
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |  | XLFA has guarantied
  certain of XLIs obligations in connection with certain transactions where
  XLIs customer required such credit enhancement. Each of these transactions
  has a double trigger structure, meaning that 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 guaranty and XLI
  grants XLFA a security interest in a portion of the payments received by it
  from its client. As of September 30, 2006 and December 31, 2005, XLFAs aggregate net par
  outstanding relating to such guaranties was $526.8 million.                                                                                                                                                                                                     
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  | Effective May 1, 2004, XLI
  entered into an agreement with XLCA which unconditionally and irrevocably
  guaranties 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 guarantied by XLI under this
  agreement was approximately $93.8 billion as of September 30, 2006. The XLI
  guaranty 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.                                                                                                                                                                                                                                     
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |  | The Company provides
  financial guaranty insurance policies insuring timely payment of investment
  agreements issued by XL Asset Funding Company I LLC (XLAF), an affiliate of
  the Company. As of September 30, 2006 and December 31, 2005, the aggregate face amount of
  such investment agreements insured by the Company was $4.0 billion and $3.7
  billion, respectively. In addition, the Company insures XLAFs obligations
  under certain derivative contracts issued and purchased by XLAF. As of
  September 30, 2006 the total notional value of such contracts insured was
  $179.1 million. For the three months ended September 30, 2006 and 2005, the Company recorded earned premiums of $1.0 million and $0.8 million, respectively from such business. For the nine months ended September 30, 2006 and 2005, the Company recorded earned premiums of $2.9 million and $2.2 million, respectively from such business.

13

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

7. 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 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  see Note 12).
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. 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. As of September 30, 2006 and December 31,
2005, the Company had a U.S. federal income tax payable of $2.6 million and
$1.0 million, respectively.

As of September 30, 2006 and December 31, 2005, the
Company had deferred income tax assets of $18.1 million and $18.8 million,
respectively.  As of December 31, 2005,
the Company established a valuation allowance relating to net unrealized
capital losses and a net realized capital loss carry forward. The valuation
allowance at September 30, 2006 of $1.7 million and December 31, 2005 of $0.9 million relates to net unrealized
capital losses and a net realized capital loss carry forward that may not be
realized within a reasonable period.  At
September 30, 2006, the Company has net unrealized capital losses and a net
realized capital loss carry forward of approximately $3.1 million and $1.9
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.

8. Segments

The
Companys business activities are organized and managed in two operating segments:
financial guaranty insurance and financial guaranty reinsurance. These segments
are managed separately because they provide different products or services to
different customers, are subject to different regulation, and require different
strategies.

Products
comprising the financial guaranty insurance segment primarily include
financial  guaranty insurance of public
finance and structured finance debt securities and credit default swaps.
Products comprising the reinsurance segment primarily include reinsurance of
financial guaranty insurance products issued by financial guaranty insurance
companies.

14

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

Set
forth in the tables below is certain financial information with respect to the
Companys operating segments for each of the three-month and nine-month periods
ended September 30, 2006 and 2005. The accounting policies of the segments are
the same as those described in the summary of significant accounting policies
included in the notes to the Companys audited historical financial statements
as of December 31, 2005 and 2004 and the years ended December 31, 2005, 2004
and 2003 included in our Registration Statement on Form S-1 (SEC File No.
333-133066). 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.

|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|-------------------------------------------------------------- |  | --------------------------------------- | ------- | ---------------------------------- | - | ------- | - | - | ------- | -
|                                                               |  | Three
  Months Ended September 30, 2006 |        
|                                                               |  |                                         |        
|(U.S. dollars in thousands)                                    |  | Financial
  Guaranty
  Insurance        |         | Financial
  Guaranty
  Reinsurance |   | Total   |  
|                                                               |  |                                         |         |                                    |   |         |  
|Gross premiums written                                         |  | $                                       | 65,081  |                                    | $ |        |   | $ | 65,081  |  
|Reinsurance premiums assumed                                   |  |                                         |        |                                    |   | 20,489  |   |   | 20,489  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Total premiums written                                         |  |                                         | 65,081  |                                    |   | 20,489  |   |   | 85,570  |  
|Ceded premiums                                                 |  |                                         | 14,908  |                                    |   |        |   |   | 14,908  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net premiums written                                           |  |                                         | 79,989  |                                    |   | 20,489  |   |   | 100,478 |  
|Change in net deferred premium revenue                         |  |                                         | (41,550 | )                                  |   | (13,473 | ) |   | (55,023 | )
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net premiums earned                                            |  |                                         | 38,439  |                                    |   | 7,016   |   |   | 45,455  |  
|Fee income and other                                           |  |                                         | 59      |                                    |   |        |   |   | 59      |  
|Net losses and loss adjustment expenses                        |  |                                         | 4,302   |                                    |   | 692     |   |   | 4,994   |  
|Acquisition costs, net                                         |  |                                         | 4,232   |                                    |   | 1,592   |   |   | 5,824   |  
|Operating expenses                                             |  |                                         | 16,731  |                                    |   | 1,395   |   |   | 18,126  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Underwriting profit                                            |  | $                                       | 13,233  |                                    | $ | 3,337   |   |   | 16,570  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net investment income                                          |  |                                         |         |                                    |   |         |   |   | 21,835  |  
|Corporate expenses                                             |  |                                         |         |                                    |   |         |   |   | 2,735   |  
|Net realized losses on investments                             |  |                                         |         |                                    |   |         |   |   | (156    | )
|Net realized and unrealized losses on
  credit derivatives     |  |                                         |         |                                    |   |         |   |   | (3,216  | )
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Income before income tax and minority
  interest               |  |                                         |         |                                    |   |         |   |   | 32,298  |  
|Income tax expense                                             |  |                                         |         |                                    |   |         |   |   | 2,747   |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Income before minority interest                                |  |                                         |         |                                    |   |         |   |   | 29,551  |  
|Minority interest  dividends on redeemable
  preferred shares |  |                                         |         |                                    |   |         |   |   | 1,139   |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net income                                                     |  |                                         |         |                                    |   |         |   | $ | 28,412  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  

15

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|-------------------------------------------------------------- |  | --------------------------------------- | ------- | ---------------------------------- | - | ------- | - | - | ------- | -
|                                                               |  | Three
  Months Ended September 30, 2005 |        
|                                                               |  |                                         |        
|(U.S. dollars in thousands)                                    |  | Financial
  Guaranty
  Insurance        |         | Financial
  Guaranty
  Reinsurance |   | Total   |  
|                                                               |  |                                         |         |                                    |   |         |  
|Gross premiums written                                         |  | $                                       | 63,757  |                                    | $ |        |   | $ | 63,757  |  
|Reinsurance premiums assumed                                   |  |                                         |        |                                    |   | 19,222  |   |   | 19,222  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Total premiums written                                         |  |                                         | 63,757  |                                    |   | 19,222  |   |   | 82,979  |  
|Ceded premiums                                                 |  |                                         | (9,435  | )                                  |   |        |   |   | (9,435  | )
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net premiums written                                           |  |                                         | 54,322  |                                    |   | 19,222  |   |   | 73,544  |  
|Change in net deferred premium revenue                         |  |                                         | (22,156 | )                                  |   | (10,252 | ) |   | (32,408 | )
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net premiums earned                                            |  |                                         | 32,166  |                                    |   | 8,970   |   |   | 41,136  |  
|Fee income and other                                           |  |                                         |        |                                    |   |        |   |   |        |  
|Net losses and loss adjustment expenses                        |  |                                         | 1,875   |                                    |   | (780    | ) |   | 1,095   |  
|Acquisition costs, net                                         |  |                                         | 1,418   |                                    |   | 1,817   |   |   | 3,235   |  
|Operating expenses                                             |  |                                         | 15,012  |                                    |   | 1,674   |   |   | 16,686  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Underwriting profit                                            |  | $                                       | 13,861  |                                    | $ | 6,259   |   |   | 20,120  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net investment income                                          |  |                                         |         |                                    |   |         |   |   | 13,259  |  
|Corporate expenses                                             |  |                                         |         |                                    |   |         |   |   |        |  
|Net realized losses on investments                             |  |                                         |         |                                    |   |         |   |   | (768    | )
|Net realized and unrealized losses on
  credit derivatives     |  |                                         |         |                                    |   |         |   |   | (1,919  | )
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Income before income tax and minority
  interest               |  |                                         |         |                                    |   |         |   |   | 30,692  |  
|Income tax benefit                                             |  |                                         |         |                                    |   |         |   |   | (632    | )
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Income before minority interest                                |  |                                         |         |                                    |   |         |   |   | 31,324  |  
|Minority interest  dividends on redeemable
  preferred shares |  |                                         |         |                                    |   |         |   |   | (49     | )
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net income                                                     |  |                                         |         |                                    |   |         |   | $ | 31,373  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  

16

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

|                                                               |  |                                        |          |                                    |   |         |   |   |          |  
|-------------------------------------------------------------- |  | -------------------------------------- | -------- | ---------------------------------- | - | ------- | - | - | -------- | -
|                                                               |  | Nine
  Months Ended September 30, 2006 |         
|                                                               |  |                                        |         
|(U.S. dollars in thousands)                                    |  | Financial
  Guaranty
  Insurance       |          | Financial
  Guaranty
  Reinsurance |   | Total   |  
|                                                               |  |                                        |          |                                    |   |         |  
|Gross premiums written                                         |  | $                                      | 235,212  |                                    | $ |        |   | $ | 235,212  |  
|Reinsurance premiums assumed                                   |  |                                        |         |                                    |   | 40,184  |   |   | 40,184   |  
|                                                               |  |                                        |          |                                    |   |         |   |   |          |  
|Total premiums written                                         |  |                                        | 235,212  |                                    |   | 40,184  |   |   | 275,396  |  
|Ceded premiums                                                 |  |                                        | 1,156    |                                    |   |        |   |   | 1,156    |  
|                                                               |  |                                        |          |                                    |   |         |   |   |          |  
|Net premiums written                                           |  |                                        | 236,368  |                                    |   | 40,184  |   |   | 276,552  |  
|Change in net deferred premium revenue                         |  |                                        | (118,292 | )                                  |   | (19,451 | ) |   | (137,743 | )
|                                                               |  |                                        |          |                                    |   |         |   |   |          |  
|Net premiums earned                                            |  |                                        | 118,076  |                                    |   | 20,733  |   |   | 138,809  |  
|Fee income and other                                           |  |                                        | 2,290    |                                    |   |        |   |   | 2,290    |  
|Net losses and loss adjustment expenses                        |  |                                        | 9,149    |                                    |   | 2,174   |   |   | 11,323   |  
|Acquisition costs, net                                         |  |                                        | 8,561    |                                    |   | 4,487   |   |   | 13,048   |  
|Operating expenses                                             |  |                                        | 46,776   |                                    |   | 5,937   |   |   | 52,713   |  
|                                                               |  |                                        |          |                                    |   |         |   |   |          |  
|Underwriting profit                                            |  | $                                      | 55,880   |                                    | $ | 8,135   |   |   | 64,015   |  
|                                                               |  |                                        |          |                                    |   |         |   |   |          |  
|Net investment income                                          |  |                                        |          |                                    |   |         |   |   | 53,026   |  
|Corporate expenses                                             |  |                                        |          |                                    |   |         |   |   | 2,735    |  
|Net realized losses on investments                             |  |                                        |          |                                    |   |         |   |   | (16,556  | )
|Net realized and unrealized losses on
  credit derivatives     |  |                                        |          |                                    |   |         |   |   | (6,765   | )
|                                                               |  |                                        |          |                                    |   |         |   |   |          |  
|Income before income tax and minority
  interest               |  |                                        |          |                                    |   |         |   |   | 90,985   |  
|Income tax expense                                             |  |                                        |          |                                    |   |         |   |   | 2,559    |  
|                                                               |  |                                        |          |                                    |   |         |   |   |          |  
|Income before minority interest                                |  |                                        |          |                                    |   |         |   |   | 88,426   |  
|Minority interest  dividends on redeemable
  preferred shares |  |                                        |          |                                    |   |         |   |   | 6,877    |  
|                                                               |  |                                        |          |                                    |   |         |   |   |          |  
|Net income                                                     |  |                                        |          |                                    |   |         |   | $ | 81,549   |  
|                                                               |  |                                        |          |                                    |   |         |   |   |          |  

17

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

|                                                               |  |                                        |         |                                    |   |         |   |   |         |  
|-------------------------------------------------------------- |  | -------------------------------------- | ------- | ---------------------------------- | - | ------- | - | - | ------- | -
|                                                               |  | Nine
  Months Ended September 30, 2005 |        
|                                                               |  |                                        |        
|(U.S. dollars in thousands)                                    |  | Financial
  Guaranty
  Insurance       |         | Financial
  Guaranty
  Reinsurance |   | Total   |  
|                                                               |  |                                        |         |                                    |   |         |  
|Gross premiums written                                         |  | $                                      | 179,812 |                                    | $ |        |   | $ | 179,812 |  
|Reinsurance premiums assumed                                   |  |                                        |        |                                    |   | 37,073  |   |   | 37,073  |  
|                                                               |  |                                        |         |                                    |   |         |   |   |         |  
|Total premiums written                                         |  |                                        | 179,812 |                                    |   | 37,073  |   |   | 216,885 |  
|Ceded premiums                                                 |  |                                        | (29,336 | )                                  |   |        |   |   | (29,336 | )
|                                                               |  |                                        |         |                                    |   |         |   |   |         |  
|Net premiums written                                           |  |                                        | 150,476 |                                    |   | 37,073  |   |   | 187,549 |  
|Change in net deferred premium revenue                         |  |                                        | (67,431 | )                                  |   | (13,287 | ) |   | (80,718 | )
|                                                               |  |                                        |         |                                    |   |         |   |   |         |  
|Net premiums earned                                            |  |                                        | 83,045  |                                    |   | 23,786  |   |   | 106,831 |  
|Fee income and other                                           |  |                                        | 750     |                                    |   |        |   |   | 750     |  
|Net losses and loss adjustment expenses                        |  |                                        | 21,822  |                                    |   | (1,778  | ) |   | 20,044  |  
|Acquisition costs, net                                         |  |                                        | 3,651   |                                    |   | 5,669   |   |   | 9,320   |  
|Operating expenses                                             |  |                                        | 44,037  |                                    |   | 5,978   |   |   | 50,015  |  
|                                                               |  |                                        |         |                                    |   |         |   |   |         |  
|Underwriting profit                                            |  | $                                      | 14,285  |                                    | $ | 13,917  |   |   | 28,202  |  
|                                                               |  |                                        |         |                                    |   |         |   |   |         |  
|Net investment income                                          |  |                                        |         |                                    |   |         |   |   | 36,829  |  
|Corporate expenses                                             |  |                                        |         |                                    |   |         |   |   |        |  
|Net realized losses on investments                             |  |                                        |         |                                    |   |         |   |   | (2,139  | )
|Net realized and unrealized losses on
  credit derivatives     |  |                                        |         |                                    |   |         |   |   | (4,214  | )
|                                                               |  |                                        |         |                                    |   |         |   |   |         |  
|Income before income tax and minority
  interest               |  |                                        |         |                                    |   |         |   |   | 58,678  |  
|Income tax benefit                                             |  |                                        |         |                                    |   |         |   |   | (1,655  | )
|                                                               |  |                                        |         |                                    |   |         |   |   |         |  
|Income before minority interest                                |  |                                        |         |                                    |   |         |   |   | 60,333  |  
|Minority interest  dividends on redeemable
  preferred shares |  |                                        |         |                                    |   |         |   |   | 6,902   |  
|                                                               |  |                                        |         |                                    |   |         |   |   |         |  
|Net income                                                     |  |                                        |         |                                    |   |         |   | $ | 53,431  |  
|                                                               |  |                                        |         |                                    |   |         |   |   |         |  

|   |                                                  
|-- | -------------------------------------------------
|9. | Liability for Losses and Loss Adjustment Expenses

The
Companys liability for losses and loss adjustment expenses consists of case
basis reserves and unallocated reserves. Activity in the liability for losses
and loss adjustment expenses is summarized as follows:

18

---



SECURITY CAPITAL ASSURANCE LTD 
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

|                                                                                                  |  |                                            |         |                                    |   |                 |   |                        |         |   |   |         |  
|------------------------------------------------------------------------------------------------- |  | ------------------------------------------ | ------- | ---------------------------------- | - | --------------- | - | ---------------------- | ------- | - | - | ------- | -
|                                                                                                  |  | Nine
  Months Ended
  September 30,
  2006 |         | Year
  Ended
  December 31,
  2005 |  
|                                                                                                  |  |                                            |         |                                    |  
|(U.S. dollars in thousands)                                                                       |  | Case
  Reserves                            |         | Unallocated
  Reserves             |   | Case
  Reserves |   | Unallocated
  Reserves |        
|                                                                                                  |  |                                            |         |                                    |   |                 |   |                        |        
|Unpaid losses and loss adjustment expenses
  at beginning of year                                 |  | $                                          | 69,382  |                                    | $ | 77,986          |   | $                      | 50,771  |   | $ | 64,963  |  
|Reinsurance balances recoverable on unpaid
  losses                                               |  |                                            | (52,316 | )                                  |   | (16,901         | ) |                        | (43,407 | ) |   | (17,507 | )
|                                                                                                  |  |                                            |         |                                    |   |                 |   |                        |         |   |   |         |  
|Net unpaid losses and loss adjustment
  expenses at beginning of year                             |  |                                            | 17,066  |                                    |   | 61,085          |   |                        | 7,364   |   |   | 47,456  |  
|Increase in net losses and loss adjustment
  expenses incurred in respect of losses occurring in: |  |                                            |         |                                    |   |                 |   |                        |         |   |   |         |  
|Current year                                                                                      |  |                                            |        |                                    |   | 9,935           |   |                        | 12,392  |   |   | 13,629  |  
|Prior years                                                                                       |  |                                            | 1,388   |                                    |   |                |   |                        |        |   |   |        |  
|                                                                                                  |  |                                            |         |                                    |   |                 |   |                        |         |   |   |         |  
|                                                                                                 
|Total net incurred losses and loss
  adjustment expenses                                          |  |                                            | 1,388   |                                    |   | 9,935           |   |                        | 12,392  |   |   | 13,629  |  
|Less net losses and loss adjustment
  expenses paid                                               |  |                                            | (3,134  | )                                  |   |                |   |                        | (2,690  | ) |   |        |  
|                                                                                                  |  |                                            |         |                                    |   |                 |   |                        |         |   |   |         |  
|Net unpaid losses and loss adjustment
  expenses at end of period                                 |  |                                            | 15,320  |                                    |   | 71,020          |   |                        | 17,066  |   |   | 61,085  |  
|Reinsurance balances recoverable on unpaid
  losses                                               |  |                                            | 52,745  |                                    |   | 17,565          |   |                        | 52,316  |   |   | 16,901  |  
|                                                                                                  |  |                                            |         |                                    |   |                 |   |                        |         |   |   |         |  
|Unpaid losses and loss adjustment expenses
at end of period                                       |  | $                                          | 68,065  |                                    | $ | 88,585          |   | $                      | 69,382  |   | $ | 77,986  |  
|                                                                                                  |  |                                            |         |                                    |   |                 |   |                        |         |   |   |         |  

Set
forth below is a discussion of certain case basis reserves established by the
Company. 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.

| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (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 unearned premium 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
  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. There was no change in the Companys carried reserve with
  respect to this insured project financing during the three and nine months
  ended September 30, 2006. The total remaining par insured by the Company in
  connection with this transaction (net of applicable carried case reserves),
  which amortizes over the next 12 years, aggregated approximately $164.9
  million at September 30, 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. Pursuant to an agreement entered into with XL
  Capital, which became effective on the date of the IPO, XL Capital agreed to
  indemnify the Company for all losses and loss adjustment expenses relating to
  this insured transaction in excess of its carried reserve at the effective
  date of the agreement (see Note 6).

19

---



SECURITY CAPITAL ASSURANCE LTD 
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (b) | In December
  2005, certain notes which 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 are reflected in the accompanying consolidated
  balance sheets 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 which, as previously discussed,
  consisted of loans to medical providers. Certain of these loans were made to
  Intrepid USA Healthcare Services (Intrepid), a national provider of home
  nursing services to patients with acute illnesses. Intrepid declared
  bankruptcy in 2004. On February 3, 2006, Intrepid emerged from bankruptcy. In
  connection therewith, in February 2006, the Company accepted preferred stock
  of Intrepid in exchange for the cancellation of a portion of the Insured
  Notes. This preferred stock represented a 49% ownership interest in Intrepid.
  In connection with, and critical to, Intrepids emergence from bankruptcy was
  certain exit financing obtained by Intrepid. Pursuant to the terms of the
  related credit agreement, Intrepid must achieve certain financial targets
  over certain periods of time. In certain cases, if such targets are not met,
  the provider of such financing can foreclose on all ownership interest in
  Intrepid. During the three months ended March 31, 2006, the Company
  recognized an impairment charge aggregating $5.0 million
  pre-tax on the Insured Notes and the preferred stock in Intrepid. At March
  31, 2006, the carrying value of the Insured Notes and preferred stock was
  $2.1 million and $10.1 million, respectively.                                                     
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |     | In June
  2006, in recognition of the challenges facing Intrepid in achieving the
  aforementioned financial targets, the Company and other equity holders and
  creditors in Intrepid, negotiated an agreement in principle to effect a
  restructuring of Intrepids capitalization. Pursuant to the restructuring,
  the Companys ownership interest in Intrepid was to be reduced from 49% to
  approximately 12%. Accordingly, the Company recognized an impairment charge
  of approximately $9.0 million on its investment in Intrepid as of June 30,
  2006 reflecting managements best estimate of the value of such investment at
  that date, which considered the aforementioned restructuring and an updated
  forecast of Intrepids expected future operating performance, as well as a
  valuation of the Companys investment in Intrepid by an outside valuation
  consulting firm. During the three months ended September 30, 2006, one of
  Intrepids creditors (the provider of its bankruptcy exit financing) rejected
  the agreement in principle and foreclosed on the Companys preferred shares.
  As a result, the Company wrote-off the remaining carrying value of its investment
  in Intrepid of approximately $1.1 million. The Company is fully indemnified
  for this charge by XLA pursuant to an agreement entered into at the effective
  date of the IPO (see note 6). Also during the three months ended September
  30, 2006, the Company received payment in full on the Insured Notes.
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | (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. There was no change in the
  Companys carried reserve during the three and nine months ended September
  30, 2006. The total remaining par insured by the Company in connection with
  these transactions aggregated approximately $181.6 million ($118.4 million
  net of reinsurance) at September 30, 2006, and amortizes over many years into
  the future. The estimate of loss was based on assumptions and estimates
  extending over many years into the future. There is currently no payment
  default with respect to these transactions. Management continues to monitor the
  exposure and will revise its loss estimate if necessary, as new information
  becomes available.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

20

---



SECURITY CAPITAL ASSURANCE LTD 
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

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.

10. Earnings Per Share

Basic
earnings per share is computed by dividing net income by the weighted average
number of common shares outstanding during the period excluding the dilutive
effect of stock option and restricted stock awards outstanding. Diluted
earnings per share is computed by dividing net income by the weighted average
number of common shares outstanding including the dilutive effect stock option
and restricted stock awards outstanding.

The
following table sets forth the computation of basic and diluted earnings per
share:

|                                                  |  |                                       |        |                                      |   |        |  |      |        |  |   |        | 
|------------------------------------------------- |  | ------------------------------------- | ------ | ------------------------------------ | - | ------ |  | ---- | ------ |  | - | ------ | 
|                                                  |  | Three
  Months Ended 
  September 30, |        | Nine
  Months Ended 
  September 30, |  
|(U.S. Dollars in thousands, except share amounts) |  | 2006                                  |        | 2005                                 |   | 2006   |  | 2005 |       
|                                                  |  |                                       |        |                                      |  
|                                                  |  |                                       |        |                                      |   |        |  |      |        |  |   |        | 
|Net income                                        |  | $                                     | 28,412 |                                      | $ | 31,373 |  | $    | 81,549 |  | $ | 53,431 | 
|                                                  |  |                                       |        |                                      |   |        |  |      |        |  |   |        | 
|                                                  |  |                                       |        |                                      |   |        |  |      |        |  |   |        | 
|Basic shares
  (1)                                |  |                                       | 58,068 |                                      |   | 46,127 |  |      | 50,151 |  |   | 46,127 | 
|Common stock
  equivalents                        |  |                                       | 27     |                                      |   |       |  |      | 9      |  |   |       | 
|                                                  |  |                                       |        |                                      |   |        |  |      |        |  |   |        | 
|Diluted
  shares (1)                              |  |                                       | 58,095 |                                      |   | 46,127 |  |      | 50,160 |  |   | 46,127 | 
|                                                  |  |                                       |        |                                      |   |        |  |      |        |  |   |        | 
|                                                  |  |                                       |        |                                      |   |        |  |      |        |  |   |        | 
|Net income:                                       |  |                                       |        |                                      |   |        |  |      |        |  |   |        | 
|Basic EPS                                         |  | $                                     | 0.49   |                                      | $ | 0.68   |  | $    | 1.63   |  | $ | 1.16   | 
|                                                  |  |                                       |        |                                      |   |        |  |      |        |  |   |        | 
|Diluted EPS                                       |  | $                                     | 0.49   |                                      | $ | 0.68   |  | $    | 1.63   |  | $ | 1.16   | 
|                                                  |  |                                       |        |                                      |   |        |  |      |        |  |   |        | 

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Amounts for
  the three and nine months ended September 30, 2005 are 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 IPO. The accompanying Consolidated Financial
  Statements and share amounts have been retroactively adjusted for the effects
  of such stock split.

11. Stock-Based Compensation

Effective
August 4, 2006 the Board of Directors of the Company adopted the 2006 Long-Term
Incentive and Share Award Plan, which we refer to as the Plan. The Plan
provides for the grant 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 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.

21

---



SECURITY CAPITAL ASSURANCE LTD
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)

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.

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 three and nine months ended September 30, 2006, the Company recognized
approximately $0.2 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:

22

---



SECURITY CAPITAL ASSURANCE LTD 
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

|                          |  |  |                                                    |  
|------------------------- |  |  | -------------------------------------------------- | -
|                          |  |  | Three and Nine
  Months Ended
  September 30, 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 September 30, 2006, and related activity for the nine months ended
September 30, 2006

|                                    |  |                    |           |                                       |   |                                                     |  |                                 |            |  |   |           | 
|----------------------------------- |  | ------------------ | --------- | ------------------------------------- | - | --------------------------------------------------- |  | ------------------------------- | ---------- |  | - | --------- | 
|                                    |  | Number of
  Shares |           | Weighted
  Average
  Exercise
  Price |   | Weighted
  Average
  Remaining
  Contractual
  Term |  | Aggregate 
  Intrinsic 
  Value |           
|                                    |  |                    |           |                                       |   |                                                     |  |                                 |           
|Outstanding
   beginning of period |  |                    | 0         |                                       |   |                                                     |  |                                 |            |  |   |           | 
|Granted                             |  |                    | 647,963   |                                       | $ | 20.50                                               |  |                                 |            |  |   |           | 
|Exercised                           |  |                    | 0         |                                       |   |                                                     |  |                                 |            |  |   |           | 
|Cancelled                           |  |                    | 0         |                                       |   |                                                     |  |                                 |            |  |   |           | 
|                                    |  |                    |           |                                       |   |                                                     |  |                                 |            |  |   |           | 
|Outstanding
   end of period       |  |                    | 647,963   |                                       | $ | 20.50                                               |  |                                 | 7.65 years |  | $ | 2,235,472 | 
|                                    |  |                    |           |                                       |   |                                                     |  |                                 |            |  |   |           | 
|Options
  exercisable               |  |                    | 0         |                                       |   |                                                     |  |                                 |            |  |   |           | 
|                                    |  |                    |           |                                       |   |                                                     |  |                                 |            |  |   |           | 
|Options
  available for grant*      |  |                    | 2,699,791 |                                       |   |                                                     |  |                                 |            |  |   |           | 
|                                    |  |                    |           |                                       |   |                                                     |  |                                 |            |  |   |           | 




* Available
for grant includes all shares that are available to be granted under the
Companys Plan at September 30, 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 third quarter of fiscal 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
September 30, 2006. Total unrecognized stock based compensation expense related
to non-vested stock options was approximately $3.6 million as of the end of
September 30, 2006, related to approximately 647,963 options, which is expected
to be recognized over a weighted-average period of 2.4 years.

23

---



SECURITY CAPITAL ASSURANCE LTD 
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

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 three and nine months ended
September 30, 2006, SCA recognized approximately $0.5 million of compensation
expense related to its restricted stock awards. There were no restricted stock
vested or forfeited during the nine months ended September 30, 2006.          Total
unrecognized stock based compensation expense related to non-vested restricted
stock was approximately $9.8 million at September 30, 2006, which is expected
to be recognized over a weighted-average period of 4.3 years.

12. Other Matters

Contribution of Operating and Other
Subsidiaries to SCA and Formation Transactions 

Effective
July 1, 2006, XL Insurance (Bermuda) Ltd (XLI) contributed to the Company
all its and XL Capitals direct and indirect ownership interest in XLCA, XLFA,
and XL Financial Administrative Services Inc. (XLFAS). In addition, all
Formation Transactions described in the Companys Registration Statement on
Form S-1 (SEC File No. 333-133066) were consummated on the effective date of
the IPO other than the receipt by SCA of a capital contribution from XL Capital
of what was estimated to be $8.4 million relating to the conversion to SCAs long-term compensation plans of certain
eligible compensation awarded by XL Capital under its long-term compensation plans to SCA employees. The final
amount and timing of such capital contribution will be determined once a
conversion plan is finalized by the managements and boards of directors of SCA
and XL Capital. The Company currently expects that the conversion plan will be
finalized by the end of the current fiscal year.

XLFAS
will be the employer of personnel providing services exclusively to XLCA and
certain other SCA owned companies. In addition, at the date of the contribution
of XLFAS to SCA, XLFASs assets consisted solely of certain fixed assets
(consisting of leasehold improvements, software, and furniture and fixtures)
and cash. The aggregate carrying value of XLFASs net assets was approximately
$15.4 million at July 1, 2006.

Proceeds from IPO 

In
connection with 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 $5.9 million
resulting in estimated net proceeds of approximately $341.1 million. Of the net
proceeds, $25.0 million and $175.0 million were contributed to the Companys
insurance and reinsurance businesses, respectively, to support their continuing
growth, and $141.1 million was retained at the holding company. Of the proceeds
retained at the holding company, the Company intends to retain less than 10% of
such proceeds for general corporate purposes and to contribute over time the
balance of such proceeds to the capital of its insurance and reinsurance
subsidiaries to support future growth in their respective businesses.

24

---



SECURITY CAPITAL ASSURANCE LTD 
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(continued)

Commitments 

On October 1,
2006, the Company entered into an agreement with International Business
Machines Corporation and various affiliates (IBM). 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.

25

---



ITEM 2. 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 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. See also, Cautionary Note Regarding Forward-Looking
Statements below for a list of factors that could
cause actual results to differ materially from those contained in
any forward-looking statement.

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
guaranty insurance policies and credit default swaps, as well as the
reinsurance of financial guaranty insurance and credit default products written
by other insurers. Financial guaranty insurance provides an unconditional and
irrevocable guaranty 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 guaranty
reinsurance provides a means by which financial guaranty 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 approximately $5.9 million resulting in
net proceeds of approximately $341.1 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 commons 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% 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. See Liquidity and Capital Resources for further
details regarding the use of proceeds.

In
addition, all Formation Transactions described in the Companys Registration
Statement dated August 1, 2006 were consummated on the effective date of the
IPO other than the receipt by SCA of a capital contribution from XL Capital of
what was estimated to be $8.4 million relating to the conversion to SCAs long-term compensation plans of certain
eligible compensation awarded by XL Capital under its long-term compensation plans to SCA employees. The final
amount and timing of such capital contribution will be determined once a
conversion plan is finalized by the managements and boards of directors of SCA
and XL Capital. We currently expect that the conversion plan will be finalized
by the end of the current fiscal year.

26

---



Key
Factors Affecting Profitability

We
believe that the financial guaranty 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
guaranty 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 guaranty 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 guaranty
products. However, a prolonged period of weak or declining economic activity could
stress in-force financial guaranty 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 guaranty, market prices and the type of debt obligation
guarantied. 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 financial
statements. 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 financial guaranty 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 period are sometimes reported by financial guarantors as a
component of adjusted gross premiums, a non-GAAP financial measure, which is
discussed in more detail below. 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 a deterioration in underlying credit quality).

27

---



Our
expenses primarily consist of losses and loss adjustment expenses, acquisition
costs, and operating expenses. Losses and loss adjustment
expenses are a function of the quality, amount and type of business we guaranty
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, 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
Commission Revenue. Operating expenses consist primarily of costs relating to
compensation of our employees, information technology, office premises and
professional fees.

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 a view at the time 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. 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.

|                                                                                                                                           |  |                                       |      |      |   |       | 
|------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------------------------- | ---- | ---- | - | ----- | 
|                                                                                                                                           |  | Three
  Months 
  Ended September 30, |     
|                                                                                                                                           |  |                                       |     
|(U.S dollars in millions)                                                                                                                  |  | 2006                                  |      | 2005 |  
|                                                                                                                                           |  |                                       |      |      |  
|Total upfront premiums written                                                                                                             |  | $                                     | 47.1 |      | $ | 40.4  | 
|Total installment premiums written                                                                                                         |  |                                       | 38.5 |      |   | 42.6  | 
|                                                                                                                                           |  |                                       |      |      |   |       | 
|Total premiums written                                                                                                                     |  |                                       | 85.6 |      |   | 83.0  | 
|Present value of estimated future
  installment premiums written and assumed on contracts issued in the current
  period, discounted at 7% |  |                                       | 5.7  |      |   | 20.5  | 
|                                                                                                                                           |  |                                       |      |      |   |       | 
|Adjusted gross premiums                                                                                                                    |  | $                                     | 91.3 |      | $ | 103.5 | 
|                                                                                                                                           |  |                                       |      |      |   |       | 

|                                                                                                                                           |  |                                      |       |      |   |       | 
|------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------------------------ | ----- | ---- | - | ----- | 
|                                                                                                                                           |  | Nine
  Months 
  Ended September 30, |      
|                                                                                                                                           |  |                                      |      
|(U.S dollars in millions)                                                                                                                  |  | 2006                                 |       | 2005 |  
|                                                                                                                                           |  |                                      |       |      |  
|Total upfront premiums written                                                                                                             |  | $                                    | 174.2 |      | $ | 113.1 | 
|Total installment premiums written                                                                                                         |  |                                      | 101.2 |      |   | 103.8 | 
|                                                                                                                                           |  |                                      |       |      |   |       | 
|Total premiums written                                                                                                                     |  |                                      | 275.4 |      |   | 216.9 | 
|Present value of estimated future installment
  premiums written and assumed on contracts issued in the current period,
  discounted at 7% |  |                                      | 83.5  |      |   | 69.3  | 
|                                                                                                                                           |  |                                      |       |      |   |       | 
|Adjusted gross premiums                                                                                                                    |  | $                                    | 358.9 |      | $ | 286.2 | 
|                                                                                                                                           |  |                                      |       |      |   |       | 

28

---



We
also measure our performance by excluding from net income: (i) net realized
gains (losses) on investments and net realized and unrealized gains (losses) on 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 $20.70 at September 30, 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 guaranty insurance and financial guaranty reinsurance. Our financial
guaranty insurance segment offers financial guaranty insurance policies and
credit default swaps. Our financial guaranty reinsurance segment reinsures
financial guaranty policies and credit default swaps issued by other monoline
financial guaranty 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 in our
Registration Statement on Form S-1 (SEC File No. 333-133066).

Executive Overview

See
certain information with respect to members of our Board of Directors,
Executive Officers and Key Employees in our Registration Statement on Form S-1
(SEC File No. 333-133066).

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 will likely 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 audited financial statements and interim consolidated
financial statements in our Registration Statement on Form S-1 (SEC File No.
333-133066), as well as the notes to our interim consolidated
financial statements presented elsewhere herein.

29

---



Reserves
for Losses and Loss Adjustment Expenses

The
financial guaranties that we issue 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 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 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.

Case
basis reserves on financial guaranty 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 almost exclusively limited to the two cases explained below,
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
guarantied 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 guarantied 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.

30

---



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

31

---



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 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.

We
adopted our current unallocated reserve methodology in 2001. In selecting our
initial expected loss ratio we analyzed the data available to us on historic
earned premium and ultimate losses of the financial guaranty industry. Our
analysis of industry loss ratios is updated on an annual basis. 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 encompassing years 1991 through 2000 was
13%.

Our
most recent analysis included years 1995 through 2004 and indicated an average
industry loss ratio of 16%, or three percentage points higher than the 2001
analysis. Management further reviewed the individual loss years and, where
possible, the events that caused this industry increase. 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 guaranty insurance and reinsurance business
(e.g., principally the mix of our in-force financial guaranty 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, as well as the credit profile of our insured and
reinsured portfolio of business), (ii) our actual loss experience, (iii) the
characteristics, discussed above, of our in-force financial guaranty insurance
and reinsurance business in relation to the insured in-force business of
companies comprising the financial guaranty 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.

32

---



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.

Since
the selection of our initial expected loss ratio of 25%, our periodic update
and analysis of the adequacy of such loss ratio resulted in no change to the
ratio for each of the years ended December 31, 2002 and 2003. During the three
months ended September 30, 2004 we adjusted our initial expected loss ratio to
20% 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 which resulted from the decision of management in 2003
to expand its insurance business in that sector. 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 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 analysis in
2005 indicated that no change was necessary in our expected loss ratio of 20%
from that in 2004. During the third quarter of 2006 the aforementioned analysis
was updated again. Based on this analysis we did not change our expected loss
ratio and there was no material change to the loss emergence pattern.

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.

33

---



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 guaranty contract.

For
the purposes of the following example, we assume a 15-year financial guaranty
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 guaranty
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.

|     |  |  |                           |   |               |                  |                            |               |                   |        |   |    |  |  |      |   |  | 
|---- |  |  | ------------------------- | - | ------------- | ---------------- | -------------------------- | ------------- | ----------------- | ------ | - | -- |  |  | ---- | - |  | 
|     |  |  |                           |   |               |                  |                            |               | Selected          |        |   |    | 
|     |  |  |                           |   |               | ITD (Cumulative) |                            | Unallocated   |                   |        |  
|     |  |  |                           |   |               | Fraction of      |                            | Reserve As of |                   | Booked |  
|     |  |  | Inception-to-Date (ITD) |   | Loss Exposure |                  | December 31 of             |               | Unallocated Ratio |       
|Year |  |  | Earned
  Premium(1)       |   | Exhausted(2)  |                  | the
  Applicable Year      |               | 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.

34

---



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.

|     |  |  |            |   |                       |          |                          |           |                   |    |  |  |  |   |     |  |  |  |   |     |  | 
|---- |  |  | ---------- | - | --------------------- | -------- | ------------------------ | --------- | ----------------- | -- |  |  |  | - | --- |  |  |  | - | --- |  | 
|     |  |  |            |   |                       | Selected |                          | Estimated |                   |    | 
|     |  |  |            |   | Unallocated           |          | Cumulative               |           | Cumulative        |   
|     |  |  | ITD        |   | Reserve As of         |          | Reported Losses          |           | Total             |   
|     |  |  | Earned     |   | December 31 of        |          | As of December 31        |           | Estimated         |   
|Year |  |  | Premium(1) |   | the
  Applicable Year |          | of the
  Applicable Year |           | 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.

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 guaranty contract generates $170 in
losses, yielding a 17% actual ultimate loss ratio.

|     |  |  |            |   |                       |          |                          |             |                   |    |  |  |  |   |     |  |  |  |   |     |  | 
|---- |  |  | ---------- | - | --------------------- | -------- | ------------------------ | ----------- | ----------------- | -- |  |  |  | - | --- |  |  |  | - | --- |  | 
|     |  |  |            |   |                       | Selected |                          | Alternative |                   |    | 
|     |  |  |            |   | Unallocated           |          | Cumulative               |             | Cumulative        |   
|     |  |  | ITD        |   | Reserve As of         |          | Reported Losses          |             | Total             |   
|     |  |  | Earned     |   | December 31 of        |          | As of December 31        |             | Estimated         |   
|Year |  |  | Premium(1) |   | the
  Applicable Year |          | of the
  Applicable Year |             | 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.

35

---



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 guaranty
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. Accounting practices in the financial guaranty 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.

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 2,200 credits in our in-force
portfolio only 23 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. 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.

36

---



The
following table presents our consolidated in-force financial guaranty net par
outstanding at December 31, 2005 and September 30, 2006 by category of closely
monitored credit:

|                                               |  |                            |         |                           |  |             |   |              |        |  |  |       |  
|---------------------------------------------- |  | -------------------------- | ------- | ------------------------- |  | ----------- | - | ------------ | ------ |  |  | ----- | -
|                                               |  | As of
  September 30, 2006 |         | As of
  December 31, 2005 | 
|                                               |  |                            |         |                           | 
|                                               |  | Net Par                    |         | Net Par                   |  | Net Par     |   | % of Net Par |       
|(U.S. dollars in millions, except percentages) |  | Outstanding                |         | Outstanding               |  | Outstanding |   | Outstanding  |       
|                                               |  |                            |         |                           |  |             |   |              |       
|Fundamentally
  sound normal risk              |  | $                          | 109,591 |                           |  | 98.9        | % | $            | 80,572 |  |  | 98.4  | %
|Closely
  monitored credits(1):                |  |                            |         |                           |  |             |   |              |        |  |  |       |  
|Special monitoring                             |  |                            | 790     |                           |  | 0.7         | % |              | 692    |  |  | 0.8   | %
|Yellow flag                                    |  |                            | 76      |                           |  | 0.1         | % |              | 230    |  |  | 0.3   | %
|Red flag                                       |  |                            | 38      |                           |  | 0.0         | % |              | 40     |  |  | 0.1   | %
|Loss list(2)                                   |  |                            | 286     |                           |  | 0.3         | % |              | 357    |  |  | 0.4   | %
|                                               |  |                            |         |                           |  |             |   |              |        |  |  |       |  
|Subtotal                                       |  |                            | 1,190   |                           |  | 1.1         | % |              | 1,319  |  |  | 1.6   | %
|                                               |  |                            |         |                           |  |             |   |              |        |  |  |       |  
|Total                                          |  | $                          | 110,781 |                           |  | 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.                                                                                                                                                                                           
|    |                                                                                                                                                                                                                                                                                                                                                                                          
|(2) | At December 31, 2005 and
  September 30, 2006, the loss list consisted of the same five guaranty
  contracts, respectively, with remaining net par outstanding of $357.3 million
  and $286.1 million, respectively, against which reserves of $69.4 million and $66.1
  million have been established, respectively- see Note 9 to the accompanying Consolidated Financial
  Statements.

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

|                                               |  |                  |         |               |  |                |   |               |        |  |  |       |  
|---------------------------------------------- |  | ---------------- | ------- | ------------- |  | -------------- | - | ------------- | ------ |  |  | ----- | -
|                                               |  | Outstanding      |         | Percent of    |  | Outstanding at |   | Percent of    |       
|                                               |  | at September 30, |         | Total Net Par |  | December 31,   |   | Total Net Par |       
|(U.S. dollars in millions, except percentages) |  | 2006             |         | Outstanding   |  | 2005           |   | Outstanding   |       
|                                               |  |                  |         |               |  |                |   |               |       
|S&P
  Rating Category(1):                      |  |                  |         |               |  |                |   |               |        |  |  |       |  
|AAA                                            |  | $                | 30,549  |               |  | 27.6           | % | $             | 22,697 |  |  | 27.7  | %
|AA                                             |  |                  | 16,793  |               |  | 15.2           | % |               | 10,640 |  |  | 13.0  | %
|A                                              |  |                  | 33,160  |               |  | 29.9           | % |               | 27,185 |  |  | 33.2  | %
|BBB                                            |  |                  | 29,614  |               |  | 26.7           | % |               | 20,962 |  |  | 25.6  | %
|Below
  investment grade(2)                    |  |                  | 665     |               |  | 0.6            | % |               | 407    |  |  | 0.5   | %
|                                               |  |                  |         |               |  |                |   |               |        |  |  |       |  
|Total                                          |  | $                | 110,781 |               |  | 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.                                                                                                                          
|    |                                                                                                                                                                                                                                    
|(2) | Protection with respect to
  loss development relating to $164.9MM of the portfolio rated below investment
  grade at September 30, 2006 was provided by affiliates of XL Capital in
  connection with the consummation of the IPO.

37

---



As
discussed above, the initial expected loss ratio selected by management to
determine our unallocated reserves is based on historical financial guaranty
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 unallocated reserves by approximately $19.5 million or 25.0%
more than that recorded at December 31, 2005. Similarly, decreasing our initial
expected loss ratio by 5 percentage points, which would be indicative of a
robust economy would decrease our unallocated reserves by $19.5 million or
25.0% less than that recorded at December 31, 2005. See Key Factors
Affecting Profitability above.

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 guaranty 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 guaranty 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.

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 guaranty business, they do not
qualify for the financial guaranty insurance scope exception under SFAS 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 guaranty
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 premiums 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.

38

---



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 will 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 increased the value of the net derivative asset at September 30, 2006 by
$0.1million. 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 September
30, 2006 and December 31, 2005, the carrying value of our investments was $1.9
billion and $1.4 billion, respectively. The fair values of our investments are
based upon quoted market prices from a nationally recognized pricing service or
on dealer quotes.

As
of September 30, 2006, based on fair value, approximately 89.7% of our
investments were long-term debt securities, and our portfolio had an average
duration of 3.2 years, compared with 96.4% 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 investment portfolio as of September 30, 2006 based upon an assumed
parallel shift in interest rates across the entire yield curve:

|                            |  |                                                 |        |  
|--------------------------- |  | ----------------------------------------------- | ------ | -
|(U.S. dollars in millions)  |  | Estimated
  Increase
  (Decrease) in Fair Value
|                            |  |                                                
|Change in
  interest rates: |  |                                                 |        |  
|300 basis point rise        |  | $                                               | (192.1 | )
|200 basis point rise        |  |                                                 | (128.1 | )
|100 basis point rise        |  |                                                 | (64.0  | )
|100 basis point decrease    |  |                                                 | 64.0   |  
|200 basis point decrease    |  |                                                 | 128.1  |  
|300 basis point decrease    |  |                                                 | 192.1  |  

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.

39

---



For
the three and nine month periods ended September 30, 2006, we recorded
impairment charges of $1.1 million and $15.1 million relating primarily to an
investment acquired in satisfaction of a claim see Note 9 (b) to the
accompanying Consolidated Financial Statements herein for details. There were no such
impairments recorded during the comparable periods in 2005.

The
following is an analysis of how long each of our debt securities and short-term
investments with an unrealized loss at September 30, 2006 has been in a
continual unrealized loss position:

|                                                   |  |                      |         |                   |   |              |  |                   |         |              |   |                   |  |   |           |  |   |        | 
|-------------------------------------------------- |  | -------------------- | ------- | ----------------- | - | ------------ |  | ----------------- | ------- | ------------ | - | ----------------- |  | - | --------- |  | - | ------ | 
|                                                   |  | As of                |        
|                                                   |  | September
  30, 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               |  | $                    | 220,252 |                   | $ | 526          |  | $                 | 371,875 |              | $ | 10,776            |  | $ | 592,127   |  | $ | 11,302 | 
|U.S. Government and government agencies            |  |                      | 18,609  |                   |   | 277          |  |                   | 356,277 |              |   | 7,322             |  |   | 374,886   |  |   | 7,599  | 
|Corporate                                          |  |                      | 54,800  |                   |   | 368          |  |                   | 198,221 |              |   | 5,651             |  |   | 253,021   |  |   | 6,019  | 
|U.S. states and political subdivisions             |  |                      | 404     |                   |   | 1            |  |                   | 4,308   |              |   | 87                |  |   | 4,712     |  |   | 88     | 
|Non-U.S. sovereign government                      |  |                      | 503     |                   |   | 2            |  |                   | 8,424   |              |   | 214               |  |   | 8,927     |  |   | 216    | 
|                                                   |  |                      |         |                   |   |              |  |                   |         |              |   |                   |  |   |           |  |   |        | 
|Total debt securities and short-term
  investments |  | $                    | 294,568 |                   | $ | 1,174        |  | $                 | 939,105 |              | $ | 24,050            |  | $ | 1,233,673 |  | $ | 25,224 | 
|                                                   |  |                      |         |                   |   |              |  |                   |         |              |   |                   |  |   |           |  |   |        | 

Premium Revenue Recognition

Premiums
charged by us in connection with the issuance of our guaranties are received
either upfront or in installments. Such premiums are recognized as written when
due. Installment premiums written are earned ratably over the installment period,
generally one to nine 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 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 include $0.4 million and $25.6 million for the three and nine months ended September 30, 2006, respectively, and $4.1 million and $4.3 million for the three and nine months ended September 30, 2005, 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.

40

---



For
the three and nine months ended September 30, 2006, approximately 55.0% and
64.3%, respectively, of our total premiums written were received upfront and
45.0% and 35.7%, respectively, were received in installments. This compares to
approximately 48.7% and 52.1%, respectively, of our total premiums written
received upfront and 51.3% and 47.9% received in installments, respectively,
during the same periods in 2005.

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 Commission Revenue

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. We net deferred ceding commission revenue
against deferred acquisition costs and earn these ceding commissions over the
period in which the related premiums are earned. As of September 30, 2006 and
December 31, 2005, we had deferred acquisition costs of $85.6 million and $59.6
million, respectively. Each year we conduct a study to determine the amount of
costs that vary with, and are directly related to, the acquisition of new
business. The amount of expenses that qualify for deferral is dependent on the
level of new business production, the level of ceding commission revenue
negotiated with primary insurers, and managements judgment as to what costs and
the portions thereof that are deferrable. 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.

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. The valuation
allowance relates to net unrealized capital losses and a net realized capital
loss carryforward that may not be realized in a reasonable period of time.

As
of September 30, 2006 and December 31, 2005, our consolidated financial statements
reflect a deferred income tax asset of $18.1 million and $18.8 million,
respectively, primarily resulting from the operations of XLCA, which is subject
to U.S. federal income taxes. Such deferred tax assets were net of a valuation
allowance of $1.7 million and $0.9 million as of September 30, 2006 and
December 31, 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 September 30, 2006, the
Company had net unrealized capital losses and a net realized capital loss carry
forward of approximately $3.1 million and $1.9 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.

41

---



Our
income tax benefit or expense has fluctuated historically, due to fluctuating
U.S. pre-tax income or loss and U.S. transfer pricing adjustments giving rise
to additional taxable income and additional U.S. income tax.

Results of Operations

Consolidated Results of Operations

The
following table presents summary consolidated statement of operations data for
the three and nine month periods ended September 30, 2006 and 2005.

|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|--------------------------------------------------------------------------------------------------- |  | ------------------------------------------------ | ------- | -------------------------------------------- | - | ------- | - | ---- | -------- | - | - | ------- | -
|                                                                                                    |  | (Unaudited)
  Three Months Ended
  September 30, |         | (Unaudited)
  Nine Months EndedSeptember 30, |  
|                                                                                                    |  |                                                  |        
|(U.S. dollars in thousands)                                                                         |  | 2006                                             |         | 2005                                         |   | 2006    |   | 2005 |         
|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |         
|Revenues                                                                                            |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|Gross premiums written                                                                              |  | $                                                | 65,081  |                                              | $ | 63,757  |   | $    | 235,212  |   | $ | 179,812 |  
|Reinsurance premiums assumed                                                                        |  |                                                  | 20,489  |                                              |   | 19,222  |   |      | 40,184   |   |   | 37,073  |  
|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|Total premiums written                                                                              |  |                                                  | 85,570  |                                              |   | 82,979  |   |      | 275,396  |   |   | 216,885 |  
|Ceded premiums                                                                                      |  |                                                  | 14,908  |                                              |   | (9,435  | ) |      | 1,156    |   |   | (29,336 | )
|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|Net premiums written                                                                                |  |                                                  | 100,478 |                                              |   | 73,544  |   |      | 276,552  |   |   | 187,549 |  
|Change in net deferred premium revenue                                                              |  |                                                  | (55,023 | )                                            |   | (32,408 | ) |      | (137,743 | ) |   | (80,718 | )
|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|Net premiums earned (net of ceded premiums
  earned of $1,576, and $6,875; and $19,800 and $21,367) |  |                                                  | 45,455  |                                              |   | 41,136  |   |      | 138,809  |   |   | 106,831 |  
|Net investment income                                                                               |  |                                                  | 21,835  |                                              |   | 13,259  |   |      | 53,026   |   |   | 36,829  |  
|Net realized losses on investments                                                                  |  |                                                  | (156    | )                                            |   | (768    | ) |      | (16,556  | ) |   | (2,139  | )
|Net realized and unrealized losses on
  credit derivatives                                          |  |                                                  | (3,216  | )                                            |   | (1,919  | ) |      | (6,765   | ) |   | (4,214  | )
|Fee income and other                                                                                |  |                                                  | 59      |                                              |   |        |   |      | 2,290    |   |   | 750     |  
|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|Total revenues                                                                                      |  |                                                  | 63,977  |                                              |   | 51,708  |   |      | 170,804  |   |   | 138,057 |  
|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|Expenses                                                                                            |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|Net losses and loss adjustment expenses                                                             |  |                                                  | 4,994   |                                              |   | 1,095   |   |      | 11,323   |   |   | 20,044  |  
|Acquisition costs, net                                                                              |  |                                                  | 5,824   |                                              |   | 3,235   |   |      | 13,048   |   |   | 9,320   |  
|Operating expenses                                                                                  |  |                                                  | 20,861  |                                              |   | 16,686  |   |      | 55,448   |   |   | 50,015  |  
|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|Total expenses                                                                                      |  |                                                  | 31,679  |                                              |   | 21,016  |   |      | 79,819   |   |   | 79,379  |  
|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|Income before income tax and minority
  interest                                                    |  |                                                  | 32,298  |                                              |   | 30,692  |   |      | 90,985   |   |   | 58,678  |  
|Income tax expense (benefit)                                                                        |  |                                                  | 2,747   |                                              |   | (632    | ) |      | 2,559    |   |   | (1,655  | )
|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|Income before minority interest                                                                     |  |                                                  | 29,551  |                                              |   | 31,324  |   |      | 88,426   |   |   | 60,333  |  
|Minority interest  dividends on redeemable
  preferred shares                                      |  |                                                  | 1,139   |                                              |   | (49     | ) |      | 6,877    |   |   | 6,902   |  
|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  
|Net income                                                                                          |  | $                                                | 28,412  |                                              | $ | 31,373  |   | $    | 81,549   |   | $ | 53,431  |  
|                                                                                                    |  |                                                  |         |                                              |   |         |   |      |          |   |   |         |  

42

---



Segment Results of Operations

The
following tables present summary statement of operations data for our operating
segments for the three and nine months ended September 30, 2006 and 2005:

|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|-------------------------------------------------------------- |  | --------------------------------------- | ------- | ---------------------------------- | - | ------- | - | - | ------- | -
|                                                               |  | (Unaudited)                             |        
|                                                               |  | Three
  Months Ended September 30, 2006 |        
|                                                               |  |                                         |        
|(U.S. dollars in thousands)                                    |  | Financial
  Guaranty
  Insurance        |         | Financial
  Guaranty
  Reinsurance |   | Total   |  
|                                                               |  |                                         |        
|Gross premiums written                                         |  | $                                       | 65,081  |                                    | $ |        |   | $ | 65,081  |  
|Reinsurance premiums assumed                                   |  |                                         |        |                                    |   | 20,489  |   |   | 20,489  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Total premiums written                                         |  |                                         | 65,081  |                                    |   | 20,489  |   |   | 85,570  |  
|Ceded premiums                                                 |  |                                         | 14,908  |                                    |   |        |   |   | 14,908  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net premiums written                                           |  |                                         | 79,989  |                                    |   | 20,489  |   |   | 100,478 |  
|Change in net deferred premium revenue                         |  |                                         | (41,550 | )                                  |   | (13,473 | ) |   | (55,023 | )
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net premiums earned                                            |  |                                         | 38,439  |                                    |   | 7,016   |   |   | 45,455  |  
|Fee income and other                                           |  |                                         | 59      |                                    |   |        |   |   | 59      |  
|Net losses and loss adjustment expenses                        |  |                                         | 4,302   |                                    |   | 692     |   |   | 4,994   |  
|Acquisition costs, net                                         |  |                                         | 4,232   |                                    |   | 1,592   |   |   | 5,824   |  
|Operating expenses                                             |  |                                         | 16,731  |                                    |   | 1,395   |   |   | 18,126  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Underwriting profit                                            |  | $                                       | 13,233  |                                    | $ | 3,337   |   |   | 16,570  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net investment income                                          |  |                                         |         |                                    |   |         |   |   | 21,835  |  
|Corporate expenses                                             |  |                                         |         |                                    |   |         |   |   | 2,735   |  
|Net realized losses on investments                             |  |                                         |         |                                    |   |         |   |   | (156    | )
|Net realized and unrealized losses on
  credit derivatives     |  |                                         |         |                                    |   |         |   |   | (3,216  | )
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Income before income tax and minority
  interest               |  |                                         |         |                                    |   |         |   |   | 32,298  |  
|Income tax expense                                             |  |                                         |         |                                    |   |         |   |   | 2,747   |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Income before minority interest                                |  |                                         |         |                                    |   |         |   |   | 29,551  |  
|Minority interest  dividends on redeemable
  preferred shares |  |                                         |         |                                    |   |         |   |   | 1,139   |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  
|Net income                                                     |  |                                         |         |                                    |   |         |   | $ | 28,412  |  
|                                                               |  |                                         |         |                                    |   |         |   |   |         |  

43

---



|                                                               |  |                                         |         |             |   |         |   |   |         |  
|-------------------------------------------------------------- |  | --------------------------------------- | ------- | ----------- | - | ------- | - | - | ------- | -
|                                                               |  | (Unaudited)                             |        
|                                                               |  | Three
  Months Ended September 30, 2005 |        
|                                                               |  |                                         |        
|                                                               |  | Financial                               |         | Financial   |   |         |   |  
|                                                               |  | Guaranty                                |         | Guaranty    |   |         |   |  
|(U.S. dollars in thousands)                                    |  | Insurance                               |         | Reinsurance |   | Total   |  
|                                                               |  |                                         |         |             |   |         |  
|Gross
  premiums written                                       |  | $                                       | 63,757  |             | $ |        |   | $ | 63,757  |  
|Reinsurance
  premiums assumed                                 |  |                                         |        |             |   | 19,222  |   |   | 19,222  |  
|                                                               |  |                                         |         |             |   |         |   |   |         |  
|Total
  premiums written                                       |  |                                         | 63,757  |             |   | 19,222  |   |   | 82,979  |  
|Ceded
  premiums                                               |  |                                         | (9,435  | )           |   |        |   |   | (9,435  | )
|                                                               |  |                                         |         |             |   |         |   |   |         |  
|Net premiums
  written                                         |  |                                         | 54,322  |             |   | 19,222  |   |   | 73,544  |  
|Change in
  net deferred premium revenue                       |  |                                         | (22,156 | )           |   | (10,252 | ) |   | (32,408 | )
|                                                               |  |                                         |         |             |   |         |   |   |         |  
|Net premiums
  earned                                          |  |                                         | 32,166  |             |   | 8,970   |   |   | 41,136  |  
|Fee income
  and other                                         |  |                                         |        |             |   |        |   |   |        |  
|Net losses
  and loss adjustment expenses                      |  |                                         | 1,875   |             |   | (780    | ) |   | 1,095   |  
|Acquisition
  costs, net                                       |  |                                         | 1,418   |             |   | 1,817   |   |   | 3,235   |  
|Operating
  expenses                                           |  |                                         | 15,012  |             |   | 1,674   |   |   | 16,686  |  
|                                                               |  |                                         |         |             |   |         |   |   |         |  
|Underwriting profit                                            |  | $                                       | 13,861  |             | $ | 6,259   |   |   | 20,120  |  
|                                                               |  |                                         |         |             |   |         |   |   |         |  
|Net
  investment income                                        |  |                                         |         |             |   |         |   |   | 13,259  |  
|Corporate
  expenses                                           |  |                                         |         |             |   |         |   |   |        |  
|Net realized
  losses on investments                           |  |                                         |         |             |   |         |   |   | (768    | )
|Net realized
  and unrealized losses on credit derivatives     |  |                                         |         |             |   |         |   |   | (1,919  | )
|                                                               |  |                                         |         |             |   |         |   |   |         |  
|Income before income tax and minority interest                 |  |                                         |         |             |   |         |   |   | 30,692  |  
|Income tax benefit                                             |  |                                         |         |             |   |         |   |   | (632    | )
|                                                               |  |                                         |         |             |   |         |   |   |         |  
|Income before minority interest                                |  |                                         |         |             |   |         |   |   | 31,324  |  
|Minority interest  dividends on redeemable
  preferred shares |  |                                         |         |             |   |         |   |   | (49     | )
|                                                               |  |                                         |         |             |   |         |   |   |         |  
|Net income                                                     |  |                                         |         |             |   |         |   | $ | 31,373  |  
|                                                               |  |                                         |         |             |   |         |   |   |         |  

44

---



|                                                               |  |                                        |          |             |   |         |   |   |          |  
|-------------------------------------------------------------- |  | -------------------------------------- | -------- | ----------- | - | ------- | - | - | -------- | -
|                                                               |  | (Unaudited)                            |         
|                                                               |  | Nine
  Months Ended September 30, 2006 |         
|                                                               |  |                                        |         
|                                                               |  | Financial                              |          | Financial   |   |         |   |  
|                                                               |  | Guaranty                               |          | Guaranty    |   |         |   |  
|(U.S. dollars in thousands)                                    |  | Insurance                              |          | Reinsurance |   | Total   |  
|                                                               |  |                                        |          |             |   |         |  
|Gross
  premiums written                                       |  | $                                      | 235,212  |             | $ |        |   | $ | 235,212  |  
|Reinsurance
  premiums assumed                                 |  |                                        |         |             |   | 40,184  |   |   | 40,184   |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Total
  premiums written                                       |  |                                        | 235,212  |             |   | 40,184  |   |   | 275,396  |  
|Ceded
  premiums                                               |  |                                        | 1,156    |             |   |        |   |   | 1,156    |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Net premiums
  written                                         |  |                                        | 236,368  |             |   | 40,184  |   |   | 276,552  |  
|Change in
  net deferred premium revenue                       |  |                                        | (118,292 | )           |   | (19,451 | ) |   | (137,743 | )
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Net premiums
  earned                                          |  |                                        | 118,076  |             |   | 20,733  |   |   | 138,809  |  
|Fee income
  and other                                         |  |                                        | 2,290    |             |   |        |   |   | 2,290    |  
|Net losses
  and loss adjustment expenses                      |  |                                        | 9,149    |             |   | 2,174   |   |   | 11,323   |  
|Acquisition
  costs, net                                       |  |                                        | 8,561    |             |   | 4,487   |   |   | 13,048   |  
|Operating
  expenses                                           |  |                                        | 46,776   |             |   | 5,937   |   |   | 52,713   |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Underwriting profit                                            |  | $                                      | 55,880   |             | $ | 8,135   |   |   | 64,015   |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Net
  investment income                                        |  |                                        |          |             |   |         |   |   | 53,026   |  
|Corporate
  expenses                                           |  |                                        |          |             |   |         |   |   | 2,735    |  
|Net realized
  losses on investments                           |  |                                        |          |             |   |         |   |   | (16,556  | )
|Net realized
  and unrealized losses on credit derivatives     |  |                                        |          |             |   |         |   |   | (6,765   | )
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Income before income tax and minority interest                 |  |                                        |          |             |   |         |   |   | 90,985   |  
|Income tax expense                                             |  |                                        |          |             |   |         |   |   | 2,559    |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Income before minority interest                                |  |                                        |          |             |   |         |   |   | 88,426   |  
|Minority interest  dividends on redeemable
  preferred shares |  |                                        |          |             |   |         |   |   | 6,877    |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Net income                                                     |  |                                        |          |             |   |         |   | $ | 81,549   |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|                                                               |  | (Unaudited)                            |         
|                                                               |  | Nine
  Months Ended September 30, 2005 |         
|                                                               |  |                                        |         
|                                                               |  | Financial                              |          | Financial   |   |         |   |  
|                                                               |  | Guaranty                               |          | Guaranty    |   |         |   |  
|(U.S. dollars in thousands)                                    |  | Insurance                              |          | Reinsurance |   | Total   |  
|                                                               |  |                                        |          |             |   |         |  
|Gross
  premiums written                                       |  | $                                      | 179,812  |             | $ |        |   | $ | 179,812  |  
|Reinsurance
  premiums assumed                                 |  |                                        |         |             |   | 37,073  |   |   | 37,073   |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Total
  premiums written                                       |  |                                        | 179,812  |             |   | 37,073  |   |   | 216,885  |  
|Ceded
  premiums                                               |  |                                        | (29,336  | )           |   |        |   |   | (29,336  | )
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Net premiums
  written                                         |  |                                        | 150,476  |             |   | 37,073  |   |   | 187,549  |  
|Change in
  net deferred premium revenue                       |  |                                        | (67,431  | )           |   | (13,287 | ) |   | (80,718  | )
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Net premiums
  earned                                          |  |                                        | 83,045   |             |   | 23,786  |   |   | 106,831  |  
|Fee income
  and other                                         |  |                                        | 750      |             |   |        |   |   | 750      |  
|Net losses
  and loss adjustment expenses                      |  |                                        | 21,822   |             |   | (1,778  | ) |   | 20,044   |  
|Acquisition
  costs, net                                       |  |                                        | 3,651    |             |   | 5,669   |   |   | 9,320    |  
|Operating
  expenses                                           |  |                                        | 44,037   |             |   | 5,978   |   |   | 50,015   |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Underwriting profit                                            |  | $                                      | 14,285   |             | $ | 13,917  |   |   | 28,202   |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Net
  investment income                                        |  |                                        |          |             |   |         |   |   | 36,829   |  
|Corporate
  expenses                                           |  |                                        |          |             |   |         |   |   |         |  
|Net realized
  losses on investments                           |  |                                        |          |             |   |         |   |   | (2,139   | )
|Net realized
  and unrealized losses on credit derivatives     |  |                                        |          |             |   |         |   |   | (4,214   | )
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Income before income tax and minority interest                 |  |                                        |          |             |   |         |   |   | 58,678   |  
|Income tax benefit                                             |  |                                        |          |             |   |         |   |   | (1,655   | )
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Income before minority interest                                |  |                                        |          |             |   |         |   |   | 60,333   |  
|Minority interest  dividends on redeemable
  preferred shares |  |                                        |          |             |   |         |   |   | 6,902    |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  
|Net income                                                     |  |                                        |          |             |   |         |   | $ | 53,431   |  
|                                                               |  |                                        |          |             |   |         |   |   |          |  

45

---



Three Months Ended September 30, 2006
Compared to Three Months Ended September 30, 2005

Summary
Discussion of Net Income

Net
income for the three months ended September 30, 2006 was $28.4 million, a
decrease of $3.0 million over the same period in 2005. Net income for the three
months ended September 30, 2006 included $0.2 million of net realized losses on
investments, as compared to net realized losses of approximately $0.8 million
recorded in the same period in 2005. In addition, also included in net income
was approximately $3.2 million of net realized and unrealized losses on credit
derivatives, as compared to net realized and unrealized losses on credit
derivatives of $1.9 million recorded in the comparable period in 2005.

The
decrease in our net income of $3.0 million for the three months ended September
30, 2006, as compared to the same period in 2005, was primarily driven by the
following: (i) an increase in operating expenses of $4.2 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,
(ii) higher acquisition costs of $2.6 million reflecting growth in our in force
business, (iii) higher losses and loss adjustment expenses of $3.9 million
reflecting a higher provision for unallocated reserves of approximately $2.8
million due to growth in our in force business and the reduction of a case
reserve in our reinsurance segment of approximately $1.5 million that benefited
the third quarter of 2005, (iv) higher net unrealized losses on credit
derivatives of $1.3 million due to changes in long-term interest rates, (v)
higher dividends on redeemable preferred shares of $1.1 million, and (vi) an
increase in income tax expense of $3.4 million reflecting higher
profitability in our primary insurance operations in the United States for
2006, offset in part by (i) an increase in earned premiums of $4.3 million largely
reflecting the effect of a commutation of certain business previously ceded to
an affiliate of XL Capital, the reinsurance of certain business written by the
aforementioned affiliate, and an increase in installment premium from new
structured finance business and (ii) an increase in investment income of $8.6
million reflecting higher yields on new money investments and an increase in
average invested assets.

Set
forth below is additional information with respect to certain of the items
discussed above.

Net
premiums earned for the three months ended September 30, 2006 included $0.4
million of earnings from the early retirement of certain guarantied obligations
(e.g. refundings of insured obligations) ($0.3 million, net of accelerated amortization
of deferred acquisition costs related to the earnings from such refundings), as
compared to $4.1 million during the comparable period in 2005. Our business
production as measured by Adjusted Gross Premiums written (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 $91.3 million
for the three months ended September 30, 2006, a 11.8% decrease over $103.5
million for the comparable period in 2005.

The
yield on our investment portfolio during the three months ended September 30,
2006 was approximately 4.9%, as compared to 3.9% the same period in 2005.
Average invested assets were $1,771.1 million during the three months ended
September 30, 2006, as compared to $1,349.4 million in the same period in 2005.
The increase in average invested assets resulted primarily from the proceeds
from our IPO of $344.2 million, cash capital contributions from XL Capital at
the effective date of our IPO of $15.0 million, cash received in connection
with the commutation and reinsurance agreement referred to above of
approximately $22.1 million, and operating cash flows. See Investments for
information regarding the credit quality of our debt securities.

46

---



The
increase in dividends on the redeemable preferred shares of XLFA during the
three months ended September 30, 2006, as compared to the comparable period in
2005 was due to an amendment of the terms of the preferred shares pursuant to
an agreement with FSAH in April 2006. In accordance with the agreement: (i) the
participating dividend and redemption provisions of the preferred shares, which
were in effect prior to 2006, were eliminated, (ii) the stated value of the
preference shares held by FSAH was increased to $54.0 million, and (iii) the
fixed dividend rate, which was in effect prior to 2006, was increased from 5.0%
to 8.25%. As a result of the aforementioned amendments to the dividend
provisions of the preferred shares, dividends on the preference shares will be
$1.1 million quarterly subsequent to March 31, 2006.

Gross
Premiums Written

All
our gross premiums written are from our financial guaranty 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
guaranty 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.

|                               |  |                       |        |      |   |        | 
|------------------------------ |  | --------------------- | ------ | ---- | - | ------ | 
|                               |  | Three
  Months        |       
|                               |  | Ended
  September 30, |       
|                               |  |                       |       
|(U.S dollars in thousands)     |  | 2006                  |        | 2005 |  
|                               |  |                       |        |      |  
|Gross
  premiums written       |  |                       |        |      |   |        | 
|Upfront policies/contracts     |  | $                     | 32,220 |      | $ | 36,119 | 
|Installment policies/contracts |  |                       | 32,861 |      |   | 27,638 | 
|                               |  |                       |        |      |   |        | 
|Total                          |  | $                     | 65,081 |      | $ | 63,757 | 
|                               |  |                       |        |      |   |        | 

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

|                           |  |                       |        |      |   |        | 
|-------------------------- |  | --------------------- | ------ | ---- | - | ------ | 
|                           |  | Three
  Months        |       
|                           |  | Ended
  September 30, |       
|                           |  |                       |       
|(U.S dollars in thousands) |  | 2006                  |        | 2005 |  
|                           |  |                       |        |      |  
|Gross
  premiums written   |  |                       |        |      |   |        | 
|Public finance             |  | $                     | 30,249 |      | $ | 30,861 | 
|Structured finance         |  |                       | 17,804 |      |   | 17,492 | 
|International finance      |  |                       | 17,028 |      |   | 15,404 | 
|                           |  |                       |        |      |   |        | 
|Total                      |  | $                     | 65,081 |      | $ | 63,757 | 
|                           |  |                       |        |      |   |        | 

Gross
premiums written were $65.1 million for the three months ended September 30,
2006, an increase of $1.3 million or 2.0%, from $63.8 million recorded in the
comparable period in 2005 notwithstanding a continued tight credit spread
environment. The increase was primarily attributable to an increase in
international finance gross premiums, which was driven primarily by the
strength in the global utility sector. This increase was partially offset by
the decrease in public finance gross premiums written, reflecting lower insured
penetration and overall market issuance.

Reinsurance Premiums
Assumed

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

47

---



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

|                               |  |                       |        |      |   |        | 
|------------------------------ |  | --------------------- | ------ | ---- | - | ------ | 
|                               |  | Three
  Months        |       
|                               |  | Ended
  September 30, |       
|                               |  |                       |       
|(U.S dollars in thousands)     |  | 2006                  |        | 2005 |  
|                               |  |                       |        |      |  
|Reinsurance
  premiums assumed |  |                       |        |      |   |        | 
|Affiliates of FSA              |  | $                     | 11,317 |      | $ | 15,846 | 
|XLI                            |  |                       | 7,985  |      |   | 838    | 
|Third-party companies          |  |                       | 1,187  |      |   | 2,538  | 
|                               |  |                       |        |      |   |        | 
|Total                          |  | $                     | 20,489 |      | $ | 19,222 | 
|                               |  |                       |        |      |   |        | 

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

|                               |  |                       |        |      |   |        | 
|------------------------------ |  | --------------------- | ------ | ---- | - | ------ | 
|                               |  | Three
  Months        |       
|                               |  | Ended
  September 30, |       
|                               |  |                       |       
|(U.S dollars in thousands)     |  | 2006                  |        | 2005 |  
|                               |  |                       |        |      |  
|Reinsurance
  premiums assumed |  |                       |        |      |   |        | 
|Upfront policies/contracts     |  | $                     | 14,847 |      | $ | 4,233  | 
|Installment policies/contracts |  |                       | 5,642  |      |   | 14,989 | 
|                               |  |                       |        |      |   |        | 
|Total                          |  | $                     | 20,489 |      | $ | 19,222 | 
|                               |  |                       |        |      |   |        | 

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

|                               |  |                       |        |      |   |        | 
|------------------------------ |  | --------------------- | ------ | ---- | - | ------ | 
|                               |  | Three
  Months        |       
|                               |  | Ended
  September 30, |       
|                               |  |                       |       
|(U.S dollars in thousands)     |  | 2006                  |        | 2005 |  
|                               |  |                       |        |      |  
|Reinsurance
  premiums assumed |  |                       |        |      |   |        | 
|Public finance                 |  | $                     | 400    |      | $ |       | 
|Structured finance             |  |                       | 1,915  |      |   | 12,074 | 
|International finance          |  |                       | 18,174 |      |   | 7,148  | 
|                               |  |                       |        |      |   |        | 
|Total                          |  | $                     | 20,489 |      | $ | 19,222 | 
|                               |  |                       |        |      |   |        | 

Reinsurance
premiums assumed were $20.5 million for the three months ended September 30,
2006, an increase of $1.3 million or 6.8%, as compared to $19.2 million
recorded in the comparable prior year period. The increase was primarily due to
a $11.1 million increase in international finance assumed premiums partially
offset by a $10.2 million decrease in structured finance assumed premiums.
The decrease in structured finance assumed premiums was due to one significant
transaction during the three months ended September 30, 2005. The amount of
reinsurance ceded to us depends upon the type and amount of insurance written by
primary companies, their capital needs and other factors. Such reinsurance is
generally structured on a facultative basis.

48

---



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 XLI 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 RE AM and other third-party reinsurers:

|                             |  |                                     |         |      |   |       | 
|---------------------------- |  | ----------------------------------- | ------- | ---- | - | ----- | 
|                             |  | Three Months 
  Ended September 30, |        
|                             |  |                                     |        
|(U.S dollars in thousands)   |  | 2006                                |         | 2005 |  
|                             |  |                                     |         |      |  
|Ceded
  premiums             |  |                                     |         |      |   |       | 
|XLI                          |  | $                                   | (26,546 | )    | $ | 4,298 | 
|XL RE AM                     |  |                                     | 8,024   |      |   | 1,114 | 
|Other third-party reinsurers |  |                                     | 3,614   |      |   | 4,023 | 
|                             |  |                                     |         |      |   |       | 
|Total                        |  | $                                   | (14,908 | )    | $ | 9,435 | 
|                             |  |                                     |         |      |   |       | 

All
our ceded premiums are from our financial guaranty insurance segment. Ceded
premiums were $(14.9) million for the three months ended September 30, 2006, a
decrease of $24.3 million or 258.5%, as compared to $9.4 million recorded in
the comparable prior year period. Ceded premiums to XLI for the three months
ended September 30, 2006 reflect the return of $26.5 million of premiums previously ceded to XLI
in accordance with a commutation effected on the date of our IPO pursuant to
certain Formation Transactions that were described in our Registration
Statement on Form S-1 (SEC File No. 333-133066). Such business was originally
reinsured to XLI principally due to single risk constraints and rating agency
capital adequacy requirements applicable to us at the time that business was
first written. In general, the Company has required less reinsurance protection
as a result of the growth in capital, accordingly, cessions excluding the
formation transactions have declined.

Net
Premiums Earned

Financial
guaranty upfront premiums are earned in proportion to the expiration of the
related risk and financial guaranty 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 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:

|                               |  |                                     |        |      |   |        | 
|------------------------------ |  | ----------------------------------- | ------ | ---- | - | ------ | 
|                               |  | Three Months 
  Ended September 30, |       
|                               |  |                                     |       
|(U.S dollars in thousands)     |  | 2006                                |        | 2005 |  
|                               |  |                                     |        |      |  
|Net premiums
  earned          |  |                                     |        |      |   |        | 
|Upfront policies/contracts     |  | $                                   | 13,846 |      | $ | 14,026 | 
|Installment policies/contracts |  |                                     | 31,609 |      |   | 27,110 | 
|                               |  |                                     |        |      |   |        | 
|Total                          |  | $                                   | 45,455 |      | $ | 41,136 | 
|                               |  |                                     |        |      |   |        | 

49

---



Net
premiums earned were $45.5 million for the three months ended September 30,
2006, an increase of $4.4 million or 10.7%, as compared to $41.1 million in the
comparable period in 2005. The increase in earned premiums was primarily
attributable to higher earned premiums in the financial guaranty insurance
segment of $6.3 million, offset by lower earned premiums in the financial
guaranty reinsurance segment of $2.0 million. Higher earned premiums in the
financial guaranty insurance segment were due to: (i) earned premiums of $3.8
million from the commutation of certain business previously ceded to an
affiliate as part of the Formation Transactions that were described in our
Registration Statement on Form S-1 (SEC File No. 333-133066) and (ii) $2.5
million of earned premiums attributable to growth in our in force business. The
$2.0 million decrease in earned premiums in our financial guaranty reinsurance
segment was primarily due to a higher proportion of upfront business in the
current period relative to prior period.

Net
Investment Income

Net
investment income was $21.8 million for the three months ended September 30,
2006, an increase of $8.5 million or 63.9% as compared to $13.3 million in the
comparable period in 2005. The increase in net investment income was due
primarily to higher yields on new money investments and higher average invested
assets resulting from the proceeds from our IPO of $344.2 million, cash capital
contributions from XL Capital effective on the IPO date of $15.0 million, cash
received in connection with the commutation and reinsurance agreement referred
to above of approximately $22.1 million, and operating cash flows. The increase
in investment yields is attributable primarily to the general rise in interest
rates over the time period, particularly short- and medium-term interest rates.
The five-year Treasury rate, for example, increased from 4.18% at September 30,
2005 to 4.59% at September 30, 2006.

The
following tables present net investment income, average invested assets, and
the effective yield on our average invested assets for the three months ended
September 30, 2006 and 2005, and the average duration of our invested assets as
of September 30, 2006 and 2005:

|                                               |  |                                     |           |      |   |           |  
|---------------------------------------------- |  | ----------------------------------- | --------- | ---- | - | --------- | -
|                                               |  | Three Months 
  Ended September 30, |          
|                                               |  |                                     |          
|(U.S dollars in thousands, except percentages) |  | 2006                                |           | 2005 |  
|                                               |  |                                     |           |      |  
|Net
  investment income                        |  | $                                   | 21,835    |      | $ | 13,259    |  
|Average
  invested assets(1)                   |  | $                                   | 1,771,093 |      | $ | 1,349,400 |  
|Effective
  yield(2)                           |  |                                     | 4.9       | %    |   | 3.9       | %

|    |                                                                                                                                                                                                                                                                                        | 
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|   
|(1) | Represents the quarterly
  average of the amortized cost of debt securities, short-term investments and
  cash and cash equivalents for the respective periods.                                                                                                                       
|    |                                                                                                                                                                                                                                                                                       
|(2) | Effective yield represents
  net investment income, on an annualized basis, as a percentage of average
  invested assets during the period. The increase in the effective yield was
  due to the turnover in our investment portfolios capturing the trend of
  rising interest rates.

|                            |  |                     |     |      |  |     | 
|--------------------------- |  | ------------------- | --- | ---- |  | --- | 
|                            |  | As of September 30, |    
|                            |  |                     |    
|                            |  | 2006                |     | 2005 | 
|                            |  |                     |     |      | 
|Average
  duration in years |  |                     | 3.2 |      |  | 3.6 | 

Net
Realized (Losses) Gains on Investments

Net
realized losses on investments were $0.2 million for the three months ended
September 30, 2006 as compared to a net realized
loss of $0.8 million in the comparable period in 2005. The change in net
realized losses was primarily attributable to portfolio management actions
relating to the management of duration, yield and exposure to certain credit
risks.

50

---



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 losses on credit derivatives were $3.2
million for the three months ended September 30, 2006, an increase of $1.3
million, as compared to losses of $1.9 million in the comparable period in 2005. The
increase is primarily attributable to an increase in in force insured interest
rate swaps, as well as a decline in long-term interest rates during the quarter
ended September 30, 2006 compared to a slight increase in long-term interest
rates during the quarter ended September 30, 2005. There was no significant
variance related to credit default swaps as credit spreads changed comparably
in each respective quarter.

Net Losses and Loss Adjustment
Expenses

Net
losses and loss adjustment expenses include current year net losses incurred
and adverse or favorable development of prior year net loss and loss adjustment
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:

|                                          |  |                                    |        |                                      |   |                         |   |   |        |  
|----------------------------------------- |  | ---------------------------------- | ------ | ------------------------------------ | - | ----------------------- | - | - | ------ | -
|(U.S. Dollars in thousands)               |  | Financial 
  Guaranty 
  Insurance |        | Financial 
  Guaranty 
  Reinsurance |   | Consolidated
  
  Total |  
|                                          |  |                                    |        |                                      |   |                         |  
|                                          |  |                                    |        |                                      |   |                         |   |   |        |  
|Beginning balance, June 30, 2005          |  | $                                  | 56,543 |                                      | $ | 16,428                  |   | $ | 72,971 |  
|Case reserve provision                    |  |                                    | (300   | )                                    |   | (1,151                  | ) |   | (1,451 | )
|Loss adjustment expense reserve provision |  |                                    | 479    |                                      |   |                        |   |   | 479    |  
|Unallocated reserve provision             |  |                                    | 1,696  |                                      |   | 371                     |   |   | 2,067  |  
|                                          |  |                                    |        |                                      |   |                         |   |   |        |  
|Net losses and loss adjustment expenses   |  |                                    | 1,875  |                                      |   | (780                    | ) |   | 1,095  |  
|Paid losses and loss adjustment expenses  |  |                                    | (207   | )                                    |   |                        |   |   | (207   | )
|                                          |  |                                    |        |                                      |   |                         |   |   |        |  
|Ending balance, September 30, 2005        |  | $                                  | 58,211 |                                      | $ | 15,648                  |   | $ | 73,859 |  
|                                          |  |                                    |        |                                      |   |                         |   |   |        |  
|                                          |  |                                    |        |                                      |   |                         |   |   |        |  
|Beginning balance, June 30, 2006          |  | $                                  | 64,239 |                                      | $ | 18,678                  |   | $ | 82,917 |  
|Case reserve provision                    |  |                                    |       |                                      |   | 128                     |   |   | 128    |  
|Loss adjustment expense reserve provision |  |                                    | 3      |                                      |   | 5                       |   |   | 8      |  
|Unallocated reserve provision             |  |                                    | 4,299  |                                      |   | 559                     |   |   | 4,858  |  
|                                          |  |                                    |        |                                      |   |                         |   |   |        |  
|Net losses and loss adjustment expenses   |  |                                    | 4,302  |                                      |   | 692                     |   |   | 4,994  |  
|Assumption of obligation by XLI
(1)       |  |                                    |       |                                      |   | (1,177                  | ) |   | (1,177 | )
|Paid losses and loss adjustment expenses  |  |                                    | (389   | )                                    |   | (5                      | ) |   | (394   | )
|                                          |  |                                    |        |                                      |   |                         |   |   |        |  
|Ending balance, September 30, 2006        |  | $                                  | 68,152 |                                      | $ | 18,188                  |   | $ | 86,340 |  
|                                          |  |                                    |        |                                      |   |                         |   |   |        |  

(1) In
  connection with the cancellation from inception of certain business ceded by
  the Company to XLI, XLI assumed the Companys obligation for such loss
  adjustment expenses  see Note 6 to the consolidated financial statements herein.

51

---



Net
losses and loss adjustment expenses were $5.0 million for the three months
ended September 30, 2006, an increase of $3.9 million, or 354.5%, as compared
to $1.1 million recorded in the comparable period in 2005. The increase in net
losses and loss adjustment expenses was primarily attributable to higher net
losses and loss adjustment expenses in the financial guaranty insurance segment
of $2.4 million, and higher net losses and loss adjustment expenses in the
financial guaranty reinsurance segment of $1.5 million.


          Higher net losses and
loss adjustment expenses in the financial guaranty insurance segment during the
three months ended September 30, 2006 were primarily due to a period over period
increase in unallocated reserves of $2.6 million. The increase was attributable
to growth in our in force business as evidenced by an increase in net premiums
earned of $6.2 million period over period. Higher net losses and loss
adjustment expenses in the financial guaranty reinsurance segment during the
three months ended September 30, 2006 resulted from nominal increase in case
basis provisions for losses and loss adjustment expenses of $0.1 million during
the three months ended September 30, 2006, as compared with a large decrease in
case reserves of $1.2 million during the three months ended September 30, 2005 due
to favorable development on certain case basis reserves reported by certain
primary companies.

Acquisition Costs, Net

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

|                                                                    |  |                                     |       |      |   |        |  
|------------------------------------------------------------------- |  | ----------------------------------- | ----- | ---- | - | ------ | -
|                                                                    |  | Three Months 
  Ended September 30, |      
|                                                                    |  |                                     |      
|(U.S dollars in thousands)                                          |  | 2006                                |       | 2005 |  
|                                                                    |  |                                     |       |      |  
|Amortization
  of deferred acquisition costs and ceding commissions |  |                                     |       |      |   |        |  
|Financial
  Guaranty Insurance:                                     |  |                                     |       |      |   |        |  
|Acquisition costs                                                   |  | $                                   | 4,636 |      | $ | 3,211  |  
|Ceding commissions                                                  |  |                                     | (404  | )    |   | (1,793 | )
|                                                                    |  |                                     |       |      |   |        |  
|Net acquisition costs                                               |  |                                     | 4,232 |      |   | 1,418  |  
|Financial
  Guaranty Reinsurance:                                   |  |                                     |       |      |   |        |  
|Acquisition costs                                                   |  |                                     | 1,592 |      |   | 1,817  |  
|                                                                    |  |                                     |       |      |   |        |  
|Consolidated
  acquisition costs, net                               |  | $                                   | 5,824 |      | $ | 3,235  |  
|                                                                    |  |                                     |       |      |   |        |  

Capitalized
acquisition costs in the financial guaranty 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 guaranty insurance segment was $4.6
million for the three months ended September 30, 2006, an increase of $1.4
million, or 43.8%, as compared to $3.2 million in the comparable period in 2005
(which included $0.1 million and $0.5 million, respectively, of accelerated
amortization of deferred acquisition costs due to refundings in the three
months ended September 30, 2006 and 2005). Excluding the impact of refundings,
the increase of $1.8 million primarily reflects growth in, and the changing mix
of, our in-force business. During the three months ended September 30, 2006,
there was a higher proportion of installment business written as compared to
the comparable period in 2005, which had a higher up-front proportion. Premium
and excise taxes related to current quarter installment based business added
$1.1 million to acquisiton expenses in the current quarter whereas such
expenses were only $0.1 million in the year ago quarter.

Amortization
of deferred ceding commission revenue in the financial guaranty insurance
segment was $0.4 million for the three months ended September 30, 2006, a
decrease of $1.4 million or 77.8% as compared to $1.8 million in the comparable
period in 2005. The decrease is primarily attributable to a commutation of
certain business previously ceded to XLI as described in our Registration
Statement on Form S-1 (SEC File No. 333-133066). Of the $26.5 million of ceded
premiums commuted, $1.3 million was installment business resulting in a
reduction of ceding commission revenue of $0.4 million. In the year ago period,
ceding commision revenue related to business ceded to XLI was $0.9 million.

52

---



Acquisition
costs in the financial guaranty 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 local insurance regulators. Amortization of
acquisition costs in the financial guaranty reinsurance segment was $1.6
million for the three months ended September 30, 2006, a decrease of $0.2
million, or 11.1% as compared to $1.8 million in the comparable period in 2005.
The decrease was primarily attributable to a higher mix of upfront business
assumed in the three months ended September 30, 2006 as compared to the same
period in 2005.

Operating Expenses

Operating
expenses were $20.9 million for the three months ended September 30, 2006, an
increase of $4.2 million or 25.1%, as compared to $16.7 million in the
comparable period in 2005. The increase in operating expenses resulted from
higher operating expenses in both the financial guaranty insurance and
reinsurance segments, as well as certain corporate expenses incurred as a
result of SCA being a standalone public company. The increase in operating
expenses in the segments primarily resulted 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. Corporate expenses, which
prior to the IPO we did not incur, primarily consists of directors and officers
liability insurance, directors fees, printing and distribution costs, and audit
costs, as well as an allocation of compensation costs.

Income tax expense (benefit)

Income tax
expense was $2.7 million for the three months ended September 30, 2006, an
increase of $3.3 million as compared to an income tax benefit of $0.6 million
in the comparable period in 2005. The increase in income tax expense resulted
primarily from higher profitability in our U.S.-based primary insurance
operations during 2006.

Nine Months Ended September 30, 2006 Compared
to Nine Months Ended September 30, 2005

Summary Discussion of Net Income

Net
income for the nine months ended September 30, 2006 was $81.5 million, an
increase of $28.1 million or 52.6% from $53.4 million during the same period in
2005. Net income for the nine months ended September 30, 2006 included $16.6
million of net realized losses on investments, as compared to net realized
losses of $2.1 million recorded in the same period in 2005. In addition,
included in net income was approximately $6.8 of net realized and unrealized
losses on credit derivatives, as compared to net realized and unrealized losses
on credit derivatives of $4.2 million recorded in the comparable period in
2005.

The
increase in our net income of $28.1 million for the nine months ended September
30, 2006, as compared to the same period in 2005, was primarily driven by: (i)
significant growth in net premiums earned of $32.0 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, and the growth of our
insured in force business, (ii) an increase in investment income of $16.2
million reflecting higher yields on new money investments and an increase in
average invested assets, and (iii) lower net losses and loss adjustment
expenses of $8.7 million, offset in part by (i) higher net realized losses on
investments of $14.4 million which primarily resulted from a $14.0 million
impairment charge recorded during the nine month period ended September 30,
2006 on an investment acquired in satisfaction of a claim, (ii) higher net
realized and unrealized losses on credit derivatives of $2.6 million due
primarily to higher mark to market losses on credit default swaps caused by a
widening of credit spreads, offset in part by lower mark to market losses on
insured interest rate swaps resulting from higher interest rates (iii) higher
net acquisition costs of $3.7 million primarily reflecting the effect of the
aforementioned refunding activity and growth in our in force business, (iv) an
increase in operating expenses of $5.4 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 (v) an increase in
income tax expense of $4.2 million resulting from higher profitability in the
Companys operations in the United States.

53

---



Set
forth below is additional information with respect to certain of the items
discussed above:

The
increase in our net premiums earned resulted from earnings from the early
retirement of certain guarantied obligations (e.g., refundings of insured obligations)
of $25.6 million ($23.4 million, net of accelerated amortization of deferred
acquisition costs related to the earnings from such refundings) during the nine
months ended September 30, 2006, as compared to $4.3 million in the comparable
period in 2005. Our business production as measured by adjusted gross premiums
(which includes upfront premiums written in the period, current installment
premiums due on business written in the period and expected future installment
premiums discounted at 7% on business written during the period) totaled $358.9
million for the nine months ended September 30, 2006, a 25.4% increase over
$286.2 million for the comparable period in 2005.

The
increase in our investment income during the nine months ended September 30,
2006, as compared to the comparable period in 2005, was primarily due to the
growth in our investment portfolio, as well as the higher yields on new
investments. Average invested assets were $1,575.4 million during the nine
months ended September 30, 2006, as compared to $1,289.9 million in the
comparable period in 2005. The increase in average invested assets resulted
primarily from the net proceeds from our IPO of $344.2 million, cash capital
contributions from XL Capital at the effective date of our IPO of $15.0
million, cash received in connection with the commutation and reinsurance
agreement referred to above of approximately $22.1 million, and operating cash
flows. See Investments for information regarding the credit quality of our
debt securities.

For
the nine months ended September 30, 2006, we recorded a provision for net
losses and loss adjustment expenses of $11.3 million, a decrease of $8.7
million, or 43.5%, from the $20.0 million recorded in the comparable period in
2005. The decrease resulted from lower provisions for case basis reserves and
favorable development of unallocated reserves due to changes in our in-force
business during the nine months ended September 30, 2006, as compared to the
same period in 2005. During the nine months ended September 30, 2006 there were
nominal provisions for case basis reserves, whereas such activity for the nine
months ended September 30, 2005 included a provision for case basis reserves of
$12.2 million, of which $12.1 million related to two insured transactions,
which are further described in Notes 9 (a) and 9 (c) to our interim
consolidated financial statements included elsewhere herein.

Gross Premiums Written

All
our gross premiums written are from our financial guaranty 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
guaranty 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.

|                               |  |                                    |         |      |   |         | 
|------------------------------ |  | ---------------------------------- | ------- | ---- | - | ------- | 
|                               |  | Nine Months 
  Ended September 30, |        
|                               |  |                                    |        
|(U.S dollars in thousands)     |  | 2006                               |         | 2005 |  
|                               |  |                                    |         |      |  
|Gross
  premiums written       |  |                                    |         |      |   |         | 
|Upfront policies/contracts     |  | $                                  | 151,280 |      | $ | 104,196 | 
|Installment policies/contracts |  |                                    | 83,932  |      |   | 75,616  | 
|                               |  |                                    |         |      |   |         | 
|Total                          |  | $                                  | 235,212 |      | $ | 179,812 | 
|                               |  |                                    |         |      |   |         | 

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

54

---



|                           |  |                                    |         |      |   |         | 
|-------------------------- |  | ---------------------------------- | ------- | ---- | - | ------- | 
|                           |  | Nine Months 
  Ended September 30, |        
|                           |  |                                    |        
|(U.S dollars in thousands) |  | 2006                               |         | 2005 |  
|                           |  |                                    |         |      |  
|Gross
  premiums written   |  |                                    |         |      |   |         | 
|Public finance             |  | $                                  | 104,130 |      | $ | 76,717  | 
|Structured finance         |  |                                    | 54,486  |      |   | 50,715  | 
|International finance      |  |                                    | 76,596  |      |   | 52,380  | 
|                           |  |                                    |         |      |  
|Total                      |  | $                                  | 235,212 |      | $ | 179,812 | 
|                           |  |                                    |         |      |  

Gross
premiums written were $235.2 million for the nine months ended September 30,
2006, an increase of $55.4 million or 30.8%, from $179.8 million recorded in
the comparable period in 2005, notwithstanding a continued tight credit spread
environment. The increase was primarily attributable to an increase public
finance and international finance gross premiums written. We guarantied a total
of $12.4 billion of municipal debt for the first nine months of 2006, which
represents a market share of 9.2%, up from 5.3% for the same period last year.
The increase in international finance gross premiums was driven primarily by
the strength in the global utility sector.

Reinsurance Premiums Assumed

All
our reinsurance premiums assumed are from our financial guaranty reinsurance
segment. The majority of our financial guaranty 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 and other third-party primary
companies:

|                               |  |                                    |        |      |   |        | 
|------------------------------ |  | ---------------------------------- | ------ | ---- | - | ------ | 
|                               |  | Nine Months 
  Ended September 30, |       
|                               |  |                                    |       
|(U.S dollars in thousands)     |  | 2006                               |        | 2005 |  
|                               |  |                                    |        |      |  
|Reinsurance
  premiums assumed |  |                                    |        |      |   |        | 
|Affiliates of FSA              |  | $                                  | 20,880 |      | $ | 28,804 | 
|XLI                            |  |                                    | 9,161  |      |   | 2,369  | 
|Third-party primary companies  |  |                                    | 10,143 |      |   | 5,900  | 
|                               |  |                                    |        |      |   |        | 
|Total                          |  | $                                  | 40,184 |      | $ | 37,073 | 
|                               |  |                                    |        |      |   |        | 

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

|                               |  |                                    |        |      |   |        | 
|------------------------------ |  | ---------------------------------- | ------ | ---- | - | ------ | 
|                               |  | Nine Months 
  Ended September 30, |       
|                               |  |                                    |       
|(U.S dollars in thousands)     |  | 2006                               |        | 2005 |  
|                               |  |                                    |        |      |  
|Reinsurance
  premiums assumed |  |                                    |        |      |   |        | 
|Upfront policies/contracts     |  | $                                  | 22,873 |      | $ | 8,898  | 
|Installment policies/contracts |  |                                    | 17,311 |      |   | 28,175 | 
|                               |  |                                    |        |      |   |        | 
|Total                          |  | $                                  | 40,184 |      | $ | 37,073 | 
|                               |  |                                    |        |      |   |        | 

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

55

---



|                               |  |                                     |        |      |   |        | 
|------------------------------ |  | ----------------------------------- | ------ | ---- | - | ------ | 
|                               |  | Nine
  Months
  Ended September 30, |       
|                               |  |                                     |       
|(U.S dollars in thousands)     |  | 2006                                |        | 2005 |  
|                               |  |                                     |        |      |  
|Reinsurance premiums
  assumed |  |                                     |        |      |   |        | 
|Public finance                 |  | $                                   | 717    |      | $ | 1,361  | 
|Structured finance             |  |                                     | 6,741  |      |   | 20,937 | 
|International finance          |  |                                     | 32,726 |      |   | 14,775 | 
|                               |  |                                     |        |      |   |        | 
|Total                          |  | $                                   | 40,184 |      | $ | 37,073 | 
|                               |  |                                     |        |      |   |        | 

Reinsurance premiums assumed
were $40.2 million for the nine months ended September 30, 2006, an increase of
$3.1 million or 8.4%, as compared to $37.1 million recorded in the comparable
prior year period. The increase was primarily due to a $17.9 million increase
in international finance premiums assumed and was partially offset by a $14.2
million decrease in structured finance premiums assumed. The amount of
reinsurance ceded to us depends upon the type and amount of insurance written
by primary companies, their capital needs and other factors. Such reinsurance
is generally structured on a facultative basis.

Ceded
Premiums

All
our ceded premiums are from our financial guaranty insurance segment. Ceded
premiums were ($1.2) million for the nine months ended September 30, 2006, a
decrease of $30.5 million or 104.1%, as compared to $29.3 million recorded in
the comparable prior year period. Ceded premiums for the nine months ended
September 30, 2006 reflect the return of $26.5 million of premiums previously ceded to an
affilitate as part of the Formation Transactions that were described in our
Registration Statement on Form S-1 (SEC File No. 333-133066). Specificially, we
transferred or reassumed exposures under certain financial guaranty policies
that were originally reinsured to, or written on our behalf by, XLI
principally due to single risk constraints and rating agency capital adequacy
requirements applicable to us at the time that business was first written. In
general, the Company has required less reinsurance protection as a result of
the growth in capital, accordingly, cessions excluding the formation
transactions have declined.

The
following table presents, for the periods indicated, the amount of premiums
ceded to XLI, XL RE AM and other third-party reinsurers:

|                             |  |                                     |         |      |   |        | 
|---------------------------- |  | ----------------------------------- | ------- | ---- | - | ------ | 
|                             |  | Nine
  Months
  Ended September 30, |        
|                             |  |                                     |        
|(U.S dollars in thousands)   |  | 2006                                |         | 2005 |  
|                             |  |                                     |         |      |  
|Ceded premiums               |  |                                     |         |      |   |        | 
|XLI                          |  | $                                   | (18,804 | )    | $ | 13,567 | 
|XL RE AM                     |  |                                     | 8,567   |      |   | 1,173  | 
|Other third-party reinsurers |  |                                     | 9,081   |      |   | 14,596 | 
|                             |  |                                     |         |      |   |        | 
|Total                        |  | $                                   | (1,156  | )    | $ | 29,336 | 
|                             |  |                                     |         |      |   |        | 

Net Premiums
Earned

Financial
guaranty upfront premiums are earned in proportion to the expiration of the
related risk and financial guaranty 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 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.

56

---



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

|                               |  |                                     |         |      |   |         | 
|------------------------------ |  | ----------------------------------- | ------- | ---- | - | ------- | 
|                               |  | Nine
  Months
  Ended September 30, |        
|                               |  |                                     |        
|(U.S dollars in thousands)     |  | 2006                                |         | 2005 |  
|                               |  |                                     |         |      |  
|Net premiums earned            |  |                                     |         |      |   |         | 
|Upfront policies/contracts     |  | $                                   | 53,398  |      | $ | 34,501  | 
|Installment policies/contracts |  |                                     | 85,411  |      |   | 72,330  | 
|                               |  |                                     |         |      |   |         | 
|Total                          |  | $                                   | 138,809 |      | $ | 106,831 | 
|                               |  |                                     |         |      |   |         | 

Net
premiums earned were $138.8 million for the nine months ended September 30,
2006, an increase of $32.0 million or 29.9%, as compared to $106.8 million in
the comparable period in 2005. The increase in earned premiums was primarily
attributable to higher earned premiums in the financial guaranty insurance
segment of $35.1 million, offset by lower earned premiums in the financial
guaranty reinsurance segment of $3.1 million. Higher earned premiums in the
financial guaranty insurance segment were due to: (i) earned premiums of $25.0
million from the early retirement or refunding of insured securities for the
nine months ended September 30, 2006, as compared to $2.5 million relating to
refunding activity for the comparable period in 2005 and (ii) earned premiums
of $3.8 million from the portfolio transferred / assumed from XLI, as compared
to ceded premiums of $2.8 million for the comparable period in 2005 and (iii) $4.4
million of earned premiums attributable to growth in our in force business. The
$3.1 million decrease in earned premiums in our financial guaranty reinsurance
segment was primarily due to a heavier mix of upfront business in the first
nine months ended September 30, 2006 relative to prior comparable period and
the $1.2 million reduction in earned premiums from the early retirement or
refunding of insured securities. Earned premiums in the financial guaranty
reinsurance segment from the early retirement or refunding of insured
securities were $0.6 million for the nine months ended September 30, 2006 as
compared to $1.8 million in the comparable period in 2005.

Net
Investment Income

Net
investment income was $53.0 million for the nine months ended September 30,
2006, an increase of $16.2 million or 44.0% as compared to $36.8 million in the
comparable period in 2005. The increase in net investment income was due
primarily to higher average invested assets resulting from net cash inflows from
operations, and higher effective yields. The increase in investment yields is
attributable primarily to the general rise in interest rates over the time
period, particularly short- and medium-term interest rates. The five-year
Treasury rate, for example, increased from 4.18% at September 30, 2005 to 4.59%
at September 30, 2006.

The following tables present net investment income,
average invested assets, and the effective yield on our average invested assets
for the nine months ended September 30, 2006 and 2005, and the average duration
of our invested assets as of September 30, 2006 and 2005:

|                                                 |  |                                   |           |      |   |           |  
|------------------------------------------------ |  | --------------------------------- | --------- | ---- | - | --------- | -
|                                                 |  | Nine
  Months Ended September 30, |          
|                                                 |  |                                   |          
|(U.S dollars in thousands, except
  percentages) |  | 2006                              |           | 2005 |  
|                                                 |  |                                   |           |      |  
|Net investment income                            |  | $                                 | 53,026    |      | $ | 36,829    |  
|Average invested assets(1)                       |  | $                                 | 1,575,541 |      | $ | 1,289,884 |  
|Effective yield(2)                               |  |                                   | 4.5       | %    |   | 3.8       | %

|    |                                                                                                                                                                                                                                                                                       
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(1) | Represents the quarterly
  average of the amortized cost of debt securities, short-term investments and
  cash and cash equivalents for the respective periods.                                                                                                                       
|    |                                                                                                                                                                                                                                                                                       
|(2) | Effective yield represents
  net investment income, on an annualized basis, as a percentage of average
  invested assets during the period. The increase in the effective yield was
  due to the turnover in our investment portfolios capturing the trend of
  rising interest rates.

|                          |  |                       |     |      |  |     | 
|------------------------- |  | --------------------- | --- | ---- |  | --- | 
|                          |  | As of
  September 30, |    
|                          |  |                       |    
|                          |  | 2006                  |     | 2005 | 
|                          |  |                       |     |      | 
|Average duration in years |  |                       | 3.2 |      |  | 3.6 | 

57

---



Net Realized
Losses on Investments

Net
realized losses on investments were $16.6 million for the nine months ended
September 30, 2006, an increase of $14.5 million, as compared to net realized
losses of $2.1 million in the comparable period in 2005. The increase in net
realized losses was primarily attributable to $14.0 million of impairment
charges on an investment acquired in satisfaction of a claim on an insured
structured financing (see Note 9 (b) to the interim consolidated
financial statements herein). The remaining net realized gain and loss activity
during the nine months ended September 30, 2006 and 2005 was primarily
attributable to portfolio management actions relating to the management of
duration, yield and exposure to certain credit risks.

Net Realized
and Unrealized Losses on Credit Derivatives

Net
realized and unrealized losses on credit derivatives were $6.7 million for the
nine months ended September 30, 2006, an increase of $2.5 million, as compared
to $4.2 million in the comparable period in 2005. The increase is primarily
attributable to credit default swaps as credit spreads increased during the
nine months ended September 30, 2006 as compared to a nominal change in spreads
during the nine months ended September 30, 2005. This was partially offset by a
positive variance in insured interest rate swaps as long-term interest rates
increased in the nine months ended September 30, 2006 whereas long-term
interest rates decreased slightly during the nine months ended September 30,
2005.

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:

|                                          |  |                                  |        |                                    |   |                   |   |   |        |  
|----------------------------------------- |  | -------------------------------- | ------ | ---------------------------------- | - | ----------------- | - | - | ------ | -
|(U.S.
Dollars in thousands)               |  | Financial
  Guaranty
  Insurance |        | Financial
  Guaranty
  Reinsurance |   | ConsolidatedTotal |  
|                                          |  |                                  |        |                                    |   |                   |  
|                                          |  |                                  |        |                                    |   |                   |   |   |        |  
|Beginning balance, December 31, 2004      |  | $                                | 37,394 |                                    | $ | 17,426            |   | $ | 54,820 |  
|Case reserve provision                    |  |                                  | 12,157 |                                    |   | (3,396            | ) |   | 8,761  |  
|Loss adjustment expense reserve provision |  |                                  | 117    |                                    |   |                  |   |   | 117    |  
|Unallocated reserve provision             |  |                                  | 9,548  |                                    |   | 1,618             |   |   | 11,166 |  
|                                          |  |                                  |        |                                    |   |                   |   |   |        |  
|Net losses and loss adjustment expenses   |  |                                  | 21,822 |                                    |   | (1,778            | ) |   | 20,044 |  
|Paid loss and loss adjustment expenses    |  |                                  | (1,005 | )                                  |   |                  |   |   | (1,005 | )
|                                          |  |                                  |        |                                    |   |                   |   |   |        |  
|Ending balance, September 30, 2005        |  | $                                | 58,211 |                                    | $ | 15,648            |   | $ | 73,859 |  
|                                          |  |                                  |        |                                    |   |                   |   |   |        |  
|                                          |  |                                  |        |                                    |   |                   |   |   |        |  
|Beginning balance, December 31, 2005      |  | $                                | 60,811 |                                    | $ | 17,340            |   | $ | 78,151 |  
|Case reserve provision                    |  |                                  |       |                                    |   | 774               |   |   | 774    |  
|Loss adjustment expense reserve provision |  |                                  | 465    |                                    |   | 149               |   |   | 614    |  
|Unallocated reserve provision             |  |                                  | 8,684  |                                    |   | 1,251             |   |   | 9,935  |  
|                                          |  |                                  |        |                                    |   |                   |   |   |        |  
|Net losses and loss adjustment expenses   |  |                                  | 9,149  |                                    |   | 2,174             |   |   | 11,323 |  
|Assumption of obligation by XLI
(1)       |  |                                  |       |                                    |   | (1,177            | ) |   | (1,177 | )
|Paid loss and loss adjustment expenses    |  |                                  | (1,808 | )                                  |   | (149              | ) |   | (1,957 | )
|                                          |  |                                  |        |                                    |   |                   |   |   |        |  
|Ending balance, September 30, 2006        |  | $                                | 68,152 |                                    | $ | 18,188            |   | $ | 86,340 |  
|                                          |  |                                  |        |                                    |   |                   |   |   |        |  

|                                                                                                                                                                                                                                               | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|(1) In connection with the
  cancellation from inception of certain business ceded by the Company to XLI,
  XLI assumed the Companys obligation for such loss adjustment expenses  see
  Note 6 to consolidated financial statements herein.

58

---



Net
losses and loss adjustment expenses were $11.3 million for the nine months
ended September 30, 2006, a decrease of $8.7 million or 43.5%, as compared to
$20.0 million recorded in the comparable period 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 guaranty insurance segment
of $12.7 million, offset in part by higher net losses and loss adjustment
expenses in the financial guaranty reinsurance segment of $4.0 million.

Lower
net losses and loss adjustment expenses in the financial guaranty insurance
segment during the nine months ended September 30, 2006 reflected: (i) nominal
case basis provisions for losses and loss adjustment expenses during the nine
months ended September 30, 2006 relating to certain insured transactions,
whereas such activity for the nine months ended September 30, 2005 included a
provision for case basis reserves of $12.2 million, of which $12.1 million
related to two insured transactions, which are further described in Note 9 (a)
and 9 (c) to our interim consolidated financial statements elsewhere
herein), and (ii) a period over period decrease in unallocated reserves of $0.8
million related to changes in our in-force book of business resulting in
slightly faster expiration of our in-force par partially offset by growth in
the portfolio.

Higher net losses and loss adjustment expenses in the financial
guaranty reinsurance segment during the nine months ended September 30, 2006,
as compared to the same period in 2005, resulted from: (i) nominal case basis
provisions for losses and loss adjustment expenses during the nine months ended
September 30, 2006, as compared with a net decrease in case reserves during the
nine months ended September 30, 2005 due to favorable development on certain
case basis reserves reported by certain primary companies, offset in part by
(ii) a period over period decrease in unallocated reserves due to changes in
our in-force book of business resulting in slightly faster expiration of our
in-force par.

Acquisition
Costs, Net

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

|                                                                  |  |                                     |        |      |   |        |  
|----------------------------------------------------------------- |  | ----------------------------------- | ------ | ---- | - | ------ | -
|                                                                  |  | Nine
  Months Ended
  September 30, |       
|                                                                  |  |                                     |       
|(U.S dollars in thousands)                                        |  | 2006                                |        | 2005 |  
|                                                                  |  |                                     |        |      |  
|Amortization of deferred acquisition costs and ceding
commissions |  |                                     |        |      |   |        |  
|Financial Guaranty Insurance:                                     |  |                                     |        |      |   |        |  
|Acquisition costs                                                 |  | $                                   | 13,868 |      | $ | 9,579  |  
|Ceding commissions                                                |  |                                     | (5,307 | )    |   | (5,928 | )
|                                                                  |  |                                     |        |      |   |        |  
|Net acquisition costs                                             |  |                                     | 8,561  |      |   | 3,651  |  
|Financial Guaranty Reinsurance:                                   |  |                                     |        |      |   |        |  
|Acquisition costs                                                 |  |                                     | 4,487  |      |   | 5,669  |  
|                                                                  |  |                                     |        |      |   |        |  
|Consolidated acquisition costs, net                               |  | $                                   | 13,048 |      | $ | 9,320  |  
|                                                                  |  |                                     |        |      |   |        |  

Capitalized
acquisition costs in the financial guaranty 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 guaranty insurance segment was $13.9
million for the nine months ended September 30, 2006, an increase of $4.3
million, or 44.8%, as compared to $9.6 million in the comparable period in 2005
(which included $2.1 million and $0.2 million, respectively, of accelerated
amortization of deferred acquisition costs due to refundings in the nine months
ended September 30, 2006 and 2005). Excluding the impact of refundings, the
increase of $2.4 million primarily reflects growth in our in-force business.

59

---



Amortization
of deferred ceding commission revenue in the financial guaranty insurance
segment was $5.3 million for the nine months ended September 30, 2006, an
decrease of $0.6 million or 10.2% as compared to $5.9 million in the comparable
period in 2005. Business previously ceded to XLI was commuted back to the Company
coincident with the IPO. Of the $26.5 million of ceded premiums commuted, $1.3
million was installment business resulting in a reduction of ceding commission
revenue of $0.4 million. The total ceding commission revenues related to
business ceded to XLI was $2.5 million compared to $3.5 million in the year ago
period.

Acquisition
costs in the financial guaranty 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 local insurance regulators. Amortization of
acquisition costs in the financial guaranty reinsurance segment was $4.5
million for the nine months ended September 30, 2006, a decrease of $1.2
million, as compared to $5.7 million in the comparable period in 2005. The
decrease was primarily the result of a decrease in LOC fees of $0.8 million, as
well as a higher mix of upfront business assumed in the current year period as
compared to the prior year period.

Operating
Expenses

Operating
expenses were $55.4 million for the nine months ended September 30, 2006, an
increase of $5.4 million or 10.8% as compared to $50.0 million in the
comparable period in 2005. The increase in operating expenses resulted from
higher operating expenses in the financial guaranty insurance segment, as well
as certain corporate expenses incurred as a result of SCA being a standalone
public company. The increase in operating expenses in the financial guaranty
insurance segmen primarily resulted 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. Corporate expenses, which
prior to the IPO we did not incur, primarily consists of directors and officers
liability insurance, directors fees, printing and distribution costs, and audit
costs, as well as an allocation of compensation costs.

Income tax
expense (benefit)

Income
tax expense was $2.6 million for the nine months ended September 30, 2006, an
increase of $4.3 million as compared to an income tax benefit of $1.7 million
in the comparable period in 2005. The increase in income tax expense resulted
primarily from higher profitability in our U.S.-based primary insurance
operations during 2006.

Investments

The
finance and risk oversight committee of our Board of Directors approves our
general investment objectives and policies. 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.

Market
risk arises due factors that can affect the value of our investments and the
impact such a change in value could have on our earnings. Such factors include
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.

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 guaranty.

60

---



At
September 30, 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 3.2 years at September 30,
2006, as compared to 3.5 years at December 31, 2005.

Our
fixed-income portfolio is exposed to credit and interest rate risk. At
September 30, 2006, the fair value of our consolidated fixed-income portfolio
was approximately $1.9 billion, as compared to approximately $1.3 billion at
December 31, 2005.

The
table below shows the percentage of our consolidated fixed-income portfolio by
credit rating (including debt securities, short-term investments, cash and cash
equivalents and net payable for investments purchased) at September 30, 2006.

|                    |  |       |       |  
|------------------- |  | ----- | ----- | -
|Credit
  Rating(1): |  | Total |      
|                    |  |       |      
|AAA                 |  |       | 76.4  | %
|AA                  |  |       | 12.5  | %
|A                   |  |       | 11.0  | %
|Not rated           |  |       | 0.1   | %
|                    |  |       |       |  
|Total               |  |       | 100.0 | %
|                    |  |       |       |  

|    |                                                                                            
|--- | -------------------------------------------------------------------------------------------
|   
|(1) | At September 30, 2006 the
  average credit quality of our fixed-income portfolio was AAA.

As
at September 30, 2006, the top 10 corporate holdings, which exclude government
guaranteed and government sponsored enterprises, represented approximately 7.3%
of the total fixed-income portfolio and approximately 40.4% of all corporate
holdings. At September 30, 2006, none of our corporate holdings exceeded 2.0%
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 accounting 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 September 30,
2006 would have decreased the fair value of our fixed-income portfolio by
approximately 3.4%, or $64.0 million.

The
following table summarizes our consolidated investment portfolio at September
30, 2006.

|                                                       |  |                  |           |                            |                            |                             |  |              |         |   |   |           | 
|------------------------------------------------------ |  | ---------------- | --------- | -------------------------- | -------------------------- | --------------------------- |  | ------------ | ------- | - | - | --------- | 
|                                                       |  |                  |           |                            | As of
  September 30, 2006 |                             |  |              |        
|                                                       |  |                  |           |                            |                            |                             |  |              |        
|(in thousands)                                         |  | Amortized
  Cost |           | Gross
  Unrealized
  Gains |                            | Gross
  Unrealized
  Losses |  | Fair
  Value |        
|                                                       |  |                  |           |                            |                            |                             |  |              |        
|Debt
  securities                                      |  |                  |           |                            |                            |                             |  |              |         |   |   |           | 
|Mortgage and asset-backed
  securities                 |  | $                | 991,670   |                            | $                          | 4,119                       |  | $            | (11,302 | ) | $ | 984,487   | 
|U.S. Government and
  government agencies              |  |                  | 337,091   |                            |                            | 1,965                       |  |              | (6,199  | ) |   | 332,857   | 
|Corporate                                              |  |                  | 350,555   |                            |                            | 1,307                       |  |              | (6,020  | ) |   | 345,842   | 
|Non-U.S. sovereign
  government                        |  |                  | 10,141    |                            |                            | 100                         |  |              | (216    | ) |   | 10,025    | 
|U.S. states and political
  subdivisions of the states |  |                  | 3,755     |                            |                            | 62                          |  |              | (88     | ) |   | 3,729     | 
|                                                       |  |                  |           |                            |                            |                             |  |              |         |   |   |           | 
|Total debt securities                                  |  | $                | 1,693,212 |                            | $                          | 7,553                       |  | $            | (23,825 | ) | $ | 1,676,940 | 
|                                                       |  |                  |           |                            |                            |                             |  |              |         |   |   |           | 
|Short-term
  investments                               |  |                  |           |                            |                            |                             |  |              |         |   |   |           | 
|Total short-term
  investments                         |  | $                | 194,580   |                            | $                          | 16                          |  | $            | (1,400  | ) | $ | 193,196   | 
|                                                       |  |                  |           |                            |                            |                             |  |              |         |   |   |           | 

61

---



The
amortized cost and estimated fair value of debt securities and short-term
investments available for sale as of September 30, 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.

|                                       |  |                            |           |            |   |           | 
|-------------------------------------- |  | -------------------------- | --------- | ---------- | - | --------- | 
|                                       |  | As of
  September 30, 2006 |          
|                                       |  |                            |          
|(in
  thousands)                       |  | Amortized Cost             |           | Fair Value |  
|                                       |  |                            |           |            |  
|Due within one year                    |  | $                          | 194,580   |            | $ | 193,196   | 
|Due after one through five
  years     |  |                            | 312,205   |            |   | 307,331   | 
|Due after five through ten
  years     |  |                            | 353,551   |            |   | 349,039   | 
|Due after ten years                    |  |                            | 35,786    |            |   | 36,083    | 
|                                       |  |                            |           |            |   |           | 
|                                       |  |                            | 896,122   |            |   | 885,649   | 
|                                       |  |                            |           |            |   |           | 
|Mortgage and asset-backed
  securities |  |                            | 991,670   |            |   | 984,487   | 
|                                       |  |                            |           |            |   |           | 
|Total                                  |  | $                          | 1,887,792 |            | $ | 1,870,136 | 
|                                       |  |                            |           |            |   |           | 

Liquidity and Capital Resources

Capital
Resources

We manage our capital resources to minimize our cost of capital while
maintaining appropriate claims-paying resources to sustain the Triple-A
claims-paying ratings of our insurance subsidiaries. Capital resources are
defined by us to include our total consolidated investments in debt
securities, short-term investments, cash and cash equivalents, and accrued
investment income, less payable for investments purchased, if any, and with
respect to XLFA, its soft capital credit facility. At September 30, 2006 and
December 31, 2005, our total consolidated capital resources were $2.2 billion
and $1.6 billion, respectively.

Total
consolidated net cash inflows for the nine months ended September 30, 2006 were
$622.4 million. This consisted of $259.6 million in cash flow generated by
operations, $344.2 million generated from our IPO (such amount represents gross
proceeds $369.2 million less underwriters allowance and other issuance costs
paid of $25.0 million), and $22.3 million from capital contributions from XL
Capital (which includes cash held by a contributed subsidiary). Of these cash
flows $458.7 million was used for net purchases of new investments. The balance
of cash inflows increased cash and cash equivalents by $163.7 million which were
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.

SCA

SCAs
cash flow consists of dividends from its operating subsidiaries (XLCA and
XLFA), 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, 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. In addition, we intend to pay
quarterly cash dividends on our common shares at an initial rate of $.02 per
common share. The first such dividend was declared on October 31, 2006 and will
be paid on December 29, 2006 to shareholders of record on December 11, 2006.
The timing and amount of cash dividends is at the discretion of our Board of
Directors.

62

---



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. The payment of dividends from our
operating subsidiaries is subject to regulatory restrictions. As a result,
there can be no assurance that our operating subsidiaries will be able to pay
us dividends, or that any dividends paid to us by our operating 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. Because we are a holding company and substantially all of our
business activities are conducted by our operating 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 operating subsidiaries, which are regulated insurance companies
that depend upon ratings from independent rating agencies. Our operating
subsidiaries ability to pay dividends, or make loans, to us is consequently
limited by regulatory and rating agency constraints.

In
the ordinary course of our business, we will evaluate our liquidity needs and
capital resources in light of our expenses, our dividend policy and the
dividend paying ability of our operating subsidiaries. At September 30, 2006,
total capital resources of SCA as a standalone entity was $148.7 million. Based on the amount of SCAs
capital resources, dividends we expect to receive from our operating
subsidiaries, and the income we expect to receive on our invested assets, and
the expected amount of our capital resources (principally the net proceeds from
the IPO retained by us), as well as other resources expected to be available to
us, management believes that we will have sufficient liquidity to satisfy our
anticipated liquidity needs over the next twelve months.

Our
ongoing capital requirements depend on many factors, including our operating
subsidiaries in-force books 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 operating subsidiaries growth and
reduce their 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.

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 dividends on our preferred
stock and 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.

Initial Public Offering and Other Capital
Transactions

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. Net proceeds from the offering after
underwriters allowance and all other issuance costs were $341.1 million (see Operating Subsidiaries- Cash Flows below
for details of the amount of underwriters allowance and other issuance costs
paid as of September 30, 2006). Of net proceeds, $25.0 million and $175.0
million were contributed to the Companys insurance and reinsurance businesses,
respectively, to support their continuing growth, and $141.1 million was
retained at the holding company. Of the proceeds retained at the holding
company, the Company intends to retain less than 10% of such proceeds for
general corporate purposes and to contribute over time the balance of such
proceeds to the capital of the insurance and reinsurance subsidiaries to
support future growth in their respective businesses.

In
connection with the IPO, XL Capital made a capital contribution to the Company
in the form of cash of approximately $22.3 million. In addition, pursuant to an
agreement between us and XL Capital we expect XL Capital to make a capital
contribution to us of approximately $8.4 million relating to the conversion of
certain eligible compensation awarded by XL Capital to SCA employees under its
long-term compensation plans. The final amount and timing of such contribution
will be determined once a conversion plan is finalized by the managements and
boards of directors of SCA and XL Capital. The Company currently expects that
the conversion plan will be finalized by the end of the current fiscal year.

63

---



Operating
Subsidiaries

Liquidity
at our operating subsidiaries is primarily used to pay their operating
expenses, claims, payment obligations with respect to credit derivatives,
reinsurance premiums and dividends to us, as well as in the case of XLCA to
make capital investments from time to time in its subsidiary, XLCA-UK. Our
operating subsidiaries principal sources of liquidity 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 can be affected by changes in interest rates and the amount
and timing of loss payments as well as the other factors described under
OverviewKey Factors Affecting Profitability.

We
believe that our operating subsidiaries have sufficient liquidity and capital
resources to meet their short-term and long-term obligations. Their liquidity
is subject to market conditions, regulation and rating agency requirements and
we cannot guarantee that they will have sufficient liquidity in the future or
that they will not have to seek alternative sources of liquidity, which may be
more expensive than their current liquidity options. We also believe that our
subsidiaries would have sufficient internal and external liquidity sources in
the unlikely and remote event that they were required to record or fund a cash
outlay of up to $1.4 billion with respect to our closely watched credits over
the scheduled payment dates with respect to such credits.

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 September 30, 2006 and December 31, 2005,
the operating subsidiaries on a consolidated basis had readily marketable debt
securities and short-term investments with a carrying value of $1.7 billion and
$1.3 billion, respectively. At those dates, approximately 99.9% of our
operating subsidiaries consolidated investment portfolio was rated A or
higher.

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 $250,000,000 and up to $250,000,000 of
revolving credit loans with the aggregate amount of outstanding letters of
credit and revolving credit loans thereunder not to exceed $500,000,000.

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
$828.6 million, (b) after August 4, 2008, maintain a minimum net worth equal to
the greater of (1) $828.6 million (our net worth, defined as total shareholders
equity before accumulated other comprehensive income, was approximately
$1,345.1 million at September 30, 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%. 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.

64

---



Assumed Reinsurance Collateral
Requirements

In
connection with our reinsurance operations, we may be required to post
collateral or provide letters of credit in favor of certain of our ceding
insurers in order for them to receive reinsurance credit under certain U.S.
state laws. In addition, we have the option, under certain reinsurance
treaties, to post collateral or letters of credit in favor of our ceding
insurers, in the event of a downgrade in our credit rating or other similar
ratings event. As of September 30, 2006, we have drawn letters of credit under
the facility discussed above for the benefit of primary companies reinsured by
us in the amount of $133.1 million. Prior to our IPO, 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 us.

Ceded Reinsurance Recoverables

We
manage our in-force portfolio of guarantied 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 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 September 30, 2006 and December 31, 2005, we had $52.7 million and $52.3
million 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 September 30, 2006 and
December 31, 2005:

|                                  |  |                            |     |                            |  |                           |   |                            |     |  |  |      |  
|--------------------------------- |  | -------------------------- | --- | -------------------------- |  | ------------------------- | - | -------------------------- | --- |  |  | ---- | -
|                                  |  | As of
  September 30, 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                          |  | $                          | 0.5 |                            |  | 0.43                      | % | $                          | 0.3 |  |  | 0.33 | %
|XLI(1)                            |  |                            | 0.5 |                            |  | 0.45                      | % |                            | 4.0 |  |  | 4.41 | %
|AAA
  Companies(2)                |  |                            | 2.5 |                            |  | 2.11                      | % |                            | 2.0 |  |  | 2.21 | %
|AA Companies
  & others(3)        |  |                            | 3.0 |                            |  | 2.55                      | % |                            | 2.5 |  |  | 2.76 | %
|                                  |  |                            |     |                            |  |                           |   |                            |     |  |  |      |  
|Total                             |  | $                          | 6.5 |                            |  | 5.54                      | % | $                          | 8.8 |  |  | 9.71 | %
|                                  |  |                            |     |                            |  |                           |   |                            |     |  |  |      |  



---

|    |                                                                                                                                                                                                                                                                                         
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In connection with the
  transfer of business from XLI to us as described under Formation
  Transactions in our Registration Statement on Form S-1 (SEC File No.
  333-133066) 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/or 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.                          

65

---



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 and redemption
provisions of the preference shares were 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 nine months ended September 30, 2006 and 2005, XLFA paid total dividends to
the holders of its redeemable preferred shares of $3.7 million and $7.5
million, respectively.

66

---



Commitments

On
October 1, 2006, the Company entered into an agreement with International
Business Machines Corporation and various affiliates (IBM). 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 the services the
Company is obligated to pay IBM approximately $4.0 million per annum for the
five year term of the contract.

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 guaranty 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. The FASB arrived at a
tentative decision during the third quarter of 2006 which will form the basis
of the forthcoming Exposure Draft. The Company will continue to apply the
accounting policies as disclosed in its audited historical consolidated
financial statements as of December 31, 2005 and 2004 and for the years ended
December 31, 2005, 2004, and 2003 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 implications of SFAS 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 is not expected to have
a material effect on our financial condition or results of operations.

67

---



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 effective for fiscal years
beginning after December 15, 2006. The adoption of FIN 48 is not expected to
have a material effect on the Companys financial condition or results of
operations.

In
September 2006, the FASB issued proposed FSP FAS 123(R)-e, Amendment of FASB
Staff Position FAS 123(R)-1, which addresses whether the modification of an
instrument in connection with an equity restructuring or a business combination
should be considered a modification for purposes of applying FSP FAS 123(R)-1,
Classification and Measurement of Freestanding Financial Instruments
Originally Issued in Exchange for Employee Services under FASB Statement No. 123(R).
The FASB staff has taken the position that for instruments that were originally
issued as employee compensation and then exchanged or changed, where the only
change is a change to the terms of an award to reflect an equity restructuring
or a business combination that occurs when the holders are no longer employees,
then no change in the recognition and measurement (due to a change in
classification) of these instruments will result if, there is (i) no increase
in value to the holders of the instrument or (ii) the exchange or change in the
terms of the award is not made in contemplation of an equity restructuring or a
business combination and (iii) all holders of the same class of equity
instruments (for example, stock options) are treated in a similar manner. These
provisions must be applied in the first reporting period beginning after the
date the final FSP is posted to the FASBs website. This guidance is not
expected to have a significant impact on the Companys financial condition or
results of operations.

In
September 2006, the Securities and Exchange Commission (the SEC) issued Staff
Accounting Bulletin No. 108 (SAB 108), Considering the Effects of Prior Year
Misstatements when Qualifying Misstatements in Current Year Financial Statements,
which provides interpretive guidance on the consideration of the effects of
prior year misstatements in quantifying current year misstatements for the
purpose of a materiality assessment. SAB 108 is effective for companies with
fiscal years ending after November 15, 2006 and is required to be adopted by
the Company in its fiscal year ending December 31, 2006. However, early
application is encouraged in any report for an interim period filed after the
publication of this guidance. The Company is currently assessing the impact of
the adoption of SAB 108. The Company does not anticipate a significant impact
as a result of adopting this standard.

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 will be
effective for interim and annual financial statements issued after January 1,
2008. The Company is currently assessing the impact of the adoption of SFAS
157.

Off-Balance Sheet Arrangements

As
of September 30, 2006 and December 31, 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 Note 2 to our Interim Consolidated
Financial Statements.

68

---



CAUTIONARY NOTE REGARDING FORWARD-LOOKING
STATEMENTS

The
Private Securities Litigation Reform Act of 1995 (PSLRA) provides a safe
harbor for forward-looking statements. Any Registration Statement, prospectus
supplement, the Companys Annual Report to ordinary shareholders, any proxy
statement, any other Form 10-K, Form 10-Q or Form 8-K of the Company or any
other written or oral statements made by or on behalf of the Company may
include forward-looking statements that reflect the Companys current views
with respect to future events and financial performance. Such statements
include forward-looking statements both with respect to the Company in general,
and to the insurance and reinsurance sectors in particular (both as to
underwriting and investment matters). 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 for purposes of the PSLRA or otherwise. 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. The Company believes 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
  FSAH;                                                                                                                                                           
| |   |                                                                                                                                                                                                                                                          
| |  | 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 ratings or 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;                                                                                                                                                                                                                

69

---



| |   |                                                                                                                                        
| | - | ---------------------------------------------------------------------------------------------------------------------------------------
| |  | 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. The Company undertakes no obligation to update
publicly or revise any forward-looking statement, whether as a result of new
information, future developments or otherwise.

ITEM 3. QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK

Quantitative
and qualitative disclosure regarding our exposures to market risk, as well as
our objectives, policies and strategies relating to the management of such
risks, is set forth in our Registration Statement on Form S-1 (SEC File No.
333-133066). Our relative sensitivity to changes in fair value from interest
rates and equity prices at September 30, 2006 is not materially different from
that presented in the aforementioned Registration Statement.

ITEM 4. 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(e) and 15d-15(e) 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.

70

---



PART II 
OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The
Company believes that the ultimate outcome of all outstanding litigation and
arbitration will not have a material adverse effect on its consolidated
financial condition, future operating results and/or liquidity, although an
adverse resolution of a number of these items could have a material adverse
effect on the Companys results of operations in a particular fiscal quarter or
year.

ITEM 1A. RISK FACTORS

Refer
to Risk Factors in our Registration Statement on Form S-1 (SEC File No.
333-133066) for further information.

ITEM 6. EXHIBITS

|                 |                                                                                                                                                                                                                                        
|---------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit
  Number | Description of Document                                                                                                                                                                                                                
|                 |                                                                                                                                                                                                                                        
|                 |                                                                                                                                                                                                                                        
|10.1             | 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.
|                 |                                                                                                                                                                                                                                        
|31               | Rule
  13a-14(a)/15d-14(a) Certifications                                                                                                                                                                                              
|                 |                                                                                                                                                                                                                                        
|32               | Section 1350
  Certification                                                                                                                                                                                                           
|                 |                                                                                                                                                                                                                                        
|99.1             | XL Capital
  Assurance Inc. and Subsidiary interim consolidated financial statements
  (unaudited) as of September 30, 2006 and for the three and nine month periods ended September 30, 2006 and
  2005.                              
|                 |                                                                                                                                                                                                                                        
|99.2             | XL Financial
  Assurance Ltd. interim financial statements (unaudited) as of September 30, 2006 and for the three and
  nine month periods ended September 30, 2006 and 2005.                                                          

| | 
| | 
| | 

71

---



SIGNATURES

Pursuant
to the requirements of the Securities and Exchange Act of 1934, the registrant
has duly caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.

|                        |                                                     
|----------------------- | ----------------------------------------------------
|                        | SECURITY CAPITAL ASSURANCE LTD                      
|                        | (Registrant)                                        
|                        |                                                     
|Date:
November 14, 2006 | /s/ PAUL S.
  GIORDANO                              
|                        |                                                     
|                        | Paul S.
  Giordano                                  
|                        | President, Chief Executive Officer and Director     
|                        | (Principal Executive Officer)                       
|                        |                                                     
|Date:
November 14, 2006 | /s/ DAVID P.
  SHEA                                 
|                        |                                                     
|                        | David P. Shea                                       
|                        | Executive Vice President and Chief Financial Officer
|                        | (Principal Financial Officer)                       

72

---