(a) Prepared in accordance with accounting principles generally accepted in the United States of America.
Including both primary and secondary U.S. municipal obligations with closing dates in 2005, FSA’s U.S. municipal par originated increased 32.3%, and the related PV premiums originated increased 11.8%. In 2005, the mix of business shifted toward a greater volume of general obligations, including school bonds, and other tax-backed transactions that tend to have lower absolute premiums than revenue bonds because of their lower risk. In 2004, FSA’s U.S. municipal par originated declined 10.7%, and the related PV premiums originated declined 10.3%. FSA increased its PV premiums originated in the health care revenue and general obligation sectors during 2004, but those increases were offset by declines in the non-general obligation tax-supported sector and various revenue-backed sectors.
Net interest income and net interest expense are reflected in the statements of operations and comprehensive income but are limited to current-year earnings. As GIC contracts extend beyond the current period, management considers the non-GAAP measure PV NIM to be a useful indicator of future
PV NIM originated increased 25.6% in 2005 as the book of business increased. Throughout 2005, the Company generally took a cautious approach to asset acquisitions because of the narrow spread environment, although it did find some long-dated purchasing opportunities. The growth in the book of business is largely a function of increased GIC issuance activity in both municipal and structured GICs. In 2004, PV NIM originated increased 67.1%.
Net investment income increased 16.7% in 2005 and 11.7% in 2004, primarily due to higher invested balances arising from new business writings and dividend income from the Company’s equity investment in XL Financial Assurance Ltd (“XLFA”).
Other operating expenses decreased 5.5% in 2005 compared with an increase of 6.5% in 2004. Excluding compensation expenses related to the Company’s deferred compensation and supplemental executive retirement plans, other operating expenses were $91.4 million in 2005, $80.8 million in 2004 and $65.6 million in 2003. The increases in 2005 and 2004 relate primarily to increased personnel costs and increases in premises and equipment expense as a result of the move to the Company’s new headquarters. The Company purchases assets selected by participants in the deferred compensation and supplemental executive retirement plans to economically defease the Company’s liability under these plans. Deferred compensation and supplemental executive retirement plan expenses are recorded in other operating expenses and the related income on the assets is recorded in other income. Such expenses and income therefore have no effect on net income.
Realized interest income and expense associated with economic interest rate hedges is an element of derivative gains and losses added back to calculate FP operating NIM. Derivatives that qualify for hedge accounting are classified in the consolidated statements of operations and comprehensive income with the underlying item being hedged. Gains and losses on derivatives that do not qualify for hedge accounting are shown under the caption net realized and unrealized gains (losses) on derivative instruments. Unrealized derivative gains and losses are excluded from FP operating NIM.
For the first three quarters of 2004 and all prior years, equity in earnings of unconsolidated affiliates included the results of XLFA. In accordance with EITF 02-14, “Whether an Investor Should Apply the Equity Method of Accounting for Investments Other Than Common Stock,” the Company no longer accounts for its investment in XLFA under the equity method of accounting. Effective October 1, 2004, the Company’s investment in XLFA has been included in equity securities as an available-for-sale security. The fair value of the investment at December 31, 2005 and 2004 was $54.3 million. In March 2006, the XLFA Board of Directors approved a by-law amendment changing the coupon on XLFA’s preferred shares from the participating dividend described above to an 8.25% per annum fixed dividend effective January 1, 2006. Such by-law amendment remains subject to XLFA shareholder approval. Pending such approval, a dividend will be declared at this new rate on XLFA’s preferred shares for the first quarter of 2006.
Asset-backed and, to a lesser extent, municipal transactions insured by FSA may employ VIEs for a variety of purposes. A typical asset-backed transaction, for example, employs a VIE as the purchaser of the
On July 1, 2003, the Company consolidated $1.9 billion in assets and $1.9 billion in liabilities relating to variable interest entities with no corresponding cash movement. The Company received tax benefits of $1.2 million in 2004 and $0.3 million in 2003 from its parent company, which were recorded as capital contributions. There were no such benefits recorded in 2005. See Note 10 for disclosure of non-cash transactions relating to restricted treasury stock transactions.
obtaining control rights. The Company refinanced certain defaulted transactions by employing refinancing vehicles to raise funds for the refinancings. These refinancing vehicles are also consolidated.
The Company enters into derivative contracts to manage interest-rate and foreign currency exposure of the Company’s GIC and VIE debt, GIC bond portfolio and VIE bond portfolio. The derivatives are recorded at fair value. These derivatives generally include interest-rate futures and interest rate and currency swap agreements, which are primarily utilized to convert the Company’s fixed-rate obligations on its GIC and VIE debt, GIC bond portfolio and VIE bond portfolio into U.S.-dollar floating-rate obligations. The gains and losses relating to the fair value of derivatives are included in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income.
GIC and VIE debt is recorded at amortized cost. The Company may enter into associated transactions in order to reduce the Company’s exposure to fluctuations in interest and foreign exchange rates and its related effect on the fair value of the debt. The change in the fair value of the hedged item in a qualifying accounting hedge attributable to the hedged risk adjusts the carrying amount of the hedged item and is recognized in income currently. VIE debt may include hybrid debt instruments that contain embedded derivatives. Under certain conditions, embedded derivatives are required to be separated from the debt instrument and accounted for at fair value, with all changes reflected through earnings.
In addition to its insurance company and certain non-insurance subsidiaries’ investments (the “Investment Portfolio”), the Company maintains investments from proceeds of FSA-insured GICs (the “FP Investment Portfolio”) and investments in the portfolio of securities owned by the VIEs (the “VIE Portfolio”) and assets acquired in refinancing transactions (see Note 22).
The American Jobs Creation Act of 2004 (the “Act”), enacted on October 22, 2004, added Section 965 to the Internal Revenue Code. Section 965 provides for the repatriation of dividends from a controlled foreign corporation to its U.S. shareholder at an effective tax rate of 5.25%, provided that proceeds from the repatriation are utilized for qualified domestic investment activities. The U.S. Treasury Department issued Notice 2005-10, which provided guidance on acceptable investment activities. The Company believes it qualifies for the beneficial treatment under Section 965 and accordingly accrued a tax liability and expense of $5.3 million at December 31, 2004. This amount approximated the tax effect on FSA International’s tax dividend distribution made in the fourth quarter of 2005.
FSA has a credit arrangement aggregating $150.0 million that is provided by commercial banks and intended for general application to insured transactions. If FSA is downgraded below Aa3 and AA-, the lenders may terminate the commitment and the commitment commission becomes due and payable. If FSA is downgraded below Baa3 and BBB-, any outstanding loans become due and payable. At December 31, 2005, there were no borrowings under this arrangement, which expires on April 21, 2006, if not extended.
FSA has a standby line of credit commitment in the amount of $350.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $350.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $1,220.0 million at December 31, 2005. The obligation to repay loans made under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a term expiring on April 30, 2015 and contains an annual renewal provision, commencing April 30, 2008, subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2005.
Performance shares issued prior to January 1, 2005 permitted the participant to elect, at the time of award, growth rates including or excluding realized and unrealized gains and losses on the Investment Portfolio. Performance shares issued after January 1, 2005 do not offer the option to include the impact of unrealized gains and losses on the Investment Portfolio. No payout occurs if the compound annual growth rate of adjusted book value and book value per outstanding share over specified three-year performance cycles is less than 7%, and a 200% payout occurs if the compound annual growth rate is 19% or greater. Payout percentages are interpolated for compound annual growth rates between 7% and 19%.
(1) Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
The net par outstanding of insured obligations in the municipal insured portfolio includes the following amounts by type of issue (in millions):
relating to swaps where Dexia was the counterparty. In addition, at December 31, 2005 and 2004, the Company had $172.0 million and $163.0 million in VIE debt, respectively, relating to debt issued by the Company and purchased by Dexia. During 2005 and 2004, the Company recorded $9.3 million and $8.8 million, respectively, in VIE net interest expense relating to such debt.
For notes payable, the carrying amount of notes payable represents the principal amount due at maturity. The fair value is based on the quoted market price.
On November 12, 2003, the FTC announced a settlement with SPS, resolving the FTC’s civil allegations against SPS. Pursuant to that settlement, SPS paid $40.0 million to the FTC to compensate consumers who suffered harm. The settlement enjoins SPS from future law violations and imposes new restrictions on SPS’s business practices. A related settlement of numerous class action lawsuits against SPS has been approved by a federal district court in Massachusetts. The $10.3 million additional equity