Derivative Contracts. All derivative instruments are recognized in our consolidated balance sheet as either assets or liabilities depending on the fair value to us as a credit protection seller as of the determination date. All derivative instruments are measured at estimated fair value. We value derivative contracts based on quoted market prices, when available. However, if quoted prices are not available, the fair value is estimated using valuation models specific to the type of credit protection. Valuation models include the use of management estimates and current market information. We utilize both proprietary and vendor based models (including rating agency models) and a variety of market data to provide the best estimate of fair value. Some of the more significant types of market data that influence our models include, but are not limited to, credit ratings, interest rates, credit spreads, default probabilities and recovery rates. If management’s underlying assumptions for evaluating fair value prove to be inaccurate, there could be material changes in our consolidated operating results.
CDO Asset Management. Net income increased to $21.4 million in 2006 compared to $10.5 million in 2005 primarily as a result of an increase in fee and other income attributable to increased assets under management. In 2006, we increased assets under management by $5.8 billion for a total of $15.7 billion at year end. We also experienced improved returns on our equity investments in various CDOs. These increases were partially offset by increased operating expenses. Also, in 2005, we had greater losses in our insured credit swap and other credit swap revenues when compared to 2006 related to the valuation of these contracts under FAS 133. Unrealized losses in 2006 for these items were $0.5 million in 2006 compared to $4.2 million in 2005. In 2005, we also recognized a realized loss of $3.3 million in other credit swap revenues as a result of a credit event on a single credit swap. Net income was relatively flat when comparing 2005 to 2004, however, the drivers of each year’s results differed. We recognized increased
Net Investment Income. Allocated net investment income primarily represents the income recognized on the investment portfolio of ACA Financial Guaranty. To a much lesser degree, investment income from other companies within the group is included to the extent it is not directly related to any of the lines of business. Investment income allocated to each line of business is based upon the estimated capital utilized by the line of business which is derived from our rating agency capital adequacy model. For the year ended December 31, 2006, allocated net investment income increased to $24.9 million from $20.7 million for the year ended December 31, 2005. This increase was related to growth in the investment portfolio from $587.1 million at the end of 2005 to $670.6 million at the end of 2006. The growth in the investment portfolio was primarily related to positive cash flows generated by our businesses and, to a lesser extent, from $10 million contributed from the proceeds of our initial public offering. From 2004 to 2005, allocated net investment income increased from $13.1 million to $20.7 million. The vast majority of the increase came from the infusion of equity capital as a result of our recapitalization in 2004 whereby we raised $169.7 million in additional capital.
The 2006 increase compared to 2005 in allocated expenses was related to two principal items. First, our new status as a publicly traded company in 2006 caused an increase in certain corporate expenses. Additionally, we incurred expenses for our newly established office in the United Kingdom. This office was
(3) Represents the return on our CDO equity investments. For consolidated CDOs, this is based on the investment income of the CDO less direct interest expense, direct realized losses, operating expenses, amortization expense and management fees. For unconsolidated CDOs, equity return is the amount of income recorded on the related unconsolidated investment.
(7) Represents the minority interest portion of net unrealized gains (losses) on derivatives for two consolidated CDOs in which we own less than 100% of the equity. We exclude this item when we examine the results related to our managed CDOs.
For funded and partially funded unconsolidated CDOs, we reflect management fees and investment income in our consolidated statements of operations. As of December 31, 2006, we have 12 funded and partially funded CDOs that are not consolidated. In these instances, the investment income recorded is only on the equity investment made by us as compared to all of the assets in a consolidated CDO. Partially funded, unconsolidated CDOs in which we invest in the funded equity securities are reflected in our financial statements in the same way as funded unconsolidated CDOs.
While in early transactions we either invested in or sold credit protection through insured credit swaps on 100% of the equity tranches of our CDOs, and therefore consolidate those CDOs (to the extent the accounting rules require such consolidation), beginning in 2005 we have been able to assume reduced amounts of equity in the CDOs that we manage and therefore have not been consolidating CDOs originated since that time. We do not anticipate consolidating new CDOs in the future.
Losses and Loss Adjustment Expenses. In terms of Losses and Loss Adjustment Expenses, we continue to record losses for the trade credit business. Like premium, losses incurred on these contracts continued to decline as the underlying exposures run off. This loss activity has been within management’s expectations. Losses incurred for trade credit contracts totaled $0.6 million in 2006, $2.3 million in 2005 and $1.0 million in 2004.
Certain prior year items have been reclassified to conform to the current year presentation. These adjustments had no impact on net income, earnings per share, cash flows or total stockholders’ equity.
Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect on tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company provides a valuation allowance on its gross deferred tax assets when it is more likely than not that such assets will not be realized. A valuation allowance was established in 2006 in the amount of $1.6 million relating to the portion of the tax benefits attributable to certain net operating losses. The Company did not provide a valuation allowance as of December 31, 2005 (see Note 11).
(4) Argon 49 and Argon 57 are denominated in Euros. For purposes of this chart, we have converted the amounts to U.S. dollars at the prevailing currency exchange rate on December 31, 2006.
During 2005 and 2006, the Company retained less than a majority share of the equity position in each of its five and eight, respectively, newly issued CDOs (five fully funded ABS CDOs, two partially funded ABS CDOs, three corporate credit CDOs, and three collateralized loan obligations) and based on FIN 46(R) analyses is not deemed to be the primary beneficiary. As a result, these CDOs are not consolidated in the Company’s financial statements. Rather, the Company’s non-majority investment is recorded as an investment in a single fixed maturity security under the provisions of FAS 115 and EITF 99-20. The total investment in these CDOs is included in consolidated assets at December 31, 2006 was $72.1 million. Additionally, the Company has been engaged to act as asset manager to third-party CDOs not originated and structured by the Company for which it receives asset management fees.
In certain funded CDOs, the Company issued liabilities in the form of notes in order to fund its equity purchases. These borrowings were accomplished through the issuance of non-recourse notes by subsidiaries of the Company. These notes are insured as to the repayment of principal and interest by ACA Financial Guaranty. The premium on the policy insuring the notes payable to ACA Financial Guaranty is payable by the Company’s subsidiary that invested in the preferred shares. These subsidiaries and ACA Financial Guaranty are wholly owned by the Company and therefore this inter-company premium is eliminated in consolidation.
The unrealized losses on the Company’s non-VIE investments was generally caused by interest rate increases. Because the decline in market value of these securities is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be at maturity, it does not consider these investments to be other-than-temporarily-impaired at December 31, 2006.
In 2006, 2005 and 2004, ACA Financial Guaranty assumed reinsurance premiums written of $0.7 million, $1.0 million and $0.2 million, respectively. In 2006, 2005 and 2004, assumed earned premiums were $0.9 million, $1.0 million and $0.3 million, respectively. ACA Assurance, a subsidiary whose business (trade credit and insured loss warranty) was discontinued or placed into run-off in 2004, recorded assumed
the following CDO transactions: ACA CDS 2002-1 Funding, Limited; ACA ABS 2003-1 Funding, Limited; ACA ABS 2003-2 Funding, Limited; Grenadier Funding, Limited; Lancer Funding, Ltd. and Zenith Funding, Limited. The Company financed its equity position in each of the following CDO transactions: ACA CLO 2005-1, Limited and ACA ABS 2005-2, Limited. The Company may use some of the remaining unallocated Deposit Amount from time to time to finance the Company’s equity position in future CDO transactions. Each such equity financing is secured by a pledge of the equity purchased with the proceeds of the financing and an ACA Financial Guaranty insurance policy.