Our financial results include four principal business segments: financial guaranty direct, financial guaranty reinsurance, mortgage guaranty and other. The other segment consists of a number of businesses that we have exited including equity layer credit protection, trade credit reinsurance, title reinsurance, life, accident and health reinsurance (“LA&H”) and auto residual value reinsurance.
The chart below demonstrates the portfolio reserve’s sensitivity to frequency and severity assumptions. The change in these estimates represent management’s estimate of reasonably possible material changes and are based upon our analysis of historical experience. Portfolio reserves were recalculated with changes made to the default and severity assumptions. In all scenarios, the starting point used to test the portfolio reserve’s sensitivity to the changes in the frequency and severity assumptions was the weighted average frequency and severity by rating and asset class of our insured portfolio. Overall the weighted average default frequency was 0.78% and the weighted average severity was 20.0% at December 31, 2005. For example, in the first scenario where the frequency was increased by 5.0%, each transaction’s contribution to the portfolio reserve was recalculated by adding 0.04% (i.e. 5.0% multiplied by 0.78%) to the individual transaction’s default frequency.
Acquisition costs primarily consist of ceding commissions, brokerage fees and operating expenses that are related to the acquisition of new business. Acquisition costs that vary with and are directly related to the acquisition of new business are deferred and are amortized in relation to earned premium. For the years ended December 31, 2005, 2004 and 2003, acquisition costs were $45.3 million, $50.9 million and $64.9 million, respectively. The decrease of $5.6 million in 2005 compared with 2004 is primarily related to $3.9 million of acquisition costs recorded in our other segment in 2004. There were no acquisition costs in our other segment during 2005. The decrease of $14.0 million in 2004 is partially related to the financial guaranty reinsurance segment, as we have negotiated lower ceding commission rates across our entire book of business in 2004 compared with prior year. Additionally, acquisition costs in our other segment have decreased due to exiting certain lines of business, particularly the trade credit business which historically incurred an acquisition ratio of 30-35%.
Gross written premiums for our financial guaranty reinsurance segment include upfront premiums on transactions underwritten during the period, plus installment premiums on business primarily underwritten in prior periods. Consequently, this amount is affected by changes in the business mix between public finance, which tends to be upfront premium, and structured finance, which tends to be installment premium. For the year ended December 31, 2005, 52% of gross written premiums in this segment were upfront premiums and 48% were installment premiums. For the years ended December 31, 2004 and 2003, 68% of gross written premiums in this segment were upfront premiums and 32% were installment premiums.
• AG Re Affiliate Reinsurance Transaction: On December 31, 2001, AG Re entered into an excess of loss reinsurance contract with a subsidiary of ACE. Under the terms of this reinsurance contract, AG Re paid $125.0 million for 25 years of reinsurance coverage. This coverage provided a $400.0 million aggregate limit, a $50.0 million per risk limit and a $5.0 million per risk deductible. We terminated this agreement effective December 31, 2003 and recorded a receivable of $131.9 million consisting of ceded unearned premium of $115.0 million and reinsurance recoverables on paid losses of $16.9 million. This amount was received in 2004. There was no earnings impact from the termination of this contract.
We anticipate that a major source of our liquidity, for the next twelve months and for the longer term, will be amounts paid by our operating subsidiaries as dividends. Certain of our operating subsidiaries are subject to restrictions on their ability to pay dividends. See “Business-Regulation.” The amount available at AGC to pay dividends in 2006 with notice to, but without the prior approval of, the Maryland Insurance Commissioner is approximately $25.6 million. Dividends paid by a U.S. company to a Bermuda holding company presently are subject to a 30% withholding tax. The amount available at AG Re to pay dividends in 2006 in compliance with Bermuda law is $590.2 million. AGC has committed to it’s rating agencies that it will not pay more than $10.0 million per year in dividends, without prior consultation.
On November 8, 2004, Assured Guaranty Ltd., AG Re and AGRO entered into a standby letter of credit agreement (the “LOC Agreement”) with KeyBank National Association (“KeyBank”). Under the LOC Agreement, KeyBank agreed to issue up to $50.0 million in letters of credit on our behalf. The obligations of the Company, AG Re and AGRO under the LOC Agreement were joint and several. The letters of credit were used to satisfy AG Re’s or AGRO’s obligations under certain reinsurance agreements and for general corporate purposes. Under the LOC Agreement, KeyBank issued two letters of credit, both on behalf of AGRO, with an aggregate stated amount of approximately $20.7 million. The parties to the LOC Agreement have agreed that no additional letters of credit would be issued, extended or renewed from and after the date of the closing of the $300.0 million credit facility and letters of credit that were outstanding on such date will, unless cancelled and surrendered by the respective beneficiaries thereof, remain outstanding until their respective stated expiration dates of December 31, 2005. The LOC Agreement contains covenants that limit debt, liens, guaranties, loans and investments, dividends, liquidations, mergers, consolidations, acquisitions, sales of assets or subsidiaries and affiliate transactions. Most of these restrictions were subject to certain minimum thresholds and exceptions. The LOC
Under agreements with our cedants and in accordance with statutory requirements, we maintain fixed maturity securities in trust accounts for the benefit of reinsured companies and for the protection of policyholders, generally in states where we or our subsidiaries, as applicable, are not licensed or accredited. The carrying value of such restricted balances as of December 31, 2005 and 2004 was $552.8 million and $304.4 million, respectively.
As of December 31, 2005 the Company has recorded $1.3 million in portfolio reserves, but has not recorded any case reserves for this event, as no case reserves have been reported to us by any of our ceding company clients. In addition, only five claims have been paid, in the amount of $0.1 million, all of which were fully recovered. We have added 4 credits with net par outstanding of $44.8 million to Category 1 of our Closely Monitored Credits (“CMC”) list and 7 credits with net par outstanding of $80.6 million to Category 2 of the CMC list related to Hurricane Katrina. Nonetheless, significant uncertainty exists with regard to both the probability of defaults occurring and the loss severities that will apply to any defaults that do occur. The Company’s surveillance department is actively monitoring specific exposures in coordination with our reinsurance clients and will continue to assess the impact of Hurricane Katrina on the credit quality of our portfolio.
Consolidated Statements of Operations and Comprehensive Income for the years ended December 31, 2005, 2004 and
On April 28, 2004, subsidiaries of ACE Limited (“ACE”), completed an initial public offering (“IPO”) of 49,000,000 of their 75,000,000 common shares, par value $0.01 per share, of Assured Guaranty Ltd. (the “Company”), formerly AGC Holdings Ltd. Assured Guaranty Ltd.’s common shares are traded on the New York Stock Exchange under the symbol “AGO”. The IPO raised approximately $840.1 million in net proceeds, all of which went to the selling shareholders. As part of the IPO, Assured Guaranty Ltd. and ACE entered into various agreements which govern various settlement issues. As part of these agreements all pre-IPO intercompany receivables and payables were settled with ACE on June 10, 2004. In connection with the IPO, the following transactions took place:
Short-term investments are recorded at cost, which approximates fair value. Short-term investments are those with original maturities of greater than three months but less than one year from date of purchase.
Portfolio reserves are not established based on a specific event, rather they are calculated by aggregating the portfolio reserve calculated for each individual transaction. Individual transaction reserves are calculated on a quarterly basis by multiplying the par in-force by the product of the ultimate loss and earning factors without regard to discounting. The ultimate loss factor is defined as the frequency of loss multiplied by the severity of loss, where the frequency is defined as the probability of default for each individual issue. The earning factor is inception to date earned premium divided by the estimated ultimate written premium for each transaction. The probability of default is estimated from historical rating agency data and is based on the transaction’s credit rating, industry sector and time until maturity. The severity is defined as the complement of historical recovery/salvage rates gathered by the rating agencies of defaulting issues and is based on the industry sector.
until the experience account is fully depleted, which can extend many years beyond the expiration of the coverage period.
The Company accounts for its stock-based compensation plans in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations. No compensation expense for options is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of the grant. Pro forma information regarding net income and earnings per share is required by FAS No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”). Effective January 1, 2006, the Company will begin recognizing compensation expense, using the modified-prospective transition method, for options and its employee stock purchase plan in accordance with FAS No. 123 (revised), “Share-Based Payment” (“FAS 123R”). See Note 3. Recent Accounting Pronouncements, for more information.
Assured Guaranty Re Ltd. (“AG Re”, formerly Assured Guaranty Re International Ltd.) a Bermuda regulated Class 3 insurer and Long-Term insurer prepares its statutory financial statements in conformity with the accounting principles set forth in The Insurance Act 1978, amendments thereto and Related Regulations. The statutory capital and surplus of AG Re was $674.3 million and $601.4 million as of December 31, 2005 and 2004, respectively. The statutory net income of AG Re was $94.4 million, $39.2 million and $91.3 million for the years ended December 31, 2005, 2004 and 2003, respectively.
In 2001, AG Re and ACE Bermuda entered into a funding facility agreement pursuant to which ACE Bermuda agreed to purchase up to $150.0 million of non-investment grade fixed income securities selected by AG Re, and AG Re agreed to enter into a total rate of return swap in respect of each security purchased. The aggregate amount received by AG Re under this funding facility agreement, net of the funding fee paid by AG Re, for the year ended December 31, 2003 was $4.8 million. All securities purchased pursuant to this agreement were sold and this agreement was terminated in connection with the IPO.
At the closing of the $300.0 million credit facility, (i) AGC guaranteed the obligations of AG (UK) under such facility, (ii) Assured Guaranty Ltd. guaranteed the obligations of AG Re and AGRO under such facility and agreed that, if the Company Consolidated Assets (as defined in the related credit agreement) of AGC and its subsidiaries were to fall below $1.2 billion, it would, within 15 days, guarantee the obligations of AGC and AG (UK) under such facility and (iii) Assured Guaranty Overseas US Holdings Inc., as a Material Non-AGC Subsidiary (as defined in the related credit agreement), guaranteed the obligations of Assured Guaranty Ltd., AG Re and AGRO under such facility. Subsequently, AG Re and AGRO, as Material Non-AGC Subsidiaries, both guaranteed the obligations of the other and of Assured Guaranty Ltd. under such facility.
fiscal quarter prior to the closing date of the facility and (y) maintain a ratio of aggregate net par outstanding to qualified statutory capital of not more than 150:1. Furthermore, the $300.0 million credit facility contains restrictions on Assured Guaranty Ltd. and its subsidiaries, including, among other things, in respect of their ability to incur debt, permit liens, become liable in respect of guaranties, make loans or investments, pay dividends or make distributions, dissolve or become party to a merger, consolidation or acquisition, dispose of assets or enter into affiliate transactions. Most of these restrictions are subject to certain minimum thresholds and exceptions. A default by one borrower will give rise to a right of the lenders to terminate the facility and accelerate all amounts then outstanding. As of December31, 2005, Assured Guaranty was in compliance with all of those financial covenants.
Under the Company’s Incentive Plan 402,747 and 1,088,292 restricted common shares were awarded during the years ended December 31, 2005 and 2004, respectively, to employees and non-employee directors of the Company. These shares vest at various dates through 2009.