(b) VIE balances are included beginning July 1, 2003 due to the adoption of Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.”
Comparing 2006 GAAP results with those of 2005, the Company’s net income increased 30.1% to $424.2 million. Gross premiums written decreased 2.1% to $816.0 million. Shareholders’ equity decreased 3.6% to $2.7 billion.
The GAAP measure “gross premiums written” captures premiums collected or accrued for in a given period, whether collected for business originated in the period, or in installments for business originated in prior periods. It is not a precise measure of current-period originations because a significant portion of the Company’s premiums are collected in installments. Therefore, to measure current-period premium production, management calculates the gross present value of premium installments originated in the accounting period and combines it with premiums received upfront in the accounting period, which produces the non-GAAP measure PV premiums originated.
Viewed at a policy level, installment premiums are generally calculated as a fixed premium rate multiplied by the insured debt outstanding as of dates established by the terms of the policy. Because the actual installment premiums received could vary from the amount estimated at the time of origination based on variances in the actual outstanding debt balances and foreign exchange rate fluctuation, the realization of PV premiums originated could be greater or less than the amount reported.
Year-to-year comparisons of PV premiums originated are affected by the application of a different discount rate each year. The discount rate employed by the Company for this purpose was 5.07% for 2006 originations, 5.30% for 2005 originations and 5.62% for 2004 originations. Management intends to revise the discount rate in future years according to the same methodology, in order to reflect specific return results realized by the Company.
Unless otherwise noted, percentage changes in this discussion and analysis compare the period named with the comparable period of the prior year.
The tables below show the PV premiums originated and gross par amount insured by FSA in its major business sectors for transactions closed in the period.
After strong new-issue volume in the fourth quarter, total issuance in the U.S. municipal bond market reached $387.7 billion for the year on a sale-date basis. This reflected a decline of approximately 5% from $408.3 billion in 2005, which was up 13% from $359.7 billion in 2004. Reduced refunding volume during 2006 was largely offset by growth in new-money issuance. Insurance penetration was approximately 49%, compared with 57% in 2005 and 54% in 2004. In all three years, low interest rates and continuing needs for infrastructure investment drove municipal borrowing levels. Of the insured par amount of municipal bonds sold each year, FSA guaranteed approximately 24% in 2006, 26% in 2005 and 24% in 2004.
Including both primary and secondary obligations with closing dates in 2006, FSA’s U.S. public finance par insured declined 28.3%, and PV premiums originated declined 36.1%, as FSA increased its strategic focus on core municipal sectors where high-quality transactions provided greater relative value.
In 2005, FSA’s U.S. public finance par origination increased 32.3% and the related PV premium originated increased 11.8%. 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.
Outside the United States, FSA increased international asset-backed par originations by 39.8% in 2006, while PV premiums originated declined 12.7%. This compares with decreases in 2005 of 11.2% in the par amount originated and 3.7% in PV premium production. As in the United States, credit spreads were narrow in international asset-backed markets in both 2006 and 2005. In both years, 90% or more of the net par volume of originations was of Triple-A or Super Triple-A quality. “Super Triple-A” indicates underlying loss protection greater than the Triple-A standard.
The majority of municipal GICs issued by the GIC Affiliates relate to debt service reserve funds and construction funds in support of municipal bond transactions. These funds may be drawn unexpectedly,
1. Economic interest rate hedges, defined as interest rate derivatives that are intended to hedge fixed rate assets and liabilities but do not meet the criteria for hedge accounting treatment under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), adjusted so that the impact of any residual hedge ineffectiveness remains in operating earnings; and
2. FSA-insured credit default swaps (“CDS”) that have investment-grade underlying credit quality and must be marked to fair value under SFAS 133.
Periodic unrealized gains and losses related to economic interest rate hedges arise primarily in the FP Segment, caused primarily by the one-sided mark-to-market derivative valuations prescribed by SFAS 133 for derivatives that do not qualify for “hedge-accounting treatment” under GAAP. Under the Company’s definition of operating earnings, the economic effect of these hedges is recognized, which, for interest rate swaps, generally results in any cash paid or received being recognized ratably as an expense or revenue over the hedged item’s life. Futures contracts used to hedge interest rate risk include both the embedded current net interest paid or received, as well as the value of the future net interest cash flow. Therefore, to reflect the equivalent of any cash paid or received being recognized ratably as an expense or revenue over the hedged item’s life, the current interest accretion amount embedded in the mark-to-market value of open futures positions is added back to operating earnings.
CDS contracts are generally non-cancelable prior to maturity, and management views insured CDS risks as comparable to other insured risks. In a typical CDS transaction, the Company, in exchange for an upfront or periodic premium, indemnifies the insured party for economic losses (in excess of some agreed-upon deductible) related to debt obligations of specified obligors, structured such that the risk insured is investment grade without the benefit of the credit protection provided by the Company. In the event a CDS were to migrate below investment grade, the fair-value impact would be fully reflected in operating earnings.
Operating earnings are subject to certain general and specific limitations that investors should carefully consider. For example, as stated above, unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting. The Company’s operating earnings are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. Unlike GAAP, the Company’s operating earnings presentation does not represent a comprehensive basis of accounting. Investors, therefore, should not compare the Company’s performance with that of other financial guaranty companies based upon operating earnings. Operating earnings results are meant only to supplement GAAP results by providing additional information regarding the operational and performance indicators management, the Company’s Board of Directors and rating agencies follow most closely to assess performance.
(1) Hedge ineffectiveness remains in operating earnings. Also, see following table for a more detailed presentation of fair-value adjustments for economic interest rate hedges.
6. elimination of the fair-value adjustments for economic interest rate hedges;
Adjustments 1, 2 and 3 above represent the sum of cumulative years’ reported PV premiums originated and PV NIM originated, less what has been earned or adjusted due to changes in estimates as described above. Adjustments 1 and 2 in the calculation of ABV together represent unearned premiums that have been collected and the Company’s best estimate of the present value of its future premium revenues (comprising current- and prior-period originations that have not yet been earned). Debt schedules related to installment transactions change from time to time. Critical assumptions underlying adjustment 2 are discussed above under “New Business Production-Financial Guaranty Insurance Originations.”
Through adjustments 5 and 6, the effect of certain items that are excluded from operating earnings is also excluded from ABV. As explained in the preceding discussion of operating earnings, management expects the financial impact of the CDS fair-value adjustments, reflected in adjustment 5, to sum to zero over the finite terms of the related exposures. Derivatives reflected in adjustment 6 reduce, on an economic basis, the interest rate risk of fixed rate assets and liabilities held in the FP Segment, which includes the FSA Global portfolios, although they do not meet SFAS 133 hedge-accounting requirements. The Company uses such derivatives to hedge against interest rate volatility, rather than to speculate on the direction of interest rates. The intent of management is to hold the derivatives until expected maturity along with the related hedged fixed rate assets or liabilities. In addition, through adjustment 7, ABV excludes the effect of fair-value adjustments made to investments and reflected in other comprehensive income. As the objective is to optimize long-term stable earnings, management generally seeks to minimize turnover and therefore any unrealized investment gain or loss is subtracted from book value to exclude it from the ABV metric. In the event that an investment is liquidated prior to its maturity, any related gain or loss is reflected in both earnings and ABV without further adjustment. Adjustment 8 reflects IFRS accounting treatment of items for which GAAP and IFRS treatments differ. These accounting differences relate primarily to foreign exchange, contingencies and fair-value adjustments.
Shareholders’ equity was $2.7 billion and non-GAAP ABV was $3.9 billion at December 31, 2006. During 2006, ABV (IFRS basis) grew 14.0%.
Net investment income from the General Investment Portfolio increased 9.0% in 2006, 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”). The dividend rate on the XLFA investment was reduced in 2006 from an effective rate of 19% in 2005 to a fixed rate of 8.25% in 2006.
The gross and net par amounts outstanding on transactions with case reserves were $483.4 million and $399.6 million, respectively, at December 31, 2006. Net case reserves consisted primarily of five collateralized debt obligation (“CDO”) risks and two municipal risks, which collectively accounted for approximately 94.9% of the total net case reserve. The remaining eight exposures were in various sectors.
The table below presents the significant assumptions inherent in the calculations of the case and non-specific reserves:
At December 31, 2006, the reinsurance recoverable on unpaid losses from reinsurers and ceded par outstanding, by Standard & Poor’s Ratings Services (“S&P”) rating levels, were as follows:
Given the broad diversification of FSA’s insured portfolio, management believes that a significant shift in overall portfolio quality is unlikely to occur except in a catastrophic economic environment. It is therefore necessary to look at particular sectors when examining the sensitivity of the insured portfolio to changes in underlying loss assumptions. Management believes that different analyses are required for the two broad sectors of the insured portfolio, public finance credits and asset-backed obligations.
In an S&P scenario analysis, S&P assumed 75% loss severity for health care credits, which means that a loss would equal 75% of par insured. If losses of this severity occurred in the lowest rated hospital exposures in FSA’s insured portfolio, the estimated loss would be as much as $50.0 million on a pre-tax basis, net of reinsurance. This calculation includes the amount the Company recorded as a case reserve in 2006 for one health care risk.
Asset-backed obligations insured by FSA are secured by pools of assets. While the assets in a given transaction are generally of one type (such as automobile loans, residential mortgage loans, corporate loans, etc.), they are diversified within that asset type. Due to characteristically low default frequency, losses on insured asset-backed transactions have been manageable, in management’s view, despite variability.
Management believes severity is not the primary determinant of possible loss in a portfolio of insured asset-backed obligations. Since introducing a non-specific reserve in 1993, actual aggregate losses have been reasonably consistent with management’s expectation in the majority of asset-backed categories, including insured obligations collateralized by automobile loan or residential mortgage debt of non-prime borrowers. The one exception involved senior bonds issued in 1998 and 1999 in connection with structured CDOs. In such a structure, the bonds insured by FSA are in second-loss positions, meaning that there are uninsured, subordinate bondholders or equity investors who must lose all of their investment outstanding at the time of default or earlier trigger event before the FSA-insured bonds become subject to loss. These transactions were structured to FSA’s requirement that the first-loss position provide FSA an investment-grade level of protection. The underlying assets supporting the insured obligations were pools of corporate bonds individually rated below investment grade. In this structure, multiple credits must fail before claims are triggered. In 2002, credit quality deteriorated across a broad spectrum of the corporate market, which led to projected claims on these transactions and charges to FSA’s statements of operations and comprehensive income, as well as an increase in the Company’s loss experience rate. Yet, even under this unprecedented stress scenario, the severity of the largest single loss was relatively modest.
Current asset-backed case reserves could vary from the current estimate of loss. In particular, the deterministic model used to establish case reserves for CDO transactions utilizes average cumulative default rates produced by a Monte Carlo simulation and applies those defaults to a cash flow model. While CDO exposures are affected by multiple variables, including default rates, collateral recovery rates, changes in interest rate movements and the prepayment speeds of the collateral, management believes default frequency is the key determinant of loss. Holding all other variables constant and assuming only that the CDO’s underlying corporate debt instruments were to default at a higher rate than the Monte Carlo average default rate, actual losses would exceed the current estimate. Applying a higher frequency of default, observed at the 90% confidence level, would result in additional present-value loss of $17.3 million.
Management is aware that there are differences regarding the method of defining and measuring both case reserves and non-specific reserves among participants in the financial guaranty industry. Other financial guarantors may establish case reserves only after a default and use different techniques to estimate probable loss. Other financial guarantors may establish the equivalent of non-specific reserves, but refer to these reserves by various terms such as, but not limited to, “unallocated losses,” “active credit reserves” and “portfolio reserves,” or may use different statistical techniques from those the Company uses to determine loss at a given point in time. Management and the industry expect accounting literature specific to the financial guaranty industry to evolve; however, management cannot predict or estimate the scope of the guidance or potential impact on the Company’s financial statements at this time. See Note 2 to the Consolidated Financial Statements in Item 8.
As of December 31, 2006, FSA had not received notice of payment default on any hurricane-related exposures. The Company’s 11 credits that have suffered the most significant economic and property loss from the 2005 hurricanes had an aggregate net par exposure of $181.7 million at December 31, 2006. FSA-insured bonds are protected by various sources of support that would be invoked before FSA would incur losses. These sources include access to pledged taxes or revenues, reserve funds, property and casualty insurance and state and federal monies. The issuers of these insured bonds have generally continued to improve financially and management does not expect that FSA will sustain permanent losses.
Among the exposures affected by the hurricane are $38.1 million of FSA-insured Orleans Levee District (the “District”) bonds. The District has explored the possibility of seeking bankruptcy protection, but has not received the authority from the State that is required to do so. In any event, FSA does not believe that payment of the FSA-insured bonds would be impaired by a bankruptcy filing. In addition, the District is a loan recipient under the State Debt Service Assistance Fund, with FSA-insured bonds receiving assistance through May 1, 2009.
The loss estimation process involves the exercise of considerable judgment and therefore FSA’s ultimate hurricane-related losses may be materially different from the current estimate and may affect future operating results.
NIM shown in accordance with classifications required under GAAP on the consolidated statements of operations and comprehensive income (“Total NIM”) is calculated as net interest income from the FP Segment, plus FP net realized gains (losses), less net interest expense from the FP Segment. Total NIM was $93.3 million for 2006, negative $11.2 million for 2005 and negative $70.7 million for 2004, and primarily represents fixed rate liabilities (which are swapped to a floating rate obligation) funding floating rate assets.
unrealized gains (losses) on derivative instruments. Ineffectiveness related to derivatives that do not qualify for hedge accounting is added back to calculate FP spread portfolio NIM.
VIE and FP net interest income are combined on the consolidated statements of operations and comprehensive income, as are VIE and FP net interest expense. VIE NIM pertains to the net interest margin derived from transactions executed by FSA Global and Premier International Funding Co. (“Premier”). The VIE NIM relates to a passively managed portfolio, while the growing GIC portfolio is actively managed. Accordingly, the VIE NIM is shown separately from the FP spread portfolio NIM.
FSA’s financial guaranty business includes insurance of CDS. The net par outstanding was $74.7 billion relating to these transactions at December 31, 2006 and $66.6 billion at December 31, 2005. Many of these transactions require periodic accounting adjustments to reflect an estimate of fair value (or the replacement cost of the Company’s financial guaranty contract) under SFAS 133. These transactions have generally been underwritten with Triple-A or higher levels of credit protection provided by significant deductibles that must be exhausted prior to claims under FSA’s guaranty. Adjustments required by SFAS 133 resulted in pre-tax income of $31.8 million for 2006, $11.1 million for 2005 and $56.4 million for 2004. The benefits during 2006, 2005 and 2004 resulted primarily from tightening credit spreads in the CDS market. None of these adjustments indicate any material improvement or deterioration in the underlying credit quality of FSA’s insured CDS portfolio. The gain or loss created by estimated fair-value adjustments will rise or fall each quarter based on estimated market pricing of highly rated swap guarantees and is not expected to be an indication of potential claims under FSA’s guaranty or an indication of potential gains to be received from the derivative transactions.
value will be reversed by an equivalent “gain” at or prior to the expiration of the guaranty, and any “gain” recorded will be reversed by an equal “loss” over the remaining life of the transaction. The average remaining life of these contracts is 3.1 years. The inception-to-date pre-tax gain on the CDS portfolio was $89.2 million at December 31, 2006 and $57.4 million at December 31, 2005. Given the very high credit quality of FSA’s insured CDS portfolio and the Company’s intent to hold to maturity, management believes that “losses” or “gains” attributable to marking these exposures to fair value do not reflect on the profitability of the Company in a meaningful way.
Total equity in earnings of unconsolidated affiliates was a pre-tax gain of $1.2 million in 2005 and a pre-tax loss of $3.3 million in 2004. There was none in 2006.
In October 2005, the Company sold its investment in SPS to an unaffiliated third party. For its interest in SPS, the Company was paid $42.9 million in cash at closing and expects to receive additional amounts, from time to time through March 31, 2008, out of income earned by SPS through December 31, 2007 from certain of its mortgage servicing activities. Under the sale documents, the Company’s subsidiary that owned the SPS investment made customary representations and warranties to, and undertook specified indemnification obligations for the benefit of, the purchaser. Based on an estimate of the assets retained and liabilities assumed, the Company recorded a $0.4 million loss on the sale of SPS. Under the terms of the agreement, the Company will receive cash payments through the first quarter of 2008 from a residual interest in mortgage servicing assets. The Company recorded an asset of $12.6 million representing this contingent payment asset. The Company and other prior shareholders indemnified the buyer for certain liabilities relating to SPS’s operations, including litigation and regulatory actions. The maximum indemnification obligation for SPS’s operations will not exceed approximately $34.0 million. The Company’s portion of this obligation is 37.4%, or $12.7 million. As of December 31, 2005, the Company recorded a $5.1 million liability related to this indemnification, representing the expected liability. As of December 31, 2006, the liability had a balance of $3.3 million. The Company has received a net amount of
FSA’s investment in preferred shares of XLFA, a financial guaranty insurance subsidiary of XL, is redeemable by XLFA at a price equal to the fair market value of the preferred shares, subject to a cap defined as the internal rate of return of 19% per annum from the date of the investment through the date of redemption, plus accrued dividends as if 100% of current-year earnings were distributed. Based on this formula, the Company carries this investment at the lesser of the current calculated redemption value or the redemption value as of the next January first, which would exclude its share of accrued current-year earnings to the extent the cap had been otherwise met. Consistent with this policy, in the third quarter of 2004, the Company charged a pre-tax amount of $11.7 million to equity in earnings of unconsolidated affiliates and reduced its carrying value in this investment to $56.4 million.
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, 2006 was $54.0 million and at December 31, 2005 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. The Company recognized dividend income from XLFA of $4.5 million during 2006.
In connection with Dexia’s acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains Insurance Group. While the Company had no legal liability in connection with the indemnity payment, the payment is treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, the Company has agreed to share 50% of the deferred tax benefit with White Mountains Insurance Group under certain circumstances, but did not satisfy the standards for recording a liability for accounting purposes as of December 31, 2006.
The Company’s critical accounting policies and estimates are described in Note 2 to the Consolidated Financial Statements in Item 8. Note 2 to the Consolidated Financial Statements includes a discussion of the financial guaranty accounting project that the FASB staff has undertaken to provide accounting guidance to the financial guaranty industry.
The Company’s consolidated invested assets at December 31, 2006, net of unsettled security transactions, were $21,261.4 million, compared with the December 31, 2005 balance of $17,392.3 million. These balances include the change in the market value of the Company’s various portfolios, which had an unrealized gain position of $333.1 million at December 31, 2006, compared with an unrealized gain position of $236.2 million at December 31, 2005. These balances exclude assets in the VIE Investment Portfolio and assets acquired under refinancing transactions that the Company’s management believes are beyond the reach of the Company and its creditors.
The Company includes variable rate demand notes (“VRDN”) and auction rate securities (“ARS”), which totaled $746.5 million at December 31, 2006 and $867.2 million at December 31, 2005, in its long-term bond portfolios. VRDNs are long-term bonds that bear floating interest rates and provide investors with the option to tender or put the bonds at par, generally on a daily, weekly or monthly basis. ARS are long-term securities with interest rate reset features and are traded in the marketplace through a bidding process. For management purposes, VRDN and ARS are managed as cash equivalents.
Cash flow from operations was $611.2 million in 2006, $654.3 million in 2005 and $550.8 million in 2004. The decrease in cash flow from operations in 2006 is attributable primarily to the decrease in premiums and the activity in the trading portfolio, partially offset by an increase in net interest received from the FP Segment and a reduction in taxes paid. In 2005, the increase in cash flow from operations was primarily attributable to net interest received from the FP Segment, due to growth in the FP book of business, and to premiums, partially offset by increases in operating expenses and taxes paid. The increase in premium receipts was due primarily to increased refunding activity. The increase in taxes paid was due primarily to the repatriation of FSA International earnings.
At December 31, 2006, Financial Security Assurance Holdings Ltd. (as a separate holding company, “FSA Holdings”) had cash and investments of $42.7 million available to fund the liquidity needs of its non-insurance operations. Because the majority of the Company’s operations are conducted through FSA, the long-term ability of FSA Holdings to service its debt will largely depend on its receipt of dividends from, or payment on surplus notes by, FSA.
The following is a summary of the Company’s contractual obligations at December 31, 2006:
(3) Amounts include principal and interest payments for the minimum contractual period.
On July 31, 2003, FSA Holdings issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the Notes.
FSA’s ability to pay dividends depends, among other things, upon FSA’s financial condition, results of operations, cash requirements and compliance with rating agency requirements for maintaining its Triple-A ratings, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York (the “New York Insurance Law”), FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (a) 10% of policyholders’ surplus as of its last statement filed with the New York Superintendent or (b) adjusted net investment income during this period. Based on FSA’s statutory statements for 2006, and
considering dividends that can be paid by its subsidiary, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the 12 months following December 31, 2006 is approximately $156.6 million. FSA paid dividends of $140.0 million in 2006, $87.0 million in 2005 and $30.0 million in 2004.
FSA may repurchase shares of its common stock from its shareholders subject to the New York Superintendent’s approval. The New York Superintendent has approved the repurchase by FSA of up to $500.0 million of its shares from FSA Holdings through December 31, 2008. In 2006, FSA repurchased $100 million of shares of its common stock from FSA Holdings and retired such shares.
FSA International paid preferred dividends of $6.9 million in 2005 and $7.0 million in 2004 to XL Capital Ltd, its minority interest owner. In October 2005, FSA purchased all the preferred shares of FSA International owned by XL Insurance (Bermuda) Ltd. for a cash purchase price of $39.1 million, in anticipation of the repatriation of earnings and profits of FSA International. Giving effect to such purchase, FSA International became an indirect wholly owned subsidiary of the Company.
Management believes that the Company’s expected operating liquidity needs, on both a short- and long-term basis, can be funded from its operating cash flow. In addition, the Company has a number of sources of liquidity available to pay claims on a short- and long-term basis: cash flow from premiums written, FSA’s investment portfolio and earnings thereon, reinsurance arrangements with third-party reinsurers, new borrowings through its GIC Affiliates, liquidity lines of credit with banks, and capital market transactions.
FSA has a credit arrangement aggregating $150.0 million, provided by commercial banks and intended for general application to transactions insured by FSA. 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, 2006, there were no borrowings under this arrangement, which expires on April 21, 2011, if not extended.
Certain FSA Global debt issuances contain provisions that could extend the stated maturities of those notes. To ensure FSA Global will have sufficient cash flow to repay its funding requirements, it entered into four liquidity facilities with Dexia for amounts totaling $419.4 million.
S&P, Moody’s and Fitch Ratings periodically assess the credits insured by FSA, and the reinsurers and other providers of capital support to FSA, to confirm that FSA continues to satisfy the rating agencies’ capital adequacy criteria necessary to maintain FSA’s Triple-A ratings. Capital adequacy assessments by the rating agencies are generally based on FSA’s qualified statutory capital, which is the aggregate of policyholders’ surplus and contingency reserves determined in accordance with statutory accounting principles.
In the case of S&P, assessments of the credits insured by FSA are reflected in defined “capital charges,” which are reduced by reinsurance and collateral to the extent “credit” is allowed for such reinsurance and collateral. Credit provided for reinsurance under the S&P capital adequacy model is generally a function of the S&P rating of the reinsurer, as well as any collateral provided by the reinsurer. Capital charges on outstanding insured transactions and reinsurer ratings are subject to change by S&P at
Capital adequacy is one of the financial strength measures under Moody’s financial guarantor model. The model includes a penalty for risk concentration and recognizes a benefit for diversification. The published results reflect four metrics of financial strength relating to the insured portfolio’s credit quality, correlation risk, concentration of risk and capital adequacy. Moody’s assesses capital adequacy by comparing FSA’s claims-paying resources to a Moody’s-derived probability of potential credit losses. Moody’s loss distribution reflects FSA’s current distribution of risk by sector, the credit quality of insured exposures, correlations that exist between transactions, the credit quality of FSA’s reinsurers and the term to maturity of FSA’s insured portfolio. The published results compare levels of theoretical loss in the tail of this distribution to various measures of FSA’s claims-paying resources.
Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2006, 2005 and 2004
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Financial Security Assurance Holdings Ltd. and Subsidiaries (the “Company”) at December 31, 2006 and December 31, 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Financial Security Assurance Holdings Ltd. (“FSA Holdings,” or together with its consolidated entities, the “Company”) is a holding company incorporated in the State of New York. The Company is principally engaged, through its insurance company subsidiaries, in providing financial guaranty insurance on public finance and asset-backed obligations. Its primary insurance company subsidiary is Financial Security Assurance Inc. (“FSA”). The Company’s underwriting policy is to insure public finance and asset-backed obligations that it determines would be investment-grade quality without the benefit of the Company’s insurance. Public finance obligations insured by the Company consist primarily of general obligation bonds that are supported by the issuers’ taxing powers and special revenue bonds and other special obligations of states and local governments that are supported by the issuers’ abilities to impose and collect fees and charges for public services or specific projects. Public finance obligations include obligations backed by the cash flow from leases or other revenues from projects serving substantial public purposes, including government office buildings, toll roads, health care facilities and utilities. Asset-backed obligations insured by the Company are generally issued in structured transactions and are backed by pools of assets, such as residential mortgage loans, consumer receivables, securities or other assets having an ascertainable cash flow or market value. The Company also insures synthetic asset-backed obligations that generally take the form of credit default swap (“CDS”) obligations or credit-linked notes that reference pools of securities or loans, with a defined deductible to cover credit risks associated with the referenced securities or loans.
The Company expects to continue to emphasize a diversified insured portfolio characterized by insurance of both public finance and asset-backed obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. The Company’s insured portfolio consists primarily of public finance and asset-backed obligations originated in the United States of America, but the Company has also written and continues to pursue business in Europe, the Asia Pacific region and elsewhere in the Americas.
The Company issues guaranteed investment contracts (“GICs”) through its consolidated affiliates FSA Capital Management Services LLC (“FSACM”), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the “GIC Affiliates”). FSACM has conducted substantially all of the Company’s GIC business since April 2003, following the receipt of an exemption from the requirements of the Investment Company Act of 1940. The GIC Affiliates lend the proceeds from their sales of GICs to FSA Asset Management LLC (“FSAM”), which invests the funds, generally in obligations that qualify for FSA insurance. FSAM wholly owns FSA Portfolio Asset Limited (“FSA-PAL”), a U.K. Company that invests in non-U.S. securities.
The Company consolidates the results of certain variable interest entities (“VIEs”), including FSA Global Funding Limited (“FSA Global”) and Premier International Funding Co. (“Premier”). The Company consolidates FSA Global in accordance with Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51”
FSA Global is a special purpose funding vehicle partially owned by a subsidiary of FSA Holdings. FSA Global issues FSA-insured medium term notes and invests the proceeds from the sale of its notes in FSA-insured obligations with a view to realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. Premier is principally engaged in debt defeasance for public finance lease transactions. The GIC Affiliates, FSAM, FSA-PAL, FSA Global and Premier are collectively referred to as the “FP Segment.”
The Company refinanced certain defaulted transactions by employing refinancing vehicles to raise funds. These refinancing vehicles are also consolidated. The Company’s management believes that the assets held by FSA Global, Premier and the refinancing vehicles, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership.
The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), which, for the insurance company subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 23). 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 in the Company’s consolidated balance sheets at December 31, 2006 and 2005, the reported amounts of revenues and expenses in the statements of operations and comprehensive income during the years ended December 31, 2006, 2005 and 2004 and disclosure of contingent assets and liabilities. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses, fair value of financial instruments and the deferral and amortization of policy acquisition costs. Actual results may differ from those estimates. Significant accounting policies under GAAP are as follows:
The Consolidated Financial Statements include the accounts of FSA Holdings and its direct and indirect subsidiaries, principally including FSA, FSA Insurance Company, Financial Security Assurance International Ltd. (“FSA International”), Financial Security Assurance (U.K.) Limited, the GIC Affiliates, FSAM, FSA Portfolio Management Inc., Transaction Services Corporation, FSA Services (Australia) Pty Limited, FSA Mexico Holdings Inc. and FSA Services (Japan) Inc. (collectively, the “Subsidiaries”). The Consolidated Financial Statements also include the accounts of certain VIEs and refinancing vehicles. All intercompany accounts and transactions have been eliminated.
Investments in debt and equity securities designated as available for sale are carried at fair value. The unrealized gain or loss on investments that are not hedged or are economically hedged but do not qualify for hedge accounting is reflected as a separate component of shareholders’ equity, net of applicable deferred income taxes. The unrealized gain or loss attributable to the hedged risk on investments that qualify as fair-value hedges is recorded in income currently. Investments in debt and equity securities designated as trading are carried at fair value. The unrealized gain or loss on trading investments are recognized in income currently. The cost of securities sold is based on specific identification of each security.
Bond discounts and premiums are amortized on the effective yield method over the remaining terms of the securities acquired. For mortgage-backed securities and any other holdings for which prepayment risk may be significant, assumptions regarding prepayments are evaluated periodically and revised as necessary. Any adjustments required due to the resulting change in effective yields are recognized in current income. Short-term investments, which are those investments with a maturity of less than one year at time of purchase, are carried at fair value. Changes in fair value of short-term investments are due to changes in foreign exchange rates. Amounts deposited in money market funds and investments with a maturity at time of purchase of three months or less are included in short-term investments.
Included in assets acquired in refinancing transactions are asset-backed senior notes that represent the Company’s purchase of less than 50% of a refinanced transaction. These assets are designated as available for sale. Certain other asset-backed securities are carried at cost, with any reduction in carrying value recognized as an adjustment to yield in accordance with American Institute of Certified Public Accountants Statement of Position 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.”
The gains and losses related to derivatives designated as fair-value hedges are included in either net interest income or net interest expense from the FP Segment, as appropriate, along with the offsetting change in the fair value of the risk being hedged.
For premiums received on an installment basis, the Company earns the premium over the installment period, typically less than one year, throughout the period of coverage. Typically, installment premiums are applicable to insured transactions that involve CDS or special purpose vehicles (“SPVs”) structured to finance pools of assets such as auto loans or mortgage loans. Premiums on such transactions are typically paid in installments, as the nature of the assets financed can have uncertain debt service schedules due to prepayments. When the Company, through its ongoing credit review process, identifies transactions where premiums are paid on an installment basis and certain default triggers have been breached, the Company ceases to earn premiums on such transactions. Premium revenue recognition is subject to change as a result of the FASB project described in “-Losses and Loss Adjustment Expenses.”
The financial guaranty industry has emerged over the past 35 years. Management believes that existing insurance accounting under Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”), does not specifically address financial guaranty insurance. Accordingly, the accounting for loss and loss adjustment expenses within the financial guaranty insurance industry has developed based on analogy to the most directly comparable elements of existing literature, including sections of SFAS 60, Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS 5”) and Emerging Issues Task Force Issue 85-20, “Recognition of fees for guaranteeing a loan” (“EITF 85-20”).
The Company calculates a loss and LAE liability based upon identified risks inherent in its insured portfolio. If an individual policy risk has a reasonably estimable and probable loss as of the balance sheet date, a case reserve is established. For the remaining policy risks in the portfolio, a non-specific reserve is established to account for the inherent credit losses that can be statistically estimated.
The Company establishes a non-specific reserve on its portfolio of credits because management believes that a portfolio of insured obligations will deteriorate over its life and that the existence of inherent loss can be proven statistically by data such as that published by rating agencies. The establishment of the reserve is a systematic process that considers this quantitative, statistical information obtained primarily from Moody’s Investors Service, Inc. (“Moody’s”) and Standard & Poor’s Ratings Services (“S&P”), together with qualitative factors such as overall credit quality trends resulting from economic and political conditions, recent loss experience in particular segments of the portfolio and changes in underwriting policies and procedures. The factors used to establish reserves are evaluated periodically by comparing the statistically computed loss amount with the incurred losses as represented by case reserve activity to develop an experience factor that is updated and applied to current-year originations. The process results in management’s best estimate of inherent losses associated with providing credit protection at each balance sheet date.
The present value of loss amounts calculated for the current-year originations plus an amount representing the accretion of discount pertaining to prior-year originations are charged to loss expense and increase the non-specific loss reserve after adjustments that may be made to reflect observed favorable or adverse experience. The entire non-specific reserve is available to absorb probable losses inherent in the portfolio. As there are no specific losses provided in the non-specific reserve, there is no identifiable reinsurance recoverable. At the time that a case reserve is identified, the gross loss liability is recognized along with the reinsurance recoverable, if any. The amount of reinsurance recoverable depends on the policy ceded and the reinsurance agreements covering such policy. Management cannot predict the specific policies that will emerge as case-basis losses from the portfolio and is not entitled to recovery from the reinsurer in advance of producing a case reserve.
Management is aware that there are differences regarding the method of defining and measuring both case reserves and non-specific reserves among participants in the financial guaranty industry. Other financial guarantors may establish case reserves only after a default and use different techniques to estimate probable loss. Other financial guarantors may establish the equivalent of non-specific reserves, but refer to these reserves by various terms such as, but not limited to, “unallocated losses,” “active credit reserves” and “portfolio reserves,” or may use different statistical techniques from those the Company uses to determine loss at a given point in time.
The Financial Accounting Standards Board (“FASB”) staff is considering additional guidance regarding financial guaranty insurance. When and if the FASB reaches a conclusion on this issue, the Company and the rest of the financial guaranty industry may be required to change some aspects of their loss reserving policies, and the potential changes could extend to premium recognition. The Company cannot predict how the FASB will resolve this issue and the resulting impact on its financial statements.
The Company does not defer origination costs relating to GICs issued by the GIC Affiliates, except for GIC commissions paid to third parties, which are included in other assets. The amortization of these commissions is recorded in net interest expense from the FP Segment.
GIC and VIE debt is recorded at amortized cost. The Company may enter into transactions in order to reduce the Company’s exposure to fluctuations in interest rates and foreign exchange rates. For GIC and VIE debt in a qualifying accounting hedge, the change in the fair value of debt adjusts the carrying amount of the debt and is recognized in income currently. VIE debt may include hybrid debt instruments that contain embedded derivatives. Under certain conditions, GAAP requires that embedded derivatives be separated from the debt instrument and accounted for at fair value, with all changes in fair value reflected through earnings.
Monetary assets and liabilities denominated in foreign currencies are translated at the spot rate at the balance sheet date. Non-monetary assets and liabilities are translated at historical rates. Revenues and expenses denominated in foreign currencies are translated at average rates prevailing during the year. Unrealized gains and losses on available-for-sale securities, net of deferred taxes, resulting from translating investments denominated in foreign currencies are recorded in shareholders’ equity. Gains and losses from transactions in foreign currencies are recorded in other income.
The provision for income taxes consists of an amount for taxes currently payable and an amount for deferred taxes arising from temporary differences between the tax bases of assets and liabilities and the
Asset-backed and, to a lesser extent, public finance transactions insured by FSA may employ special purpose entities for a variety of purposes. A typical asset-backed transaction, for example, employs a special purpose entity as the purchaser of the securitized assets and as the issuer of the insured obligations. FSA’s participation is typically requested by the sponsor of the special purpose entity or the underwriter, either via a bid process or on a sole-source basis. Special purpose entities are typically owned by transaction sponsors or charitable trusts, although FSA may have an ownership interest in some cases. FSA maintains certain contractual rights and exercises varying degrees of influence over special purpose entity issuers of FSA-insured obligations. FSA also bears some of the “risks and rewards” associated with the performance of those special purpose entities’ assets. Specifically, as issuer of the financial guaranty insurance policy insuring a given special purpose entity’s obligations, FSA bears the risk of asset performance (typically, but not always, after a significant depletion of overcollateralization, excess spread, a deductible or other credit protection). FSA’s underwriting policy is to insure only obligations that are otherwise investment grade. In addition, the special purpose entity typically pays a periodic premium to FSA in consideration of the issuance by FSA of its insurance policy, with the special purpose entity’s assets typically serving as the source of such premium, thereby providing some of the “rewards” of the special purpose entity’s assets to FSA. Special purpose entities are also employed by FSA in connection with “repackaging” of outstanding securities into new securities insured by FSA and with refinancing underperforming, non-investment-grade transactions insured by FSA.
period of adoption. The Company does not expect FIN 48 to have a material impact on its financial statements.
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”), which amends Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” SFAS 155 permits hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation to be irrevocably accounted for at fair value, with changes in fair value recognized in the statements of operations and comprehensive income. The fair-value election may be applied on an instrument-by-instrument basis. SFAS 155 also eliminates a restriction that prevents qualifying special purpose entities from holding derivative financial instruments that pertain to beneficial interests that are not derivative financial instruments. SFAS 155 is effective for all financial instruments acquired or issued after December 31, 2006. The Company does not expect SFAS 155 to have a material impact on its financial statements.
The statement of cash flows for the period ended December 31, 2006 appropriately segregates the effect of changes in foreign exchange rates on cash balances into a separate line item. The effect of foreign exchange rates on cash balances has historically been included in cash flows from operations. As part of the review of these foreign cash accounts, it was determined that certain of these accounts are appropriately classified as cash rather than as short-term investments at December 31, 2006. The statements of cash flows for the periods ended December 31, 2005 and 2004 have been revised to conform to the 2006 presentation. Changes in classification of these accounts to cash from short-term investments are also reflected in the balance sheet. The amounts revised for 2005 and 2004 from short-term investments to cash were $23.5 million and $8.3 million, respectively.
Consolidated net investment income attributable to the General Investment Portfolio consisted of the following:
The credit quality of bonds in the General Investment Portfolio, based on amortized cost, at December 31, 2006 was as follows:
The General Investment Portfolio includes bonds insured by FSA (“FSA-Insured Investments”). Of the bonds included in the General Investment Portfolio, 6.2% were Triple-A by virtue of insurance provided by FSA. Over 95% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments, which is the rating without giving effect to the FSA insurance, was in the Double-A range.
Foreign securities consist primarily of government-issued and corporate securities that are denominated in either British pound sterling or the euro.
The following table shows the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position:
Proceeds from sales of bonds for the General Investment Portfolio during 2006, 2005 and 2004 were $1,637.3 million, $1,757.6 million and $1,187.3 million, respectively. Proceeds from maturities of bonds for the General Investment Portfolio during 2006, 2005 and 2004 were $163.3 million, $130.9 million and $267.8 million, respectively. Gross gains of $0.9 million, $10.9 million and $5.2 million and gross losses of $5.8 million, $6.1 million and $5.7 million were realized on sales in 2006, 2005 and 2004, respectively.
At December 31, 2004, the Company had a 34.1% interest in SPS Holding Corp. (“SPS”) (formerly Fairbanks Capital Holding Corp.). The Company’s investment in SPS was accounted for using the equity method of accounting.
In the third quarter of 2004, the Company determined that its $7.6 million of goodwill associated with its investment in SPS was impaired, and it charged that amount to income, as a result of challenges encountered by SPS in acquiring new business, despite servicer ratings of “Average.”
interest in mortgage servicing assets. The Company recorded an asset of $12.6 million representing this contingent payment asset. The Company and other prior shareholders indemnified the buyer for certain liabilities relating to SPS’s operations, including litigation and regulatory actions. The maximum indemnification obligation for SPS’s operations will not exceed approximately $34.0 million. The Company’s portion of this obligation is 37.4% or $12.7 million. As of December 31, 2005, the Company recorded a $5.1 million liability related to this indemnification, representing the expected liability. As of December 31, 2006, the liability had a balance of $3.3 million. The Company has received a net amount of $11.2 million related to this asset and liability. The Company will continue to evaluate the appropriate carrying value of the liabilities assumed. Amounts recorded by the Company in connection with SPS at December 31, 2005 and 2004 were as follows:
Until the fourth quarter of 2004 this investment was accounted for using the equity method of accounting because the Company had significant influence over XLFA’s operations. In the second quarter of 2004, the Emerging Issues Task Force (“EITF”) reached a consensus that under EITF Issue 02-14, “Whether an Investor Should Apply the Equity of Method of Accounting to Investments Other Than Common Stock” (EITF 02-14), an investor should only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. The EITF 02-14 consensus is applicable to reporting periods beginning after September 15, 2004. In accordance with this consensus, the Company no longer accrues undistributed earnings related to its investment in XLFA.
In March 2006, the XLFA Board of Directors approved a by-law amendment changing the coupon on XLFA’s preferred shares from a participating dividend based on an internal rate of return up to 19% to a fixed rate dividend of 8.25% per annum, effective January 1, 2006. Amounts recorded by the Company in connection with XLFA as of and for the years ending December 31, 2006, 2005 and 2004 are as follows :
Net investment income for the FP Investment Portfolio consisted of the following:
The credit quality of bonds held in the FP Investment Portfolio based on amortized cost at December 31, 2006 was as follows:
The amortized cost and fair value of bonds held in the FP Investment Portfolio were as follows:
At December 31, 2006, there were 111 investments in fixed-income securities for which amortized cost exceeded fair value; the aggregate amount of the excess over fair value was $11.8 million, or 0.7%. At December 31, 2005, there were 97 such investments, for which the aggregate amount of the excess over fair value was $4.5 million, or 0.2%. Management has determined that the unrealized losses in fixed income securities at December 31, 2006 are attributable primarily to the current interest rate environment and has concluded that these unrealized losses are temporary in nature based upon (a) no principal and interest payment defaults on these securities; (b) analysis of the creditworthiness of the issuer; and (c) FSA’s ability and current intent to hold these securities until a recovery in fair value or maturity. There were no individual securities with material unrealized losses as of December 31, 2006 and 2005. As of December 31, 2006 and 2005, 100% of the securities that were in a gross unrealized loss position were rated investment grade.
The amortized cost and fair value of the FP Investment Portfolio, at December 31, 2006, by contractual maturity, are shown below. 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.
All the investments supporting VIE liabilities are insured by FSA. The credit quality of the VIE Investment Portfolio, without the benefit of FSA’s insurance, at December 31, 2006 was as follows:
(1) Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2006.
The Company periodically monitors its investment portfolio for individual investments in an unrealized loss position in order to assess whether that investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2006 and 2005, there were no securities in an unrealized loss position. The Company determined that no investments were considered other-than-temporarily impaired.
Bonds, equity securities and mortgage loans represent liquidations of previously insured obligations and subsequent purchases of the underlying collateral. Bonds and equity securities are available for sale and carried at fair value.
(1) Ratings are based on internal shadow ratings available at December 31, 2006.
The amortized cost and fair value of fixed-income assets within the refinanced asset portfolio were as follows:
The amortized cost and fair value of fixed-income assets within the refinanced asset portfolio at December 31, 2006, are shown below by contractual maturity. 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.
Acquisition costs deferred for amortization against future income and the related amortization charged to expenses are as follows:
The Company monitors its exposure to credits affected by the 2005 hurricanes in Louisiana and Mississippi. The Company believes that its estimate of its total loss liability is adequate given its current risk information and has not established a case reserve related to its 2005 hurricane-affected exposure.
On December 19, 2001, the Company issued $100.0 million of 67¤8% Quarterly Income Bond Securities due December 15, 2101, which are callable without premium or penalty on or after December 19, 2006. Debt issuance costs of $3.3 million are being amortized over the life of the debt.
The Company’s policies insure the scheduled payments of principal and interest on public finance and asset-backed (including FSA-insured CDS) obligations. The gross amount of financial guarantees in force (principal and interest) was $743.9 billion at December 31, 2006 and $668.2 billion at December 31, 2005. The net amount of financial guarantees in force was $531.4 billion at December 31, 2006 and $480.2 billion at December 31, 2005.
The par amount ceded as of December 31, 2006 and 2005 and the terms to maturity are as follows:
The Company seeks to maintain a diversified portfolio of insured public finance obligations designed to spread its risk across a number of geographic areas. The following table sets forth those states in which municipalities located therein issued an aggregate of 2% or more of the Company’s net par amount outstanding of insured public finance securities as of December 31, 2006:
Dexia Holdings, the Company and its Subsidiaries, except FSA International, file a consolidated U.S. federal income tax return. Prior to 2006, a tax-sharing agreement among the Subsidiaries provided that each member’s tax benefit or expense is calculated on a separate-return basis and that any credits or losses available to the Company are allocated among the members based on each member’s taxable income. Effective January 1, 2006, the tax sharing agreement was amended so that Dexia Holdings’ credits are no longer available to the members. For the 2006 and 2005 tax years, the Company and its Subsidiaries did not receive any such benefits from utilizing Dexia Holdings’ credits.
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.
Following a change in ownership of SPS in 2002, the Company determined that it would be appropriate to apply the 80% dividend-received deduction allowed by the Internal Revenue Service when accounting for the tax on its equity in earnings from SPS, based on management’s expectation that it would realize its gain on such investment through dividend distributions rather than through sale of its investment. For 2004 and 2003, equity in earnings from SPS was taxed at an effective rate of 7%. In the first quarter of 2005, due to the pending sale of its investment in SPS, the Company eliminated the assumption that accumulated earnings of SPS would be distributed in the form of dividends eligible for a dividend-received deduction. The net effect of this was to provide additional taxes on SPS’s accumulated earnings of approximately $1.6 million.
In connection with Dexia’s acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains. While the Company had no legal liability in connection with the indemnity payment, the payment was treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, the Company has agreed to share 50% of the deferred tax benefit with White Mountains under certain circumstances, but did not satisfy the standards for recording a liability for accounting purposes as of December 31, 2006.
Management believes it is more likely than not that the tax benefit of the deferred tax assets will be realized. Accordingly, no valuation allowance was necessary at December 31, 2006 or 2005.
The Company maintains both qualified and non-qualified, non-contributory defined contribution pension plans for the benefit of eligible employees. Contributions are based on a fixed percentage of employee compensation. Pension expense, which is funded annually, amounted to $7.5 million, $7.0 million and $5.8 million for the years ended December 31, 2006, 2005 and 2004, respectively.
The Company has an employee retirement savings plan for the benefit of eligible employees. The plan permits employees to contribute a percentage of their salaries up to limits prescribed by Internal Revenue Code Section 401(k). Contributions by the Company are discretionary, and none have been made.
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 General 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 General 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%.
The Company enters into derivative contracts to manage interest rate and foreign currency exposure in its GICs, FP Investment Portfolio, VIE debt and VIE Investment Portfolio. The inception-to-date net unrealized loss on derivatives used to hedge GIC liabilities and the FP Investment Portfolio of $23.0 million and $56.9 million at December 31, 2006 and December 31, 2005, respectively, is recorded in other assets or accrued expenses, other liabilities and minority interest, as applicable. The inception-to-date net unrealized gain on the outstanding derivatives used to economically hedge the VIE debt and VIE Investment Portfolio of $516.8 million and $433.7 million at December 31, 2006 and December 31, 2005, respectively, is recorded in other assets.
In order for a derivative to qualify for hedge accounting, it must be highly effective at reducing the risk associated with the exposure being hedged. An effective hedge is defined as one whose periodic fair value change is 80% to 125% correlated with the fair value of the hedged item. The difference between a perfect hedge (i.e., one that is 100% correlated) and the actual correlation within the 80% to 125% range is the ineffective portion of the hedge. A failed hedge is one whose correlation falls outside of the 80% to 125% range. The table below presents the net gain related to the ineffective portion of the Company’s fair-value hedges and net gain related to failed hedges at December 31, 2006 (in millions).
(1) Includes the changes in value of hedging instruments related to the passage of time, which have been excluded from the assessment of hedge effectiveness.
In the event that any or all of the reinsuring companies are unable to meet their obligations, or contest such obligations, the Company would be unable to recover such defaulted amounts. A number of FSA’s reinsurers are required to pledge collateral to secure their reinsurance obligations to FSA. Given the financial strengths of its reinsurers, FSA requires collateral from reinsurers primarily to receive statutory credit for the reinsurance, to provide liquidity to FSA in the event of claims on the reinsured exposures, and to enhance rating agency credit for the reinsurance.
Effective June 2004, the Company entered into a 21-year sublease agreement with Deutsche Bank AG for office space at 31 West 52nd Street, New York, New York, to be used as the Company’s new headquarters. The Company moved to this new space in June 2005. The lease contains scheduled rent increases every five years after a 19-month rent-free period, as well as lease incentives for initial construction costs of up to $6.0 million, as defined in the sublease. The lease contains provisions for rent increases related to increases in the building’s operating expenses. The lease also contains a renewal option for an additional ten-year period and an option to rent additional office space at various points in the future, in each case at then-current market rents. In addition, the Company and its Subsidiaries lease additional office space under non-cancelable operating leases, which expire at various dates through 2013. Future minimum rental payments are as follows:
In the ordinary course of business, the Company and certain Subsidiaries are parties to litigation. The Company is not a party to any material pending litigation.
On November 15, 2006, the Company received a subpoena from the Antitrust Division of the U.S. Department of Justice (“DOJ”) issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs. On November 16, 2006, FSA received a subpoena from the Securities and Exchange Commission (“SEC”) related to an ongoing industry-wide civil investigation of brokers of municipal GICs. The Company issues municipal GICs through the FP Segment, but does not serve as a GIC broker. The subpoenas request that the Company furnish to the DOJ and SEC records and other information with respect to the Company’s municipal GIC business. The Company is cooperating with the investigations by the DOJ and SEC.
Because the majority of the Company’s operations are conducted through FSA, the long-term ability of FSA Holdings to service its debt will largely depend on its receipt of dividends from, or payment on surplus notes by, FSA.
At December 31, 2006, FSA Holdings held $108.9 million of FSA surplus notes. Payments of principal or interest on such notes may be made only with the approval of the Superintendent of Insurance of the State of New York (the “New York Superintendent”). FSA Holdings employs surplus note purchases in lieu of capital contributions in order to allow it to withdraw funds from FSA through surplus note payments without reducing earned surplus, thereby preserving the dividend capacity of FSA.
FSA may repurchase shares of its common stock from shareholders subject to the New York Superintendent’s approval. The New York Superintendent has approved the repurchase by FSA of up to $500.0 million of its shares from FSA Holdings through December 31, 2008. In 2006, FSA repurchased $100.0 million of shares of its common stock from FSA Holdings and retired such shares.
FSAM has a $100.0 million line of credit with UBS Loan Finance LLC, which expires December 7, 2007, unless extended. This line of credit provides an additional source of liquidity should there be
unexpected draws on GICs issued by the GIC Affiliates. There were no borrowings under this agreement at December 31, 2006. Borrowings under this agreement are conditioned on FSA having a Triple-A rating by either Moody’s or S&P, and on neither Moody’s nor S&P having issued a rating to FSA below Aa1 or AA+, respectively.
In June 2003, $200.0 million of money market committed preferred trust securities (the “CPS Securities”) were issued by trusts created for the primary purpose of issuing the CPS Securities, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the “Preferred Stock”) of FSA. If FSA were to exercise a put option, the applicable trust would transfer the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $1.0 million and $1.3 million for 2006 and 2005, respectively, and was recorded within other operating expenses. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts because it does not retain the majority of the residual benefits or expected losses.
Certain FSA Global debt issuances contain provisions that could extend the stated maturities of those notes. To ensure FSA Global will have sufficient cash flow to repay its funding requirements, it has entered into four liquidity facilities with Dexia aggregating $419.4 million.
The intersegment assets consist of intercompany notes issued by FSA and held within the FP Investment Portfolio. The intersegment revenues and expenses relate to interest income and interest expense on intercompany notes and premiums paid by FSA Global on FSA-insured notes.
For assets acquired under refinancing transactions, each asset’s fair value is either the present value of expected cash flows or a quoted market price as of the reporting date.
For notes payable, the carrying amount represents the principal amount due at maturity. The fair value is based on the quoted market price or other third party sources.
For losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses, the carrying amount is equal to the present value of the expected cash flows for specifically identified claims plus statistical losses representing the inherent losses in the Company’s insured portfolio. Management believes the carrying amount is a reasonable proxy for fair value.
· upfront premiums are earned when related principal and interest have expired rather than earned over the expected period of coverage;
· acquisition costs are charged to operations as incurred rather than over the period that related premiums are earned;
· a contingency reserve (rather than a non-specific reserve) is computed based on the following statutory requirements:
· insured CDS are accounted for as insurance contracts rather than as derivative contracts recorded at fair value;
Consolidated statutory net income was $339.6 million for 2006, $293.0 million for 2005 and $242.1 million for 2004. Statutory surplus plus contingency reserves totaled $2,554.1 million for 2006, $2,417.5 million for 2005 and $2,280.9 million for 2004.