The principal executive offices of the Company and FSA are located at 350 Park Avenue, New York, New York 10022. The principal executive offices, which consist of approximately 79,000 square feet of office space, are under lease agreements, which generally expire in 2005. The Company's telephone number at its principal executive offices is (212) 826-0100. FSA or its subsidiaries also maintain leased office space in San Francisco, Dallas, Hamilton (Bermuda), London (England), Madrid (Spain), Paris (France), Singapore, Sydney (Australia) and Tokyo (Japan). The Company and its subsidiaries do not own any real property.
(b)FSA Global and Canadian Global balances are included in the 2003 balances only.
In 2003 and 2002, net premiums earned increased 13.2% and 36.3%, respectively, from each prior year's result. Excluding the effects of refundings and prepayments, net premiums earned increased 13.2% in 2003 and 29.3% in 2002. Refundings and prepayments result from interest-rate movements and other factors outside the Company's control, and no assurance can be given that refundings and prepayments will continue at the recent level. The recent slower growth rate in earned premiums is a function of the relatively higher contribution from U.S. municipal originations, which generally have longer maturities and therefore a slower earnings process.
PVNIM for 2003 was 32.9% below PVNIM for 2002. The Company constrained its GIC activity during the first four months of 2003 as it approached a regulatory limit of 100 non-qualified holders. This limit was lifted when the Company received an exemption from the Investment Company Act in April 2003. In addition, the low interest-rate environment in 2003 tended to suppress demand for long-term GICs. The Company entered the business of providing GICs in the fourth quarter of 2001.
Net investment income increased 11.4% in 2003 from that of the prior year, primarily due to higher invested balances arising from new business writings, partially offset by lower reinvestment rates stemming from the low interest-rate environment during the year. Net investment income increased 7.9% in 2002 from that of the prior year, primarily due to higher invested balances arising from new business writings. For further discussion, see "Liquidity and Capital Resources" below.
Realized gains and losses are generally a by-product of the normal investment management process and may vary substantially from period to period.
of recording case reserves on CDO transactions based on the extent to which the overcollateralization ratio (non-defaulted collateral at par value divided by the debt insured) has fallen below 100%, since management believes that claims on such transactions are probable and that the amount of the undercollateralization is a reasonable estimate of such claims. Such transactions may benefit from excess cash flow attributable in part to higher interest rates on the underlying collateral than on the insured securities. In addition, such transactions generally require insured payments of principal only at the ultimate maturity of such transactions. As a result, the Company does not expect to be required to pay claims on these transactions for several years, but may elect to do so at an earlier date at its discretion. Over time, management expects to reallocate amounts in its general reserve (including accretions thereto) to case reserves as specific losses on its insured CDO portfolio become probable and estimable in accordance with the undercollateralization methodology described above.
Beginning in the second quarter of 2002, management refined the loss factor it applies to its net par underwritten when calculating the Company's general reserve in order to reflect its recent adverse experience. As a result, and in connection with $41.1 million of CDO adjustments, the general reserve accrual for the year ended December 31, 2002 was $65.6 million, rather than the approximate $14.9 million that would have been accrued using the prior assumptions and assuming a similar mix and volume of business.
Since case and general reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates. The Company will continue, on an ongoing basis, to monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company's actual loss experience, its future mix of business and future economic conditions.
At December 31, 2003, the reinsurance recoverable on unpaid losses from reinsurers and ceded par outstanding, by Standard & Poor's Ratings Services (S&P) rating levels, are as follows:
In the fourth quarter of 2001, the Company's GIC Subsidiaries began issuing FSA-insured GICs. These transactions resulted in a net interest margin of $11.2 million, $7.8 million and $(0.2) million for the years ended December 31, 2003, 2002 and 2001, respectively.
insured obligations. Due to changes in these factors, the gain or loss from derivative instruments may vary substantially from period to period. Absent any claims under FSA's guaranty, any "losses" recorded in marking a guaranty to fair value will be reversed by an equivalent "gain" at or prior to the expiration of the guaranty. 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.
During the first half of 2002, FSA's insured portfolio contained a portfolio of CDS on 100 corporate names (each rated investment grade at inception of the swap), with $10 million of exposure per name, for which the Company had first-loss exposure. This "single-name CDS program" was the only transaction of its kind in the insured portfolio. In the third quarter of 2002, the Company terminated its exposure under this program in exchange for paying termination costs of $43.0 million. The charge was included in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income during 2002.
Fairbanks' business is subject to regulation, supervision and licensing by various federal, state and local authorities, which have increased their focus on lending and servicing practices in the sub-prime lending industry. In October 2002, the Federal Trade Commission (FTC) informed Fairbanks that it was investigating whether Fairbanks' loan servicing or other practices violated the Fair Debt Collection Practices Act, the Fair Credit Reporting Act, Section 5 of the Federal Trade Commission Act or other laws enforced by the FTC. The Company understands that, in March 2003, the U.S. Department of Housing and Urban Development (HUD) initiated a criminal investigation into Fairbanks' servicing practices. Certain of Fairbanks' shareholders, including the Company, received civil investigative demands from the FTC relating to their investments in Fairbanks and their knowledge of Fairbanks' servicing operations.
Fairbanks is highly leveraged and dependent on credit facilities to make servicing and delinquency advances in the regular course of its business, to finance the acquisition of mortgage servicing rights and for other business purposes. In May 2003, Moody's Investors Service, Inc. (Moody's) and Standard & Poor's Ratings Services (S&P) downgraded their loan servicer rankings for Fairbanks from strong to below average. These actions constituted potential events of default under Fairbanks' credit facilities, which led to a restructuring of and amendments to the credit facilities in June 2003.
In order to address alleged violations of various federal and state laws, Fairbanks is reimbursing certain fees allegedly collected improperly and is changing certain of its loan servicing practices,
On November 12, 2003, the FTC announced a settlement with Fairbanks, resolving the FTC's and HUD's civil allegations against Fairbanks. The settlement requires Fairbanks to pay $40.0 million to the FTC to compensate consumers who suffered harm, enjoins Fairbanks from future law violations and imposes new restrictions on Fairbanks' business practices. The settlement is contingent on approval by a federal district court in Massachusetts and is expected to be coordinated with a related settlement in a class action lawsuit. The settlement amount and other costs, aggregating $55.0 million, have been reflected in Fairbanks', and hence the Company's, results for 2003.
Asset-backed and, to a lesser extent, municipal transactions insured by FSA may employ variable interest entities (VIEs) for a variety of purposes. A typical asset-backed transaction, for example, employs a VIE as the purchaser of the securitized assets and as the issuer of the obligations insured by FSA. FSA's participation is typically requested by the sponsor of the VIE or the underwriter, either via a bid process or on a sole source basis. VIEs 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 VIE issuers of FSA-insured obligations. FSA also bears some of the "risks and rewards" associated with the performance of the VIE's assets. Specifically, as issuer of a financial guaranty insurance policy insuring the VIE'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 VIE typically pays a periodic premium to FSA in consideration of the issuance by FSA of its insurance policy, with the VIE's assets typically serving as the source of such premium, thus providing some of the "rewards" of the VIE's assets to FSA. VIEs 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. The degree of influence exercised by FSA over these VIEs varies from transaction to transaction, as does the degree to which "risks and rewards" associated with asset performance are assumed by FSA. While all transactions insured by FSA are included in the Company's outstanding exposure, and losses under these obligations are reflected in the Notes to Consolidated Financial Statements for the year ended December 31, 2003, the assets and liabilities of these VIEs, except for refinanced transactions discussed in Note 22 to the Consolidated Financial Statements and as discussed below, have not been consolidated with those of the Company for financial reporting purposes as the Company is not the primary beneficiary.
In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities, an interpretation of ARB No. 51" (FIN 46). FIN 46 addresses consolidation of VIEs that have one or both of the following characteristics: (i) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity; and (ii) the equity investors lack the direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights, the obligation to absorb the expected losses of the entity if they occur or the right to receive the expected residual returns of the entity if they occur. In December 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003), "Consolidation of Variable Interest Entities, an interpretation of ARB 51" (FIN 46R). FIN 46R replaced FIN 46 and is effective for public companies for periods after December 15, 2003.
The Company applied FIN 46 and consolidated for financial reporting purposes, effective July 1, 2003, FSA Global Funding Limited (FSA Global) and Canadian Global Funding Corporation (Canadian Global). In addition, as a result of the Company obtaining control rights of another VIE, Premier International Funding Co. (Premier), on July 1, 2003, the Company consolidated Premier beginning July 1, 2003. FIN 46 requires that, upon consolidation, the Company initially measure the VIE's assets, liabilities and minority interest at their carrying amounts under existing GAAP as if the entity had been consolidated from the time the Company was considered its primary beneficiary (or parent). The aggregate increase in the balance sheet related to the consolidation of these three entities was $2.0 billion. Any differences upon consolidation were reflected as a cumulative effect of a change in accounting principle. The cumulative effect of a change in accounting principle for Canadian Global resulted in additional income of $4.8 million, net of income tax. There were no cumulative income statement effects from consolidating FSA Global and Premier. FSA Global is managed as a "matched funding vehicle," in which the proceeds from the issuance of FSA-guaranteed notes are invested in obligations having cash flows substantially matched to those of, and maturing prior to, such notes. In certain cases, investments of FSA Global consist of GICs issued by the GIC Subsidiaries. Similarly, Canadian Global and Premier have GICs issued by the GIC Subsidiaries in their investment portfolios. In each such case, the Company's GIC liability and GIC asset are eliminated in consolidation. At December 31, 2003, $559.9 million was eliminated as a result of such consolidation. In the cases of FSA Global and Canadian Global, permitted activities are limited by charter and do not involve active management; the legal documents that establish the VIEs do not permit the sale or other disposal of the financial assets they hold, except in automatic response to the terms of such financial assets; and the VIEs are structured as bankruptcy-remote entities. The Company's management believes that the assets held by the VIEs, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. All intercompany insured amounts between FSA and FSA Global or Canadian Global previously included in the Company's outstanding exposure are excluded from the Notes to the Consolidated Financial Statements for the year ended December 31, 2003.
required to be marked to fair value under SFAS No. 133. Management views insured CDS risks as comparable to other insured risks and enters into such non-cancelable contracts fully intending to hold them to maturity. Management expects that the SFAS No. 133 adjustments for each guaranteed CDS will sum to zero over the life of the transaction, as explained above under "Net Realized and Unrealized Gains (Losses) on Derivatives." Management therefore considers operating earnings a key measure of normal operating results. The following table is a reconciliation of net income to operating earnings for 2003, 2002 and 2001.
(1)Amount for 2001 differs from that originally disclosed because the current definition of operating earnings was not employed during 2001.
Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments. The market risks related to financial instruments of the Company relate primarily to its investment portfolio, of which over 95% was invested in long-term fixed-income securities at December 31, 2003. Changes in interest rates affect the value of the Company's fixed-income portfolio. As interest rates rise, the fair value of fixed-income securities decreases. Sensitivity to interest-rate movements can be estimated by projecting a hypothetical increase in interest rates of 1.0%. Based on market values and interest rates at year-end 2003, this hypothetical increase in interest rates of 1.0% across the entire yield curve would result in an after-tax decrease of $133.0 million in the net fair value of the Company's fixed-income portfolio. For the GIC Portfolio, this hypothetical increase in interest rates would result in an after-tax decrease of $51.1 million, partially offset by a gain of $47.0 million relating to futures and interest-rate swaps used to hedge the interest-rate risks on the GIC Portfolio. Since the Company does not expect to trade these investments prior to maturity, absent an unusually large demand for funds, it does not expect to recognize any material adverse impact to income or cash flows under the above scenario. Under the above scenario, reported income and cash flows would be expected to increase due to higher yields on newly invested funds generated from earnings and run-off of the outstanding investment portfolio. The VIE Portfolio is hedged against interest-rate risk.
The Company's investment portfolio holdings are primarily U.S. dollar-denominated fixed-income securities, including municipal bonds, U.S. government and agency bonds, and mortgage-backed, asset-backed, corporate and foreign securities. In calculating the sensitivity to interest rates for the taxable securities, U.S. Treasury rates are changed instantaneously by 1.0%, and the option-adjusted spreads of the securities are held constant. Tax-exempt securities are subjected to a change in the municipal Triple-A obligation curve that would be equivalent to a 1.0% taxable interest-rate change based on the average taxable/tax-exempt ratios for the prior 12 months. The simulation for tax-exempts calculates duration by taking into account the applicable call date if the bond is at a premium or the maturity date if the bond is at a discount.
The GIC Portfolio consists primarily of U.S. dollar-denominated asset-backed securities, U.S. agency and government securities and mortgage-backed securities. FSAM generally converts all fixed-rate assets and liabilities to floating rates using hedging instruments. As interest rates change, and assuming a highly effective fair-value hedging arrangement has been designated, the change in value of the fixed-income securities will be substantially offset by a similar but opposite change in value of the related hedging instruments.
The Company's losses and loss adjustment expenses comprise case reserves and a non-specific general reserve. FSA establishes a case reserve for unpaid losses and loss adjustment expenses for the net present value of the estimated loss when, in management's opinion, the likelihood of a future loss on a particular insured obligation is probable and determinable at the balance sheet date. A case reserve is determined using primarily cash flow or similar models and represents FSA's estimate of the net present value of the anticipated shortfall, net of reinsurance, between (i) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (ii) anticipated cash flow from and proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries. For CDOs, a case reserve is recorded based on the extent to which the overcollateralization ratio (non-defaulted collateral at par divided by the debt insured) has fallen below 100% and there is a projected loss when calculating the present value of cash flows. The non-specific general reserve is available to be applied against future additions or accretions to existing case reserves or to new case reserves. The general reserve is calculated by applying a loss factor to the total net par amount underwritten of the Company's insured obligations over the terms of such insured obligations and discounting the result at the then current risk-free rates. The loss factors used for this purpose are determined on the basis of an independent rating agency study of default rates and the Company's portfolio characteristics and history. The selection of loss factors and a discount rate involves judgment as to which factors to use and whether those factors reflect the Company's insured obligations. Management's judgments may also consider macroeconomic factors, political developments and changes in underwriting standards or mix of business.
Management conducts periodic credit reviews of its exposures to identify events, as they occur, that might cause a default on a transaction. With timely identification of these events, the Company may limit its potential for loss by taking actions to improve transaction performance. Certain events have occurred in the past, such as the decline in commercial real estate values in the early 1990s and the deterioration in the CDO portfolio in 2002, that have had a significant impact on the Company's losses and loss adjustment expenses. Although these events are difficult to predict, the Company's credit review process is designed to identify such events early so the Company can act to limit its exposure. In addition, management may decide to exercise its rights to accelerate insured obligations in order to mitigate expected losses by lowering financing costs when market conditions so permit. See "Results of Operations-Losses and Loss Adjustment Expenses," above, for a discussion of the refinanced transactions.
A large portion of the Company's investment portfolio and its derivative instruments are carried at fair value. Fair value is defined as the amount at which an asset or a liability could be bought or sold in a current transaction between willing parties. The fair value of substantially all of the Company's investment portfolio and derivative instruments used in hedging the interest-rate risk of the financial products business and FSA Global is determined based on quoted market prices. For derivative instruments where a quoted market price exists, the Company uses that price. If quoted market prices are not available (as is the case primarily with CDS referencing pools of assets and the determination of the fair-value change of interest-rate risk of a hedged asset or liability), then the determination of fair value is based on internally developed estimates. Management applies judgment when developing estimates for CDS and considers factors such as current prices charged for similar agreements, performance of underlying assets, changes in internal shadow ratings, the level at which the deductible has been set and FSA's ability to obtain reinsurance for its insured obligations.
Premiums are received either up front or over time on an installment basis. Premiums are earned in proportion to the amount of risk outstanding over the expected period of coverage. The amount of risk outstanding is equal to the sum of the par amount of debt insured. Deferred premium revenue and prepaid reinsurance premiums represent the portion of premium that is applicable to coverage of risk to be provided in the future on policies in force. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred premium revenue and prepaid reinsurance premium, less any amount credited to a refunding issue insured by the Company, are recognized. Some industry peers receive so-called structuring or advisory fees in connection with transactions insured by them or their affiliates and earn such fees upon receipt. Unlike these industry peers, the Company allocates all fees (net of reimbursed expenses) received for its account on closed transactions to premiums (or ceding commissions) that are earned (or, in the case of ceding commissions, employed to offset deferred acquisition costs) over time. When the Company, through its ongoing credit review process, identifies transactions where certain triggers have been breached, the Company ceases to earn premiums on such transactions. The amount of any case reserves established for these transactions will be net of the unearned premiums for such transactions.
Deferred acquisition costs comprise expenses that vary with, and are primarily related to, the production of business, including commissions paid on reinsurance assumed, compensation and related costs of underwriting and marketing personnel, certain rating agency fees, premium taxes and certain other underwriting expenses, reduced by ceding commission income on premiums ceded to reinsurers. As general costs are incurred, they are allocated to individual cost centers, and a percentage of those costs is deferred based on a weighted-average calculation of time spent on the production of new business by the personnel in that cost center. Variable costs that are a direct result of acquiring business are deferred in their entirety. The Company does not defer acquisition costs relating to GICs issued by the GIC Subsidiaries, except for GIC commissions. GIC commissions are paid only upon execution of a transaction and represent third-party finder fees that are amortized over the life of the GIC. Deferred general costs are grouped by the underwriting year in which they were incurred and amortized over the period in which the related underwriting year's premium is earned. Deferred variable direct costs and ceding commission income are grouped by upfront or installment classification, as well as by underwriting year, and are amortized over the period in which the related premiums are earned. Recoverability of deferred acquisition costs is determined by considering anticipated losses and loss adjustment expenses.
The Company paid no dividends to its shareholders in 2003. Dividends paid by the Company to its shareholders were $11.7 million and $31.1 million in 2002 and 2001, respectively.
Following is a summary of the Company's long-term obligations at December 31, 2003:
In 2003, 2002 and 2001, the Company made additional equity investments of $0, $13.4 million and $15.0 million, respectively, to Fairbanks. At December 31, 2003, the Company had an equity ownership in Fairbanks of 29.8%.
The Company believes that FSA's expected operating liquidity needs, on both a short- and long-term basis, can be funded from its operating cash flow. In addition, FSA has a number of sources of liquidity that are available to pay claims on a short- and long-term basis: cash flow from written premiums, FSA's investment portfolio and earnings thereon, reinsurance arrangements with third-party reinsurers, new borrowings through its financial products segment, liquidity lines of credit with banks, and capital market transactions.
FSA has a standby line of credit in the amount of $325.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $325.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $865.6 million at December 31, 2003. The obligation to repay loans made under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a term that will expire on April 30, 2010 and contains an annual renewal provision subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2003.
The Company's asset management group has a $100.0 million line of credit with UBS Loan Finance LLC, which expires December 10, 2004, unless extended. This line of credit provides an additional source of liquidity should there be unexpected draws on GICs issued by the GIC Subsidiaries. There were no borrowings under this arrangement at December 31, 2003.
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 providing the reinsurance, 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 any time. In recent years, a number of Triple-A-rated reinsurers employed by FSA have been downgraded by S&P. Downgrade of these reinsurers by S&P to the Double-A category resulted in a decline in the credit allowed for reinsurance by S&P from 100% to 70% or 65% under present criteria. While a downgrade by S&P of all reinsurers to the Double-A category would not impair FSA's Triple-A ratings, it may reduce the "margin of safety" by which FSA would survive a theoretical catastrophic depression modeled by S&P. A reduction by S&P in credit for reinsurance used by FSA would also be expected ultimately to reduce the Company's return on equity to the extent that ceding commissions paid to FSA by such reinsurers were not increased to compensate for such reduction. FSA employs considerable reinsurance in its business to manage its single-risk exposures on insured credits. Any material increase in capital charges by S&P on FSA's insured portfolio would likewise be expected to have an adverse effect on FSA's margin of safety under the S&P capital adequacy model and, ultimately, the Company's return on equity. The Company may seek to raise additional capital to replenish capital eliminated by any of the rating agencies and their assessment of FSA's capital adequacy.
In the case of Moody's, 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 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 (asset-backed and municipal), 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.
service reserve funds and construction funds in support of municipal bond transactions. Debt service reserve fund GICs may be drawn unexpectedly upon a payment default by the municipal issuer. Construction fund GICs may be drawn unexpectedly when construction of the underlying municipal project does not proceed as expected. In addition, most FSA-insured GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below AA- by S&P or Aa3 by Moody's, unless the GIC provider posts collateral or otherwise enhances its credit. Some FSA-insured GICs also allow for withdrawal of GIC funds in the event of a downgrade of FSA below A- by S&P or A3 by Moody's, with no right of the GIC provider to avoid such withdrawal by posting collateral or otherwise enhancing its credit. The Company manages this risk through the maintenance of liquid collateral and bank liquidity facilities.
As of December 31, 2003, the Company had no material commitments for capital expenditures. The Company is considering relocating its corporate headquarters to another location in New York City. In the event that the Company relocates, it will enter into commitments for capital expenditures relating to the new space.
Consolidated Statements of Operations and Comprehensive Income for the Years Ended December 31, 2003, 2002 and 2001
Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 2003, 2002 and 2001
As discussed in Note 25 to the consolidated financial statements, the Company changed its method of accounting for its interest in certain variable interest entities.
On July 1, 2003, the Company consolidated $1.9 billion in assets and $1.9 billion in liabilities relating to variable interest entities with no corresponding cash movement. In 2003, the Company received tax benefits of $0.3 million from its parent company, which was recorded as a capital contribution. In 2002 and 2001, restricted treasury stock of $0.3 million and $0.3 million, respectively, was distributed to a director as deferred compensation plan payouts.
Financial Security Assurance Holdings Ltd. (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 asset-backed and municipal obligations. The Company's underwriting policy is to insure asset-backed and municipal obligations that it determines would be of investment-grade quality without the benefit of the Company's insurance. The 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 municipal obligations insured by the Company consist primarily of general obligation bonds that are supported by the issuers' taxing power and of special revenue bonds and other special obligations of states and local governments that are supported by the issuers' ability to impose and collect fees and charges for public services or specific projects. Municipal obligations include obligations backed by the cash flow from leases or other revenues from projects serving a substantial public purpose, including government office buildings, toll roads, healthcare facilities and utilities. Financial guaranty insurance written by the Company guarantees scheduled payments on an issuer's obligation. In the case of a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other amounts due in accordance with the obligation's original payment schedule or, at its option, to pay such amounts on an accelerated basis.
The Company offered guaranteed investment contracts (GICs) through two of its wholly owned subsidiaries, FSA Capital Markets Services LLC and FSA Capital Management Services LLC (collectively, the GIC Subsidiaries) through April 2003. FSA Capital Management Services LLC has conducted all GIC business since April 2003, following receipt of an exemption from the requirements of the Investment Company Act of 1940. The GICs are provided to municipalities and other market participants, and are insured by the Company's insurance company subsidiary. The GICs provide for the return of principal and the payment of interest at a pre-specified rate.
The consolidated financial statements include the accounts of the Company and its direct and indirect subsidiaries, Financial Security Assurance Inc. (FSA), FSA Insurance Company, Financial Security Assurance International Ltd. (FSA International), Financial Security Assurance (U.K.) Limited, FSA Capital Markets Services LLC, FSA Capital Management Services LLC, FSA Asset Management LLC (FSAM), FSA Portfolio Management Inc., Transaction Services Corporation, FSA Services (Australia) Pty Limited and FSA Services (Japan) Inc. (collectively, the Subsidiaries). The consolidated financial statements also include the accounts of FSA Global, Canadian Global and Premier, beginning July 1, 2003. All intercompany accounts and transactions have been eliminated. Certain prior-year balances have been reclassified to conform to the 2003 presentation.
Investments in debt securities designated as available for sale are carried at fair value. The unrealized gain or loss on the investments that are not hedged is reflected as a separate component of shareholders' equity, net of applicable deferred income taxes. The unrealized gain or loss on the investments that qualify as fair-value hedges is recorded in income currently. All of the Company's debt securities are classified as available for sale.
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, which approximates cost. Cash equivalents are amounts deposited in money market funds and investments with a maturity at time of
Investments in unconsolidated affiliates are based on the equity method of accounting (see Note 18). The Company records its share of unrealized gains or losses, net of applicable deferred taxes, in other comprehensive income.
Derivative instruments, which are primarily designated as fair-value hedges, are entered into to manage the interest-rate and currency exchange-rate exposure of the Company's GICs, GIC bond portfolio, VIE debt and VIE bond portfolio and are recorded at fair value. These derivatives generally include interest-rate futures and interest-rate and currency swap agreements, which are primarily utilized to convert the Company's fixed-rate obligations on its GICs, GIC bond portfolio, VIE debt and VIE bond portfolio into U.S.-dollar floating-rate obligations. The gains and losses relating to these fair-value hedges, including any ineffective portion, are included in financial products net interest income, financial products net interest expense, VIE net interest income and VIE net interest expense, as appropriate, along with the offsetting change in fair value of the hedged item attributable to the risk being hedged, on the consolidated statements of operations and comprehensive income. Gains and losses relating to derivatives that fail hedge effectiveness are recorded at fair value through earnings and included in financial products net interest income and net interest expense, as appropriate.
Management of the Company periodically evaluates its estimates for losses and loss adjustment expenses and establishes reserves that management believes are adequate to cover the net present value of the ultimate net cost of claims. However, because of the uncertainty involved in developing these estimates, the ultimate liability may differ from current estimates.
The debt is recorded at amortized cost. The Company may enter into associated transactions in order to reduce the Company's exposure to fluctuations in interest and foreign currency rates and its related effect on the fair value of the debt. For fair-value hedges, changes in the fair value of the hedging instrument are recognized in income currently. The change in the fair value of the hedged item in a qualifying hedge, attributable to the hedged risk, adjusts the carrying amount of the hedged item and is recognized in income currently. VIE debt may include hybrid debt instruments that contain embedded derivatives. Under certain conditions, embedded derivatives are required to be accounted for separately, at fair value through earnings.
In addition to its insurance company assets and other assets (the investment portfolio), the Company also maintains investments from proceeds of FSA-insured GICs (the GIC Portfolio) and the portfolio of securities owned by FSA Global and Canadian Global (the VIE Portfolio).
The credit quality of bonds in the investment portfolio at December 31, 2003 was as follows:
The amortized cost and fair value of bonds in the investment portfolio were as follows (in thousands):
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, at December 31, 2003 (in thousands):
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, 2003, the Company determined that no investments were considered other-than-temporarily impaired.
The amortized cost and fair value of bonds in the investment portfolio at December 31, 2003, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
The credit quality of bonds held in the GIC Portfolio at December 31, 2003 was as follows:
(1)Ratings are based on the higher of Moody's or S&P ratings available at December 31, 2003. Of the bonds included in the GIC Portfolio, 11.3% were AAA by virtue of insurance provided by FSA. Without giving effect to the FSA guaranty, the weighted-average rating of the FSA-insured investments was in the Double-A range, and all of these investments were investment grade.
The following table shows the gross unrealized losses and fair value for the GIC Portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2003 (in thousands):
The Company periodically monitors the GIC 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, 2003, there were nine securities that were in an unrealized loss position for a continuous 12-month period or longer. None of the nine securities had an unrealized loss that exceeded book value by 20% or greater at December 31, 2003. At December 31, 2003, the Company determined that no investments were considered other-than-temporarily impaired.
Proceeds from sales of bonds held in the GIC Portfolio during 2003, 2002 and 2001 were $190.7 million, $274.1 million and $174.2 million, respectively. Gross gains of $10.5 million were realized on sales in 2003, offset by $11.5 million of unrealized losses on derivatives used to hedge the securities that were sold. Gross losses of $0 million, $0.2 million and $0.3 million were realized on sales in 2003, 2002 and 2001, respectively.
GAAP differs in certain significant respects from accounting practices prescribed or permitted by insurance regulatory authorities, which are applicable to the Company's insurance company subsidiaries. The principal differences result from the following statutory accounting practices:
•Upfront premiums on municipal business are recognized as earned when related principal and interest have expired rather than over the expected coverage period;
2)For all policies written on or after July 1, 1989, an amount equal to the greater of 50% of premiums written for each category of insured obligation or a designated percentage of principal guaranteed for that category. These amounts are provided each quarter as either 1/60th or 1/80th of the total required for each category, less permitted reductions;
•Deferred tax assets are generally admitted to the extent reversals of existing temporary differences in the subsequent year can be recovered through carryback;
•Surplus notes are recognized as surplus rather than as a liability; and
A reconciliation of net income for the calendar years 2003, 2002 and 2001 and shareholders' equity at December 31, 2003 and 2002, reported by the Company on a GAAP basis, to the amounts reported by the insurance company subsidiaries on a statutory basis, is as follows (in thousands):
Prior to the Dexia merger, the Company and its Subsidiaries, except FSA International, filed a consolidated federal income tax return. The calculation of each company's tax benefit or expense was controlled by a tax-sharing agreement that based the allocation of such benefit or expense on a separate-return calculation. Dexia Holdings, Inc. and the Company and its Subsidiaries, except FSA International, filed a consolidated federal income tax return for periods subsequent to the merger, under a new tax-sharing agreement.
Federal income taxes have not been provided on substantially all of the undistributed earnings of FSA International, since it is the Company's practice and intent to reinvest such earnings in the operations of this subsidiary. The cumulative amount of such untaxed earnings was $86.7 million, $57.1 million and $41.9 million at December 31, 2003, 2002 and 2001, respectively.
No valuation allowance was necessary at December 31, 2003 or 2002.
In 2002, the Company changed its method of accounting for taxes in respect of its equity earnings from Fairbanks Capital Holding Corp. (Fairbanks), an unconsolidated affiliate of the Company (see Note 18). Prior to 2002, the Company accounted for its equity earnings from Fairbanks net of income tax at the statutory rate of 35%. Following a change in Fairbanks' investors, 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 earnings from Fairbanks, based on management's expectation that it would realize its gain on such investment through dividend distributions rather than through sale of its investment. In 2002, the Company recorded a cumulative-to-date benefit of $4.0 million, included in tax-exempt investments in the above reconciliation, relating to this change.
on FSA's last filed statement, or adjusted net investment income, as defined, for such 12-month period. As of December 31, 2003, FSA had $112.6 million available for the payment of dividends over the next 12 months. In addition, at December 31, 2003, the Company held $152.9 million of surplus notes of FSA. Payments of principal or interest on such notes may be made with the approval of the New York Superintendent. In 2003, with the approval of the New York Superintendent, FSA repaid $60.0 million of principal on such notes. In 2002, FSA repaid $28.0 million and subsequently issued an additional $96.9 million of surplus notes to the Company.
FSA has a credit arrangement aggregating $150.0 million, which is provided by commercial banks and intended for general application to transactions insured by the Subsidiaries. At December 31, 2003, there were no borrowings under this arrangement, which expires on April 23, 2004, if not extended.
FSAM has a $100.0 million line of credit with UBS Loan Finance LLC, which expires December 10, 2004, unless extended. There were no borrowings under this agreement at December 31, 2003.
The Company and its Subsidiaries maintain both qualified and non-qualified non-contributory defined contribution pension plans for the benefit of eligible employees. The Company and its Subsidiaries' contributions are based on a fixed percentage of employee compensation. Pension expense, which is funded annually, amounted to $4.9 million, $5.1 million and $3.6 million for the years ended December 31, 2003, 2002 and 2001, respectively.
Performance shares granted under the 1993 Equity Participation Plan were as follows:
Rent expense for the years ended December 31, 2003, 2002 and 2001 was $7.3 million, $6.2 million and $6.2 million, respectively.
The Company's policies insure the scheduled payments of principal and interest on asset-backed (including FSA-insured CDS) and municipal obligations. The net par outstanding as of December 31, 2003 and 2002 and the contractual terms to maturity are as follows (in millions):
(1)Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
(2)Excludes $4,474 million and $2,430 million, in 2003 and 2002, respectively, relating to FSA-insured GICs issued by the GIC Subsidiaries. Such amounts are included in FSA's insurance exposures. The consolidated financial statements of the Company reflect the FSA-insured GICs as GIC liabilities instead of as insurance exposure because the GIC Subsidiaries are consolidated with the Company.
The par amount ceded as of December 31, 2003 and 2002 and the terms to maturity are as follows (in millions):
(1)Excludes $4,474 million and $2,430 million, in 2003 and 2002, respectively, relating to FSA-insured GICs issued by the GIC Subsidiaries. Such amounts are included in FSA's insurance exposures. The consolidated financial statements of the Company reflect the FSA-insured GICs as GIC liabilities instead of as insurance exposure because the GIC Subsidiaries are consolidated with the Company. The net par outstanding of insured obligations in the municipal insured portfolio includes the following amounts by type of issue (in millions):
by the Company to be significant, given other more relevant measures of diversification, such as issuer or industry diversification.
The Subsidiaries ceded premiums of $48.8 million, $23.4 million and $12.8 million to subsidiaries of XL Capital Ltd (XL), which owns an interest in FSA International, for the years ended December 31, 2003, 2002 and 2001, respectively. The amounts included in prepaid reinsurance premiums at December 31, 2003 and 2002 for reinsurance ceded to subsidiaries of XL were $60.8 million and $32.0 million, respectively. The amounts included in reinsurance recoverable for unpaid losses at December 31, 2003 and 2002 for reinsurance ceded to subsidiaries of XL were $10.9 million and $7.4 million, respectively.
The Subsidiaries had premiums earned of $2.5 million, $5.0 million and $4.4 million in the first half of 2003 and the years ended 2002 and 2001, respectively, relating to the guarantees of debt issued or assets purchased by FSA Global. Intercompany premiums earned relating to FSA Global have been eliminated in consolidation for periods subsequent to July 1, 2003.
Bonds, GIC bond portfolio, GIC bond portfolio pledged as collateral and VIE bond portfolio-The carrying amount represents fair value. The fair value is based on quoted market price.
Notes payable-The carrying amount of notes payable represents the principal amount. The fair value is based on quoted market price.
Activity in the liability for losses and loss adjustment expenses, which consists of the case and general reserves, is summarized as follows (in thousands):
During 2003, the Company charged $34.5 million to loss expense, comprised of $9.2 million related to the CDO portfolio discussed above, $22.4 million for origination of new business and $2.9 million for the accretion of the discount on prior years' reserves. The general reserve increased by $21.8 million in 2003, consisting of the loss expense, a transfer to the general reserve of $1.4 million representing recoveries received on prior-year transactions and a transfer of $14.1 million from the general reserve to case reserves. In addition, the Company reclassified $2.2 million of case reserves relating to a restructured transaction to securitized loans on the balance sheet (see Note 22). Giving effect to these transfers, the general reserve totaled $111.5 million at December 31, 2003.
The cumulative amount of discount taken was approximately $65.9 million, $44.7 million and $29.6 million at December 31, 2003, 2002 and 2001, respectively.
Fairbanks is highly leveraged and dependent on credit facilities to make servicing and delinquency advances in the regular course of its business, to finance the acquisition of mortgage servicing rights and for other business purposes. In May 2003, Moody's and S&P downgraded their loan servicer rankings for Fairbanks from strong to below average. These actions constituted potential events of default under Fairbanks' credit facilities, which led to a restructuring of and amendments to the credit facilities in June 2003.
In order to address alleged violations of various federal and state laws, Fairbanks is reimbursing certain fees allegedly collected improperly and is changing certain of its loan servicing practices, including the types and amounts of fees collected without admitting any violations. Due to these developments, future income from Fairbanks' operations is expected to be reduced. While the impairment analysis performed by the Company did not result in a write-down of the investment, the Company continues to monitor the value of its investment in Fairbanks.
The Company has a 15% interest in XL Financial Assurance Ltd, a financial guaranty insurance subsidiary of XL. The Company's investment in XLFA is accounted for using the equity method of accounting because the Company has significant influence over XLFA's operations. Amounts recorded by the Company in connection with XLFA as of December 31, 2003, 2002 and 2001 are as follows (in thousands):
At December 31, 2003 and 2002, the Company's retained earnings included $25.7 million and $13.2 million, respectively, of accumulated undistributed earnings of XLFA.
In November 1998, FSA International sold to XL $20.0 million of preferred shares representing a minority interest in FSA International, which is a Bermuda-based financial guaranty subsidiary of FSA. In December 1999, FSA International sold to XL an additional $10.0 million of preferred shares to maintain its minority ownership percentage. The preferred shares are Cumulative Participating Voting Preferred Shares, which in total have a minimum fixed dividend of $1.5 million per annum. In 2003 and 2002, FSA International paid preferred dividends of $3.3 million and $8.7 million, respectively, to XL. For the years ended December 31, 2003, 2002 and 2001, the Company recognized minority interest of $9.3 million, $6.7 million and $8.9 million, respectively.
The obligations under GICs may be called at various times prior to maturity based on certain agreed-upon events. As of December 31, 2003, the interest rates on these GICs were between 0.8% and 6.07% per annum.
FSA has also insured a number of CDS agreements that it intends, in each case, to hold for the full term of the agreement. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred. The Company recorded $57.7 million, $35.0 million and $15.4 million in net earned premiums under these agreements for the years ended December 31, 2003, 2002 and 2001, respectively. The changes in fair value, which were gains of $34.8 million, losses of $50.2 million and gains of $6.7 million for the years ended December 31, 2003, 2002 and 2001, respectively, were recorded in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income and in accrued expenses and other liabilities. The Company included the net par outstanding of $63.8 billion relating to these CDS transactions at December 31, 2003 in the asset-backed balances in Note 13. The losses or gains recognized by recording these contracts at fair value will be determined each quarter based on an estimate of fair value by analyzing pricing of Super Triple-A (defined as having first-loss protection of 1.3 times the level required for a Triple-A rating) swap guarantees and other indicative market prices, as appropriate, for the implied rating of each underlying obligation. The Company does not believe the fair-value adjustments are an indication of potential claims under FSA's guarantees. The inception-to-date net unrealized loss was recorded in accrued expenses and other liabilities and was $9.4 million and $44.2 million at December 31, 2003 and 2002, respectively.
In 2003 and 2002, FSA exercised certain rights available under its financial guaranty policies and indentures relating to certain loan-backed notes issued by trusts. Those rights allowed FSA to accelerate the insured notes and pay claims under its insurance policy on an accelerated basis. Refinancing vehicles reimbursed FSA in whole for its claims payments in exchange for assignments of certain of FSA's rights against the trusts. The refinancing vehicles obtained their funds from the proceeds of FSA-insured GICs issued in the ordinary course of business by the GIC Subsidiaries. FSA maintains significant first-loss and quota share reinsurance on these transactions.
Since the notes represent 100% of the debt capitalization of the trusts and since FSA maintains all the risk of further asset decline and maintains control over key decisions regarding the trusts (such as removal of the servicer, sale of the assets and liquidation of the entity), the trusts were consolidated with FSA for accounting purposes. FSA also consolidated the refinancing vehicles.
Although the securitized loans are included on FSA's balance sheet, the securitized loans continue to support FSA-insured transactions exclusively, subject to considerable first-loss and quota share reinsurance. In accordance with AICPA Practice Bulletin 6, "Amortization of Discounts on Certain Acquired Loans," the Company has recorded the securitized loans at cost net of losses at the date of purchase, has determined cash flows from the pools of securitized loans, net of reinsurance, and is recording income based on the effective yield method. The cash flows on the securitized loans will be monitored and the effective yield modified to reflect any change in the cash flow estimate on a prospective basis (see Note 26).
The detailed balances that comprise other assets and accrued expenses and other liabilities at December 31, 2003 and 2002 are as follows (in thousands):
Following is a summary of the impact on the consolidated balance sheet of consolidating the VIEs at December 31, 2003 (in thousands):
Following is a summary of the impact in the consolidated statement of operations of consolidating the VIEs for the year ended December 31, 2003 (in thousands):
The following table shows the gross unrealized losses and fair value (in thousands) of securities in the VIE Portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2003:
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, 2003, there were nine securities that were in an unrealized loss position for a continuous 12-month period or longer. None of the nine securities had an unrealized loss that exceeded book value by 20% or greater at December 31, 2003. At December 31, 2003, the Company determined that no investments were considered other-than-temporarily impaired.
SOP 03-3 requires that the investor recognize the excess of all cash flows expected at acquisition over the investor's initial investment in the loan as interest income on a level-yield basis over the life of the loan. SOP 03-3 prohibits investors from displaying differences from expected cash flows in the balance sheet. Subsequent increases in cash flows expected to be collected generally should be recognized prospectively through adjustment of the loan's yield over its remaining life. Decreases in cash flows expected to be collected should be recognized as impairment.
In December 2003, the Emerging Issues Task Force (EITF) issued EITF Issue No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" (EITF 03-01). EITF 03-01 requires the Company to disclose certain information about unrealized holding losses on its investment portfolio that have not been recognized as other-than-temporary impairments. The requirements are effective for fiscal years ending after December 15, 2003, and require the Company to make disclosure in its financial statements about investments in debt or marketable equity securities with market values below carrying values. See Notes 3 and 25 for disclosures required by EITF 03-01.