MBIA Inc. (MBIA or the Company) has made statements in this report that are not historical or current facts and are “forward-looking statements” made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The words “believe,” “anticipate,” “project,” “plan,” “expect,” “intend,” “will likely result,” “looking forward” or “will continue,” and similar expressions identify forward-looking statements. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. MBIA cautions readers not to place undue reliance on any such forward-looking statements, which speak only to their respective dates. The following are some of the factors that could affect the financial performance or could cause actual results to differ materially from estimates contained in or underlying the Company’s forward-looking statements:
• fluctuations in the economic, credit, interest rate or foreign currency environment in the United States and abroad;
teamwork; No Loss Underwriting, which expresses the pursuit of perfection in the Company’s management of credit risk and reflects the Company’s core competency; Triple-A Ratings, which the Company seeks to protect at all costs as they are the business platform from which the Company operates; and Enhance Long-Term Shareholder Value, which is the result of disciplined and rigorous adherence to the first three principles.
experience, for the relevant sectors of the fixed-income market, (ii) rating agency studies of defaults and (iii) other relevant market factors.
When a case basis reserve is established, MBIA reclassifies the required amount from its unallocated loss reserve to its case basis loss reserve. Therefore, although MBIA accrues an unallocated loss reserve by applying a loss factor to scheduled earned premium, the amount of available unallocated loss reserve is directly related to case basis reserves established in the same period. At the end of each quarter, the Company evaluates the adequacy of the remaining unallocated loss reserve.
employed within the financial guarantee industry for loss reserving. Alternate methods may produce different estimates than the method used by the Company.
The effect of the Company’s upfront premium earnings policy is to recognize greater levels of upfront premiums in the earlier years of each policy insured, thus matching revenue recognition with exposure to the underlying risk. Recognizing premium revenue on a straight-line basis over the life of each policy without allocating premiums to the sinking fund payments would materially affect the Company’s financial results. Premium earnings would be more evenly recorded as revenue throughout the period of risk than under the current method, but the Company does not believe that the straight-line method would appropriately match premiums earned to the Company’s exposure to the underlying risk. Therefore, the Company believes its upfront premium earnings methodology is the most appropriate method to recognize its upfront premiums as revenue. The premium earnings methodology used by the Company is similar to that used throughout the industry.
The Company’s exposure to derivative instruments is created through contracts into which it directly enters and through third-party contracts it insures. The majority of MBIA’s exposure to derivative instruments is related to certain synthetic collateralized debt obligations (CDOs). These contracts meet the definition of a derivative under SFAS 133 but effectively represent an alternate form of financial guarantee execution. The fair values of the Company’s derivative instruments are estimated using various valuation models that conform to industry standards. The Company utilizes both vendor-developed and proprietary models, based on the complexity of transactions. Dealer market quotes are typically obtained for regularly traded contracts and provide the best estimate of fair value. However, when reliable dealer market quotes are not available, the Company uses a variety of market data relative to the type and structure of contracts. Several of the more significant types of market and contract data that influence the Company’s valuation models include interest rates, credit quality ratings, credit spreads, default probabilities and diversity scores. This data is obtained from third party sources and is reviewed for reasonableness and applicability to the Company’s derivative portfolio. The fair value of the Company’s derivative portfolio may be materially affected by changes in existing market data, the availability of new or improved market data, changes in specific contract data or enhancements to the Company’s valuation models resulting from new market practices.
events require the termination and settlement of a contract prior to maturity, any unrealized gain or loss will typically be realized.
The Company has dedicated resources to the development and ongoing review of its valuation models and has instituted procedures for the approval and control of data inputs. In addition, regular reviews are performed to ensure that the Company’s valuation models are appropriate and produce values reflective of the current market environment. See “Note 25: Fair Value of Financial Instruments” in the Notes to Consolidated Financial Statements for additional information on the various types of instruments entered into by MBIA and a comparison of carrying values as reported in the Company’s balance sheet to estimated fair values.
The Company completed its transitional impairment testing on its existing goodwill as of January 1, 2002 in accordance with SFAS 142. As of January 1, 2002, goodwill in the insurance reporting segment totaled $76.9 million. SFAS 142 requires a two-step approach in determining any impairment in goodwill. Step one entails evaluating whether the fair value of a reporting segment exceeds its carrying value. In performing this evaluation the Company determined that the best measure of the fair value of the insurance reporting segment is its book value adjusted for the after-tax effects of net deferred premium revenue less deferred acquisition costs and the present value of installment premiums to arrive at adjusted book value. Adjusted book value is a common measure used by analysts to determine the value of financial guarantee companies. As of January 1, 2002, the insurance reporting segment’s adjusted book value significantly exceeded its carrying value, and thus there was no impairment of its existing goodwill.
Total goodwill for the segments within the investment management services operations was $13.1 million as of January 1, 2002. In performing step one of the impairment testing, the fair values of the reporting segments were determined using a multiple of earnings before income tax, depreciation and amortization (EBITDA), as this is a common measure of fair value in the
investment management industry. The multiple was determined based on a review of current industry valuation practices. As of January 1, 2002, the fair values of the investment management services’ reporting segments exceeded their carrying values indicating that goodwill was not impaired.
The Company performed its annual impairment testing of goodwill as of January 1, 2003 and January 1, 2004. The fair values of the insurance reporting segment and the investment management services’ segments were determined using the same valuation methods applied during the transition testing. The fair values of the reporting segments exceeded their carrying values indicating that goodwill was not impaired.
The following table presents highlights of the Company’s consolidated financial results for 2003, 2002 and 2001. Items listed under “Effect on net income” are items that management commonly identifies for the readers of its financial statements because they are the result of changes in accounting standards, a by-product of the Company’s operations or due to general market conditions beyond the control of the Company.
When a MBIA-insured bond issue is refunded or retired early, the related deferred premium revenue is earned immediately. The level of bond refundings and calls is influenced by a variety of factors such as prevailing interest rates, the coupon rates of the bond issue, the issuer’s desire or ability to modify bond covenants and applicable regulations under the Internal Revenue Code.
three years, particularly in the public finance sector, will drive total earned premium growth into the 15-20% range in 2004. Assuming that interest rates rise in 2004, the Company expects refunding activity to slow down.
Insurance expenses, which consist of loss and loss adjustment expenses, amortization of deferred acquisition costs and operating expenses increased 21% in 2003. The growth rates in all three insurance expense categories are in line with the increase in insurance revenues. Gross insurance expenses were up 18% for 2003, resulting from a change in expense allocation methodology between business operations, expenses related to the formation of Toll Road Funding Plc. (TRF), and a one-time cost to replace split-dollar life insurance policies in response to prohibitions on loans to executives imposed under the Sarbanes-Oxley Act. Excluding these items, insurance operating expenses increased 6% for 2003, in line with the Company’s long-term goal of 5% to 7%. While expenses in 2003 exceeded the Company’s long-term goal due to nonrecurring items, future expense growth is expected to fall within the targeted range.
GPW reflects premiums received and accrued for the period and does not include the present value of future cash receipts expected from installment premium policies originated during the year. GPW was $1.3 billion in 2003, up 33% over 2002, reflecting strong growth in both U.S. and non-U.S. business. Installment and upfront GPW grew 32% and 34%, respectively, from 2002.
NPW, which is gross premiums written net of premiums ceded to reinsurers, increased 37% to $1.0 billion from $753 million in 2002. The larger increase in NPW relative to GPW relates to slightly lower cession rates in 2003 compared with 2002. Premiums ceded to reinsurers from all insurance operations were $236 million, $199 million and $235 million for 2003, 2002 and 2001, respectively. Reinsurance enables the Company to cede exposure and comply with its single risk and credit guidelines, although the Company continues to be primarily liable on the policy being insured.
Global public finance issuance remained high in 2003, largely driven by the low interest rate environment and increased issuance by municipalities due to stress on municipal budgets. New issuance in the U.S. public finance market measured by par value increased by $2 billion from $327 billion in 2002 to $329 billion in 2003. The insured portion of this market increased from 55% in 2002 to 58% in 2003. Robust refunding activity fueled this growth in the U.S. public finance market where refundings were up 2% for the year, as lower interest rates continued to prevail.
Global public finance GPW and NPW increased 58% and 59%, respectively, over 2002. This increase was due primarily to new upfront business written in the U.S. and outside the U.S. The slightly larger increase in global public finance NPW versus GPW relates to a lower cession rate in 2003 compared with 2002. Ceded premiums as a percent of gross premiums decreased from 14% in 2002 to 13% in 2003, which was largely the result of lower cession rates on deals insured outside the U.S. In 2003, global public finance scheduled earned premiums increased 22% to $291 million from $240 million in 2002. This growth reflects earnings generated from increased levels of business written over the last several years.
In 2002, GPW and NPW increased 2% and 18%, respectively, over 2001. Solid growth in U.S. GPW offset a decrease in non-U.S. GPW, while both U.S. and non-U.S. NPW increased. Ceded premiums as a percent of gross premiums decreased from 25% in 2001 to 14% in 2002, the result of lower cession rates on deals insured outside the U.S. Premiums earned from scheduled amortization increased by 10%, driven by an increase in both U.S. and non-U.S. business. Refunded premiums earned increased 36%, reflecting the lower interest rate environment.
Overall, MBIA’s global structured finance insured business written rated A or above before giving effect to the Company’s guarantee totaled 71% in 2003, down from 77% last year. At year-end 2003, 74% of the outstanding global structured finance book of business was rated A or above before giving effect to the Company’s guarantee, up from 68% at year-end 2002.
Global structured finance GPW increased 2% in 2003, to $436 million from $426 million last year, resulting from an increase in non-U.S. business. In 2003, installments received from business written in prior years increased 10% when compared with 2002. NPW for 2003 increased 4% due to the increase in non-U.S. business activity coupled with a lower cession rate on that business. The cession rate on global structured finance business was 28%, which declined from the 30% cession rate in 2002. The lower growth in premiums written when compared to 2002 growth was a result of the Company insuring fewer mortgage and consumer asset-backed transactions due to generally unattractive market pricing and credit terms in those sectors. In 2003, global structured finance
scheduled net earned premiums of $316 million increased 15% over 2002. This increase was primarily driven by strong levels of new business written over the last 18 months. In 2003, premiums exclude those received from Triple-A One Funding Corp. (Triple-A), Meridian Funding Company, LLC (Meridian) and Polaris Funding Company, LLC (Polaris) (collectively, the Conduits) resulting from the Company’s guarantee of assets and liabilities that are now consolidated by the Company.
The credit quality of business insured during 2003 remained high as insured credits rated A or above before MBIA’s guarantee were 81% for each of the past two years, up from 78% in 2001. At year-end 2003, over 78% of the Company’s outstanding book of business was rated A or above before MBIA’s guarantee.
The Company’s insurance-related net investment income, excluding net realized gains, increased 1% to $438 million in 2003, up from $433 million in 2002. Despite an 11% growth in the average invested asset base at amortized cost, the continuing low-yield environment eroded most of the positive growth in investment income. After-tax net investment income decreased by 2% in 2003, as the Company increased its concentration of taxable investments. A portion of Conduit investment income has been reported as insurance-related net investment income, reflecting the inclusion of earnings on Conduit assets. Excluding Conduit investment income, after-tax insurance-related investment income in 2003 would have declined 3% compared with 2002.
ADVISORY FEES The Company collects advisory fees in connection with certain transactions. Depending upon the type of fee received, the fee is either earned when it is due or deferred and earned over the life of the related transaction. Work, waiver and consent, termination, administrative and management fees are earned when due. Structuring fees are earned on a straight-line basis over the life of the related transaction and commitment fees are earned over the period of the commitment contract.
Insured Portfolio Management Department (IPM). Similarly, the 29% increase in 2002 compared with 2001 was primarily a result of the Company’s focus on work fees and waiver and consent fees. Fees that are earned when due totaled 91% and 88% of 2003 and 2002 advisory fee income, respectively. Due to the one-time nature inherent in such fees, there can be no assurance that the growth in advisory fees will continue at past levels.
LOSSES AND LOSS ADJUSTMENT EXPENSES (LAE) The following table shows the case-specific, reinsurance recoverable and unallocated components of the Company’s total loss and LAE reserves at the end of the last three years, as well as its loss provision and loss ratios for the last three years:
The Company recorded $73 million in loss and loss adjustment expenses in 2003, an 18% increase compared with $62 million in 2002. This increase was a direct result of growth in scheduled earned premiums, which is the basis of the Company’s loss reserving formula. Total case-incurred activity was $60 million for 2003, $49 million for 2002 and $43 million for 2001. 2003 case-incurred activity included additional case reserves for MBIA’s guaranteed tax lien portfolios, and losses associated with the guarantees of an older vintage CDO and a Trenwick America Corp. debt obligation.
Loss ratios are calculated by dividing losses incurred by net premiums earned and are a measurement of the Company’s underwriting performance. The
MBIA’s IPM Division is responsible for monitoring MBIA insured issues. The level and frequency of MBIA’s monitoring of any insured issue depends on the type, size, rating and performance of the insured issue. If IPM identifies concerns with respect to the performance of an insured issue it may designate such insured issue as “Caution List-Low,” “Caution List-Medium” or “Caution List-High.” The designation of any insured issue as “Caution List-Medium” or “Caution List-High” is based on the nature and extent of these concerns and requires that an increased monitoring and, if needed, a remediation plan be implemented for the related insured issue.
RISK MANAGEMENT In an effort to mitigate losses, MBIA is regularly involved in the ongoing remediations of credits that may involve, among other things, waivers or renegotiations of financial covenants or triggers, waivers of contractual provisions, the granting of consents, and the taking of various other remedial actions. The nature of any remedial action is based on the type of the insured issue and the nature and scope of the event giving rise to the remediation. In most cases, as part of any such remedial activity, MBIA is able to improve its security position and to obtain concessions from the issuer of the insured bonds. Since it commenced operations, the Company has
Two reinsurers within the AAA rating category represent approximately 27% of total par ceded by MBIA; two reinsurers within the AA rating category represent approximately 20% of total par ceded by MBIA; and two reinsurers within the A rating category represent approximately 21% of total par ceded by MBIA. After giving effect to the 2004 cessions to Channel Reinsurance Ltd. (Channel Re) described below, the percentage of cessions to AAA rated reinsurers would have been approximately 60% at December 31, 2003.
In 2003, MBIA launched several initiatives aimed at maximizing its Triple-A reinsurance capacity, including the investment of $25 million in RAM Reinsurance Company, a Triple-A rated financial guarantee reinsurer located in Bermuda. The Company’s investment, among other things, enabled RAM Reinsurance Company to maintain its Triple-A rating. In addition, on February 13, 2004, the Company announced that Channel Re, a new financial guarantee reinsurer based in Bermuda, was formed and funded. Channel Re was capitalized with total equity capital of approximately $366 million from four investors. Channel Re has received financial strength ratings of Aaa from Moody’s and AAA from S&P. MBIA has a 17.4% ownership interest in Channel Re. Channel Re has assumed a $27 billion portfolio of in-force business from MBIA and will participate in the Company’s reinsurance treaty and provide facultative reinsurance support. Following the assumption of the in-force business, Channel Re had total claims-paying resources of approximately $700 million. Business ceded to Channel Re was reassumed from various other reinsurers during February and March of 2004.
POLICY ACQUISITION COSTS AND OPERATING EXPENSES Expenses related to the production of the Company’s insurance business (policy acquisition costs) are deferred and recognized over the period in which the related premiums are earned. If an insured bond issue is refunded and the related premium is earned early, the associated acquisition costs previously deferred are also recognized early.
permits the anticipation of investment income when determining a premium deficiency, MBIA currently does not include this in making its determination.
The Company’s policy acquisition costs, operating expenses and total insurance operating expenses, as well as related expense ratios, are shown in the following table:
In 2003, the amortization of deferred acquisition costs increased 21% over 2002, in line with the increase in insurance premiums earned. The amortization of deferred acquisition costs increased 12% in 2002 compared with 2001. The ratio of policy acquisition costs, net of deferrals, to earned premiums has remained steady at 8% in 2003, 2002 and 2001. In addition, during the last three years there has been a decline in the ratio of deferred expenses carried as assets on the balance sheet to deferred revenues carried as liabilities on the balance sheet plus the present value of future installment premiums. This declining ratio indicates the Company has deferred proportionately more revenues than expenses over the last three years.
MBIA’s investment management operations have been consolidated under MBIA Asset Management, LLC since 1998. MBIA Asset Management, LLC owns 1838 Investment Advisors, LLC (1838), MBIA Municipal Investors Service Corp. (MBIA-MISC), MBIA Investment Management Corp. (IMC) and MBIA Capital Management Corp. (CMC), as well as the Conduits, which were consolidated in the third quarter of 2003. MBIA Global Funding, LLC (GFL) and Euro Asset Acquisition, Ltd. (EAAL), subsidiaries of the Company, also operate as part of the asset management business.
In general, the asset management businesses have had solid performances since 1998. However, in 2002, the asset management business suffered from a further weakening in the equity markets and, to a lesser extent, the low interest rate environment. The equity investment management business has not recovered from this turbulence in the U.S. equity markets while the fixed-income business showed promising results. Fixed-income results improved primarily as a result of growth in investment agreement and medium-term note activities. Investment agreement and medium-term note activities represented 59% of investment management services 2003 operating income, up from 34% in 2002 and 27% in 2001. Investment management services net revenues were up 9% over 2002, while consolidated expenses were up 14%, resulting in an operating income increase of 1% compared with 2002. If stock option expense relating to the adoption of the fair value recognition provisions of SFAS 123 had been recorded in 2001, pro forma operating income would still have declined 15% in 2002.
Ending assets under management at the end of 2003, which do not include Conduit assets, were $37.5 billion, 8% above the 2002 year-end level. Fixed-income assets increased 14%, while equity assets decreased 33%. Conduit assets are held to their contractual maturity and are originated and managed differently from those held as available-for-sale by the Company or those managed for third-parties. The following table summarizes the consolidated investment management results and assets under management over the last three years:
MBIA-MISC provides investment management programs including pooled investment products, customized asset management and bond proceeds investment services. In addition, MBIA-MISC provides portfolio accounting and reporting for state and local governments including school districts. MBIA-MISC is a Securities and Exchange Commission (SEC)-registered investment adviser. MBIA-MISC had $11.2 billion in assets under management at year-end 2003, up 11% from 2002. While assets under management have increased, the low interest rate environment has had a negative impact on revenues.
IMC provides customized investments for bond proceeds and other public funds for such purposes as construction, loan origination, escrow and debt service or other reserve fund requirements. It also provides customized products for funds that are invested as part of asset-backed or structured product issuance.
CMC is a SEC-registered investment adviser and National Association of Securities Dealers member firm. CMC specializes in fixed-income management for institutional funds and provides investment management services to IMC’s
investment agreement portfolio, GFL’s medium-term note and investment agreement portfolio, MBIA-MISC’s municipal cash management programs and the Company’s insurance and corporate investment portfolios. At year-end 2003, the market value of CMC’s third-party assets under management was $3.1 billion, compared with $2.6 billion at year-end 2002. The market value of assets related to the Company’s insurance and corporate investment portfolios managed by CMC were $9.8 billion at December 31, 2003, up 12% from the previous year-end.
MBIA has consolidated the Conduits in accordance with SFAS 94, “Consolidation of all Majority-Owned Subsidiaries” by acquiring controlling financial interests through the direct ownership of all of the voting interests of each Conduit. As a result of the consolidation of the Conduits, MBIA has included in its balance sheet the gross assets and liabilities of each Conduit, which consist primarily of various types of investments and medium- and short-term debt, and included in its income statement the gross operating revenues and expenses of the Conduits subsequent to their acquisition date. The investments and debt obligations of the Conduits, along with the investments and debt obligations of TRF, are reported separately as conduit investments and conduit debt obligations on the face of the Company’s balance sheet. Since Conduit revenues and expenses are consolidated from the date the Company purchased the Conduits, the impact on the Company’s income statement is immaterial. Certain of MBIA’s consolidated subsidiaries have invested in Conduit debt obligations or have received compensation for services provided to the Conduits. As such, MBIA has eliminated intercompany transactions with the Conduits from its balance sheet and income statement. After the elimination of such intercompany assets and liabilities, Conduit
investments and Conduit debt obligations were $8.4 billion and $7.8 billion, respectively at December 31, 2003. The difference between the investments and debt obligations is primarily the result of the elimination of Conduit debt owned by other MBIA subsidiaries. Other than the potential impact of the unrealized gains or losses from derivative instruments, MBIA does not expect its net income to change materially as a result of the consolidation of the Conduits due to the inconsequential level of residual profits of these entities.
The consolidation of the Conduits has not impacted MBIA’s liquidity requirements since Triple-A, an MBIA-administered multi-seller commercial paper conduit, had independently entered into liquidity agreements with third-party providers and MBIA does not guarantee payment of the commercial paper, and the assets and liabilities of the other Conduits are structured on a match-funded basis. In addition, the consolidation has not affected MBIA’s credit ratings or statutory capital requirements. Each of the transactions funded through the Conduits was underwritten in accordance with the Company’s underwriting standards and has been reviewed by the rating agencies. MBIA’s guarantees of the underlying investments and/or liabilities of the Conduits have historically been included in MBIA’s reported insurance exposure. Lastly, the consolidation of the Conduits will have no adverse affect on MBIA Corp.’s ability or capacity to declare dividends to MBIA Inc.
MBIA MuniServices Company (MBIA MuniServices) provides revenue enhancement services and products to public-sector clients nationwide, consisting of discovery, audit, collections/recovery, enforcement and information (data) services. The municipal services operations also include Capital Asset Holdings GP, Inc. and certain affiliated entities (Capital Asset), a servicer of delinquent tax certificates.
The Company owns Capital Asset, which was in the business of acquiring and servicing tax liens. The Company became the majority owner in December 1998 when it acquired the interest of Capital Asset’s founder and acquired the remaining equity in Capital Asset in the fourth quarter of 2003. MBIA Corp. has insured three securitizations of tax liens that were originated and continue to be serviced by Capital Asset. These securitizations were structured through the sale by Capital Asset of substantially all of its tax liens to three off-balance sheet qualifying special purpose entities (QSPEs) that were established in connection with these securitizations. These QSPEs are not the MBIA conduits discussed in the investment management services section of this report and are not included in the consolidation of the MBIA group. In the third quarter of 1999, Capital Asset engaged a specialty servicer of residential mortgages to help manage its business and operations and to assist in administering the portfolios supporting the securitizations insured by MBIA Corp. As of December 31, 2003, the aggregate gross insured
In 2003, Capital Asset finalized the settlement of a class action lawsuit that principally involved the rate of interest that Capital Asset could legally charge on tax and water and sewer liens in Pittsburgh. As part of the settlement, Capital Asset refunded $8.9 million in interest collected with respect to the Pittsburgh liens, and the special purpose entity that held the liens wrote down $17.6 million in accrued interest on the Pittsburgh liens. Capital Asset’s reserves were sufficient to cover the full amount of any refunds due.
NET INVESTMENT INCOME Net investment income was $9 million in 2003 and 2002, respectively. Despite an average asset base growth at the holding company level of 16%, corporate investment income was flat over last year due to the low interest rate environment.
CORPORATE EXPENSES Corporate expenses decreased 14% compared with 2002. In 2003, corporate expenses benefited by $8 million due to a reallocation of expenses among MBIA’s business operations. This benefit was offset by higher legal, auditing, consulting and severance expenses.
portfolio. In 2002, net realized gains were $15 million, consisting of gross realized gains of $74 million and gross realized losses of $59 million. Net realized gains in 2001 were $9 million, consisting of gross realized gains of $85 million and gross realized losses of $76 million. In 2002 and 2001, the gains and losses were generated from the ongoing active total return management of the investment portfolio.
NET GAINS OR LOSSES ON DERIVATIVE INSTRUMENTS AND FOREIGN EXCHANGE Net gains on derivative instruments and foreign exchange were $100 million for the year ended December 31, 2003 compared with $82 million of net losses in 2002. This change was primarily attributable to the Company’s insured synthetic CDO portfolio. MBIA’s valuation of synthetic CDOs is sensitive to, among other factors, changes in credit spreads, and, therefore, the unrealized gain reflects the impact of tighter credit spreads in the investment grade bond market in 2003. Other factors that will affect the fair value of the Company’s insured credit derivatives are underlying collateral performance, changes in interest rates and the remaining time to maturity. The requirement to fair value the Company’s synthetic CDOs can cause significant volatility in its reported results without necessarily providing any additional information regarding the likelihood of future credit losses. The Company added an additional third-party data source in 2003 for generic credit spread information used by the Company in its valuation model to avoid undue reliance on any single data vendor, as well as to enhance its assessment of fair values.
2002. Components of total claim-paying resources are shown in the following table:
At January 1, 2003, the Company maintained $211 million of stop-loss reinsurance coverage with three reinsurers. At the end of the third quarter, the Company elected not to renew two of the facilities with $175 million of
MBIA Inc. also maintained two ten-year facilities maturing in 2011 and 2012 for $100 million and $50 million, respectively. These facilities allowed the Company to issue subordinated securities and could be drawn upon if the Company incurred cumulative losses (net of any recoveries) above an annually adjusted attachment point, which was $1.76 billion for 2003. The $50 million facility was not renewed in the fourth quarter due to a rating downgrade of the related provider, however, the $100 million facility remained in effect as of December 31, 2003.
From time to time, MBIA accesses the capital markets to support the growth of its businesses. MBIA filed a registration statement on Form S-3 with the SEC utilizing a “shelf” registration process. Under this filing, the Company currently has in effect a shelf registration with the SEC for $500 million. The Company may issue securities described in the prospectus filed as part of the registration, namely, senior debt securities, subordinated debt securities, preferred stock and common stock of the Company.
The fixed-maturity investment portfolios are considered to be available-for-sale, with the exception of the Conduit portfolios, and the differences between fair value and amortized cost, net of applicable taxes, are reflected in accumulated other comprehensive income in shareholders’ equity. Fair value is based on quoted market prices, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Differences between fair value and amortized cost arise primarily as a result of changes in interest rates occurring after a fixed-income security is purchased, although other factors influence fair value, including credit-related actions, supply and demand forces and other market factors. The weighted-average credit quality of the Company’s fixed-income portfolios has been maintained at Double-A since its inception. The quality distribution of the Company’s fixed-maturity investment portfolios, which is based on ratings from Moody’s for year-end 2003 is presented in the following table:
In general, market risk relates to changes in the value of financial instruments that arise from adverse movements in factors such as interest rates, credit spreads, equity prices and foreign exchange rates. MBIA is exposed mainly to changes in interest rates that affect the fair value of its financial instruments, namely investment securities, investment agreement liabilities, debentures and certain derivative transactions. The Company’s investment portfolio holdings are primarily U.S. dollar-denominated fixed-income securities including municipal bonds, U.S. government bonds, mortgage-backed securities, collateralized mortgage obligations, corporate bonds and asset-backed securities. In periods of rising and/or volatile interest rates, profitability could be adversely affected should the Company have to liquidate these securities. Some mortgage-backed securities are subject to significant pre-payment risk in periods of declining interest rates.
Interest rate sensitivity can be estimated by projecting a hypothetical instantaneous increase or decrease in interest rates. As of December 31, 2003, a hypothetical increase in interest rates of 100 and 300 basis points would have resulted in an after-tax decrease in the net fair value of the Company’s financial instruments of approximately $215.4 million and $678.1 million, respectively. A decrease in interest rates of 100 basis points would have resulted in an after-tax increase in the net fair value of the Company’s financial instruments of approximately $204.6 million.
The Company’s earnings are also subject to changes in investment grade corporate credit spreads through fair valuing its credit derivative transactions. These transactions primarily consist of synthetic structured credit derivatives guaranteed by MBIA Corp., as well as single name credit default swaps directly entered into by the investment management services operations as part of their asset management activities. Sensitivity to changes in credit spreads for these transactions can be estimated by projecting a hypothetical instantaneous shift in credit spreads. As of December 31, 2003, a hypothetical instantaneous increase in investment grade corporate credit spreads of 25, 50 and 75 basis points would have resulted in an after-tax decrease in the net fair value of the Company’s credit derivatives of approximately $7.9 million, $17.3 million, and $30.4 million, respectively. Conversely, a hypothetical instantaneous decrease in investment grade corporate credit spreads of 25, 50 and 75 basis points would have resulted in an after-tax increase in the net fair value of the Company’s credit derivatives of approximately $6.2 million, $8.6 million, and $9.0 million, respectively. Under SFAS 133, if such hypothetical shifts in credit spreads were to occur, the resulting change in the net fair value of the Company’s credit derivatives would be recorded within the Company’s income statement.
MBIA’s internal controls are designed to provide reasonable assurance as to the integrity and reliability of the financial statements and to adequately safeguard, verify and maintain accountability of assets. Such controls are based on established written policies and procedures and are implemented by trained, skilled personnel with an appropriate segregation of duties. These policies and procedures prescribe that MBIA and all its employees are to maintain the highest ethical standards and that its business practices are to be conducted in a manner that is above reproach.
Under the Sarbanes-Oxley Act of 2002, two new certifications by a company’s CEO and CFO of periodic reports are required. Under Section 302 of the Act, and as implemented by the Securities and Exchange Commission (“SEC”), a company’s CEO and CFO are required to certify the accuracy and completeness of the information contained in each quarterly and annual report, and the maintenance and effectiveness of disclosure controls and
procedures. Under Section 906 of the Act, in addition to certifying the accuracy and completeness of the information, the Company’s CEO and CFO must also certify that each report complies with the Securities Exchange Act of 1934. For all quarterly and annual reports filed with the SEC after August 2002, copies of MBIA’s certifications can be found as exhibits to those reports.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, changes in shareholders’ equity and cash flows present fairly, in all material respects, the financial position of MBIA Inc. and its subsidiaries at December 31, 2003 and 2002 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which 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.
As discussed in Note 5 to the consolidated financial statements, the Company changed its method of accounting for certain variable interest entities, effective January 31, 2003 for new entities and effective December 31, 2003 for previously existing entities. As discussed in Note 2 to the consolidated financial statements, effective January 1, 2002, the Company changed its method of accounting for goodwill and for stock options compensation. In addition, as discussed in Note 2 to the consolidated financial statements, effective January 1, 2001, the Company changed its method of accounting for derivative instruments.
The Company also provides investment services through several of its subsidiaries which are wholly owned by MBIA Asset Management, LLC (MBIA-AMC), formed in 1998 and converted to a limited liability corporation in December 2000. MBIA-AMC is a wholly owned subsidiary of MBIA Inc. MBIA Municipal Investors Service Corporation (MBIA-MISC) operates cooperative cash management programs for school districts and municipalities. In May 2000, MBIA-MISC merged with another subsidiary, American Money Management Associates, Inc. (AMMA), which provides investment and treasury management consulting services to municipal and quasi-public sector clients. This merger combined the investment expertise into a consolidated investment management business. MBIA Investment Management Corp. (IMC) provides customized investment agreements for bond proceeds and other public funds, as well as for funds that are invested as part of asset-backed or structured product issuance. MBIA Capital Management Corp. (CMC) provides fixed-income investment management services for the Company, its affiliates and third-party institutional clients. 1838 Investment Advisors, LLC (1838) manages domestic and international equity, fixed-income and balanced portfolios for
high net-worth individuals, mutual funds, endowments, foundations and employee benefit plans.
MBIA Global Funding, LLC (GFL) was formed as a wholly owned subsidiary of the Company in May 2002. GFL is authorized to issue medium-term notes,
investment agreements and other debt obligations for the purpose of funding financial assets within the Company’s asset management business.
In May 2003, the Company sponsored the formation of Toll Road Funding, Plc. (TRF), a public company limited by shares and incorporated in Ireland under the Irish Companies Act. TRF was established to acquire a loan participation related to the financing of an Italian toll road. TRF is a variable interest entity (VIE), of which MBIA is the primary beneficiary. Therefore, while MBIA does not have a direct ownership interest in TRF, it is consolidated in the financial statements of the Company in accordance with Financial Accounting Standards Board (FASB) Interpretation Number (FIN) 46 “Consolidation of Variable Interest Entities.”
In September 2003, MBIA purchased the equity and acquired all controlling interests of Triple-A One Funding Corporation (Triple-A), Meridian Funding Company, LLC (Meridian) and Polaris Funding Company, LLC (Polaris) (the Conduits) through Asset Finance. As such, these entities are now consolidated in the financial statements of the Company in accordance with Statement of Financial Account Standards No. (SFAS) 94, “Consolidation of All Majority-Owned Subsidiaries.” See Note 5 for additional disclosures related to the consolidation of the Conduits.
From time to time, MBIA may consolidate a VIE under the provisions of FIN 46. Consolidation of such an entity is likely to result from MBIA’s guarantee of the assets or liabilities of a VIE through a financial guarantee policy when MBIA’s interest, represented by the financial guarantee policy, meets the criteria for consolidation under FIN 46. See Note 5 for additional disclosures related to the consolidation of variable interest entities.
The consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States of America (GAAP). 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 and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. As additional information becomes available or actual amounts become determinable, the recorded estimates are revised and reflected in operating results. Actual results could differ from those estimates. Significant accounting policies are as follows:
Other investments include the Company’s interest in equity-oriented and equity-method investments. The Company records its share of the unrealized gains and losses on equity-oriented investments, net of applicable deferred income taxes, in accumulated other comprehensive income in shareholders’ equity. The carrying amounts of equity-method investments are initially recorded at cost and adjusted to recognize the Company’s share of the profits or losses, net of any intercompany gains and losses, of the investee through earnings subsequent to the date of investment. Dividends are applied as a reduction of the carrying amount of the investment.
CONDUIT INVESTMENTS AND CONDUIT DEBT OBLIGATIONS Conduit investments consist mainly of debt securities, loans, lease receivables and trade receivables. These investments are classified as held-to-maturity and as such, are recorded at amortized cost. The related debt associated with the Conduits consists mainly of short-term commercial paper and medium-term notes.
POLICY ACQUISITION COSTS Policy acquisition costs include only those expenses that relate primarily to, and vary with, premium production. The Company periodically conducts a study to determine which operating costs vary with, and primarily relate to, the acquisition of new insurance business and qualify for deferral. For business produced directly by MBIA Corp., such costs include compensation of employees involved in underwriting and policy issuance functions, certain rating agency fees, state premium taxes and certain other underwriting expenses, reduced by ceding commission income on premiums ceded to reinsurers. Policy acquisition costs are deferred and amortized over the period in which the related premiums are earned.
GOODWILL Goodwill represents the excess of the cost of acquiring business enterprises over the fair value of the net assets acquired. Prior to 2002, goodwill attributed to the acquisition of MBIA Corp. and MBIA-MISC was amortized using the straight-line method over 25 years. Goodwill attributed to the acquisition of MBIA Illinois was amortized in proportion to the recognition of future profits from its deferred premium revenue and installment premiums, except for a minor portion attributed to state licenses, which was amortized using the straight-line method over 25 years. Goodwill attributed to the acquisition of all other subsidiaries was amortized using the straight-line method over 15 years.
Effective January 1, 2002 the Company adopted SFAS 142, “Goodwill and Other Intangible Assets.” Under SFAS 142, goodwill is no longer amortized but rather is tested for impairment at least annually. See Note 4 for an explanation of the impact of adoption of this Statement on the Company’s financial statements.
Leasehold improvements are depreciated over the life of the underlying lease agreement, generally seven to ten years. Maintenance and repairs are charged to current earnings as incurred.
The nature of the Company’s business activities requires the management of various financial and market risks, including those related to changes in interest rates and currency exchange rates. The Company uses derivative instruments to mitigate or eliminate certain of those risks. See Note 6 for a further discussion of the impact of the adoption of SFAS 133 on the Company’s financial statements.
LOSSES AND LOSS ADJUSTMENT EXPENSES Loss and loss adjustment expense (LAE) reserves are established in an amount equal to the Company’s estimate of identified or case basis reserves and unallocated losses, including costs of settlement, on the obligations it has insured. The unallocated loss and loss
adjustment expense reserves and specific case basis reserves are established by the Company’s Loss Reserve Committee, which is comprised of members of senior management.
Under the method employed by the Company since 2002, unallocated loss reserves are adjusted on a quarterly basis by using a formula that applies a “loss factor” (determined as set forth below) to the Company’s scheduled earned premiums for such quarter. Annually, the Loss Reserve Committee determines the appropriate loss factor for the year based on (i) a loss reserving study that assesses the mix of the Company’s insured portfolio and the latest industry data, including historical default and recovery experience, for the relevant sectors of the fixed-income market, (ii) rating agency studies of defaults and (iii) other relevant market factors. As of December 31, 2003, the Company calculates its unallocated loss reserve based on 12% of scheduled net earned premium.
When a case basis reserve is established, MBIA reclassifies the required amount from its unallocated loss reserve to its case basis loss reserve. Therefore, although MBIA accrues an unallocated loss reserve by applying a loss factor to earned premium, the available unallocated loss reserve will be directly related to case basis reserves established in the same period. At the end of each quarter the Company evaluates the adequacy of the remaining unallocated loss reserve.
INVESTMENT AGREEMENTS AND MEDIUM-TERM NOTES Investment agreements and medium-term notes are recorded on the balance sheet at the time such agreements are executed. The liabilities for investment agreements and medium-term notes are carried at their face value plus accrued interest, whereas the related assets are recorded at fair value.
SECURITIES BORROWED OR PURCHASED UNDER AGREEMENTS TO RESELL AND SECURITIES LOANED OR SOLD UNDER AGREEMENTS TO REPURCHASE Securities borrowed or purchased under agreements to resell and securities loaned or sold under agreements to repurchase are accounted for as collateralized transactions and are recorded at contract value plus accrued interest, subject to the provisions of SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” It is the Company’s policy to take possession of securities borrowed or purchased under agreements to resell. Securities borrowed or loaned are primarily entered into to obtain securities that are repledged as part of MBIA’s collateralized investment and repurchase
agreement activity and are only transacted with high quality dealer firms. In addition, securities sold under agreements to repurchase provide liquidity to the Company’s investment agreement and medium-term note programs.
PREMIUM REVENUE RECOGNITION Upfront premiums are earned in proportion to the expiration of the related risk. Therefore, for transactions in which the premium is received upfront, premium earnings are greater in the earlier periods when there is a higher amount of exposure outstanding. The upfront premiums are apportioned to individual sinking fund payments of a bond issue according to an amortization schedule. After the premiums are allocated to each scheduled sinking fund payment, they are earned on a straight-line basis over the period of that sinking fund payment. When an insured issue is retired early, is called by the issuer, or is in substance paid in advance through a refunding accomplished by placing U.S. Government securities in escrow, the remaining deferred premium revenue is earned at that time since there is no longer risk to the Company. Accordingly, deferred premium revenue represents the portion of premiums written that is applicable to the unexpired risk of insured bonds and notes. Installment premiums are earned over each installment period, generally one year or less.
ADVISORY FEE REVENUE RECOGNITION The Company collects advisory fees in connection with certain transactions. Depending upon the type of fee received, the fee is either earned when it is due or deferred and earned over the life of the related transaction. Work, waiver and consent, termination, administrative and management fees are earned when due. Structuring and commitment fees are earned on a straight-line basis over the life of the related transaction.
EMPLOYEE STOCK COMPENSATION Prior to 2002, the Company elected to follow Accounting Principles Board Opinion No. (APB) 25, “Accounting for Stock Issued to Employees” and related interpretations in accounting for its employee stock options. No stock-based employee compensation cost for stock options is reflected in net income prior to 2002 as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2002 the Company adopted the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation.” Under the modified prospective transition method selected by the Company under the provisions of SFAS 148, “Accounting for Stock-Based
MUNICIPAL SERVICES OPERATIONS Municipal services results are comprised of the net investment income, operating revenues and expenses of MBIA MuniServices, MTB, MRC and Capital Asset.
CORPORATE Corporate consists of net investment income, interest expense and general corporate expenses.
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 disclosures in its financial statements about investments in debt or marketable equity securities with market values below carrying values. See Note 11 for disclosures required by EITF 03-01.
In April 2003, the FASB issued SFAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS 133. SFAS 149 amends SFAS 133 for decisions made as part of the Derivatives Implementation Group process that effectively required amendments to SFAS 133, decisions made in connection with other FASB
expense. However, this method also requires that all periods presented in the financial statements be restated to reflect stock option expense. Restatement of periods prior to those presented is permitted but not required.
SFAS 148 also requires additional disclosure in the “Summary of Significant Accounting Policies” footnote of both annual and interim financial statements. MBIA has chosen to report its stock option expense under the Modified Prospective Method. See Note 2 for disclosures required by SFAS 148 and Note 23 for further information about the effect of adoption on the Company’s financial statements.
In November 2002, the FASB issued FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 outlines certain accounting guidelines, effective for fiscal years beginning after December 15, 2002, from which the Company’s insurance transactions and derivative contracts are excluded. In addition, FIN 45 expands the disclosures required by a guarantor in its interim and annual financial statements regarding obligations under certain guarantees. These disclosure requirements are effective for the year ended December 31, 2002. See Note 20 for additional disclosures. The Company’s financial position and results of operations did not change as a result of the adoption of FIN 45.
Effective January 1, 2002 the Company adopted SFAS 141, “Business Combinations” and SFAS 142. SFAS 141, which supercedes APB 16, “Business Combinations,” requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting and provides specific criteria for initial recognition of intangible assets apart from goodwill. SFAS 142, which supercedes APB 17, “Intangible Assets,” requires that goodwill and intangible assets with indefinite lives are no longer amortized but instead tested for impairment at least annually. The standard includes a two-step process aimed at determining the amount, if any, by which the carrying value of a reporting unit exceeds its fair value. Other intangible assets are amortized over their useful lives.
The following table contains a reconciliation of reported net income to net income adjusted for the effect of goodwill amortization for the years ended December 31, 2003, 2002 and 2001:
the implied fair value of goodwill was calculated by subtracting the fair value of the net assets from the fair value of the reporting segment. In comparing the implied fair value of goodwill to the carrying amount of goodwill, it was determined that the entire amount was impaired and was therefore written off as of January 1, 2002 and reported as a cumulative effect of accounting change. The per share effect of the cumulative effect of accounting change was to reduce 2002’s net income per share by five cents.
The Company performed its annual impairment testing of goodwill as of January 1, 2003 and January 1, 2004. The fair values of the insurance reporting segment and the investment management services’ reporting segments were determined using the same valuation methods applied during the transition testing. The fair values of the reporting segments exceeded their carrying values indicating that goodwill was not impaired.
On September 30, 2003, prior to the applicable effective date of FIN 46, MBIA purchased the equity and acquired all controlling interests of the Conduits. These entities are reflected in the consolidated financial statements of the Company. As a result, MBIA has included in its balance sheet the gross assets and liabilities of each Conduit, which consist primarily of various types of investments and medium- and short-term debt, and included in its income statement the gross operating revenues and expenses of the Conduits subsequent to their acquisition date. Certain of MBIA’s consolidated subsidiaries have invested in Conduit debt obligations or have received compensation for services provided to the Conduits. As such, MBIA has eliminated intercompany transactions with the Conduits from its balance sheet and income statement. After the elimination of such
intercompany assets and liabilities, Conduit investments and Conduit debt obligations were $8.4 billion and $7.8 billion, respectively, at December 31, 2003. Other than the potential impact of the unrealized gains or losses from derivative instruments, MBIA does not expect its net income to change materially as a result of the consolidation of the Conduits due to the inconsequential level of residual profits of these entities. As a result, the Company has not provided pro forma information on the acquisition of the Conduits.
As a result of having to adhere to MBIA’s underwriting standards and criteria, Conduit transactions have, in general, the same underlying shadow ratings that similar non-Conduit transactions guaranteed by MBIA have at the time they are closed. Like all credits underwritten by MBIA, the shadow ratings on Conduit transactions may be downgraded by either one or both rating agencies after they are closed. In general, the underlying shadow ratings on Conduit transactions have been downgraded no more frequently than similar non-Conduit transactions guaranteed by MBIA.
Effective January 1, 2001 the Company adopted SFAS 133. SFAS 133 requires all derivative instruments to be recorded at fair value on the balance sheet. Changes in the fair value of derivatives are recorded each period in current earnings or accumulated other comprehensive income, depending on whether the derivative is designated as a hedge, and if so designated, the type of hedge.
INVESTMENT MANAGEMENT SERVICES The Investment Management Services (IMS) operations have entered into derivative transactions primarily consisting of interest rate, cross currency, credit default and total return swaps and equity guarantee fund commitments. Interest rate swaps are entered into to hedge the risks associated with fluctuations in interest rates or fair values of certain contracts. Cross currency swaps are entered into to hedge the variability in cash flows resulting from fluctuations in foreign currency rates. A number of interest rate and cross currency swaps are treated as hedges for accounting purposes. Credit default swaps are entered into as an extension of the Company’s investment management business and are consistent with the Company’s risk objectives. Total return swaps are entered into to enable the Company to earn returns on certain obligations without directly owning the underlying obligations. The Company has also provided loss protection on certain MBIA-MISC managed municipal pools that invest in highly rated short-term fixed-income securities. Such protection is accounted for as a derivative under SFAS 133 and is included as part of the Company’s equity guarantee funds.
Some of these derivatives qualify as cash flow hedges and fair value hedges under SFAS 133. The cash flow hedges mitigate or offset fluctuations in cash flows arising from variable rate assets or liabilities. The fair value hedges are used to protect against changes in the value of the hedged assets or liabilities. The unrealized gains and losses relating to the cash flow hedges are reported in accumulated other comprehensive income and will be reclassified into earnings as interest revenue and expense are recognized on those assets and liabilities. The gains and losses relating to the fair value hedges are recorded directly in earnings. Cash flow and fair value hedges are hedging existing assets, liabilities or forecasted transactions. During 2003, most of the cash flow and fair value hedges were 100% effective for accounting purposes, due to the application of the shortcut method, or the matching of all critical terms. Therefore, the change in fair value of these derivative instruments is recorded in accumulated other comprehensive income or offset by corresponding changes in the fair value of the underlying hedged items in the income statement. During 2003, the amount of ineffectiveness on fair value and cash flow hedges recorded in the income statement was $0.8 million (net of tax) and $5 thousand (net of tax), respectively.
The Company has entered into one master netting agreement with a specific counterparty covering derivative transactions within an investment management services total return swap program. This agreement allows the Company to mitigate the credit risk of the counterparty and, therefore, the Company has the ability to net all amounts due to and owed by the specified counterparty. For financial statement presentation purposes the Company has chosen not to net the receivable and payable balances pertaining to these derivative transactions in the balance sheet but instead report these amounts on a gross basis in both the asset and liability sections of the balance sheet.
The cross currency swap has been designated as a cash flow hedge and hedges the variability arising from currency exchange rate movements on the foreign denominated fixed rate debt. Changes of the fair value of the cross currency swap are recorded as part of accumulated other comprehensive income. As the debt is revalued at the spot exchange rate in accordance with SFAS 52, “Foreign Currency Translation,” an amount that will offset the related transaction gain or loss arising from the revaluation will migrate each period from accumulated other comprehensive income into earnings. This cash flow hedge was 100% effective during 2003.
from accumulated other comprehensive income into earnings during 2004 and the remaining balance over the term of the contract.
FINANCIAL STATEMENT IMPACT As of December 31, 2003 and 2002, the Company held derivative assets of $256.7 million and $191.8 million, respectively, and derivative liabilities of $437.7 million and $309.7 million, respectively, which are shown separately on the consolidated balance sheet. The following tables display the amount of the derivative assets and liabilities by business operations for the years ended December 31, 2003 and 2002.
The impact for all derivative transactions for 2003 was an after-tax increase in net income of $96.7 million. The impact for all derivative transactions for 2002 and 2001 was an after-tax reduction in net income of $38.5 million and $9.9 million, respectively. In 2001, the total after-tax effect of the adoption of SFAS 133 was a $13.1 million reduction in net income. The income statement impact of derivative activity is broken down into revenues, expenses, net realized gains (losses) and net gains (losses) on derivative instruments and foreign exchange. The following tables display the impact on the 2003, 2002 and 2001 income statements by business operation of all derivative transactions.
The fair value of the Company’s derivative instruments is estimated using various valuation models that conform to industry standards. The Company utilizes both vendor-developed and proprietary models, based on the complexity of transactions. Dealer market quotes are typically obtained for regularly traded contracts and provide the best estimate of fair value. However, when reliable dealer market quotes are not available, the Company uses a variety of market and portfolio data relative to the type and structure of contracts. Several of the more significant types of data that influence the Company’s valuation models include interest rates, credit quality ratings, credit spreads, default probabilities and diversity scores. This data is obtained from highly recognized sources and is reviewed for reasonableness and applicability to the Company’s derivative portfolio.
The use of market data requires management to make assumptions on how the fair value of derivative instruments is affected by current market conditions. Therefore, results can significantly differ between models and due to changes in management assumptions. The Company has dedicated resources to the development and ongoing review of its valuation models and has instituted procedures for the approval and control of data inputs. In addition, regular reviews are performed to ensure that the Company’s valuation models are appropriate and produce values reflective of the current market environment.
In 2002, the Company revised several market data inputs used in determining the fair value of its insured credit derivatives. Market-based discount rates replaced the fixed discount rate previously established by the Company. In addition, a change in the data source received from a pricing data vendor resulted in a recalibration of credit spreads within the Company’s valuation model. This information was validated by comparisons to three independent data sources. The Company also introduced dealer collateralized debt obligations (CDO) market quotes to improve the quality of transaction-specific data. These modifications resulted in a negative change to the value of the Company’s insured credit derivative portfolio for 2002. No modifications were made to the Company’s non-insurance derivative valuation models. In 2003, the Company added an additional third-party data source for generic credit spread information used by the Company in its valuation
process to avoid undue reliance on any single data vendor, as well as to enhance its assessment of fair values.
In accordance with SFAS 140, the Company does not reflect on its balance sheet financial assets involving the borrowing of securities that meet specific criteria. The Company had no security borrowing transactions at December 31, 2003. The fair value of securities received under security borrowing transactions not reflected on the balance sheet at year-end 2002 was $149 million. All of the securities borrowed were repledged for 2002. As of year-end 2002, the Company owned financial assets reflected in total investments and related to security borrowing transactions with a fair value of $126 million.
SFAS 140 also requires the Company to reclassify financial assets pledged as collateral under certain agreements and to report those assets at fair value as a separate line item on the balance sheet. As of year-end 2003 and 2002, the Company had $596 million and $668 million, respectively, in financial assets pledged as collateral.
upon the present value of projected servicing costs in excess of servicing revenues, discounted at 4.72%. The balance of the servicing liability as of December 31, 2003 is $3.8 million. Since the fourth quarter of 1999, a specialty servicing concern oversees the management of Capital Asset, whose activities consist of the administration and servicing of the assets securitized and other delinquent tax liens and related assets.
The financial statements have been prepared on the basis of GAAP, which differs in certain respects from the statutory accounting practices prescribed or permitted by the insurance regulatory authorities. Statutory accounting practices differ from GAAP in the following respects:
• acquisition costs are charged to operations as incurred rather than deferred and amortized as the related premiums are earned;
• tax and loss bonds purchased are reflected as admitted assets as well as payments of income taxes;
Consolidated net income of MBIA Corp. determined in accordance with statutory accounting practices for the years ended December 31, 2003, 2002 and 2001 was $669.2 million, $617.9 million and $571.0 million, respectively.
Included in the preceding tables are investments that have been insured by MBIA Corp. At December 31, 2003, MBIA Corp. insured investments at fair value represented $4.3 billion or 22% of the total portfolio (excluding the Conduits). At December 31, 2002, MBIA Corp. insured investments at fair value represented $3.0 billion or 19% of the total portfolio.
A portion of the obligations under investment and repurchase agreements requires the Company to pledge securities as collateral. As of December 31, 2003 and 2002, the fair value of securities pledged as collateral with respect to these obligations approximated $3.3 billion.
The following table sets forth the distribution by contractual maturity of the available-for-sale fixed-maturity and short-term investments at amortized cost and fair value at December 31, 2003. Contractual maturity may differ from expected maturity because borrowers may have the right to call or prepay obligations.
The following table sets forth the gross unrealized losses of the fixed-maturity and equity investments included in accumulated other comprehensive income as of December 31, 2003. The table has segregated investments that have been in a continuous unrealized loss position for less than 12 months from those that have been in a continuous unrealized loss position for twelve months or longer.
The following table includes investment income from the insurance and corporate operations. Realized gains are generated as a result of the
The Company files a consolidated tax return that includes all of its U.S. subsidiaries. The provision for income taxes is comprised of:
The Company has determined that a valuation allowance is unnecessary in connection with the deferred tax assets.
The Company’s investment management services operations provide an array of products and services to the public, not-for-profit and corporate sectors. Such products and services are provided primarily through wholly owned subsidiaries of MBIA-AMC and include cash management, discretionary asset management and fund administration services and investment agreements and medium-term notes related to the origination of assets for investment management purposes. The investment management services operations’ reportable segments are comprised of investment agreements and medium-term notes (MTNs), fixed-income advisory services, conduits and equity advisory services.
The Company’s corporate operations include investment income, interest expense and general expenses that relate to general corporate activities and not to one of the Company’s three principal business operations. The Company views its corporate operations as a reportable segment.
The following table summarizes the segments within the investment management services operations for the years ended December 31, 2003, 2002 and 2001:
In the third quarter of 1999, the Company began acquiring shares of its common stock in connection with its stock repurchase plan. The plan authorizes the Company to repurchase up to 11.25 million of its outstanding common shares. During 2003, 2002 and 2001, the Company purchased 1.9 million, 4.2 million, and 0.2 million shares of common stock at an aggregate cost of $79.9 million, $208.1 million, and $7.8 million, respectively. As of December 31, 2003 the Company had repurchased a total of 9.5 million shares at an average price of $41.71 per share leaving approximately 1.7 million shares in the Company’s share repurchase plan. The Company will only repurchase shares under this program when it is economically attractive and within rating agency constraints, including the Triple-A claims-paying ratings of MBIA Corp. Treasury stock is carried at cost as a component of stockholders’ equity.
In November 2003 the interest rate swap associated with the 6.95% notes due 2038 was terminated. As a result, the Company reversed $310 thousand out of its derivative assets, which was offset by the reversal of the fair value adjustment on the debt being hedged.
The aggregate maturity of long-term debt obligations as of December 31, 2003 for each of the next five years and thereafter commencing in 2004 was:
MBIA Corp. has a standby line of credit commitment in the amount of $700 million with a group of major Triple-A-rated banks to provide loans to MBIA Corp. This facility can be drawn upon if MBIA Corp. incurs cumulative losses (net of expected recoveries) on the covered portfolio (which is comprised of the Company’s insured public finance obligations, with certain adjustments) in excess of the greater of $900 million or 5.0% of average annual debt service. 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 including certain installment premiums and other collateral. This commitment has a seven-year term expiring on October 31, 2010.
In December 2003, MBIA Corp. had access to $400 million of Money Market Committed Preferred Custodial Trust securities (CPS securities) that were issued by eight Trusts which were created for the primary purpose of issuing CPS securities and investing the proceeds in high quality commercial paper or short-term U.S. government obligations. MBIA Corp. has a put option to sell to the Trusts the perpetual preferred stock of MBIA Corp. If MBIA Corp. exercises its put option, the Trusts will transfer the proceeds to MBIA Corp. in exchange for MBIA Corp. preferred stock. The Trusts will hold the preferred stock and distribute the preferred dividend to their holders. MBIA Corp. has the right to redeem the preferred shares, and then put the preferred stock back to the Trust again, indefinitely. Any preferred stock issued by MBIA Corp. would be non-cumulative unless MBIA Corp. pays dividends on its common stock, during which time the dividends on its preferred stock would be cumulative. Preferred stockholders would have rights that are subordinated to insurance claims, as well as to the general unsecured creditors, but senior to any common stockholders of MBIA Corp.
The trusts were created as a vehicle for providing capital support to MBIA Corp. by allowing it to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put options. S&P and Moody’s rate the trusts AA/aa2, respectively. To date, MBIA Corp. has not exercised its put options under any of these arrangements.
Obligations under investment agreements are recorded as liabilities on the balance sheet based upon proceeds received plus unpaid accrued interest from that date. Upon the occurrence of certain contractually agreed-upon events, some of these funds may be withdrawn at various times prior to maturity at the option of the investor. As of December 31, 2003, the annual interest rates on these agreements ranged from 0.84% to 8.02% and the weighted-average interest rate was 3.7%.
Principal payments due under these investment agreements in each of the next five years ending December 31 and thereafter, based upon expected withdrawal dates, are as follows:
* Principal amounts include transactions that reflect the principal at maturity for liabilities issued at a discount.
IMC also provides agreements obligating it to purchase designated securities in a bond reserve fund at par value upon the occurrence of certain contractually agreed-upon events. The opportunities and risks in these agreements are analogous to those of investment agreements. The total par value of securities subject to these agreements was $21.1 million at December 31, 2003.
Medium-term note obligations are recorded as liabilities on the balance sheet based upon proceeds received plus unpaid accrued interest. In 2003, GFL issued $1.6 billion U.S. dollar and 15 billion Japanese yen floating rate medium-term notes. The rates of the medium-term notes are fixed, or are indexed to LIBOR or the effective Federal Funds rate. As of December 31, 2003 the annual interest rates of the medium-term notes ranged from 1.1% to 6.0% and the weighted average interest rate was 2.2%.
* Principal amounts of yen denominated medium-term notes have been converted from yen into U.S. dollars. Additionally, principal amounts include transactions that reflect the principal at maturity for liabilities issued at a discount.
Principal payments due under the Conduit long-term, medium-term and commercial paper note obligations based on their contractual maturity dates are as follows:
* Principal amounts of GBP denominated medium-term notes have been converted from GBP into U.S. dollars.
The insurance policies issued by MBIA Corp. are unconditional commitments to guarantee timely payment on the bonds and notes to bondholders. The creditworthiness of each insured issue is evaluated prior to the issuance of insurance, and each insured issue must comply with MBIA Corp.’s underwriting guidelines. Further, the payments to be made by the issuer on the bonds or notes may be backed by a pledge of revenues, reserve funds, letters of credit, investment contracts or collateral in the form of mortgages or other assets. The right to such money or collateral would typically become MBIA Corp.’s upon the payment of a claim by MBIA Corp.
MBIA Corp. maintains underwriting guidelines based on those aspects of credit quality that it deems important for each category of obligation considered for insurance. For global public finance transactions these include economic and social trends, debt and financial management, adequacy of anticipated cash flow, satisfactory legal structure and other security
provisions, viable tax and economic bases, adequacy of loss coverage and project feasibility. For global structured finance transactions, MBIA Corp.’s underwriting guidelines, analysis and due diligence focus on seller/servicer credit and operational quality. MBIA also analyzes the quality of the asset pool as well as its historical and projected performance. The strength of the structure, including legal segregation of the assets, cash flow analysis, the size and source of first loss protection, asset performance triggers and financial covenants are also reviewed. Such guidelines are subject to periodic review by management, who are responsible for establishing the criteria for the Company’s underwriting standards as well as maintaining the standards in its insurance operations.
As of December 31, 2003, insurance in force, net of cessions to reinsurers, had an expected range of maturity of 1 - 46 years. The distribution of net insurance in force by geographic location, excluding $9.7 billion and $8.0 billion relating to transactions guaranteed by MBIA Corp. on behalf of various investment management services’ affiliated companies in 2003 and 2002, respectively, is set forth in the following table:
The net insurance in force by type of bond is set forth in the following table.
Amounts deducted from gross insurance in force for reinsurance ceded by MBIA Corp. and its subsidiaries were $170.0 billion and $171.0 billion at December 31, 2003 and 2002, respectively. The distribution of ceded insurance in force by geographic location is set forth in the following table:
The board of directors of the Company has authorized a maximum of 7,350,000 shares of the Company’s common stock to be granted as options under the 2000 plan. As of December 31, 2003, 5,001,931 options had been granted under the 2000 plan, net of expirations and cancellations, leaving the total available for future grants at 2,348,069.
The stock option grants, which may continue to be awarded every year, provide the right to purchase shares of common stock at the fair value of the stock on the date of the grant. In 2003, 1,436,010 options were awarded under the 2000 plan. These options vest over four or five years depending on the level of the recipient. Prior option grants are not taken into account in determining the number of options granted in any year.
In December 1995, the MBIA Inc. board of directors approved the “MBIA Long-Term Incentive Program” (the incentive program). The incentive program includes a stock option component (described above) and a compensation component linked to the growth in book value per share, including certain adjustments, of the Company’s stock (modified book value) over a three-year period following the grant date. Target levels for the incentive program awards are established as a percentage of total salary and bonus, based upon the recipient’s position. Awards under the incentive program typically are granted from the vice president level up to and including the chairman and chief executive officer. Actual amounts to be paid are adjusted upward or downward depending on the growth of modified book value versus a baseline target, with a minimum growth of 8% necessary to receive any payment and an 18% growth necessary to receive the maximum payment. Awards under the incentive program are divided equally between the two components, with approximately 50% of the award to be given in stock options and approximately 50% of the award to be paid in cash or shares of Company stock. Payments are made at the end of each three-year measurement period. During 2003, 2002 and 2001, $21.8 million, $18.8 million, and $17.0 million, respectively, were recorded as an expense related to modified book value awards.
In July 1999, the Company contributed 20,096 additional shares to the ESOP plan. Subsequent to this contribution, the ESOP plan was merged with the MBIA Inc. Employee Profit-Sharing/401(k) plan. In conjunction with the merger of the plans, released ESOP shares are used to fund the 401(k) company match obligations. During 2003, 2002 and 2001, 36,030, 62,709, and 45,611 shares, respectively, were utilized for the 401(k) company match. As of December 31, 2003, 2002 and 2001, respectively, a total of 546,034, 510,004, and 447,295 shares have been allocated to the participants. During 2003 all of the remaining unallocated ESOP shares were allocated to the participants.
Prior to 2002, the Company elected to follow APB 25 and related interpretations in accounting for its employee stock options. No stock-based employee compensation cost for stock options is reflected in net income prior to 2002 as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. Pro forma information regarding net income and earnings per share is required by SFAS 123 and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement.
The following table displays the total number of options granted during the last three years. The proxy officers represent the five most highly compensated officers as disclosed in the Company’s proxy statement.
A summary of the Company’s stock option plan as of December 31, 2003, 2002 and 2001, and changes during the years ending on those dates, is set forth in the following table:
indirectly, the power to direct the management and policies of the Company through ownership, by contract or otherwise.
• Entities for which investments are accounted for by the equity method by the Company.
• Members of the immediate families of principal owners of the Company and its management. This includes family members whom a principal owner or a member of management might control or influence or by whom they may be controlled or influenced because of the family relationship.
• Other parties that can significantly influence the management or policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to the extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.
CONDUIT INVESTMENTS-The Conduit investments are comprised of fixed and floating rate fixed maturity securities and short-term investments. The carrying values of the floating rate investments approximate their fair values. The fair value of the fixed rate investments is determined by calculating the net present value of estimated future cash flows assuming prepayments, defaults and discount rates that the Company believes market participants would use for similar assets. The short-term investments are carried at amortized cost, which approximates fair value.
SHORT-TERM INVESTMENTS-Short-term investments are carried at amortized cost, which approximates fair value.
OTHER INVESTMENTS-Other investments include the Company’s interest in equity-oriented and equity-method investments. The fair value of these investments is based on quoted market prices, investee financial statements or cash flow modeling.
CASH AND CASH EQUIVALENTS, RECEIVABLE FOR INVESTMENTS SOLD, SHORT-TERM DEBT, AND PAYABLE FOR INVESTMENTS PURCHASED-The carrying amounts of these items are a reasonable estimate of their fair value.
VARIABLE INTEREST ENTITY ASSETS-Variable interest entity assets consist of floating rate notes and related accrued interest. The carrying values of variable interest entity assets approximate their fair values due to the term of the applicable interest rates.
SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE-The fair value is estimated based upon the quoted market prices of the transactions’ underlying collateral.
CONDUIT DEBT OBLIGATIONS-The carrying values of Conduit debt obligations approximate their fair values primarily due to their liquidity or variability in interest rates.