(b)Amounts are FSA separate company statutory data and therefore include amounts relating to FSA-insured GICs issued by CMS.
(c)The sum of statutory capital, statutory unearned premium reserve, present value of future net installment premiums, statutory loss reserve, and credit available under standby line of credit (soft capital) facility.
Management and investors consider the following measures important in analyzing the financial results of the Company: adjusted book value, operating earnings and gross present value of originations (PV originations). However, none of these measures are promulgated in accordance with accounting principles generally accepted in the United States of America (GAAP) and should not be considered as substitutes for shareholders' equity (book value), net income and gross premiums written.
Year Ended December 31, 2002 versus Year Ended December 31, 2001
The Company's 2002 net income was $181.1 million, compared with $209.5 million for 2001, a decrease of 13.6%. Operating earnings reached $215.2 million for 2002 versus $205.1 million for 2001, an increase of $10.1 million, or 4.9%. In 2002, net income was negatively affected by $34.1 million of mark-to-market adjustments for pooled credit default swaps (CDS) under Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133). Additional derivative losses have been reflected in net income and operating earnings and relate primarily to the termination of the single-name CDS program described in more detail below.
The Company's gross premiums written increased 65.5% to $803.7 million for 2002 from $485.6 million for 2001. Net premiums written were $532.7 million during 2002, an increase of 66.7% compared with 2001 results. Reinsurance cessions totaled 33.7% of 2002 gross premiums written, compared with 34.2% in 2001. Net premiums earned in 2002 were $314.9 million, compared with $231.0 million in 2001, an increase of 36.3%. Premiums earned from refundings and prepayments were $28.0 million for 2002 and $9.1 million for 2001, contributing $15.4 million and $4.4 million, respectively, to after-tax earnings. Excluding the effects of refundings, net premiums earned grew 29.3% over the comparable 2001 result. No assurance can be given that refundings and prepayments will continue at the level experienced in 2002 or 2001.
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 in respect of these transactions until 2010, 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 basis reserves as specific losses on its insured CDO portfolio become probable and estimable in accordance with the undercollateralization methodology described above. Application of this methodology resulted in recording $68.8 million in gross case basis reserves and $29.8 million in reinsurance recoverable on unpaid losses, resulting in a $39.0 million increase in net case basis reserves.
Beginning in the second quarter of 2002, management refined the loss factor it applies to its net par underwritten when calculating the 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. Management expects future reserve contributions to be approximately double the amounts under the prior practice. Since the reserves are based upon 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.
In 2002, FSA exercised certain rights available under its financial guaranty policies and indentures relating to loan-backed notes issued by FMAC Loan Receivables Trust 1998-D and 2000-A (the 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 funds from the proceeds of FSA-insured GICs issued in the ordinary course of business by FSA Capital Markets Services LLC and FSA Capital Management Services LLC (collectively, CMS). Since the notes represent 100% of the debt capitalization of the Trusts and since FSA maintains all of the risk of further asset decline and maintains control over key decisions regarding the Trusts (i.e., removal of servicer, sale of assets, liquidation of the entity), the Trusts were consolidated with FSA for accounting purposes. 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, has determined cash flows from the pools of securitized loans, net of reinsurance, and is recording income based upon the constant yield method. The cash flows on the securitized loans will be monitored and the constant yield modified to reflect any change in the cash flow estimates. As a result of these transactions, the Company recorded $437.5 million of securitized loans and $6.3 million of other income related to those securitized loans during the year ended December 31, 2002.
Over the past two years, a growing percentage of FSA's business has been in the form of insured CDS referencing diversified pools of corporate obligations. Many of these require periodic adjustments to reflect an estimate of fair value under SFAS No. 133. These transactions have generally been underwritten with Triple-A or higher levels of credit protection provided by a significant deductible that must be exhausted prior to any claim under FSA's guaranty. Adjustments required by SFAS No. 133 resulted in a pre-tax charge to income for the year ended December 31, 2002 of $50.2 million. The charge resulted primarily from widening spreads in the CDS market and does not indicate any material deterioration in the underlying
credit quality of FSA's insured CDS portfolio. While a small number of transactions have been downgraded from their original levels, the underlying credit quality of FSA's insured pooled corporate CDS transactions, based on net par outstanding at December 31, 2002, was 53% Super Triple-A (defined as having first-loss protection of at least 1.3 times the level required for a Triple-A rating) and 96% Double-A or higher. Excluding CDS referencing collateralized loan obligations (CLOs) and CDS referencing collateralized bond obligations (CBOs), the pooled corporate CDS portfolio was 64% Super Triple-A and 96% Double-A or higher. From a credit perspective, the Company generally groups CDS of CLOs with CLOs and groups CDS of CBOs with CBOs. The gain or loss created by estimated fair value adjustments will rise or fall each quarter based on estimated market pricing of highly rated swap guarantees and is not expected to be an indication of potential claims under FSA's guaranty. 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 is determined based upon quoted market prices, if available. If quoted market prices are not available, as is the case primarily with CDS on pools of assets, then the determination of fair value is based upon internally developed estimates. Management applies judgment when developing these estimates 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. Due to changes in these factors, the gain or loss from derivative instruments can vary substantially from period to period. Absent any claims under FSA's guaranty, any "losses" recorded in marking a guaranty to market will be reversed by an equivalent mark-to-market "gain" at or prior to the expiration of the guaranty. Given the very high credit quality of FSA's insured CDS portfolio, management believes that "losses" or "gains" attributable to marking these exposures to market do not reflect upon the profitability of the Company in a meaningful way.
The Company's effective tax rate for 2002 was 16.2%, compared with 22.3% for 2001. In the third quarter of 2002, the Company changed its method of taxing its equity earnings on Fairbanks Capital Holding Corp. (Fairbanks), an unconsolidated affiliate of the Company. Prior to 2002, the Company taxed 100% of its equity earnings from Fairbanks 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 calculating the tax on its equity earnings from Fairbanks, based upon 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. In 2002, the effective tax rate differs from the statutory rate of 35% due primarily to this change in taxing method as well as tax-exempt interest income and income from Financial Security Assurance International Ltd. (FSA International). Although FSA International is subject to U.S. income taxes as a controlled foreign corporation, it nonetheless benefits from a lower overall effective tax rate than the Company's domestic insurance company subsidiaries.
FSA Asset Management LLC (FSAM) manages the investments in the GIC bond portfolio. The primary objective in managing the GIC bond portfolio is to generate stable net interest margin, maintain liquidity and optimize risk-adjusted returns.
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 87.4% (excluding the GIC bond portfolio) was invested in long-term fixed-income securities at December 31, 2002. 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 2002, this hypothetical increase in interest rates would result in an after-tax decrease of $127.1 million in the net fair value of the Company's fixed-income portfolio, excluding the GIC bond portfolio, and an after-tax decrease of $26.9 million for the GIC bond 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.
The Company's investment portfolio holdings, excluding the GIC bond portfolio, are primarily U.S. dollar-denominated fixed-income securities, including municipal bonds, U.S. government and agency bonds, and mortgage-backed, asset-backed and corporate 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 bond portfolio consists primarily of U.S. dollar-denominated U.S. agency securities, mortgage-backed securities and asset-backed securities.
The Company's losses and loss adjustment expenses comprise case basis reserves and a non-specific general reserve. FSA establishes a case basis reserve for the net present value of an 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 basis 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 basis reserve is recorded to the extent that the overcollateralization ratio (non-defaulted collateral at par divided by the debt insured) has fallen below 100%. The non-specific general reserve is available to be applied against future additions or accretions to existing case basis reserves or to new case basis reserves. The general reserve is calculated by applying a loss factor to the total net par amount outstanding 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 are reflective of 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 in the early 1990s and 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 "Losses and Loss Adjustment Expenses", above, for a discussion of the FMAC refinancings.
Deferred acquisition costs comprise those 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 acquisition costs are incurred, they are allocated to individual cost centers and a percentage of those costs are 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 CMS, except for brokerage fees. Deferred acquisition 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 installments as well as by underwriting year and are amortized over the period in which the related premiums are earned. When an insured issue is retired or defeased prior to the end of the expected coverage, the remaining deferred acquisition cost is recognized. Adjustments to the amortization of the deferred acquisition costs are made periodically to reflect changes in assumptions based on prepayment speeds of the underlying insured asset-backed securities. Recoverability of deferred acquisition costs is determined by considering anticipated losses and loss adjustment expenses.
FSA had an exceptional year in 2001, with strong results across its three core businesses-U.S. municipal, U.S. asset-backed and international. Asset-backed business was particularly strong, in both the United States and Europe, due to market uncertainty, widening credit spreads and demand for liquidity. The Company generated $696.5 million of PV originations in 2001, 55.4% higher than the $448.3 million in 2000. In 2001, the annual gross par value of obligations insured by FSA rose 82.4% to $114.2 billion.
During 2001, new issue volume in the U.S. municipal bond market reached $286.3 billion, the second highest level in history, due in part to a decline in interest rates that encouraged municipal borrowing, and insurance
In the fourth quarter of 2001, the Company's newly formed asset management group began issuing FSA-insured GICs and had recorded $600.0 million of GICs as of December 31, 2001. These transactions resulted in a net interest margin of $(0.2) million for the year ended December 31, 2001 and a present value of future net interest margin of $3.8 million.
Total policy acquisition and other operating expenses (excluding the cost of equity-based compensation programs, which was $25.2 million for 2001 and $27.1 million for 2000) were $56.9 million in 2001, compared with $51.2 million in 2000, an increase of $5.7 million. Further excluding the effect of refundings, total policy acquisition and other operating expenses were $54.5 million in 2001, compared with $47.9 million in 2000, an increase of $6.6 million. The increase resulted from higher personnel costs. In 2000, the Company recognized $105.5 million in merger-related expenses, of which $85.8 million represented an increase in equity-based compensation and $19.7 million was for various fees.
FSA's ability to pay dividends is dependent upon FSA's financial condition, results of operations, cash requirements, determination that FSA's ratings will not be adversely affected and other related factors, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York, FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (i) 10% of policyholders' surplus as of its last statement filed with the Superintendent of Insurance of the State of New York (the New York Superintendent) or (ii) adjusted net investment income during this period. FSA paid no dividends in 2002 and 2001. Based upon FSA's statutory statements for the year ended December 31, 2002, and considering dividends that can be paid by its subsidiary, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the following 12 months is approximately $114.0 million. In 2002 and 2001, FSA International paid preferred dividends of $8.7 million and $1.6 million, respectively, to its minority interest owner.
Income Debt Securities (Senior QUIDS) due September 30, 2097. The Company had two other debt issues outstanding at December 31, 2002: $100.0 million of 67/8% Quarterly Income Bond Securities due December 15, 2101 and callable without premium or penalty on or after December 19, 2006; and $100.0 million of 6.950% Senior QUIDS due November 1, 2098 and callable on or after November 1, 2003.
In 2002 and 2001, the Company contributed an additional $13.4 million and $15.0 million, respectively, to Fairbanks. At December 31, 2002, 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 asset management group operations, liquidity lines of credit with banks, and capital market transactions.
The Company's asset management group has a $100 million line of credit with UBS AG, Stamford Branch, which expires December 12, 2003, unless extended. This line of credit provides an additional source of liquidity should there be unexpected draws on GICs issued by CMS. There were no borrowings under this arrangement at December 31, 2002.
FSA-insured GICs subject the Company to risk associated with early withdrawal of principal allowed by the terms of the GICs. The majority of municipal GICs insured by FSA relate to debt 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.
(a)In 2000, $14,088 in treasury stock was distributed to employees to settle the Company's deferred equity obligation. In 2002 and 2001, restricted treasury stock of $271 and $288, 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 or trade 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. 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 expects to continue to emphasize a diversified insured portfolio characterized by insurance of both asset-backed and municipal obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. The Company's insured portfolio consists primarily of asset-backed and municipal obligations originated in the United States of America, but the Company has also written and continues to pursue business in Europe and the Asia Pacific region.
In the fourth quarter of 2001, the Company began offering guaranteed investment contracts (GICs) through its wholly owned subsidiaries, FSA Capital Markets Services LLC and FSA Capital Management Services LLC (collectively, CMS). 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 guaranteed rate.
The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP), which, for the insurance company subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 5). 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 disclosure of contingent assets and liabilities in the Company's consolidated balance sheets at December 31, 2002 and 2001 and the reported amounts of revenues and expenses in the consolidated statements of operations and comprehensive income during the years ended December 31, 2002, 2001 and 2000. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses, fair value of financial instruments and the deferral and amortization of deferred policy acquisition costs. Actual results may differ from those estimates. Significant accounting policies under GAAP are as follows:
The consolidated financial statements include the accounts of 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) (collectively, the Subsidiaries). All intercompany accounts and transactions have been eliminated. Certain prior-year balances have been reclassified to conform to the 2002 presentation.
The Company has also insured a number of credit default swap 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. Changes in fair value are recorded in net realized and unrealized gains (losses) on derivative instruments and in other assets or other liabilities. The Company uses quoted market prices, when available, to determine fair value. If quoted prices are not available, management uses internally developed estimates. Due to a lack of a quoted market for the CDS obligations written by the Company, estimates generated from the Company's valuation process may differ materially from values that may be realized in market transactions.
Gross and ceded 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. When the Company, through its ongoing credit review process, identifies transactions where certain triggers have been breached, the Company ceases to earn premiums. If a case basis reserve is established for these transactions, the unearned premium will reduce such reserve.
The Company establishes a case basis 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. The estimated loss on a transaction is discounted using the then current risk-free rates ranging from 4.77% to 6.1%. For collateralized debt obligations (CDOs), a case basis reserve is recorded to the extent that the overcollateralization ratio (non-defaulted collateral at par value divided by the debt insured) has fallen below 100%.
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. The reserves are necessarily based on estimates, and there can be no assurance that the ultimate liability will not differ from such estimates. The Company will, on an ongoing basis, monitor these reserves and may periodically adjust such reserves based on the Company's actual loss experience, its future mix of business, and future economic conditions.
Deferred acquisition costs comprise those 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. The Company does not defer acquisition costs relating to GICs issued by CMS, except for brokerage fees. Deferred acquisition costs and the cost of acquired business are
The Company enters into GICs whereby the Company receives deposits at a contractual interest rate. These contracts are recorded at amortized cost. Additionally, the Company may enter into associated transactions in order to reduce the Company's exposure to fluctuations in interest rates related to the GICs. 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, attributable to the hedged risk, adjusts the carrying amount of the hedged item and is recognized in income currently.
Bonds at amortized cost of $8,474,000 and $8,493,000 at December 31, 2002 and 2001, respectively, were on deposit with state regulatory authorities as required by insurance regulations.
Consolidated net investment income, excluding income attributable to the GIC bond portfolio and the GIC short-term investment portfolio (collectively, the GIC Portfolio), consisted of the following (in thousands):
The credit quality of bonds, excluding the GIC bond portfolio, at December 31, 2002 was as follows:
The amortized cost and estimated market value of bonds, excluding the GIC bond portfolio, at December 31, 2002, 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.
Proceeds from sales of bonds, excluding the GIC bond portfolio, during 2002, 2001 and 2000 were $772,034,000, $537,062,000 and $1,452,485,000, respectively. Gross gains of $30,312,000, $9,120,000 and $10,262,000 and gross losses of $1,303,000, $1,763,000 and $41,217,000 were realized on sales in 2002, 2001 and 2000, respectively.
The Company held open positions in U.S. Treasury bond futures contracts, Eurodollar futures contracts, and municipal bond index futures during 2000. Such positions were marked to market on a daily basis and, for the year ended December 31, 2000, resulted in net realized gains of $480,000. In 2002, the Company purchased foreign currency calls with a notional amount of $74.1 million. These calls were marked to market through earnings and for the year ended December 31, 2002, resulted in net unrealized gains of $195,000.
The credit quality of bonds held in the GIC bond portfolio at December 31, 2002 was as follows:
The amortized cost and estimated market value of bonds held in the GIC bond portfolio were as follows (in thousands):
Proceeds from sales of bonds held in the GIC Portfolio during 2002 and 2001 were $274,085,000 and $174,195,000, respectively. Gross losses of $154,000 and $346,000 were realized on sales in 2002 and 2001, respectively. The change in net unrealized gains in 2002 was $27,229,000 and the net change in unrealized losses was as $23,000 for 2001.
•Acquisition costs are charged to operations as incurred rather than as related premiums are earned;
•A contingency reserve (rather than a general reserve) is computed based on the following statutory requirements:
•Surplus notes are recognized as surplus rather than as a liability.
A reconciliation of net income for the calendar years 2002, 2001 and 2000 and shareholders' equity at December 31, 2002 and 2001, reported by the Company on a GAAP basis, to the amounts reported by the Subsidiaries on a statutory basis, is as follows (in thousands):
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 19). 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 upon 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.
Under the insurance laws of the State of New York, FSA may pay a dividend to the Company without the prior approval of the Superintendent of Insurance of the State of New York (the New York Superintendent) only from earned surplus subject to the maintenance of a minimum capital requirement. In addition, the dividend, together with all dividends declared or distributed by FSA during the preceding twelve months, may not exceed the lesser of 10% of its policyholders' surplus shown on FSA's last filed statement, or adjusted net investment income, as defined, for such twelve-month period. As of December 31, 2002, FSA had $113,983,000 available for the payment of dividends over the next twelve months. In 2002 and 2001, FSA International paid preferred dividends of $8,671,000 and $1,589,000, respectively, to its minority interest owner. In addition, at December 31, 2002, the Company held $212,850,000 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 2002 and 2001, with the approval of the New York Superintendent, FSA repaid $28,000,000 and $26,000,000, respectively, of principal on such notes and subsequently issued an additional $96,850,000 and $50,000,000 in 2002 and 2001, respectively, of surplus notes to the Company.
FSA has a credit arrangement aggregating $125,000,000 at December 31, 2002, which is provided by commercial banks and intended for general application to transactions insured by the Subsidiaries. At December 31, 2002, there were no borrowings under this arrangement, which expires on April 25, 2003, if not extended. In addition, there are credit arrangements assigned to specific insured transactions. In August 1994, FSA entered into a facility agreement with Canadian Global Funding Corporation (Canadian Global) and Hambros Bank Limited. Under the agreement, which expires in August 2004, FSA can arrange financing for transactions subject to certain conditions. Canadian Global has total assets of $196.8 million, of which $87.6 million has been invested in a GIC issued by CMS. The amount of this facility was $186,911,000, of which $125,161,000 was unutilized at December 31, 2002.
The Company's asset management group has a $100 million line of credit with UBS AG, Stamford Branch, which expires December 12, 2003, unless extended. There were no borrowings under this agreement at December 31, 2002.
On November 26, 2002, the Company issued $230,000,000 principal amount of 6.25% Notes due November 1, 2102 and callable without premium or penalty in whole or in part at any time on or after November 26, 2007. The Company used a portion of the proceeds of this issuance to redeem in whole the Company's $130,000,000 principal amount of 7.375% Senior Quarterly Income Debt Securities (Senior QUIDS) due September 30, 2097. Unamortized debt issuance costs of the retired debt, at the date of redemption, of $4,097,000 were charged to earnings. Interest on the notes is payable quarterly beginning on February 1, 2003. Debt issuance costs of the new debt of $7,395,000 are being amortized over the life of the debt.
On December 19, 2001, the Company issued $100,000,000 of 67/8% Quarterly Income Bond Securities due December 15, 2101 and callable without premium or penalty on or after December 19, 2006. Interest is payable quarterly. Debt issuance costs of $3,250,000 are being amortized over the life of the debt.
The Company applies APB Opinion 25 and related Interpretations in accounting for its performance shares. The Company estimates the final cost of these performance shares and accrues for this expense over the performance period. The accrued expense for the performance shares was $58,916,000, $48,238,000 and $50,076,000 for the years ended December 31, 2002, 2001 and 2000, respectively. The accrued expense for 2000 includes $26,177,000 of merger-related costs. Prior to the merger, in tandem with this accrued expense, the Company estimated those performance shares that it expected to settle in stock and recorded this amount in shareholders' equity as deferred compensation. The remainder of the accrual, which represented the amount of performance shares that the Company estimated it would settle in cash, was recorded in accrued expenses and other liabilities. As a result of the merger, the Company revised its assumption by assuming that all future payments would be settled in cash and recharacterized $39,599,000 from shareholders' equity to a liability. Had the compensation cost for the Company's performance shares been determined based upon the provisions of SFAS No. 123, there would have been no effect on the Company's reported net income.
The Company's policies insure the scheduled payments of principal and interest on asset-backed and municipal obligations. The principal amount insured (in millions) as of December 31, 2002 and 2001 (net of amounts ceded to other insurers) and the terms to maturity are as follows:
(1)Excludes $2,430 million and $479 million, in 2002 and 2001, respectively, relating to FSA-insured GICs issued by CMS that are included in FSA's exposures. The consolidated financial statements of the Company reflect the FSA-insured GICs as GIC liabilities instead of as insurance exposure because CMS is consolidated with the Company. The principal amount of insured obligations in the municipal insured portfolio includes the following types of issues (in millions):
In its asset-backed business, the Company considers geographic concentration as a factor in underwriting insurance covering securitizations of pools of such assets as residential mortgages or consumer receivables. However, after the initial issuance of an insurance policy relating to such securitizations, the geographic concentration of the underlying assets may not remain fixed over the life of the policy. In addition, in writing
The Subsidiaries ceded premiums of $30,701,000 to Tokio Marine and Fire Insurance Co., Ltd. (Tokio Marine), a partial owner of the Company prior to the merger, for the year ended December 31, 2000. The Subsidiaries ceded losses and loss adjustment expenses of $2,935,000 to Tokio Marine for the year ended December 31, 2000. The Subsidiaries ceded premiums of $23,393,000, $12,795,000 and $22,581,000 to subsidiaries of XL, a partial owner of the Company prior to the merger and a current owner of an interest in FSA International, for the years ended December 31, 2002, 2001 and 2000, respectively. The amounts included in prepaid reinsurance premiums at December 31, 2002 and 2001 for reinsurance ceded to subsidiaries of XL were $31,976,000 and $27,509,000, respectively.
The Subsidiaries ceded premiums of $(1,401,000) on a quota share basis to Commercial Reinsurance Company (Comm Re), an affiliate of MediaOne Capital Corporation (MediaOne), a partial owner of the Company prior to the merger, for the year ended December 31, 2000. The Subsidiaries assumed premiums of $8,568,000 from Comm Re for the year ended December 31, 2000, in connection with the acquisition of Comm Re by the Company in June 2000. The sellers have either posted a letter of credit or assumed Comm Re's exposure themselves to cover any losses on its exposure at the time of the acquisition, all of which is being accounted for as reinsurance by the Company. The Subsidiaries ceded losses and loss adjustment expense recoveries of $501,000 to this affiliate for the year ended December 31, 2000.
The Subsidiaries had premiums written of $59,103,000, $54,295,000 and $4,412,000 in 2002, 2001 and 2000, respectively, relating to the guaranty of debt issued and of debt obligations purchased by FSA Global Funding Limited (FSA Global), in which the Company holds a 29% ownership interest (see Note 19). The amounts included in deferred premium revenue relating to FSA Global transactions are $35,452,000 and $40,090,000 at December 31,
The Subsidiaries had premiums earned of $17,272,000 and $7,159,000 for the years ended December 31, 2002 and 2001, respectively, relating to business with affiliates of Dexia. Deferred premium revenue relating to those transactions was $7,675,000 and $4,336,000 at December 31, 2002 and 2001, respectively. Gross par outstanding relating to those transactions were $16,165,980,000 and $10,906,755,000 at December 31, 2002 and 2001, respectively. The Company also paid Dexia a fee of $3,300,000 relating to business in which both Dexia and the Company are involved.
The following estimated fair values have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret the data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
Bonds, equity investments and GIC bond portfolio-The carrying amount represents fair value. The fair value is based upon quoted market price.
Securitized loans-The fair value of the loans is the present value of the expected cash flows as of the reporting date.
Notes payable-The carrying amount of notes payable represents the principal amount. The fair value is based upon quoted market price.
Installment premiums-Consistent with industry practice, there is no carrying amount for installment premiums since the Company will receive premiums on an installment basis over the term of the insurance contract. Similar to deferred premium revenue, the fair value of installment premiums is the estimated present value of the future contractual premium revenues that would be paid under a reinsurance agreement with a third party to transfer the Company's financial guaranty risk, net of that portion of the premium retained by the Company to compensate it for originating and servicing the insurance contract.
Losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses-The carrying amount is fair value, which is the net present value of the expected cash flows for specifically identified claims and potential losses in the Company's insured portfolio.
During 2000, the Company increased its general reserve by $9,403,000, of which $6,672,000 was for originations of new business and $2,731,000 was for the accretion of the discount on prior years' reserves. Also during 2000, the Company transferred to the general reserve $2,053,000 representing recoveries received on prior-year transactions and transferred $1,223,000 from the general reserve to case basis reserves. Giving effect to these transfers, the general reserve totaled $65,204,000 at December 31, 2000.
During 2001, the Company increased its general reserve by $12,497,000, of which $8,203,000 was for originations of new business and $4,294,000 was for the accretion of the discount on prior years' reserves. Also during 2001, the Company transferred to the general reserve $89,000 representing recoveries received on prior-year transactions and transferred $8,719,000 from the general reserve to case basis reserves. Giving effect to these transfers, the general reserve totaled $69,071,000 at December 31, 2001.
In the second quarter of 2002, as part of the Company's ongoing credit review process, management identified certain transactions not performing as expected in its portfolio of insured collateralized debt obligations (CDOs). As a result, management analyzed all CDO transactions in its insured portfolio that breached overcollateralization triggers, which were included in such transactions as one measure of adverse performance. A present value "deterministic" approach was utilized to estimate the loss inherent in this portfolio. The deterministic model applies a run of the collateral portfolio for each transaction considering each CDO transaction's unique attributes (such as reinsurance, individual collateral ratings and status, derivatives purchased, premiums due to the guarantor, etc.) utilizing a Moody's default pattern for frequency of defaults, an estimate of collateral recovery values for severity, and a risk-free rate of interest. Management assumed that current default rates on CDO collateral would improve in a manner consistent with an economic recovery following a period of significant credit deterioration similar to that experienced in 1991/1992 and, as a result, management selected Moody's 1992 idealized default curve as a predictor of future defaults on the CDO collateral. The per period default rate was calculated based on the Moody's weighted average rating factor for each piece of surviving collateral. Recovery rates were judgmentally established by the Company. In considering the recovery rates to be utilized, management adjusted Moody's average recovery rates (observed since 1982) downward to reflect more recent and more adverse observations. At June 30, 2002, this analysis produced a present value of expected losses of $51.5 million, net of reinsurance recoveries and net of unearned premiums and future ceding commissions. As described in more detail below, management addressed this net present value of expected loss ($51.5 million) through (i) an increase in the Company's general reserve ($31.0 million) and (ii) amounts already existing in its general reserve ($20.5 million), including general reserve amounts reallocated to case basis reserves ($11.3 million). The $31.0 million increase in the Company's general reserve resulted in a corresponding increase to losses and loss adjustment expense in the income statement of $31.0 million. An additional adjustment of $10.1 million was made in the fourth quarter of 2002 as a result of further deterioration of the CDO portfolio. Management has established a methodology of recording case basis reserves on CDO transactions to the extent that 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 in respect of these transactions until 2010, but may elect to do so at an earlier date at its discretion. Application of this methodology resulted in recording $68.8 million in gross case basis reserves and $29.8 million in reinsurance recoverable on unpaid losses, resulting in a $39.0 million increase in net case basis reserves. Management, beginning in the second quarter of 2002, has refined the loss factor it applies to its net par underwritten when calculating the general reserve in order to reflect its recent adverse experience. As a result, 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.
During 2002, the Company increased its general reserve by $65.6 million, of which $41.1 million related to the CDO portfolio discussed above, $21.1 million was for originations of new business and $3.4 million was for the accretion of the discount on prior years' reserves. Also during 2002, the Company transferred to the general reserve $0.8 million representing recoveries received on prior-year transactions and transferred $45.8 million from the general reserve to case basis reserves. Giving effect to these transfers, the general reserve totaled $89.7 million at December 31, 2002.
At December 31, 2002 and 2001, the Company's retained earnings included $17,032,000 and $3,237,000, respectively, of accumulated undistributed earnings of Fairbanks (net of goodwill amortization).
The Company owns 29% of the equity of FSA Global, a Cayman Islands domiciled issuer of FSA-insured notes and other obligations sold in international markets (generally referred to as medium term notes or "MTNs"). FSA Global issues securities at the request of interested purchasers in a process known as "reverse inquiry," which generally results in lower interest rates and borrowing costs than would apply to direct borrowings. FSA Global also issues securities in traditional private placements to institutional investors and to participants in lease financings in which Company affiliates may play a number of financing roles. FSA Global is managed as a "matched funding vehicle," in which the proceeds from the sale of FSA Global notes are invested in obligations chosen to provide cash flows substantially matched to those of the FSA Global notes (taking into account, in some cases, dedicated third party liquidity). The matched funding structure minimizes the market risks borne by FSA Global and FSA. FSA Global raises funds in U.S. dollars at LIBOR-based floating borrowing rates and invests its funds in obligations insured by FSA, maturing prior to the maturity of the related FSA Global notes and paying a higher interest rate than the interest rate on the related FSA Global notes. Total assets for FSA Global at December 31, 2002 and 2001 were $9,182,028,000 (unaudited) and $3,561,344,000, respectively. Total liabilities at December 31, 2002 and 2001 were $9,188,967,000 (unaudited) and $3,565,255,000, respectively. The foregoing assets and liabilities include assets and matched liabilities that are "economically defeased" in lease financings in which Company affiliates may play a number of financing roles. These economically defeased liabilities, and associated assets, are held in separate special purpose entities, FSA Global and Premier International Funding Co. At December 31, 2002 and 2001, FSA Global's economically defeased obligations were $6,708,688,000 and $1,982,961,000, respectively. For the years ended December 31, 2002 and 2001, total revenues for FSA Global were $285,897,000 (unaudited) and $151,135,000, respectively. For the years ended December 31, 2002 and 2001, total expenses for FSA Global were $284,945,000 (unaudited) and $150,530,000, respectively. FSA Global's net income for 2002, 2001 and 2000 was $952,000 (unaudited), $605,000 and $383,000. FSA Global's net income is determined net of premiums paid by FSA Global to FSA. For the years ended December 31, 2002 and 2001, FSA Global paid premiums to FSA of $7,707,000 and $7,502,000, respectively. All amounts insured by FSA relating to FSA Global are included in the Company's outstanding exposure, included in the Notes to the Consolidated Financial Statements for December 31, 2002. As of December 31, 2002, there were no case basis reserves required for any transactions related to FSA Global.
In November 1998, FSA International sold to XL $20,000,000 of preferred shares representing a minority interest in FSA International, which is a Bermuda-based financial guaranty subsidiary of FSA (see Note 7). In December 1999, FSA International sold to XL an additional $10,000,000 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 $1,500,000 per annum. For the years ended December 31, 2002, 2001 and 2000, the Company recognized minority interest of $6,684,000, $8,929,000 and $5,295,000, respectively.
The obligations under GICs may be called at various times prior to maturity based upon certain agreed-upon events. As of December 31, 2002, the interest rates on these GICs were between 1.50% and 5.95%.
In August 2002, the Company terminated its exposure under its single-corporate-name credit default swap program in exchange for paying termination costs of $43.0 million, which was included in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income.
The Company operates in two business segments, financial guaranty and financial services. The financial guaranty segment is primarily in the business of providing financial guaranty insurance on asset-backed and municipal obligations. Financial services includes the operations of the Company's asset management group, which issues GICs to municipalities and other market participants. The GICs provide for the return of principal and the payment of interest at a guaranteed rate. The following table is a summary of the financial information by segment as of and for the years ended December 31, 2002 and 2001:
In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46 "Consolidation of Variable Interest Entities" (FIN No. 46), which is an interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements". FIN No. 46 addresses consolidation of VIEs which 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. The provisions of FIN No. 46 will be effective immediately for VIEs created after January 31, 2003 and to VIEs in which an enterprise obtains an interest after that date. For VIEs in which an enterprise holds a variable interest that it acquired prior to February 1, 2003, the interpretation is effective in the first fiscal year or interim period beginning after June 15, 2003. Management believes that the implementation of FIN No. 46, on July 1, 2003, will cause the Company to consolidate for financial reporting purposes, for the first time, FSA Global (see Note 19) and Canadian Global (see Note 9). FIN No. 46 requires that, upon consolidation, the Company shall initially measure the VIEs' 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). Any differences upon consolidation on July 1, 2003 will be reflected as a cumulative effect of a change in accounting principle. The carrying amounts of assets, liabilities and minority interest may change significantly from December 31, 2002 to July 1, 2003 as a result of transactions entered into during that period. The Company will continue to analyze the effects of FIN No. 46, considering the timing of its release and the complexity of practical application to the Company's transactions.
In November 2002, the FASB issued FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an Interpretation of FASB Statements No. 5, 57 and 107 and Rescission of FASB Interpretation No. 34 (FIN No. 45). FIN No. 45 relates to the accounting for and disclosure of guarantees. FIN No. 45 excludes financial guarantee insurance contracts, including those accounted for as insurance contracts and those accounted for as derivatives, from its initial recognition and measurement requirements. However, those contracts accounted for as derivatives are subject to its disclosure requirements. The disclosure requirements in FIN No. 45 are consistent with those already provided by the Company.