This following Selected Consolidated Financial Data should be read in conjunction with the Consolidated Financial Statements and accompanying notes included elsewhere herein.
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. FSA issued insurance policies generating $696.5 million of gross PV premiums written 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.
In international markets, FSA's asset-backed business continued to grow during 2001, led by European synthetic and funded CDOs and other structured finance transactions. The Asia Pacific group also closed a number of synthetic CDOs and consumer asset securitizations during the year. In addition, FSA made progress in global public infrastructure markets, where transactions generally have long lead times, and ended the year with mandates for a number of transactions scheduled to close in 2002. During 2001, FSA insured $21.1 billion of international par, compared with $13.2 billion in 2000, to generate gross PV premiums written of $120.3 million, compared with $109.3 million in 2000.
Net investment income was $128.9 million for 2001 and $121.1 million for 2000, an increase of 6.4%. This increase was due primarily to higher invested balances arising from new business writings. For further discussion, see "Liquidity and Capital Resources" below. The Company's effective tax rate on investment income was 11.0% for 2001, compared with 13.1% for 2000. In 2001, the Company realized $7.2 million in net capital gains, compared with $36.8 million of net capital losses in 2000. Capital losses in 2000 were affected by losses purposely incurred to take advantage of expiring tax loss carry-back opportunities against previously realized capital gains. Capital gains and losses are generally a by-product of the normal investment management process and can vary substantially from period to period.
The primary objective in managing the Company's investment portfolio, excluding the GIC bond portfolio, is generation of an optimal level of after-tax investment income while preserving capital and maintaining adequate liquidity. Investment strategies are based on many factors, including the Company's tax position, fluctuation in interest rates, regulatory and rating agency criteria and other market factors. One internal investment manager and two external investment managers execute fixed-income investments. These investment decisions are based on guidelines established by management and approved by the board of directors. FSA Asset Management LLC manages the investments in the GIC bond portfolio.
Management conducts periodic credit reviews of its exposures to identify events, as they happen, 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, 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.
A large portion of the Company's investment portfolio and its derivative instruments are carried at fair value. Fair value is defined as the amount at which an asset or a liability could be bought or sold in a current transaction between willing parties. The fair value of substantially all of the Company's investment portfolio is determined based upon quoted market prices. For derivative instruments where a quoted market price exists, the Company uses that price.
If quoted market prices are not available, as is the case primarily with credit default swaps 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.
In the U.S. municipal bond market, the Company confronted reduced market volume. A strong economy created budget surpluses, reducing the need for bond issues to fund capital expenditures, and interest rate conditions discouraged refundings. The U.S. municipal business contributed $140.1 million in gross PV premiums written, compared with $183.0 million written in 1999. FSA's U.S. municipal par insured fell to $21.5 billion in 2000 from $26.3 billion in 1999. The business was well diversified across sectors, average capital charges declined, and FSA guaranteed approximately 25% of the insured bonds issued during the year.
At December 31, 2000, the Company held $120.0 million of surplus notes of FSA. In October 2001, FSA repaid $26.0 million of such surplus notes. In December 2001, the Company purchased an additional $50.0 million of surplus notes from FSA. At December 31, 2001, the Company held $144.0 million of FSA surplus notes. Payments of principal or interest on such notes may be made only with the approval of the New York Superintendent.
At the time of the merger with a subsidiary of Dexia, the Company was party to forward agreements with certain counterparties and made the economic benefit and risk of a number of forward shares available for subscription by certain of the Company's employees and directors. All of the Company's forward agreements and corresponding employee and director subscriptions were settled in connection with the merger with a subsidiary of Dexia and, at June 30, 2000, the Company recognized a $39.4 million increase in the Company's additional paid-in capital, reflecting the amounts received from the counterparties.
In December 2001, the Company contributed an additional $15.0 million to Fairbanks Capital Holding Corp., increasing its equity ownership in that company to 28.36%.
FSA has a credit arrangement, aggregating $125.0 million at December 31, 2001, that is provided by commercial banks and intended for general application to transactions insured by FSA and its insurance company subsidiaries. At December 31, 2001, there were no borrowings under this arrangement, which expires on April 26, 2002, unless extended.
The Company has no plans for material capital expenditures during the next twelve months.
In August 1994, FSA entered into a facility agreement with Canadian Global and Hambros Bank Limited. Canadian Global was established to provide a source of liquidity to refinance FSA-insured transactions that experience difficulty in meeting debt service obligations. Canadian Global was capitalized with $180.6 million of debt securities and $6.3 million in preferred equity sold to third-party investors. Under the agreement, FSA pays an annual fee to Canadian Global to compensate it for making its liquidity available and can arrange financing for transactions subject to certain conditions. When Canadian Global purchases an FSA-insured obligation, the new obligation is insured by FSA for a premium and case basis reserves are established when required. As of December 31, 2001, FSA was carrying gross and net case basis reserves of $15.7 million and $3.9 million, respectively, against transactions refinanced by Canadian Global. Canadian Global invests its funds in high-quality, short-term investments. Canadian Global has total assets of $197.3 million. The amount of this facility was $186.9 million, of which $124.3 million was unutilized at December 31, 2001.
The Company owns 29% of the equity of FSA Global, a Cayman Islands domiciled issuer of FSA-insured notes and other obligations in international markets (generally referred to as medium term notes or "MTNs"). FSA Global generally 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. Funds raised by FSA Global are raised at or converted to U.S. dollars and LIBOR-based floating rates and are generally invested in obligations that are insured by FSA and, in some cases, another financial guaranty insurer and that mature prior to the maturity of the related FSA Global notes and pay a higher interest rate than the interest rate on the related FSA Global notes. FSA Global is managed as a "matched funding vehicle", in which the proceeds from the sale of FSA Global notes are generally invested in obligations chosen to provide cash flows substantially matched to those of the FSA Global notes. The matched funding structure minimizes the market risks borne by FSA Global and FSA. At December 31, 2001, FSA Global had total assets and total liabilities of $3.5 billion and $3.5 billion, respectively, and for the year ended December 31, 2001, FSA Global had net income of $0.6 million. As of December 31, 2001, there were no case basis reserves required for any transactions related to FSA Global.
To the Shareholders and Board of Directors of Financial Security Assurance Holdings Ltd.:
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
(a) In 2000, $14,088 in treasury stock was distributed to employees to settle the Company's deferred equity obligation. In 2001, restricted treasury stock of $288 was distributed to a Director as a deferred compensation plan payout.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
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. The GICs are provided primarily to municipalities 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, 2001 and 2000 and the reported amounts of revenues and expenses in the consolidated statements of operations and comprehensive income during the years ended December 31, 2001, 2000 and 1999. 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:
Investments in debt securities designated as available for sale are carried at market value. Equity investments are carried at market value. The unrealized gain or loss on the investments that are not hedged is reflected as a separate component of shareholders' equity, net of applicable deferred income taxes. The unrealized gain or loss on the investments that qualify as fair value hedges is recorded in income currently. All of the Company's debt and equity securities are classified as available for sale.
Derivative instruments, which are primarily designated as fair-value hedges, are entered into to manage the interest rate exposure of the Company's GICs and GIC bond portfolio and are recorded at fair value. These derivatives generally include interest rate futures and interest rate swap agreements, which are primarily utilized to convert the Company's fixed-rate obligations on its GICs and GIC bond portfolio into floating-rate obligations. The gains and losses relating to these fair value hedges are included in guaranteed investment contract net revenues and expenses, as appropriate, along with the offsetting change in fair value of the hedged item attributable to the risk being hedged, on the consolidated statements of operations and comprehensive income. Any ineffective portion of the hedge is recognized in earnings.
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 premiums earned and in other assets. The Company uses quoted market prices, when available, to determine fair value. If quoted prices are not available, management uses internally developed estimates.
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.
The provision for income taxes consists of an amount for taxes currently payable and a provision for the deferred tax consequences of temporary differences between the tax basis of assets and liabilities and the financial statement basis.
The amortized cost and estimated market value of bonds, excluding the GIC bond portfolio, at December 31, 2001, 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 2001, 2000 and 1999 were $537,062,000, $1,452,485,000 and $2,162,425,000, respectively. Gross gains of $9,120,000, $10,262,000 and $17,896,000 and gross losses of $1,763,000, $41,217,000 and $32,406,000 were realized on sales in 2001, 2000 and 1999, respectively.
The amortized cost and estimated market value of bonds held in the GIC bond portfolio, were as follows (in thousands):
The amortized cost and estimated market value of the GIC bond portfolio, at December 31, 2001, 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 held in the GIC Portfolio during 2001 were $174,195,000. Gross losses of $346,000 were realized on sales. The change in net unrealized loss for bonds was $24,000 for 2001.
o Upfront premiums on municipal business are recognized as earned when related principal and interest have expired rather than over the expected coverage period;
o Acquisition costs are charged to operations as incurred rather than as related premiums are earned;
2) For all policies written on or after July 1, 1989, an amount equal to the greater of 50% of premiums written for each category of insured obligation or a designated percentage of principal guaranteed for that category. These amounts are provided each quarter as either 1/60th or 1/80th of the total required for each category, less permitted reductions;
Prior to the Dexia merger, the Company and its Subsidiaries, except International, filed a consolidated federal income tax return. The calculation of each company's tax benefit or liability was controlled by a tax-sharing agreement that based the allocation of such benefit or liability upon a separate return calculation. Dexia Holdings, Inc. and the Company and its Subsidiaries, except International, filed a consolidated federal income tax return for periods subsequent to the merger, under a new tax-sharing agreement.
Federal income taxes have not been provided on substantially all of the undistributed earnings of International, since it is the Company's practice and intent to reinvest such earnings in the operations of this subsidiary. The cumulative amount of such untaxed earnings was $41,899,000 and $18,629,000 at December 31, 2001 and 2000, respectively.
FSA has a standby line of credit commitment in the amount of $240,000,000 with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $240,000,000 or the average annual debt service of the covered portfolio multiplied by 5.75%, which amounted to $653,671,000 at December 31, 2001. The obligation to repay loans made under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a term expiring on April 30, 2008 and contains an annual renewal provision subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2001.
On September 18, 1997, the Company issued $130,000,000 of 7.375% Senior Quarterly Income Debt Securities (Senior QUIDS) due September 30, 2097 and callable without premium or penalty on or after September 18, 2002. Interest on these notes is paid quarterly beginning on December 31, 1997. Debt issuance costs of $4,320,000 are being amortized over the life of the debt.
On December 19, 2001, the Company issued $100,000,000 of 6 7/8% Quarterly Income Bond Securities due December 15, 2101 and callable without premium or penalty on or after December 19, 2006. Interest is paid quarterly beginning on March 15, 2002. Debt issuance costs of $3,250,000 are being amortized over the life of the debt.
Rent expense for the years ended December 31, 2001, 2000 and 1999 was $6,207,000, $5,067,000 and $4,352,000, respectively.
The Company limits its exposure to losses from writing financial guarantees by underwriting investment-grade obligations, diversifying its portfolio and maintaining rigorous collateral requirements on asset-backed obligations, as well as through reinsurance. The gross principal amounts of insured obligations in the asset-backed insured portfolio are backed by the following types of collateral (in millions):
The gross principal amount of insured obligations in the municipal insured portfolio includes the following types of issues (in millions):
The Subsidiaries ceded premiums of $(1,401,000) and $84,000 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 years ended December 31, 2000 and 1999, respectively. 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 and $22,000 to this affiliate for the years ended December 31, 2000 and 1999, respectively.
The Subsidiaries had premiums earned of $7,159,000 for the year ended December 31, 2001 relating to business with affiliates of Dexia. Deferred premium revenue and gross par outstanding relating to those transactions were $4,336,000 and $10,906,755,000, respectively, at December 31, 2001.
Short-term investments, including the GIC short-term investment portfolio - - The carrying amount is fair value, which approximates cost due to the short maturity of these instruments.
Deferred premium revenue, net of prepaid reinsurance premiums - The carrying amount of deferred premium revenue, net of prepaid reinsurance premiums, represents the Company's future premium revenue, net of reinsurance, on policies where the premium was received at the inception of the insurance contract. The fair value of deferred premium revenue, net of prepaid reinsurance premiums, is an estimate of the premiums 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 premiums retained by the Company to compensate it for originating and servicing the insurance contract.
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 1999, the Company increased its general reserve by $8,829,000, of which $8,575,000 was for originations of new business and $254,000 was for the reestablishment of the general reserve. Also during 1999, the Company transferred to the general reserve $3,549,000 representing recoveries received on prior-year transactions and transferred $4,580,000 from the general reserve to case basis reserves. Giving effect to these transfers, the general reserve totaled $54,971,000 at December 31, 1999.
In June 1998, the Company invested $10,000,000 to purchase 1,000,000 shares of common stock, representing a 25% interest, in Fairbanks Capital Holding Corp. (Fairbanks), which buys, sells and services residential mortgage loans. In October 1999, the Company invested $4,517,000 to purchase 361,333 shares of Fairbanks preferred stock, resulting in the Company owning a 22.2% interest in Fairbanks as of December 31, 1999. In December 2001, the Company invested an additional $14,980,000 in Fairbanks, resulting in the Company owning a 28.36% interest in Fairbanks as of December 31, 2001. The Company's investment in Fairbanks is accounted for using the equity method of accounting. Amounts recorded by the Company in connection with Fairbanks as of December 31, 2001, 2000 and 1999 were as follows (in thousands):
In November 1998, the Company invested $19,900,000 to purchase a 19.9% interest in XL Financial Assurance Ltd (XLFA), a financial guaranty insurance subsidiary of XL (see Note 7). In February 1999, the Company sold $4,900,000 of its interest back to XLFA, giving the Company a 15.0% interest in XLFA as of December 31, 1999. In December 2000, the Company invested an additional $24,000,000 to maintain its 15.0% interest. The Company's investment in XLFA is accounted for using the equity method of accounting because the Company has significant influence over XLFA's operations. Amounts recorded by the Company in connection with XLFA as of December 31, 2001, 2000 and 1999 are as follows (in thousands):
At December 31, 2001 and 2000, the Company's retained earnings included $10,726,000 and $3,862,000, respectively, of accumulated undistributed earnings of XLFA.
In 1998, the Company purchased a 29% interest in FSA Global. The investment is accounted for using the equity method of accounting. Total assets and total liabilities for FSA Global at December 31, 2001 were $3,491,906,000 (unaudited) and $3,495,817,000 (unaudited), respectively. Total revenues and total expenses for FSA Global were $151,135,000 (unaudited) and $150,530,000 (unaudited), respectively, for the year ended December 31, 2001. FSA Global's net income for 2001, 2000 and 1999 was $605,000 (unaudited), $383,000 and $164,000, respectively.
Principal payments due under these GICs in each of the next five years ending December 31 and thereafter, based upon expected withdrawal dates, are as follows (in thousands):
In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133). SFAS No. 133 was subsequently amended by SFAS No. 137 and No. 138. These statements established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and hedging activities. It requires that entities recognize all derivatives as either assets or liabilities in the statement of financial position and measure the instruments at fair value. At December 31, 2000, the Company had a limited number of insurance policies considered to be derivatives for accounting purposes and had no open positions in U.S. Treasury bond futures, call options or other derivative instruments used for hedging purposes. For the year ended December 31, 2001, the Company recorded, as an increase to premiums earned, a fair value adjustment of $6,743,000 relating to these policies. The adoption on January 1, 2001 of this standard did not have a material impact on the Company's financial position, results of operations or cash flows. In connection with the establishment of the Company's GIC business in the fourth quarter of 2001, the Company enters into derivative instruments to hedge the interest rate risks in certain of its fixed- rate assets and liabilities. In 2001, the Company recorded a net gain of $161,000 relating to the ineffectiveness of these hedges.