fluctuations in the economic, credit, interest rate or foreign currency environment in the United States (U.S.) and abroad;
MBIA is a leading provider of financial guarantee products and specialized financial services. MBIA provides innovative and cost-effective products and services that meet the credit enhancement, financial and investment needs of its public- and private-sector clients worldwide. MBIA manages its activities primarily through three principal business operations: insurance, investment management services and municipal services. The Company’s corporate operations include revenues and expenses that arise from general corporate activities and not from one of the Company’s three principal business operations.
MBIA’s insurance operations are principally conducted through MBIA Insurance Corporation and its subsidiaries (MBIA Corp.). MBIA Insurance Corporation has Triple-A financial strength ratings from Standard and Poor’s Corporation (S&P), Moody’s Investors Service, Inc. (Moody’s), Fitch, Inc. and Rating and Investment Information, Inc. Additionally, MBIA Insurance Corporation’s insurance subsidiaries have Triple-A financial strength ratings from at least S&P and Moody’s. MBIA Corp. issues financial guarantees for municipal bonds, asset-backed and mortgage-backed securities, investor-owned utility bonds, bonds backed by publicly or privately funded public-purpose projects, bonds issued by sovereign and sub-sovereign entities, obligations collateralized by diverse pools of corporate loans and credit default swaps and pools of corporate and asset-backed bonds, both in the new issue and secondary markets. The financial guarantees provide an unconditional and irrevocable guarantee of the payment of principal and interest on insured obligations when due.
MBIA’s municipal services operations provide revenue enhancement services and products to public-sector clients nationwide, consisting of discovery, audit, collections/recovery and information services through MBIA MuniServices Company and its wholly owned subsidiaries. Additionally, the municipal services operations include Capital Asset Holdings GP, Inc. and certain affiliated entities (Capital Asset), a servicer of delinquent tax certificates.
The restatement of the Company’s financial statements did not have a material effect on its financial condition and MBIA does not expect the restatement to have any impact on its ratings or on the Triple-A ratings of MBIA Insurance Corporation. The following information presented in Management’s Discussion and Analysis of Financial Condition and Results of Operations gives effect to the restatement.
The Company’s financial instruments categorized as assets are mainly comprised of investments in debt and equity instruments. The majority of the Company’s debt and equity investments are accounted for in accordance with SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” SFAS 115 requires that all debt instruments and certain equity instruments be classified in the Company’s balance sheet according to their purpose and, depending on that classification, be carried at either amortized cost or fair market value. Quoted market prices are generally available for these investments. However, if a quoted market price is not available, a price is derived from internally developed models which use available market data. Equity investments outside the scope of SFAS 115 are accounted for under cost or equity method accounting principles. Other financial assets that require fair value reporting or disclosures within the Company’s financial notes are valued based on underlying collateral or the Company’s estimate of discounted cash flows.
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, measured by notional values, is related to certain synthetic collateralized debt obligations (CDOs) that it insures. 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 for those contracts. However, when reliable dealer market quotes are not available, the Company uses a variety of market data relative to the type and structure of derivative contracts entered into by the Company. 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. The 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.
In performing the impairment test for the investment management services operations, 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.
Consolidated revenues from continuing operations for 2004 were $2.1 billion compared with $1.9 billion for 2003, a 9% increase. The growth in consolidated revenues was primarily due to increases in insurance premium earnings and investment income, investment management services medium-term note program revenues and the full-year impact of the consolidation of conduit revenues. Consolidated expenses for 2004 were $882 million compared with $723 million for 2003, a 22% increase. This increase was primarily due to an increase in investment management services medium-term note program interest and operating expenses and the full year impact of the consolidation of conduit expenses. Net income for 2004 of $843 million was up 2% from $825 million recorded in 2003. Net income per share for 2004 was $5.82 compared with $5.69 for 2003, also a 2% increase.
The municipal obligations that MBIA Corp. insures include tax-exempt and taxable indebtedness of states, counties, cities, utility districts and other political subdivisions, as well as airports, higher education and healthcare facilities and similar authorities and obligations issued by private entities that finance projects which serve a substantial public purpose. The asset-backed and structured finance obligations insured by MBIA Corp. typically consist of securities that are payable from or which are tied to the performance of a specified pool of assets that, in most cases, have a defined cash flow. Securities of this type include residential and commercial mortgages, a variety of consumer loans, corporate loans and bonds, trade and export receivables, aircraft, equipment and real property leases, and infrastructure projects.
Revenues from the Company’s insurance operations decreased 9% to $1.35 billion in 2005 compared with $1.48 billion in 2004. The decline in insurance operations’ revenues was primarily the result of a decrease in net gains from investment securities and, to a lesser extent, a decrease in advisory fee income and net gains on derivative instruments. Net investment income increased 4%, partially offsetting the overall decline in revenues. Insurance expenses, which consist of loss and LAE, the amortization of deferred acquisition costs and operating costs, increased 8% to $295 million in 2005 compared with $273 million in 2004. Loss and LAE and the amortization of deferred acquisition costs remained relatively flat. Operating costs increased largely due to loss prevention costs, costs associated with the Company’s Money Market Committed Preferred Custodial Trust securities (CPCT securities), consulting services and a decrease in the rate at which compensation and other costs are deferred as policy acquisition costs. Gross insurance expenses (expenses before ceding commission income and the deferral or amortization of acquisition costs) increased 3% in 2005 compared with 2004.
In 2004, revenues from insurance operations of $1.48 billion increased 4% compared with 2003. The growth in insurance operations revenues in 2004 was due to increases in earned premiums, net investment income and net realized gains offset by decreases in advisory fee income and net gains on derivative instruments. Insurance expenses increased 7% in 2004 compared with 2003. Loss and LAE and the amortization of deferred acquisition costs both increased in line with the increase in earned premiums. Operating expenses increased 3%, principally due to higher compensation costs, premiums related to the renewal of directors’ and officers’ liability insurance and loss prevention costs. Gross insurance expenses for 2004 increased 1% compared with 2003.
The Company’s gross premiums written (GPW), net premiums written (NPW) and net premiums earned for the last three years are presented in the following table:
GPW reflects premiums received and accrued for in the period and does not include the present value of future cash receipts expected from installment premium policies originated during the period. GPW was $985 million in 2005, down 12% from 2004.
GLOBAL PUBLIC FINANCE MARKET MBIA’s premium writings and premium earnings in both the new issue and secondary global public finance markets are shown in the following table:
In 2004, global public finance GPW and NPW decreased 20% and 22%, respectively, over 2003. The decrease in GPW was primarily due to a significant decline in first quarter U.S. production and third quarter U.S. and non-U.S. production, which resulted from lower market issuance, increased competition and lower overall pricing. In 2004, the cession rate on total global public finance business written was 12%, which increased from an 11% cession rate in 2003. The increase in the 2004 cession rate resulted from an increase in non-U.S. business ceded. The greater decline in NPW compared with the decline in GPW was a result of the increase in cessions to reinsurers. Global public finance net premiums earned increased 14% over 2003. This growth reflects earnings generated from increased levels of U.S. and non-U.S. business written over the last several years and a 10% increase in refunded premiums earned.
The Company’s insurance-related net investment income, excluding net realized gains and losses, increased 4% to $492 million from $474 million in 2004. After-tax net investment income also increased 4% in 2005 as the proportion of taxable investments remained relatively consistent with 2004. Growth in investment income has been adversely impacted by the continued low interest rate environment, however, benefited from slightly higher average yields and an increase in average invested assets as a result of a reduction in dividends paid by MBIA Corp. to MBIA Inc. during 2005 as compared with 2004.
In 2004, insurance-related net investment income, excluding net realized gains and losses, increased 8% to $474 million in 2004, up from $438 million in 2003. After-tax net investment income also increased 8% compared with 2003 as the proportion of taxable investments remained consistent from year to year. The increase in investment income for 2004 was principally the result of an increase in invested assets due to premium collections and reinvested interest. Since the fourth quarter of 2003, a portion of MBIA-administered conduit investment income has been reported as insurance-related net investment income. Excluding investment income related to MBIA-administered conduits, after-tax insurance-related investment income would have increased 6% from 2003.
Net losses on derivative instruments and foreign exchange in the insurance operations, which primarily represent changes in the market value of the Company’s insured credit derivative portfolio, were $4 million in 2005 compared with net gains of $7 million and $104 million in 2004 and 2003, respectively. The 2005 net losses primarily resulted from the reversal of gains recorded in prior years on credit derivatives as transactions approach their maturity and that terminated in 2005, net of foreign currency gains. The 2004 and 2003 net gains were primarily due to an increase in the value of the Company’s insured credit derivative portfolio, reflecting a tightening of credit spreads. Gains or losses on derivatives are largely driven by movements in credit spreads affecting the insurance operations’ insured portfolio of synthetic CDOs. However, credit spreads did not move significantly in 2005 and 2004 relative to 2003.
Total case basis activity transferred from the Company’s unallocated loss reserve was $189 million in 2005, $127 million in 2004 and $60 million in 2003. During 2005, case basis activity primarily consisted of loss reserves for insured obligations within the aircraft enhanced equipment trust certificates (EETCs), CDO and manufactured housing sectors and within MBIA’s guaranteed tax lien portfolios. Case basis activity during 2004 primarily consisted of loss reserves for insured obligations issued by Fort Worth Osteopathic Hospital, MBIA’s guaranteed tax lien portfolios, AHERF, an older vintage CDO and a manufactured housing exposure. During 2003, case basis activity included reserves for MBIA’s guaranteed tax lien portfolios, losses associated with the guarantee of an older vintage CDO and a Trenwick America Corp. debt obligation.
MBIA established a case loss reserve of $76 million in the fourth quarter of 2005 in connection with $686 million of net par exposure under four insured EETCs secured by 64 aircraft financed by Northwest Airlines. Northwest Airlines filed for bankruptcy protection in September 2005 and, subsequently, did not make scheduled payments on leases supporting outstanding senior debt for 31 aircraft in three of the four MBIA-insured EETCs. MBIA established the case loss reserve based on projected lower lease income related to these leases, the projected revenue from the potential redeployment of certain aircraft and estimated valuations for the aircraft subject to the defaulted leases. Currently, the leases related to the remaining 33 aircraft are performing according to the original contract terms. Temporary extensions are in place to allow Northwest Airlines to continue flying the non-compliant aircraft, with negotiations regarding the future of the aircraft underway at this time.
The Company has significant exposures in its insured portfolio relating to regions impacted by hurricanes Katrina, Rita and Wilma. Insured credits in these regions encompass various types of sectors, including general obligation bonds, tax-backed, healthcare, transportation and higher education, among others. The Company is continuing its communication efforts with issuers, trustees and relevant state officials to evaluate the actual and potential impact that the hurricanes may have on its insured credits. Based on available information, the Company does not currently expect there to be material cases of prolonged nonpayment that would result in unreimbursed losses. As a result, during 2005, MBIA did not establish specific reserves for its exposure to the regions impacted by these hurricanes. To date, MBIA has paid $2 million in claim payments, for which it has been fully reimbursed.
In the event MBIA determines that it must pay a claim or that a claim is probable and estimable with respect to an insured issue, it places the issue on its “Classified List” and establishes a case basis reserve for that insured issue. As of December 31, 2005, MBIA had 38 open case basis issues on its “Classified List” that had $454 million in aggregate case reserves, net of reinsurance. The Company does not establish any case basis reserves for issues that are listed as “Caution List-Low,” “Caution List-Medium” or “Caution List-High” until such issues are placed on the Company’s “Classified List.”
Included in the Company’s case basis reserves are both loss reserves for insured obligations for which a payment default has occurred and MBIA has already paid a claim and also for which a payment default has not yet occurred but a claim is probable and estimable in the future. At December 31, 2005, case basis reserves were comprised of the following:
When MBIA becomes entitled to the underlying collateral of an insured credit under salvage and subrogation rights as a result of a claim payment, it records salvage and subrogation as an asset. Such amounts are included in the Company’s balance sheet within “Other assets.” As of December 31, 2005 and 2004, the Company had salvage and subrogation of $143 million and $154 million, respectively. The decrease was principally due to $19 million of impairment losses in 2005 on receivables the Company recorded as a result of claim payments it previously made on insured credits.
RISK MANAGEMENT In an effort to mitigate losses, MBIA is regularly involved in the ongoing remediation 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. From time to time, the issuer of an MBIA-insured obligation may, with the consent of MBIA, restructure the insured obligation by extending the term, increasing or decreasing the par amount or decreasing the related interest rate with MBIA insuring the restructured obligation. If, as the result of the restructuring, MBIA estimates that it will suffer an ultimate loss on the restructured obligation, MBIA will record a case basis loss reserve for the restructured obligation or, if it has already recorded a case basis loss reserve, it will re-evaluate the impact of the restructuring on the recorded reserve and adjust the amount of the reserve as appropriate.
As of December 31, 2005, the aggregate amount of insured par ceded by MBIA to reinsurers under reinsurance agreements was $73.5 billion. Additionally, the Company has other reimbursement agreements not accounted for as reinsurance, primarily with a Single-A rated reinsurer, covering $7.2 billion of insured par. The following table displays the percentage ceded to and reinsurance recoverable from reinsurers by rating levels:
While Channel Reinsurance Ltd. (Channel Re) continues to be a Triple-A rated reinsurer of MBIA, S&P has revised their outlook on Channel Re from stable to negative in 2005. MBIA does not expect S&P’s revised outlook on Channel Re to have a material negative impact on the Company’s financial condition or results of operations. Additionally, MBIA owned an equity interest of 17.4% and 11.4% in Channel Re and RAM Holdings Inc., the holding company of Ram Reinsurance Company, Ltd., respectively, at December 31, 2005.
Annually, MBIA reviews its insurance-related expenses to determine if there have been any changes in its business or cost structure that would materially change the amount of costs accounted for as policy acquisition costs. If so, the Company conducts a policy acquisition cost study to determine the amount of insurance costs that relate to acquiring new insurance policies and that are deferrable under GAAP. MBIA completed its latest study in July 2005. The current policy acquisition cost study, which was effective beginning with the third quarter of 2005, resulted in a decrease of approximately $9.6 million in deferred policy acquisition costs for the year with a corresponding increase in insurance operating expenses. The change was principally driven by a reduction in the rate at which compensation costs associated with acquiring new insurance policies are deferred. The Company expects the quarterly change to be in the $5 million range going forward. However, policy acquisition costs and operating expenses will be influenced by the level of actual future expenses that qualify for deferral.
The Company’s insurance expenses, as well as its expense ratio, are shown in the following table:
In 2005, the amortization of deferred acquisition costs remained flat compared with 2004, in line with insurance premiums earned. The amortization of deferred acquisition costs increased 10% in 2004 compared with 2003 resulting from an increase in related premium earnings. At December 31, 2005 and 2004 there was an increase 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. The increasing ratio in 2004 and 2005 reflects higher costs associated with acquiring new policies relative to the smaller growth in deferred premiums.
Financial guarantee insurance companies use the expense ratio (expenses divided by net premiums earned) as a measure of expense management. The Company’s 2005 expense ratio of 24.9% is higher than the 2004 ratio of 22.2% and the 2003 ratio of 23.2% as a result of the 17% increase in operating expenses.
VARIABLE INTEREST ENTITIES The Company provides structured funding and credit enhancement services to global finance clients through the use of certain MBIA-administered, bankruptcy-remote special purpose vehicles (SPVs) and through third-party SPVs. Third-party SPVs are used in a variety of structures guaranteed or managed by MBIA, whereby the Company has risks analogous to those of MBIA-administered SPVs. The Company has determined that such SPVs fall within the definition of a variable interest entity (VIE) under FASB Interpretation No. (FIN) 46(R), “Consolidation of Variable Interest Entities (Revised).” Under the provisions of FIN 46(R), MBIA must determine whether it has a variable interest in a VIE and if so, whether that variable interest would cause MBIA to be the primary beneficiary. The primary beneficiary is the entity that will absorb the majority of the expected losses, receive the majority of the expected residual returns, or both, of the VIE and is required to consolidate the VIE.
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 Asset Management, LLC (MBIA-AML) and include cash management, discretionary asset management and fund administration services and investment agreement, medium-term note and commercial paper programs related to funding assets for third-party clients and for investment purposes. The investment management services operations are comprised of three operating segments: asset/liability products, which include investment agreements and medium-term notes (MTNs) not related to the conduit programs; advisory services, which consist of third-party and related-party fee-based asset management; and conduit programs. During the third quarter of 2004, the Company completed the sale of the assets of 1838 Investment Advisors, LLC, which comprised the Company’s equity advisory services segment. This segment has been reported as a discontinued operation in the Company’s financial statements. See “Note 16: Discontinued Operations” in the Notes to Consolidated Financial Statements for additional information.
Net realized gains from investment securities in the investment management services operations were $1 million in 2005 compared with net realized losses of $4 million in 2004 and net realized gains of $17 million in 2003. Net realized gains and losses in the investment management services operations were generated from the ongoing management of its investment portfolios.
Fixed-income ending assets under management as of December 31, 2005, which do not include conduit assets, were $44.2 billion, 13% above the 2004 year-end level and 29% above the 2003 year-end level. Conduit assets are held to their contractual maturities 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 services’ results and assets under management over the last three years:
The following provides a summary of each of the investment management services’ businesses by segment. See “Note 15: Business Segments” for a tabular presentation of the results of the investment management services’ segments.
Advisory services’ pre-tax income, excluding realized gains and losses from investment securities and gains and losses on derivative instruments and foreign exchange, totaled $19.6 million in 2005, up 19% over 2004. Third-party ending assets under management were $17.9 billion and $16.0 billion at December 31, 2005 and December 31, 2004, respectively. The market values of assets related to the Company’s insurance and corporate investment portfolios managed by the investment management services operations at December 31, 2005 were $10.2 billion, slightly down from the balance at December 31, 2004 of $10.3 billion. In 2004, advisory services pre-tax income, excluding realized gains and losses from investment securities and gains and losses on derivative instruments and foreign exchange, totaled $16.5 million compared with $17.3 million in 2003, a 4% decrease.
Conduit program pre-tax income, excluding gains and losses on derivative instruments and foreign exchange, totaled $10.7 million in 2005 compared with $7.6 million in 2004 and $0.4 million in 2003. Certain of MBIA’s consolidated subsidiaries have invested in MBIA’s conduit debt obligations or have received compensation for services provided to MBIA’s conduits. As such, MBIA has eliminated intercompany transactions with its conduits from its balance sheet and income statement. After the elimination of such intercompany assets and liabilities, conduit investments and conduit debt obligations were $4.5 billion and $4.2 billion, respectively, at December 31, 2005. The difference between the investments and debt obligations is primarily the result of the elimination of conduit debt owned by other MBIA subsidiaries. The effect of the elimination on the Company’s consolidated balance sheet is a reduction of fixed-maturity investments, representing investments in conduit medium-term notes by other MBIA subsidiaries, with a corresponding reduction of conduit medium-term notes.
In October 2005, Moody’s announced that it is undertaking a review of the non-core activities of financial guaranty insurance companies in order to assess the impact of such activities on the overall credit profile of financial guarantors. In its announcement,
MBIA’s municipal services operations are consolidated under MBIA MuniServices Company (MBIA MuniServices) and provide revenue enhancement services and products to public-sector clients nationwide, consisting of discovery, audit, collections/recovery and information (data) services. The municipal services operations also include Capital Asset, a servicer of delinquent tax certificates. MBIA currently insures an unconsolidated Capital Asset securitization, which matures in 2008 and has an outstanding balance of $117 million or $49 million net of existing loss reserves of $68 million. This securitization was structured through the sale by Capital Asset of tax liens to an off-balance sheet qualifying special purpose entity that was established in 1999 in connection with the securitization.
In 2005, the municipal services operations reported pre-tax income of $2.1 million, compared with pre-tax income of $1.6 million in 2004. Revenues decreased by 10% and expenses decreased by 13% due to a decline in the delinquent tax certificate portfolio serviced by Capital Asset as a result of tax certificate redemptions. In addition, revenue enhancement services’ margins improved in 2005 compared with 2004. Excluding gains and losses on investment securities and derivatives instruments, operating income was $2.1 million in 2005 compared to $1.9 million in 2004 and $1.0 million in 2003.
The Company carefully manages its capital resources to minimize its cost of capital while maintaining appropriate claims-paying resources to sustain its Triple-A claims-paying ratings. Capital resources are defined by the Company as total shareholders’ equity, long-term debt issued for general corporate purposes and various soft capital credit facilities. At December 31, 2005, total shareholders’ equity was $6.6 billion and total long-term debt was $1.2 billion. The Company uses debt financing to lower its overall cost of capital. MBIA maintains debt at levels it considers to be prudent based on its cash flow and total capital (shareholders’ equity plus long-term debt). The following table shows the Company’s long-term debt and the ratio used to measure it:
In August 1999, the Company announced that its board of directors had authorized the repurchase of 11.25 million shares of common stock of the Company, after adjusting for the 2001 stock split. The Company began the repurchase program in the fourth quarter of 1999. In July 2004, the Company completed the repurchase of all 11.25 million shares at an average price of $44.08 per share and received authorization from its board of directors to repurchase 1 million shares under a new repurchase program. On August 5, 2004, the Company’s board of directors authorized the repurchase of an additional 14 million shares of common stock in connection with the new repurchase program. As of December 31, 2005, the Company had repurchased a total of 10.0 million shares under the current plan at an average price of $57.25 per share. A total of 5.9 million shares were repurchased in 2005 at an average price of $57.77 per share, all of which were repurchased in the first and second quarters of the year.
The available-for-sale investment portfolio provides a high degree of liquidity, since it is comprised of readily marketable high-quality fixed-income securities and short-term investments. At year-end 2005, the fair value of the consolidated available-for-sale investment portfolio was $26.4 billion, as shown in the following table:
The increase in the amortized cost of insurance-related available-for-sale investments in 2005 was the result of positive cash flow from operations. The increase in the amortized cost of available-for-sale investments in the investment management services operations was the result of growth in the Company’s asset/liability products program. Corporate investments decreased in 2005 compared with 2004 due to a decrease in dividends received from the insurance operations while share repurchase activity continued during the first half of 2005.
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, excluding short-term investments, based on ratings from Moody’s as of December 31, 2005 is presented in the following table. Alternate ratings sources, such as S&P, have been used for a small percentage of securities that are not rated by Moody’s.
The Company generates significant liquidity from its operations, as described above. Because of its risk management policies and procedures, diversification and reinsurance, the Company believes that the occurrence of an event that would significantly adversely affect liquidity is unlikely.
Investment agreements, commercial paper, medium-term notes, variable interest entity floating rate notes, securities sold under agreement to repurchase and long-term debt include accrued interest and exclude premiums or discounts and estimates of future interest payments. Gross insurance claim obligations represent the future value of payments MBIA expects to make, before estimated recoveries and reinsurance, under actual or probable insurance policy claims. The discounted value of such actual or estimated claims, after estimated recoveries, is reported as case basis reserves within loss and loss adjustment expense reserves on the Company’s consolidated balance sheet.
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 prepayment 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, 2005, 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 $322.2 million and $927.7 million, respectively. A decrease in interest rates of 100 and 300 basis points would have resulted in an after-tax increase in the net fair value of the Company’s financial instruments of approximately $318.3 million and $952.2 million, respectively.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of MBIA Inc. and its subsidiaries at December 31, 2005 and 2004 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a) (2), present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements 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.
MBIA’s municipal services operations provide revenue enhancement services and products to public-sector clients nationwide, consisting of discovery, audit, collections/recovery and information services through MBIA MuniServices Company and its wholly owned subsidiaries. Additionally, the municipal services operations include Capital Asset Holdings GP, Inc. and certain affiliated entities (collectively, Capital Asset), a servicer of delinquent tax certificates.
In 1998, three reinsurers, Converium Reinsurance (North America) Inc. (Converium), AXA Re Finance S.A. (ARF) and Muenchener Rueckversicherungs-Gesellshaft (Munich Re) paid the Company $170 million under three separate agreements (the Excess-of-Loss Agreements) in connection with losses the Company incurred on $265 million of MBIA-insured bonds issued by the Alleghany Health, Education and Research Foundation (AHERF). The Excess-of-Loss Agreements were structured as three successive excess-of-loss facilities that aggregated to $170 million. Under the Excess-of-Loss Agreements, Converium paid the Company $70 million, and Munich Re and ARF each paid the Company $50 million.
Additionally, in the third quarter of 2005, the Company completed a detailed review of its derivative instruments for which it applied shortcut method hedge accounting under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended. Shortcut method hedge accounting allows the assumption that the change in fair value of a hedged item exactly offsets the change in fair value of the related derivative. After completing its review, the Company determined that certain hedging relationships did not meet every technical aspect of shortcut method hedge accounting, although, such hedging relationships would have qualified for basic hedge accounting. Since the documentation that the Company prepared was designed to support shortcut method hedge accounting, it was not sufficient to support basic hedge accounting. As a result, the Company must account for these derivatives, from 2001 through September 30, 2005, as if they were not part of hedging relationships, which requires the change in fair value of these derivatives to be reflected in the Company’s income statement without an offsetting change in fair value of the hedged items. The Company has restated its financial statements to correct the accounting for these derivatives for the year ended December 31, 2001 and subsequent periods through June 30, 2005. As of October 1, 2005, all of the subject hedging relationships met the requirements for basic hedge accounting and have been recorded as such in the Company’s financial statements for the year ended December 31, 2005.
INVESTMENTS The Company classifies its fixed-maturity investments as either available-for-sale or held-to-maturity, as defined by SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” Available-for-sale investments are reported in the financial statements at fair value, with unrealized gains and losses, net of deferred taxes, reflected in accumulated other comprehensive income in shareholders’ equity. Bond discounts and premiums are amortized using the effective yield method over the remaining term of the securities. For pre-refunded bonds, the remaining term is determined based on the contractual refunding date. Investment income is recorded as earned. Realized gains or losses on the sale of investments are determined by specific identification and are included as a separate component of revenues.
Held-to-maturity investments consist mainly of debt securities, loans, lease receivables, trade receivables and floating rate notes. These investments are reported in the financial statements at amortized cost. Discounts and premiums are amortized using the straight-line method over the remaining term of the securities. Using an effective yield method to amortize discounts and premiums would not have produced materially different results. Investment income is recorded as earned.
CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash on hand and demand deposits with banks with original maturities of less than 90 days.
POLICY ACQUISITION COSTS Policy acquisition costs include those expenses that relate primarily to, and vary with, the acquisition of new insurance business. The Company periodically conducts a study to determine which operating costs have been incurred to acquire 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, net of ceding commissions, are deferred and amortized over the period in which the related premiums are earned.
MBIA will recognize a premium deficiency if the sum of expected loss and loss adjustment expenses and unamortized policy acquisition costs exceed the related unearned premiums. If MBIA were to have a premium deficiency that is greater than unamortized acquisition costs, the unamortized acquisition costs would be reduced by a charge to expense, and a liability (if necessary) would be established for any remaining deficiency. As of December 31, 2005, there have been no premium deficiencies. Although GAAP permits the inclusion of anticipated investment income when determining a premium deficiency, it is currently not being included in the Company’s evaluation.
LOSSES AND LOSS ADJUSTMENT EXPENSES The financial guarantees issued by MBIA Corp. insure scheduled payments of principal and interest due on various types of financial obligations against a payment default on such payments by the issuers of the obligations. Loss and loss adjustment expense (LAE) reserves are established by the Company’s Loss Reserve Committee, which is comprised of members of senior management, and require the use of judgment and estimates with respect to the occurrence, timing and amount of a loss on an insured obligation. As discussed below, the accounting for non-derivative financial guarantee loss reserves is possibly subject to change.
Each quarter, the Company calculates its provision for the unallocated loss reserve as a fixed percent of scheduled net earned premium. This amount is recorded as “Losses and loss adjustment expense” on the income statement. Annually, the Loss Reserve Committee evaluates the appropriateness of the fixed percent loss factor. In performing this evaluation, the Loss Reserve Committee considers the composition of the Company’s insured portfolio by municipal sector, structured asset class, remaining maturity and credit quality, along with the latest industry data, including historical default and recovery experience for the relevant sectors of the fixed-income market in order to determine if a trend is developing that indicates the loss factor should be increased or decreased. In addition, the Company considers its own historical loss activity and how those losses develop over time. The Loss Reserve Committee reviews the results of its annual evaluation over several years to determine whether any long-term trends are developing. The Company’s additions to specific case basis reserves in the years ended December 31, 2005 and 2004 exceeded the 12% loss factor currently used by the Company. The Loss Reserve Committee is continuing to monitor this trend and evaluate whether an adjustment to the Company’s current loss factor is appropriate. During the years ended December 31, 2005, 2004 and 2003, the Company calculated its provision for the unallocated loss reserve as 12% of scheduled net earned premium.
MBIA establishes new case basis reserves with respect to a specific insurance policy when the Loss Reserve Committee determines that (i) a claim has been made or is probable in the future with respect to such policy based on specific credit events that have occurred and (ii) the amount of the ultimate loss that MBIA will incur under such policy can be reasonably estimated. The amount of the case basis reserve with respect to any policy is based on the net present value of the expected ultimate losses and loss adjustment expense payments that the Company expects to pay with respect to such policy, net of expected recoveries under salvage and subrogation rights. The amount of the expected loss, net of expected recoveries, is discounted based on a discount rate equal to the actual yield of the fixed-income portfolio held by the Company’s insurance subsidiaries at the end of the preceding fiscal quarter. The Company believes this yield is an appropriate rate of return for present valuing its reserves as it reflects the rate of return on the assets supporting future claim payments by the Company. The discount rate used at December 31, 2005, 2004 and 2003 was 5.0%, 4.8% and 4.7%, respectively. When a case basis reserve is established for an insured obligation, the Company continues to record premium revenue until it believes that premiums will no longer be collected on that obligation.
credit under salvage and subrogation rights as a result of a claim payment, it records salvage and subrogation as an asset. Such amounts are included in the Company’s balance sheet within “Other assets.”
The Company believes its loss reserving policy reflects the requirements of applicable accounting literature, as well as the fact that financial guarantee losses occur over time as a result of credit deterioration, operational difficulties of the insured obligor or fraud, which may not be specifically detected when they occur but which can be generally estimated across a portfolio of insured obligations based on the credit quality and nature of the portfolio and historical default data. The Company does, however, recognize premium revenue and policy acquisition costs in a manner consistent with the guidance provided in SFAS 60 for short-duration contracts. If the Company and the rest of the financial guarantee industry were required to classify its insurance contracts as either short-duration or long-duration or if new specific guidance for financial guarantee insurance emerges, different methods of accounting could apply with respect to loss reserving and liability recognition, and possibly extend to premium revenue and policy acquisition cost recognition. Additionally, there are differences in the methodology and measurement of loss reserves followed by other financial guarantee companies.
As a result of discussions in January and February 2005 between the SEC staff and several financial guarantee industry participants, including MBIA, the FASB staff is considering whether additional guidance with respect to accounting for financial guarantee insurance should be provided. In June 2005, the FASB decided to add to its agenda a project to consider the accounting by insurers for financial guarantee insurance. As part of this project, the FASB is considering several aspects of the insurance accounting model for financial guarantee insurers, including claims liability recognition, premium recognition and the related amortization of deferred policy acquisition costs. When the FASB or the SEC reaches a conclusion on this issue, the Company and its financial guarantor peers may be required to change some aspects of their respective loss reserving policies and the potential changes could extend to premium and expense recognition. The Company cannot currently assess how the FASB and SEC staff’s ultimate resolution of this issue will impact its loss reserving policy or the effect it might have on recognizing premium revenue and policy acquisition costs. Until the issue is resolved, the Company intends to continue to apply its existing policy with respect to the establishment of both case basis and unallocated loss reserves and the recognition of premium revenue and policy acquisition costs.
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.
ADVISORY FEE REVENUE RECOGNITION The Company collects advisory fees in connection with certain transactions. Depending upon the type of fee received and whether it is related to an insurance policy, 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 and expense reimbursements are earned when the related services are completed. Structuring fees are earned on a straight-line basis over the life of the related insurance policy and commitment fees are earned on a straight-line basis over the commitment period.
MUNICIPAL SERVICES OPERATIONS Municipal services results are comprised of the net investment income, operating revenues, expenses and gains and losses of MBIA MuniServices Company and its subsidiaries. Operating revenues primarily consist of fees, which are recognized in earnings as the related services are performed.
CORPORATE Corporate results consist of net investment income, interest expense on MBIA Inc. debt and general corporate expenses. All legal and consulting costs associated with the investigations by the SEC, the NYAG and the NYSID are expensed as incurred.
GAINS AND LOSSES Net realized gains and losses are primarily generated from the sale of investments. Realized losses also include amounts resulting from the write-down of assets for which a decline in fair value below the Company’s carry value is determined to be other than temporary. Net gains and losses on derivative instruments and foreign exchange are the result of fair valuing the Company’s derivative instruments and gains and losses resulting from revaluing transactions denominated in foreign currencies.
FOREIGN CURRENCY TRANSLATION Assets and liabilities denominated in foreign currencies are translated at year-end exchange rates. Operating results are translated at average rates of exchange prevailing during the year. Unrealized gains or losses, net of deferred taxes, resulting from translation are included in accumulated other comprehensive income in shareholders’ equity. Gains and losses resulting from transactions in foreign currencies are recorded in current earnings.
INCOME TAXES Deferred income taxes are provided with respect to the temporary differences between the tax bases of assets and liabilities and the reported amounts in the financial statements that will result in deductible or taxable amounts in future years when the reported amounts of assets and liabilities are recovered or settled. Such temporary differences relate principally to premium revenue recognition, deferred acquisition costs, unrealized appreciation or depreciation of investments and derivatives, and MBIA Corp.’s statutory contingency reserve.
In December 2004, the FASB issued SFAS 123(R), “Share-Based Payment.” SFAS 123(R) is a revision of SFAS 123 and supersedes APB 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) requires the Company to expense the fair value of employee stock options and other forms of stock-based compensation. In addition, SFAS 123(R) classifies share-based payment awards as either liability awards, which are remeasured at fair value at each balance sheet date, or equity awards, which are measured at fair value on the grant date and not subsequently remeasured. Generally, awards with cash-based settlement, repurchase features or that are settled at a fixed dollar amount are classified as liability awards, and changes in fair value will be reported in earnings. Awards with net-settlement features or that permit a cashless exercise with third-party brokers are classified as equity awards and changes in fair value are not reported in earnings. The requirements are effective for the Company as of January 1, 2006. The Company’s long-term incentive plans include features which would result in both liability and equity awards. The Company adopted the fair value provisions of SFAS 123 effective January 1, 2002 and does not believe that the adoption of SFAS 123(R) for equity awards will have a material effect on the Company’s financial position or results of operations. For liability awards, the Company currently remeasures these awards and does not believe that the adoption of SFAS 123(R) will have a material effect on the Company’s financial position or results of operations.
Under the provisions of FIN 46(R), an entity is considered a VIE subject to consolidation if the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support or if the equity investors lack one of three characteristics of a controlling financial interest. First, the equity investors lack the ability to make decisions about the entity’s activities through voting rights or similar rights. Second, they do not bear the obligation to absorb the expected losses of the entity if they occur. Lastly, they do not claim the right to receive expected returns of the entity if they occur, which is the compensation for the risk of absorbing the expected losses. A VIE is consolidated with its primary beneficiary, which is the entity that will absorb the majority of the expected losses, receive the majority of the expected residual returns, or both, of the VIE.
notes and commercial paper, and has included in its income statement the 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 total assets and liabilities were $4.6 billion and $4.4 billion, respectively, at December 31, 2005 and $7.0 billion and $6.7 billion, respectively, at December 31, 2004.
In 2004, the Company consolidated two VIEs established in connection with the securitization of Capital Asset tax liens. As a result of a clean-up call exercised for the Capital Asset Research Funding Series 1997A and Series 1998A tax lien securitizations, these securitizations no longer met the conditions of a qualifying special purpose entity under SFAS 140. MBIA holds a variable interest in these entities, which resulted from its insurance policies, and has determined that it is the primary beneficiary under FIN 46(R). MBIA has reported the assets of the securitizations, totaling $2.5 million and $16.8 million at December 31, 2005 and December 31, 2004, respectively, principally within “Other assets” on its consolidated balance sheet. Liabilities of the securitizations substantially represented amounts due to MBIA, which were eliminated in consolidation.
INVESTMENT MANAGEMENT SERVICES The investment management services operations have entered into derivative transactions primarily consisting of interest rate, cross currency, credit default and total return swaps and principal protection guarantees. 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. Credit default swaps are entered into to hedge credit risk or to replicate investments in cash assets consistent with the Company’s risk objectives and credit guidelines for its investment management business. The maximum amount of future payments the Company may be required to make under credit default swap contracts, should a full credit event occur on all of its outstanding contracts, is $1.6 billion. These credit default swaps reference credits with an average quality of AA-/Aa3 and have a maturity range of 1-5 years. In accordance with SFAS 133, the fair values of these credit default swaps at December 31, 2005 are recorded on the consolidated balance sheet as assets and liabilities, representing gross gains and losses, of $5.2 million and $17 thousand, respectively. 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 principal protection guarantees.
The Conduits primarily enter into interest rate and cross currency swaps as economic hedges against interest rate and currency risks. The cross currency swaps qualify as fair value hedges of foreign currency risk under SFAS 133. During 2005, the Company recorded gains of $1.7 million (net of tax) in earnings due to the ineffectiveness of these hedges. The Company also recorded gains of $12.4 million (net of tax) on economic hedges that did not qualify for hedge accounting under SFAS 133.
Cash flow hedges related to the investment management services operations resulted in an aggregate net unrealized gain of $4.2 million (net of tax) in accumulated other comprehensive income at December 31, 2005. The aggregate net unrealized gain is composed of both positive and negative future cash flows. The Company expects that approximately $.8 million of unrealized gains (net of tax) will migrate from accumulated other comprehensive income into earnings during 2006 and the remaining amount over the term of the contracts.
MUNICIPAL SERVICES Capital Asset entered into an interest rate collar to economically hedge interest rate risk on a floating rate note. The change in the fair value of the collar is recorded each period in earnings, as the collar is not a qualifying hedge under SFAS 133.
The notional values of the derivative instruments, net of reinsurance contracts where applicable, by business operations for the years ended December 31, 2005 and 2004 are as follows:
The Company manages counterparty credit risk on an individual counterparty basis through master netting agreements covering derivative transactions in the investment management services, municipal services and corporate operations. These agreements allow the Company to contractually net amounts due from a counterparty with those amounts due to such counterparty when certain triggering events occur. The Company only executes swaps under master netting agreements, which typically contain mutual credit downgrade provisions that generally provide the ability to require assignment or termination in the event either MBIA or the counterparty is downgraded below a specified credit rating. If the Company were to settle all transactions covered under netting agreements as of December 31, 2005, the amount required to be paid to counterparties would have been reduced by $173.4 million as a result of its contractual right to offset amounts due from such counterparties. The Company has chosen not to net receivables due from counterparties with payables due to counterparties in its balance sheet, but instead report these amounts on a gross basis as assets and liabilities.
In certain cases, the Company also manages credit risk through collateral agreements that give the Company the right to hold or the obligation to provide collateral when the current market value of certain derivative contracts exceeds an exposure threshold. Under these arrangements, the Company may receive or provide U.S. Treasury and other highly rated securities or cash to secure counterparties’ exposure to the Company or its exposure to counterparties, respectively. Such collateral is available to the holder to
FINANCIAL STATEMENT IMPACT As of December 31, 2005 and 2004, the Company held derivative assets of $326.9 million and $288.6 million, respectively, and derivative liabilities of $384.6 million and $527.5 million, respectively, which are shown separately on the consolidated balance sheets. The following tables display the amount of the derivative assets and liabilities by business operations for the years ended December 31, 2005 and 2004.
The income statement impact for all derivative transactions for 2005 was an after-tax increase in net income of $77.9 million. The impact of all derivative transactions for 2004 and 2003 was an after-tax increase in net income of $32.1 million and $95.5 million, respectively. The income statement impact of derivative activity is broken down into revenues, net realized gains (losses), net gains (losses) on derivative instruments and foreign exchange and expenses. Interest and fee income, including premiums received on insured derivatives, and interest and fee expense on derivatives are recorded within revenues and expenses. For derivatives that have been designated as qualifying hedges, income and expense are recorded as an adjustment to those of the hedged items. The following tables display the impact described above on the 2005, 2004 and 2003 income statements by business operation of all derivative transactions.
At December 31, 2005, the Company reported an accumulated unrealized gain of $6.0 million (net of tax) in other comprehensive income related to the fair value of the cash flow hedges compared to a $3.3 million unrealized gain (net of tax) at December 31, 2004. The change resulted from a $2.3 million after-tax unrealized gain in the fair value of the cash flow hedges and the transfer of $.5 million of after-tax net expense to earnings as a result of scheduled interest payments and receipts on the cash flow hedges. At December 31, 2005, the maximum term of derivative instruments that hedge forecasted transactions was approximately 13 years.
The Company enters into securities borrowing and lending contracts in connection with MBIA’s collateralized investment and repurchase agreement activities and to invest short-term cash balances or provide liquidity to the Company’s asset/liability programs. Such contracts are only transacted with high quality dealer firms. It is the Company’s policy to take possession of securities borrowed under these contracts.
SFAS 140 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. At December 31, 2005 and 2004, the fair values of financial assets pledged as collateral under securities borrowing contracts were $729 million and $731 million, respectively.
Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted earnings per share shows the dilutive effect of all stock options and other items outstanding during the period that could potentially result in the issuance of common stock. As of December 31, 2005, 2004 and 2003 there were 2,837,793, 2,294,297 and 5,606,205 stock options, respectively, that were not included in the diluted earnings per share calculation because they were antidilutive.
the acquisitions of MBIA Corp. and MBIA Illinois were recorded at statutory book value. Therefore, no goodwill was recorded. Under GAAP, goodwill represents the excess of the cost of acquisitions over the fair value of the net assets acquired;
Consolidated net income of MBIA Corp. determined in accordance with statutory accounting practices for the years ended December 31, 2005, 2004 and 2003 was $633.0 million, $768.5 million and $669.2 million, respectively.
The following is a reconciliation of consolidated shareholders’ equity presented on a GAAP basis for the Company and its consolidated subsidiaries to statutory capital and surplus for MBIA Corp. and its subsidiaries:
The NYSID recognizes only statutory accounting practices prescribed or permitted by the State of New York and the NYSID has adopted the National Association of Insurance Commissioners (NAIC) Accounting Practices and Procedures Manual as a component of the NYSID’s prescribed or permitted practices.
The NYSID does not allow goodwill to be an admitted asset, while the NAIC requires goodwill recognition. At December 31, 2005 and 2004, MBIA Corp. has reduced admitted assets by $76.9 million related to goodwill. The NYSID prescribes discounting of case basis loss reserves. Incurred losses and LAE include amounts discounted at 5.0% and 4.8% for 2005 and 2004, respectively. The discount for 2005 was $28.1 million and for 2004 was $37.6 million. NYSID prescribed procedure enables MBIA Corp. to account for Channel Reinsurance Ltd. (Channel Re), a Triple-A rated financial guarantee reinsurance company in which MBIA Corp. holds a 17.4% ownership interest, as other investments rather than as an affiliate. The NYSID prescribes the treatment of estimated lease receipts related to a paid loss as a non-admitted asset, while the NAIC requires these anticipated receipts to offset loss reserves. As of December 31, 2005 and 2004, MBIA Corp. has reduced admitted assets by $22.2 million and $34.4 million, respectively.
The following tables set forth the amortized cost and fair value of the available-for-sale fixed-maturity and short-term investments included in the consolidated investment portfolio of the Company as of December 31, 2005 and 2004:
Fixed-maturity investments carried at fair value of $12.9 million and $13.8 million as of December 31, 2005 and 2004, respectively, were on deposit with various regulatory authorities to comply with insurance laws.
A portion of the obligations under investment agreements require the Company to pledge securities as collateral. As of December 31, 2005 and 2004, the fair value of securities pledged as collateral with respect to these obligations approximated $4.6 billion and $3.6 billion, respectively.
Included in the preceding tables are investments that have been insured by MBIA Corp. (MBIA Insured Investments). At December 31, 2005, MBIA Insured Investments, at fair value, represented $8.8 billion or 28% of the total portfolio, of which $4.5 billion or 14% relate to Conduit investments. Without giving effect to the MBIA guarantee of the MBIA Insured Investments, the underlying ratings (those given to an investment without the benefit of MBIA’s guarantee) of the MBIA Insured Investments as of December 31, 2005 are reflected in the following table. Amounts represent the fair value of such investments including the benefit of the MBIA guarantee. The ratings in the table below are the lower underlying rating assigned by S&P or Moody’s when an underlying rating exists from either rating service, or when an external underlying rating is not available, the underlying rating is based on the Company’s best estimate of the rating of such investment.
It is MBIA’s policy to obtain an underlying rating from both Moody’s and S&P for each new Conduit transaction prior to the execution of such transactions. All transactions currently funded in the Conduits have an underlying rating of investment grade by Moody’s and S&P prior to funding. The weighted-average underlying rating for transactions currently funded in the Conduits was A- by S&P and A3 by Moody’s at the time such transactions were funded. MBIA estimates that the weighted-average underlying rating of all outstanding Conduit transactions was A- by S&P and A3 by Moody’s as of December 31, 2005.
The following table sets forth the gross unrealized losses included in accumulated other comprehensive income as of December 31, 2005 related to available-for-sale fixed-maturity and equity investments. The table segregates 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 sets forth the gross unrealized losses of the held-to-maturity investments as of December 31, 2005. Held-to-maturity investments are reported at amortized cost on the Company’s balance sheet. The table segregates 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.
As of December 31, 2005, the Company’s available-for-sale fixed-maturity, equity and held-to-maturity investment portfolios’ gross unrealized losses totaled $167.3 million. There were 244 securities that were in an unrealized loss position for a continuous twelve-month period or longer. Only two of the 244 securities had unrealized losses in which their book value exceeded market value by more than 5%. MBIA determined that the unrealized losses on these two securities were temporary in nature because there was no deterioration of credit quality spreads or a downgrade to below investment grade by at least one rating agency. Additionally, the Company has both the ability and intent to hold these investments until the value recovers to an amount at least equal to amortized cost or to maturity. See Note 13 for information on realized losses due to other-than-temporary impairments.
The Company files a consolidated tax return that includes all of its U.S. subsidiaries. The effect of income taxes on income and shareholders’ equity is comprised of:
The tax effects of temporary differences that give rise to deferred tax assets and liabilities at December 31, 2005 and 2004 are presented in the following table:
As it is the Company’s practice and intent to permanently reinvest the earnings of MBIA Assurance, S.A. and MBIA UK Insurance Limited (MBIA UK), no U.S. deferred income taxes have been provided with respect to the undistributed earnings of these entities. The cumulative amounts of such untaxed earnings were $144.4 million, $106.0 million and $67.2 million at December 31, 2005, 2004 and 2003, respectively.
MBIA provides innovative and cost-effective products and services that meet the credit enhancement, financial and investment needs of its public- and private-sector clients worldwide. MBIA manages its activities primarily through three principal business operations: insurance, investment management services and municipal services. The Company has defined reportable segments within its business operations based on the way management assesses the performance and resource requirements of such operations.
The asset/liability products segment is principally comprised of the activities of MBIA Investment Management Corp. (IMC), MBIA Global Funding, LLC (GFL) and Euro Asset Acquisition Limited (EAAL). IMC, along with MBIA Inc., provides customized investment agreements, guaranteed by MBIA Corp., 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 issuances. GFL raises funds through the issuance of MTNs with varying maturities, which are in turn guaranteed by MBIA Corp. GFL lends the proceeds of these MTN issuances to MBIA Inc. and EAAL (GFL Loans). MBIA Inc. and EAAL invest the proceeds of investment agreements and GFL Loans in eligible investments, which consist of investment grade securities with a minimum average Double-A credit quality rating. These investments are pledged to MBIA Corp. as security for its guarantees on investment agreements and MTNs. MBIA Inc. primarily purchases domestic assets and EAAL primarily purchases foreign assets as permitted under the Company’s investment guidelines.
The Company’s conduit segment administers three multi-seller conduit financing vehicles, Triple-A, Meridian and Polaris through MBIA Asset Finance, LLC. The Conduits provide funding for multiple customers through special purpose vehicles that issue primarily commercial paper and medium-term notes.
The Company’s corporate operations constitute a reportable segment and 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.
Under New York State insurance law, without prior approval of the superintendent of the state insurance department, financial guarantee insurance companies can pay dividends from earned surplus subject to retaining a minimum capital requirement. In MBIA Corp.’s case, regular dividends in any twelve-month period cannot be greater than 10% of policyholders’ surplus as shown on MBIA Corp.’s latest filed statutory financial statements. In 2005 and 2004, MBIA Corp. declared and paid regular dividends of $95 million and $372 million, respectively, to MBIA Inc.
In addition to its regular dividends, in the fourth quarter of 2004 MBIA Corp. declared and paid a special dividend of $375 million to MBIA Inc., which was approved by the NYSID. MBIA Corp.’s capital position, relative to its insured exposure, had improved substantially over the past several years as a result of improved premium rates and a higher quality insured portfolio, exceeding both the capital required by New York State insurance law and the rating agencies for purposes of maintaining its Triple-A ratings. The proceeds have been used primarily for share repurchases, general liquidity and other corporate purposes.
During 2005, 2004 and 2003, the Company purchased 5.9 million, 5.8 million and 1.9 million shares of common stock at an aggregate cost of $341.5 million, $328.9 million and $79.9 million, respectively. As of December 31, 2005, the Company had repurchased a total of 21.3 million shares under these plans at an average price of $50.28 per share. 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. Share repurchases increase the Company’s treasury stock, which is carried at cost as a component of stockholders’ equity.
The Company’s short-term debt consists of floating rate certificates issued as part of Tender Option Bond (TOB) trades. A TOB trade is a repackaging of municipal bonds, effectively providing MBIA with leveraged securitized financing of long-term bonds at short-term tax-exempt rates. At December 31, 2005 and 2004, floating rate certificates related to the TOB trades included in short-term debt totaled $58.7 million. The aggregate weighted-average interest rate as of December 31, 2005 and 2004 was 3.55% and 1.43%, respectively. Assets supporting these certificates are included in the Company’s available-for-sale fixed-maturity investment portfolio.
Bears interest at three-month LIBOR plus a fixed spread. The interest rate in effect as of December 31, 2005 and 2004 was 5.180% and 3.170%, respectively.
In December 2005, the Company called and redeemed its $100 million outstanding 8% Public Income Notes Securities (PINES) due on December 15, 2040. The PINES were redeemed at a price equal to one hundred percent of the principal amount plus accrued and unpaid interest thereon to the date of redemption.
MBIA Corp. has access to $400 million of Money Market Committed Preferred Custodial Trust securities (CPCT securities) issued by eight trusts, which were created for the primary purpose of issuing CPCT 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 the 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 general unsecured creditors, but senior to any common stockholders of MBIA Corp.
The trusts are vehicles 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 and Aa2, respectively. To date, MBIA Corp. has not exercised its put options under any of these arrangements.
Medium-term note obligations are recorded as liabilities on the Company’s balance sheet based upon proceeds received, net of unamortized discounts and premiums, plus unpaid accrued interest at the balance sheet date. Medium-term notes are issued by GFL as part of MBIA’s asset/liability products and by Meridian, Triple-A and Polaris as part of MBIA’s conduit program. In 2005, GFL issued 2.3 billion of U.S. dollar and 250.0 million of Euro-denominated medium-term notes. Medium-term notes have been issued with either fixed or floating interest rates. As of December 31, 2005, the annual interest rates of the medium-term notes ranged from 2.80% to 5.89% and the weighted-average interest rate was 5.24%. As of December 31, 2004, the annual interest rates of the medium-term notes ranged from 0.09% to 5.98% and the weighted-average interest rate was 3.09%. Principal payments due under medium-term note obligations based on their contractual maturity dates are as follows:
MBIA Corp. guarantees the timely payment of principal and interest on municipal, asset-/mortgage-backed and other non-municipal securities. MBIA Corp.’s ultimate exposure to credit loss in the event of nonperformance by the insured is represented by the net insurance in force in the tables that follow.
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 asset pools, as well as their historical and projected performance. The strength of a 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, which is 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, 2005, insurance in force, net of cessions to reinsurers and other reimbursement agreements, had an expected maturity range of 1-51 years. Other reimbursement agreements that have been netted from the Company’s insurance in force as reported below relate to contracts under which the Company is entitled to reimbursement of losses on its insured portfolio but which do not qualify as reinsurance under GAAP. These agreements resulted in deductions of $11.2 billion and $14.1 billion for 2005 and 2004, respectively. The distribution of net insurance in force by geographic location, excluding $15.7 billion and $12.7 billion relating to transactions guaranteed by MBIA Corp. on behalf of various investment management services’ affiliated companies in 2005 and 2004, 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 $106.7 billion and $112.8 billion. The distribution of ceded insurance in force by geographic location is set forth in the following table:
The distribution of ceded insurance in force, including other reimbursement agreements, by type of bond is set forth in the following table:
Reinsurance enables the Company to cede exposure for purposes of increasing its capacity to write new business while complying with its single risk and credit guidelines. The rating agencies continuously review reinsurers providing coverage to the financial guarantee industry. When a reinsurer is downgraded, less capital credit is given to a financial guarantee provider under rating agency models. Over the past several years, many of MBIA’s reinsurers have been downgraded and others remain under review. Any reduced capital credit associated with reinsurer downgrades has not and is not expected to have a material adverse effect on the Company. The Company generally retains the right to reassume the business ceded to reinsurers under certain circumstances, including rating downgrades of its reinsurers. Additionally, MBIA requires certain reinsurers to maintain bank letters of credit or establish trust accounts to cover liabilities ceded to such reinsurers under reinsurance contracts. As of December 31, 2005, the total amount available under these letters of credit and trust arrangements was $593.5 million. For the years ended December 31, 2005, 2004 and 2003, recoveries received under reinsurance contracts totaled $5.8 million, $17.7 million and $6.4 million, respectively. The following table shows the percentage ceded to and reinsurance recoverable from reinsurers by rating levels:
While Channel Re continues to be a Triple-A rated reinsurer of MBIA, S&P has revised their outlook on Channel Re from stable to negative in 2005. Additionally, MBIA owned an equity interest of 17.4% and 11.4% in Channel Re and RAM Holdings Ltd., the holding company of Ram Reinsurance Company, Ltd., respectively, at December 31, 2005.
In February 2004, MBIA Corp. and Channel Re entered into treaty and facultative reinsurance arrangements whereby Channel Re agreed to provide committed reinsurance capacity to MBIA Corp. through June 30, 2008 and subject to renewal thereafter. Under these reinsurance arrangements, MBIA Corp. agreed to cede to Channel Re and Channel Re agreed to assume from MBIA Corp. varying percentages of designated policies issued by MBIA Corp. The amount of any policy subject to the committed reinsurance arrangements is based on the type of risk insured and on other factors. Additionally, the reinsurance arrangements provide Channel Re with certain preferential terms, including those related to ceding commissions.
(1) Represents the amount of losses and LAE incurred that have been eliminated in proportion to MBIA’s ownership interest in Channel Re, which is carried on an equity method accounting basis.
Unallocated loss reserves approximated $209 million at December 31, 2005, which represent the Company’s estimate of losses associated with credit deterioration that has occurred in the Company’s insured portfolio and are available for future case-specific activity. The Company incurred $84 million of loss and loss adjustment expenses in 2005 based on 12% of scheduled earned premium. Additionally, the Company had salvage and subrogation of $143 million and $154 million as of December 31, 2005 and 2004, respectively, included in “Other assets.”
The Company has a non-contributory, defined contribution pension plan to which the Company contributes 10% of each eligible employee’s annual compensation. Annual compensation consists of base salary, bonus and commissions, as applicable, for determining such contributions. Pension benefits vest over a five-year period with 60% vesting after three years and 20% in years four and five. Pension expense for the years ended December 31, 2005, 2004 and 2003 was $9.5 million, $9.7 million and $10.1 million, respectively.
On May 5, 2005, the Company’s shareholders approved the MBIA Inc. 2005 Omnibus Incentive Plan (the Omnibus plan). Under the Omnibus plan, a maximum of 6,000,000 shares of the Company’s common stock can be used for any type of award including stock options, performance shares, performance units, restricted stock, restricted stock units and dividend equivalents. Any shares issued under the Omnibus plan in connection with stock options shall be counted against this limit as one share covered by such option. For all awards other than stock options, any shares issued shall be counted against this limit as two shares for every share issued.
In 2005 and 2004, under all plans in effect, a total of 465,676 and 603,267, respectively, restricted shares (net of cancellations) of the Company’s common stock were granted to employees and directors of the Company. The fair value of the shares awarded (net of cancellations) in 2005 and 2004, determined on the grant date, was $27.2 million and $36.6 million, respectively. Restricted shares have been recorded as a separate component of shareholders’ equity as “Unearned compensation-restricted stock” on the Company’s Consolidated Balance Sheets and have been included in “Stock-based compensation” on the Company’s Consolidated Statements of Changes in Shareholders’ Equity. Unearned compensation is amortized to expense over the appropriate three- to five-year vesting period (except for a minor portion granted to members of the MBIA Inc. board of directors which is amortized over a ten-year period). Compensation expense related to the restricted stock was $18.5 million, $12.1 million and $6.3 million for the years ended December 31, 2005, 2004 and 2003, respectively.
In December 1995, the MBIA Inc. board of directors approved the “MBIA Long-Term Incentive Program” (the incentive program). The incentive program has been superceded by the Omnibus plan. The incentive program included a stock option component and a compensation component linked to the growth in modified book value over a three-year period following the grant date. Target levels for the incentive program awards were established as a percentage of total salary and bonus, based upon the recipient’s position. Awards under the incentive program typically were granted from the vice president level up to and including the 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 were 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 2005, 2004 and 2003, $8.5 million, $25.1 million and $21.8 million, respectively, were recorded as an expense related to modified book value awards.
The fair value for these options was estimated at the date of grant using the Black-Scholes option pricing model. The number of significant options granted and the assumptions used for valuing such option grants during the last three years are shown in the following table:
Principal owners of the Company defined as owners of record or known beneficial owners of more than 10 percent of the voting interests of the Company.
MBIA Inc., through its subsidiaries, is responsible for providing investment advisory and certain related administrative services to the MBIA Capital/Claymore Managed Duration Investment Grade Municipal Fund and, prior to the sale of 1838, provided such services to the 1838 Bond-Debenture Trading Fund and the 1838 Investment Advisors Funds (collectively, the “Funds”). Additionally, MBIA, Inc., through its subsidiaries, earned investment management, accounting, administration and service fees related to the Funds, which aggregated $0.7 million, $0.9 million and $1.4 million for the years ended December 31, 2005, 2004 and 2003, respectively, and are included in investment management services revenues in the Company’s income statement.
SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE-The fair value is estimated using discounted cash flow calculations based upon interest rates currently being offered for similar agreements.
DERIVATIVES-The fair value is derived from market information and appropriate valuation methodologies which reflect the estimated amounts that the Company would receive or pay to terminate the transaction at the reporting date.
On October 3, 2005, the Court of Appeals for the Third Circuit upheld the decision of the United States District Court for the District of Delaware enforcing the Royal insurance policies and remanded the case to the District Court for a determination of whether the Royal policies cover all losses claimed under the policies. In particular, the Court of Appeals directed the District Court to consider whether the Royal policies cover losses resulting from the misappropriation rather than from defaults by students. MBIA Corp. believes that the Royal policies cover losses even if they result from misappropriations of student payments, but in any event it appears that all or substantially all of the claims made under the Royal policies relate to defaults by students rather than misappropriation of funds. Therefore, MBIA Corp. expects Royal to be required to pay all or substantially all of the claims made under its policies and to be reimbursed for any payments MBIA Corp. made under its policies. Royal has requested that the case be reheard en banc.
The allegations contained in the lawsuit include, among other things, violations of the federal securities laws arising out of the Company’s allegedly false and misleading statements about its financial condition and the nature of the arrangements entered into by MBIA Corp. in connection with the AHERF loss. The plaintiffs allege that, as a result of these misleading statements or omissions, the Company’s stock traded at artificially inflated prices. These lawsuits seek unspecified compensatory damages in connection with purchases by members of the class of the Company’s stock at such allegedly inflated prices during the Class Period. The Company does not expect the outcome of the private securities litigation to have a material adverse affect on its financial condition, although the outcome is uncertain and no assurance can be given that the Company will not suffer a loss.