Year Ended December 31, 2000 versus Year Ended December 31, 1999
Adjusted book value per common share of the Company was $59.52 at December 31, 2000, up 18.3% including dividends since year-end 1999. Excluding realized and unrealized capital gains and losses, adjusted book value per share rose 12.5% including dividends. Management and some equity analysts use adjusted book value per common share as a proxy for the Company's intrinsic value, exclusive of franchise value. It is defined as book value plus the after-tax present value of all deferred premium income and the change in value of forward shares (for 1999), less deferred expenses. Adjusted book value is not a substitute for GAAP book value.
The Company's 2000 net income was $63.3 million ($138.8 million excluding merger-related costs), compared with $125.4 million for 1999, a decrease of 49.5%. Core net income was $176.0 million for 2000, compared with $140.0 million for 1999, an increase of 25.7%. Total core revenues increased in 2000 by $46.6 million, to $303.7 million for 2000 from $257.1 million for 1999, while total core expenses increased only $3.0 million. Operating net income was $181.5 million for 2000 versus $146.7 million for 1999, an increase of $34.8 million, or 23.7%.
In the U.S. asset-backed securities market, strong collateralized debt obligation (CDO) production and repeat business from auto loan and residential mortgage issuers contributed to FSA's 2000 results. FSA also increased its participation in other sectors, including franchise loans, sub-prime credit cards and manufactured housing. For the year, par value reached $28.0 billion and PV premiums totaled $198.9 million, compared to $24.8 billion and $200.4 million, respectively, for 1999.
The Company's investment portfolio holdings are primarily U.S. dollar-denominated fixed-income securities, including municipal bonds, U.S. government and agency bonds, and mortgage-backed, asset-backed and corporate securities. In calculating the sensitivity to interest rates for the taxable securities, U.S. Treasury rates are changed instantaneously by 1.0%, and the option-adjusted spreads of the securities are held constant. Tax-exempt securities are subjected to a change in the municipal Triple-A obligation curve that would be equivalent to a 1.0% taxable interest rate change based on the average taxable/tax-exempt ratios for the prior 12 months. The simulation for tax-exempts calculates duration by taking into account the applicable call date if the bond is at a premium or the maturity date if the bond is at a discount.
The Company encountered no problems in its systems or its vendors' systems due to the arrival of Year 2000. The cost to the Company for Y2K compliance was immaterial. Based on the information FSA has received from servicers and trustees, management believes that FSA will not incur any claims under its financial guaranty contracts as a result of Y2K.
Year Ended December 31, 1999 versus Year Ended December 31, 1998
Adjusted book value per common share was $52.57 at December 31, 1999, up 11.4% including dividends since year-end 1998. Excluding realized and unrealized capital gains and losses, adjusted book value per share rose 17.5% including dividends.
The Company's 1999 net income was $125.4 million, compared with $115.4 million for 1998, an increase of 8.7%. Core net income was $140.0 million for 1999, compared with $107.5 million for 1998, an increase of 30.3%. Total core revenues increased in 1999 by $55.7 million, to $257.1 million for 1999 from $201.4 million for 1998, while total core expenses increased $15.0 million. Operating net income was $146.7 million for 1999 versus $114.9 million for 1998, an increase of $31.8 million, or 27.6%.
In international markets, FSA had a breakthrough year, as the asset-backed and infrastructure markets expanded. FSA insured $8.7 billion of international par, compared with $2.5 billion in 1998, to generate PV premiums of $133.8 million, compared with $23.2 million in 1998. In its international business, FSA focuses on Western Europe and on certain developed countries in the Asia Pacific region, specifically Japan, Australia and New Zealand. During 1999 in Europe, FSA expanded its participation in financings under the United Kingdom's Private Finance Initiative (PFI), a government-sponsored program designed to privatize public assets. It also guaranteed several large structured finance transactions and was active in the synthetic CDO sector. Proposed changes in international guidelines for bank regulation are driving growth in the synthetic market. In Japan, despite modest volume, FSA completed transactions in the consumer receivables and CDO markets and prepared for greater participation as the Japanese securitization market matures.
FSA's ability to pay dividends is dependent upon FSA's financial condition, results of operations, cash requirements, rating agency approval and other related factors, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under New York insurance law, FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (i) 10% of policyholders' surplus as of its last statement filed with the New York Superintendent of Insurance or (ii) adjusted net investment income during this period. FSA paid no dividends in 2000. Based upon FSA's statutory statements for the year ended December 31, 2000, and considering dividends that can be paid by its subsidiary, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the following 12 months is approximately $79.7 million. However, as a customary condition for approving the application of Dexia for a change in control of FSA, the prior approval of the Superintendent of the New York State Insurance Department is required for any payment of
dividends by FSA to the Company for a period of two years following the change in control, which occurred July 5, 2000. In addition, the Company holds $120.0 million of surplus notes of FSA. Payments of principal or interest on such notes may be made only with the approval of the New York Insurance Department.
In connection with the merger, FSA repurchased $55.0 million of its stock from the Company, and the Company sold 511,031 of its shares held in a rabbi trust to Dexia for $38.6 million. The proceeds from these transactions were used to fund the Company's obligations under certain of its long-term, equity-based compensation programs.
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 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.
FSA's primary uses of funds are to pay operating expenses and to pay dividends to, or repay surplus notes held by, its parent. FSA's funds are also required to satisfy claims under insurance policies in the event of default by an issuer of an insured obligation and the unavailability or exhaustion of other payment sources in the transaction, such as the cash flow or collateral underlying the obligations. FSA seeks to structure asset-backed transactions to address liquidity risks by matching insured payments with available cash flow or other payment sources. The insurance policies issued by FSA provide, in general, that payments of principal, interest and other amounts insured by FSA may not be accelerated by the holder of the obligation but are paid by FSA in accordance with the obligation's original payment schedule or, at FSA's option, on an accelerated basis. These policy provisions prohibiting acceleration of certain claims are mandatory under Article 69 of the New York Insurance Law and serve to reduce FSA's liquidity requirements.
FSA has a credit arrangement, aggregating $150.0 million at December 31, 2000, that is provided by commercial banks and intended for general application to transactions insured by FSA and its insurance company subsidiaries. At December 31, 2000, there were no borrowings under this arrangement, which expires on April 27, 2001, unless extended. In addition, there are credit arrangements assigned to specific insured transactions. In August 1994, FSA entered into a facility agreement with Canadian Global Funding Corporation and Hambros Bank Limited. Under the agreement, FSA can arrange financing for transactions subject to certain conditions. The amount of this facility was $186.9 million, of which $113.4 million was unutilized at December 31, 2000.
FSA has a standby line of credit in the amount of $240.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $240.0 million or 5.75% of average annual debt service of the covered portfolio. 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 beginning on April 30, 2000 and expiring on April 30, 2007 and contains an annual renewal provision subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2000.
The Company has no plans for material capital expenditures within the next twelve months.
Financial Security Assurance Holdings Ltd. and Subsidiaries Index to Consolidated Financial Statements and Schedules
Consolidated Balance Sheets as of December 31, 2000 and 1999 34
Consolidated Statements of Operations and Comprehensive Income for the years ended December 31, 2000, 1999 and 1998 35
Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2000, 1999 and 1998 36
II Condensed Financial Statements of the Registrant as of December 31, 2000 and 1999 and for the years ended December 31, 2000, 1999 and 1998 74
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Financial Security Assurance Holdings Ltd. and Subsidiaries at December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents 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 schedule are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share data)
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, 2000 and 1999 and the reported amounts of revenues and expenses in the consolidated statements of operations and comprehensive income during the years ended December 31, 2000, 1999 and 1998. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses and the deferral and amortization of deferred policy acquisition costs. Actual results may differ from those estimates. Significant accounting policies under GAAP are as follows:
The consolidated financial statements include the accounts of the Company and its direct and indirect subsidiaries, FSA Portfolio Management Inc., Transaction Services Corporation, Financial Security Assurance Inc. (FSA), FSA Insurance Company, Financial Security Assurance International Ltd. (International), FSA Services (Australia) Pty Limited, Financial Security Assurance of Oklahoma, Inc. and Financial Security Assurance (U.K.) Limited (collectively, the Subsidiaries). All intercompany accounts and transactions have been eliminated. Certain prior-year balances have been reclassified to conform to the 2000 presentation.
The Company also maintains a non-specific general reserve, which is available to be applied against future additions or accretions to existing case basis reserves or to new case basis reserves to be established in the future. The general reserve is calculated by applying a loss factor to the total net par amount outstanding of the Company's insured obligations over the term of such insured obligations and discounting the result at risk-free rates. The loss factor used for this purpose has been determined based upon an independent rating agency study of bond defaults and the Company's portfolio characteristics and history.
The provision for income taxes consists of an amount for taxes currently payable and a provision for tax consequences deferred to future periods reflected at current income tax rates.
The credit quality of bonds at December 31, 2000 was as follows:
The amortized cost and estimated market value of bonds were as follows (in thousands):
2000 1999 1998 ---- ---- ---- Bonds $ 172,180 $(120,006) $ 15,319 Equity investments 6,239 (10,449) 2,842 Other (1,017) 1,017 --------- --------- --------- Change in net unrealized gains (losses) $ 178,419 $(131,472) $ 19,178 ========= ========= =========
The amortized cost and estimated market value of bonds at December 31, 2000, 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 during 2000, 1999 and 1998 were $1,452,485,000, $2,162,425,000 and $1,889,130,000, respectively. Gross gains of $10,262,000, $17,896,000 and $27,439,000 and gross losses of $41,217,000, $32,406,000 and $8,585,000 were realized on sales in 2000, 1999 and 1998, respectively.
Proceeds from sales of equity investments during 2000, 1999 and 1998 were $14,167,000, $87,471,000 and $33,613,000, respectively. Gross gains of $0, $11,707,000 and $2,684,000 and gross losses of $5,927,000, $5,008,000 and $1,331,000 were realized on sales in 2000, 1999 and 1998, respectively. Equity investments had no gross unrealized gains and gross unrealized losses of $259,000 and $6,498,000 as of December 31, 2000 and 1999, respectively.
GAAP for the Subsidiaries differs in certain significant respects from accounting practices prescribed or permitted by insurance regulatory authorities. The principal differences result from the following statutory accounting practices:
- Upfront premiums on municipal business are recognized as earned when related principal and interest have expired rather than over the expected coverage period;
- Acquisition costs are charged to operations as incurred rather than as related premiums are earned;
- A contingency reserve (rather than a general reserve) is computed based on the following statutory requirements:
(ii) 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;
- Certain assets designated as "non-admitted assets" are charged directly to statutory surplus but are reflected as assets under GAAP;
- Federal income taxes are provided only on taxable income for which income taxes are currently payable;
- Surplus notes are recognized as surplus rather than a liability.
GAAP BASIS $ 1,465,733 $ 1,251,984 Non-insurance companies liabilities, net 23,133 42,962 Premium revenue recognition (124,878) (110,650) Loss and loss adjustment expense reserves 65,204 54,971 Deferred acquisition costs (201,136) (198,048) Contingency reserve (608,335) (473,387) Unrealized loss (gain) on investments, net of tax (104,080) 67,179 Deferred income taxes 123,121 53,357 Accrual of deferred compensation 52,004 80,811 Surplus notes 120,000 120,000 Other 17,580 (42,484) ----------- -----------
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, will file 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 $18,629,000 and $6,537,000 at December 31, 2000 and 1999, respectively.
The cumulative balance sheet effects of deferred tax consequences are (in thousands):
No valuation allowance was necessary at December 31, 2000 or 1999.
The Company was party to forward share agreements with certain counterparties and made the economic benefit and risk of a number of these shares available for subscription by certain of the Company's employees and directors. The Company has recognized compensation expense relating to the forward shares at December 31, 1999 and 1998 of $(1,865,000) and $2,495,000, respectively. As part of the merger, the Company settled all of its forward share agreements and corresponding employee and director subscriptions at the merger price. The Company recognized compensation expense of $30,324,000 as a result of the settlement. In addition, the Company recognized an increase to additional paid-in capital of $39,408,000, reflecting the amounts received from the counterparties.
Under New York Insurance Law, FSA may pay a dividend to the Company without the prior approval of the Superintendent of the New York State Insurance Department only from earned surplus subject to the maintenance of a minimum capital requirement. In addition, the dividend, together with all dividends declared or distributed by FSA during the preceding twelve months, may not exceed the lesser of 10% of its policyholders' surplus shown on FSA's last filed statement, or adjusted net investment income, as defined, for such twelve-month period. As of December 31, 2000, FSA had $79,737,000 available for the payment of dividends over the next twelve months. However, as a customary condition for approving the application of Dexia for a change in control of FSA, the prior approval of the Superintendent of the New York State Insurance Department is required for any payment of dividends by FSA to the Company for a period of two years following the change in control, which occurred July 5, 2000. In addition, the Company holds $120,000,000 of surplus notes of FSA. Payments of principal or interest on such notes may be made with the approval of the New York Insurance Department. In 1998, FSA repurchased $8,500,000 of its shares from its parent, representing the balance remaining of $75,000,000 that had been approved for repurchase by the New York Insurance Department. In July 2000, in connection with the merger, FSA repurchased $55,000,000 of its stock from the Company.
FSA has a credit arrangement aggregating $150,000,000 at December 31, 2000, which is provided by commercial banks and intended for general application to transactions insured by the Subsidiaries. At December 31, 2000, there were no borrowings under this arrangement, which expires on April 27, 2001, if not extended. In addition, there are credit arrangements assigned to specific insured transactions. In August 1994, FSA entered into a facility agreement with Canadian Global Funding Corporation and Hambros Bank Limited. Under the agreement, which expires in August 2004, FSA can arrange financing for transactions subject to certain conditions. The amount of this facility was $186,911,000, of which $113,426,000 was unutilized at December 31, 2000.
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 $544,642,000 at December 31, 2000. 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 beginning on April 30, 2000 and expiring on April 30, 2007 and contains an annual renewal provision subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2000.
Performance shares are awarded under the Company's 1993 Equity Participation Plan. The Plan authorizes the discretionary grant of performance shares by the Human Resources Committee to key employees of the Company and its subsidiaries. The amount earned for each performance share depends upon the attainment by the Company of certain growth rates of adjusted book value per outstanding share over a three-year period. No payout occurs if the compound annual growth rate of the Company's adjusted book value per outstanding share is less than 7% and a 200% payout occurs if the compound annual growth rate is 19% or greater. Payout percentages are interpolated for compound annual growth rates between 7% and 19%.
Year Ended December 31, ----------------------- 2001 $2,915 2002 2,660 2003 2,683 2004 2,683 2005 2,459 ------- Total $13,400 =======
Rent expense for the years ended December 31, 2000, 1999 and 1998 was $5,067,000, $4,352,000 and $4,372,000, respectively.
The Subsidiaries obtain reinsurance to increase their policy-writing capacity, on both an aggregate-risk and a single-risk basis; to meet rating agency, internal and state insurance regulatory limits; to diversify risk; to reduce the need for additional capital; and to strengthen financial ratios. The Subsidiaries reinsure portions of their risks with affiliated (see Note 15) and unaffiliated reinsurers under quota share, first-loss and excess-of-loss treaties and on a facultative basis.
Amounts of reinsurance ceded and assumed were as follows (in thousands):
The Company's policies insure the scheduled payments of principal and interest on asset-backed and municipal obligations. The principal amount insured (in millions) as of December 31, 2000 and 1999 (net of amounts ceded to other insurers) and the terms to maturity are as follows:
The principal amount ceded as of December 31, 2000 and 1999 and the terms to maturity are as follows (in millions):
The Subsidiaries ceded premiums of $25,659,000 on a quota share basis to Enhance Reinsurance Company and Asset Guaranty Insurance Company, former affiliates of MediaOne, for the year ended December 31, 1998. The Subsidiaries ceded loss and loss adjustment expense recoveries of $4,134,000 to these affiliates for the year ended December 31, 1998.
Bonds and equity investments -- The carrying amount represents fair value. 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 present value of the expected cash flows for specifically identified claims and potential losses in the Company's insured portfolio.
The Company's liability for losses and loss adjustment expenses consists of the case basis and general reserves. Activity in the liability for losses and loss adjustment expenses is summarized 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, 2000, 1999 and 1998 are as follows (in thousands): 2000 1999 1998 ---- ---- ----
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133). SFAS No. 133 was subsequently amended by SFAS No. 137 and SFAS No. 138. These statements established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and hedging activities. They require 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 that would be considered 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. The adoption on January 1, 2001 of this standard will not have a material impact on the Company's financial position, results of operations or cash flows.