We and our subsidiaries currently occupy approximately over 142,000 square feet of leased office space in Bermuda, New York, London and Sydney. Included in that amount are 45,000 square feet for New York office space for the lease that will expire in March 2009. In June 2008, the Company's subsidiary, Assured Guaranty Corp., entered into a new five-year lease agreement for New York office space. Management believes that the office space is adequate for its current and anticipated needs.
(1)Other income for the year ended December 31, 2008 and 2007 included a change in fair value of $42.7 million and $8.3 million related to Assured Guaranty Corp.'s committed capital securities entered into in April 2005. The change in fair value was $0 in 2006 and 2005.
(3)Expense ratio is calculated by dividing the sum of ceding commissions expense (income), profit commission expense, acquisition costs and operating expenses by net earned premiums plus net credit derivative premiums received and receivable, which is included in realized gains and other settlements on credit derivatives.
(6)Combined policyholders' surplus represents the addition of our combined U.S. based statutory surplus and our Bermuda based statutory surplus.
On July 21, 2008, Moody's placed under review for possible downgrade the Aaa insurance financial strength ratings of Assured Guaranty Corp. ("AGC") and its wholly owned subsidiary, Assured Guaranty (UK) Ltd., as well as the Aa2 insurance financial strength ratings of Assured Guaranty Re Ltd. ("AG Re") and its affiliated insurance operating companies. Moody's has placed under review for possible downgrade the Aa3 senior unsecured rating of parent company, Assured Guaranty US Holdings Inc. and the Aa3 issuer rating of the ultimate holding company, Assured Guaranty Ltd. Moody's revised assessment of stress-case loss estimates on our residential mortgage-backed securities portfolio did not change meaningfully from their prior estimates.
On November 21, 2008, Moody's downgraded the insurance financial strength ratings of AGC and its wholly owned subsidiary, Assured Guaranty (UK) Ltd., to Aa2 from Aaa and also downgraded the insurance financial strength ratings of AG Re and its affiliated insurance operating companies to Aa3 from Aa2. In the same rating action, Moody's downgraded the senior unsecured rating of Assured
With respect to a significant portion of our in-force financial guaranty reinsurance business, in the event that AG Re were downgraded from Aa3 to A1, subject to the terms of each reinsurance agreement, the ceding company may have the right to recapture business ceded to AG Re and assets representing substantially all of the statutory unearned premium and loss reserves (if any) associated with that business. As of December 31, 2008, the statutory unearned premium, which represents deferred revenue to the Company, subject to recapture is approximately $188 million. If this entire amount was recaptured, it would result in a corresponding one-time reduction to net income of approximately $4 million. With respect to one of AG Re's ceding companies, the right to recapture business can only be exercised if AG Re were downgraded to the A category by more than one rating agency, or below A2/A by any one rating agency. As of December 31, 2008, the statutory unearned premium subject to recapture by this ceding company is approximately $390 million. If this entire amount were recaptured, it would result in a corresponding one-time reduction to net income of approximately $43 million. Alternatively, the ceding company can increase the commissions it charges AG Re for cessions. Any such increase may be retroactive to the date of the cession. As of December 31, 2008, the potential increase in ceding commissions would result in a one-rime reduction to net income of approximately $42 million. The effect on net income under these scenarios is exclusive of any capital gains or losses that may be realized.
If a credit derivative is terminated, the Company could be required to make a mark-to-market payment as determined under the ISDA documentation. For example, if AGC's rating were downgraded to A+, under market conditions at December 31, 2008, if the counterparties exercised their right to terminate their credit derivatives, AGC would have been required to make payments that the Company estimates to be approximately $261 million. Further, if AGC's rating was downgraded to a level below BBB- it would have been required to make additional payments that the Company estimates to be approximately $620 million at December 31, 2008. The Company's mark-to-market methodology is, however, not the basis on which any such payment amount would be determined. The process for determining the amount of such payment is set forth in the credit derivative documentation and generally follows market practice for derivative contracts. The actual amounts could be materially larger than the Company's estimate.
On April 8, 2008, investment funds managed by WL Ross & Co. LLC ("WL Ross") purchased 10,651,896 shares of the Company's common equity at a price of $23.47 per share, resulting in proceeds to the Company of $250.0 million. The Company contributed $150.0 million of these proceeds to its subsidiary, Assured Guaranty Re Ltd. In addition, the Company contributed $100.0 million of these proceeds to its subsidiary, Assured Guaranty US Holdings Inc., which in turn contributed the same amount to its subsidiary, AGC. The commitment to purchase these shares was previously announced on February 29, 2008. In addition, Wilbur L. Ross, Jr., President and Chief Executive Officer of WL Ross, has been appointed to the Board of Directors of the Company to serve a term expiring at the Company's 2009 annual general meeting of shareholders. Mr. Ross's appointment became effective immediately following the Company's 2008 annual general meeting of shareholders, which was held on May 8, 2008. WL Ross has a remaining commitment through April 8, 2009 to purchase up to $750.0 million of the Company's common equity, at the Company's option, subject to the terms and conditions of the investment agreement with the Company dated February 28, 2008. In accordance with the investment agreement, the Company may exercise this option in one or more drawdowns, subject to a minimum drawdown of $50 million, provided that the purchase price per common share for the subsequent shares is not greater than $27.57, or less than $19.37, the price per common share for the initial shares. The purchase price per common share for such shares will be equal to 97% of the volume weighted average price of a common share on the NYSE for the 15 NYSE trading days prior to the applicable drawdown notice. As of December 31, 2008, and as of the date of this filing, the purchase price per common share is outside of this range and therefore the Company may not, at this time, exercise its option for WL Ross to purchase additional shares.
On September 16, 2008, the Company agreed to waive the standstill provisions of the investment agreement to permit investment funds managed by WL Ross (the "WLR Funds") to purchase up to 5,000,000 additional common shares of the Company in open market transactions from time to time. The timing and amount of any such purchases are in the sole discretion of WL Ross and they are not obligated to purchase any such shares. The additional shares purchased by the WLR Funds, if any, will be purchased from current shareholders and therefore will not result in an increase in shareholders' equity at the Company or its subsidiaries. If all 5,000,000 additional shares were purchased, the WLR Funds would beneficially own 17,166,396 shares or approximately 18.9% of the Company's outstanding common shares based on shares outstanding as of December 31, 2008. As of the date of this filing the Company has not been notified that WLR Funds purchased any additional shares of the Company.
We regularly evaluate potential acquisitions of other companies, lines of business and portfolios of risks and hold discussions with potential third parties regarding such transactions. As a general rule, we publicly announce such transactions only after a definitive agreement has been reached.
On November 14, 2008, Assured Guaranty Ltd. announced that it had entered into a definitive agreement ("the Purchase Agreement") with Dexia Holdings, Inc. ("Dexia") to purchase Financial Security Assurance Holdings Ltd. ("FSAH") and, indirectly, all of its subsidiaries, including the financial guaranty insurance company, Financial Security Assurance, Inc. The definitive agreement provides that the Company will be indemnified against exposure to FSAH's Financial Products segment,
Under the Purchase Agreement, the Company may elect to pay $8.10 per share in cash in lieu of up to 22,283,951 of the Company's common shares that it would otherwise deliver as part of the purchase price.
We derive our revenues principally from premiums from our insurance and reinsurance businesses, unrealized gains and losses and realized gains and other settlements on credit derivatives, net investment income, and net realized gains and losses from our investment portfolio. Our premiums and realized gains and other settlement on credit derivatives are a function of the amount and type of contracts we write as well as prevailing market prices. We receive payments on an upfront basis when the policy is issued or the contract is executed and/or on an installment basis over the life of the applicable transaction.
Investment income is a function of invested assets and the yield that we earn on those assets. The investment yield is a function of market interest rates at the time of investment as well as the type, credit quality and maturity of our invested assets. In addition, we could realize capital losses on securities in our investment portfolio from other than temporary declines in market value as a result of changing market conditions, including changes in market interest rates, and changes in the credit quality of our invested assets.
Changes in the fair value of the Company's credit derivatives do not reflect actual claims or credit losses, and have no impact on the Company's claims paying resources, rating agency capital or regulatory capital positions.
In 2008 and 2007 the Company also recorded a fair value gain of $42.7 million and $8.3 million, pre-tax, respectively, related to Assured Guaranty Corp.'s committed capital securities.
Reserves for losses and loss adjustment expenses for non-derivative transactions in our financial guaranty direct, financial guaranty assumed reinsurance and mortgage guaranty business include case reserves and portfolio reserves. See the "Fair Value of Credit Derivatives" of the Critical Accounting Estimates section for more information on our derivative transactions. Case reserves are established when there is significant credit deterioration on specific insured obligations and the obligations are in default or default is probable, not necessarily upon non-payment of principal or interest by an insured. Case reserves represent the present value of expected future loss payments and LAE, net of estimated recoveries, but before considering ceded reinsurance. This reserving method is different from case reserves established by traditional property and casualty insurance companies, which establish case reserves upon notification of a claim and establish incurred but not reported ("IBNR") reserves for the
The weighted average default frequencies and severities as of December 31, 2008 and December 31, 2007 are as follows:
The Company incorporates default frequency and severity by asset class into its portfolio loss reserve models. Average default frequency and severity are based on information published by rating agencies. The increase in average default frequency shown in 2008 is reflective of downgrades within the Company's direct insured portfolio, including HELOC exposures. Rating agencies update default frequency and severity information on a periodic basis, as warranted by changes in observable data.
(1)Includes portfolio reserve on credit derivatives of $39.1 million, which balance is included in credit derivative liability in the Company's consolidated balance sheets.
Specifically with respect to reserves related to our U.S. home equity line of credit ("HELOC") and other U.S. residential mortgage exposures, there exists significant uncertainty as to the ultimate performance of these transactions. As of December 31, 2008, the Company had net par outstanding of $1.7 billion related to HELOC securitizations, of which $1.5 billion are transactions with Countrywide and $1.1 billion were written in the Company's financial guaranty direct segment ("direct Countrywide transactions" or "Countrywide 2005-J" and "Countrywide 2007-D").
The performance of our HELOC exposures deteriorated during 2007 and 2008 and transactions, particularly those originated in the period from 2005 through 2007, continue to perform below our original underwriting expectations. In accordance with our standard practice, during the year ended December 31, 2008, we evaluated the most currently available information, including trends in delinquencies and charge-offs on the underlying loans, draw rates on the lines of credit, and the servicer's ability to fulfill its contractual obligations including its obligation to fund additional draws. In recent periods, Constant Default Rate (CDR), Constant Payment Rate (CPR), Draw Rates and delinquency percentages have fluctuated within ranges that we believe make it appropriate to use rolling averages to project future performance. Accordingly, the Company is using modeling assumptions that are based upon or which approximate recent actual historical performance to project future performance and potential losses. During 2008, the Company extended the time frame during which it expects the CDR to remain elevated. The Company also revised its assumptions with respect to the overall shape of the default and loss curves. Among other things, these changes assume that a higher proportion of projected defaults will occur over the near term. This revision was based upon management's judgment that a variety of factors including the deterioration of U.S. economic conditions could lead to a longer period in which default rates remain high. The Company continues to model sensitivities around the results booked using a variety of CDR rates and stress periods as well as other modeling approaches including roll rates and hybrid roll rate/CDR methods. As a result of this modeling and analysis, the Company incurred loss and loss adjustment expenses of $111.0 million for
Credit support for HELOC transactions comes primarily from two sources. In the first instance, excess spread is used to build a certain amount of credit enhancement and absorb losses. Over the past 12 months, excess spread (the difference between the interest collections on the collateral and the interest paid on the insured notes) has averaged approximately 270 basis points per annum. Additionally, for the transactions serviced by Countrywide, the servicer is required to fund additional draws on the HELOC loans following the occurrence of a Rapid Amortization Event. Among other things, such an event is triggered when claim payments by us exceed a certain threshold. Prior to the occurrence of a Rapid Amortization Event, during the transactions' revolving period, new draws on the HELOC loans are funded first from principal collections. As such, during the revolving period no additional credit enhancement is created by the additional draws, and the speed at which our exposure amortizes is reduced to the extent of such additional draws, since principal collections are used to fund those draws rather than pay down the insured notes. Subsequent to the occurrence of a Rapid Amortization Event, new draws are funded by Countrywide and all principal collections are used to pay down the insured notes. Any draws funded by Countrywide are subordinate to us in the cash flow waterfall and hence represent additional credit enhancement available to absorb losses before we have to make a claim payment. Additionally, since all principal collections are used to pay down the insured notes, rather than fund additional draws, our exposure begins to amortize more quickly. A Rapid Amortization Event occurred for Countrywide 2007-D in April 2008 and for Countrywide 2005-J in May 2008.
We have modeled our HELOC exposures under a number of different scenarios, taking into account the multiple variables and structural features that materially affect transaction performance and potential losses to us. The key variables include the speed or rate at which borrowers make payments on their loans, as measured by the CPR(3), the default rate, as measured by the CDR(4), excess spread, and the amount of loans that are already delinquent more than 30 days. We also take into account the pool factor (the percentage of the original principal balance that remains outstanding), and the timing of the remaining cash flows. Additionally, it should be noted that our contractual rights allow us to retroactively claim that loans included in the insured pool were inappropriately included in the pool by the seller, and to put these loans back to the seller such that we would not be responsible for losses related to these loans. Such actions would benefit us by reducing potential losses. We have included in our loss model an estimated benefit for loans we expect Countrywide will repurchase.
(4)The CDR is the annualized default rate, so that a 1.0% CDR implies that 1.0% of the remaining collateral will default each year.
The key assumptions used in our case loss reserves on the direct Countrywide transactions is presented in the following table:
The problems affecting the subprime mortgage market have been widely reported, with rising delinquencies, defaults and foreclosures negatively impacting the performance of Subprime RMBS transactions. Those concerns relate primarily to Subprime RMBS issued in the period from 2005 through 2007. The $6.1 billion exposure that we have to such transactions in our direct financial guaranty segment benefits from various structural protections, including credit enhancement that on average currently equals approximately 54.3% of the remaining principal balance of the transactions.
We also have exposure of $433.1 million to Closed-End Second ("CES") RMBS transactions, of which $424.2 million is in the direct segment. As with other types of RMBS, we have seen significant deterioration in the performance of our CES transactions. On two transactions, which had exposure of $185.0 million, during 2008 we have seen a significant increase in delinquencies and collateral losses, which resulted in erosion of the Company's credit enhancement and the payment of claims totaling $16.2 million. Based on the Company's analysis of these transaction and their projected collateral losses, the Company had case reserves of $37.7 million as of December 31, 2008 in its direct segment. Additionally, as of December 31, 2008, the Company had portfolio reserves of $0.1 million in its financial guaranty direct segment and no case or portfolio reserves in its financial guaranty reinsurance segment related to its U.S. Closed-End Second RMBS exposure.
Another type of RMBS transaction is generally referred to as "Alt-A RMBS". The collateral supporting such transactions is comprised of first-lien residential mortgage loans made to prime quality borrowers that lack certain ancillary characteristics that would make them prime. Included in this category is Alt-A Option ARMs, which include transactions where 66% or more of the collateral is comprised of mortgage loans that have the potential to negatively amortize. As of December 31, 2008, the Company had net par outstanding of $7.6 billion related to Alt-A RMBS securitizations. Of that amount, $7.5 billion is from transactions issued in the period from 2005 through 2007 and written in the Company's financial guaranty direct segment. As of December 31, 2008, the Company had portfolio reserves of $6.5 million and case reserves of $1.5 million related to its $7.6 billion Alt-A RMBS exposure, in the financial guaranty direct and reinsurance segments, respectively.
The Company has exposure on two life insurance reserve securitization transactions based on two discrete blocks of individual life insurance business reinsured by Scottish Re (U.S.) Inc. ("Scottish Re"). The two transactions relate to Ballantyne Re p.l.c. ("Ballantyne") (gross exposure of $500 million) and Orkney Re II, p.l.c. ("Orkney II") (gross exposure of $423 million). Under both transactions, monies raised through the issuance of the insured notes support present and future U.S. statutory life insurance reserve requirements. The monies were invested at inception of each transaction in accounts managed by a large, well-known investment manager. However, those investment accounts have incurred substantial mark-to-market losses since mid-year 2007, principally as a result of their exposure to subprime and Alt-A RMBS transactions. Largely as a result of these mark-to-market losses both we and the rating agencies have downgraded our exposure to both Ballantyne and Orkney II to below investment grade. As regards the Ballantyne transaction, the Company is working with the directing guarantor, who has insured exposure of $900 million, to remediate the risk. On the Orkney Re II transaction, the Company, as directing financial guarantor, is taking remedial action.
Some credit losses have been realized on the securities in the Ballantyne and Orkney Re II portfolios and significant additional credit losses are expected to occur. Performance of the underlying blocks of life insurance business thus far generally has been in accordance with expectations. The combination of cash flows from the investment accounts and the treaty settlements currently is sufficient to cover interest payments due on the notes that we insure. Adverse treaty performance and/or a rise in credit losses on the invested assets are expected to lead to interest shortfalls. Additionally, the transactions also contain features linked to the market values of the invested assets, reserve funding requirements on the underlying blocks of life insurance business, and minimum capital
Another key risk is that the occurrence of certain events may result in a situation where either Ballantyne and/or Orkney Re II are required to sell assets and potentially realize substantial investment losses and for Assured Guaranty Ltd. to incur corresponding insured losses ahead of the scheduled final maturity date. For example, cedants to Scottish Re may have the right to recapture blocks of life insurance business which Scottish Re has ceded to Orkney Re II. Such recaptures could require Orkney Re II to sell assets and realize investment losses. In the Ballantyne transaction, further declines in the market value of the invested assets and/or an increase in the reserve funding requirements could lead to a similar mandatory realization of investment losses and for Assured Guaranty Ltd. to incur corresponding insured losses ahead of the scheduled final maturity date.
In order for the Company to incur an ultimate net loss on these transactions, adverse experience on the underlying block of life insurance policies and/or credit losses in the investment portfolio would need to exceed the level of credit enhancement built into the transaction structures. Based on its analysis of the information currently available, including estimates of future investment performance, projected credit impairments on the invested assets and performance of the blocks of life insurance business, at December 31, 2008, the Company established a case reserve of $17.2 million for the Ballantyne transaction. This case reserve reflects expected losses resulting primarily from the deterioration in the investment portfolio as discussed above. At this time we do not expect the shut off triggers or recaptures by cedants discussed above to occur. Should these events occur our losses could be significantly greater than our case reserve. The Company has not established a case loss reserve for the Orkney Re II transaction.
We also record IBNR reserves for our other segment. IBNR is an estimate of losses for which the insured event has occurred but the claim has not yet been reported to us. In establishing IBNR, we use traditional actuarial methods to estimate the reporting lag of such claims based on historical experience, claim reviews and information reported by ceding companies. We record IBNR for trade credit reinsurance within our other segment, which is 100% reinsured. The other segment represents lines of business that we exited or sold as part of our 2004 IPO.
We believe the guidance of FAS 60 does not expressly address the distinctive characteristics of financial guaranty insurance, so we also apply the analogous guidance of Emerging Issues Task Force ("EITF") Issue No. 85-20, "Recognition of Fees for Guaranteeing a Loan" ("EITF 85-20"), which provides guidance relating to the recognition of fees for guaranteeing a loan, which has similarities to financial guaranty insurance contracts. Under the guidance in EITF 85-20, the guarantor should assess the probability of loss on an ongoing basis to determine if a liability should be recognized under FAS No. 5, "Accounting for Contingencies" ("FAS 5"). FAS 5 requires that a loss be recognized where it is probable that one or more future events will occur confirming that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated.
(1)Included in Reserves for losses and loss adjustment expenses on the Balance Sheet.
(2)Total does not add due to rounding. The change in ratings above is mainly related to the Company's U.S. RMBS exposures.
Our surveillance department is responsible for monitoring our portfolio of credits and maintains a list of closely monitored credits ("CMC"). The closely monitored credits are divided into four categories: Category 1 (low priority; fundamentally sound, greater than normal risk); Category 2 (medium priority; weakening credit profile, may result in loss); Category 3 (high priority; claim/default probable, case reserve established); Category 4 (claim paid, case reserve established for future payments). The closely monitored credits include all below investment grade ("BIG") exposures where there is a material amount of exposure (generally greater than $10.0 million) or a material risk of the Company incurring a loss greater than $0.5 million. The closely monitored credits also include investment grade ("IG") risks where credit quality is deteriorating and where, in the view of the Company, there is significant potential that the risk quality will fall below investment grade. As of December 31, 2008, the closely monitored credits include approximately 99% of our BIG exposure, and the remaining BIG exposure of $92.3 million was distributed across 89 different credits. As of December 31, 2007, the closely monitored credits include approximately 99% of our BIG exposure, and the remaining BIG exposure of $19.8 million was distributed across 46 different credits. Other than those excluded BIG credits, credits that are not included in the closely monitored credit list are categorized as fundamentally sound risks.
(2)Includes case reserves on credit derivatives of $12.7 million at December 31, 2008 and $3.2 million at December 31, 2007, which balances are included in credit derivative liabilities in the Company's consolidated balance sheets. The following table summarizes movements in CMC exposure by risk category:
The increase of $4,517 million in financial guaranty CMC net par outstanding during 2008 is mainly attributable to the downgrade of RMBS or RMBS related exposures.
The Company is aware that there are certain differences regarding the measurement of portfolio loss liabilities among companies in the financial guaranty industry. In January and February 2005, the Securities and Exchange Commission ("SEC") staff had discussions concerning these differences with a number of industry participants. Based on those discussions, in June 2005, the Financial Accounting Standards Board ("FASB") staff decided additional guidance is necessary regarding financial guaranty contracts. In May 2008, the FASB issued FAS No. 163, "Accounting for Financial Guarantee Insurance Contracts-An Interpretation of FASB Statement No. 60" ("FAS 163"). FAS 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. FAS 163 also clarifies the methodology to be used for financial guaranty premium revenue recognition and claim liability measurement as well as requiring expanded disclosures about the insurance enterprise's risk management activities. The provisions of FAS 163 related to premium revenue recognition and claim liability measurement are effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years. Earlier application of these provisions is not permitted. The expanded risk management activity disclosure provisions of FAS 163 are effective for the third quarter of 2008 and are included in Note 11 "Significant Risk Management Activities" to the consolidated financial statements in Item 8 of this Form 10-K. FAS 163 will be applied to all existing and future financial guaranty insurance contracts written by us. The cumulative effect of initially applying FAS 163 will be recorded as an adjustment to retained earnings as of January 1, 2009. The adoption of FAS 163 is expected to have a material effect on our financial statements. We are in the process of estimating the impact of the adoption of FAS 163. We will continue to follow our existing accounting policies in regards to premium revenue recognition and claim liability measurement until we complete our first quarter 2009 financial statements.
Our CDS contracts provide for credit protection against payment default and have substantially the same terms and conditions as its financial guaranty insurance contracts. Under United States Generally Accepted Accounting Principles, however, CDS contracts are subject to derivative accounting rules and financial guaranty policies are subject to insurance accounting rules.
In our accompanying consolidated statements of operations and comprehensive income, we have reclassified CDS revenues from "net earned premiums" to "realized gains and other settlements on credit derivatives." Loss and loss adjustment expenses and recoveries that were previously included in "loss and loss adjustment expenses (recoveries)" will be reclassified to "realized gains and other settlements on credit derivatives," as well. Portfolio and case loss and loss adjustment expenses will be reclassified from "loss and loss adjustment expenses (recoveries)" and will be included in "unrealized
gains (losses) on credit derivatives," which previously included only unrealized mark to market gains or losses on our contracts written in CDS form. In the consolidated balance sheet, we reclassified all CDS-related balances previously included in "unearned premium reserves," "reserves for losses and loss adjustment expenses," "prepaid reinsurance premiums," "premiums receivable" and "reinsurance balances payable" to either "credit derivative liabilities" or "credit derivative assets," depending on the net position of the CDS contract at each balance sheet date.
FAS 157 specifies a fair value hierarchy based on whether the inputs to valuation techniques used to measure fair value are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect Company-based market assumptions. In accordance with FAS 157, the fair value hierarchy prioritizes model inputs into three broad levels as follows:
contract. Realized gains or losses are recorded related to the early termination of credit derivative contracts.
Our unrealized gains and losses on credit derivatives represent changes in fair value of these instruments that are required to be recorded under FAS 133. The unrealized gains and losses on credit derivatives will reduce to zero as the exposure approaches its maturity date, unless there is a payment default on the exposure. However, in the event that we terminate a credit derivative contract prior to maturity the unrealized gain or loss will be realized through realized gains or losses and other settlements on credit derivatives. Changes in the fair value of our credit derivative contracts do not reflect actual claims or credit losses, and have no impact on the Company's claims-paying resources, rating agency capital or regulatory capital positions or debt covenants.
The fair value of these instruments represents the difference between the present value of remaining contractual premiums charged for the credit protection and the estimated present value of premiums that a comparable financial guarantor would hypothetically charge for the same protection at the balance sheet date. The fair value of these contracts depends on a number of factors including notional amount of the contract, expected term, credit spreads, changes in interest rates, the credit ratings of the referenced entities, our own credit risk and remaining contractual flows.
Remaining contractual cash flows, which are included in the realized gains and other settlements on credit derivatives component of credit derivatives, are the most readily observable variables since they are based on the CDS contractual terms. These variables include i) net premiums received and receivable on written credit derivative contracts, ii) net premiums paid and payable on purchased contracts, iii) losses paid and payable to credit derivative contract counterparties and iv) losses recovered and recoverable on purchased contracts. The remaining key variables described above impact unrealized gains (losses) on credit derivatives.
The fair value adjustment excluding incurred losses on credit derivatives recognized in our statement of operations for the year ended December 31, 2008 was a $81.7 million gain compared with a $666.9 million loss for the year ended December 31, 2007 and a $5.5 million loss for the year ended December 31, 2006. The 2008 gain includes a gain of $4,147.6 million associated with the change in AGC's credit spread, which widened substantially from 180 basis points at December 31, 2007 to 1,775 basis points at December 31, 2008. Management believes that the widening of AGC's credit spread is due to the correlation between AGC's risk profile and that experienced currently by the broader financial markets and increased demand for credit protection against AGC as the result of its increased business volume. Offsetting the gain attributable to the significant increase in AGC's credit spread were declines in fixed income security market prices primarily attributable to widening spreads in certain markets as a result of the continued deterioration in credit markets and some credit rating downgrades, rather than from delinquencies or defaults on securities guaranteed by the Company. The higher credit spreads in the fixed income security market are due to the recent lack of liquidity in the high yield collateralized debt obligation and collateralized loan obligation markets as well as continuing market concerns over the most recent vintages of subprime residential mortgage backed securities and commercial mortgage backed securities. The 2007 loss is primarily related to spreads widening and includes no credit losses. For the year ended 2007, approximately 45% of the Company's unrealized loss on credit derivatives was due to a decline in the market value of high yield and investment grade corporate collateralized loan obligation transactions, with the balance generated by lower market values principally in the residential and commercial mortgage-backed securities markets. The 2006 loss of $5.5 million is primarily related to the run-off of transactions and changes in credit spreads. With considerable volatility continuing in the market, the fair value adjustment amount will fluctuate significantly in future periods.
The fair value of CCS Securities represents the present value of remaining expected put option premium payments under the CCS Securities agreements and the value of such estimated payments based upon the quoted price for such premium payments as of December 31, 2008 and 2007. The $51.1 million and $8.3 million fair value asset for CCS Securities as of December 31, 2008 and 2007, respectively, is included in the consolidated balance sheets. Changes in fair value of this asset are included in other income in the consolidated statements of operations and comprehensive income. In 2008 and 2007 the Company recorded a fair value gain of $42.7 million and $8.3 million, pre-tax, respectively, related to Assured Guaranty Corp.'s CCS Securities.
As of December 31, 2008, approximately 87% of our investments were long-term fixed maturity securities, and our portfolio had an average duration of 4.1 years, compared with 82% and 3.9 years as of December 31, 2007. Changes in interest rates affect the value of our fixed maturity portfolio. As interest rates fall, the fair value of fixed maturity securities increases and as interest rates rise, the fair value of fixed maturity securities decreases. The Company's portfolio is comprised primarily of high-quality, liquid instruments. We continue to receive sufficient information to value our investments and have not had to modify our approach due to the current market conditions.
The following table summarizes the estimated change in fair value on our investment portfolio as of December 31, 2008 based upon an assumed parallel shift in interest rates across the entire yield curve:
•whether we have the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value.
If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss on our balance sheet in "accumulated other comprehensive income" in
As of December 31, 2008, excluding the securities described above, the Company's gross unrealized loss position stood at $122.5 million compared to $8.9 million at December 31, 2007. The $113.6 million increase in gross unrealized losses was primarily attributable to mortgage and asset-backed securities, $54.3 million, municipal securities, $48.6 million, and corporate securities, $10.4 million. The increase in these unrealized losses during the year ended December 31, 2008 was related to the overall illiquidity in the financial markets and resulted in a sudden and severe depressed demand for non-cash investments.
(1)Includes $71.3 million of other than temporary realized losses in 2008. There were no other than temporary realized losses in 2007. Premium Revenue Recognition
Premiums are received either upfront or in installments. Upfront premiums are earned in proportion to the expiration of the amount at risk. Each installment premium is earned ratably over its installment period, generally one year or less. Premium earnings under both the upfront and installment revenue recognition methods are based upon and are in proportion to the principal amount guaranteed and therefore result in higher premium earnings during periods where guaranteed principal is higher. For insured bonds for which the par value outstanding is declining during the insurance
relate principally to unrealized gains and losses on investments and credit derivatives, deferred acquisition costs, reserves for losses and LAE, unearned premium reserves, net operating loss carryforwards ("NOLs") and statutory contingency reserves. A valuation allowance is recorded to reduce a deferred tax asset to the amount that in management's opinion is more likely than not to be realized.
Subsequent to the adoption of FIN 48, the IRS published final regulations on the treatment of consolidated losses. As a result of these regulations the utilization of certain capital losses is no longer at a level that would require recording an associated liability for an uncertain tax position. As such, the
Company decreased its liability for unrecognized tax benefits and its provision for income taxes $4.1 million during the period ended March 31, 2007. In September 2007, upon completion of the IRS audit of Assured Guaranty Overseas US Holdings Inc. and subsidiaries, the liability for unrecognized tax benefits was reduced by approximately $6.0 million.
The total liability for unrecognized tax benefits as of December 31, 2008 and 2007 was $5.1 million and $2.8 million, respectively, and is included in other liabilities on the balance sheets. During the year ended December 31, 2008 the net liability increased by approximately $2.3 million due to a position management intends to take on the Company's 2008 tax return. The Company does not believe it is reasonably possible that this amount will change significantly in the next twelve months.
As a result of the election, the Company has adjusted its net deferred tax liability to reflect the new tax basis of the Company's affected assets. The additional basis is expected to result in increased future income tax deductions and, accordingly, may reduce income taxes otherwise payable by the Company. Any tax benefit realized by the Company will be paid to AFS. Such tax benefits will generally be calculated by comparing the Company's affected subsidiaries' actual taxes to the taxes that would have been owed by those subsidiaries had the increase in basis not occurred. After a 15 year period, to the extent there remains an unrealized tax benefit, the Company and AFS will negotiate a settlement of the unrealized benefit based on the expected realization at that time.
Prior to January 1, 2006, we accounted for our share-based employee compensation plans under the measurement and recognition provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related Interpretations, as permitted by FAS No. 123, "Accounting for Stock-Based Compensation" ("FAS 123").
Effective January 1, 2006, we adopted the fair value recognition provisions of FAS No. 123 (revised), "Share-Based Payment" ("FAS 123R") using the modified prospective transition method. Under that transition method, compensation expense includes: (a) compensation expense for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair
value estimated in accordance with the original provisions of FAS 123, and (b) compensation expense for all share-based payments granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of FAS 123R. Because we elected to use the modified prospective transition method, results for prior periods have not been restated.
At December 31, 2008, there was $12.3 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under all equity compensation plans. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures. We expect to recognize that cost over a weighted average period of 1.5 years. As a result of the adoption of FAS 123R, the income tax effects of compensatory stock options are included in the computation of the income tax expense (benefit), and deferred tax assets and liabilities, subject to certain prospective adjustments to shareholders' equity for the differences between the income tax effects of expenses recognized in the results of operations and the related amounts deducted for income tax purposes. Prior to the adoption of FAS 123R, the tax benefits relating to the income tax deductions for compensatory stock options were recorded directly to shareholders' equity.
The weighted-average grant-date fair value of options granted were $7.59, $6.83 and $6.71 for the years ended December 31, 2008, 2007 and 2006, respectively. The fair value of options issued is
estimated on the date of grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions used for grants in 2008, 2007 and 2006:
•The expected life is based on the average expected term of our guideline companies, which are defined as similar or peer entities, since the Company has insufficient expected life data,
The Company's compensation expense for the years ended December 31, 2008 and 2007 was in the form of performance retention awards and the awards that were made in 2008 (which vest over a four year period) and 2007 (which cliff vest after 4 years). The Company recognized approximately $5.7 million ($4.5 million after tax) and $0.2 million ($0.1 million after tax) of expense for performance retention awards in 2008 and 2007, respectively. Included in the 2008 amount was $3.3 million of accelerated expense related to retirement-eligible employees.
As part of the impairment test of goodwill, there are inherent assumptions and estimates used by management in developing discounted future cash flows related to our direct and reinsurance lines of business that are subject to change based on future events. Management's estimates include projecting earned premium, incurred losses, expenses, interest rates, cost of capital and tax rates. Many of the factors used in assessing fair value are outside the control of management and it is reasonably likely that assumptions and estimates will change in future periods. These changes can result in future impairments.
The Company has concluded that it is reasonably likely that the goodwill associated with our reinsurance line of business could become impaired in future periods if the volume of new business in the financial guaranty reinsurance market does not return to historical levels experienced prior to 2008 or if the Company is not able to continue to execute portfolio based reinsurance contracts on blocks of business for other financial guarantors in financial distress. Also, the pending FSAH transaction may cause a triggering event that will cause management to reassess its goodwill amounts related to its reinsurance line of business. See Note 22. "Goodwill", to the consolidated financial statements in Item 8 of this 10-K for greater detail about Goodwill.
The tables below provide information on the risk ratings and certain other risk characteristics of the Company's RMBS, subprime RMBS, CDOs of ABS and Prime exposures as of December 31, 2008 (dollars in millions):
Distribution of U.S. RMBS by Rating(1) and Type of Exposure as of December 31, 2008
(1)Assured's internal rating. Assured's scale is comparable to that of the nationally recognized rating agencies. The super senior category, which is not generally used by rating agencies, is used by the Company in instances where Assured's AAA-rated exposure has additional credit enhancement due to either (1) the existence of another security rated AAA that is subordinated to Assured's exposure or (2) Assured's exposure benefits from a different form of credit enhancement that would pay any claims first in the event that any of the exposures incurs a loss and such credit enhancement, in management's opinion, causes Assured's attachment point to be materially above the AAA attachment point.
Distribution of U.S. RMBS by Rating(1) and Year Insured as of December 31, 2008
Distribution of U.S. Prime HELOC RMBS by Rating(1) and Year Insured as of December 31, 2008
Distribution of U.S. Alt-A RMBS by Rating(1) and Year Insured as of December 31, 2008
Distribution of Financial Guaranty Direct U.S. RMBS by Rating(1) and Type of Exposure as of December 31, 2008
Distribution of Financial Guaranty Direct U.S. RMBS by Year Insured as of December 31, 2008
Distribution of Financial Guaranty Direct U.S. Mortgage-Backed Securities Issued January 1, 2005 or Later by Exposure Type, Average Pool Factor, Subordination, Cumulative Losses and 60+ Day Delinquencies as of December 31, 2008(1)
(4)Cumulative losses are defined as net charge-offs on the underlying loan collateral divided by the original pool balance.
(1)A "CDO of ABS" is a collateralized debt obligation (CDO) transaction whose collateral pool consists primarily of asset-backed securities (ABS), including mortgage-backed securities (MBS). ABS transactions securities generally represent an ownership interest in a trust that contains collateral supporting the notes. Those interests are divided into several tranches that can have varying levels of subordination, credit protection triggers and credit ratings.
(2)"Legal Final Maturity" represents the final date for payment specified in the transaction documents and does not take into account prepayments that shorten the expected maturity and weighted average life.
(4)"CDOs of High Grade ABS" is a market term that refers to transactions where the underlying collateral at issuance is comprised of mezzanine tranches rated single-A or higher.
(5)"CDOs of Pooled AAA ABS" is a market term that refers to transactions where the underlying collateral at issuance is comprised of the senior-most AAA rated securities. Assured's exposure to CDOs of Pooled AAA ABS was rated, based on rating information as of December 31, 2008: 100% AAA.
(6)Represents the sum of subordinate tranches and over-collateralization and does not include any benefit from excess interest collections that may be used to absorb losses.
The following table presents summary consolidated results of operations data for the years ended December 31, 2008, 2007 and 2006.
•a $38.0 million unrealized gain on credit derivatives in 2008 compared with a $(670.4) million unrealized loss on credit derivatives in 2007. In 2008, the widening of the Company's own credit spread, which was substantially offset by an overall general widening of credit spreads in the market, leading to a relatively small net unrealized gain. During 2007, market spreads widened more substantially than the Company's own credit spread leading to the $(670.4) million unrealized loss. The unrealized loss on credit derivatives, net of related income taxes, was $(4.1) million and $(487.9) million for 2008 and 2007, respectively. With considerable volatility continuing in the market, this amount will fluctuate significantly in future periods, See Note 4 "Credit Derivatives" to the consolidated financial statements in Item 8 of this Form 10-K for more information on our credit derivatives as of December 31, 2008 and 2007,
•an increase of $102.1 million in net earned premium to $261.4 in 2008 from $159.3 million in 2007, which is attributable to the continued overall growth in our in-force book of business and an increase in net earned premiums attributable to refunded and called bonds, which reflect the unscheduled pre-payment or refundings of underlying municipal bonds, of $61.9 million in 2008 compared to $17.6 million in 2007,
•an increase of $34.6 million in other income, which included a fair value gain of $42.7 million pre-tax, $27.8 million after-tax, related to Assured Guaranty Corp.'s committed capital securities.
•an increase in net realized investment (losses) of $(68.5) million primarily related to the $(71.3) million write down of securities due to other than temporary impairment,
•an increase of $3.6 million in operating expenses during 2008, resulting from (1) the amortization of restricted stock and stock option awards, due to new stock awards in 2008 and the related amortization as well as the accelerated vesting of these awards for retirement eligible employees as required by FAS 123R and (2) expansion of our performance retention plan, and
•a $(670.4) million unrealized loss on credit derivatives in 2007 compared with a $11.8 million unrealized gain on credit derivatives in 2006, attributable to credit spreads widening in all asset classes including residential and commercial real estate and corporate collateral. This unrealized loss included no credit losses. Net of related income taxes, the unrealized (loss) gain on credit derivatives, was $(487.9) million and $8.8 million for 2007 and 2006, respectively,
•an increase of $8.4 million in other income, which included a fair value gain of $8.3 million pre-tax, $5.4 million after-tax, related to Assured Guaranty Corp.'s committed capital securities,
Gross written premiums for the year ended December 31, 2008 were $618.3 million, compared with $424.5 million for the year ended December 31, 2007, an increase of $193.8 million, or 46%. Gross written premiums in our financial guaranty direct operations increased $317.6 million for 2008 compared with 2007 primarily due to a $371.8 million increase in U.S. generated business, of which
Gross written premiums for the year ended December 31, 2007 were $424.5 million compared with $261.3 million for the year ended December 31, 2006, an increase of $163.2 million, or 62%. Our 2007 financial guaranty direct segment increased $42.3 million due to an increase of $24.7 million in our U.S. public finance business and $18.1 million in our U.S. structured finance business, while our international infrastructure business remained flat. Our financial guaranty reinsurance segment increased $127.1 million in 2007 compared with 2006 primarily due to execution of a reinsurance transaction with Ambac Assurance Corporation ("Ambac") whereby we assumed a diversified portfolio of financial guaranty transactions, which resulted in gross written premiums of $143.2 million. Gross written premiums for 2007 in our mortgage guaranty segment decreased $5.7 million compared with 2006, primarily attributable to run-off of our quota share contracts and commutations executed in the latter part of 2006.
Net earned premiums for the year ended December 31, 2008 increased $102.1 million, or 64%, compared with the year ended December 31, 2007. Financial guaranty direct net earned premiums increased $37.2 million in 2008, compared with 2007. This increase is attributable to the continued growth of our in-force book of business, resulting in increased net earned premiums. The year ended December 31, 2008 had $1.3 million of earned premiums from public finance refundings in the financial guaranty direct segment compared to $2.8 million in 2007. Public finance refunding premiums reflect the unscheduled pre-payment or refundings of underlying municipal bonds. The increase in financial guaranty reinsurance segment was due to the increase in public finance refundings of $45.8 million to $60.6 million in 2008. This increase is primarily a result of greater refundings of municipal auction rate and variable rate debt as reported by our ceding companies. Excluding refundings, our financial guaranty reinsurance segment increased $31.2 million in 2008 compared with 2007 due mainly to the portfolio assumed from Ambac in December 2007, which contributed $56.9 million to net premiums earned in 2008. The $11.8 million decrease in net earned premiums in our mortgage guaranty segment in 2008 compared with 2007 reflects the run-off of our quota share treaty business as well as commutations executed in the latter part of 2007.
Net earned premiums for the year ended December 31, 2007 increased $14.5 million, or 10%, compared with the year ended December 31, 2006. Net earned premiums from our financial guaranty direct operations increased to $52.8 million in 2007 compared with $27.8 million in 2006 due to the continued growth of our in-force book of business, resulting in increased net earned premiums, and to public finance refundings which were $2.8 million in 2007. The year ended December 31, 2006 amounts had no earned premiums from public finance refundings in the financial guaranty direct segment. The decreases in net earned premiums in the financial guaranty reinsurance and mortgage guaranty segments in 2007 compared to 2006 were primarily related to the non-renewal and expiration of certain treaties.
Realized investment gains and losses are determined using the specific identification method and are credited or charged to income. Net realized investment losses, principally from the sale of fixed maturity securities, were $(69.8) million, $(1.3) million and $(2.0) million for the years ended December 31, 2008, 2007 and 2006, respectively. The Company recognized $71.3 million of other than temporary impairment losses substantially related to mortgage-backed and corporate securities for the year ended December 31, 2008 primarily due to the fact that it does not have the intent to hold these securities until there is a recovery in their value. The Company had no write downs of investments for other than temporary impairment losses in 2007 and 2006. Net realized investment losses, net of related income taxes, were $(62.7) million, $(1.3) million and $(1.5) million for the years ended December 31, 2008, 2007 and 2006, respectively.
and 2006, respectively, relates to recoveries received by us in those years for claim payments made in prior years. We did not have any losses paid or payable under these contracts in either 2008, 2007 or 2006.
Credit derivatives are recorded at fair value as required by FAS 133, FAS 149 and FAS 155. The change in fair value for the year ended December 31, 2008 was a $38.0 million gain compared with a $670.4 million loss for the year ended December 31, 2007 and a $11.8 million gain for the same period in 2006. The change in fair value for 2008 was attributable to the widening of credit default spreads traded on AGC, which increased from 180 basis points at December 31, 2007 to 1,775 basis points at December 31, 2008. For the year ended December 31, 2008, approximately 50% of our unrealized gain on credit derivatives is attributable to the fair value of high yield and investment grade corporate collateralized loan obligation transactions, with the balance of the change in fair values principally in the residential and commercial mortgage backed securities markets. The change in fair value for 2007 was attributable to spreads widening and includes no credit losses. For the year ended 2007, approximately 45% of the Company's unrealized loss on credit derivatives was due to a decline in the market value of high yield and investment grade corporate collateralized loan obligation transactions, with the balance generated by lower market values principally in the residential and commercial mortgage-backed securities markets. Changes in the fair value of our derivative contracts do not reflect actual claims or credit losses, and have no impact on the Company's claims-paying resources, rating agency capital or regulatory capital positions. With considerable volatility continuing in the market, the fair value adjustment amount will fluctuate significantly in future periods. The change in fair value of $11.8 million for 2006 was related to many factors but primarily due to run-off of transactions and tightening in credit spreads. Unrealized gains (losses) on credit derivatives, excluding incurred losses on credit derivatives, net of related income taxes, were $29.3 million, $(485.4) million and $4.0 million in 2008, 2007 and 2006, respectively.
Management also calculates portfolio and case reserve expenses on our credit derivative contracts in the same manner as we do for our financial guaranty insurance contracts. Prior to the First Quarter 2008, incurred losses on credit derivatives were apportioned in our financial statements from unrealized gains (losses) on credit derivatives and included in loss and loss adjustment expenses. As a result of reclassifying our accounting activity related to credit derivative contracts commencing with the First Quarter 2008, we no longer make this apportionment in our financial statements, but believe it is an important metric in evaluating the credit quality of our credit derivative contracts. The incurred (losses) gains on credit derivatives were $(43.7) million ($(33.4) million loss after-tax), $(3.6) million ($(2.5) million loss after-tax) and $6.3 million ($4.8 million after-tax) for the years ended December 31, 2008, 2007 and 2006, respectively. The increase for 2008 as compared with 2007 is primarily due to an increase in portfolio reserves as a result of downgrades within our U.S. RMBS credit derivative book of business.
The years ended December 31, 2008 and 2007 included a fair value gain of $42.7 million and $8.3 million, pre-tax, respectively, related to Assured Guaranty Corp.'s committed capital securities. The increase was due to the widening of the Company's credit spreads. The Company recorded a fair value gain of $0 in the year ended December 31, 2006, as the fair value of CCS securities was $0 as of December 31, 2006 and December 31, 2005.
In 2007, loss and LAE for the financial guaranty direct segment included a $2.4 million case reserve increase and a $30.2 million portfolio reserve increase, primarily attributable to downgrades of transactions in our CMC list related to the subprime mortgage market, particularly U.S. home equity line of credit ("HELOC") exposures. Portfolio reserves also increased as a result of growth in new business and revised rating agency default statistics used in the portfolio reserving model. The financial guaranty reinsurance segment had a $(24.1) million loss benefit principally due to the restructuring of a European infrastructure transaction, as well as loss recoveries and increases in salvage reserves for aircraft-related transactions.
In 2006, the financial guaranty direct segment had loss and loss adjustment expenses of $2.6 million mainly due to an increase of $4.5 million associated with the increase in net earned premiums and downgrades of a sub-prime mortgage transaction, partially offset by a case loss reserves
Interest expense was $23.3 million, $23.5 million and $13.8 million for the years ended December 31, 2008, 2007 and 2006, respectively. The 2008 and 2007 amounts were mainly comprised of $13.4 million of interest expense, net of amortization of our cash flow hedge, related to the issuance of our 7% Senior Notes ("Senior Notes") in May 2004 and $9.8 million of interest expense related to the issuance of our 6.40% Series A Enhanced Junior Subordinated Debentures (the "Debentures") in
December 2006. The coupon on the Senior Notes is 7.0%, however, the effective rate is approximately 6.4%, which reflects the effect of a cash flow hedge executed by the Company in March 2004, the term of which matches that of the Senior Notes. In addition, the 2007 amount included $0.2 million of interest expense on taxes owed. The 2006 amount included $13.4 million of interest expense, net of amortization of our cash flow hedge, on our Senior Notes and $0.3 million of interest expense on our Debentures.
Loss and loss adjustment expense ratio, which is a non-GAAP financial measure, is defined as loss and loss adjustment expenses (recoveries) plus the Company's net estimate of credit derivative incurred case and portfolio loss and loss adjustment expense reserves, which is included in unrealized gains (losses) on credit derivatives, plus net credit derivative losses (recoveries), which is included in realized gains and other settlements on credit derivatives, divided by net earned premiums plus net credit
derivative premiums received and receivable, which is included in realized gains and other settlements on credit derivatives. Expense ratio is calculated by dividing the sum of ceding commissions expense (income), profit commission expense, acquisition costs and operating expenses by net earned premiums plus net credit derivative premiums received and receivable, which is included in realized gains and other settlements on credit derivatives. Combined ratio, which is a non-GAAP financial measure, is the sum of the loss and loss adjustment expense ratio and the expense ratio.
The financial guaranty direct segment contributed $484.7 million, $167.1 million and $124.8 million to overall gross written premiums, for the years ended December 31, 2008, 2007 and 2006, respectively. Gross written premiums in our financial guaranty direct operations increased $317.6 million in 2008 compared with 2007 primarily due to a $371.8 million increase in U.S. generated business, of which $355.8 million was from our upfront public finance business, as we continue to increase our book of business. Partially offsetting this increase was a reduction of our international infrastructure business to $16.9 million in 2008, compared with $71.3 million for 2007, as the prior included a few large infrastructure transactions. Gross written premiums in our financial guaranty direct operations increased $42.3 million in 2007 from 2006 primarily due to a $42.7 million increase in U.S. generated business, mainly from our upfront public finance and installment structured finance business, as we continue to execute our direct business strategy. Our international business was basically flat, and generated $71.3 million of gross written premiums in 2007 compared with $71.6 million in 2006.
Generally, gross and net written premiums from the public finance market are received upfront, while the structured finance and credit derivatives markets have been received on an installment basis. The contribution of upfront premiums to gross written premiums were 87.7%, 72.4% and 79.2% of gross written premiums, or $425.0 million, $121.1 million and $98.9 million in 2008, 2007 and 2006, respectively. In 2008, 2007 and 2006, installment premiums represented 12.3%, 27.6% and 20.8% of gross written premiums in this segment, or $59.7 million, $46.0 million and $25.9 million, respectively.
Net earned premiums for the years ended December 31, 2008, 2007 and 2006, were $90.0 million, $52.8 million and $27.8 million, respectively. The increase in net earned premiums reflects our increased market penetration, which has resulted in growth of our in-force book of business. Net earned premiums in 2008 increased $37.2 million compared with 2007 for the same reason. Net earned premiums increased $25.0 million in 2007 from 2006 due to the continued growth in our in-force book of business. Included in 2008 and 2007 financial guaranty direct net earned premiums were $1.3 million and $2.8 million, respectively, of public finance refundings, which reflect the unscheduled pre-payment or refundings of underlying municipal bonds. These unscheduled refundings are sensitive to market
Incurred losses (gains) on credit derivatives were $38.4 million in 2008 compared with $3.6 million in 2007. The increase is primarily due to an increase in portfolio reserves as a result of downgrades within our U.S. RMBS credit derivative book of business.
Gross written premiums for our financial guaranty reinsurance segment include upfront premiums on transactions underwritten during the period, plus installment premiums on business primarily underwritten in prior periods. Consequently, this amount is affected by changes in the business mix between public finance and structured finance. For the years ended December 31, 2008, 2007 and 2006, 59%, 84% and 68%, respectively, of gross written premiums in this segment were upfront premiums and 41%, 16% and 32%, respectively, were installment premiums.
The following table summarizes the Company's reinsurance gross written premiums by significant client:
(2)In December 2007, the Company's reinsurance subsidiary, AG Re, reinsured a diversified portfolio of financial guaranty contracts totaling approximately $29 billion of net par outstanding from Ambac.
For the years ended December 31, 2008, 2007 and 2006, net written premiums were $129.1 million, $250.8 million and $123.2 million, respectively. The changes in all periods are consistent with the changes in gross written premiums because, to date, we have not retroceded a significant amount of premium to external reinsurers.
Loss and LAE were $68.4 million, $(24.1) million and $13.1 million for the years ended December 31, 2008, 2007 and 2006, respectively. Our loss and LAE ratios for the years ended December 31, 2008, 2007 and 2006 were 43.2%, (27.1)% and 13.9%, respectively. Loss and LAE in 2008 included $48.5 million of loss and LAE related to our assumed HELOC exposures. Additionally, 2008 loss and LAE included $14.6 million of incurred losses related to two public finance transactions. In 2007, the financial guaranty reinsurance segment had $(12.8) million of incurred losses due to the restructuring of a European infrastructure transaction, as well as losses incurred of $(17.7) million related to loss recoveries and increased salvage reserves for aircraft-related transactions. These benefits were partially offset by increases to case and portfolio reserves of $2.5 million and $2.4 million, respectively, for HELOC exposures. Portfolio reserves also increased $2.9 million as a result of management's annual updating of its rating agency default statistics. The 2006 loss and loss adjustment expenses included $6.8 million of net case loss and LAE reserve additions, primarily related to the rating downgrades of a U.S. public infrastructure transaction as well as other asset backed securities and a $1.6 million write-down of expected litigation recoveries, reported from a cedant. These recoveries were established in 1998 from a bankruptcy estate. In addition, the Company increased portfolio reserves $6.2 million primarily due to the ratings downgrade of a European infrastructure transaction and management updating its rating agency default statistics, as part of our normal portfolio reserve process and due to the rating downgrade of various credits.
Profit commission expense was $1.0 million, $2.7 million and $2.7 million for the years ended December 31, 2008, 2007 and 2006, respectively. Not all of our treaties have a profit commission component, however the changes in profit commission expense correspond with the net earned
For the years ended December 31, 2008, 2007 and 2006, acquisition costs incurred were $46.6 million, $31.3 million and $34.1 million, respectively. The changes in acquisition costs incurred over the periods are directly related to the changes in net earned premiums from non-derivative transactions and also reflect a decrease in negotiated ceding commission rates for transactions executed in recent years.
Operating expenses for the years ended December 31, 2008, 2007 and 2006, were $19.7 million, $17.3 million and $14.5 million, respectively. During 2006, the Company implemented a new operating expense allocation methodology to more closely allocate expenses to the individual operating segments. This new methodology was based on a comprehensive study which was based on departmental time estimates and headcount. The increases in operating expenses for both 2008 and 2007 were attributable to increased staff additions and merit increases as well as the increase in the amortization of restricted stock and stock option awards, due to new stock awards and other performance retention programs each year and the related amortization as well as the accelerated vesting of these awards for retirement eligible employees as required by FAS 123R.
For the years ended December 31, 2008, 2007 and 2006, net earned premiums were $5.7 million, $17.5 million and $22.7 million, respectively. The decrease in net earned premiums for both periods reflects the run-off of our quota share treaty business as well as commutations executed in the latter parts of 2007 and 2006.
Operating expenses for the years ended December 31, 2008, 2007 and 2006 were $2.2 million, $2.0 million and $1.3 million, respectively. During 2006, the Company implemented a new operating expense allocation methodology to more closely allocate expenses to the individual operating segments. This new methodology was based on a comprehensive study which was based on departmental time estimates and headcount. The increase in operating expenses for both 2008 and 2007 were attributable to increased salaries due to increased staff additions and merit increases as well as the increase in the amortization of restricted stock and stock option awards, due to new stock awards and other performance retention programs each year and the related amortization as well as the accelerated vesting of these awards for retirement eligible employees as required by FAS 123R.
Our liquidity, both on a short-term basis (for the next twelve months) and a long-term basis (beyond the next twelve months), is largely dependent upon: (1) the ability of our operating subsidiaries to pay dividends or make other payments to us, (2) external financings and (3) net investment income from our invested assets. Our liquidity requirements include the payment of our operating expenses, interest on our debt, and dividends on our common shares. We may also require liquidity to make periodic capital investments in our operating subsidiaries. In the ordinary course of our business, we evaluate our liquidity needs and capital resources in light of holding company expenses, debt-related expenses and our dividend policy, as well as rating agency considerations. Based on the amount of dividends we expect to receive from our subsidiaries and the income we expect to receive from our invested assets, management believes that we will have sufficient liquidity to satisfy our needs over the next twelve months, including the ability to pay dividends on our common shares. Total cash paid in 2008, 2007 and 2006 for dividends to shareholders was $16.0 million, or $0.18 per common share, $11.0 million, or $0.16 per common share, and $10.5 million, or $0.14 per common share, respectively. Beyond the next twelve months, the ability of our operating subsidiaries to declare and pay dividends may be influenced by a variety of factors including market conditions, insurance and rating agencies regulations and general economic conditions. Consequently, although management believes that we will continue to have sufficient liquidity to meet our debt service and other obligations over the long term, it remains possible that we may be required to seek external debt or equity financing in order to meet our operating expenses, debt service obligations or pay dividends on our common shares. These external sources of financing may or may not be available to us, and if available, the costs of such financing may be higher than our current levels.
We anticipate that a major source of our liquidity, for the next twelve months and for the longer term, will be amounts paid by our operating subsidiaries as dividends. Certain of our operating subsidiaries are subject to restrictions on their ability to pay dividends. See "Business-Regulation." The amount available at AGC to pay dividends in 2009 with notice to, but without the prior approval of, the Maryland Insurance Commissioner is approximately $37.8 million. Dividends paid by a U.S. company to a Bermuda holding company presently are subject to a 30% withholding tax. The amount available at AG Re to pay dividends or make a distribution of contributed surplus in 2009 in compliance with Bermuda law is $1,125.0 million. However, any distribution which results in a reduction of 15% or more of AG Re's total statutory capital, as set out in its previous year's financial statements, would require the prior approval of the Bermuda Monetary Authority.
Liquidity at our operating subsidiaries is used to pay operating expenses, claims, payment obligations with respect to credit derivatives, including collateral postings, reinsurance premiums and dividends to AGUS for debt service and dividends to us, as well as, where appropriate, to make capital investments in their own subsidiaries. In addition, certain of our operating companies may be required to post additional collateral in connection with credit derivatives and reinsurance transactions. Management believes that these subsidiaries' operating needs generally can be met from operating cash flow, including gross written premium and investment income from their respective investment portfolios.
Net cash flows used in investing activities were $(649.6) million, $(664.4) million and $(228.5) million during the years ended December 31, 2008, 2007 and 2006, respectively. These investing activities were primarily net purchases of fixed maturity investment securities during 2008, 2007 and 2006. The increase in 2008 was due to purchases of fixed maturity securities with the cash generated from positive cash flows from operating activities and capital received from the equity offerings in April 2008 and December 2007. The increase in 2007 was due to purchases of fixed maturity securities with the cash proceeds from the December 2007 public offering, as discussed below.
Net cash flows provided by (used in) financing activities were $229.3 million, $281.4 million and $(35.1) million during the years ended December 31, 2008, 2007 and 2006, respectively.
On December 21, 2007, the Company completed the sale of 12,483,960 of its common shares at a price of $25.50 per share. The net proceeds of the sale totaled approximately $303.8 million. The Company has contributed the net proceeds of the offering to its reinsurance subsidiary, AG Re. AG Re has used the proceeds to provide capital support in the form of a reinsurance portfolio transaction with Ambac Assurance Corp. for approximately $29 billion of net par outstanding, as well as to support the growth of AGC, the Company's direct financial guaranty subsidiary, by providing reinsurance. AG Re is AGC's principal financial guaranty reinsurer.
On April 8, 2008, investment funds managed by WL Ross & Co. LLC ("WL Ross") purchased 10,651,896 shares of the Company's common equity at a price of $23.47 per share, resulting in proceeds to the Company of $250.0 million. The Company contributed $150.0 million of these proceeds to its subsidiary, AG Re. In addition, the Company contributed $100.0 million of these proceeds to its subsidiary, Assured Guaranty US Holdings Inc., which in turn contributed the same amount to its subsidiary, AGC. The commitment to purchase these shares was previously announced on February 29, 2008. WL Ross has a remaining commitment through April 8, 2009 to purchase up to $750.0 million of the Company's common equity, at the Company's option, subject to the terms and conditions of the investment agreement with the Company dated February 28, 2008. In accordance with the investment agreement, the Company may exercise this option in one or more drawdowns, subject to a minimum drawdown of $50 million, provided that the purchase price per common share for the subsequent shares is not greater than $27.57, or less than $19.37, the price per common share for the initial shares. The purchase price per common share for such shares will be equal to 97% of the volume weighted average price of a common share on the NYSE for the 15 NYSE trading days prior to the applicable drawdown notice. As of December 31, 2008, and as of the date of this filing, the purchase price per common share is outside of this range and therefore the Company may not, at this time, exercise its option for WL Ross to purchase additional shares.
During 2008 we paid $16.0 million in dividends, $3.6 million, net, under our option and incentive plans and $1.0 million for offering costs incurred in connection with the December 2007 equity offering and issuance of common shares to WL Ross.
and 2006, we paid $3.7 million and $21.1 million to repurchase 0.2 million shares and 0.8 million shares of our Common Stock, respectively.
The following table summarizes our contractual obligations as of December 31, 2008:
(3)We have estimated the timing of these payments based on our historical experience and our expectation of future payment patterns. However, the timing of these payments may vary significantly from the amounts shown above, especially for our portfolio reserves. Amounts include payments for derivative reserves of $48.7 million and mortgage reserves of $1.5 million. These amounts are not discounted.
In June 2008, the Company's subsidiary, Assured Guaranty Corp., entered into a new five-year lease agreement for New York office space. Future minimum annual payments of $5.3 million for the first twelve month period and $5.7 million for subsequent twelve month periods will commence October 1, 2008 and are subject to escalation in building operating costs and real estate taxes.
As of December 31, 2008 and 2007, no amounts were outstanding under this facility nor have there been any borrowings under this facility.
The 2006 credit facility replaced a $300.0 million three-year credit facility. Letters of credit totaling approximately $2.9 million remained outstanding as of December 31, 2008 related to the Real Estate Lease agreement discussed above. No letters of credit were outstanding as of December 31, 2007.
As of December 31, 2008 and 2007, no amounts were outstanding under this facility nor have there been any borrowings under the life of this facility.
Subject to the Replacement Capital Covenant, the Debentures may be redeemed in whole or in part, subject to minimum amounts outstanding, at any time, on or after December 15, 2016, at the cash redemption price of 100% of the principal amount of the Debentures to be redeemed, plus accrued and unpaid interest, together with any compounded interest, on such Debentures to the date of redemption (the "par redemption amount"). AGUS may redeem the Debentures prior to December 15, 2016, in whole but not in part, at a price equal to the greater of (i) the par redemption amount and (ii) the applicable make-whole redemption amount.
On April 8, 2005, AGC entered into separate agreements (the "Put Agreements") with each of Woodbourne Capital Trust I, Woodbourne Capital Trust II, Woodbourne Capital Trust III and Woodbourne Capital Trust IV (each, a "Custodial Trust") pursuant to which AGC may, at its option, cause each of the Custodial Trusts to purchase up to $50,000,000 of perpetual preferred stock of AGC (the "AGC Preferred Stock").
commercial paper and (in limited cases) U.S. Treasury Securities (the "Eligible Assets"), (iii) entering into the Put Agreement with AGC; and (iv) entering into related agreements.
Initially, all of the CCS Securities were issued to a special purpose pass-through trust (the "Pass-Through Trust"). The Pass-Through Trust was dissolved in April 2008 and the committed capital securities were distributed to the holders of the Pass-Through Trust's securities. Neither the Pass-Through Trust nor the Custodial Trusts are consolidated in Assured Guaranty's financial statements.
Upon exercise of the put option granted to AGC pursuant to the Put Agreement, a Custodial Trust will liquidate its portfolio of Eligible Assets and purchase the AGC Preferred Stock and will hold the AGC Preferred Stock until the earlier of (i) the redemption of such AGC Preferred Stock and (ii) the liquidation or dissolution of the Custodial Trust.
calculated from the date of the failure to pay the put premium through the end of the applicable period.
AGC Preferred Stock under the Put Agreement will be issued in one or more series, with each series in an aggregate liquidation preference amount equal to the aggregate face amount of a Custodial Trust's outstanding CCS Securities, net of fees and expenses, upon exercise of the put option. Unless redeemed by AGC, the AGC Preferred Stock will be perpetual.
Upon a Fixed Rate Distribution Event, the distribution rate on the AGC Preferred Stock will equal the fixed rate equivalent of one-month LIBOR plus 2.50%. A "Fixed Rate Distribution Event" will be deemed to have occurred when AGC Preferred Stock is outstanding, if: (1) AGC elects to have the AGC Preferred Stock bear dividends at a fixed rate, (2) AGC fails to pay dividends on the AGC Preferred Stock for the related distribution period and such failure continues for five business days or (3) AGC fails to pay the fees and expenses of the Custodial Trust for the related distribution period pursuant to the Custodial Trust Expense Reimbursement Agreement and such failure continues for five business days.
During the period in which AGC Preferred Stock is held by a Custodial Trust and unless a Fixed Rate Distribution Event has occurred, dividends will be paid every 49 days. Following a Fixed Rate Distribution Event, dividends will be paid every 90 days.
Our investment portfolio consisted of $3,154.1 million of fixed maturity securities, $477.2 million of short-term investments and a duration of 4.1 years as of December 31, 2008, compared with $2,587.0 million of fixed maturity securities, $552.9 million of short-term investments and a duration of 3.9 years as of December 31, 2007. Our fixed maturity securities are designated as available-for-sale in accordance with FAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("FAS 115"). Fixed maturity securities are reported at their fair value in accordance with FAS 115, and the change in fair value is reported as part of accumulated other comprehensive income. If we believe the decline in fair value is "other than temporary," we write down the carrying value of the investment and record a realized loss in our statement of operations.
The following table summarizes our investment portfolio as of December 31, 2008:
The amortized cost and estimated fair value of our available-for-sale fixed maturity securities as of December 31, 2008 and 2007, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
(1)Total may not add due to rounding. Fair value of the fixed maturity securities is based upon market prices provided by either independent pricing services or, when such prices are not available, by reference to broker or underwriter bid indications. Our investment portfolio does not include any non-publicly traded securities. For a detailed description of our valuation of investments see "-Critical Accounting Estimates."
The following table summarizes the ratings distributions of our investment portfolio as of December 31, 2007 and 2006. Ratings are represented by the lower of the Moody's and S&P classifications.
As of December 31, 2008 and December 31, 2007, our investment portfolio contained three securities that were not rated or rated below investment grade. The change in the rating distributions reflected above is mainly the result of downgrades of certain financial guaranty insurance companies during the Second Quarter 2008. As of December 31, 2008 and December 31, 2007, the weighted average credit quality of our entire investment portfolio was AA+ and AAA, respectively.
(1)Excludes $4.6 million of fixed maturity securities wrapped by Assured Guaranty Corp. and rated below investment grade.
As of December 31, 2008 and to date, the Company has had no investments in or asset positions with any of these guarantors.
Under agreements with our cedants and in accordance with statutory requirements, we maintain fixed maturity securities in trust accounts for the benefit of reinsured companies and for the protection of policyholders, generally in states where we or our subsidiaries, as applicable, are not licensed or accredited. The carrying value of such restricted balances as of December 31, 2008 and 2007 was $1,233.4 million and $936.0 million, respectively.
Under certain derivative contracts, the Company is required to post eligible securities as collateral, generally cash or U.S. government or agency securities. The need to post collateral under these transactions is generally based on mark-to-market valuation in excess of contractual thresholds. The fair market value of the Company's pledged securities totaled $157.7 million and $0.4 million as of December 31, 2008 and 2007, respectively.
As of December 31, 2008, the present value of future installments ("PVI") of our CDS contracts with counterparties in the financial services industry is approximately $495.1 million. The largest counterparties are:
are responsible for monitoring risk limits and applying risk measurement methodologies. The estimation of potential losses arising from adverse changes in market conditions is a key element in managing market risk. We use various systems, models and stress test scenarios to monitor and manage market risk. These models include estimates made by management that use current and historic market information. The valuation results from these models could differ materially from amounts that actually are realized in the market. See "-Critical Accounting Estimates-Valuation of Investments."
thresholds would be eliminated and the amount of par that could be subject to collateral posting requirements would be $2.4 billion. Based on market values as of December 31, 2008, such a downgrade would have resulted in AGC posting an additional $88.7 million of collateral. Currently no additional collateral posting is required or anticipated for any other transactions.
The impact of changes in credit spreads will vary based upon the volume, tenor, interest rates, and other market conditions at the time these fair values are determined. In addition, since each transaction has unique collateral and structure terms, the underlying change in fair value of each transaction may vary considerably. The fair value of credit derivatives also reflects the change in our own credit cost based on the price to purchase credit protection on AGC. During the year ended December 31, 2008, we incurred net pre-tax unrealized gains on credit derivative contracts of $38.0 million. The 2008 gain includes a gain of $4,147.6 million associated with the change in AGC's credit spread, which widened substantially from 180 basis points at December 31, 2007 to 1,775 basis points at December 31, 2008. Management believes that the widening of AGC's credit spread is due to the correlation between AGC's risk profile and that experienced currently by the broader financial markets. Offsetting the gain attributable to the significant increase in AGC's credit spread were declines in fixed income security market prices primarily attributable to widening spreads in certain markets as a result of the continued deterioration in credit markets and some credit rating downgrades, rather than from delinquencies or defaults on securities guaranteed by the Company. The higher credit spreads in the fixed income security market are due to the recent lack of liquidity in the high yield collateralized debt obligation and collateralized loan obligation markets as well as continuing market concerns over the most recent vintages of subprime residential mortgage backed securities.
The total notional amount of credit derivative exposure outstanding as of December 31, 2008 and December 31, 2007 and included in our financial guaranty exposure was $75.1 billion and $71.6 billion, respectively.
In September 2006, the FASB issued FAS No. 157, "Fair Value Measurement" ("FAS 157"). FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. FAS 157 applies to other accounting pronouncements that require or permit fair value measurements, since the FASB had previously concluded in those accounting pronouncements that fair value is the relevant measure. Accordingly, FAS 157 does not require any new fair value measurements. FAS 157 is effective for the measurement of financial assets and liabilities in financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. FASB Staff Position ("FSP") No. 157-2 extended the effective date of FAS 157 for non-financial assets and liabilities for fiscal years beginning after November 15, 2008. We adopted FAS 157 for financial assets and liabilities effective January 1, 2008 and will adopt FAS 157 for non-financial assets and liabilities effective January 1, 2009. FAS 157 did not have a material impact on our results of operations or financial position.
In April 2007, the FASB Staff issued FASB Staff Position No. FIN 39-1, "Amendment of FASB Interpretation No. 39" ("FSP FIN 39-1"), which permits companies to offset cash collateral receivables or payables with net derivative positions under certain circumstances. FSP FIN 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. FSP FIN 39-1 did not affect the Company's results of operations or financial position.
In December 2007, the FASB issued FAS No. 141 (revised), "Business Combinations" ("FAS 141R"). FAS 141R establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. FAS 141R also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statement to evaluate the nature and financial effects of the business combination. FAS 141R is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim statements within those fiscal years. Early adoption is not permitted. Since FAS 141R applies prospectively to business combinations whose acquisition date is subsequent to the statement's adoption. The Company plans to apply the provisions of FAS 141R to account for its pending acquisition of FSAH. As of December 31, 2008, the Company had paid $2.7 million of expenses related to the Company's pending acquisition of FSAH that the Company plans to expense in the first quarter 2009.
In May 2008, the FASB issued FAS 163. FAS 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. FAS 163 also clarifies the methodology to be used for financial guaranty premium revenue recognition and claim liability measurement, as well as requiring expanded disclosures about the insurance enterprise's risk management activities. The provisions of FAS 163 related to premium revenue recognition and claim liability measurement are effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years. Earlier application of these provisions is not permitted. The expanded risk management activity disclosure provisions of FAS 163 were effective for the third quarter of 2008 and are included in Note 11 "Significant Risk Management Activities" to the consolidated financial statements in Item 8 of this Form 10-K. FAS 163 will be applied to all existing and future financial guaranty insurance contracts written by the Company. The cumulative effect of initially applying FAS 163 will be recorded as an adjustment to retained earnings as of January 1, 2009. The adoption of FAS 163 is expected to have a material effect on the Company's financial statements. The Company is in the process of estimating the impact of its adoption of FAS 163. The Company will continue to follow its existing accounting policies in regards to premium revenue recognition and claim liability measurement until it completes its first quarter 2009 financial statements.
fiscal years beginning after December 15, 2008; earlier application is not permitted. This FSP also requires that all prior period EPS data be adjusted retrospectively. The Company does not expect adoption of the FSP to have a material effect on its results of operations or earnings per share.
Management's Responsibility for Financial Statements and Internal Controls Over Financial Reporting
Consolidated Statements of Shareholders' Equity for the years ended December 31, 2008, 2007 and 2006
Management's Responsibility for Financial Statements and Internal Control Over Financial Reporting
As of December 31, 2008, management has evaluated the effectiveness of the Company's internal control over financial reporting based on the criteria established in "Internal Control-Integrated Framework," issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, we have concluded that Assured Guaranty Ltd.'s internal control over financial reporting was effective as of December 31, 2007.
The effectiveness of the Company's internal controls over financial reporting as of December 31, 2008 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report included in this Item under the heading "Report of Independent Registered Public Accounting Firm."
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and comprehensive income, of shareholders' equity and of cash flows, present fairly, in all material respects, the financial position of Assured Guaranty Ltd. and its subsidiaries (the "Company") at December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Responsibility for Financial Statements and Internal Control over Financial Reporting appearing under Item 8. Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included 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. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
(in thousands of U.S. dollars except per share and share amounts)
On December 20, 2006, Assured Guaranty US Holdings Inc., a subsidiary of the Company, completed the issuance of $150.0 million Series A Enhanced Junior Subordinated Debentures and used the proceeds to repurchase 5,692,599 of the Company's common shares from a subsidiary of ACE. As of December 31, 2008 ACE owns approximately 21% of the Company's outstanding common shares.
The Company has participated in several lines of business that are reflected in its historical financial statements but that the Company exited in connection with its 2004 initial public offering ("IPO"). The results from these lines of business make up the Company's Other segment discussed in Note 23.
On April 8, 2008, investment funds managed by WL Ross & Co. LLC ("WL Ross") purchased 10,651,896 shares of the Company's common equity at a price of $23.47 per share, resulting in proceeds to the Company of $250.0 million. The Company contributed $150.0 million of these proceeds to its Bermuda domiciled reinsurance subsidiary, AG Re. In addition, the Company contributed $100.0 million of these proceeds to its subsidiary, Assured Guaranty US Holdings Inc., which in turn contributed the same amount to its Maryland domiciled insurance subsidiary, AGC. The commitment to purchase these shares was previously announced on February 29, 2008. In addition, Wilbur L. Ross, Jr., President and Chief Executive Officer of WL Ross, was appointed to the Board of Directors of the Company to serve a term expiring at the Company's 2009 annual general meeting of shareholders. Mr. Ross's appointment became effective immediately following the Company's 2008 annual general meeting of shareholders, which was held on May 8, 2008. WL Ross has a remaining commitment through April 8, 2009 to purchase up to $750.0 million of the Company's common equity, at the Company's option, subject to the terms and conditions of the investment agreement with the Company dated February 28, 2008. In accordance with the investment agreement, the Company may exercise this option in one or more drawdowns, subject to a minimum drawdown of $50 million, provided that the purchase price per common share for the subsequent shares is not greater than $27.57 or less than $19.37. The Company must also be rated triple-A (Stable) by Moody's, Standard & Poor's and Fitch to drawdown on the commitment. The purchase price per common share for such shares will be equal to 97% of the volume weighted average price of a common share on the NYSE for the 15 NYSE trading days prior to the applicable drawdown notice. As of December 31, 2008, and as of the date of this filing, the purchase price per common share is outside of this range and therefore the Company may not, at this time, exercise its option for WL Ross to purchase additional shares.
Funds would beneficially own 17,166,396 shares or approximately 18.9% of the Company's outstanding common shares based on shares outstanding as of December 31, 2008. As of the date of this filing, the Company has not been notified that WLR Funds purchased any additional shares of the Company.
The Company's subsidiaries have been assigned the following insurance financial strength ratings:
The WLR Funds have no obligation to purchase these common shares pursuant to the WLR Backstop Commitment until the closing under the stock purchase agreement occurs. The Company may use the proceeds from the sale of the Company's common shares pursuant to the WLR Backstop Commitment solely to pay a portion of the purchase price under the stock purchase agreement. The WLR Funds' obligations under the WLR Backstop Commitment have been secured by letters of credit issued for the benefit of the Company by Bank of America, N.A. and RBS Citizens Bank, N.A., each in the amount of $180.5 million.
The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"), which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. (See Notes 4 and 11 for discussion of significant estimates of derivatives and losses.)
The volatility and disruption in the global financial markets have reached unprecedented levels. The availability and cost of credit has been materially affected. These factors, combined with volatile oil prices, depressed home prices and increasing foreclosures, falling equity market values, declining business and consumer confidence and the risks of increased inflation and unemployment, have precipitated an economic slowdown and fears of a severe recession. These conditions may adversely affect our profitability, financial position, investment portfolio, cash flow, statutory capital, financial strength ratings and stock price. Additionally, future legislative, regulatory or judicial changes in the
jurisdictions regulating our Company may adversely affect our ability to pursue our current mix of business, materially impacting our financial results.
Certain prior year items have been reclassified to conform to the current year presentation.
In general, the Company structures credit derivative transactions such that circumstances giving rise to our obligation to make payments is similar to that for financial guaranty policies and generally occurs as losses are realized on the underlying reference obligation. Nonetheless, credit derivative transactions are governed by International Swaps and Derivatives Association, Inc. ("ISDA") documentation and operates differently from financial guaranty insurance policies. Under GAAP CDS contracts are subject to derivative accounting rules and financial guaranty policies are subject to insurance accounting rules.
(1)A fair value gain of $8.3 million related to Assured Guaranty Corp.'s committed capital securities, which was included in "Unrealized gains on derivative financial instruments" at December 31, 2007 has been reclassified to "Committed capital securities, at fair value" to conform with the 2008 presentation.
Premiums are received either upfront or in installments. Upfront premiums are earned in proportion to the expiration of the amount at risk. Each installment premium is earned ratably over its
The Company accounts for its investments in fixed maturity securities in accordance with the Financial Accounting Standards Board's ("FASB") Statement of Financial Accounting Standards ("FAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("FAS 115"). Management determines the appropriate classification of securities at the time of purchase. As of December 31, 2008 and 2007, all investments in fixed maturity securities were designated as available-for-sale and are carried at fair value with a corresponding adjustment to accumulated other comprehensive income. The fair values of all the Company's investments are calculated from independent market valuations. The fair values of the Company's U.S. Treasury securities are primarily determined based upon broker dealer quotes obtained from several independent active market makers. The fair values of the Company's portfolio other than U.S. Treasury securities are determined primarily using matrix pricing models. The matrix pricing models incorporate factors such as tranche type, collateral coupons, average life, payment speeds, and spreads, in order to calculate the fair values of specific securities owned by the Company.
Realized gains and losses on sales of investments are determined using the specific identification method. Unrealized gains and losses on investments, net of applicable deferred income taxes, are
If the Company believes a decline in the value of a particular investment is temporary, the decline is recorded as an unrealized loss on the balance sheet in "accumulated other comprehensive income" in shareholders' equity. If the Company believes the decline is "other than temporary," the Company will write down the carrying value of the investment and record a realized loss in its consolidated statements of operations and comprehensive income. In periods subsequent to the recognition of an other-than-temporary impairment, the impaired security is accounted for as if it had been purchased on the measurement date of the impairment. Accordingly, the discount (or reduced premium) based on the new cost basis is accreted into net investment income in future periods based upon the amount and timing of expected future cash flows of the security, if the recoverable value of the investment based upon those cash flows is greater than the carrying value of the investment after the impairment.
The Company's assessment of a decline in value includes management's current assessment of the factors noted above. The Company also seeks advice from its outside investment managers. If that assessment changes in the future, the Company may ultimately record a loss after having originally concluded that the decline in value was temporary.
Portfolio reserves are not established based on a specific event, rather they are calculated by aggregating the portfolio reserve calculated for each individual transaction. Individual transaction reserves are calculated on a quarterly basis by multiplying the par in-force by the product of the ultimate loss and earning factors without regard to discounting. The ultimate loss factor is defined as
the frequency of loss multiplied by the severity of loss, where the frequency is defined as the probability of default for each individual issue. The earning factor is inception to date earned premium divided by the estimated ultimate written premium for each transaction. The probability of default is estimated from rating agency data and is based on the transaction's credit rating, industry sector and time until maturity. The severity is defined as the complement of recovery/salvage rates gathered by the rating agencies of defaulting issues and is based on the industry sector.
Portfolio reserves are recorded gross of reinsurance. The Company has not ceded any amounts under these reinsurance contracts, as the Company's recorded portfolio reserves have not exceeded the Company's contractual retentions, required by said contracts.
The Company records an incurred loss that is reflected in the statement of operations upon the establishment of portfolio reserves. When the Company initially records a case reserve, the Company reclassifies the corresponding portfolio reserve already recorded for that credit within the balance sheet. The difference between the initially recorded case reserve and the reclassified portfolio reserve is recorded as a charge in the Company's statement of operations. Any subsequent change in portfolio reserves or the initial case reserves are recorded quarterly as a charge or credit in the Company's statement of operations in the period such estimates change. Due to the inherent uncertainties of estimating loss and LAE reserves, actual experience may differ from the estimates reflected in the Company's consolidated financial statements, and the differences may be material.
For mortgage guaranty transactions the Company records portfolio reserves in a manner consistent with its financial guaranty business. While other mortgage guaranty insurance companies do not record portfolio reserves, rather just case and IBNR reserves, the Company records portfolio reserves because the Company writes business on an excess of loss basis, while other industry participants write quota share or first layer loss business. The Company manages and underwrites this business in the same manner as its financial guaranty insurance and reinsurance business because they have similar characteristics as insured obligations of mortgage-backed securities.
FAS No. 60 is the authoritative guidance for an insurance enterprise. FAS 60 prescribes differing reserving methodologies depending on whether a contract fits within its definition of a short-duration contract or a long-duration contract. Financial guaranty contracts have elements of long-duration insurance contracts in that they are irrevocable and extend over a period that may exceed 30 years or more, but for regulatory purposes are reported as property and liability insurance, which are normally considered short-duration contracts. The short-duration and long-duration classifications have different methods of accounting for premium revenue and contract liability recognition. Additionally, the accounting for deferred acquisition costs ("DAC") could be different under the two methods.
Under the terms of certain of the Company's reinsurance contracts, the Company is obligated to pay the ceding company at predetermined future dates a contingent commission based upon a specified percentage of the net underwriting profits. The Company's liability for the present value of expected future payments is shown on the balance sheet under the caption, "Profit commissions payable". The unamortized discount on this liability was $0 as of both December 31, 2008 and 2007.
In the ordinary course of business, the Company's insurance subsidiaries assume and retrocede business with other insurance and reinsurance companies. These agreements provide greater diversification of business and may minimize the net potential loss from large risks. Retrocessional contracts do not relieve the Company of its obligation to the reinsured. Reinsurance recoverable on ceded losses includes balances due from reinsurance companies for paid and unpaid losses and LAE that will be recovered from reinsurers, based on contracts in force, and is presented net of any provision for estimated uncollectible reinsurance. Any change in the provision for uncollectible reinsurance is included in loss and loss adjustment expenses. Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers relating to the unexpired terms of the reinsurance contracts in force.
The Company has concluded that it is reasonably likely that the goodwill associated with our reinsurance line of business could become impaired in future periods if the volume of new business in the financial guaranty reinsurance market does not return to historical levels experienced prior to 2008 or if the Company is not able to continue to execute portfolio based reinsurance contracts on blocks of business for other financial guarantors in financial distress. Also, the pending FSAH transaction may cause a triggering event that will cause management to reassess its goodwill amounts related to its reinsurance line of business. See Note 22. Goodwill, for more information.
Effective January 1, 2006, the Company adopted the fair value recognition provisions of FAS No. 123 (revised), "Share-Based Payment" ("FAS 123R") using the modified prospective transition method. Under that transition method, compensation expense includes: (a) compensation expense for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of FAS 123, and (b) compensation expense for all share-based payments granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of FAS 123R. See Note 20 for further discussion regarding the methodology utilized in recognizing share-based compensation expense.
In December 2007, the FASB issued FAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No. 51" ("FAS 160"). FAS 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary for the deconsolidation of a
subsidiary. FAS 160 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim statements within those fiscal years. The Company is currently evaluating the impact, if any, FAS 160 will have on its consolidated financial statements.
In March 2008, the FASB issued FAS No. 161, "Disclosures About Derivative Instruments and Hedging Activities-An Amendment of FASB Statement No. 133" ("FAS 161"). FAS 161 establishes the disclosure requirements for derivative instruments and for hedging activities. FAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. Early application is encouraged. FAS 161 is not expected to have an impact on the Company's current results of operations or financial position.
The FASB adopted FSP FAS 133-1 and FIN 45-4, "Disclosures About Credit Derivatives and Certain Guarantees" and FAS 161, "Disclosures about Derivative Instruments and Hedging Activities" to address concerns that current derivative disclosure requirements did not adequately address the potential adverse effects that these instruments can have on the financial performance and operations of an entity. Companies will be required to provide enhanced disclosures about their derivative activities to enable users to better understand: (1) how and why a company uses derivatives, (2) how it accounts for derivatives and related hedged items, and (3) how derivatives affect its financial statements. These should include the terms of the derivatives, collateral posting requirements and triggers, and other significant provisions that could be detrimental to earnings or liquidity. Disclosures specific to credit derivatives must be included in the December 31, 2008 financial statements. Certain other derivative and hedging disclosures must be included in the Company's March 31, 2009 Form 10-Q. Management believes that the Company's current derivatives disclosures are in compliance with the items required by FSP 133-1 and FAS 161.
Realized gains and other settlements on credit derivatives include credit derivative premiums received and receivable for credit protection the Company has sold under its insured CDS as well as any contractual claim losses paid and payable related to insured credit events under these contracts, ceding commissions (expense) income and realized gains or losses related to their early termination. The Company generally holds credit derivative contracts to maturity. However, in certain circumstances such as for risk management purposes or as a result of a decision to exit a line of business, the Company may decide to terminate a credit derivative contract prior to maturity.
The impact of changes in credit spreads will vary based upon the volume, tenor, interest rates, and other market conditions at the time these fair values are determined. In addition, since each transaction has unique collateral and structure terms, the underlying change in fair value of each transaction may vary considerably. The fair value of credit derivative contracts also reflects the change in the Company's own credit cost based on the price to purchase credit protection on AGC. During 2008, the Company incurred net pre-tax unrealized gains on credit derivative contracts of $38.0 million. The 2008 gain includes an amount of $4,147.6 million associated with the change in AGC's credit spread, which widened substantially from 180 basis points at December 31, 2007 to 1,775 basis points at
The total notional amount of credit derivative exposure outstanding as of December 31, 2008 and December 31, 2007 and included in the Company's financial guaranty exposure was $75.1 billion and $71.6 billion, respectively.
The components of the Company's unrealized gain (loss) on credit derivatives as of December 31, 2008 are:
(1)Based on the Company's internal rating, which is on a comparable scale to that of the nationally recognized rating agencies.
Corporate collateralized loan obligations, market value CDO's, and trust preferred securities, which comprise the Company's pooled corporate exposures, include all U.S. structured finance pooled corporate obligations and international pooled corporate obligations. Commercial mortgage-backed securities are comprised of commercial U.S. structured finance and commercial international mortgage
backed securities. Residential mortgage-backed securities are comprised of prime and subprime U.S. mortgage-backed and home equity securities, international residential mortgage-backed and international home equity securities. Other includes all other U.S. and international asset classes, such as commercial receivables, and international infrastructure and pooled infrastructure securities.
The unrealized loss of $(339.2) million on Other CDS contracts for the year ended December 31, 2008 is primarily attributable to a change in the call date assumption and widening of spreads for a pooled infrastructure transaction during the Second Quarter 2008, that resulted in a unrealized loss of $(145.8) million, and the ratings downgrades on a wrapped film securitization transaction where the Company provided credit protection on a transaction insured by another financial guarantor. The ratings downgrade of that other financial guarantor caused the downgrade and credit spread widening of the film securitization transaction that resulted in an unrealized loss of $(104.6) million.
The following table presents additional details about the Company's unrealized gain on pooled corporate obligation credit derivatives, which includes collateralized loan obligations, market value CDOs and trust preferred securities, by asset type as of December 31, 2008:
(2)Represents the sum of subordinate tranches and over-collateralization and does not include any benefit from excess interest collections that may be used to absorb losses. The following table presents additional details about the Company's unrealized gain on credit derivatives associated with commercial mortgage-backed securities by vintage as of December 31, 2008:
In general, the Company structures credit derivative transactions such that the circumstances giving rise to our obligation to make payments is similar to that for financial guaranty policies and generally occurs as losses are realized on the underlying reference obligation. Nonetheless, credit derivative transactions are governed by ISDA documentation and operate differently from financial guaranty insurance policies. For example, our control rights with respect to a reference obligation under a credit derivative may be more limited than when the Company issues a financial guaranty insurance policy on a direct primary basis. In addition, while the Company's exposure under credit derivatives, like the Company's exposure under financial guaranty insurance policies, is generally for as long as the reference obligation remains outstanding, unlike financial guaranty insurance policies, a credit derivative may be terminated for a breach of the ISDA documentation or other specific events. In some older credit derivative transactions, one such specified event is the failure of AGC to maintain specified financial strength ratings ranging from AA- to BBB-. If a credit derivative is terminated the Company could be required to make a mark-to-market payment as determined under the ISDA documentation. For example, if AGC's rating were downgraded to A+, under market conditions at December 31, 2008, if the counterparties exercised their right to terminate their credit derivatives, AGC would have been required to make payments that the Company estimates to be approximately $261 million. Further, if AGC's rating was downgraded to levels between "BBB+" and "BB+" it would have been required to make additional payments that the Company estimates to be approximately $620 million at December 31, 2008.
Under a limited number of credit derivative contracts, the Company is required to post eligible securities as collateral, generally cash or U.S. government or agency securities. The need to post collateral under these transactions is generally based on mark-to-market valuation in excess of contractual thresholds. The particular thresholds decline if the Company's ratings decline. As of December 31, 2008 the Company had pre-IPO transactions with approximately $1.9 billion of par subject to collateral posting due to changes in market value. Of this amount, as of December 31, 2008, the Company posted collateral totaling approximately $157.7 million (including $134.2 million for AGC) based on the unrealized mark-to-market loss position for transactions with two of its counterparties. Any amounts required to be posted as collateral in the future will depend on changes in the market values of these transactions. Additionally, in the event AGC were downgraded below A-, contractual thresholds would be eliminated and the amount of par that could be subject to collateral posting requirements would be $2.4 billion. Based on market values as of December 31, 2008, such a downgrade would have resulted in AGC posting an additional $88.7 million of collateral. Currently no additional collateral posting is required or anticipated for any other transactions.
As of December 31, 2008 and December 31, 2007, the Company considered the impact of its own credit risk, in combination with credit spreads on risk that it assumes through CDS contracts, in determining the fair value of its credit derivatives. The Company determines its own credit risk based on quoted CDS prices traded on the Company at each balance sheet date. The quoted price of CDS contracts traded on AGC at December 31, 2008 and December 31, 2007 was 1,775 basis points and 180 basis points, respectively. Historically, the price of CDS traded on AGC moves directionally the same as general market spreads. Generally, a widening of the CDS prices traded on AGC has an effect of offsetting unrealized losses that result from widening general market credit spreads, while a narrowing of the CDS prices traded on AGC has an effect of offsetting unrealized gains that result from narrowing general market credit spreads. An overall narrowing of spreads generally results in an unrealized gain on credit derivatives for the Company and an overall widening of spreads generally results in an unrealized loss for the Company. At December 31, 2008, the values of our CDS contracts before and after considering implications of our credit spreads were $(4,686.8) million and $(539.2) million, respectively. At December 31, 2007 the effect of our own credit was not significant. As noted above, our own credit spread widened from 180 basis points at December 31, 2007 to 1,775 basis points at December 31, 2008. As such, the impact of our own credit spread significantly affected the 2008 values but not the 2007 values.
FAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The price shall represent that available in the principal market for the asset or liability. If there is no principal market, then the price is based on the market that maximizes the value received for an asset or minimizes the amount paid for a liability (i.e. the most advantageous market).
FAS 157 applies to both amounts recorded in the Company's financial statements and to disclosures. Amounts recorded at fair value in the Company's financial statements on a recurring basis are fixed maturity securities available for sale, short-term investments, credit derivative assets and
Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial instruments also include those for which the determination of fair value requires significant management judgment or estimation. A brief description of the valuation techniques used for Level 3 assets and liabilities is provided below.
The fair value of the Company's credit derivative contracts represents the difference between the present value of remaining expected premiums the Company receives for the credit protection and the estimated present value of premiums that a comparable financial guarantor would hypothetically charge the Company for the same protection at the balance sheet date. The fair value of the Company's credit derivatives depends on a number of factors including notional amount of the contract, expected term, credit spreads, changes in interest rates, the credit ratings of referenced entities, the Company's own credit risk and remaining contractual cash flows. Contractual cash flows, which are included in the "Realized gains and other settlements on credit derivatives" fair value component of credit derivatives, are the most readily observable variables of the fair value of credit derivative contracts since they are based on contractual terms. These variables include (i) net premiums received and receivable on written credit derivative contracts, (ii) net premiums paid and payable on purchased contracts, (iii) losses paid and payable to credit derivative contract counterparties and (iv) losses recovered and recoverable on purchased contracts. The remaining key variables described above impact "Unrealized gains (losses) on credit derivatives".
Valuation models include the use of management estimates and current market information. Management is also required to make assumptions on how the fair value of credit derivative instruments is affected by current market conditions. Management considers factors such as current prices charged for similar agreements, performance of underlying assets, life of the instrument, and the extent of credit derivative exposure the Company ceded under reinsurance agreements, and the nature and extent of activity in the financial guaranty credit derivative marketplace. The assumptions that management uses to determine its fair value may change in the future due to market conditions. Due to the inherent uncertainties of the assumptions used in the valuation models to determine the fair value of these credit derivative products, actual experience may differ from the estimates reflected in the Company's consolidated financial statements and the differences may be material.
Listed below are various inputs and assumptions that are key to the establishment of our fair value for CDS contracts.
•Gross spread on a financial guarantee written in CDS form gets allocated among 1) profit the originator, usually an investment bank, realizes for putting the deal together and funding the transaction, 2) premiums paid to us for our credit protection provided and 3) the cost of CDS
protection purchased on us by the originator to hedge their counterparty credit risk exposure to the Company. The premium the Company receives is referred to as the net spread. The Company's own credit risk is factored into the determination of net spread based on the impact of changes in the quoted market price for credit protection bought on the Company, as reflected by quoted market prices on CDS sold on Assured Guaranty Corp. The cost to acquire CDS protection sold on AGC affects the amount of spread on CDS deals that the Company captures and, hence, their fair value. As the cost to acquire CDS protection sold on AGC increases the amount of premium we capture on a deal generally decreases. As the cost to acquire CDS protection sold on AGC decreases the amount of premium we capture on a deal generally increases. In our model, the premium we capture is not permitted to go below the historic minimum rate charged by us to assume similar risks. This has the effect of mitigating the amount of unrealized gains that are recognized on certain CDS contracts.
•The Company determines the fair value of its CDS contracts by applying the net spread for the remaining duration of each contract to the notional value of its CDS contracts.
•Actual transactions are used to validate the model results and to explain the correlation between various market indices and indicative CDS market prices.
The specific model inputs are listed below, including how we derive inputs for market credit spreads on the underlying transaction collateral.
market source against quotes received from another market source to ensure reasonableness. In addition, we compare the relative change in price quotes received from one quarter to another, with the relative change experienced by published market indices for a specific asset class. Collateral specific spreads obtained from third-party, independent market sources are un-published spread quotes from market participants and or market traders whom are not trustees. Management obtains this information as the result of direct communication with these sources as part of the valuation process.
•Credit spreads on the Company's name-The Company obtains the quoted price of CDS contracts traded on AGC from market data sources published by third parties.
The following is an example of how changes in gross spreads, the Company's own credit spread and the cost to buy protection on the Company affect the amount of premium the Company can demand for its credit protection. Scenario 1 represents the market conditions in effect on the transaction date and Scenario 2 represents market conditions at a subsequent reporting date.
In Scenario 1, the gross spread is 185bps. The bank or deal originator captures 115bps of the original gross spread and hedges 10% of its exposure to AGC, when the CDS spread on AGC was 300bps (300bps × 10% = 30bps). Under this scenario AGC received premium of 40bps, or 22% of the gross spread.
In Scenario 2, the gross spread is 500bps. The bank or deal originator captures 50bps of the original gross spread and hedges 25% of its exposure to AGC, when the CDS spread on AGC was 1,760bps (1,760bps × 25% = 440bps). Under this scenario AGC would receive premium of 10bps, or 2% of the gross spread.
In this example, the contractual cash flows exceed the amount a market participant would require AGC to pay in today's market to accept its obligations under the credit default swap contract, thus resulting in an asset. This credit derivative asset is equal to the difference in premium rate discounted at a risk adjusted rate over the weighted average remaining life of the contract. The expected future cash flows for the Company's credit derivatives were discounted at rates ranging from 1.0% to 17.0% over LIBOR at December 31, 2008, with over 97% of the transactions ranging from 1.0% to 6.0% over LIBOR.
A credit derivative asset under FAS 157 is the result of contractual cash flows on in-force deals in excess of what a hypothetical financial guarantor could receive if it sold protection on the same risk as of the current reporting date. If the Company were able to freely exchange these contracts (i.e., assuming its contracts did not contain proscriptions on transfer and there was a viable exchange market), it would be able to realize an asset representing the difference between the higher contractual premiums to which it's entitled and the current market premiums for a similar contract.
1.Actual collateral specific credit spreads (if up-to-date and reliable market-based spreads are available, they are used).
2.Credit spreads are interpolated based upon market indices or deals priced or closed during a specific quarter within a specific asset class and specific rating.
4.Credit spreads are extrapolated based upon transactions of similar asset classes, similar ratings, and similar time to maturity.
As of December 31, 2008, the Company obtained approximately 8% of its credit spread information, based on notional par outstanding, from actual collateral specific credit spreads, while 78% was based on market indices and 14% was based on spreads provided by the CDS counterparty. The Company interpolates a curve based on the historical relationship between premium the Company receives when a financial guarantee written in CDS form closes to the daily closing price of the market index related to the specific asset class and rating of the deal. This curve indicates expected credit spreads at each indicative level on the related market index. For specific transactions where no price quotes are available and credit spreads need to be extrapolated, an alternative transaction for which the Company has received a spread quote from one of the first three sources within the Company's spread hierarchy is chosen. This alternative transaction will be within the same asset class, have similar underlying assets, similar credit ratings, and similar time to maturity. The Company then calculates the percentage of relative spread change quarter over quarter for the alternative transaction. This percentage change is then applied to the historical credit spread of the transaction for which no price quote was received in order to calculate the transactions current spread. Counterparties determine credit spreads by reviewing new issuance pricing for specific asset classes and receiving price quotes from their trading desks for the specific asset in question. These quotes are validated by cross-referencing quotes received from one market source with those quotes received from another market source to ensure reasonableness. In addition, management compares the relative change experienced on published market indices for a specific asset class for reasonableness and accuracy.
•The model takes account of transaction structure and the key drivers of market value. The transaction structure includes par insured, weighted average life, level of subordination and composition of collateral.
•The model is a well-documented, consistent approach to valuing positions that minimizes subjectivity The Company has developed a hierarchy for market-based spread inputs that helps mitigate the degree of subjectivity during periods of high illiquidity.
•There is no exit market or actual exit transactions. Thus our exit market is a hypothetical one based on our entry market.
The net par outstanding of the Company's credit derivative contracts was $75.1 billion and $71.6 billion at December 31, 2008 and December 31, 2007, respectively. The estimated remaining average life of these contracts at December 31, 2008 was 7.0 years.
The table below presents a reconciliation of the Company's credit derivatives whose fair value included significant unobservable inputs (Level 3) during the year ended December 31, 2008.
The fair value of the Company's unearned premium reserves is based on the estimated cost of entering into a cession of entire financial guaranty insurance portfolio with third party reinsurers under current market conditions. This figure is based on management's estimate of what a similarly rated financial guaranty insurance company would demand to assume the Company's in-force book of financial guaranty insurance business. This amount is based on the pricing assumptions we have
observed in recent portfolio transfers that have occurred in the financial guaranty market and includes adjustments to the carrying value of unearned premiums reserves for stressed losses and ceding commissions. The significant inputs for stressed losses and ceding commissions are not readily observable inputs, therefore, the Company classified this fair value measurement as Level 3.
The fair value of the Company's $200.0 million of Senior Notes and $150.0 million of Series A Enhanced Junior Subordinated Debentures are determined by calculating the midpoint of quoted bid/ask prices over the U.S. Treasury yield at the year-end date and the appropriate credit spread for similar debt instruments. The significant market inputs used are observable, therefore, the Company classified this fair value measurement as Level 2.
The Company's U.S. domiciled insurance companies prepare statutory financial statements in accordance with accounting practices prescribed or permitted by the National Association of Insurance Commissioners ("NAIC") and their respective Insurance Departments. Prescribed statutory accounting practices are set forth in the NAIC Accounting Practices and Procedures Manual. There are no permitted accounting practices on a statutory basis. The combined capital and statutory surplus of the Company's U.S. domiciled insurance companies was $408.7 million and $430.5 million as of December 31, 2008 and 2007, respectively. The statutory combined net income of the Company's U.S. domiciled insurance companies was $27.6 million, $73.2 million and $66.0 million for the years ended December 31, 2008, 2007 and 2006, respectively.
As of December 31, 2008 and 2007, net financial guaranty par in force, including insured CDS, was approximately $222.7 billion and $200.3 billion, respectively. The portfolio was broadly diversified by payment source, geographic location and maturity schedule, with no single risk representing more than 0.7% and 0.8% of the total net par in force as of December 31, 2008 and 2007, respectively.
(2)Totals may not add due to rounding. As part of its financial guaranty business, the Company enters into CDS transactions whereby one party pays a periodic fee in fixed basis points on a notional amount in return for a contingent payment by the other party in the event one or more defined credit events occurs with respect to one or more third party referenced securities or loans. A credit event may be a nonpayment event such as a failure to pay, bankruptcy, or restructuring, as negotiated by the parties to the CDS transaction. The total notional amount of insured CDS exposure outstanding as of December 31, 2008 and 2007 and included in the Company's financial guaranty exposure was $75.1 billion and $71.6 billion, respectively.
As of December 31, 2008 and 2007, the Company's net mortgage guaranty insurance in force (representing the current principal balance of all mortgage loans currently reinsured) was approximately $0.4 billion and $1.1 billion, respectively, and net risk in force was approximately $0.4 billion and $1.1 billion, respectively. These amounts are not included in the above table.
Net earned premiums include $61.9 million, $17.6 million and $11.2 million for 2008, 2007 and 2006, respectively, related to refunded and called bonds, which reflect the unscheduled pre-payment or refundings of underlying municipal bonds. The increase in 2008 compared to 2007 is primarily a result of greater refundings of municipal auction rate and variable rate debt as reported by the Company's ceding companies. The 2008 year included $1.3 million of public finance refundings in the financial
The following table summarizes the Company's aggregate investment portfolio as of December 31, 2008:
The following table summarizes the Company's aggregate investment portfolio as of December 31, 2007:
Approximately 29% and 28% of the Company's total investment portfolio as of December 31, 2008 and 2007, respectively, was composed of mortgage-backed securities, including collateralized mortgage obligations and commercial mortgage-backed securities. As of December 31, 2008 and December 31, 2007, respectively, approximately 69% and 55% of the Company's total mortgage-backed securities were government agency obligations. As of December 31, 2008 and 2007, the weighted average credit quality of the Company's entire investment portfolio was AA+ and AAA, respectively. The Company's portfolio is comprised primarily of high-quality, liquid instruments. The Company continues to receive sufficient information to value its investments and has not had to modify its approach due to the current market conditions.
The amortized cost and estimated fair value of available-for-sale fixed maturity securities as of December 31, 2008, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from the sale of available-for-sale fixed maturity securities were $532.1 million, $786.6 million and $657.0 million for the years ended December 31, 2008, 2007 and 2006, respectively.
The change in net unrealized gains (losses) of available-for-sale fixed maturity securities consists of:
The above unrealized loss balances are comprised of 218 and 161 fixed maturity securities as of December 31, 2008 and 2007, respectively. The Company has considered factors such as sector credit ratings and industry analyst reports in evaluating the above securities for impairment. As of December 31, 2008, the Company's gross unrealized loss position stood at $122.5 million compared to $8.9 million at December 31, 2007. The $113.6 million increase in gross unrealized losses was primarily attributable to mortgage and asset-backed securities, $54.3 million, municipal securities, $48.6 million, and corporate securities, $10.4 million. The increase in these unrealized losses during the year ended December 31, 2008 was related to the overall illiquidity in the financial markets and resulted in a sudden and severe depressed demand for non-cash investments.
The Company recognized $71.3 million of other than temporary impairment losses substantially related to mortgage-backed and corporate securities for the year ended December 31, 2008 primarily due to the fact that it does not have the intent to hold these securities until there is a recovery in their value. The Company continues to monitor the value of these investments. Future events may result in further impairment of the Company's investments. The Company had no write downs of investments for other than temporary impairment losses for the years ended December 31, 2007 and 2006.
No material investments of the Company were non-income producing for the years ended December 31, 2008, 2007 and 2006.
The financial guaranty case basis reserves have been discounted using the taxable equivalent yield on our investment portfolio, which approximated 6% in 2008, 2007 and 2006, resulting in a discount of $(8.7) million, $3.9 million and $9.6 million, respectively.
conditions, and evaluation of servicer or collateral manager performance and financial condition. Additionally, the Company uses various quantitative tools and models to assess transaction performance and identify situations where there may have been a change in credit quality. For all transactions, surveillance activities may include discussions with or site visits to issuers, servicers or other parties to a transaction.
In accordance with FAS 163, the above table includes financial guaranty contracts written in insurance form. It does not include financial guaranty contracts written in CDS form, mortgage guaranty insurance or the Company's other lines of insurance.
The performance of our HELOC exposures deteriorated during 2007 and 2008 and transactions, particularly those originated in the period from 2005 through 2007, continue to perform below our
In recent periods, CDR, CPR, Draw Rates and delinquency percentages have fluctuated within ranges that we believe make it appropriate to use rolling averages to project future performance. Accordingly, the Company is using modeling assumptions that are based upon or which approximate recent actual historical performance to project future performance and potential losses. During 2008, the Company extended the time frame during which it expects the CDR to remain elevated. The Company also revised its assumptions with respect to the overall shape of the default and loss curves. Among other things, these changes assume that a higher proportion of projected defaults will occur over the near term. This revision was based upon management's judgment that a variety of factors including the deterioration of U.S. economic conditions could lead to a longer period in which default rates remain high. The Company continues to model sensitivities around the results booked using a variety of CDR rates and stress periods as well as other modeling approaches including roll rates and hybrid roll rate/CDR methods.
As a result of this modeling and analysis, the Company incurred loss and loss adjustment expenses of $111.0 million for its direct Countrywide transactions during 2008. The Company's cumulative incurred loss and loss adjustment expenses on the direct Countrywide transactions as of December 31, 2008 were $111.0 million ($87.2 million after-tax). During 2008, the Company paid losses and loss adjustment expenses for its direct Countrywide transactions of $170.0 million, of which we expect to recover $59.0 million from the receipt of excess spread from future cash flows as well as funding of future draws. This amount of $59.0 million is included in "salvage recoverable" on the balance sheet.
There were no incurred loss and loss adjustment expenses or salvage recoverable amounts on these transactions in 2007.
For the year ended December 31, 2008, the Company incurred loss and loss adjustment expenses of $168.1 million for its HELOC exposures. Of this amount, $130.0 million related to the Company's financial guaranty direct segment, including $111.0 million of incurred loss and loss adjustment expenses for the direct Countrywide transactions. The remaining $38.1 million of incurred loss and loss adjustment expenses related to the Company's assumed HELOC exposures in its financial guaranty reinsurance segment.
The ultimate performance of the Company's HELOC transactions will depend on many factors, such as the level and timing of loan defaults, interest proceeds generated by the securitized loans, repayment speeds and changes in home prices, as well as the levels of credit support built into each transaction. Other factors also may have a material impact upon the ultimate performance of each transaction, including the ability of the seller and servicer to fulfill all of their contractual obligations including its obligation to fund future draws on lines of credit, as well as the amount of benefit received from repurchases of ineligible loans by Countrywide. The variables affecting transaction performance are interrelated, difficult to predict and subject to considerable volatility. If actual results differ materially from any of our assumptions, the losses incurred could be materially different from our estimate. We continue to update our evaluation of these exposures as new information becomes available.
A summary of the Company's exposure to these two deals and their actual performance statistics through December 31, 2008 are as follows:
(1)Cumulative collateral losses expressed as a percentage of the original deal balance.
(2)Total delinquencies (loans >30 days past due) as a percentage of the current deal balance.
(5)Time period (usually 5-10 years) in which the borrower may draw funds from their HELOC.
We also have exposure of $433.1 million to Closed-End Second ("CES") RMBS transactions, of which $424.2 million is in the direct segment. As with other types of RMBS, we have seen significant deterioration in the performance of our CES transactions. On two transactions, which had exposure of $185.0 million, during 2008 we have seen a significant increase in delinquencies and collateral losses, which resulted in erosion of the Company's credit enhancement and the payment of claims totaling $16.2 million. Based on the Company's analysis of these transaction and their projected collateral losses, the Company had case reserves of $37.7 million as of December 31, 2008. Additionally, as of December 31, 2008, the Company had portfolio reserves of $0.1 million in its financial guaranty direct segment and no case or portfolio reserves in its financial guaranty reinsurance segment related to its U.S. Closed-End Second RMBS exposure.
In order for the Company to incur an ultimate net loss on these transactions, adverse experience on the underlying block of life insurance policies and/or credit losses in the investment portfolio would need to exceed the level of credit enhancement built into the transaction structures. Based on its analysis of the information currently available, including estimates of future investment performance, projected credit impairments on the invested assets and performance of the blocks of life insurance business, at December 31, 2008, the Company established a case reserve of $17.2 million for the Ballantyne transaction. The Company has not established a case loss reserve for the Orkney Re II transaction.
Prior to the IPO in April 2004, Assured Guaranty US Holdings Inc. ("AGUS"), Assured Guaranty Corp. ("AGC"), Assured Value Insurance Company ("AVIC"), an AGC subsidiary prior to its merger into AGC in December 2006, AG Financial Products Inc. ("AGFP") and AFP Transferor Inc. ("AFP") had historically filed their U.S. income tax returns in the consolidated U.S. tax return of its former shareholder. For periods after April 2004, AGUS and its subsidiaries, AGC, AVIC (prior to merger into AGC in December 2006), AGFP and AFP (for the period ended May 18, 2005) file a consolidated federal income tax return. Assured Guaranty Overseas US Holdings Inc. ("AGOUS") and its subsidiaries, Assured Guaranty Re Overseas Ltd. ("AGRO"), Assured Guaranty Mortgage Insurance Company and AG Intermediary Inc., have historically filed a consolidated federal income tax return. AGRO, a Bermuda domiciled company, has elected under Section 953(d) of the Internal Revenue Code to be taxed as a U.S. domestic corporation. Each company, as a member of its respective consolidated tax return group, has paid its proportionate share of the consolidated federal tax burden
for its group as if each company filed on a separate return basis with current period credit for net losses.
The following table provides the Company's income tax (benefit) provision and effective tax rates:
The change in the effective tax rate from year to year is primarily due changes in the proportion of pre tax income earned in different tax jurisdictions at varying statutory rates.
The U.S. Internal Revenue Service ("IRS") has completed audits of all of the Company's U.S. subsidiaries' federal income tax returns for taxable years through 2001. In September 2007, the IRS completed its audit of tax years 2002 through 2004 for Assured Guaranty Overseas US Holdings Inc. and subsidiaries, which includes Assured Guaranty Overseas US Holdings Inc., AGRO, Assured Guaranty Mortgage Insurance Company and AG Intermediary Inc. As a result of the audit there were no significant findings and no cash settlements with the IRS. In addition the IRS is reviewing AGUS for tax years 2002 through the date of the IPO. AGUS includes Assured Guaranty US Holdings Inc., AGC and AG Financial Products and were part of the consolidated tax return of a subsidiary of ACE, for years prior to the IPO. The Company is indemnified by ACE for any potential tax liability associated with the tax examination of AGUS as it relates to years prior to the IPO. In addition, tax years 2005 and subsequent remain open.
Subsequent to the adoption of FIN 48, the IRS published final regulations on the treatment of consolidated losses. As a result of these regulations the utilization of certain capital losses is no longer at a level that would require recording an associated liability for an uncertain tax position. As such, the Company decreased its liability for unrecognized tax benefits and its provision for income taxes $4.1 million during the period ended March 31, 2007. In September 2007, upon completion of the IRS audit of Assured Guaranty Overseas US Holdings Inc. and subsidiaries, the liability for unrecognized tax benefits was reduced by approximately $6.0 million. The total liability for unrecognized tax benefits as of December 31, 2008 and 2007 was $5.1 million and $2.8 million, respectively, and are included in other liabilities on the balance sheet. During the year ended December 31, 2008 the net liability of $2.8 million as of December 31, 2007 increased by approximately $2.3 million due to a position management intends to take on the Company's 2008 tax return. The Company does not believe it is reasonably possible that this amount will change significantly in the next twelve months.
The Company initially recorded a $49.0 million reduction of its existing deferred tax liability, based on an estimate of the ultimate resolution of the Section 338(h)(10) election. Under the tax allocation agreement, the Company estimated that, as of the IPO date, it was obligated to pay $20.9 million to AFS and accordingly established this amount as a liability. The initial difference, which is attributable to the change in the tax basis of certain liabilities for which there is no associated step-up in the tax basis of its assets and no amounts due to AFS, resulted in an increase to additional paid-in capital of $28.1 million. As of December 31, 2008 and December 31, 2007, the liability for tax basis step-up adjustment, which is included in the Company's balance sheets in "Other liabilities," was $9.1 million and $9.9 million, respectively. The Company has paid ACE and correspondingly reduced its liability by $0.7 million and $5.1 million in 2008 and 2007, respectively.
The Company treats the guaranty it provides on CDS as insurance contracts for tax purposes and as such a taxable loss does not occur until the Company expects to make a loss payment to the buyer of credit protection based upon the occurrence of one or more specified credit events with respect to the contractually referenced obligation or entity. The Company holds its CDS to maturity, at which time any unrealized mark to market loss would revert to zero absent any credit related losses. As of
The tax treatment of CDS is an unsettled area of the law. The uncertainty relates to the IRS's determination of the income or potential loss associated with CDS as either subject to capital gain (loss) or ordinary income (loss) treatment. In treating CDS as insurance contracts the Company treats both the receipt of premium and payment of losses as ordinary income and believes it is more likely than not that any CDS credit related losses will be treated as ordinary by the IRS. To the extent the IRS takes the view that the losses are capital losses in the future and the Company incurred actual losses associated with the CDS the Company would need sufficient taxable income of the same character within the carryback and carryforward period available under the tax law.
•The mark to market loss on CDS is not considered a tax event, and therefore no taxable loss has occurred.
•The Company is in a cumulative net gain position related to the taxable activity on CDS contracts.
•The amortization of the tax-basis unearned premium reserve of $528.0 million as of December 31, 2008 as well as the collection of future installment premiums of contracts already written we believe will result in significant taxable income in the future.
•Although the Company has a significant tax exempt portfolio, this can be converted to taxable securities as permitted as a tax planning strategy under FAS 109.
•The mark-to-market loss is reflective of market valuations and will change from quarter to quarter. It is not indicative of the Company's ability to enter new business. The Company writes and continues to write new business which will increase the amortization of unearned premium and investment portfolio resulting in expected taxable income in future periods.
After examining all of the available positive and negative evidence, the Company believes that no valuation allowance is necessary in connection with the deferred tax asset. The Company will continue to analyze the need for a valuation allowance on a quarter to quarter basis.
The Company enters into reinsurance agreements with non-affiliated companies to limit its exposure to risk on an on-going basis. In the event that any or all of the reinsurers are unable to meet their obligations, the Company would be liable for such defaulted amounts. Direct, assumed, and ceded premium and loss and loss adjustment expense amounts for the years ended December 31, 2008, 2007 and 2006 were as follows (2007 and 2006 amounts have been reclassified as discussed in Note 2):
13. Analysis of Premiums Written, Premiums Earned And Loss And Loss Adjustment Expenses (Continued)
Reinsurance recoverable on ceded losses and LAE as of December 31, 2008 and December 31, 2007 were $6.5 million and $8.8 million, respectively, and are mainly related to the Company's other segment. In the event that any or all of the reinsurers are unable to meet their obligations, the Company would be liable for such defaulted amounts. Of these amounts, $4.8 million and $8.8 million, respectively, relate to reinsurance agreements with ACE.
AGC entered into an agreement with CIFG Assurance North America, Inc. ("CIFG") to assume a diversified portfolio of financial guaranty contracts totaling approximately $13.3 billion of net par outstanding. The Company closed the transaction in January 2009 and received $75.6 million, which included $85.7 million of upfront premiums net of ceding commissions, and approximately $12.2 million of future installments related to this transaction.
AG Re's and AGRO's dividend distribution are governed by Bermuda law. Under Bermuda law, dividends may only be paid if there are reasonable grounds for believing that the Company is, or would after the payment be, able to pay its liabilities as they become due and if the realizable value of its assets would thereby not be less than the aggregate of its liabilities and issued share capital and share premium accounts. Distributions to shareholders may also be paid out of statutory capital, but are subject to a 15% limitation without prior approval of the Bermuda Monetary Authority. Dividends are limited by requirements that the subject company must at all times (i) maintain the minimum solvency margin required under the Insurance Act of 1978 and (ii) have relevant assets in an amount at least equal to 75% of relevant liabilities, both as defined under the Insurance Act of 1978. The amount available at AG Re to pay dividends in 2009 in compliance with Bermuda law is $1,125.0 million. However, any distribution which results in a reduction of 15% of more of AG Re's total statutory capital, as set out in its previous year's financial statements, would require the prior approval of the Bermuda Monetary Authority. During 2008, AG Re declared and paid dividends of $31.3 million to its parent, Assured Guaranty Ltd. During 2007 and 2006, AG Re declared dividends of $36.0 million and paid $35.3 million, and $46.5 million and paid $42.6 million, respectively.
In 2004 the Company entered into reinsurance transactions with ACE subsidiaries as part of the IPO. The business ceded was part of the Company's other segment, and is no longer written. The following table summarizes the activity with ACE subsidiaries ("affiliated") and non-affiliated entities for each line item where applicable in the income statements (certain 2007 and 2006 amounts have been reclassified as discussed in Note 2). The affiliated amounts relate primarily to these legacy reinsurance transactions.
Effective January 1, 2004, Assured Guaranty Mortgage Insurance Company ("AGMIC") reinsured a private mortgage insurer (the "Reinsured") under a Mortgage Insurance Stop Loss Excess of Loss Reinsurance Agreement (the "Agreement"). Under the Agreement, AGMIC agreed to cover the Reinsured's aggregate mortgage guaranty insurance losses in excess of a $25 million retention and subject to a $95 million limit. Coverage under the Agreement was triggered only when the Reinsured's: (1) combined loss ratio exceeded 100%; and (2) risk to capital ratio exceeded 25 to 1, according to insurance statutory accounting. In April 2008, AGMIC notified the Reinsured it was terminating the Agreement because of the Reinsured's breach of the terms of the Agreement. The Reinsured notified
It is the opinion of the Company's management, based upon the information available, that the expected outcome of litigation against the Company, individually or in the aggregate, will not have a material adverse effect on the Company's financial position or liquidity, although an adverse resolution of litigation against the Company could have a material adverse effect on the Company's results of operations in a particular quarter or fiscal year.
In the ordinary course of their respective businesses, certain of the Company's subsidiaries assert claims in legal proceedings against third parties to recover losses paid in prior periods. The amounts, if any, the Company will recover in these proceedings are uncertain, although recoveries in any one or more of these proceedings during any quarter or fiscal year could be material to the Company's results of operations in that particular quarter or fiscal year.
During 2006, the Company's wholly owned subsidiary, AGRO, and a number of other parties, completed various settlements with defendants in the In re: National Century Financial Enterprises Inc. Investment Litigation now pending in the United States District Court for the Southern District of Ohio-Eastern District. AGRO received approximately $0.4 million (pre-tax) in 2008, $1.3 million (pre-tax) in 2007 and $13.5 million (pre-tax) in 2006 from the settlements. AGRO originally paid claims in 2003 of approximately $41.7 million (pre-tax) related to National Century Financial Enterprises Inc. To date, including the settlements described above, the Company has recovered $20.5 million (pre-tax), representing a partial settlement of the litigation. The litigation will continue against other parties.
deadline for renewal, (ii) at the option of the primary insurer if the Company fails to maintain certain financial, regulatory and rating agency criteria which are equivalent to or more stringent than those the Company is otherwise required to maintain for its own compliance with state mandated insurance laws and to maintain a specified financial strength rating for the particular insurance subsidiary or (iii) upon certain changes of control of the Company. Upon termination under the conditions set forth in (ii) and (iii) above, the Company may be required (under some of its reinsurance agreements) to return to the primary insurer all statutory unearned premiums, less ceding commissions, attributable to reinsurance ceded pursuant to such agreements after which the Company would be released from liability with respect to the ceded business. Upon the occurrence of the conditions set forth in (ii) above, whether or not an agreement is terminated, the Company may be required to obtain a letter of credit or alternative form of security to collateralize its obligation to perform under such agreement or it may be obligated to increase the level of ceding commission paid.
The Company's client base includes all of the major monoline primary financial guaranty insurance companies, many banks and several European insurance and reinsurance companies. Of the Company's total non-CDS gross premiums written for the year ended December 31, 2008, 15.3% came from FSA, a primary financial guaranty insurance company. Of the Company's total non-derivative gross premiums written for the year ended December 31, 2007, 37.0% and 13.8% came from Ambac and FSA, respectively, both of which are primary financial guaranty insurance companies. Of the Company's total non-CDS gross premiums written for the year ended December 31, 2006, 22.0% came from FSA. No other client represented more than 10% of the Company's total non-CDS gross premiums written for the years ended December 31, 2008, 2007 and 2006.
On May 18, 2004, AGUS, a subsidiary of the Company, issued $200.0 million of 7.0% Senior Notes due 2034 for net proceeds of $197.3 million. The proceeds of the offering were used to repay substantially all of a $200.0 million promissory note issued to a subsidiary of ACE in April 2004 as part of the IPO related formation transactions. The coupon on the Senior Notes is 7.0%, however, the effective rate is approximately 6.4%, taking into account the effect of a cash flow hedge executed by the Company in March 2004, the term of which matches that of the Senior Notes. The Company recorded interest expense of $13.4 million, including $0.6 million of amortized gain on the cash flow hedge, for each of the years ended December 31, 2008, 2007 and 2006, respectively. These Senior Notes are fully and unconditionally guaranteed by Assured Guaranty Ltd.
offering were used to repurchase 5,692,599 of Assured Guaranty Ltd.'s common shares from ACE Bermuda Insurance Ltd., a subsidiary of ACE. The Debentures pay a fixed 6.40% rate of interest until December 15, 2016, and thereafter pay a floating rate of interest, reset quarterly, at a rate equal to 3 month LIBOR plus a margin equal to 2.38%. AGUS may elect at one or more times to defer payment of interest for one or more consecutive periods for up to ten years. Any unpaid interest bears interest at the then applicable rate. AGUS may not defer interest past the maturity date. The Company recorded interest expense of $9.8 million, $9.8 million and $0.3 million for the years ended December 31, 2008, 2007 and 2006, respectively. These Debentures are guaranteed on a junior subordinated basis by Assured Guaranty Ltd.
At the closing of the 2006 credit facility, (i) AGC guaranteed the obligations of AG (UK) under such facility, (ii) Assured Guaranty Ltd. guaranteed the obligations of AG Re and AGRO under such facility and agreed that, if the Company Consolidated Assets (as defined in the related credit agreement) of AGC and its subsidiaries were to fall below $1.2 billion, it would, within 15 days, guarantee the obligations of AGC and AG (UK) under such facility, (iii) Assured Guaranty Overseas US Holdings Inc. guaranteed the obligations of Assured Guaranty Ltd., AG Re and AGRO under such facility and (iv) Each of AG Re and AGRO guarantees the other as well as Assured Guaranty Ltd.
quarter prior to November 6, 2006. Furthermore, the 2006 credit facility contains restrictions on Assured Guaranty Ltd. and its subsidiaries, including, among other things, in respect of their ability to incur debt, permit liens, become liable in respect of guaranties, make loans or investments, pay dividends or make distributions, dissolve or become party to a merger, consolidation or acquisition, dispose of assets or enter into affiliate transactions. Most of these restrictions are subject to certain minimum thresholds and exceptions. The 2006 credit facility has customary events of default, including (subject to certain materiality thresholds and grace periods) payment default, failure to comply with covenants, material inaccuracy of representation or warranty, bankruptcy or insolvency proceedings, change of control and cross-default to other debt agreements. A default by one borrower will give rise to a right of the lenders to terminate the facility and accelerate all amounts then outstanding. As of December 31, 2008 and 2007, Assured Guaranty was in compliance with all of those financial covenants.
Income distributions on the Pass-Through Trust Securities and CCS Securities were equal to an annualized rate of One-Month LIBOR plus 110 basis points for all periods ending on or prior to April 8, 2008. Following dissolution of the Pass-Through Trust, distributions on the CCS Securities are determined pursuant to an auction process. On April 7, 2008 this auction process failed, thereby increasing the annualized rate on the CCS Securities to One-Month LIBOR plus 250 basis points. Distributions on the AGC Preferred Stock will be determined pursuant to the same process.
For the years ended December 31, 2008, 2007 and 2006, the Company has incurred $5.7 million, $2.6 million and $2.5 million, respectively, of put option premiums which are an on-going expense. The increase in 2008 compared with 2007 was due to the increase in annualized rates from One-Month LIBOR plus 110 basis points to One-Month LIBOR plus 250 basis points as a result of the failed auction process in April 2008. These expenses are presented in the Company's consolidated statements of operations and comprehensive income under other expense.
The CCS securities had a fair value of $51.1 million (see Note 5) and $8.3 million as of December 31, 2008 and December 31, 2007, respectively, and a change in fair value during 2008 and 2007 of $42.7 million and $8.3 million, respectively. The change in fair value is recorded in the consolidated statements of operations and comprehensive income in other income. The change in fair value of CCS securities was $0 during 2006, as the fair value was $0 at December 31, 2006 or 2005.
The following table presents changes in the Company's common stock issued and outstanding for each of the three years ended December 31, 2008.
At the time of the IPO, ACE beneficially owned 26,000,000 common shares of Assured Guaranty Ltd. In December 2006, Assured Guaranty US Holdings Inc. repurchased 5,692,599 of the Company's common shares from a subsidiary of ACE. In addition, in December 2006 ACE sold 1,150,000 shares of the Company's common shares to Banc of America Securities LLC. Assured Guaranty did not receive any proceeds from this transaction. Following the closing of these two transactions, ACE's ownership in Assured Guaranty Ltd. was reduced to approximately 19.2 million of Assured Guaranty Ltd.'s outstanding common shares.
Share-based compensation expense in 2008, 2007 and 2006 was $11.9 million ($9.6 million after tax), $17.3 million ($14.3 million after tax) and $12.1 million ($10.0 million after tax), respectively. The effect on both basic and diluted earnings per share for 2008 was $0.11. The effect on both basic and diluted earnings per share for 2007 was $0.21. The effect on basic and diluted earnings per share for 2006 was $0.14 and $0.13, respectively. Included in 2008, 2007 and 2006 expense were $3.3 million ($2.9 million after tax), $5.9 million ($5.1 million after tax) and $2.2 million ($1.8 million after tax), respectively, related to accelerated vesting for stock award grants to retirement-eligible employees. FAS 123R requires these awards be expensed over the period through the date the employee first becomes eligible to retire and is no longer required to provide service to earn part or all of the award, regardless of the employee's intent of retirement. The amount of share-based compensation capitalized in 2008, 2007 and 2006 as DAC was $3.3 million, $2.7 million and $2.6 million, respectively.
return for the participant surrendering other compensation that may be due, or may be contingent on the achievement of performance or other objectives during a specified period, or may be subject to a risk of forfeiture or other restrictions that will lapse upon the achievement of one or more goals relating to completion of service by the participant, or achievement of performance or other objectives. Awards under the Incentive Plan may accelerate and become vested upon a change in control of the Company.
The Incentive Plan is administered by a committee of the Board of Directors. The Compensation Committee of the Board serves as this committee except as otherwise determined by the Board. The Board may amend or terminate the Incentive Plan. As of December 31, 2008, 1,041,161 common shares were available for grant under the Incentive Plan.
The weighted average grant-date fair value of options granted were $7.59, $6.83 and $6.71 for the years ended December 31, 2008, 2007 and 2006, respectively. The fair value of options issued is estimated on the date of grant using the Black Scholes option pricing model, with the following weighted average assumptions used for grants in 2008, 2007 and 2006:
•The expected dividend yield is based on the current expected annual dividend and share price on the grant date,
•The expected life is based on the average expected term of the Company's guideline companies, which are defined as similar or peer entities, since the Company has insufficient expected life data,
first becomes eligible to retire and is no longer required to provide service to earn part or all of the award. The Company may elect to use different assumptions under the Black-Scholes option valuation model in the future, which could materially affect the Company's net income or earnings per share.
The total intrinsic value of options exercised during the years ended December 31, 2008, 2007 and 2006 was $45 thousand, $0.7 million and $1.2 million, respectively. During the years ended December 31, 2008, 2007 and 2006, $0.3 million, $1.5 million and $2.5 million, respectively, was received from the exercise of stock options and $16 thousand, $0.2 million and $0.2 million, respectively, related tax benefit was recorded and included in the financing section in the statement of cash flows. In order to satisfy stock option exercises, the Company will either issue new shares or reissue shares held at AGUS due to the repurchase of 5,692,599 of the Company's common shares from ACE Bermuda. See Note 19 for further information.
The Company recorded $6.6 million ($4.9 million after tax) in share-based compensation, related to restricted stock awards, during the year ended December 31, 2008.
The following table summarizes restricted stock unit activity (excluding dividend equivalents) for the year ended December 31, 2008:
In Bermuda the savings incentive plan is available to all full-time employees upon their first date of employment. Eligible participants may contribute a percentage of their salary subject to a maximum of $15,500 for 2008. Contributions are matched by the Company at a rate of 100% up to 6% of the participant's compensation, subject to IRS limitations. Eligible participants also receive a Company core contribution equal to 6% of the participant's compensation, subject to IRS limitations, without requiring the participant to contribute to the plan. Participants generally vest in Company contributions upon the completion of one year of service. With respect to those employees who are Bermudian or spouses of Bermudians and who must participate in the Bermuda national pension scheme plan maintained by the Company, a portion of the foregoing contributions are made to the Bermuda
In February 2006, the Company established the Assured Guaranty Ltd. Performance Retention Plan which permits the grant of cash based awards to selected employees. Awards granted to participants before 2008 vest after four years of continued employment (or if earlier, on employment termination, if the participant's termination occurs as a result of death, disability, or retirement), and participants receive the designated award in a single lump sum when it vests, except that participants who vest as a result of retirement receive the bonus at the end of the four year period during which the award would have vested had the participant continued in employment. The value of the award paid is greater than the originally-designated amount only if actual company performance, as measured by an increase in the company's modified adjusted book value, improves during the four year performance period. For those participants who vest prior to the end of the four year period as a result of their termination of employment resulting from retirement, death or disability, the value of the award paid is greater than the originally-designated amount only if actual company performance, as measured by an increase in the company's modified adjusted book value, improves during the period ending on the last day of the calendar quarter prior to the date of the participant's termination of employment. Awards under the plan may be treated as nonqualified deferred compensation subject to the rules of Internal Revenue Code Section 409A, and the plan was revised to satisfy those rules for the first award granted under the Plan, which occurred in 2007.
The plan was again revised in 2008 to be a sub-plan under our Long-Term Incentive Plan (enabling awards under the plan to be performance-based compensation exempt from the $1 million limit on tax deductible compensation). The revisions also give the Compensation Committee greater flexibility in establishing the terms of performance retention awards, including the ability to establish different performance periods and performance objectives.
Two types of awards were granted in 2008. Under the first type, the award is divided into three installments, with 25% of the award allocated to a performance period that includes 2008 and 2009, 25% of the award allocated to a performance period that includes 2008 through 2010, and 50% of the award allocated to a performance period that includes 2008 through 2011. Each installment of an award vests if the participant remains employed through the end of the performance period for that installment (or vests on the date of the participant's death, disability, or retirement if that occurs during the performance period). Payment for each performance period is made at the end of that performance
Under the second type of award granted in 2008, the entire award is allocated to a performance period that includes 2008 through 2012. The award vests if the participant remains employed through the end of the performance period (or vests on the date of the participant's death, disability, or retirement if that occurs during the performance period). Payment is made at the end of the performance period. One half of the award is increased or decreased in proportion to the increase or decrease of modified adjusted book value during the performance period, and one half of the award is increased or decreased in proportion to the increase or decrease of operating return on equity during the performance period. (However, if, during the performance period, a participant dies or becomes disabled while employed, the amount is based on performance through the quarter ending before death or disability and is paid after the occurrence of death or disability.)
Modified adjusted book value as of any date is determined by the Compensation Committee and equals:
•the present value of estimated net future installment premiums, as reported in the Company's quarterly Financial Supplement, excluding the effects of accumulated other comprehensive income, and the effects of unrealized gains and losses on derivative financial instruments in accordance with FAS 133.
•accumulated other comprehensive income and after-tax unrealized gains (losses) on derivative financial instruments.
The Company recognized approximately $5.7 million ($4.5 million after tax) and $0.2 million ($0.1 million after tax) of expense for performance retention awards in 2008 and 2007, respectively. Included in 2008 amounts were $3.3 million, respectively, of accelerated expense related to retirement-eligible employees. The Company's compensation expense for 2007 was in the form of performance retention awards and the awards that were made in 2007 vest over a four year period.
Potentially dilutive securities representing approximately 2.4 million, 5.0 million and 0.8 million shares of common stock for the years ended December 31, 2008, 2007 and 2006, respectively, were excluded from the computation of diluted earnings per share for these periods because their effect would have been antidilutive.
Goodwill of $94.6 million arose from ACE's acquisition of Capital Re Corporation, Assured's corporate predecessor, as of December 31, 1999 and was being amortized over a period of twenty-five years. On January 1, 2002, the Company ceased amortizing goodwill as part of its adoption of FAS 142 and now evaluates it for impairment at least annually in accordance with FAS 142. No such impairment was recognized in the years ended December 31, 2008, 2007 and 2006.
The Company's Step 1 goodwill impairment test is based on determining the fair value of the Company's direct and reinsurance operations and then reconciling these fair values to the Company's consolidated fair value. The Company determined the current in-force values of our direct and reinsurance books of business on a discounted cash flow basis to assess goodwill for impairment. The inputs to our discounted cash flow model for both the direct and reinsurance lines of business were unearned premium at carrying value, future installment premiums discounted at 15%, a future expense load equal to 25% of premiums, recorded loss reserves and taxes. Management has determined that the discounted cash flows supported the Company's goodwill balances for both the direct and reinsurance lines of business as of December 31, 2008.
The Company has four principal business segments: (1) financial guaranty direct, which includes transactions whereby the Company provides an unconditional and irrevocable guaranty that indemnifies the holder of a financial obligation against non-payment of principal and interest when due, and could take the form of a credit derivative; (2) financial guaranty reinsurance, which includes agreements whereby the Company is a reinsurer and agrees to indemnify a primary insurance company against part or all of the loss which the latter may sustain under a policy it has issued; (3) mortgage guaranty, which
includes mortgage guaranty insurance and reinsurance whereby the Company provides protection against the default of borrowers on mortgage loans; and (4) other, which includes lines of business in which the Company is no longer active.
Management uses underwriting gains and losses as the primary measure of each segment's financial performance. Underwriting gain is calculated as net earned premiums plus realized gains and other settlements on credit derivatives, less the sum of loss and loss adjustment expenses (recoveries) including incurred losses on credit derivatives, profit commission expense, acquisition costs and other operating expenses that are directly related to the operations of the Company's insurance businesses. This measure excludes certain revenue and expense items, such as net investment income, realized investment gains and losses, unrealized losses on credit derivatives, other income, and interest and other expenses, that are not directly related to the underwriting performance of the Company's insurance operations, but are included in net income.
The other segment had an underwriting gain of $1.9 million, $1.3 million and $13.5 million for the years ended December 31, 2008, 2007 and 2006, respectively. The Company recorded net credit derivative loss recoveries of $0.4 million, $1.3 million and $13.5 million for the years ended December 31, 2008, 2007 and 2006, respectively.
*Due to the accounting for subsidiaries under common control, net income in the consolidating adjustment column does not equal parent company equity in earnings of subsidiaries, due to 1) recognition of income by Assured Guaranty US Holdings Inc. for dividends received from Assured Guaranty Ltd. and 2) the residual effects of the FSA agreement.
The net change in fair value of credit derivatives in the third and fourth quarters of 2007 reflected the decline in market values of the Company's credit derivative portfolio. These losses resulted from the significant widening of credit spreads observed in the third and fourth quarters of 2007. Derivatives are discussed further in Note 4.