The following selected financial data should be read together with the other information contained in this Form 10-K, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this Form 10-K.
(5) The expense ratio is calculated by dividing the sum of profit commission expense, acquisition costs and operating expenses by net earned premiums.
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 “Valuation of Derivative Financial Instruments” 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 difference between actuarially estimated ultimate losses and recorded case reserves. Financial guaranty insurance and assumed reinsurance case reserves and related salvage and subrogation, if any, are discounted at 6%, which is the approximate taxable equivalent yield on our investment portfolio in all periods presented.
Statement of Financial Accounting Standards (“FAS”) No. 60, “Accounting and Reporting by Insurance Enterprises” (“FAS 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.
The following table sets forth the financial guaranty in-force portfolio by underlying rating:
We issue credit derivative financial instruments, which prior to 2004 included a few index-based derivative financial instruments, that we view as an extension of our financial guaranty business but which do not qualify for the financial guaranty insurance scope exception under FAS 133 and FAS 149 and therefore are reported at fair value, with changes in fair value included in our earnings.
During the first quarter 2005 review of its valuation models, management identified a limitation in its valuation models highlighted by the current widening credit spread environment. Management adjusted its valuation models for this limitation in the first quarter 2005 resulting in an adjustment to unrealized gains on derivative financial instruments of $4.3 million, net of income taxes. Management will continue to perform additional analysis, as necessary, to address market anomalies and its effect on its valuation models.
We have a formal review process for all securities in our investment portfolio, including a review for impairment losses. Factors considered when assessing impairment include:
· 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.
The Company recorded $0.1 million of other than temporary declines in the fair value of fixed maturity securities for the year ended December 31, 2003. We did not record any realized losses due to other than temporary declines in 2005 and 2004.
The following table summarizes the unrealized losses in our investment portfolio by type of security and remaining time to maturity as of the dates indicated:
The following table summarizes, for all securities sold at a loss through December 31, 2005 and 2004, the fair value and realized loss by length of time such securities were in a continuous unrealized loss position prior to the date of sale:
remaining unearned premium reserve is earned at that time. Unearned premium reserves represent the portion of premiums written that are applicable to the unexpired amount at risk of insured bonds.
In our reinsurance businesses, we estimate the ultimate written and earned premiums to be received from a ceding company at the end of each quarter and the end of each year because some of our ceding companies report premium data anywhere from 30 to 90 days after the end of the relevant period. Written premiums reported in our statement of operations are based upon reports received from ceding companies supplemented by our own estimates of premium for which ceding company reports have not yet been received. As of December 31, 2005, 2004 and 2003 the assumed premium estimate and related ceding commissions included in our consolidated financial statements are $14.3 million and $4.5 million, $30.4 million and $9.7 million and $31.7 million and $9.1 million, respectively. Key assumptions used to arrive at management’s best estimate of assumed premiums are premium amounts reported historically and informal communications with ceding companies. Differences between such estimates and actual amounts are recorded in the period in which the actual amounts are determined. Historically, the differences have not been material. We do not record a provision for doubtful accounts related to our assumed premium estimate. Historically there have not been any material issues related to the collectibility of assumed premium. No provision for doubtful accounts related to our premium receivable was recorded for 2005, 2004 or 2003.
As of December 31, 2005 and 2004, we had a net deferred income tax liability of $26.6 million and $40.1 million, respectively. Certain of our subsidiaries are subject to U.S. income tax. Deferred income tax assets and liabilities are established for the temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities using enacted rates in effect for the year in which the differences are expected to reverse. Such temporary differences relate principally to deferred acquisition costs, reserves for losses and LAE, unearned premium reserves, net operating loss carryforwards (“NOLs”), unrealized gains and losses on investments and derivative financial instruments 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.
The following table presents summary consolidated results of operations data for the years ended December 31, 2005, 2004 and 2003.
We organize our business around four principal business segments: financial guaranty direct, financial guaranty reinsurance, mortgage guaranty and other. There are a number of lines of business that we have exited as part of our IPO in April 2004, which are included in the other segment. However, the results of
Net income was $188.4 million, $182.8 million and $214.5 million for the years ended December 31, 2005, 2004 and 2003, respectively. The increase of $5.6 million in 2005 compared with 2004 is primarily due to an underwriting gain of $151.1 million in 2005, representing a $54.1 million increase compared with the $97.0 million underwriting gain in 2004. This underwriting gain was offset by a $56.0 million decline in unrealized (losses) gains on derivative financial instruments which were $(3.5) million in 2005, compared with $52.5 million in 2004. Also contributing to the increase was a $9.3 million reduction in our income tax provision which was $41.2 million in 2005, compared with $50.5 million in 2004, primarily attributable to the relative distribution of taxable income across our taxable and non-taxable jurisdictions. The decrease in net income of $31.7 million in 2004 compared with 2003 is primarily due to a $45.9 million decrease in unrealized gains on derivative financial instruments coupled with the accelerated vesting of stock awards at the IPO date of $11.3 million. This was partially offset by an increase of $46.4 million in our underwriting gain in 2004, compared with 2003.
guaranty operations gross premiums written was a decrease of $165.2 million in 2004 compared with 2003 in our other segment. This decrease was due to the unwinding of equity layer credit protection products which reduced gross written premiums by $97.8 million in 2004. Also contributing to the decrease in the other segment is that we exited certain lines of business during 2004, that we wrote business in for the entire year in 2003.
Net investment income was $96.8 million, $94.8 million and $96.3 million and had pre-tax yields to maturity of 4.9%, 4.8% and 4.9% for the years ended December 31, 2005, 2004 and 2003, respectively. The increase in investment income in 2005 compared with 2004 was due to the increase in investment yields as well as an increase in our invested assets during the year. Net investment income decreased in 2004 compared with 2003 due to declining investment yields and a decrease in our invested assets.
Net realized investment gains, principally from the sale of fixed maturity securities, were $2.2 million, $12.0 million and $5.5 million for the years ended December 31, 2005, 2004 and 2003, respectively. 2004 included realized gains of $6.0 million as a result of investments sold in connection with a commutation settlement of a residual value transaction. This transaction was the primary cause of the fluctuations with 2005 and 2003 when compared to 2004. Also included in net realized gains for 2004 was a write down of $1.3 million related to the Company’s exited title reinsurance business. The investment related to this write
Loss and LAE for the years ended December 31, 2005, 2004 and 2003 were $(69.6) million, $(32.0) million and $144.6 million. Included in 2005 financial guaranty direct results, is a reduction of $7.0 million in portfolio reserves attributable to changes in credit quality and from continued runoff from maturing CDO exposures, as well as management updating its loss reserving data, as part of our normal portfolio reserve process, to include the most current rating agency default studies, offset by $4.6 million of incurred case reserve activity. Our 2004 results included $12.3 million related to the closing out of transaction types that we no longer underwrite. The financial guaranty reinsurance segment decreased in 2005 compared with 2004 primarily due to $71.0 million in loss recoveries from a third party litigation settlement agreement, with two parties, relating to a reinsurance claim incurred in 1998 and 1999. This recovery was offset by an addition to loss reserves of $6.0 million, consisting of a $10.4 million addition to case reserves and a reduction of $4.4 million to portfolio reserves due to a reinsurance client ceding losses on two Northwest Airlines Enhanced Equipment Trust Certificate (EETC) credits with net par outstanding of $66.1 million. Our other segment was impacted by the commutation and retrocession of certain lines of business that we no longer underwrite as well as a $2.4 million recovery related to the equity layer credit protection business in 2005.
Gross and net written premiums in this segment generally have been received on an installment basis, reflecting our focus on the structured finance and credit derivatives markets. In 2005, 2004 and 2003, installment premiums represented 79%, 93% and 98% of gross written premiums in this segment, or $75.9 million, $75.1 million and $69.6 million, respectively. However, as we continue to execute in the public finance market this percentage should decrease as premium is generally received upfront. The contribution of upfront premiums to gross written premiums were $20.3 million, $5.7 million and $1.5 million in 2005, 2004 and 2003, respectively.
For the years ended December 31, 2005, 2004 and 2003, net written premiums were $93.9 million, $77.7 million and $70.0 million, respectively. The growth in net written premiums is primarily due to growth in gross written premiums as we typically retain a substantial portion of this business.
For the years ended December 31, 2005, 2004 and 2003, acquisition costs were $6.3 million, $4.5 million and $2.2 million, respectively. 2005 acquisition costs increased $1.8 million compared with 2004, while 2004 increased $2.3 million compared with 2003, as the Company has been successfully executing its direct business plan, as demonstrated by our gross written premium growth across both periods, noted above. Increases in acquisition costs are primarily due to the proportion of such premiums subject to premium taxes.
As of April 1, 2005 our quota share reinsurance treaty with Ambac Assurance Corporation (“Ambac”) was renewed. In addition, AG Re entered into a master facultative agreement with Ambac on March 31, 2005. On April 20, 2005, Ambac provided notice of a non-renewal of the quota share treaty on a run-off basis, effective July 1, 2006. This non-renewal will not affect business ceded from Ambac in any prior year, or business ceded under the current quota share treaty through June 30, 2006.
For 2005, $45.3 million, excluding the aforementioned $18.4 million of reassumption premiums related to our healthcare business, $32.8 million and $15.5 million of our gross written premiums was ceded by FSA, Ambac and MBIA Insurance Corporation (“MBIA”), respectively, compared with $79.8 million, $37.4 million and $28.3 million, respectively in 2004 and $88.4 million, $24.8 million and $37.7 million, respectively in 2003.
Operating expenses for the years ended December 31, 2005, 2004 and 2003, were $19.5 million, $17.4 million and $12.0 million, respectively. During 2005 the Company implemented a new operating expense methodology to more closely apply expenses to the individual operating segments starting with 2004, the year of the IPO. This new methodology was based on a comprehensive cost study. The prior allocation was based on segment net earned premium. Basing the allocation on earned premium for 2005 and 2004 would have caused the financial guaranty reinsurance and mortgage guaranty segments to receive a disproportionate amount of the expenses. 2004 amounts have been adjusted to reflect this new allocation. The earned premium allocation methodology was kept for 2003, as the current business strategy of focusing on direct business was not in place in 2003 and thus the net earned premium allocation methodology allocated an appropriate amount of operating expense to the segments. The increase during 2005 compared with 2004 was primarily due salary and related expenses as the Company has increased staffing levels to meet its business needs. The increase during 2004 compared with 2003 is due to the increase in holding company expenses associated with the Company’s IPO in April 2004.
Mortgage guaranty insurance provides protection to mortgage lending institutions against the default of borrowers on mortgage loans that, at the time of the advance, had a loan-to-value (“LTV”) ratio in excess of a specified ratio. We primarily function as a reinsurer in this industry and assume all or a portion of the risks undertaken by primary mortgage insurers.
Net written premiums for the years ended December 31, 2005, 2004 and 2003 were $25.7 million, $24.4 million and $24.4 million, respectively. This is consistent with the trend in gross written premiums, as we do not cede a significant amount of our mortgage guaranty business.
Acquisition costs for the years ended December 31, 2005, 2004 and 2003 were $2.0 million, $3.7 million and $4.1 million, respectively. The decrease in acquisition costs in 2005 compared with 2004 is directly related to the decline in net earned premiums. The decrease in acquisition costs, for 2004 compared with 2003 is related to the accelerated amortization of deferred acquisition costs due to the commutation of an excess of loss reinsurance contract discussed above.
(1) The Company had $32.2 million of gross written premiums, all of which was ceded, mainly attributable to a pre-IPO reinsurance agreement with a subsidiary of ACE under which we provided reinsurance to CGA and retroceded 100% of this exposure to the ACE subsidiary.
On April 15, 2004, AGRO sold 100% of the common stock of its subsidiary, ACE Capital Title Reinsurance Company, to ACE Bermuda Insurance Ltd., a subsidiary of ACE, for $39.8 million. There was no gain or loss associated with this transaction. This sale was the primary reason for the decline in net earned premiums in 2004 from 2003 as we only wrote business during the period we owned the subsidiary. Net earned premiums for the title reinsurance business were $10.7 million for year ended December 31, 2003. The $6.8 million of underwriting gain for the year ended December 31, 2003 was primarily due to favorable prior year loss reserve development.
We exited the LA&H business in 2002. The underwriting losses of $0.6 million in 2003 were related to the litigation and settlement of a disputed contract.
Auto residual value reinsurance net earned premiums were $(32.2) million in 2004 as we commuted our remaining auto residual value reinsurance business and transferred assets with a market value of $108.3 million to a subsidiary of ACE. This transaction caused a $6.5 million underwriting loss, partially offset by a $6.8 realized gain. For 2003 we had net earned premiums of $4.2 million and underwriting loss $35.1 million. The underwriting loss of $35.1 million in 2003 was a result of an increase in reserves for losses and loss adjustment expenses related to a dispute with World Omni. This matter was settled on December 15, 2005. In connection with the settlement, the Company paid its $34.4 million funds held liability to the ACE subsidiary and released $54.2 million of reinsurance recoverables and loss and loss adjustment expense reserves.
Net earned premiums related to affiliate reinsurance were negative $7.7 million for the year ended December 31, 2003 and primarily represent the cost of the AGC Affiliate Reinsurance Transaction and AG Re Affiliate Reinsurance Transaction for these periods. As a result of losses of $14.4 million ceded under these contracts in 2003, affiliate reinsurance generated an underwriting gain of $8.2 million.
• AGC Affiliate Reinsurance Transaction: AGC entered into an excess of loss reinsurance contract with a subsidiary of ACE, effective January 1, 2001. This coverage provided a $150.0 million aggregate limit. We terminated this agreement effective June 30, 2003 and received a cash payment of $53.8 million, consisting of ceded unearned premium of $39.8 million, reinsurance recoverables on paid losses of $12.5 million and profit commissions receivable of $1.5 million. There was no earnings impact from the termination of this contract.
• AGRO Affiliate Reinsurance Transactions: AGRO entered into a reinsurance transaction with an affiliate of ACE, which the ACE affiliate fully ceded to a subsidiary of ACE, both effective July 1, 2001, resulting in both gross and ceded premiums written of $25.8 million, $2.7 million and $6.0 million in 2005, 2004 and 2003, respectively. Accordingly, this transaction had no effect on our net written premiums or our net income.
Net cash flows (used in) provided by investing activities were $(153.6) million, $22.3 million and $(145.3) million during the years ended December 31, 2005, 2004 and 2003, respectively. These investing activities were primarily net (purchases) sales of fixed maturity investment securities during 2005, 2004 and 2003. In addition, during 2004 AGRO, an indirect subsidiary of Assured Guaranty Ltd., sold 100% of the common stock of its subsidiary, ACE Capital Title Reinsurance Company, to ACE Bermuda Insurance Ltd., a subsidiary of ACE, for $39.8 million. There was no gain or loss associated with the sale.
(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.
On April 15, 2005, Assured Guaranty Ltd. and certain of its subsidiaries entered into a $300.0 million three-year unsecured revolving credit facility (the “$300.0 million credit facility”) with a syndicate of banks, for which ABN AMRO Incorporated and Bank of America, N.A. acted as lead arrangers and KeyBank National Association (“KeyBank”) acted as syndication agent. Under the $300.0 million credit facility, each of AGC, Assured Guaranty (UK) Ltd. (“AG (UK)”), a subsidiary of AGC organized under the laws of the United Kingdom, Assured Guaranty Ltd., AG Re and AGRO are entitled to request the banks to make loans to such borrower or to request that letters of credit be issued for the account of such borrower. The $300.0 million credit facility replaced (1) the $250.0 million credit facility and (2) the Letter of Credit Agreement, both discussed below.
At the closing of the $300.0 million 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
The $300.0 million credit facility’s financial covenants require that Assured Guaranty Ltd. (a) maintain a minimum net worth of $1.2 billion, (b) maintain an interest coverage ratio of at least 2.5:1, and (c) maintain a maximum debt-to-capital ratio of 30%. In addition, the $300.0 million credit facility requires that AGC: (x) maintain qualified statutory capital of at least 80% of its statutory capital as of the fiscal quarter prior to the closing date of the facility and (y) maintain a ratio of aggregate net par outstanding to qualified statutory capital of not more than 150:1. Furthermore, the $300.0 million 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. 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, 2005, Assured Guaranty was in compliance with all of those financial covenants.
The $250.0 million credit facility was a 364-day facility available for general corporate purposes. As of its termination, no amounts were outstanding under this facility nor had there been any borrowings under the life of this facility.
Each Put Agreement has no scheduled termination date or maturity, however, it will terminate if (1) AGC fails to pay the put premium in accordance with the Put Agreement, and such failure continues for five business days, (2) during the Auction Rate Mode, AGC elects to have the AGC Preferred Stock bear a fixed rate dividend (a “Fixed Rate Distribution Event”), (3) AGC fails to pay (i) dividends on the AGC Preferred Stock, or (ii) the fees and expenses of the Custodial Trust, for the related dividend period, and such failure continues for five business days, (4) AGC fails to pay the redemption price of the AGC Preferred Stock and such failure continues for five business days, (5) the face amount of a Custodial Trust’s CCS Securities is less than $20,000,000, (6) AGC elects to terminate the Put Agreement, or (7) a decree of judicial dissolution of the Custodial Trust is entered. If, as a result of AGC’s failure to pay the put premium, the Custodial Trust is liquidated, AGC will be required to pay a termination payment which will be distributed to the holders of the Pass-Through Trust Securities. The termination payment will be at a rate equal to 1.10% per annum of the amount invested in Eligible Assets calculated from the date of the failure to pay the put premium through the end of the applicable period.
AGC Preferred Stock 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.
For each distribution period, holders of the outstanding AGC Preferred Stock of any series, in preference to the holders of common stock and of any other class of shares ranking junior to the AGC Preferred Stock, will be entitled to receive out of any funds legally available therefore when, as and if declared by the Board of Directors of AGC or a duly authorized committee thereof, cash dividends at a rate per share equal to the dividends rate for such series of AGC Preferred Stock for the respective distribution period. Prior to a Fixed Rate Distribution Event, the dividend rate on the AGC Preferred Stock will be equal to the distribution rate on the CCS Securities. The Custodial Trust’s expenses (including any expenses of the Pass-Through Trust) for the period will be paid separately by AGC pursuant to the Custodial Trust Expense Reimbursement Agreement.
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 during the Auction Rate Mode 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.
The amortized cost and estimated fair value of our available-for-sale fixed maturity securities as of December 31, 2005 and 2004, 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.
As of December 31, 2005 and 2004, our investment portfolio did not contain any securities that were not rated or rated below investment grade.
Under certain derivative contracts, we are 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 marked to market valuations in excess of contractual thresholds. The fair market values of our pledged securities totaled $1.8 million as of December 31, 2005 and $1.9 million as of December 31, 2004.
Financial instruments that may be adversely affected by changes in interest rates consist primarily of investment securities. The primary objective in managing our investment portfolio is generation of an optimal level of after-tax investment income while preserving capital and maintaining adequate liquidity.
As a result, our investment portfolio consists of highly rated fixed income securities with a relatively short composite portfolio duration. Investment strategies are based on many factors, including our tax position, fluctuation in interest rates, regulatory and rating agency criteria and other market factors. As of January 1, 2005 we have retained BlackRock Financial Management, Inc to manage our investment portfolio. Prior to January 1, 2005 Lazard Freres Asset Management and Hyperion Capital Management, Inc. performed this function. These investment managers manage our fixed maturity investment portfolio in accordance with investment guidelines approved by our Board of Directors.
In December 2004, the FASB issued FAS No. 123 (revised 2004), “Share-Based Payment” (“FAS 123R”). FAS 123R is effective January 1, 2006 and replaces FAS No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”) and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). As permitted by FAS 123, the Company currently accounts for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognizes no compensation expense for employee stock options, or its employee stock purchase plan. Accordingly, the adoption of FAS 123R’s fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. At December 31, 2005, unamortized compensation expense related to outstanding unvested options, as determined in accordance with FAS 123, that the Company expects to record during fiscal 2006 was approximately $2.0 million, before income taxes. The total impact of adoption of FAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted and shares purchased by employees under the employee stock purchase plan in the future. However, had the Company adopted FAS 123R in prior periods, the impact of that standard would have approximated the impact of FAS 123 as described in the disclosure of pro forma net income and earnings per share in Note 2 to our consolidated financial statements. FAS 123R also requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were $4.1 million, $5.4 million and $5.7 million in 2005, 2004 and 2003, respectively.
The Company’s net par outstanding on public finance exposures in counties designated by the Federal Emergency Management Agency (“FEMA”) for both individual and public assistance in the states of Louisiana, Mississippi and Alabama totals $220.6 million, and of that amount $142.3 million is in Greater New Orleans (comprised of Orleans, St. Bernard and Jefferson parishes). Over 96% of that exposure comes through our reinsurance segment. Details by asset category are included in Table 1 below. A list of the Company’s top ten public finance exposures in counties designated by FEMA for both individual and public assistance in the affected states is provided in Table 2.
The Company’s exposure to investor-owned utilities in the affected states totals $53.1 million and is presented in Table 3. With respect to the Company’s structured finance net par outstanding, management’s review of Assured Guaranty’s structured finance portfolio shows no significant concentrations in the areas affected by Hurricane Katrina, as these exposures are generally secured by geographically diverse pools of assets.
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2005, 2004
We have completed an integrated audit of Assured Guaranty Ltd.’s 2005 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005 and audits of its 2004 and 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
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. at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Also, in our opinion, management’s assessment, included in Internal Control Over Financial Reporting appearing under item 8, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
· On April 15, 2004 Assured Guaranty Re Overseas Ltd. (“AGRO”) (an indirect subsidiary of Assured Guaranty Ltd.) sold 100% of the common stock of its subsidiary, ACE Capital Title Reinsurance Company (“ACTR”), to ACE Bermuda Insurance Ltd., a subsidiary of ACE, for $39.8 million. There was no gain or loss associated with the sale.
· On April 28, 2004, AGRO commuted its remaining auto residual value reinsurance business and transferred assets with a market value of $108.3 million to a subsidiary of ACE. This transaction caused a $(6.5) million underwriting loss, offset by a $6.8 million realized gain from the asset transfer.
Assured Guaranty Ltd. is a Bermuda-based holding company which provides, through its operating subsidiaries, credit enhancement products to the public finance, structured finance and mortgage markets. Credit enhancement products are financial guarantees or other types of support, including credit derivatives, that improve the credit of underlying debt obligations. Assured Guaranty Ltd. applies its credit expertise, risk management skills and capital markets experience to develop insurance, reinsurance and derivative products that meet the credit enhancement needs of its customers. Under a reinsurance agreement, the reinsurer, in consideration of a premium paid to it, agrees to indemnify another insurer, called the ceding company, for part or all of the liability of the ceding company under one or more insurance policies that the ceding company has issued. A derivative is a financial instrument whose characteristics and value depend upon the characteristics and value of an underlying security. Assured Guaranty Ltd. markets its products directly to and through financial institutions, serving the U.S. and international markets. Assured Guaranty Ltd.’s financial results include four principal business segments: financial guaranty direct, financial guaranty reinsurance, mortgage guaranty and other. These segments are further discussed in Note 22.
Financial guaranty insurance provides an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due. Financial guaranty insurance may be issued to the holders of the insured obligations at the time of issuance of those obligations, or may be issued in the secondary market to holders of public bonds and structured securities. A loss event occurs upon existing or anticipated credit deterioration, while a payment under a policy occurs when the insured obligation defaults. This requires the Company to pay the required principal and interest when due in accordance with the underlying contract. The principal types of obligations covered by the Company’s financial guaranty direct and financial guaranty assumed reinsurance businesses are structured finance obligations and public finance obligations. Because both businesses involve similar risks, the
Company analyzes and monitors its financial guaranty direct portfolio and financial guaranty assumed reinsurance portfolio on a coordinated basis.
Mortgage guaranty insurance is a specialized class of credit insurance that provides protection to mortgage lending institutions against the default of borrowers on mortgage loans that, at the time of the advance, had a loan to value in excess of a specified ratio. Reinsurance in the mortgage guaranty insurance industry is used to increase the insurance capacity of the ceding company, to assist the ceding company in meeting applicable regulatory and rating agency requirements, to augment the financial strength of the ceding company, and to manage the ceding company’s risk profile. The Company provides mortgage guaranty protection on an excess of loss basis.
Amounts presented prior to April 28, 2004, the IPO date, were prepared on an historical combined basis, since Assured Guaranty Ltd. and its subsidiaries were included in the results of ACE. However, since the entities are the same for all periods presented, the financial statements have been prepared and reported on a consolidated basis. This presentation has no impact on the Company’s results of operations or financial condition. Certain expenses reflected in the combined financial statements include allocations of corporate expenses incurred by ACE, related to general and administrative services provided to the Company, including tax consulting and preparation services, internal audit services and liquidity facility costs. These expenses were allocated based on estimates of the cost incurred by ACE to provide these services to the Company and are mainly reflected in 2003. All intercompany accounts and transactions have been eliminated. Certain items in the prior year financial statements have been reclassified to conform with the current year presentation.
Due to the customary lag (ranging from 30 to 90 days) in reporting premium data by some of the ceding companies, the Company must estimate the ultimate written and earned premiums to be received from a ceding company as of each balance sheet date for the reinsurance business. Actual written premiums reported in the consolidated statements of operations and comprehensive income are based upon reports received by ceding companies supplemented by the Company’s own estimates of premium for which ceding company reports have not yet been received. Differences between such estimates and actual amounts are recorded in the period in which the actual amounts are determined.
· whether the Company has the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value.
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 believe 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. 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 the Company’s assessment changes in the future, the Company may ultimately record a loss after having originally concluded that the decline in value was temporary.
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. It would be a remote occurrence when the case reserve is not greater than the reclassified portfolio reserve. 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.
The Company also records IBNR reserves for its mortgage guaranty and other segments. IBNR is an estimate of losses for which the insured event has occurred but the claim has not yet been reported to the Company. In establishing IBNR, the Company uses traditional actuarial methods to estimate the reporting lag of such claims based on historical experience, claim reviews and information reported by ceding companies. The Company records IBNR for mortgage guaranty quota-share reinsurance contracts, all of which are in run-off, within its mortgage guaranty segment. The Company also records IBNR for title reinsurance, auto residual value reinsurance and trade credit reinsurance within its other segment. The other segment represents lines of business the Company has exited or sold prior to the IPO.
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 these discussions, in June 2005, the FASB staff decided additional guidance is necessary regarding financial guaranty contracts. When the FASB staff reaches a conclusion on this issue, which is expected during the first half of 2006, the Company and the rest of the financial guaranty industry may be required to change some aspects of their loss reserving policies, but the Company cannot currently assess how the FASB or SEC staffs’ ultimate resolution of this issue will impact the Company’s reserving policy or other balances, i.e., premiums and DAC. Until the issue is resolved, the Company intends to continue to apply its existing policy with respect to the establishment of both case and portfolio reserves.
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, using a 5% discount rate for 2005 and 2004, is shown on the balance sheet under the caption, “Profit commissions payable”. The unamortized discount on this liability was $1.4 million and $2.4 million as of December 31, 2005 and 2004, respectively.
Certain of the Company’s subsidiaries are subject to U.S. income tax. In accordance with FAS No. 109, “Accounting for Income Taxes”, deferred income taxes are provided for with respect to the temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities, using enacted rates in effect for the year in which the differences are expected to reverse. Such temporary differences relate principally to deferred acquisition costs, reserves for losses and LAE, unearned premium reserves, unrealized gains and losses on investments, unrealized gains and losses on derivative financial instruments and statutory contingency reserves. A valuation allowance is recorded to reduce the deferred tax asset to that amount that is more likely than not to be realized.
For restricted stock awards, the Company records the market value of the shares awarded at the time of the grant as unearned stock grant compensation and includes it as a separate component of shareholders’ equity. The unearned stock grant compensation is amortized into income ratably over the vesting period. Upon adoption of FAS 123R, the unearned stock grant compensation will be netted against additional paid-in capital. This change effects presentation only and has no effect on the Company’s financial position or results of operations.
The following table outlines the Company’s net income, basic and diluted earnings per share for the years ended December 31, 2005 and 2004, had the compensation expense been determined in accordance with the fair value method recommended in FAS 123.
Goodwill of $94.6 million arose from ACE’s acquisition of Capital Re Corporation 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.
In the year ended December 31, 2004 the Company recognized a goodwill impairment of $1.6 million in its other segment for its trade credit business which the Company exited as part of its IPO. This impairment charge is presented in the Company’s consolidated statements of operations and comprehensive income under other expense. No such impairment was recognized in the years ended December 31, 2005 and 2003.
As of December 31, 2005 and 2004, net financial guaranty par in force, including insured credit default swaps (“CDS”), was approximately $102.5 billion and $95.6 billion, respectively. The portfolio was broadly diversified by payment source, geographic location and maturity schedule, with no single risk representing more than 1.1% and 1.6% of the total net par in force as of December 31, 2005 and 2004, respectively. The composition of net par in force by bond type was as follows:
Maturities for public finance obligations range from 1 to 45 years, with the typical life in the 12 to 15 year range. Structured finance transactions have legal maturities that range from 1 to 40 years with a typical life of 6 to 8 years. CDS transactions are included in all structured finance categories and tax-backed and investor-owned utilities categories in public finance.
(1) The Company had $25.0 million net par outstanding as of 12/31/04.
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 reference 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, 2005 and 2004 and included in the Company’s financial guaranty exposure was $27.7 billion and $23.2 billion, respectively.
As of December 31, 2005 and 2004, the Company’s net mortgage guaranty insurance in force (representing the current principal balance of all mortgage loans currently reinsured) was approximately $3.0 billion and $3.6 billion, respectively, and net risk in force was approximately $2.3 billion for both years. These amounts are not included in the above table.
Premiums earned include $12.1 million, $17.4 million and $19.2 million for 2005, 2004 and 2003, respectively, related to refunded and called bonds.
The following table summarizes the Company’s aggregate investment portfolio as of December 31, 2004:
The amortized cost and estimated fair value of available-for-sale fixed maturity securities as of December 31, 2005, 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.
The change in net unrealized gains of available-for-sale fixed maturity securities consists of:
The following tables summarize, for all securities in an unrealized loss position as of December 31, 2005 and 2004, the aggregate fair value and gross unrealized loss by length of time the amounts have continuously been in an unrealized loss position.
Under agreements with its cedants and in accordance with statutory requirements, the Company maintains fixed maturity securities in trust accounts of $552.8 million and $304.4 million as of December 31, 2005 and 2004, respectively, for the benefit of reinsured companies and for the protection of policyholders, generally in states in which the Company or its subsidiaries, as applicable, are not licensed or accredited.
As part of its insured CDS business, the Company is party to certain contractual agreements that require collateral to be posted for the benefit of either party depending on ratings of the parties to the agreement and changes in fair value relative to applicable specified thresholds of the insured swap transactions. As of December 31, 2005 and 2004, the Company posted collateral of $1.8 million and $1.9 million, respectively, for the benefit of CDS customers.
Reinsurance recoverables and loss and loss adjustment expense reserves decreased in 2005 compared with 2004 due to a quota share retrocession agreement that the Company entered into on April 28, 2004 with ACE INA Overseas Insurance Company Ltd. (“AIOIC”), a subsidiary of ACE, whereby it ceded 100% of any potential losses associated with an action filed by World Omni Financial Corp. (“World Omni”) against AG Intermediary Inc. and AGRO, subsidiaries of the Company, for a premium of $32.2 million. The matter was settled on December 15, 2005 between AIOIC and World Omni. Upon settlement, the Company released $54.2 million of reinsurance recoverables and loss and loss adjustment expense reserves, representing its entire obligation to World Omni (see Note 15. Commitments and Contingencies). Also contributing to the decreases was $53.3 million of released reinsurance recoverables and loss and loss adjustment expense reserves, due to the run-off and novation of our trade credit business, which is included in our other segment.
Losses and loss adjustment expenses (received) paid, net of recoveries, were $(77.2) million, $241.6 million and $99.8 million, respectively, for the years ended December 31, 2005, 2004 and 2003. The loss recovery of $ 77.2 million in 2005 is primarily due to $71.0 million in loss recoveries from a third party litigation settlement agreement, with two parties, relating to a reinsurance claim incurred in 1998 and 1999 as well as a $2.4 million recovery related to the equity layer credit protection business, mentioned above. Of the total net loss payments in 2004 and 2003, $56.2 million and $77.1 million, respectively, related to equity layer CDO losses paid in those years. No amounts were paid in 2005 relating to equity layer CDO losses.
In connection with the IPO, the Company and ACE Financial Services Inc. (“AFS”), a subsidiary of ACE, entered into a tax allocation agreement, whereby the Company and AFS made a “Section 338 (h)(10)” election that had the effect of increasing the tax basis of certain affected subsidiaries tangible and intangible assets to fair value. Future tax benefits that the Company derives from the election will be payable to AFS when realized by the Company.
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 the IPO in April 2004, Assured Guaranty US Holdings Inc. (“AGUS”), Assured Guaranty Corp. (“AGC”), Assured Value Insurance Company (“AVIC”), 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,
The following table provides the Company’s income tax provision and effective tax rates:
As of December 31, 2005, AGRO had a standalone net operating loss carry-forward of $59.2 million, which is available to offset future U.S. federal taxable income through 2023. As a Section 953(d) company, any standalone net operating losses of AGRO are treated as dual consolidation losses and are not permitted to offset income of any other members of the consolidated group. Management believes it is more likely than not that $20.0 million of AGRO’s $59.2 million net operating loss will not be utilized before it expires and has established a $7.0 million valuation allowance related to the net operating loss carry-forward deferred tax asset. This valuation allowance is reviewed quarterly.
To limit its exposure on assumed risks, at the time of the IPO, the Company entered into certain proportional and non-proportional retrocessional agreements with other insurance companies, primarily ACE subsidiaries, to cede a portion of the risk underwritten by the Company. In addition, the Company enters into reinsurance agreements with non-affiliated companies to limit its exposure to risk on an on-going basis.
(1) The 2004 amount is 100% guaranteed by ACE INA Overseas Ins. Co.
FSA has also reassumed from AG Re approximately $12.0 million of unearned premium reserves, net of ceding commissions, of healthcare related business with an approximate par value of $820.0 million.
AGC is a Maryland domiciled insurance company and a subsidiary of the Company. Under Maryland’s 1993 revised insurance law, the amount of surplus available for distribution as dividends is subject to certain statutory provisions, which generally prohibit the payment of dividends in any twelve-month period in an aggregate amount exceeding the lesser of 10% of surplus or net investment income (at the preceding December 31) without prior approval of the Maryland Commissioner of Insurance. The amount available for distribution from the Company during 2006 with notice to, but without prior approval of, the Maryland Commissioner of Insurance under the Maryland insurance law is approximately $25.6 million. During the year ended December 31, 2005, AGC declared and paid $4.3 million in dividends to AGUS. During the year ended December 31, 2003, AGC paid $10.0 million in dividends to ACE Financial. There were no such dividends paid in 2004. Under Maryland insurance regulations, AGC is required at all times to maintain a minimum surplus of $750,000.
· AGC and AGRO, effective April 1, 2004, entered into 100% quota share retrocession agreement with ACE American. ACE American reinsures both existing and new trade credit reinsurance business written by these entities. The aggregate premium paid under these agreements was approximately $35.4 million in respect of existing business.
· AGRO and ACE INA Overseas Insurance Company entered into a 100% quota share retrocession agreement, effective April 1, 2004, under which AGRO retrocedes to ACE INA Overseas an auto residual value reinsurance transaction. The premium payable under this agreement was approximately $32.2 million.
In July 2001, the Company entered into a reinsurance transaction with an affiliate of ACE which it fully ceded to ACE American. Under the terms of these reinsurance agreements, the Company assumed and ceded premium of $2.7 million, and $6.0 million in 2004 and 2003, respectively. Under the terms of these reinsurance agreements, the Company assumed and ceded losses of $12.6 million and $6.0 million in 2004 and 2003, respectively. There were no amounts assumed or ceded during 2005.
In September 2001, AGC entered into an excess of loss reinsurance agreement with ACE Bermuda which was effective January 1, 2001. Under the terms of the agreement, the Company paid $52.5 million in premium, in two installments of $27.5 million and $25.0 million in September 2001 and March 2002, respectively, for a 10-year cover with a $150.0 million limit. In June 2003, this agreement was cancelled and the unearned premium of $39.8 million, loss reserves of $12.5 million and profit commission of $1.5 million were returned to AGC. This agreement was not replaced with a third party reinsurance contract. The Company ceded losses of $2.5 million in 2003, under this cover.
ACE has historically provided certain general and administrative services to some of the Company’s subsidiaries, including AGC, AG Re and AGRO. Those services have included information technology (“IT”) related services, tax consulting and preparation services, internal audit services, administrative services, including accounts payable, payroll, human resources and a liquidity facility line of credit. Expenses included in the Company’s financial statements related to these services were $0.9 million, $1.2 million and $1.1 million for the years ended December 31, 2005, 2004 and 2003, respectively. As of December 31, 2005 the only services performed under this agreement are IT related and tax consulting and preparation services.
AGC provided a variety of administrative services to ACE American Insurance Company, ACE Asset Management Inc. and ACE Financial Services, including human resources, legal, data processing, accounting, tax and financial planning. The aggregate fees recorded under these services agreements for the years ended December 31, 2004 and 2003 were $0.1 million and $3.4 million, respectively. As of the IPO, these agreements have been terminated.
AGC and AG Re were parties to an intercompany service agreement, effective in 2001, with ACE Asset Management whereby ACE Asset Management provided investment services such as determining asset allocation and reviewing performance of external investment managers. For the year ended December 31, 2003, the Company incurred expenses of approximately $0.3 million, while in 2004 the Company recorded an immaterial expense under this intercompany service agreement. As of the IPO date, this agreement has been terminated.
During 2004 and 2003, ACE contributed capital of $78.9 million and $3.7 million, respectively to the Company. These were non-cash contributions. The capital contribution in 2004 was mainly comprised of $75.0 million of cumulative monthly income preferred shares transferred to ACE (see Note 17), $3.5 million of the accelerated vesting of options to purchase ordinary shares, and other items related to the formation transactions due to the IPO. In 2003, the $3.7 million capital contribution was utilized to pay interest on long-term debt. All expenses are net of related income taxes. No such contribution occurred during 2005.
On April 28, 2004 the Company entered into a quota share retrocession agreement with ACE INA Overseas Insurance Company Ltd. (“AIOIC”), a subsidiary of ACE, whereby it ceded 100% of any potential losses associated with the above litigation for a premium of $32.2 million. The matter was settled on December 15, 2005 between AIOIC and World Omni. Upon settlement, the Company paid its $34.4 million funds held liability to AIOIC. Also in connection with the settlement the Company released $54.2 million of reinsurance recoverable and loss and loss adjustment expense reserves, representing its entire obligation to World Omni.
In April 2005, AGC received a Notice of Order to Preserve (“Order”) from the Office of the Commissioner of Insurance, State of Georgia (“Commissioner”). The Order was directed to “ACE Limited, and all affiliates” and requires the preservation of documents and other items related to “finite
insurance” and a broad group of other insurance and reinsurance agreements. Also in April, AGC, and numerous other insurers, received a subpoena from the Commissioner related to the “initial phase” of the Commissioner’s investigation into “finite-risk” transactions. The subpoena requests information on AGC’s assumed and ceded reinsurance contracts in force during 2004. AGC is cooperating with the Commissioner.
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.
The Company is party to reinsurance agreements with all of the major monoline primary financial guaranty insurance companies. The Company’s facultative and treaty agreements are generally subject to termination (i) upon written notice (ranging from 90 to 120 days) prior to the specified 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.
As of December 31, 2005, no amounts were outstanding under this facility nor have there been any borrowings under this facility.
On November 8, 2004, Assured Guaranty Ltd., AG Re and AGRO entered into a standby letter of credit agreement (the “LOC Agreement”) with KeyBank National Association (“KeyBank”). Under the LOC Agreement, KeyBank agreed to issue up to $50.0 million in letters of credit on the Company’s behalf. The obligations of the Company, AG Re and AGRO under the LOC Agreement were joint and several. The letters of credit were used to satisfy AG Re’s or AGRO’s obligations under certain reinsurance agreements and for general corporate purposes. Under the LOC Agreement, KeyBank issued two letters of credit, both on behalf of AGRO, with an aggregate stated amount of approximately $20.7 million. The parties to the LOC Agreement have agreed that no additional letters of credit would be issued, extended or renewed from and after the date of the closing of the $300.0 million credit facility and letters of credit that were outstanding on such date will, unless cancelled and surrendered by the respective beneficiaries thereof, remain outstanding until their respective stated expiration dates of December 31, 2005. The LOC Agreement contains covenants that limit debt, liens, guaranties, loans and investments, dividends, liquidations, mergers, consolidations, acquisitions, sales of assets or subsidiaries and affiliate transactions. Most of these restrictions were subject to certain minimum thresholds and exceptions. The LOC Agreement also contained financial covenants that required the Company: (i) to maintain the ratio of consolidated debt to total capitalization at not greater than 0.30 to 1.0; (ii) to maintain consolidated net worth of at least seventy-five percent (75%) of its consolidated net worth as of June 30, 2004; and (iii) to maintain the consolidated interest coverage ratio for any test period ending on the last day of a fiscal quarter at not less than 2.50 to 1.0. In addition, the LOC Agreement provided that the obligations of KeyBank to issue letters of credit may be terminated, and the Company’s obligations under the agreement may be accelerated, upon an event of default. As of December 31, 2004, no amounts were payable under any letter of credit issued under this facility. The LOC Agreement expired on April 28, 2005 and was replaced by the $300.0 million credit facility discussed above.
AGC is also party to a non-recourse credit facility with a syndicate of banks which provides up to $175.0 million specifically designed to provide rating agency-qualified capital to further support AGC’s claims paying resources. The facility expires in December 2010. As of December 31, 2005 and December 31, 2004, no amounts were outstanding under this facility nor have there been any borrowings under the life of this facility.
The Company’s failure to comply with certain covenants under the Company’s credit facilities could, subject to grace periods in the case of certain covenants, result in an event of default. This could require the Company to repay any outstanding borrowings in an accelerated manner.
For the year ended December 31, 2005, AGC has incurred $3.7 million of fees associated with the committed capital securities consisting of $2.0 million of one-time investment banking fees incurred during Second Quarter 2005 and $1.7 million of put option premiums which are on-going. These expenses are presented in the Company’s consolidated statements of operations and comprehensive income under other expense.
The following table presents changes in the Company’s common stock issued and outstanding for the year ended December 31, 2005 and the period from the IPO date through December 31, 2004.
Since the Company was a subsidiary of ACE during 2003, management has determined that disclosing common stock related to that year would not be meaningful, as the Company was recapitalized due to the IPO.
In April 2005, the Company completed a Board of Directors authorized stock repurchase program spending approximately $25.0 million to repurchase approximately 1.3 million shares of its Common Stock at an average price of $18.69.
Prior to the IPO, Assured Guaranty’s officers and employees participated in ACE’s long-term incentive plans providing options to purchase ACE ordinary shares and restricted share unit awards.
In connection with the IPO, awards of options and restricted common shares were made to the Company’s officers and employees. Each of the options will vest in equal annual installments over a three-year period and will expire on the tenth anniversary of the date of grant. The exercise price of the options is $18.00, the public offering price of the IPO. Restricted common shares will vest in equal annual installments over a four-year period. Options to purchase an aggregate of 1,873,300 common shares and an
aggregate of 966,400 restricted common shares were issued in connection with the IPO. As of December 31, 2005, 3,764,626 common shares were available for grant under the Incentive Plan.
* Balance related to ACE restricted stock awards prior to the IPO
Prior to the IPO, Assured Guaranty’s officers and employees participated in ACE’s long-term incentive plans. The Company’s officers and employees have been covered under additional benefit plans, including retirement programs providing 401(k) plan benefits, health and life insurance benefits; medical, dental and vision benefits for active employees; disability and life insurance protection; and severance. Prior to the IPO, these additional benefits had been provided to the Company’s employees and officers who work in the United States by plans maintained by AGC and to the Company’s employees and officers who work in Bermuda and the United Kingdom through plans maintained by ACE covering ACE employees in those locations. Since the completion of the IPO, the Company’s United States and Bermuda officers and employees generally have been covered by benefit plans established by the Company, although Bermuda officers and employees continued to be covered by ACE health and welfare plans until December 31, 2004. Employees located in the United Kingdom continued to participate in the ACE benefit plans in which they participated prior to the IPO until December 31, 2004 and now participate in plans maintained by the Company.
The Company maintains savings incentive plans, which are qualified under Section 401(a) of the Internal Revenue Code. The U.S. savings incentive plan is available to all full-time employees with a minimum of six months of service. Eligible participants may contribute a percentage of their salary subject to a maximum of $14,000 for 2005. Contributions are matched by the Company at a rate of 100% up to 7% of the participant’s compensation, subject to IRS limitations. In addition, the Company may contribute an additional amount to eligible employees’ savings incentive plan accounts at the discretion of the Board of Directors. For 2005, the Company made a discretionary contribution equal to 5% of the compensation of eligible participants, which discretionary contribution was made to a U.S. savings incentive plan up to the amount permitted by IRS limits, with amounts in excess of those permitted by the IRS limits contributed to the U.S. nonqualified plan. Participants generally vest in Company contributions at a rate of 33.3% per year starting with the completion of one year of service. Beginning January 1, 2006, the Company has amended the U.S. savings incentive plan. The amendments include matching employee contributions up to 6%, subject to IRS limitations, with an additional 6% contribution up to the amount permitted by IRS limits, with amounts in excess of those permitted by the IRS limits contributed to the U.S. supplemental executive retirement nonqualified plan, regardless if the employee contributes to the plan. In addition, employees will be fully vested after 1 year of service, as defined in the plan and plan eligibility is immediate upon hire.
The fair value of the Company’s $200 million of Senior Notes is 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 the similar debt instruments.
The Company does not segregate assets and liabilities at a segment level since management reviews and controls these assets and liabilities on a consolidated basis. The Company allocates operating expenses to each segment based on a comprehensive cost study. During 2005 the Company implemented a new operating expense methodology to more closely apply expenses to the individual operating segments starting with 2004, the year of the IPO. This new methodology was based on a comprehensive cost study. The prior allocation was based on segment net earned premium. Basing the allocation on earned premium for 2005 and 2004 would have caused the financial guaranty reinsurance and mortgage guaranty segments to receive a disproportionate amount of the expenses. 2004 amounts have been adjusted to reflect this new allocation. The earned premium allocation methodology was kept for 2003, as the current business strategy of focusing on direct business was not in place in 2003 and thus the net earned premium allocation methodology allocated an appropriate amount of operating expense to the segments. The other segment received proportional share of operating expenses up to the IPO date. From the IPO date, the other segment was not allocated operating expenses. Management uses underwriting gains and losses as the primary measure of each segment’s financial performance.