We and our subsidiaries currently lease office space in Bermuda; New York, New York; Norwalk, Connecticut; Walnut Creek, California; London; Madrid and Singapore.
2002 - 2005 based on 46,127,245 shares outstanding immediately prior to the initial public offering of our common stock. See note 20 to our consolidated financial statements for additional information.
On October 31, 2006 the Board of Directors of the Company declared a cash dividend on our common shares of $0.02 per share, aggregating $1.3 million. The dividend was paid on December 29, 2006 to shareholders of record on December 11, 2006. Also, on February 27, 2007, our board of directors declared a dividend of $.02 per common share, which is payable on March 30, 2007 to shareholders of record on March 15, 2007. Any future dividends will be subject to the discretion and approval of the Board of Directors.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes which appear in Item 8. This discussion and analysis contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and under the headings “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements.”
On August 4, 2006, we completed the sale of 18,009,119 of our common shares through an initial public offering (the “IPO”) at $20.50 per share for aggregate consideration of $369.2 million. Underwriting expenses were $22.2 million and other issuance costs were $5.7 million resulting in net proceeds of approximately $341.3 million. In addition, XL Capital sold 4,438,609 of its common share holdings in SCA directly to the public in a secondary offering concurrent with our IPO and another 992,165 common shares of SCA pursuant to the exercise of the underwriters’ over-allotment option. As a result, after the IPO, the aforementioned secondary offering, the exercise of the underwriters’ over-allotment option, and restricted share awards to management of SCA, XL Capital’s ownership of SCA’s outstanding common shares represents approximately a 63 percent economic interest in SCA. As a result of limitations on XL Capital’s voting power contained in our Bye-laws, the votes conferred by the common shares owned by XL Capital will not exceed, with respect to elections of directors, 50.1% of the aggregate voting power of all common shares entitled to vote generally at any election of directors or, with respect to any other matter presented to our shareholders for their action or consideration, 47.5% of the aggregate voting power of all common shares entitled to vote on such matter. If, however, the rating agencies would permit XL Capital’s voting rights to be commensurate with its economic interest in SCA, without adversely affecting the ratings of SCA or its operating subsidiaries, XL Capital’s voting power would automatically increase and consequently the voting power of all other shareholders in the aggregate would correspondingly decrease, thereby eliminating preferential voting rights of all SCA’s other shareholders. See Liquidity and Capital Resources for further details regarding the use of proceeds.
Concurrent with the IPO, we entered into arrangements with affiliates of XL Capital to: (i) provide us with protection with respect to adverse development on certain transactions, (ii) have exposures transferred to us or re-assume exposures under certain financial guarantee policies that were originally reinsured to, or written on our behalf by, XLI, due principally to single risk constraints and rating agency capital adequacy requirements applicable to us at the time that business was first written, (iii) cancel our reinsurance of certain non-financial guarantee business ceded to us by XLI, (iv) govern certain aspects of our relationship with XL Capital after the IPO, including a series of service agreements under which subsidiaries of XL Capital provide certain services to us or receive certain services from us for a period of time after the IPO, (v) contribute to us the proceeds from the redemption of an investment related to our financial guarantee business which aggregated $15.0 million (this contribution was made on the effective date of the IPO), and (vi) fund a portion of long-term compensation awarded by XL Capital to our employees prior to the IPO. In this regard, in December 2006 XL Capital contributed $6.2 million to us to fund the aforementioned long-term compensation awards of SCA employees which were voluntarily or involuntarily converted from XL Capital long-term incentive plans to our long-
term incentive plans and will make periodic contributions in the future for such awards that were not so converted. Such future contributions are not expected to exceed $1.6 million in the aggregate.
On August 4, 2006, we terminated a facultative quota share reinsurance treaty with XLI that had been effective since 2001. As a result of the termination, XLI returned $26.5 million of premiums to us, we returned ceding commissions of $7.8 million to XLI, and XLI paid us $18.7 million.
We derive our revenues principally from: (i) premiums from our insurance and reinsurance businesses, (ii) net investment income and net realized gains and losses from our investment portfolio supporting these businesses and (iii) realized and unrealized gains and losses on credit derivatives.
Our expenses primarily consist of losses and loss adjustment expenses, acquisition costs, operating expenses, and income taxes. Losses and loss adjustment expenses are a function of the quality, amount and type of business we guarantee and are based upon estimates. The risks inherent in our credit enhancement businesses have a low expected frequency of loss and, at the time we accept such risk, generally will be of investment-grade quality without the benefit of credit enhancement provided by us through the issuance of our insurance policies and credit default swaps. Acquisition costs are related to the production of new business and are generally deferred and recognized over the period in which the related premiums are earned. See “-Critical Accounting Policies and Estimates-Deferred Acquisition Costs and Deferred Ceding Commissions.” Operating expenses consist primarily of costs relating to compensation of our employees, information technology, office premises and professional fees. Income taxes are a function of our profitability and the applicable tax rate in the various jurisdictions in which we do business.
We review our periodic sales performance by reviewing a non-GAAP measure known as “adjusted gross premiums.” Adjusted gross premiums for any period equals the sum of: (i) upfront premiums written in such period, (ii) current installment premiums on business written in such period and (iii) expected future installment premiums on contracts written during such period that remain in force and for which there is a binding obligation on the part of the insured to pay the future installment premiums, discounted at 7%, which we refer to as the “present value of future installment premiums,” or “PVFIP,” on business written during such period. The 7% discount rate was established when our subsidiaries first started reporting adjusted gross premiums based upon the view that 7% was the appropriate discount for these future premiums and that rate has not been changed in order to preserve comparability among periods. This measure adjusts for the fact, as described above, that upfront premiums are recorded in full as total premiums written at inception of the contract but future installment premiums are not, even though the volume of insured business we are writing is essentially the same. PVFIP is not reflected on our consolidated balance sheet. PVFIP can be negatively affected by prepayments and refundings, early terminations, credit losses or other factors impacting our in-force book of business.
The following is a reconciliation of total premiums written to adjusted gross premiums. Total premiums written is the most directly comparable GAAP financial measure.
We also measure our performance by excluding from net income: (i) net realized gains (losses) on investments and credit derivatives and (ii) earned premiums from refundings. Management believes that net income adjusted to exclude the aforementioned items provides a better measure of the operating performance of its business, as such items are largely not subject to management discretion or control.
The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates, and those differences may be material.
An understanding of our accounting policies for these items is of critical importance to understanding our consolidated financial statements. The following discussion provides more information regarding the estimates and assumptions used for these items and should be read in conjunction with the notes to our consolidated financial statements.
Our financial guarantees insure scheduled payments of principal and interest due on various types of financial obligations against payment default by the issuers of such obligations. We establish reserves for losses and loss adjustment expenses on such business based on our best estimate of the ultimate expected incurred losses. Our estimated ultimate expected incurred losses are comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. Establishment of such reserves requires the use and exercise of significant judgment by management, including estimates regarding the occurrence and amount of a loss on an insured obligation. Estimates of losses may differ from actual results and such difference may be material, due to the fact that the ultimate dispositions of claims are subject to the outcome of events that have not yet occurred. Examples of these events include changes in the
The following tables summarize our gross reserves (before the effect of reinsurance ceded) for losses and loss adjustment expenses by segment and by type of reserve as of the dates presented. For an explanation of changes in these reserves see “-Consolidated Results of Operations.”
Case basis reserves on financial guarantee insurance business written are established by us with respect to a specific policy or contract upon receipt of a claim notice or when management determines that (i) a claim is probable in the future based on specific credit events that have occurred and (ii) the amount of the ultimate loss that we will incur can be reasonably estimated. As specific case basis reserves are established we consider whether any changes are required to the assumptions underlying the calculation of unallocated reserves (which are discussed below) as a result of such activity. As case basis reserve activity to date has been limited, we have not adjusted our unallocated reserves assumptions due to such activity. The amount of the case basis reserve is based on the net present value of the expected ultimate loss and loss adjustment expense payments that we expect to make, net of expected recoveries under salvage and subrogation rights. Case basis reserves are determined using cash flow or similar models to estimate the net present value of the anticipated shortfall between (i) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (ii) anticipated cash flow from the proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries. A number of quantitative and qualitative factors are considered when determining or assessing, in management’s judgment, the need for a case basis reserve. These factors may include the creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured, the projected cash flow or market value of any assets that collateralize or secure the insured obligation, and the historical and projected loss rates on such assets. Other factors that may affect the actual ultimate loss include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. Case basis reserves are generally discounted at a rate reflecting the yield on our investment portfolio during the period the case basis reserve is established. We believe this yield is an appropriate rate to discount our reserves because it reflects the rate of return on the assets supporting such business. When a case basis reserve is established for a guaranteed obligation whose premium is paid on an upfront basis, we continue to record premium earnings on such policy over its remaining life, unless we have recorded a full limit loss with respect to such policy, in which case the remaining deferred premium revenue relating thereto is immediately reflected in earnings. When a case basis reserve is established for a guaranteed obligation whose premium is paid on an installment basis, those premiums, if expected to be received prospectively, are considered a form of recovery and are no longer earned as premium revenue.
Case basis reserves on financial guarantee reinsurance assumed are generally established by us upon notification from ceding companies. Based on our evaluation of the loss activity reported to us from our ceding companies, as well as the results from our periodic reviews of our ceding companies’ underwriting and surveillance procedures, we may, in management’s judgment, establish case reserves greater than those reported by the ceding companies. Our
In addition to case basis reserves, we maintain an unallocated loss reserve for expected losses inherent in our in-force business (consisting of both financial guarantee insurance and reinsurance business) that we expect to emerge in the future. Our unallocated loss reserves represent our estimated ultimate liability from claims expected to be incurred in the future under our in-force insured and reinsured policies less outstanding case basis reserves and cumulative paid claims to date on such policies. Our unallocated reserves are estimated by management based upon an actuarial reserving analysis. The actuarial methodology applied by us is in accordance with Actuarial Standards of Practice No. 36, Determination of Reasonable Provision. The methodology applied is based on the selection of an initial expected loss ratio, as well as an expected loss emergence pattern (i.e., the expected pattern of the expiration of risk on insured and reinsured in-force policies). Salvage and subrogation recoveries are implicit in our selected expected ultimate loss ratio as such ratio is derived from industry loss experience, which is net of salvage and subrogation recoveries (i.e., from the liquidation of supporting or pledged collateral assets). The implicit inclusion of salvage and subrogation recoveries in our selected expected ultimate loss ratio is consistent with management’s explicit consideration of collateral support in the establishment of its case basis reserves.
thereof represents management’s best estimate of the ultimate losses it expects to incur on our in-force business. The process of establishing unallocated reserves and periodically revising such reserves to reflect the underlying par risk amortization and management’s current best estimate of ultimate losses will ultimately cause the cumulative loss experience over the life of a particular underwriting year’s business to equal the cumulative inception-to-date actual paid losses on such business.
The selection of our initial expected loss ratio is based on an analysis, which we update annually, of the historic earned premium and ultimate losses of the financial guaranty industry. The analysis utilizes loss and premium data filed by the three largest companies in the financial guaranty insurance industry in Schedule P of their annual statutory financial statements. These statutory filings provide data for ten calendar years and exclude unallocated reserves. Information on unallocated reserves is obtained from Annual Reports filed with the SEC on Form 10-K and is combined with the Schedule P data to estimate ultimate loss ratios for each of the preceding ten years. The mean ten-year observed historic industry loss ratio resulting from our initial analysis in 2001 (which was conducted when we first adopted our unallocated reserve methodology) encompassing years 1991 through 2000 was 13%. Later analyses performed in 2005 (encompassing years 1995 through 2004) and 2006 (encompassing years 1996 through 2005) indicated that the average industry loss ratio was 16%.
When we adopted our current unallocated reserve methodology in 2001 we selected an initial expected loss ratio of 25%. Our selection was based on the following qualitative factors, which involved the exercise of management’s judgment: (i) the low-frequency/high-severity nature of the business which resulted in considerable volatility in the loss ratios by year and by company reflected in the analysis discussed above, (ii) our limited loss experience reflecting the fact that we commenced operations in 1999, and (iii) the fact that the sample loss ratio data in the analysis was drawn from industry data which reflect a balanced mix of public and structured finance business during a robust growth economy, whereas our in-force insurance business was more heavily weighted toward structured finance business. Accordingly, the ultimate loss ratios from the industry data were lower than that expected for our in-force business.
considered its industry studies described above as supportive of management’s change in the initial expected loss ratio in 2004, for the reasons described above. Our updated analyses in 2005 and 2006 indicated that no change was necessary in our expected loss ratio of 20% from that in 2004.
Our unallocated loss reserve is established on an undiscounted basis and represents management’s best estimate of losses that we will incur in the future as a result of credit deterioration in our in-force business but which have not yet been specifically identified. We do not attempt to apportion unallocated reserves by type of product.
The following example illustrates our method for calculating unallocated reserves over the life of a financial guarantee contract.
Our total reserves for losses and loss adjustment expenses represent a small fraction of our insured and reinsured in-force par outstanding, which reflects the nature of the business we underwrite and the loss experience of the industry. We believe that our reserves are adequate to cover our expected ultimate losses. However, due to the inherent uncertainties of estimating reserves for loss and loss adjustment expenses, actual experience may differ from the estimates reflected in our consolidated financial statements, and the differences may be material. Differences exist within the financial guarantee industry with regard to the methodology and measurement of such reserves. While we believe that the principles we apply are the most appropriate for our business and have applied them consistently within the periods presented, alternate methods may produce different estimates as compared to the current methodology we use. See “Risk Factors-Risks Related to Our Company-Rules relating to certain accounting practices in the financial guarantee insurance and reinsurance industry are currently being reviewed by applicable regulatory bodies and any changes required by that review could have a material effect on the reported operating results and financial condition of the industry or particular market participants, including us, depending on the extent to which current policies differ from those promulgated by such regulatory bodies.”
Our surveillance department is responsible for monitoring the performance of our in-force portfolio. They maintain a list of credits that they have determined need to be closely monitored and, for certain of those credits, they undertake remediation activities they determine to be appropriate in order to mitigate the likelihood and/or amount of any loss that we could incur with respect to such credits.
The activities of our surveillance department are integral to the identification of specific credits that have experienced deterioration in credit quality and to the assessment of whether losses on such credits are probable, as well as any estimation of the amount of loss expected to be incurred with respect to such credits. Closely monitored credits are divided into four categories: (i) Special Monitoring List-investment grade credits where a covenant or trigger may be breached or is close to being breached and warrants closer monitoring; (ii) Yellow Flag List-credits that we determine to be non-investment grade but a loss or claim is unlikely; (iii) Red Flag List-credits where we do not expect an ultimate loss but a claim is possible but not probable; and (iv) Loss List-credits where we have either paid a loss or expect to suffer a loss and have recorded a case reserve. Out of over 2,500 credits in our in-force portfolio only 17 credits are in one of the four above categories. Credits that are not closely monitored credits are considered fundamentally sound, normal risk.
Protection with respect to loss development relating to the two closely monitored credits described in this section was provided by affiliates of XL Capital in connection with the IPO. See “- “Formation Transactions.”
If unrated by S&P, an internal assessment of underlying credit quality is used to calculate a rating. See “-Ratings.”
At December 31, 2006, the loss list consisted of 4 credits, 3 of which had case reserves. Gross case basis reserves at December 31, 2006 were $83.9 million (or $13.6 million net of ceded reinsurance). One credit did not have a case reserve because it had been fully paid and it remains on the loss list to monitor certain ongoing related litigation. One other credit, aggregating at December 31, 2006, has $1.6 million of case reserves and $2.8 million of par outstanding is not viewed by us as significant. The remaining two insured transactions, of which one was a single-structured risk project financing and the other was a mortgage-backed securitization are discussed in Note 13 (a) and 13 (c) to the Consolidated Financial Statements elsewhere herein. We have not received a claim on any of these credits that have case reserves.
Case basis reserve established represents a point estimate reflecting management’s best estimate, in its judgment, of the ultimate loss expected to be incurred on the policies. Management’s estimate was based on projections of cash flows expected from the assets supporting the insured obligations’ debt service requirements, as well as qualitative factors considered by management.
See Note 13 in our Consolidated Financial Statements for a discussion of the significant activity in our reserves for losses and loss adjustment expenses including both current and prior year development.
Because we view these derivative contracts as an extension of our financial guarantee business, we believe that the most meaningful presentation of these derivatives is to reflect: (i) fees that we receive from the issuance of such contracts in the line item captions in the statement of operations entitled “gross premiums written,” “reinsurance premium assumed,” “net premiums written” and “net premiums earned,” as appropriate, (ii) losses from actual and expected payments to counterparties under such contracts in the line item caption in the statement of operations entitled “net losses and loss adjustment expenses” and (iii) changes in the fair value of such instruments which are attributable to market factors, as discussed below, in the line item caption in the statement of operations entitled “net realized and unrealized gains (losses) on credit derivatives.”
For the years ended December 31, 2006, 2005 and 2004, approximately 69%, 57% and 63%, respectively, of our gross premiums written were received upfront, and 31%, 43% and 37%, respectively, were received in installments. For the years ended December 31, 2006, 2005 and 2004 approximately 65%, 59% and 45%, respectively, of our reinsurance premiums assumed were received upfront, and 35%, 41% and 55%, respectively, were received in installments.
We describe our premium revenue recognition for reinsurance contracts under “-Reserves for Losses and Loss Adjustment Expenses” and with regard to ceded reinsurance under “-Liquidity and Capital Resources-Ceded Reinsurance Recoverables.”
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 ceding commissions, reserves for losses and loss adjustment expenses, deferred premium revenue, realized and 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 is estimated to be more likely than not to be realized.
As of December 31, 2006 and 2005, our consolidated financial statements reflect a deferred federal income tax asset of $18.2 million, and $17.6 million, respectively, resulting from the operations of the SCA Holdings U.S. Inc. group which are subject to U.S. federal income taxes. Such deferred tax assets are net of a valuation allowance of $1.9 million and $0.9 million as of December 31, 2006 and 2005, respectively. The valuation allowance relates to net unrealized capital losses and a net realized capital loss carry forward that may not be realized within a reasonable period. At December 31, 2006, the Company has net unrealized capital losses and a net realized capital loss carry forward of approximately $3.2 million and $2.2 million respectively, against which a valuation allowance has been established. The net realized capital loss carry forward will expire in 2011.
The following table presents summary statement of operations data for our operating segments for the years ended December 31, 2006, 2005 and 2004:
Discussion of Consolidated and Segment Results of Operations for the Fiscal Years 2006, 2005 and 2004
Comparison of Year Ended December 31, 2006 to Year Ended December 31, 2005. Net income for the year ended December 31, 2006 was $117.4 million, an increase of $36.9 million from that reported in 2005. Net income for the year ended December 31, 2006 included $16.2 million of net realized losses on investments, as compared to net realized losses of $3.2 million in 2005. In addition, also included in net income in 2006 was approximately $8.4 million of net realized and unrealized losses on credit derivatives, as compared to net realized and unrealized losses on credit derivatives of $6.7 million in 2005.
For the year ended December 31, 2006, we recorded a provision for net losses and loss adjustment expenses of $15.0 million, a decrease of $11.0 million, or 42.3%, from the $26.0 million recorded in 2005. The decrease resulted from lower provisions for case basis reserves after reinsurance, offset in part by a nominal increase in the provision for unallocated reserves, as compared to 2005. During the year ended December 31, 2006 there were nominal net provisions for case
Dividends on the Series A preferred shares of XLFA decreased by 44.7% in 2005 as compared to 2004. The dividend on the XLFA Series A preferred shares varied from period to period, prior to December 31, 2005, because it was based in part on the average dividend rate paid by a select group of financial guarantee companies. Effective January 1, 2006, the dividend rate on the Series A preferred shares was changed to a fixed rate of 8¼% per year. See Note 5 to our consolidated financial statements for details.
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations -Other Measures Used by Management to Evaluate Operating Performance” for information management reviews to evaluate new business production.
All our reinsurance premiums assumed are from our financial guarantee reinsurance segment. The majority of our financial guarantee reinsurance business is assumed from affiliates of FSA.
Reinsurance premiums assumed in 2005 were $52.2 million, an increase of $8.2 million or 18.6%, as compared to $44.0 million recorded in 2004. The increase was largely due to a new reinsurance arrangement with a large third-party financial guarantee primary company, which generated $7.0 million of assumed premiums.
The following table presents, for the periods indicated, the amount of reinsurance premiums assumed attributable to upfront and installment policies and contracts:
The following table presents, for the periods indicated, the amount of gross reinsurance premiums assumed by principal market:
The following table presents, for the periods indicated, the amount of earned premiums attributable to upfront and installment policies:
Net investment income was $77.7 million in 2006, an increase of $26.5 million or 51.8% as compared to $51.2 million in 2005. The increase in net investment income was due primarily to higher average invested assets and higher new money yields. The increase in our average invested assets in 2006, as compared to 2005, was primarily attributable to the net proceeds from our IPO and the net cash inflows from our operations. Net investment income of $51.2 million in 2005, increased $15.5 million, or 43.4%, as compared to $35.7 million in 2004. The increase in net investment income in 2005, as compared to 2004, was similarly due to higher average invested assets and higher new money yields. The increase in our average invested assets in 2005, as compared to 2004, resulted primarily from net cash inflows from our operations and a $125.0 million capital infusion during the fourth quarter of 2004.
Effective yield represents net investment income as a percentage of average invested assets. The increase in the effective yield was due to the turnover in our investment portfolios capturing the trend of rising interest rates.
Net realized losses on investments were $(16.2) million, $(3.2) million, and $(0.2) million in 2006, 2005 and 2004, respectively. Net realized losses in 2006 were primarily due to an impairment charge of $15.1 million relating to notes acquired in satisfaction of a claim (see Note 13 (b) to the Consolidated Financial Statements for a more detailed discussion). Net realized losses in 2005 and 2004 were primarily attributable to portfolio management actions relating to the management of duration, yield and exposure to certain credit risks.
Changes in the fair value of credit default swaps attributable to earnings from premiums received by us from the issuance of such contracts are recorded in net premiums earned in the consolidated statement of operations. In addition, changes in the fair value of credit default swaps attributable to losses from actual and expected payments to counterparties under such contracts are recorded in losses and loss adjustment expense in the consolidated statement of operations, and the remaining components of the change in fair value of credit default swaps, which are attributable to changes in interest rates, credit spreads, credit quality, expected recovery rates and other market factors, are recorded in net realized and unrealized gains (losses) on credit derivatives. See “-Critical Accounting Policies and Estimates-Valuation of Credit Default Swaps.”
Also, during 2006 we recorded a $15.2 million increase in our gross case reserve relating to an insured project financing, as well as a $5.0 million gross case reserve in connection with an insured transaction supported by loans to medical providers (see Note 13 (a) and 13 (b) of our Consolidated Financial Statements, respectively, included elsewhere herein for further details of the aforementioned two insurance transactions). These increases in case reserves in 2006 had no effect on our results of operations due to reinsurance and indemnities provided to us by XL Capital in connection with our IPO. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations -Formation Transactions” for further details. In addition, during 2006 one of the two insured transactions discussed in Note 13 (c) to our Consolidated Financial Statements included elsewhere herein was retired pursuant to rights exercised by the sponsor of the obligation. As a result thereof, we recorded a reduction in our net case reserves of $1.1 million in the financial guarantee insurance segment. This reduction was offset by a $1.3 million increase in case reserves relating to the other insured transaction discussed in Note 13 (c) to the Consolidated Financial Statements resulting from the cancellation of reinsurance protection on the transaction which we had purchased from a third-party financial guarantee company.
The following table presents the components of acquisition costs, net, during the periods indicated:
Amortization of deferred ceding commission revenue from third party reinsurers increased $1.1 million from 2004 to 2005 due to higher cessions of installment business, while amortization of deferred ceding commission revenue from XLI and XL RE AM decreased $3.5 million from 2004 to 2005 primarily as a result of lower cessions of installment business.
Amortization of acquisition costs in the financial guarantee reinsurance segment was $7.6 million in 2005, an increase of $1.3 million or 20.6% as compared to $6.3 million in 2004. The increase was primarily due to an increase in letter of credit fees consistent with growth in our in-force reinsurance book of business.
Our total consolidated net cash inflows for the year ended December 31, 2006 were $762.5 million, which consisted of $392.9 million in net cash flow generated by operations, $342.3 million generated from our IPO ($341.3 million excluding certain offering costs not yet paid), and $28.5 million from capital contributions from XL Capital (which includes cash held by a contributed subsidiary). Of these cash flows $608.6 million was used for net purchases of new investments, and $7.2 million was used to pay dividends to holders of our common stock and the redeemable preferred shares of our subsidiary. The balance of cash inflows increased cash and cash equivalents by $148.0 million which are primarily invested in high yielding, high quality commercial paper of less than a 90 day maturity. Cash inflows from operations were driven by new business written and investment income.
As a result of significant business production by our operating subsidiaries in 2006 and anticipated future business growth, management is exploring raising additional capital in the form of preferred securities or debt and, in addition, increasing the use of third-party reinsurance. Any such transaction in this regard will be subject to market, regulatory and other considerations.
In connection with our IPO, our operating subsidiaries have each agreed that, until the second anniversary of the IPO each will not declare or pay dividends on its common stock other than to fund certain parent holding company operating expenses and debt service requirements and to fund “nominal” dividends on our common stock. In addition, New York Insurance law contains a test governing the amount of dividends that XLCA can pay in any year and, as a result of the application of such test, XLCA cannot currently pay dividends, without notice to, and prior approval from, the New York Superintendent. As a U.S. company paying dividends to a Bermuda holding company, XLCA’s dividends are subject to a 30% withholding tax rate.
The credit and liquidity facility contains financial covenants that require that SCA at any time (a) prior to August 4, 2008, maintain a minimum net worth of $857.4 million, (b) after August 4, 2008, maintain a minimum net worth equal to the greater of (1) $857.4 million (our net worth, defined as total shareholders’ equity before accumulated other comprehensive income, was approximately $1,386.2 million at December 31, 2006) or (2) an amount equal to 65% of the consolidated net worth as of the end of the then most recent fiscal year or fiscal quarter of SCA for which financial statements shall have been delivered, and (c) maintain a maximum total funded debt-to-total capitalization ratio of 30% (at December 31, 2006, we had no debt outstanding). The letter of credit and liquidity facility also contains certain covenants, including restrictions on mergers, acquisitions and other business consolidations; the sale of assets; incurrence of indebtedness; liens on our assets; and transactions with affiliates. In addition, the letter of credit and liquidity facility contains certain customary provisions regarding events of default, including payment defaults, breaches of representations and warranties, covenant defaults, cross-default and cross-acceleration to certain other indebtedness, certain events of bankruptcy and insolvency, material judgments, certain events under the Employee Retirement Income Security Act of 1974, as amended, and changes of control.
Pursuant to an agreement with FSAH in April 2006, XLFA restructured the terms of its Series A Redeemable Preferred Shares and changed its bye-laws accordingly. In accordance with the agreement, the participating dividend provision of the preference shares was eliminated, the stated value of the preference shares held by FSAH were increased to $54.0 million, and the fixed dividend rate was increased from 5% to 8.25%. For the year ended December 31, 2006 and 2005, XLFA paid total dividends to the holders of its redeemable preferred shares of $5.9 million and $7.5 million, respectively.
The following table presents our long-term contractual obligations and related payments as at December 31, 2006, due by period:
The Company is liable under an information technology outsourcing agreement that it entered into with International Business Machines Corporation (“IBM”) on October 1, 2006. Pursuant to the agreement IBM will: (i) provide the Company with all its information technology hardware, (ii) provide all support services to maintain such hardware and provide for efficient disaster recovery, (iii) develop a transition plan for the Company’s systems from its existing hardware to new hardware, and (iv) maintain the Company’s technology at a level that allows the Company to take advantage of technological advances. In consideration for these services the Company is obligated to pay IBM approximately $4.0 million per annum for the five year term of the contract. No expense was incurred by the Company under this agreement during 2006.
The timing and amounts of actual claims payments related to these reserves vary based on many factors. The ultimate amount of the claims payments could differ materially from our estimated amounts. For information regarding the estimates for unpaid loss and loss expenses as well as factors affecting potential payment patterns of reserves for actual and potential claims related to our different lines of business see “-Critical Accounting Policies and Estimates” above.
In June 2005, at the request of the Securities and Exchange Commission, the FASB added a project to their agenda to review and provide guidance for the accounting for financial guarantee insurance contracts under which it will consider claims liability recognition, premium recognition, and the related amortization of deferred policy acquisition costs. Current accounting literature, specifically FASB Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”), and FASB Statement of Financial Accounting Standards No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” (“SFAS 97”), does not specifically address the unique characteristics of accounting for financial guarantee insurance contracts. Consequently, the accounting principles applied by the industry, as well as us, have evolved over time and incorporate the concepts of both short-duration and long-duration contract accounting under the provisions of SFAS 60 and SFAS 97, as well as other accounting literature, such as FASB Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS No. 5”) and Emerging Issues Task Force (“EITF”) Issue No. 85-20, “Recognition of Fees for Guaranteeing a Loan.” An exposure draft is expected to be issued by the FASB during the first quarter of 2007. We will continue to apply the accounting policies described in Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and our Consolidated Financial Statements elsewhere herein until further guidance is provided by the FASB.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”), which amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”), and addresses issues raised in SFAS 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” The primary objectives of SFAS 155 are: (i) with respect to SFAS 133, to address the accounting for beneficial interests in securitized financial assets and (ii) with respect to SFAS 140, to eliminate a restriction on the passive derivative instruments that a qualifying special purpose entity may hold. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. We will adopt SFAS 155 on January 1, 2007 and are currently evaluating the implications of SFAS No. 155 to our financial statements.
In April 2006, the FASB issued FSP FIN 46(R)-6, “Determining the Variability to be Considered in Applying FIN 46(R),” which states that the variability to be considered when applying FIN 46(R) should be based on an analysis of the design of an entity, which entails analyzing the nature of the risks in the entity and determining the purpose for which the entity was created and determining the variability the entity is designed to create and pass along to its interest holders. Typically, assets and operations of the entity create the variability (and thus are not variable interests), while liabilities and equity interests absorb that variability (and thus, are variable interests). The role of a contract or arrangement in the design of the entity, regardless of its legal form or accounting classification, shall dictate whether that interest should be treated as creating or absorbing variability for the entity. We adopted the guidance in this FSP as of July 1, 2006 and it did not have any material effect on our financial statements.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is applicable for fiscal years beginning after December 15, 2006. We will adopt FIN 48 on January 1, 2007 and are currently evaluating the effect of this Interpretation on our financial statements.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”) which defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about fair value measurements. This Statement is applicable in conjunction with other accounting pronouncements that require or permit fair value measurements, where the FASB previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within these fiscal years. We are currently evaluating the effect of SFAS 157 on our financial statements.
The financial risk and oversight committee of our Board of Directors approves our general investment objectives, policies, and guidelines. Independent investment managers manage all of our consolidated investment portfolios.
Our primary investment objective is the preservation of capital, subject to an appropriate degree of liquidity, and a steady stream of investment income. A secondary objective is to optimize long-term returns.
We seek to manage the risks of our investment portfolio through a combination of asset class, industry and security level diversification. In addition, individual security and issuer exposures are controlled and monitored at the investment portfolio level via specific investment constraints outlined in our investment guidelines and agreed with the external investment professionals. Additional constraints are generally agreed upon with the external investment professionals and may address exposures to eligible securities, prohibited investments/transactions, credit quality and concentrations limits. We also have a policy not to invest in any securities that we guarantee.
The average duration of our investment portfolio was 3.1 years at December 31, 2006.
Our fixed-income portfolio is exposed to credit and interest rate risk. At December 31, 2006, the fair value of our fixed-income portfolio was approximately $2.1 billion, as compared to approximately $1.4 billion as at December 31, 2005.
The table below shows the percentage of our fixed-income portfolio by credit rating (excluding cash and cash equivalents) at December 31, 2006:
Our fixed-income portfolio is exposed to interest rate risk. Interest rate risk is the price sensitivity of a fixed-income security to changes in interest rates. We manage interest rate risk by setting duration targets for our investment portfolio, thus mitigating the overall economic effect of interest rate risk. We remain nevertheless exposed to interest rate risk since the assets are marked-to-market, thus subject to market conditions, while liabilities are accrued at a static rate. The hypothetical case of an immediate 100 basis point adverse parallel shift in global bond curves at December 31, 2006 would have decreased the fair value of our fixed-income portfolio by approximately 3.1%, or $66.5 million.
The amortized cost and estimated fair value of debt securities available for sale as of December 31, 2006, by contractual maturity, are presented 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. See Note 3 of the notes to our Consolidated Financial Statements for additional information regarding our debt securities available for sale as of December 31, 2006 and 2005.
availability of capital (whether in the form of debt or equity) and liquidity (including letter of credit facilities);
the timing of claims payments being faster or the receipt of reinsurance recoverables being slower than anticipated by us;
greater frequency or severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than our underwriting, reserving or investment practices anticipate based on historical experience or industry data;
changes in regulation or tax laws applicable to us or our customers or suppliers such as our reinsurers;
On March 17, 2006, XL Capital Ltd (“XL Capital”) formed Security Capital Assurance Ltd (“SCA”), a Bermuda based holding company, in anticipation of contributing its ownership interests in its financial guarantee insurance and financial guarantee reinsurance operating businesses to SCA and selling an interest therein to the public through an initial public offering of SCA common shares (the “IPO”). The contribution of the businesses to SCA occurred on July 1, 2006 and the IPO was consummated on August 4, 2006 - see Initial Public Offering below for further information. The aforementioned operating businesses contributed to SCA by XL Capital consisted of: (i) XL Capital Assurance Inc. (“XLCA”) and its wholly-owned subsidiary, XL Capital Assurance (U.K.) Limited (“XLCA-UK”) and (ii) XL Financial Assurance Ltd. (“XLFA”). In addition, on July 1, 2006, XL Capital contributed all its ownership interest in XL Financial Administrative Services Inc. (“XLFAS”) to SCA. XLFAS employs personnel whom provide services exclusively to SCA and its subsidiaries. Prior to the IPO, XLCA and XLFAS were indirect wholly owned subsidiaries of XL Capital and substantially all of XLFA was owned by XL Capital, except for a $54.0 million preferred stock interest which is owned by Financial Security Assurance Holdings Ltd. (“FSAH”) - see Note 5.
XLCA is an insurance company domiciled in the State of New York and is licensed to conduct financial guarantee insurance business throughout all 50 of the United States, as well as in the Commonwealth of Puerto Rico, the District of Columbia and the U.S. Virgin Islands. In addition, XLCA through its wholly owned subsidiary, XLCA-UK, which is an insurance company organized under the laws of England, is permitted to conduct business in England, Ireland, Spain, France, Portugal, Italy, The Netherlands, Greece, Norway and Germany. To facilitate distribution of their products, XLCA maintains a branch office abroad in Singapore and XLCA-UK maintains a branch office in Madrid. In addition, XLCA has an office in California.
XLFA is primarily engaged in the business of providing reinsurance of financial guarantee insurance policies and credit default swaps issued by XLCA, subsidiaries of FSAH (see Note 5), and certain other non-affiliated triple-A-rated financial guarantee primary insurance companies.
XLCA, XLCA-UK, and XLFA all have triple-A financial strength ratings from Standard & Poor’s Ratings Services, Moody’s Investors Service, Inc. and Fitch Inc. SCA, XLCA, XLFA, XLFAS and all other subsidiaries of SCA are hereafter collectively referred to as the “Company.”
In the IPO SCA issued 18,009,119 common shares at $20.50 per share for aggregate consideration of $369.2 million. Underwriting expenses were $22.2 million and other issuance costs were approximately $5.7 million resulting in net proceeds of approximately $341.3 million. After the IPO, a secondary offering of SCA common stock by XL Capital, the exercise of the underwriters’ over-allotment option and restricted share awards to management of SCA, XL Capital’s ownership of SCA’s outstanding common shares represented approximately a 63 percent economic interest in SCA. As a result of limitations on XL Capital’s voting power contained in SCA’s Bye-laws, the votes conferred by the common shares owned by XL Capital will not exceed, with respect to elections of directors, 50.1% of the aggregate voting power of all common shares entitled to vote generally at any election of directors or, with respect to any other matter presented to our shareholders for their action or consideration, 47.5% of the aggregate voting power of all common shares entitled to vote on such matter. Either or both of such limitations on XL Capital shall cease to apply, or may be adjusted upwards, upon our receipt of written confirmation from each nationally recognized rating agency then providing a financial strength rating for us and/or our subsidiaries that such financial strength rating is or will be determined without reference to the ratings of XL Capital or that the then financial strength rating issued by it will not at the time of such confirmation be adversely affected by the elimination or adjustment of such limitation, and, in the case of any adjustment (as opposed to elimination), the applicable percentages set forth above shall automatically be adjusted to those percentages
as so determined by the foregoing; provided, however, that, in the event that such written confirmation shall later be rescinded, such limitation shall be reinstated at a percentage equal to the lesser of (i) such percentage as is required by the rescinding rating agency and (ii) the percentage set forth above originally applicable to such limitation.
All of the Company’s investments in debt securities are considered available-for-sale and accordingly are carried at fair value. The fair value of investments is based on quoted market prices received from a nationally recognized pricing service or, in the absence of quoted market prices, on dealer quotes. The net unrealized appreciation or depreciation on investments, net of deferred income taxes, is included in accumulated other comprehensive income (loss). Any unrealized depreciation in value considered by management to be other-than-temporary is charged to income in the period that such determination is made.
At the end of each accounting period, the Company reviews unrealized losses on its investment securities to identify declines in fair value that are other-than-temporary. This review involves consideration of several factors including: (i) the time period during which the security has been in a continuous unrealized loss position, (ii) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (iii) the significance of the decline, (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question and (v) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company concludes that a decline in fair value is other-than-temporary, the cost of the security is written down to fair value and a corresponding loss is realized in the period such determination is made. For the years ended December 31, 2006, 2005 and 2004, there were no declines in fair value deemed to be other-than-temporary.
With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, changing information, general market conditions and assessing value relative to other comparable securities.
Bond discounts and premiums are amortized on the effective yield method over the remaining terms of securities acquired. For pre-refunded bonds, the remaining term is determined based on the contractual refunding date. For mortgage-backed securities, and any other holdings for which prepayment risk may be significant, assumptions regarding prepayments are evaluated periodically and revised as necessary. Any adjustments required due to the resulting change in effective yields are recognized in income.
The Company’s policy is to not invest in obligations which it insures, and there were no such obligations included in the Company’s investment portfolio of December 31, 2006 or 2005.
Other invested assets consisted of certain notes acquired in connection with the satisfaction of a claim resulting from the default of an insured obligation-see Note 13. Income on such notes was recognized based on the effective yield method. Under the effective yield method, the excess of all cash flows expected from the notes at acquisition over the Company’s initial investment in the notes was recognized as interest income on a level-yield basis over the expected life of the notes. Subsequent increases in cash flows expected to be collected were recognized prospectively through adjustment of the notes’ yield over its expected remaining life. Decreases in cash flows expected to be collected were recognized as impairments and are reflected in the accompanying consolidated statement of operations under the caption “Net realized losses on investments.”
In addition, when an insured issue is retired early, is called by the issuer or is in substance paid in advance through a refunding accomplished by placing U.S. government securities in escrow, the remaining deferred premium revenue is earned at that time since there is no longer risk to the Company. Premiums earned for the years ended December 31, 2006, 2005, and 2004 include $27.4 million, $14.7 million and $6.0 million, respectively, related to refunded and called bonds.
The Company updates its estimates of losses and loss adjustment expense reserves quarterly and any resulting changes in reserves are recorded as a charge or credit to earnings in the period such estimates are changed. In connection therewith, the Company’s unallocated reserves are adjusted each period to reflect (i) any revisions to management’s estimate of expected ultimate losses, if any, and (ii) the underlying par risk amortization (or “loss development”) of the related insured and reinsured in-force business (i.e., loss emergence pattern). As stated above, the Company’s estimated ultimate expected incurred losses are comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. As the Company establishes case basis reserves and pays claims it may, based on its judgment, reduce or increase the ultimate expected loss ratio used to determine unallocated reserves to reflect its best estimate of expected ultimate loss experience. In addition, under the Company’s accounting policy the Company may, based on its judgment, reduce unallocated reserves in response to significant case basis reserve and/or paid loss activity. The Company would only expect such reductions to occur in limited instances, such as economic events generating significant loss activity. The Company has not viewed its case basis reserve and unallocated reserve activity to date to warrant a reduction of its unallocated reserves. Each quarterly period there is an interplay between case basis
In June 2005, at the request of the Securities and Exchange Commission, the Financial Accounting Standards Board (“FASB”) added a project to their agenda to review and provide guidance for the accounting for financial guarantee insurance contracts under which it will consider claims liability recognition, premium recognition, and the related amortization of deferred policy acquisition costs. The Company will continue to apply the accounting policies noted herein until further guidance is provided by the FASB. See Recent Accounting Pronouncements for further information.
In the normal course of business, the Company purchases reinsurance coverage principally to increase aggregate capacity, manage its risk guidelines and to reduce the risk of loss on its in-force business. Reinsurance premiums ceded are earned over the period the reinsurance coverage is provided. Prepaid reinsurance premiums represent the portion of premiums ceded which is applicable to the unexpired term of reinsured policies in-force. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Provision is made for any estimated uncollectible reinsurance.
Intangible assets are comprised of licenses to conduct financial guarantee insurance business in 45 states of the United States. The recoverability of the carrying value of these intangible assets are evaluated annually for impairment. The Company has not recorded any adjustments to the carrying value of its intangible assets since its their acquisition.
Credit default swaps issued by the Company meet the definition of a derivative under FASB Statement of Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended by SFAS No. 149. Credit default swaps are recognized at fair value and recorded in either assets or liabilities in the accompanying consolidated balance sheet. The Company intends to hold these derivative instruments until maturity.
The fair value of credit default swaps is determined using a model developed by the Company, the results of which are dependent upon a number of factors including changes in interest rates, credit spreads, changes in credit quality, expected recovery rates and other market factors. The change in fair value during the period resulting from movements in these factors is unrealized as the credit default swaps are not traded to realize this value. Other elements of the change in fair value are based upon pricing established at the inception of the contract, as well as events triggering loss payments under the contracts by the Company.
The Company insures obligations issued by variable interest entities (“VIEs”) in the ordinary course of the Company’s business. The Company provides financial guarantee insurance of structured transactions backed by pools of assets of specified types, municipal obligations supported by the issuers’ ability to charge fees for specified services or projects, and corporate risk obligations including essential infrastructure projects and obligations backed by receivables from future sales of commodities and other specified services. The obligations related to these transactions are often securitized through VIEs. In synthetic transactions, the Company guarantees payment obligations of counterparties, including VIEs, through credit default swaps referencing asset portfolios. The Company only provides financial guarantee insurance of these VIEs for premiums at market rates but does not hold any equity positions or subordinated debt in these off-balance sheet arrangements. These financial guarantee contracts represent variable interests held by the Company in VIEs.
In underwriting financial guarantees, the Company generally requires that guaranteed obligations be investment-grade prior to the provision of credit enhancement. Typically, in the case of asset-backed securities and other structured obligations, such investment grade ratings are based upon subordination, cash reserves and other structural protections. Consequently, the Company has determined that it is not the primary beneficiary of any VIEs in which it holds a variable interest. Accordingly, these VIEs are not consolidated by the Company.
In February 2007, the FASB issued SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 provides the Company an irrevocable option to report selected financial assets and liabilities at fair value with
The Company’s primary investment objective is the preservation of capital through maintenance of high-quality investments with adequate liquidity. A secondary objective is optimizing long-term, after-tax returns.
The amortized cost and fair value of investments as of December 31, 2006 and 2005 are as follows:
The following tables present the aggregate gross unrealized losses and fair value by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2006 and 2005, respectively:
(1) Securities in a continuous unrealized loss position for 12 months or more consist of U.S. Government and Agency securities aggregating $7.6 million and corporate bonds, mortgage-backed, and asset-backed securities (“non-government securities”) aggregating $16.4 million. Of the non-government securities 59.2%, 74.7%, and 100% are rated “AAA”, “AA-” or better, and “A-” or better, respectively, by S&P as of December 31, 2006. In addition, of the non-government securities in a continuous unrealized loss position of 12 months or more, securities aggregating 87% of the total unrealized loss in such category have a price decline of less than 6% from their cost and 13% have a price decline between 6% and 9% of their cost as of December 31, 2006.
The Company’s business activities are organized and managed in two operating segments: financial guarantee insurance and financial guarantee reinsurance. These segments are managed separately because they provide different products or services to different customers, are subject to different regulation, require different strategies and have different technology requirements. Products comprising the financial guarantee insurance segment primarily include financial guarantee insurance of public finance and structured finance debt securities and credit default swaps. Products comprising the reinsurance segment primarily include reinsurance of financial guarantee insurance products issued by financial guarantee insurance companies. Refer to Note 1 and Note 12 for additional information with regard to the products offered by the Company’s operating segments.
Set forth in the table below is certain financial information with respect to the Company’s operating segments as of and for the years ended December 31, 2006, 2005 and 2004. Except for various allocations discussed below, the accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates the performance of each operating segment based on underwriting profit or loss before income taxes, nonrecurring items (e.g. items of an unusual or infrequent nature), and inter-segment transactions. Certain costs and operating expenses are allocated to each of the segments based on: (i) a review of the nature of such costs, and (ii) time studies analyzing the amount of employee compensation costs incurred by each segment.
XLFA was originally formed in 1998 as part of an investment venture between XL Capital and FSAH and was initially capitalized through a series of transactions resulting in the issuance by XLFA of 2,057 common shares to XL Insurance (Bermuda) Ltd (“XLI”), an indirect wholly owned subsidiary of XL Capital, for consideration of $221.0 million and the issuance by XLFA of 363 shares of Series A Redeemable Preferred Shares to FSAH and its subsidiaries for consideration of $39 million. FSAH is a holding company whose primary operating subsidiary, Financial Security Assurance Inc. (“FSA”), is a monoline financial guarantee insurance company. On December 7, 2004, XLFA issued an additional 392 common shares to XLI in exchange for $125 million and on July 1, 2006 all of XL Capital’s direct and indirect ownership interest in XLFA was contributed to SCA - see Note 1. In addition, on August 4, 2006 and December 22, 2006, SCA contributed $175.0 million and $123.1 million, respectively, to XLFA from the net proceeds of its IPO. There were no common or other shares of equity capital issued by XLFA to SCA in exchange for such contributions. Pursuant to XLFA’s corporate by-laws each share of common stock of XLFA is entitled to 3 votes with respect to matters requiring a vote of shareholders and each share of the Series A Redeemable Preferred Shares are entitled to 1 vote. Accordingly, at December 31, 2006 and 2005 holders of XLFA’s Series A Redeemable Preferred Shares as a group had approximately a 5% voting interest in XLFA, respectively, whereas holders of XLFA’s common shares had an approximate 95% voting interest, respectively.
Prior to April, 2006 the redemption price of the Series A Preferred Shares was estimated at the end of each reporting period and changes in the redemption value were accreted over the period from the date of issuance to the earliest redemption date using the interest method.
Pursuant to resolution of XLFA’s shareholders on April 2006, XLFA restructured the terms of its Series A Redeemable Preferred Shares and changed its bye-laws accordingly. In accordance with the resolution, the participating dividend
On February 27, 2007, the board of directors of XLFA approved: (i) an extraordinary dividend of $15.0 million on its Series A Redeemable Preferred Shares, and (ii) a reduction in the stated value of the remaining outstanding Series A Redeemable Preferred Shares by a corresponding amount. Payment of the extraordinary dividend and the reduction in the stated value of the Series A Redeemable Preferred Shares are expected to be made in March 2007. There was no change in the voting interest of the holders of the Series A Redeemable Preferred shares as a result of the extraordinary dividend and reduction in the stated value of the Series A Redeemable Preferred Shares.
In December 2004, XLFA entered into a put option agreement and an expense reimbursement agreement (the “Asset Trust Expense Reimbursement Agreement”) with Twin Reefs Asset Trust (the “Asset Trust”). The put option agreement provides XLFA with the irrevocable right to require the Asset Trust at any time and from time to time to purchase the Company’s non-cumulative perpetual Series B Preferred Shares with an aggregate liquidation preference of up to $200 million. XLFA is obligated to reimburse the Asset Trust for certain fees and ordinary expenses. To the extent that any Series B Preferred Shares are put to the Asset Trust and remain outstanding, a corresponding portion of such fees and ordinary expenses will be payable by XLFA pursuant to the Asset Trust Expense Reimbursement Agreement. The put option agreement is perpetual but would terminate on delivery of notice by XLFA on or after December 10, 2009, or under certain defined circumstances, such as the failure of XLFA to pay the put option premium when due or bankruptcy. The put option is recorded at fair value with changes in fair value recognized in earnings under the caption in the statements of operations entitled “Net realized and unrealized gains (losses) on credit derivatives.” The effect on earnings of the fair value adjustments related to the put option for the years ended December 31, 2006, 2005, and 2004 were $2.3 million, $2.3 million, and $0.1 million, respectively.
Concurrent with the IPO, the Company entered into arrangements with affiliates of XL Capital: (i) to provide it protection with respect to adverse development on certain transactions, (ii) have exposures transferred to it or re-assume exposures under certain financial guarantee policies that were originally reinsured to, or written on behalf of, the Company by XLI, due principally to single risk constraints and rating agency capital adequacy requirements applicable to the Company at the time that business was first written, (iii) cancel the Company’s reinsurance of certain non-financial guarantee business ceded to it by XLI, and (iv) to govern certain aspects of Company’s relationship with XL Capital after the IPO, including a series of service agreements under which subsidiaries of XL Capital will provide certain services to
Prior to the IPO, the Company purchased various services from affiliates of XL Capital under various agreements and continues to purchase such services under new agreements that became effective at the date of the IPO. Such services principally include: (i) information technology support, (ii) reinsurance and retrocessional consulting and management services, (iii) actuarial, finance, legal, internal audit services and certain investment management services. For the years ended December 31, 2006, 2005, and 2004, the Company incurred costs under the aforementioned agreements aggregating $58.7 million, $63.7 million, and $70.1 million, respectively, which are reflected in “operating expenses” in the accompanying consolidated statements of operations.
Effective August 4, 2006, XLA has undertaken to indemnify the Company for any dimunition in value below their carrying value at June 30, 2006 of the notes and preferred shares described in Note 13 (b), which notes and preferred shares were acquired in connection with the satisfaction of a claim under a financial guarantee insurance policy issued by XLCA. In addition, pursuant to the aforementioned indemnity, XLA agreed to indemnify the Company for any costs arising out of any litigation or future claim in connection with the aforementioned insurance policy. See Note 13 (b) for further information regarding amounts recovered or recoverable by SCA under the indemnity.
On August 4, 2006, XLFA and XLI agreed to cancel from inception the reinsurance of certain business ceded under a facultative quota share reinsurance treaty that was effective since 1999. As a result of this cancellation, XLFA paid XLI $0.2 million, XLI assumed XLFA’s obligation for $1.2 million of reserves for losses and loss adjustment expenses, and XLFA recorded a capital contribution of $1.0 million. In addition, on such date, XLFA assumed certain business from XLI pursuant to the aforementioned reinsurance treaty. As a result thereof, XLFA recorded assumed premiums of approximately $8.0 million, ceding commissions of approximately $1.0 million and received cash from XLI of approximately $7.0 million.
Effective October 1, 2001, XLFA entered into an excess of loss reinsurance agreement with XLI. This agreement covers a portion of XLFA’s liability arising as a result of losses on policies written by XLFA that are in excess of certain limits and are not covered by other reinsurance agreements. This agreement provides indemnification only for the portion of any loss covered by this agreement in excess of 10% of XLFA’s surplus, up to an aggregate amount of $500 million, and excludes coverage for liabilities arising other than pursuant to the terms of an underlying policy. The Company incurred expense under this agreement of approximately $0.5 million for each of the years ended December 31, 2006, 2005 and 2004.
Since it commenced operations, XLFA has entered into several reinsurance arrangements with subsidiaries and affiliates of FSAH (hereafter referred to as “FSA”) to reinsure certain policies issued by FSA which guarantee the timely payment of the principal of and interest on various types of debt obligations. XLFA’s obligations under certain of these arrangements are guaranteed by XLI. Effective upon the IPO, the guarantee was terminated with respect to all new business assumed by XLFA under such arrangement, but the guarantee remains in effect with respect to cessions under the agreement prior to the IPO. Premiums assumed by XLFA under its reinsurance arrangements with FSA represented 70%, 66%, and 73% of the Company’s total reinsurance premiums assumed for the years ended December 31, 2006, 2005, and 2004. respectively.
Effective May 1, 2004, XLI entered into an agreement with XLCA which unconditionally and irrevocably guarantees to XLCA the full and complete payment when due of all of XLFA’s obligations under its facultative quota share reinsurance agreement with XLCA, under which agreement XLFA has assumed business from XLCA since December 19, 2000. The par value of business guaranteed by XLI under this agreement was approximately $83.1 billion and $72.6 billion as of December 31, 2006 and 2005, respectively. The XLI guarantee agreement terminated with respect to any new business produced by XLCA and ceded to XLFA pursuant to the faculative quota share reinsurance agreement after the effective date of the IPO, but the guarantee remains in effect with respect to cessions under the such agreement prior to the IPO.
The Company enters into ceded reinsurance arrangements principally to increase aggregate capacity, manage its risk guidelines and to reduce the risk of loss on business written or assumed. This reinsurance includes the reinsurance arrangements with affiliates that are discussed in Note 7, as well as reinsurance arrangements with non-affiliated reinsurers. Reinsurance does not relieve the Company of its obligations under its guarantees. Accordingly, the Company is still liable under its guarantees in the event reinsuring companies do not meet their obligations to the Company under reinsurance agreements. The Company regularly monitors the financial condition of its reinsurers. For the years ended December 31, 2006, 2005, and 2004 there were no amounts provided by the Company for uncollectible reinsurance recoverable. The following tables set forth certain amounts ceded to affiliate and non-affiliate reinsurers as of and for the years ended December 31, 2006, 2005, and 2004. The affiliated amounts presented for 2004 do not include the effect of the commutation with XL RE AM discussed in Note 7.
On August 4, 2006, the Company entered into an aggregate $500.0 million, five-year letter of credit and revolving credit facility (the “Facility”) with a syndicate of banks, for which Citibank N.A. is the administrative agent. The Facility enables the Company to draw letters of credit of up to $250.0 million and revolving credit loans of up to $250.0 million with the aggregate amount of outstanding letters of credit and revolving credit loans thereunder not to exceed $500.0 million. Commitments under the Facility expire on, and amounts borrowed under the letter of credit and liquidity facility may be borrowed, repaid and re-borrowed from time to time until, the earlier of (i) the date that is five years after the closing date of the Facility and (ii) the date of termination in whole of the commitments upon an optional termination or reduction of the commitments or upon an event of default.
Financial guarantee insurance policies issued by the Company and assumed pursuant to reinsurance arrangements guarantee the timely payment of principal and interest on insured obligations. Credit default swaps issued by the Company guarantee the payment of the notional amounts of referenced securities. The net exposure retained on any risk guaranteed or reinsured by the Company is subject to the Company’s underwriting guidelines and regulatory risk limitations. The Company’s in-force business is diversified both domestically and internationally, across multiple industries and by type of obligations guaranteed. The Company’s total exposure, before reinsurance, to principal (or “par”) amounts insured and notional amounts guaranteed as of December 31, 2006 and 2005 was $125.3 billion and $90.7 billion, respectively. The Company’s total exposure, before reinsurance, to principal and interest amounts insured and notional amounts guaranteed as of December 31, 2006 and 2005 was $195.4 billion and $135.3 billion, respectively.
The following tables present certain information with respect to the par amounts insured and notional amounts guaranteed by the Company at December 31, 2006 and 2005, before and after reinsurance (or on a “gross” and “net” basis, respectively):
The par amounts insured as of December 31, 2006 and 2005 and the terms of maturity are as follows:
As of December 31, 2006 and 2005, par and notional amounts of the Company’s guaranteed asset-backed obligations were supported by the following types of collateral:
In addition, the Company seeks to maintain a diversified portfolio of guaranteed obligations designed to spread its risk across a number of geographic areas. Set forth below is the distribution of the Company’s par and notional exposures by geographic location as of December 31, 2006 and 2005:
The financing vehicles through which the insured exposures referred to above were issued are variable interest entities, as defined under FASB Interpretation 46/46R, Consolidation of Variable Interest Entities, however, the Company is not the primary beneficiary of such entities. If the transactions are restructured or if the Company exercises its contractual rights under such transactions in the event of a default, the primary beneficiary in such transactions may have to be reconsidered. If such events occur, the Company may be required to consolidate the financing vehicles.
XLFA is not subject to any taxes in Bermuda on either income or capital gains under current Bermuda law. In the event that there is a change such that these taxes are imposed, XLFA would be exempted from any such tax until March 2016 pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966, and Amended Act of 1987.
XLCA will file two separate short period U.S. income tax returns for 2006, one will include the pre-ownership change period and the second will include the post-ownership change period. For the pre-ownership change period, XLCA’s income tax return will be consolidated with XLA and its subsidiaries. For the post-ownership change period, XLCA will file a consolidated tax return with SCA Holdings U.S. Inc (the new U.S. common parent of the SCA group) and its subsidiaries (which consists of XLCA and SCA’s other U.S. based subsidiaries). For the pre-ownership change period filing, XLA maintains a tax sharing agreement with its subsidiaries, whereby the consolidated income tax liability is allocated among affiliates in the ratio that each affiliate’s separate return liability bears to the sum of the separate return liabilities of all affiliates that are members of the consolidated group. In addition, a complementary method is used which results in reimbursement by profitable affiliates to loss affiliates for tax benefits generated by loss affiliates.
At December 31, 2006 and 2005 XLCA had a federal income tax payable of $5.3 million and $1.0 million respectively. For the post-ownership change period, XLCA will maintain a similar tax sharing agreement with U.S. affiliates that are a member of the SCA Holdings U.S. Inc. consolidated tax filing. In addition, a complementary method is used which results in reimbursement by profitable affiliates to loss affiliates for tax benefits generated by loss affiliates.
Cash and cash equivalents: The carrying amount of these items is a reasonable estimate of their fair value due to the short maturity of these instruments.
Installment premiums: The fair value of installment premiums is estimated based on the present value of the future contractual premium revenues, net of reinsurance, that would be paid under a reinsurance agreement with a third party to transfer the Company’s financial guarantee risk, net of that portion of the premium retained by the Company to compensate it for originating and servicing the insurance contract. The fair value is derived by calculating the present value of the estimated future cash flow stream (net premium and ceding commissions) discounted at 4.80% and 4.20% at December 31, 2006 and 2005, respectively.
Department of the State of New York. The law also provides that XLCA may distribute dividends to its shareholders in excess of the aforementioned amount only upon giving notice of its intention to declare such dividend, and the amount thereof, to the New York Superintendent. The New York Superintendent may disapprove such distribution if he finds that the financial condition of XLCA does not warrant such distribution.
For the years ended December 31, 2006, 2005, and 2004, XLCA reported statutory-basis net income (loss) of $0.1 million, $(0.4) million, and $(5.7) million, respectively, and statutory-basis capital and surplus of $207.0 million and $188.8 million as of December 31, 2006 and 2005, respectively.
In addition, in connection with the IPO, XLFA has agreed with certain of the rating agencies that, until the second anniversary of the effective date of the IPO it will not declare or grant dividends on its common stock without the prior consent of those rating agencies, other than to fund certain parent holding company operating expenses and debt service requirements and “nominal” dividends on SCA’s common stock.
The Company’s exposure is fair valued taking into account changes in credit spreads, current market conditions, as well as the overall credit quality of the underlying collateral.
At the effective date of the IPO the Company awarded employees 447,963 shares under the Plan in the form of stock options and 500,428 shares under the Plan in the form of restricted stock. In addition, the Company awarded 200,000 shares under the plan in the form of stock options to directors, of which 50,000 relate to directors who, as officers of XL Capital, pledged such options to XL Capital. The Awards vest as set forth in the applicable Award agreements, and the requisite service period is equivalent to the vesting period. The Awards contain certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability.
The stock options awarded under the Plan had a weighted average grant-date fair value of $6.06 and the restricted stock had a weighted average grant-date fair value of $20.50.
During the year ended December 31, 2006, the Company recognized approximately $0.7 million of compensation expense, net of tax, related to its stock option Awards.
The following is a summary of stock options as of December 31, 2006, and related activity for the year then ended:
* Available for grant December 31, 2006 irrespective of the form of the Award (e.g. SAR’s, restricted shares, restricted share units, performance shares, performance units, dividend equivalents, and other share-based awards).
Awards of restricted stock at the effective date of the SCA IPO had a weighted average grant date fair value of $20.50. During the year ended December 31, 2006, SCA recognized approximately $1.2 million of compensation expense related to its restricted stock awards. There were 2,500 shares of restricted stock forfeited and no shares vested during the year ended December 31, 2006.
Total unrecognized stock based compensation expense related to non-vested restricted stock was approximately $9.0 million at December 31, 2006, which is expected to be recognized over a weighted-average period of 4.5 years.
Deferred cash and deferred bonus awards at the effective date of the SCA IPO were valued at $15.8 million and $0.8 million, respectively. For the period from August 4, 2006 through December 31, 2006, SCA recognized approximately $2.1 million and $0.8 million of compensation expense related to such Awards, respectively. Total unrecognized compensation expense related to non-vested deferred cash awards was approximately $13.7 million at December 31, 2006. There was no unrecognized compensation expense related to deferred bonus awards at December 31, 2006. The non-vested unrecognized compensation expense relating to the deferred cash awards are expected to be recognized over a weighted-average period of 2.0 years.
Elections under the Exchange Offer became effective on December 12, 2006; 443,532 eligible options and 97,119 shares of eligible restricted stock of XL Capital were exchanged under the Exchange Offer and SCA issued LTIP Awards with an aggregate target amount of $11.4 million. Approximately $4.1 million of eligible outstanding unvested restricted Class A Ordinary Shares of XL Capital and options to purchase Class A Ordinary Shares of XL Capital were not exchanged under the Exchange Offer and remain outstanding under XL Capital plans. See Note 7.
Under XL Capital’s 1999 Performance Incentive Plan, 1,250,000 options were available for issuance to employees who were not directors or executive officers of the Company.
Following is a summary of stock option awards to employees of the Company under XL Capital Plans and related activity. There were no awards of stock options to employees of the Company in 2006.
At December 31, 2006 outstanding stock option awards under XL Capital Plans held by employees of the Company had a range of exercise prices of $50.00 to $94.62 per share, respectively, and a weighted average exercise price, in the aggregate, of $81.78 per share. In addition, the average remaining contractual life of such options was 5.7 years.