(c) Amounts are statutory data for FSA and therefore differ from comparable GAAP amounts.
(d) Total claims-paying resources refers to a term used by Moody’s to evaluate adequacy of claims-paying resources and credit ratings. Moody’s uses its judgment in making adjustments to some of the measures. The Company provides the adjusted balances. This term represents the sum of statutory capital, statutory unearned premium reserve, present value of future net installment premiums, statutory loss reserve, credit available under standby line of credit facility and money market committed preferred trust securities.
Management’s principal business objective is to grow the intrinsic value of the Company over the long term. To this end, it seeks to accumulate an insured portfolio of conservatively underwritten municipal and asset-backed obligations and attractively priced guaranteed investment contracts (“GICs”), in order to produce a reliable, predictable earnings stream. Strategically, the Company seeks to maintain balanced capabilities across domestic and international municipal and asset-backed markets in order to allow the flexibility to pursue the most attractive opportunities available at any point in the business cycle. References to the “Company” are to Financial Security Assurance Holdings Ltd. together with its subsidiaries.
Comparing 2005 GAAP results with those of 2004, the Company’s total revenues decreased 14.5% to $981.2 million, and net income decreased 13.9% to $326.1 million. Gross premiums written increased 0.2% to $833.8 million. Shareholders’ equity increased 8.1% to $2.8 billion.
For each accounting period, the Company estimates the present value of originations (“PV originations”). This non-GAAP measure consists of the total present value of premiums originated (“PV
premiums originated”) by Financial Security Assurance Inc. and its subsidiaries (“FSA”) and the present value of net interest margin (“PV NIM”) originated by the Company’s financial products (“FP”) business (the “FP Segment”). The Company generated PV originations of $1,014.0 million in 2005, $927.2 million in 2004 and $894.6 million in 2003. Management believes that by disclosing the components of PV originations in addition to premiums written, the Company provides investors with a more comprehensive description of its new business activity in a given period.
The GAAP measure “gross premiums written” captures premiums collected in a given period, whether collected for business originated in the period, or in installments for business originated in prior periods. It is not a precise measure of current-period originations because a significant portion of the Company’s premiums are collected in installments. Therefore, to measure current-period premium production, management calculates the gross present value of premium installments originated in the accounting period and combines it with premiums received upfront in the accounting period, which produces the non-GAAP measure PV premiums originated.
Full-year international par insured for 2005 increased 37.9% and international PV premium originations increased 30.0%. In 2005, public infrastructure provided the greatest share of PV premiums, as tight spreads constrained the international asset-backed business. Full-year international par insured for 2004 approximated that of the prior year, and international PV premium originations decreased 2.1%. PV premiums for international originations are translated into U.S. dollars using month-end currency exchange rates. Actual premiums received could differ from this amount due to exchange-rate fluctuations.
The FP Segment, in which the Company conducts business through affiliates (the “GIC Affiliates”), produces net interest margin (“FP NIM”) rather than insurance premiums. Like installment premiums, the PV NIM originated is expected to be earned and collected in future periods.
FP NIM to be earned and includes it in the non-GAAP measure adjusted book value (“ABV”) as an element of intrinsic value that is not found in GAAP book value.
The majority of municipal GICs issued by the GIC Affiliates relate to debt service reserve funds and construction funds in support of municipal bond transactions. These funds may be drawn unexpectedly, with the result that the actual timing and amount of repayments may differ from the original estimates, which in turn would affect the realization of the estimate of PV NIM originated in a given accounting period.
PV outstanding is the sum of cumulative years’ reported PV premiums originated and PV NIM originated, less what has been earned or adjusted due to changes in estimates as described above. Installment payment contracts, whether in the form of premiums or NIM, are generally non-cancelable by the Company and represent a claim to future cash flows. Therefore, management includes these amounts in its estimate of ABV.
CDS contracts are generally non-cancelable prior to maturity, and the Company views insured CDS risks as comparable to other insured risks. In a typical CDS transaction, the Company, in exchange for an upfront or periodic premium, indemnifies the insured party for economic losses (in excess of some agreed-upon deductible) related to debt obligations of specified obligors, structured such that the risk insured is investment grade without the benefit of the credit protection provided by the Company. In the event a CDS were to migrate below investment grade, the fair-value impact would be fully reflected in operating earnings.
Operating earnings also do not reflect earnings variability related to CDS fair-value adjustments. A significant percentage of the Company’s CDS exposures subject to fair-value adjustments are considered Triple-A or Super Triple-A (defined as credit quality based on loss protection greater than 1.3 times the Triple-A standard), and the Company does not intend to trade these highly rated, highly structured contracts. Accordingly, management believes it is probable that the financial impact of the fair-value adjustments for the insured CDS will sum to zero over the finite terms of the exposures, which are typically five to ten years at inception. For this reason, management believes that the market volatility of credit-spread pricing, the primary driver of the Company’s change in fair-value results, should not influence a measure of the Company’s operating performance and therefore excludes CDS fair-value adjustments from operating earnings.
The following table reconciles net income to non-GAAP operating earnings for the years addressed:
To calculate ABV, the following adjustments, on an after-tax basis, are made to shareholders’ equity (GAAP “book value”):
Management considers ABV an operating measure of the Company’s intrinsic value. Book value reflects an estimate of loss for all insured risks made at the time of contract origination. ABV adds back certain GAAP liabilities and deducts certain GAAP assets (adjustments 1, 4, 5, 6 and 7 in the calculation above), and captures the estimated value of future contractual cash flows related to transactions in force as of the balance sheet date (adjustments 2 and 3 in the calculation above) because installment payment contracts, whether in the form of premiums or NIM, are generally non-cancelable and represent a claim to future cash flows. An investor attempting to evaluate the Company using GAAP measures alone would not have the benefit of this information. In addition, investors may consider the growth of ABV to be a performance measure indicating the degree to which management has succeeded in building a reliable
Through adjustments 5 and 6, the effect of certain items that are excluded from operating earnings are also excluded from ABV. As explained in the preceding discussion of operating earnings, management expects the financial impact of the CDS fair-value adjustments, reflected in adjustment 5, to sum to zero over the finite terms of the related exposures. Derivatives reflected in adjustment 6 reduce, on an economic basis, the interest-rate risk of fixed-rate assets and liabilities held in the FP Segment and FSA Global portfolios, although they do not meet SFAS 133 hedge-accounting requirements. The Company uses such derivatives to hedge against interest-rate volatility, rather than to speculate on the direction of interest rates. The intent of management is to hold the derivatives to expected maturity along with the related hedged fixed-rate assets or liabilities. In addition, through adjustment 7, ABV excludes the effect of fair-value adjustments made to investments and reflected in other comprehensive income. As the objective is to optimize long-term stable earnings, management generally seeks to minimize turnover and therefore any unrealized investment gain or loss is subtracted from book value to exclude it from the ABV metric. In the event that an investment is liquidated prior to its maturity, any related gain or loss is reflected in both earnings and ABV without further adjustment.
The provision for losses and loss adjustment expenses was $25.4 million in 2005, $20.6 million in 2004 and $34.5 million in 2003. Activity in the liability for losses and loss adjustment expenses, which consists of case and non-specific reserves, is summarized as follows:
During 2004, the Company charged $20.6 million to loss expense, consisting of $20.4 million for originations of new business, $4.6 million for accretion related to prior-year reserves and $3.2 million related to reassumptions of previously ceded business, partially offset by reserve releases, which were primarily related to favorable experience in the CDO portfolio. The non-specific reserve decreased $12.2 million in 2004, primarily due to transfers from the non-specific reserve to case reserves of $30.7 million, partially offset by loss expense of $20.6 million. Case reserves decreased $17.5 million due to a large, voluntarily accelerated transaction that had a $34.3 million payment and to reclassifications of $13.9 million from reserves to asset valuation accounts for refinanced transactions, partially offset by transfers from the non-specific reserve of $30.7 million. See Note 22 to the Consolidated Financial Statements in Item 8.
Since case and non-specific reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates. The Company will continue, on an ongoing basis, to monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company’s revised estimate of loss, actual loss experience, its mix of business and economic conditions.
Given the broad diversification of FSA’s insured portfolio, management believes that a significant shift in overall portfolio quality is unlikely to occur except in a catastrophic economic environment. It is therefore necessary to look at particular sectors when examining the sensitivity of the insured portfolio to changes in underlying loss assumptions. Management believes that different analyses are required for the two broad sectors of the insured portfolio, asset-backed obligations and municipal credits.
Current asset-backed case reserves could vary from the current estimate of loss. In particular, the deterministic model used to determine case reserves for CDO transactions utilizes average cumulative default rates produced by a Monte Carlo simulation and applies those defaults to a cash flow model. While CDO exposures are affected by multiple variables, including default rates, collateral recovery rates, changes in interest rate movements and the prepayment speeds of the collateral, management believes default frequency is the key determinant of loss. Holding all other variables constant and assuming only that the CDO’s underlying corporate debt instruments were to default at a higher rate than the Monte Carlo average default rate, actual losses would exceed the current estimate. Applying a higher frequency of default, observed at the 90% confidence level, would result in additional present-value loss of $15 million.
In a Standard & Poor’s Ratings Services (“S&P”) scenario analysis, S&P assumed 75% loss severity for health care credits, which means that a loss would equal 75% of par insured. If losses of this severity occurred in the lowest rated hospital exposure in FSA’s insured portfolio, the loss would be as much as $35.5 million on a pre-tax basis, net of reinsurance.
probability of default and its severity of loss and there can be no assurance that the liability for losses will not exceed such estimates.
Municipalities in Mississippi are not authorized to file for bankruptcy and therefore have no mechanism under law to adjust their payment obligations. Unlike the corporate market, the municipal market has no private or equity source of capital and therefore lacks any means of starting fresh with a clean slate, with debts and liabilities rejected or adjusted in bankruptcy. To file for bankruptcy, or to leave rated indebtedness unpaid in a bankruptcy proceeding, would serve to tarnish the issuer and the region and effectively deny the subject municipality and similar issuers of debt within the state access to capital. Historically, rather than bankruptcy and adjustment of debt, financially distressed municipalities have been subjected to supervision and control by state-created authorities that act both as issuers of debt, secured by a discrete, newly identified revenue stream, and as fiscal monitors.
(1) VIE NIM represents the impact of consolidation of the VIEs on the Total NIM.
VIE NIM and FP NIM are combined on the consolidated statements of operations and comprehensive income. VIE NIM pertains to the net interest margin derived from transactions executed by FSA Global, Canadian Global Funding Corporation (“Canadian Global”) and Premier International Funding Co. (“Premier”). As the VIE NIM is considered part of the financial guaranty segment and not the FP Segment, this NIM component is subtracted to calculate FP NIM. See Note 25 to the Consolidated Financial Statements in Item 8.
Income from assets acquired in refinancing transactions, excluding realized gains or losses, was $35.2 million in 2005, $31.6 million in 2004 and $25.3 million in 2003. The 2004 increase was due to refinancings of several insured transactions whereby the Company accelerated claim payments on transactions that had experienced events of default and acquired the obligations or underlying collateral in order to mitigate future claims. The increase in 2005 reflects the impact of a full year of income from transactions that were refinanced at various times during 2004.
securitized assets and as the issuer of the insured obligations. FSA’s participation is typically requested by the sponsor of the VIE or the underwriter, either via a bid process or on a sole-source basis. VIEs are typically owned by transaction sponsors or charitable trusts, although FSA may have an ownership interest in some cases. FSA maintains certain contractual rights and exercises varying degrees of influence over VIE issuers of FSA-insured obligations. FSA also bears some of the “risks and rewards” associated with the performance of VIEs’ assets. Specifically, as issuer of the financial guaranty insurance policy insuring a given VIE’s obligations, FSA bears the risk of asset performance (typically, but not always, after a significant depletion of overcollateralization, excess spread, a deductible or other credit protection). FSA’s underwriting policy is to insure only obligations that are otherwise investment grade. In addition, the VIE typically pays a periodic premium to FSA in consideration of the issuance by FSA of its insurance policy, with the VIE’s assets typically serving as the source of such premium, thereby providing some of the “rewards” of the VIE’s assets to FSA. VIEs are also employed by FSA in connection with “repackaging” of outstanding securities into new securities insured by FSA and with refinancing underperforming, non-investment-grade transactions insured by FSA.
The Company’s management believes that the assets held by the VIEs, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. All intercompany insured amounts between FSA and FSA Global or Canadian Global are excluded from the Notes to the Consolidated Financial Statements. In addition, the Company refinances certain defaulted transactions by employing refinancing vehicles to raise funds for the refinancings. These refinancing vehicles are also consolidated. See Note 22 to the Consolidated Financial Statements in Item 8.
Following a change in SPS’s investors in 2002, the Company determined that it would be appropriate to apply the 80% dividend-received deduction allowed by the Internal Revenue Service when calculating the tax on its equity earnings from SPS, based on management’s expectation that it would realize its gain on such investment through dividend distributions rather than through sale of its investment. Accordingly, for 2004 and 2003, equity in earnings from SPS was taxed at an effective rate of 7.0%. In the first quarter of 2005, the Company, due to the pending sale of its investment in SPS, eliminated the assumption that accumulated earnings of SPS would be distributed in the form of dividends eligible for a dividend-received deduction. The net effect of this was to reserve for additional taxes of approximately $1.6 million.
In connection with Dexia’s acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains Insurance Group. While the Company had no legal liability in connection with the indemnity payment, the payment should be treated
The Company includes variable-rate demand notes (“VRDN”) and auction-rate securities (“ARS”), which totalled $867.2 million at December 31, 2005 and $613.7 million at December 31, 2004, in its long-term bond portfolio. VRDNs are long-term bonds that bear floating interest rates and provide investors with the option to tender or put the bonds at par, generally on a daily, weekly or monthly basis. ARS are long-term securities with interest-rate reset features and are traded in the marketplace through a bidding process. For management purposes, VRDN and ARS are managed as cash equivalents.
Cash flow from operations was $653.0 million in 2005, $552.8 million in 2004 and $589.6 million in 2003. The increase in cash flow from operations in 2005 is attributable primarily to the increase in net interest received from the FP Segment due to the growth in book of business and premiums, partially offset by an increase in operating expenses and taxes paid. The increase in premium receipts was due primarily to increased refunding activity. The increase in taxes paid was due primarily to the repatriation of FSA International earnings.
At December 31, 2005, Financial Security Assurance Holdings Ltd. (as a separate holding company, “FSA Holdings”) had cash and investments of $60.2 million available to fund the liquidity needs of its non-insurance operations. Because the majority of the Company’s operations are conducted through FSA, the long-term ability of the Company to service its debt will largely depend on its receipt of dividends from, or payment on surplus notes by, FSA.
In its financial guaranty business, premiums and investment income are the Company’s primary sources of funds to pay its operating expenses, insured losses and taxes. In its FP Segment, the Company relies on net interest income to fund its net interest expense and operating expenses. Management believes that the Company’s operations provide sufficient liquidity to pay its obligations. If additional liquidity is needed or cash flow from operations significantly decreases, the Company can liquidate or utilize its investment portfolio as a source of funds in addition to its alternative liquidity arrangements, as discussed further below. The Company’s cash flows from operations are heavily dependent on market conditions, the competitive environment and the mix of business originated. In addition, payments made in settlement of the Company’s obligations in its insured portfolio may, and often do, vary significantly from year to year depending primarily on the frequency and severity of payment defaults and its decisions regarding whether to exercise its right to accelerate troubled insured transactions in order to mitigate future losses. In each of the three years reported, the Company has not drawn on any alternative sources of liquidity to meet its obligations, except that the Company has refinanced certain transactions using funds raised through its GIC Affiliates.
The following is a summary of the Company’s contractual obligations at December 31, 2005:
At December 31, 2003, FSA Holdings held $152.9 million of surplus notes of FSA. During 2004, FSA repaid $44.0 million of those surplus notes. At December 31, 2005, FSA Holdings held $108.9 million of FSA surplus notes. Payments of principal or interest on such notes may be made only with the approval of the Superintendent of Insurance of the State of New York (the “New York Superintendent”). FSA Holdings employs surplus note purchases in lieu of capital contributions in order to allow it to withdraw funds from FSA through surplus note payments without reducing earned surplus, thereby preserving dividend capacity of FSA.
FSA Holdings paid dividends of $71.1 million in 2005 and $22.9 million in 2004. It did not pay dividends in 2003.
On July 31, 2003, FSA Holdings issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the Notes. In September 2003, FSA Holdings called for redemption, on November 1, 2003, its 6.95% Senior Quarterly Income Debt Securities (“Senior QUIDS”) due November 1, 2098 and delivered to the trustee sufficient collateral to legally defease the 6.95% Senior QUIDS. The unamortized debt issuance costs of $3.2 million for the 6.95% Senior QUIDS were charged to interest expense in 2003. Subsequently, the trustee used the defeasance collateral to redeem all of the 6.95% Senior QUIDS.
On November 26, 2002, FSA Holdings issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt.
FSA Holdings used a portion of the proceeds of this issuance to redeem in whole FSA Holdings’ $130.0 million principal amount of 7.375% Senior QUIDS due September 30, 2097. Unamortized debt issuance costs of the retired debt of $4.1 million were charged to interest expense in 2002.
FSA’s primary uses of funds are to pay operating expenses and to pay dividends to, or pay interest or principal on surplus notes held by, its parent. FSA’s funds are also required to satisfy claims under insurance policies in the event of default by an issuer of an insured obligation and the unavailability or exhaustion of other payment sources in the transaction, such as the cash flow or collateral underlying the obligations. FSA seeks to structure asset-backed transactions to address liquidity risks by matching insured payments with available cash flow or other payment sources. Insurance policies issued by FSA guaranteeing payments under bonds and other securities provide, in general, that payments of principal, interest and other amounts insured by FSA may not be accelerated by the holder of the obligation but are paid by FSA in accordance with the obligation’s original payment schedule or, at FSA’s option, on an accelerated basis. Insurance policies issued by FSA guaranteeing payments under CDS may provide for acceleration of amounts due upon the occurrence of certain credit events subject to single-risk limits specified in the New York insurance law. These policy provisions prohibiting or limiting acceleration of certain claims are mandatory under Article 69 of the New York Insurance Law and serve to reduce FSA’s liquidity requirements.
December 31, 2005, there were no borrowings under this arrangement, which expires on April 21, 2006, if not extended.
In the case of S&P, assessments of the credits insured by FSA are reflected in defined “capital charges,” which are reduced by reinsurance and collateral to the extent “credit” is allowed for such reinsurance and collateral. Credit provided for reinsurance under the S&P capital adequacy model is generally a function of the S&P rating of the reinsurer, as well as any collateral provided by the reinsurer. Capital charges on outstanding insured transactions and reinsurer ratings are subject to change by S&P at any time. In recent years, a number of Triple-A-rated reinsurers employed by FSA have been downgraded by S&P. Downgrade of these reinsurers by S&P to the Double-A category resulted in a decline in the credit allowed for reinsurance by S&P from 100% to 70% or 65% under present criteria. While a downgrade by S&P of all reinsurers to the Double-A category would not impair FSA’s Triple-A ratings, it would reduce the “margin of safety” by which FSA would survive a theoretical catastrophic depression modeled by S&P. A reduction by S&P in credit for reinsurance used by FSA would also be expected ultimately to reduce the Company’s return on equity to the extent that ceding commissions paid to FSA by such reinsurers were not increased to compensate for such reduction. FSA employs considerable reinsurance in its business to manage its single-risk exposures on insured credits. Any material increase in capital charges by S&P on FSA’s insured portfolio would likewise be expected to have an adverse effect on FSA’s margin of safety under the S&P capital adequacy model and, ultimately, the Company’s return on equity. The Company may seek to raise additional capital to replenish capital eliminated by any of the rating agencies and their assessment of FSA’s capital adequacy.
Capital adequacy is one of the financial strength measures under Moody’s financial guarantor model. The model includes a penalty for risk concentration and recognizes a benefit for diversification. The published results reflect four metrics of financial strength relating to the insured portfolio’s credit quality, correlation risk, concentration of risk and capital adequacy. Moody’s assesses capital adequacy by comparing FSA’s claims-paying resources to a Moody’s-derived probability of potential credit losses. Moody’s loss distribution reflects FSA’s current distribution of risk by sector (municipal and asset-backed), the credit quality of insured exposures, correlations that exist between transactions, the credit quality of FSA’s reinsurers and the term to maturity of FSA’s insured portfolio. The published results compare levels of theoretical loss in the tail of this distribution to various measures of FSA’s claims-paying resources.
The Company incurred approximately $27.9 million in capital expenditures, net of lease incentives, through 2005 for leasehold improvements, furniture and fixtures related to its new corporate headquarters. The Company has and expects to continue to fund these capital expenditures out of cash flows from operations. For additional information, see “Item 2. Properties.”
Consolidated Statements of Operations and Comprehensive Income for the Years Ended
Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31,
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Financial Security Assurance Holdings Ltd. and Subsidiaries (the “Company”) at December 31, 2005 and December 31, 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with 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 includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Financial Security Assurance Holdings Ltd. (“FSA Holdings”, or together with its consolidated entities, the “Company”) is a holding company incorporated in the State of New York. The Company is principally engaged, through its insurance company subsidiaries, in providing financial guaranty insurance on municipal and asset-backed obligations. Its primary insurance company subsidiary is Financial Security Assurance Inc. (“FSA”). The Company’s underwriting policy is to insure municipal and asset-backed obligations that it determines would be investment-grade quality without the benefit of the Company’s insurance. Municipal obligations insured by the Company consist primarily of general obligation bonds that are supported by the issuers’ taxing powers and special revenue bonds and other special obligations of states and local governments that are supported by the issuers’ abilities to impose and collect fees and charges for public services or specific projects. Municipal obligations include obligations backed by the cash flow from leases or other revenues from projects serving a substantial public purpose, including government office buildings, toll roads, healthcare facilities and utilities. Asset-backed obligations insured by the Company are generally issued in structured transactions and are backed by pools of assets, such as residential mortgage loans, consumer receivables, securities or other assets having an ascertainable cash flow or market value. The Company also insures synthetic asset-backed obligations that generally take the form of credit default swap (“CDS”) obligations or credit-linked notes that reference pools of securities or loans, with a defined deductible to cover credit risks associated with the referenced securities or loans. Financial guaranty insurance written by the Company guarantees scheduled payments on an issuer’s obligation. In the case of a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other amounts due in accordance with the obligation’s original payment schedule or, at its option, to pay such amounts on an accelerated basis.
The Company’s management believes that the assets held by FSA Global, Premier and the refinancing vehicles, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. Substantially all of FSA Global’s assets are pledged as collateral to secure the repayment, on a pro rata basis, of FSA Global’s debt.
Investments in debt and equity securities designated as available for sale are carried at fair value. The unrealized gain or loss on investments that are not hedged or are economically hedged but do not qualify for hedge accounting is reflected as a separate component of shareholders’ equity, net of applicable deferred income taxes. The unrealized gain or loss attributable to the hedged risk on investments that qualify as fair-value hedges is recorded in income currently.
Variable-rate demand notes (“VRDN”) and auction-rate securities (“ARS”) are included in bonds and financial products bond portfolio at fair value. VRDNs are long-term bonds that bear floating interest rates and provide investors with the option to tender or put the bonds at par, generally on a daily, weekly or monthly basis. ARS are long-term securities with interest-rate reset features and are traded in the marketplace through a bidding process. The cash flows related to these securities are presented on a gross basis in the consolidated statements of cash flows. Mortgage loans are carried at the lower of cost or market on an aggregate basis. Realized gains or losses on sale of investments are determined on the basis of specific identification. Investment income is recorded as earned. Other-than-temporary impairments are reflected in earnings as a realized loss.
Investments in unconsolidated affiliates are based on the equity method of accounting (see Note 18). The Company records its share of unrealized gains or losses of unconsolidated affiliates, net of applicable deferred taxes, in other comprehensive income.
The gains and losses related to derivatives designated as fair-value hedges are included in net interest income from financial products and variable interest entities and net interest expense from financial products and variable interest entities, as appropriate, along with the offsetting change in the fair value of the risk being hedged.
The Company establishes loss liabilities based on its estimate of specific and non-specific losses. The Company also establishes liabilities for loss adjustment expenses (“LAE”), consisting of the estimated cost of settling claims, including legal and other fees and expenses associated with administering the claims process.
The Company calculates a loss and LAE liability based upon identified risks inherent in its insured portfolio. If an individual policy risk has a probable loss as of the balance sheet date, a case reserve is established. For the remaining policy risks in the portfolio, a non-specific reserve is established to account for the inherent credit losses that can be statistically estimated.
Case reserves for financial guaranty insurance companies differ from those of traditional property and casualty insurance companies. The primary difference is that traditional property and casualty case reserves include only claims that have been incurred and reported to the insurance company. In a traditional property and casualty company, claims are incurred when defined events occur such as an auto accident, home fire or storm. Unlike traditional property and casualty claims, financial guaranty losses arise from the extension of credit protection and occur as the result of the credit deterioration of the issuer of the insured obligations over the lives of those insured obligations. Such deterioration and ultimate loss amounts can be projected based on historical experience in order to estimate probable loss, if any. Accordingly, specific loss events that require case reserves include (1) policies under which claim payments have been made and additional claim payments are expected and (2) policies under which claim payments are probable and reasonably estimable, but have not yet been made.
The Company establishes a non-specific reserve on its portfolio of credits because management believes that a portfolio of insured obligations will deteriorate over its life and that the existence of inherent loss can be proven statistically by data such as rating agency publications. The establishment of the reserve is a systematic process that considers this quantitative, statistical information obtained primarily from Moody’s Investors Service, Inc. (“Moody’s”) and Standard & Poor’s Ratings Services
The non-specific reserve established considers all levels of protection (e.g., reinsurance and overcollateralization). Net par outstanding for policies originated in the current period is multiplied by loss frequency and severity factors, with the resulting amounts discounted at the risk-free rates using the treasury yield curve (the “statistical calculation”). The discount rate does not change and is used to accrete the loss for the life of each policy. The loss factors used for the calculation are the product of default frequency rates obtained from Moody’s and severity factors obtained from S&P. Moody’s is chosen for default frequency rates due to its credibility, large population, statistical format and reliability of future update. The Moody’s default information is applied to all credit sectors or asset classes as described below. In its publication of default rates from 1970-2004, Moody’s tracks bonds over a twenty-year horizon by credit rating at time of issuance. For the purpose of establishing appropriate severity factors, the Company’s methodology segregates the portfolio into asset classes, including health care transactions, all other municipal transactions, pooled corporate transactions, commercial real estate, and all other asset-backed transactions. The severity factors are derived from capital charge assessments provided by S&P. S&P capital charges project loss levels by asset class and are incorporated into their capital adequacy stress scenario analysis.
Since the non-specific reserve contains the inherent losses of the portfolio, when a case reserve adjustment is deemed appropriate, whether the result of adverse or positive credit developments, accretion or the addition of a new case reserve, a full transfer is made between the non-specific reserve and the case reserve balances with no effect to income. The adequacy of the non-specific reserve balance is reviewed periodically and at least annually based on a review of the Company’s inception-to-date cumulative losses divided by the total inception-to-date cumulative net par underwritten. This inception-to-date result is compared with the product of the non-specific reserves divided by the net par outstanding as of the balance sheet date. In the event that such ratios are not in line, then further analysis is performed to quantify appropriate adjustments that may be either charges or benefits on the consolidated statements of operations and comprehensive income, as occurred in 2003, 2004 and 2005.
In January and February of 2005, the Securities and Exchange Commission (“SEC”) staff discussed with financial guaranty industry participants, differences in loss recognition practices among those participants. Based on discussions with the SEC staff, the Company understands that the Financial Accounting Standards Board (“FASB”) staff is considering additional guidance regarding financial
guaranty insurance. When and if the FASB or SEC reach a conclusion on this issue, the Company and the rest of the financial guaranty industry may be required to change some aspects of their loss reserving policies, and the potential changes could extend to premium and expense recognition. The Company cannot predict how the FASB or SEC will resolve this issue and the resulting impact on its financial statements.
Until additional guidance is issued, the Company intends to continue applying its existing policy regarding the establishment of both case and non-specific loss reserves.
Deferred acquisition costs are comprised of expenses related to the production of business, including commissions paid on reinsurance assumed, compensation and related costs of underwriting and marketing personnel, certain rating agency fees, premium taxes and certain other underwriting expenses, reduced by ceding commission received on premiums ceded to reinsurers. Deferred acquisition costs are amortized over the period in which the related premiums are earned. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred acquisition cost is recognized. A premium deficiency would be recognized if the present value of anticipated losses and loss adjustment expenses exceeded the sum of deferred premium revenue and estimated installment premiums.
The Company does not defer acquisition costs relating to GICs issued by the GIC Affiliates, except for GIC commissions paid to third parties, which are included in other assets. The amortization of these commissions is recorded in net interest expense from financial products and VIEs.
Asset-backed senior notes represent the Company’s purchase of less than 50% of a refinanced transaction. Asset-backed senior notes are carried at cost, with any reduction in carrying value recognized as an adjustment to yield.
The amortized cost and fair value of the bonds in the Investment Portfolio were as follows (in thousands):
The Company periodically monitors its Investment Portfolio for individual investments in an unrealized loss position in order to assess whether any investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2005, there were 96 securities that were in an unrealized loss position for a continuous 12-month period or longer. None of the 96 securities had an unrealized loss that exceeded book value by 11% at December 31, 2005. At December 31, 2005, the Company determined that no investments were considered other-than-temporarily impaired.
Proceeds from sales of bonds for the Investment Portfolio during 2005, 2004 and 2003 were $1,757.6 million, $1,187.3 million and $1,121.0 million, respectively. Proceeds from maturities of bonds for the Investment Portfolio during 2005, 2004 and 2003 were $130.9 million, $267.8 million and $443.1 million. Gross gains of $10.9 million, $5.2 million and $12.6 million and gross losses of $6.1 million, $5.7 million and $7.5 million were realized on sales in 2005, 2004 and 2003, respectively.
Net investment income for the FP Investment Portfolio consisted of the following (in thousands):
The credit quality of bonds held in the FP Investment Portfolio at December 31, 2005 was as follows:
The amortized cost and fair value of bonds held in the FP Investment Portfolio were as follows (in thousands):
The Company periodically monitors the FP Investment Portfolio for individual investments in an unrealized loss position in order to assess whether that investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2005, there were 22 securities that were in an unrealized loss position for a continuous 12-month period or longer. None of the 22 securities had an unrealized loss that exceeded book value by 3% at December 31, 2005. At December 31, 2005, the Company determined that no investments were considered other-than-temporarily impaired.
· acquisition costs are charged to operations as incurred rather than as related premiums are earned;
1) for all policies written prior to July 1, 1989, an amount equal to 50% of cumulative earned premiums less permitted reductions, plus
· insured CDS are considered to be insurance contracts, not derivative contracts recorded at fair value;
have been recorded as capital contributions and reductions in amounts payable to Dexia Holdings in the financial statements.
Management believes it is more likely than not that the tax benefit of the deferred tax assets will be realized. Accordingly, no valuation allowance was necessary at December 31, 2005 or 2004.
The Company maintains both qualified and non-qualified, non-contributory defined contribution pension plans for the benefit of eligible employees. Contributions are based on a fixed percentage of employee compensation. Pension expense, which is funded annually, amounted to $7.0 million, $5.8 million and $4.9 million for the years ended December 31, 2005, 2004 and 2003, respectively.
In 2004, the Company adopted the 2004 Equity Participation Plan (the “2004 Equity Plan”), which continues the incentive compensation program formerly provided under the Company’s 1993 Equity Participation Plan. The 2004 Equity Plan provides for performance share units comprised 90% of performance shares (which provide for payment based upon the Company’s performance over specified three-year performance cycles as described above) and 10% of shares of Dexia restricted stock. The Dexia restricted stock component is a fixed plan, where the Company purchases Dexia shares and establishes a prepaid expense for the amount paid, which is amortized over 2.5-year and 3.5-year vesting periods. In the first quarter of 2005, FSA purchased shares to economically defease its liability for $4.4 million. This amount is being amortized to expense over the employees’ vesting periods.
Effective June 2004, the Company entered into a 21-year sublease agreement with Deutsche Bank AG for office space at 31 West 52nd Street, New York, New York, to be used as the Company’s new headquarters. The Company moved to this new space in June 2005. The lease contains scheduled rent increases every five years after a 19-month rent-free period, as well as lease incentives for initial construction costs of up to $6.0 million, as defined in the sublease. The lease contains provisions for rent increases related to increases in the building’s operating expenses. The lease also contains a renewal option for an additional ten-year period and an option to rent additional office space at various points in the future, in each case at then-current market rents. In addition, the Company and its Subsidiaries lease additional office space under non-cancelable operating leases, which expire at various dates through 2013. Future minimum rental payments are as follows (in thousands):
Rent expense was $10.1 million in 2005, $7.8 million in 2004 and $7.3 million in 2003. Rent expense in 2005 includes a $1.2 million lease termination fee related to the Company’s former headquarters.
(2) Excludes intercompany insurance of $13,463 million in 2005 and $7,143 million in 2004 relating to FSA-insured GICs issued by the GIC Affiliates.
The par amount ceded as of December 31, 2005 and 2004 and the terms to maturity are as follows (in millions):
In its asset-backed business, the Company considers geographic concentration as a factor in underwriting insurance covering securitizations of pools of such assets as residential mortgages or consumer receivables. However, after the initial issuance of an insurance policy relating to such securitizations, the geographic concentration of the underlying assets may not remain fixed over the life of the policy. In addition, in writing insurance for other types of asset-backed obligations, such as securities primarily backed by government or corporate debt, geographic concentration is not deemed by the Company to be significant, given other more relevant measures of diversification, such as issuer or industry diversification.
The Company seeks to maintain a diversified portfolio of insured municipal obligations designed to spread its risk across a number of geographic areas. The following table sets forth those states in which municipalities located therein issued an aggregate of 2% or more of the Company’s net par amount outstanding (in millions) of insured municipal securities as of December 31, 2005:
The Subsidiaries earned premiums of $2.5 million in the first half of 2003 relating to the guarantees of debt issued or assets purchased by FSA Global and Canadian Global. Intercompany premiums earned relating to VIEs have been eliminated in consolidation for periods subsequent to July 1, 2003.
For bonds, equity securities, the FP Investment Portfolio, the FP Investment Portfolio pledged as collateral and the VIE bond portfolio, the carrying amount represents fair value. The fair value is based on quoted market price or redemption value for the Company’s investment in XLFA.
For installment premiums, consistent with industry practice, there is no carrying amount since the Company will receive premiums on an installment basis over the term of the insurance contract. Similar to the treatment of deferred premium revenue, the fair value of installment premiums is the estimated present value of the future contractual premium revenues that would be received under a reinsurance agreement with a third party to transfer the Company’s financial guaranty risk, net of that portion of the premium retained by the Company to compensate it for originating and servicing the insurance contract.
For losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses, the carrying amount is the net present value of the expected cash flows for specifically identified claims and inherent losses in the Company’s insured portfolio, which management believes is a reasonable proxy for fair value.
For fair-value adjustments on derivatives, the carrying amount represents fair value. The Company uses quoted market prices when available, but if quoted market prices are not available, management uses internally developed estimates.
The gross and net par amounts outstanding on transactions with case reserves were $612.7 million and $519.5 million, respectively, at December 31, 2005. The net case reserve consisted primarily of seven CDO transactions and one municipal transaction, which collectively accounted for approximately 94% of the total net case reserve. The remaining 11 exposures were in various sectors.
During 2004, the Company charged $20.6 million to loss expense, consisting of $20.4 million for originations of new business, $4.6 million for accretion related to prior years and $3.2 million related to reassumptions of previously ceded business, offset by reserve releases primarily related to a large refinancing transaction in 2004. The non-specific reserves decreased $12.2 million in 2004, primarily due to transfers from the non-specific reserve to the case reserves of $30.7 million, offset by loss expense of $20.6 million. Case reserves decreased $17.5 million due to (1) a large, voluntarily accelerated transaction that had a $34.3 million payment and (2) reclassifications from reserves to asset valuation accounts for refinanced transactions of $13.9 million, partially offset by transfers from the non-specific reserve of $30.7 million (see Note 22).
During 2003, the Company charged $34.5 million to loss expense, comprising $9.2 million related to the CDO portfolio discussed below, $22.4 million for origination of new business and $2.9 million for the accretion of the discount on prior years’ reserves. The non-specific reserve increased by $21.8 million in 2003, consisting of the loss expense, a transfer to the non-specific reserve of $1.4 million representing recoveries received on prior-year transactions and a transfer of $14.1 million from the non-specific reserve to case reserves. In addition, the Company reclassified $2.2 million of case reserves as an asset valuation account relating to a restructured transaction involving securitized loans (see Note 22).
Since case and non-specific reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates. The Company will continue, on an ongoing basis, to
monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company’s actual loss experience, its future mix of business and future economic conditions.
The Company evaluated its insured portfolio to assess the potential impact of Hurricanes Katrina, Rita and Wilma, which occurred in 2005. The Company records a non-specific reserve to reflect the credit risks inherent in its portfolio. Together, the non-specific reserve and case reserves represent the Company’s estimate of total loss liability. The Company believes that its total loss liability is adequate given the current information. Generally, when an insured credit deteriorates to a point where unreimbursed claims are expected, a case reserve is established.
As of March 24, 2006, FSA had not received notice of payment default on any exposures related to Hurricanes Katrina, Rita or Wilma. To date, based on the Company’s review of its exposure, 11 credits, with aggregate net par exposure of $215.8 million, have the most significant risk of loss. FSA-insured bonds are protected by various sources of support that would be invoked before FSA would incur losses. These sources include access to pledged taxes or revenues, reserve funds, property and casualty insurance and state and federal monies. In the case of perpetual obligations, FSA may experience claims, but if the population returns in adequate numbers, reimbursement is likely. Eight of the 11 obligations with significant risk of loss are perpetual.
In order for a community in Louisiana to restructure and potentially reduce its indebtedness, the Bond Commission, which is headed by the State Treasurer, must authorize such action. The State Treasurer has publicly represented that the Bond Commission will not permit any Louisiana municipality to declare bankruptcy.
Municipalities in Mississippi are not authorized to file for bankruptcy and therefore have no mechanism under law to adjust their payment obligations. Unlike the corporate market, the municipal market has no private or equity source of capital and therefore lacks any means of starting fresh with a clean slate with debts and liabilities rejected or adjusted in bankruptcy. To file for bankruptcy, or to leave rated indebtedness unpaid in a bankruptcy proceeding, would serve to tarnish the issuer and the region and effectively deny the subject municipality and similar issuers of debt within the state access to capital. Historically, rather than bankruptcy and adjustment of debt, financially distressed municipalities have been subjected to supervision and control by state-created authorities that act both as issuers of debt, secured by a discrete, newly identified revenue stream, and as fiscal monitors.
In addition, FSA’s asset-backed transactions, which are generally backed by pools of geographically diverse assets, show no unusual concentrations in the affected areas.
The loss estimation process involves the exercise of considerable judgment and therefore the Company’s ultimate hurricane-related losses may be materially different from the current estimate and may affect future operating results.
The Company made an additional equity investment in SPS of $10.3 million in 2004, and did not make any equity investments in SPS in 2005 or 2003. In 2005, the Company sold its investment in SPS. At December 31, 2004, the Company had a 34.1% interest in SPS. The Company’s investment in SPS was accounted for using the equity method of accounting. Amounts recorded by the Company in connection with SPS at December 31, 2005, 2004 and 2003 were as follows (in thousands):
SPS’s business is subject to regulation, supervision and licensing by various federal, state and local authorities. In October 2002, the Federal Trade Commission (the “FTC”) informed SPS that it was investigating whether SPS’s loan servicing or other practices violated the Fair Debt Collection Practices Act, the Fair Credit Reporting Act, Section 5 of the Federal Trade Commission Act or other laws enforced by the FTC.
Until the fourth quarter of 2004 this investment was accounted for using the equity method of accounting because the Company has significant influence over XLFA’s operations. In the second quarter of 2004, the Emerging Issues Task Force (“EITF”) reached a consensus that under EITF Issue 02-14, “Whether an Investor Should Apply the Equity of Method of Accounting to Investments Other Than Common Stock” (EITF 02-14), an investor should only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. The EITF 02-14 consensus is applicable to reporting periods beginning after September 15, 2004. In accordance with this consensus, the Company no longer accrues undistributed earnings related to its investment in XLFA. Amounts recorded by the Company in connection with XLFA as of December 31, 2005, 2004 and 2003 are as follows (in thousands):
FSA has insured a number of CDS with the expectation that these transactions will not be subject to a market value termination for which the Company would be liable. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred. The Company recorded $89.2 million, $69.1 million and $57.7 million of net earned premium under these agreements for the years ended 2005, 2004 and 2003, respectively.
quoted market prices, if available. If quoted market prices are not available, then the determination of fair value is based on internally developed estimates. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, performance of underlying assets, changes in internal shadow ratings, the level at which the deductible has been set and the Company’s ability to obtain reinsurance for its insured obligations. The Company does not believe that the fair-value adjustments are an indication of potential claims under FSA’s guarantees. The average life of these contracts is 3.2 years. The inception-to-date gain on the CDS portfolio was $57.7 million at December 31, 2005 and $46.6 million at December 31, 2004, and was recorded in other assets.
The Company utilizes interest-rate derivatives to convert from fixed to floating the interest rates on assets and liabilities. All gains and losses from changes in the fair value of derivatives that do not qualify for hedge accounting are recognized immediately in the statements of operations and comprehensive income in net unrealized and realized gains (losses) on derivative instruments. Hedge accounting is applied to derivatives designated as hedging instruments in a fair-value hedge, provided certain criteria are met.
The Company enters into various other derivative contracts that do not qualify for hedge accounting treatment under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). These derivatives include swaptions, caps and other derivatives, which are used principally as protection against large interest-rate movements. Gains and losses on these derivatives are reflected in net realized and unrealized gains (losses) on derivative instruments in the statements of operations and comprehensive income.
The Company generally has rights under its financial guaranty insurance policies and indentures that allow it to accelerate the insured notes and pay claims under its insurance policies upon the occurrence of predefined events of default. To mitigate future losses, the Company may elect to purchase the outstanding insured obligation or its underlying collateral. Generally, refinancing vehicles reimburse FSA in whole for its claims payments in exchange for assignments of certain of FSA’s rights against the trusts. The refinancing vehicles obtain their funds from the proceeds of FSA-insured GICs issued in the ordinary course of business by the GIC Affiliates. The refinancing vehicles are consolidated into the Company’s financial statements. The Company maintains its reinsurance on these transactions.
The following table presents the components of the assets acquired in refinancing transactions (in thousands):
Bonds, equity securities and mortgage loans represent liquidations of previously insured obligations and subsequent purchases of the underlying collateral. Bonds and equity securities are available for sale and carried at fair value. At December 31, 2005, there were no securities in the refinanced asset portfolio in an unrealized loss position for a continuous 12-month period or longer. At December 31, 2005, the Company determined that no investments were considered other-than-temporarily impaired.
The amortized cost and fair value of fixed-income assets within the refinanced asset portfolio were as follows (in thousands):
information (in thousands) by segment as of December 31, 2005 and 2004 and for the years ended December 31, 2005, 2004 and 2003:
FSA Global is managed as a “matched funded vehicle,” in which the proceeds from the issuance of FSA-guaranteed notes are invested in obligations having cash flows substantially matched to those of, and maturing prior to, such notes. In certain cases, investments of FSA Global consist of GICs issued by the GIC Affiliates. Similarly, Premier holds GICs issued by the GIC Affiliates in their investment portfolios. In each such case, the Company’s GIC liability and asset are eliminated in consolidation. At December 31, 2005, $1,142.1 million was eliminated as a result of such consolidation. All intercompany insured amounts between FSA and FSA Global and Canadian Global previously included in the Company’s outstanding exposure are excluded from the Notes to the Consolidated Financial Statements for December 31, 2005 and 2004.
All bonds in the VIE Portfolio are insured by FSA. The credit quality of the VIE Portfolio, without the benefit of FSA’s insurance, at December 31, 2005 was as follows:
The Company periodically monitors its investment portfolio for individual investments in an unrealized loss position in order to assess whether that investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2005, there were no securities in an unrealized loss position. The Company determined that no investments were considered other-than-temporarily impaired.
The amortized cost and fair value of bonds in the VIE Portfolio at December 31, 2005, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.