The following Selected Consolidated Financial Data should be read in conjunction with the Consolidated Financial Statements and accompanying notes included elsewhere herein.
Book value of the Company at December 31, 2002 and 2001 was $1,868.4 million and $1,635.9 million, respectively. Management and some equity analysts use adjusted book value as a proxy for the Company's intrinsic value, exclusive of franchise value. It is defined as book value plus the after-tax present value of net deferred premium revenue, installment premiums and future net interest margin less deferred expenses. Following is a reconciliation of book value to adjusted book value:
(1)Includes the effect of after-tax unrealized gains in the investment portfolio, which was $134.7 million at December 31, 2002 and $63.0 million at December 31, 2001. During 2002, adjusted book value, including dividends, grew 13.9% excluding realized and unrealized capital gains and losses in the investment portfolio and 17.4% including such gains and losses.
The Company has revised its definition of operating earnings from that used in prior periods. Operating earnings is now defined as net income before the effects of SFAS No. 133 mark-to-market adjustments for pooled CDS and 2000 merger expenses. For purposes of calculating operating earnings, pooled CDS are defined as FSA-insured credit default swaps that reference pools of financial obligations and require payments by the Company if losses exceed a defined deductible providing an investment-grade level of protection to the Company. Management considers operating earnings a key measure of normal operating results, as the SFAS No. 133 adjustments for each guaranteed CDS are expected to sum to zero over the life of the transaction. Operating earnings for 2001 and 2000 disclosed in this discussion differ from those previously disclosed due to the revised definition of operating earnings.
The Company employs two measures of gross premiums originated for a given period. Gross premiums written captures premiums collected in the period, whether collected up front for business originated in the period, or in installments for business originated in prior periods. An alternative measure, gross present value of premiums written (PV premiums), reflects future installment premiums discounted to their present value, as well as upfront premiums, but only for business originated in the period. Business ceded through reinsurance placed by a third party is excluded from PV premiums. The Company considers PV premiums to be the better indicator of a given period's insurance origination activity because a substantial portion of the Company's premiums is collected in installments, a practice typical of the asset-backed business. To calculate PV premiums, management estimates the life of each transaction that has installment premiums and discounts the future installment premium payments. The present value of the future net interest margin from the Company's asset management business represents the present value of the difference between the estimated interest to be received on the investments of the Company's asset management group and the estimated interest to be paid on the guaranteed investment contracts (GICs) issued by the Company's asset management group over the estimated life of each transaction, giving effect to swaps and other derivatives which convert fixed-rate assets and liabilities to floating rates. PV premiums and the present value of the future net interest margin from the Company's asset management group are collectively referred to as PV originations. The Company calculates the discount rate for PV originations as the average pre-tax yield on its investment portfolio for the previous three years. Accordingly, year-to-year comparisons of PV originations are affected by the application of different discount factors. The rates for 2002 and 2001 were 5.91% and 5.79%, respectively. Management intends to revise the discount rate in future years according to the same formula, in order to reflect interest rate changes.
The Company's principal insurance operating subsidiary, Financial Security Assurance Inc. (FSA), and the asset management business generated PV originations of $881.8 million for the year ended December 31, 2002, an increase of 26.6% over the 2001 result. In 2002, the annual gross par value of obligations insured by FSA declined 3.9%, to $109.7 billion. The table below shows the components of PV originations for 2002 and 2001:
(2)U.S. asset-backed amounts have been restated to exclude asset management net interest margin.
(3)Present value of future net interest margin originated During 2002, new issue volume in the U.S. municipal bond market reached a record $357.9 billion, and insurance penetration increased to approximately 49% from 46% in the prior year. In this environment, FSA insured approximately 27% of the insured new issues sold during the year. FSA insured a par amount of $51.6 billion of U.S. primary and secondary municipal obligations with closing dates in 2002, an increase of 41.6% over the amount insured in the prior year. FSA's U.S. municipal PV premiums in 2002 increased 89.2% over PV premiums in 2001. FSA's municipal premiums increased more rapidly than par insured because a smaller portion of par was generated by general obligations, which tend to have lower premium rates than more complex issues of similar credit quality. In the 2002 U.S. asset-backed market, the par volume insured by FSA declined 36.4% to $35.6 billion, reflecting FSA's decision to take a hiatus in the collateralized debt obligation (CDO) business at mid-year 2002 in order to confirm its underwriting standards, as well as FSA's generally heightened selectivity in all asset-backed sectors during a period of economic weakness. In addition, FSA did not insure any large U.S. asset-backed transactions comparable to two 2001 transactions that together contributed $90 million of PV premiums that year (see "Year Ended December 31, 2001 versus Year Ended December 31, 2000" below). In international markets, FSA insured international obligations with an aggregate par amount of $19.8 billion, a decrease of 6.3%. International PV premiums rose 65.6% to $199.3 million because Triple-A and Double-A shadow-rated CDO transactions, which tend
to have low premiums relative to par, represented a smaller part of the business mix. FSA insured several transactions in the infrastructure finance sector, including public-private partnership financings such as those under the U.K. Private Finance Initiative. It also guaranteed CDS in the pooled corporate and residential mortgage sectors and completed several funded consumer finance securitizations. In 2002, the Company's asset management group completed its first full year of operations, generating $65.7 million in present value of future net interest margin.
Net investment income was $139.1 million for 2002 and $128.9 million for 2001, an increase of 7.9%. This increase was due primarily to higher invested balances arising from new business writings. For further discussion, see "Liquidity and Capital Resources" below. The Company's effective tax rate on investment income was 10.4% for 2002, compared with 11.0% for 2001. In 2002, the Company realized $29.2 million in net capital gains, compared with $7.2 million of net capital gains in 2001. Capital gains and losses are generally a by-product of the normal investment management process and can vary substantially from period to period.
The provision for losses and loss adjustment expenses in 2002 was $65.6 million, compared with $12.5 million in 2001. In the second quarter of 2002, as part of the Company's ongoing credit review process, management identified certain transactions not performing as expected in its portfolio of insured CDOs. As a result, management analyzed all CDO transactions in its insured portfolio that breached overcollateralization triggers, which were included in such transactions as one measure of adverse performance. A present value "deterministic" approach was utilized to estimate the loss inherent in this portfolio. The deterministic model applies a run of the collateral portfolio for each CDO transaction considering each transaction's unique attributes (such as reinsurance, individual collateral ratings and status, derivatives purchased, premiums due to the guarantor, etc.) utilizing a Moody's default pattern for frequency of defaults, an estimate of collateral recovery values for severity, and a risk-free rate of interest. Management assumed that current default rates on CDO collateral would improve in a manner consistent with an economic recovery following a period of significant credit deterioration similar to that experienced in 1991/1992 and, as a result, management selected Moody's 1992 idealized default curve as a predictor of future defaults on the CDO collateral. The per-period default rate was calculated based on the Moody's weighted average rating factor for each piece of surviving collateral. Recovery rates were judgmentally established by the Company. In considering the recovery rates to be utilized, management adjusted Moody's average recovery rates (observed since 1982) downward to reflect more recent and more adverse observations. At June 30, 2002, this analysis produced a present value of expected losses of $51.5 million, net of reinsurance recoveries and net of unearned premiums and future ceding commissions. Management addressed this net present value of expected loss ($51.5 million) through (i) an increase in the Company's general reserve ($31.0 million) and (ii) amounts already existing in its general reserve ($20.5 million), including general reserve amounts reallocated to case basis reserves ($11.3 million). The $31.0 million increase in the Company's general reserve resulted in a corresponding increase to losses and loss adjustment expense in the income statement of $31.0 million. An additional adjustment of $10.1 million was made to the general reserve in the fourth quarter of 2002 as a result of further deterioration of the CDO portfolio. Management has established a methodology of recording case basis reserves on CDO transactions to the extent that the
In the fourth quarter of 2001, the Company's newly formed asset management group began issuing FSA-insured GICs and recorded $2.5 billion and $600.0 million of GICs as of December 31, 2002 and 2001, respectively. These transactions resulted in a net interest margin of $7.8 million and $(0.2) million for the year ended December 31, 2002 and 2001, respectively.
During the first half of 2002, FSA's insured portfolio contained a portfolio of CDS on 100 corporate names (each rated investment grade at inception of the swap), with $10 million of exposure per name, for which the Company had first-loss exposure. This "single-name CDS program" was the only transaction of its kind in the insured portfolio. In the third quarter of 2002, the Company terminated its exposure under this program in exchange for paying termination costs of $43.0 million. The charge was included in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income.
Income before income taxes for 2002 and 2001 was $216.2 million and $269.5 million, respectively.
The primary objective in managing the Company's investment portfolio, excluding the GIC bond portfolio, is generation of an optimal level of after-tax investment income while preserving capital and maintaining adequate liquidity. Investment strategies are based on many factors, including the Company's tax position, fluctuation in interest rates, regulatory and rating agency criteria and other market factors. One internal investment manager and two external investment managers execute fixed-income investments. These investment decisions are based on guidelines established by management and approved by the board of directors.
FSAM generally converts all fixed-rate assets and liabilities to floating rates using hedging instruments. As interest rates change, the change in value of the fixed income securities will be substantially offset by a similar but opposite change in value of the related hedging instruments.
FSA-insured GICs subject the Company to risk associated with unexpected withdrawal of principal allowed by the terms of the GICs. The majority of municipal GICs insured by FSA relate to debt service reserve funds and construction funds in support of municipal bond transactions. Debt service reserve fund GICs may be drawn unexpectedly when the underlying bond issuance suffers a debt service shortfall. Construction funds may experience withdrawal deviation when the underlying municipal project does not proceed as expected. In addition, most FSA-insured GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below AA- by S&P or Aa3 by Moody's, unless the GIC provider posts collateral or otherwise enhances its credit.
Management of the Company periodically evaluates the assumptions and judgments underlying its estimate for losses and loss adjustment expenses and establishes a liability that management believes is adequate to cover the present value of the ultimate net cost of claims. Management has consistently applied this approach from period to period. Since the reserves are based upon estimates, there can be no assurance that the ultimate liability will not differ from such estimates.
Premiums are received either upfront or over time on an installment basis. Premiums are earned in proportion to the amount of risk outstanding over the expected period of coverage. The amount of risk outstanding is equal to the sum of the par amount of debt insured. Deferred premium revenue and prepaid reinsurance premiums represent the portion of premium that is applicable to coverage of risk to be provided in the future on policies in force. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred premium revenue and prepaid reinsurance premium, less any amount credited to a refunding issue insured by the Company, are recognized. Some industry peers receive so-called structuring or advisory fees in connection with transactions insured by them or their affiliates, and earn such fees upon receipt. Unlike these industry peers, the Company allocates all fees (net of reimbursed expenses) received for its account on closed transactions to premiums (or ceding commissions) that are earned (or, in the case of ceding commissions, employed to offset deferred acquisition costs) over time as described above. When the Company, through its ongoing credit review process, identifies transactions where certain triggers have been breached, the Company ceases to earn premiums. If a case basis reserve is established for these transactions, the unearned premium will reduce such reserve.
Year Ended December 31, 2001 versus Year Ended December 31, 2000
The Company's 2001 net income was $209.5 million, compared with $63.3 million ($138.8 million excluding merger-related costs) for 2000, an increase of 231.1%. Operating earnings were $205.1 million for 2001 versus $138.8 million for 2000. Operating earnings have been restated to reflect the Company's change in the definition of operating earnings, as previously discussed.
In the U.S. asset-backed market, FSA achieved record results, with business well balanced across the consumer, residential mortgage and structured finance sectors. In consumer finance, the Company enjoyed steady transaction flow from repeat issuers of asset-backed securities backed by automobile loans and credit card receivables. In the residential mortgage market, FSA developed new applications for its guaranty and, late in the year, saw increased demand for the guaranty as a way to enhance liquidity of mortgage-backed issues already rated Triple-A. In addition, funded and synthetic CDO business was strong because of a favorable credit spread environment. Fourth quarter 2001 gross PV premiums were amplified by an unusually large residential mortgage transaction and a complex, high-premium structured financial institution obligation, which together contributed $90.0 million in PV premiums. For the year, par value reached $56.7 billion and PV premiums totaled $350.1 million, compared with $28.0 billion and $198.9 million, respectively, for 2000. Par insured increased more than gross PV premiums primarily because of increased originations in the Triple-A shadow-rated CDO sector, which carries a low premium rate relative to par insured.
penetration increased to 46% from 40% in the prior year. In this positive environment, FSA held the leading market share for the first time, insuring approximately 27% of the insured new issues that were sold during the year. FSA's market share leadership does not reflect any change in business strategy, which is for FSA to insure all the transactions meeting its underwriting criteria that it can insure at appropriate returns. The U.S. municipal business contributed $222.3 million in PV premiums in 2001, compared with $140.1 million in 2000. FSA's U.S. municipal par insured increased to $36.5 billion in 2001 from $21.5 billion in 2000.
FSA's gross premiums written increased 30.4% to $485.6 million for 2001 from $372.3 million for 2000. Net premiums written were $319.6 million during 2001, an increase of 46.5% compared with the 2000 result. Reinsurance cessions totaled 34.2% of 2001 gross premiums written, compared with 41.4% in 2000. The amount ceded decreased in 2001 primarily due to some large facultative cessions on health care business in 2000 to comply with new internal single-risk limits. Net premiums earned in 2001 were $231.0 million, compared with $192.1 million in 2000, an increase of 20.2%. Premiums earned from refundings and prepayments were $9.1 million for 2001 and $11.7 million for 2000, contributing $4.4 million and $5.5 million, respectively, to after-tax earnings. Excluding the effects of refundings, net premiums earned grew 23.0% over the comparable 2000 result. No assurance can be given that refundings and prepayments will continue at the level experienced in 2001 or 2000.
Interest expense in 2001 and 2000 was $16.9 million and $16.6 million, respectively. For further discussion, see "Liquidity and Capital Resources" below.
The provision for losses and loss adjustment expenses in 2001 was $12.5 million, compared with $9.4 million in 2000, representing additions to the Company's general reserve. The additions to the general reserve represent management's estimate of the amount required to cover the present value of the net cost of future claims. The Company will, on an ongoing basis, 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. At December 31, 2001, the general reserve totaled $69.1 million.
The Company's consolidated invested assets at December 31, 2002, net of unsettled security transactions, were $5,027.2 million, compared with the December 31, 2001 balance of $3,132.6 million. These balances include the change in the market value of the investment portfolio, which had an unrealized gain position of $242.0 million at December 31, 2002, compared with an unrealized gain position of $92.4 million at December 31, 2001. In addition to the increase in unrealized gains, the growth of the Company's asset management business contributed to the increase in the Company's consolidated invested assets and cash equivalents. At December 31, 2002, the Company had, at the holding company level, an investment portfolio of $21.8 million available to fund the liquidity needs of its activities outside of its 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 upon its receipt of dividends from, or payment on surplus notes by, FSA.
At December 31, 2001, the Company held $144.0 million of surplus notes of FSA. During 2002, FSA repaid $28.0 million of such surplus notes. In November 2002, the Company purchased an additional $96.9 million of surplus notes from FSA. At December 31, 2002, the Company held $212.9 million of FSA surplus notes. Payments of principal or interest on such notes may be made only with the approval of the New York Superintendent. The Company employs surplus note purchases in lieu of capital contributions in order to allow the Company to withdraw funds from FSA through surplus note payments without reducing earned surplus.
Dividends paid by the Company to its shareholders were $11.7 million, $31.1 million and $7.9 million in 2002, 2001 and 2000, respectively.
In the second quarter of 2000, in connection with the merger of the Company with a subsidiary of Dexia S.A., FSA repurchased $55.0 million of its stock from the Company, and the Company sold 511,031 of its shares held in a rabbi trust to Dexia for $38.6 million. The proceeds from these transactions were used to fund the Company's obligations under certain of its long-term, equity-based compensation programs.
On November 26, 2002, the Company issued $230.0 million of 6.25% Notes due November 1, 2102 and callable without premium or penalty in whole or in part at any time on or after November 26, 2007. The Company used the proceeds of this issuance to redeem in whole the Company's $130.0 million of 7.375% Senior Quarterly
FSA has a credit arrangement, aggregating $125.0 million at December 31, 2002, that is provided by commercial banks and intended for general application to transactions insured by FSA and its insurance company subsidiaries. At December 31, 2002, there were no borrowings under this arrangement, which expires on April 26, 2003, unless extended.
Standard & Poor's Ratings Services (S&P), Moody's Investors Service, Inc. (Moody's) and Fitch Ratings periodically assess the credits insured by FSA, and the reinsurers and other providers of capital support to FSA, to confirm that FSA continues to satisfy the rating agencies' capital adequacy criteria necessary to maintain FSA's Triple-A ratings. Capital adequacy assessments by the rating agencies are generally based on FSA's qualified statutory capital, which is the aggregate of policyholders' surplus and contingency reserves determined in accordance with statutory accounting principles. 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 providing the reinsurance, 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. S&P has placed a number of the Triple-A reinsurers used by FSA either on "negative outlook" or "credit watch." Downgrade of these reinsurers by S&P to the Double-A category would result in a decline in the credit
allowed for reinsurance by S&P from 100% to 70% or 65% under present criteria. S&P has also undertaken to consider an increase in the credit allowed for Double-A reinsurance. While a downgrade by S&P of all such reinsurers to the Double-A category would not impair FSA's Triple-A ratings, it may 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 to ultimately 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 S&P from its capital adequacy assessment of FSA due to any such reinsurer downgrades or increased capital charges.
Asset-backed and, to a lesser extent, municipal transactions insured by FSA may employ variable interest entities (VIEs) for a variety of purposes. A typical asset-backed transaction, for example, employs a VIE as the purchaser of the securitized assets and as the issuer of the obligations insured by FSA. 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 the VIE's assets, but in most situations FSA's financial guaranty policy will not expose it to significant variability due to the significant level of other credit protection. Specifically, as issuer of a financial guaranty insurance policy insuring the 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, thus 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 degree of influence exercised by FSA over these VIEs varies from transaction to transaction, as does the degree to which "risks and rewards" associated with asset performance are assumed by FSA. While all transactions insured by FSA are included in the Company's outstanding exposure, and losses under these obligations are reflected in the Notes to Consolidated Financial Statements for December 31, 2002, the assets and liabilities of these VIEs have not been consolidated with those of the Company for financial reporting purposes and are considered "off-balance sheet" obligations. The Company believes two such VIEs, Canadian Global Funding Corporation (Canadian Global) and FSA Global Funding Limited (FSA Global), will be consolidated with the Company for financial accounting purposes during 2003 under the consolidation guidance recently issued by the Financial Accounting Standards Board (FASB) under FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN No. 46).
In August 1994, FSA entered into a facility agreement with Canadian Global and Hambros Bank Limited. Canadian Global was established to provide a source of liquidity to refinance FSA-insured transactions that experienced difficulty in meeting debt service obligations. Canadian Global was capitalized with $180.6 million of
debt securities (which were effectively converted to U.S. dollar LIBOR rate through a cross-currency swap with terms matching the underlying debt instrument) and $6.3 million in preferred equity sold to third-party investors. Under the agreement, FSA pays an annual fee to Canadian Global to compensate it for making its liquidity available and can arrange financing for transactions subject to certain conditions. When Canadian Global purchases an FSA-insured obligation, the new obligation is insured by FSA for a premium, and case basis reserves are established when required. As of December 31, 2002, FSA was carrying gross and net case basis reserves of $16.7 million and $4.2 million, respectively, against transactions refinanced by Canadian Global. Canadian Global has total assets of $196.8 million, of which $87.6 million has been invested in a GIC issued by CMS. The amount of this facility was $186.9 million, of which $125.2 million was unutilized, at December 31, 2002. The facility terminates in 2004, after which Canadian Global will be liquidated.
The Company owns 29% of the equity of FSA Global, a Cayman Islands domiciled issuer of FSA-insured notes and other obligations sold in international markets (generally referred to as medium term notes or "MTNs"). FSA Global issues securities at the request of interested purchasers in a process known as "reverse inquiry," which generally results in lower interest rates and borrowing costs than would apply to direct borrowings. FSA Global also issues securities in traditional private placements to institutional investors and to participants in lease financings in which Company affiliates may play a number of financing roles. FSA Global is managed as a "matched funding vehicle," in which the proceeds from the sale of FSA Global notes are invested in obligations chosen to provide cash flows substantially matched to those of the FSA Global notes (taking into account, in some cases, dedicated third-party liquidity). The matched funding structure minimizes the market risks borne by FSA Global and FSA. FSA Global raises funds in U.S. dollars at LIBOR-based floating borrowing rates and invests its funds in obligations insured by FSA, maturing prior to the maturity of the related FSA Global notes and paying a higher interest rate than the interest rate on the related FSA Global notes. At December 31, 2002, FSA Global had total assets and total liabilities of $9.2 billion and $9.2 billion, respectively. The foregoing assets and liabilities include assets and matched liabilities that are "economically defeased" in lease financings in which Company affiliates may play a number of financing roles. These economically defeased liabilities and associated assets are held in separate special purpose entities, FSA Global and Premier International Funding Co. At December 31, 2002 and 2001, FSA Global's economically defeased obligations were $6.7 billion and $2.0 billion, respectively. FSA Global's net income for the year ended December 31, 2002 and 2001 was $1.0 million and $0.6 million, respectively. FSA Global's net income is determined net of premiums paid by FSA Global to FSA. For the years ended December 31, 2002 and 2001, FSA Global paid premiums to FSA of $7.7 million and $7.5 million, respectively. All amounts insured by FSA relating to FSA Global are included in the Company's outstanding exposure, included in the Notes to the Consolidated Financial Statements for December 31, 2002. As of December 31, 2002, there were no case basis reserves required for any transactions related to FSA Global.
In January 2003, the FASB issued FIN No. 46, which is an interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements." FIN No. 46 addresses consolidation of VIEs that have one or both of the following characteristics: (i) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity; and (ii) the equity investors lack the direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights, the obligation to absorb the expected losses of the entity if they occur or the right to receive the expected residual returns of the entity if they occur. The provisions for FIN No. 46 will be effective immediately for VIEs created after January 31, 2003 and to VIEs in which an enterprise obtains an interest after that date. For VIEs in which an enterprise holds a variable interest that it acquired prior to February 1, 2003, the interpretation is effective in the first fiscal year or interim period beginning after June 15, 2003. Management believes that the implementation of this interpretation, on July 1, 2003, will cause the Company to consolidate for financial reporting purposes, for the first time, FSA Global and Canadian Global. FIN No. 46 requires that, upon consolidation, the Company shall initially measure the VIEs' assets, liabilities and minority interest at their carrying amounts under existing GAAP as if the entity had been consolidated from the time the Company was considered its primary beneficiary (or parent). Any differences upon consolidation on July 1, 2003 will be reflected as a cumulative effect of a change in accounting principle. The carrying amounts of assets, liabilities and minority interest may change significantly from December 31, 2002 to July 1, 2003 as a result of transactions entered
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Financial Security Assurance Holdings Ltd. and Subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
On July 5, 2000, the Company completed a merger in which the Company became a direct subsidiary of Dexia Holdings, Inc., which, in turn, is owned 90% by Dexia Crédit Local and 10% by Dexia S.A. (Dexia), a Belgian corporation whose shares are traded on the Euronext Brussels and Euronext Paris markets as well as on the Luxembourg stock exchange. Dexia Crédit Local is a wholly owned subsidiary of Dexia. At the merger date, each outstanding share of the Company's common stock was converted into the right to receive $76.00 in cash. Dexia also indirectly acquired the Company's redeemable preferred stock, which was then contributed to the Company's capital. As a result of this transaction, the Company valued its liabilities under the Company's equity-based compensation plans at the transaction price and changed its assumption regarding those plans by assuming all future payments will be settled in cash. It also reflected the settlement of its forward share agreements at the merger price and the sale of 511,031 shares of the Company's common stock to Dexia at the merger price. The net effect of the merger, reflected in the December 31, 2000 financial statements, was to decrease net income by $75.5 million and decrease shareholders' equity by $36.1 million. At December 31, 2002, the only holders of the Company's common stock were Dexia Holdings, Inc., White Mountains Insurance Group, Ltd. and certain current and former directors of the Company who owned shares of the Company's common stock or economic interests in the Company's common stock under the Director Share Purchase Program (see Note 11).
Derivative instruments, which are primarily designated as fair value hedges, are entered into to manage the interest rate exposure of the Company's GICs and GIC bond portfolio and are recorded at fair value. These derivatives generally include interest rate futures and interest rate swap agreements, which are primarily utilized to convert the Company's fixed-rate obligations on its GICs and GIC bond portfolio into floating-rate obligations. The gains and losses relating to these fair value hedges are included in guaranteed investment contract net interest income and net interest expense, as appropriate, along with the offsetting change in fair value of the hedged item attributable to the risk being hedged, on the consolidated statements of operations and comprehensive income. Any ineffective portion of the hedge is recognized in earnings. Gains and losses relating to derivatives that fail hedge effectiveness are marked to market through earnings and included in guaranteed investment contract net interest income and net interest expense, as appropriate.
In addition to insuring CDS agreements, the Company may, from time to time, enter into derivative instruments that have not been designated as hedges for accounting purposes. The Company records these instruments at fair value with a corresponding adjustment to net realized and unrealized gains (losses) on derivative instruments.
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. Recoverability of deferred acquisition costs is determined by considering anticipated losses and loss adjustment expenses.
Non-interest bearing tax and loss bonds are purchased for the tax benefit that results from deducting contingency reserves as provided under Internal Revenue Code Section 832(e). The Company records the purchase of tax and loss bonds as prepayments of federal income taxes and includes them in other assets.
Of the AAA rated bonds included in the investment portfolio, 8.7% were AAA by virtue of insurance provided by FSA.
Of the AAA rated bonds included in the investment portfolio, 9.4% were AAA by virtue of insurance provided by FSA. For purposes of the foregoing, the GIC bond portfolio excludes $523,477,000 of FSA-insured securities issued in connection with refinancing transactions (see Notes 23 and 24).
The amortized cost and estimated market value of the GIC bond portfolio, at December 31, 2002, 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.
The U.S. domiciled insurance subsidiaries file statutory-basis financial statements with state insurance departments in all states in which they are licensed. On January 1, 2001, significant changes to the statutory basis of accounting became effective. The cumulative effect of these changes, known as Codification guidance, was recorded as a direct adjustment to statutory surplus. The effect of adoption, at January 1, 2001, was a $50,293,000 decrease to statutory surplus, which related primarily to the accrual of deferred compensation obligations.
Prior to the Dexia merger, the Company and its Subsidiaries, except FSA International, filed a consolidated federal income tax return. The calculation of each company's tax benefit or liability was controlled by a tax-sharing agreement that based the allocation of such benefit or liability upon a separate return calculation. Dexia Holdings, Inc. and the Company and its Subsidiaries, except FSA International, filed a consolidated federal income tax return for periods subsequent to the merger, under a new tax-sharing agreement.
Federal income taxes have not been provided on substantially all of the undistributed earnings of FSA International, since it is the Company's practice and intent to reinvest such earnings in the operations of this subsidiary. The cumulative amount of such untaxed earnings was $57,063,000, $41,899,000 and $18,629,000 at December 31, 2002, 2001 and 2000, respectively.
The cumulative balance sheet effects of deferred federal tax consequences are as follows (in thousands):
No valuation allowance was necessary at December 31, 2002 or 2001.
The Company was party to forward share agreements with certain counterparties and made the economic benefit and risk of a number of these shares available for subscription by certain of the Company's employees and directors. As part of the merger, the Company settled all of its forward share agreements and corresponding employee and director subscriptions at the merger price. In 2000, the Company recognized compensation expense of $30,324,000 as a result of the settlement.
FSA has a standby line of credit commitment in the amount of $240,000,000 with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $240,000,000 or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $704,553,000 at December 31, 2002. The obligation to repay loans made under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a term expiring on April 30, 2009 and contains an annual renewal provision subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2002.
On November 13, 1998, the Company issued $100,000,000 of 6.950% Senior QUIDS due November 1, 2098 and callable without premium or penalty on or after November 1, 2003. Interest is payable quarterly. Debt issuance costs of $3,375,000 are being amortized over the life of the debt.
The Company and its Subsidiaries maintain both qualified and non-qualified, non-contributory defined contribution pension plans for the benefit of all eligible employees. The Company and its Subsidiaries' contributions are based upon a fixed percentage of employee compensation. Pension expense, which is funded as accrued, amounted to $5,066,000, $3,570,000 and $3,521,000 for the years ended December 31, 2002, 2001 and 2000, respectively.
For obligations under the Company's Deferred Compensation Plan (DCP) and Supplemental Executive Retirement Plan (SERP), the Company generally purchases investments, which should perform similarly to the tracking investments chosen by the participants under the plans. In the fourth quarter of 2000, the Company purchased 304,757 shares of its common stock from Dexia Holdings, Inc. for $24,004,000. This purchase was intended to fund obligations relating to the Company's Director Share Purchase Program (DSPP), which enables its participants to make deemed investments in the Company's common stock under the DCP and SERP. Under the DSPP, the deemed investments in the Company's stock are irrevocable, settlement of the deemed investments must be in stock and, after receipt, the participants must generally hold the stock for at least six months. In 2002 and 2001, $271,000 and $288,000, respectively, of restricted treasury stock was distributed to a director as a deferred equity plan payout.
Rent expense for the years ended December 31, 2002, 2001 and 2000 was $6,207,000, $6,207,000 and $5,067,000, respectively.
The Subsidiaries obtain reinsurance to increase their policy-writing capacity on both an aggregate-risk and a single-risk basis; to meet rating agency, internal and state insurance regulatory limits; to diversify risk; to reduce the need for additional capital; and to strengthen financial ratios. The Subsidiaries reinsure portions of their risks with
affiliated (see Note 15) and unaffiliated reinsurers under quota share, first-loss and excess-of-loss treaties and on a facultative basis.
(1)Excludes $2,430 million and $479 million, in 2002 and 2001, respectively, relating to FSA-insured GICs issued by CMS that are included in FSA's exposures. The consolidated financial statements of the Company reflect the FSA-insured GICs as GIC liabilities instead of as insurance exposure because CMS is consolidated with the Company.
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 of insured municipal securities as of December 31, 2002:
Short-term investments, including the GIC short-term investment portfolio-The carrying amount is fair value, which approximates cost due to the short maturity of these instruments.
GICs-The fair value of a GIC is the present value of the expected cash flows as of the reporting date.
The cumulative amount of discount taken was approximately $44,690,000, $29,578,000 and $28,748,000 at December 31, 2002, 2001 and 2000, respectively.
Certain prior quarter balances have been reclassified to conform to the year-end presentation.
In June 1998, the Company invested $10,000,000 to purchase 1,000,000 shares of common stock, representing a 25% interest, in Fairbanks, which buys, sells and services residential mortgage loans. In October 1999, the Company invested $4,517,000 to purchase 361,333 shares of Fairbanks preferred stock, resulting in the Company owning a 22.2% interest in Fairbanks as of December 31, 1999. In December 2001, the Company invested an additional $14,980,000 in Fairbanks, resulting in the Company owning a 28.36% interest in Fairbanks as of December 31, 2001. In August of 2002, the Company invested an additional $13,391,000 in Fairbanks, resulting in the Company owning a 29.8% interest in Fairbanks as of December 31, 2002. The Company's investment in Fairbanks is accounted for using the equity method of accounting. Amounts recorded by the Company in connection with Fairbanks as of December 31, 2002, 2001 and 2000 were as follows (in thousands):
In November 1998, the Company invested $19,900,000 to purchase a 19.9% interest in XLFA, a financial guaranty insurance subsidiary of XL (see Note 7). In February 1999, the Company sold $4,900,000 of its interest back to XLFA, giving the Company a 15.0% interest in XLFA as of December 31, 1999. In December 2000, the Company invested an additional $24,000,000 to maintain its 15.0% interest. The Company's investment in XLFA is accounted for using the equity method of accounting because the Company has significant influence over XLFA's operations. Amounts recorded by the Company in connection with XLFA as of December 31, 2002, 2001 and 2000 are as follows (in thousands):
At December 31, 2002 and 2001, the Company's retained earnings included $13,206,000 and $10,726,000, respectively, of accumulated undistributed earnings of XLFA.
FSA has also insured a number of CDS agreements that it intends, in each case, to hold for the full term of the agreement. 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 $35,033,000, $15,385,000 and $1,760,000 in net earned premium under these agreements for the years ended December 31, 2002, 2001 and 2000, respectively. The changes in fair value, which were losses of $50.2 million and a gain of $6.7 million for the years ended December 31, 2002 and 2001, respectively, were recorded in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income and in other assets or liabilities. The losses or gains recognized by recording these contracts at fair value will be determined each quarter based upon market pricing of Super Triple-A (defined as having first-loss protection of 1.3 times the level required for a Triple-A rating) swap guarantees. The Company does not believe the fair value adjustments are an indication of potential claims under FSA's guarantees.
Derivative instruments, which are primarily designated as fair-value hedges, are entered into to manage the interest rate exposure of the Company's GICs and GIC bond portfolio and are recorded at fair value. These derivatives generally include interest rate futures and interest rate swap agreements, which are primarily utilized to convert the Company's fixed-rate obligations on its GICs and GIC bond portfolio into floating-rate obligations. The gains and losses relating to these fair-value hedges are included in guaranteed investment contract net interest income and net interest expense, as appropriate, along with the offsetting change in fair value of the hedged item attributable to the risk being hedged, on the consolidated statements of operations and comprehensive income. For the years ended December 31, 2002 and 2001, the Company recorded a net loss of $1,402,000 and a net gain of $161,000, respectively, relating to the ineffectiveness of these hedges. For the years ended December 31, 2002 and 2001, the Company recorded a net gain of $4,266,000 and $0, respectively, relating to failed hedges.
In 2002, FSA exercised certain rights available under its financial guaranty policies and indentures relating to loan-backed notes issued by FMAC Loan Receivables Trust 1998-D and 2000-A (the Trusts). Those rights allowed FSA to accelerate the insured notes and pay claims under its insurance policy on an accelerated basis. Refinancing vehicles reimbursed FSA in whole for its claims payments in exchange for assignments of certain of FSA's rights against the Trusts. The refinancing vehicles obtained their funds from the proceeds of FSA-insured GICs issued in the ordinary course of business by CMS. FSA maintains significant reinsurance, first loss and quota share, on these transactions.
Although the securitized loans are included on FSA's balance sheet, the securitized loans continue to support FSA-insured transactions exclusively, subject to considerable first loss and quota share reinsurance. In accordance with AICPA Practice Bulletin 6, "Amortization of Discounts on Certain Acquired Loans," the Company has recorded the securitized loans at cost, has determined cash flows from the pools of securitized loans, net of reinsurance, and is recording income based upon the constant yield method. The cash flows on the securitized loans will be monitored and the constant yield modified to reflect any change in the cash flow estimates.
As a result of these transactions, the Company recorded $437.5 million of securitized loans and $6.3 million of other income related to those securitized loans during the year ended December 31, 2002.
The inter-segment assets are intercompany loans that are in the financial services investment portfolio. The inter-segment revenues relate to premiums charged by the financial guaranty segment for insuring GICs and interest income and interest expense on the inter-segment loans.