The following table sets forth our selected consolidated financial data for the periods presented. The consolidated statements of operations for the years ended December 31, 2006, 2005 and 2004 and the consolidated balance sheet data as of December 31, 2006 and 2005 are derived from our audited consolidated financial statements and related notes included Part II, Item 8 of this report. The consolidated statements of operations for the years ended December 31, 2003 and 2002 and the consolidated balance sheet data as of December 31, 2004, 2003 and 2002 are derived from our historical audited consolidated financial statements not included in this report. The results of operations for prior accounting periods are not necessarily indicative of the results to be expected for any future accounting periods. You should read this information together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II,
We are a holding company that provides financial guaranty insurance products to participants in the global credit derivatives markets, structured finance capital markets and municipal finance capital markets. We also provide asset management services to specific segments of the structured finance capital markets. We participate in our target markets both as a provider of credit protection through the sale of financial guaranty insurance products, for risk-based revenues, and as an asset manager, for fee-based revenues. We conduct our financial guaranty insurance businesses through ACA Financial Guaranty Corporation, our “A” rated, regulated insurance subsidiary. Approximately 85% of our assets on an unconsolidated basis represent our 100% indirect ownership interest in ACA Financial Guaranty. ACA Financial Guaranty
provides financial guaranty insurance policies for our Public Finance business, for the credit swaps in our Structured Credit business and for certain other transactions described in “Other.” We conduct our asset management business through ACA Management, L.L.C., a wholly-owned indirect subsidiary of ACA Financial Guaranty. Additionally, in January 2007, we obtained a license from the FSA to conduct a European asset management business, which will be done through our wholly-owned indirect subsidiary ACA Capital Management (U.K.) Pte. Limited. As of December 31, 2006, we had credit exposure of $46.3 billion and our assets under management for third parties were $15.7 billion.
Our financial results include three principal operating lines of business: Structured Credit and Public Finance, which are both financial guaranty insurance lines of business, and our CDO Asset Management business. We have a fourth line of business, Other, which encompasses specified insurance transactions in areas in which we are no longer active, including industry loss warranty transactions, trade credit reinsurance and insurance of certain asset-backed securitizations, principally, manufactured housing. Our lines of business constitute segments for accounting purposes.
Through our Structured Credit line of business, we select, structure and sell credit protection, principally in the form of insured credit swaps, against a variety of asset classes in the institutional fixed income markets. At December 31, 2006, Structured Credit also included the consolidated results of the Credit Fund. The Credit Fund was created in 2006 to leverage our expertise in the capital and credit markets and as an asset manager. The fund primarily invests in fixed income securities, particularly in the asset-backed sector.
directly attributable to the generation of insurance premiums and are deferred and recognized over the period in which the related premiums are earned. Typically, public finance premiums are received by us on an up front basis. However, they are recognized into income over the term of the underlying instrument.
In our CDO Asset Management line of business, we focus on CDO origination, structuring and asset management. Our principal revenues in this line of business are investment income, management fees, warehouse income, other credit swap revenue and premiums for credit swaps on insured equity tranches of unfunded synthetic CDOs. Also included is an allocated portion of corporate-wide investment income. The principal direct expenses are interest expense related to the CDO debt issued by us and the amortization of related capitalized debt issuance costs. This line of business also receives an allocated portion of corporate-wide operating expenses, interest expense and depreciation and amortization. Several of our CDOs are consolidated in our financial statements because we have been determined to be the primary beneficiary under FIN 46(R), Consolidation of Variable Interest Entities-an interpretation of ARB No. 51 analyses. See “Results of Operations-CDO Asset Management-Supplementary Information” for a discussion on the accounting issues associated with consolidation.
We believe it is more meaningful to analyze our financial performance on an annual, rather than a quarterly, basis in order to give our lines of business flexibility to select only those opportunities that meet our risk-adjusted return expectations. We believe this maximizes our profitability and allows our lines of business to avoid unfavorable pricing, credit spreads and general market conditions that may occur in any particular quarter. Furthermore, during any given year we enter into a limited number of transactions in each of our lines of business and do not set corporate goals based on closing a specified number of transactions in any particular quarter or year. The transactions in which we participate are often highly negotiated and often take a significant period of time from start to finish, up to one year in Public Finance and up to nine months for a CDO. Accordingly, our financial performance can vary significantly from quarter to quarter and the operating results for any quarter are not indicative of results for any future period.
We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America (GAAP). The following accounting policies and estimates are viewed by us to be critical because they require significant judgment on our part. Financial results could be materially different if alternate methodologies were used or if we modified our assumptions.
In connection with its review of certain accounting standards for financial guaranty insurance contracts, the FASB is considering potential changes relating to premium revenue recognition. See “-FASB Financial Guaranty Insurance Project” for further explanation of potential changes.
Net Insured Credit Swap Revenue-ACA Financial Guaranty insures the obligations of ACA’s affiliated special purpose entities under insured credit swaps, pursuant to which we sell credit protection. The related insured credit swap premiums are included in net insured credit swap revenue and are generally received in quarterly fixed payments over the life of the related swaps. Obtaining the fair value (as such term is defined in FAS 133) for such instruments requires the use of management judgment. These instruments are valued using pricing models based on the net present value of expected future cash flows and observed prices for other transactions bearing similar risk characteristics. The fair value of these instruments is included in derivative assets or derivative liabilities. We do not believe that our insured credit swaps meet the scope exception of FAS 133, paragraph 10d, as amended by FAS 149, because there is no contractual requirement that the protection purchaser be exposed to the underlying risk.
Net insured credit swap revenue includes insured credit swap premiums received and realized and unrealized gains and losses on such credit swaps.
Policy Acquisition Costs. Policy acquisition costs include those expenses that relate primarily to and vary with premium production. Such costs are comprised primarily of premium taxes, personnel and personnel related expenses of individuals involved in underwriting, and certain rating-agency and legal fees for municipal and non-derivative structured finance business. Anticipated claims and claim adjustment expenses are considered in determining the recoverability of acquisition costs. Net acquisition costs are deferred and amortized over the period in which the related premiums are earned. In connection with its review of certain accounting standards for financial guaranty insurance contracts, the FASB is considering potential changes relating to deferred policy acquisition costs. See “-FASB Financial Guaranty Insurance Project” for further explanation of potential changes.
The financial guaranty insurance policies we issue insure scheduled payments of principal and interest due on various types of financial obligations against a payment default on such payments by the issuers of the obligations. Active surveillance of our insured portfolio tracks the performance of insured obligations from period to period. We establish loss and loss adjustment expenses, or LAE, reserves based on surveillance group reports, the latest available industry data, and analysis of historical default and recovery experience for the relevant sectors of the fixed-income market. Together the case reserves and non-specific reserves represent management’s estimate of incurred losses on our non-derivative insured portfolio exposures.
Case specific reserves are reserves created on those obligations identified as currently or likely to be in default, and represent the present value, discounted at the U.S. Treasury Note rate applicable to the term of the underlying insured obligations, of the expected LAE payments, net of estimated recoveries (under salvage, subrogation or other recovery rights). Gross case-specific reserves, net of estimated recoveries, were $20.2 million and $17.7 million as of December 31, 2006 and 2005, respectively. We take into account a number of variables that depend primarily on the nature of the underlying insured obligation when we establish case specific reserves for individual policies. These variables include the nature and creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured and the expected recovery rates on the insured obligation, the projected cash flow or market value of any assets that support the insured obligation and the historical and projected loss rates on such assets. The state of the economy, rates of inflation and the salvage values of specific collateral, among other factors, may affect the actual ultimate realized losses for any policy. Currently, we do not believe that changes to these factors would materially change the amount of our case specific loss reserves, with the exception of significant changes in salvage values of specific collateral. However, case specific reserves are regularly reviewed in order to incorporate relevant current facts and circumstances and changes to these factors may in the future materially change the amount of our case specific loss reserves.
Our non-specific reserve was derived from the calculation of expected loss, which we estimate using a Monte Carlo simulation. A Monte Carlo simulation is a technique that is commonly used to estimate the probability of certain mathematical outcomes. It randomly selects values to create scenarios of outcomes and this random selection process is repeated many times to create multiple scenarios. Each time a value is randomly selected, it forms one possible scenario and outcome. Together, these scenarios give a range of possible outcomes, some of which are more probable and some less probable. By definition, the average
solution will give the most likely potential outcome. Our risk management team typically runs at least 100,000 trials in order to determine future expected losses. The model uses the current ratings and default frequency (net of recovery) applied to each transaction with outstanding exposure to determine the expected probability distribution of loss. Default frequency and recovery amounts are published periodically by each of the major rating agencies. From the model output, we can estimate a range of expected loss. The amount of non-specific reserve recorded in the financial statements is based on the loss ratio resulting from the calculation of total losses, including past incurred losses and expected future losses divided by premium. For this purpose, premium is defined as ever-to-date written premium as of December 31, 2006 plus future installment premium on closed transactions. This derived loss ratio is applied to total ever-to-date earned premiums as of December 31, 2006. Case specific reserves are subtracted from this amount to arrive at net non-specific reserves. The table below shows our case and non-specific reserves as of December 31, 2006 and 2005.
FASB Financial Guaranty Insurance Project. In January and February 2005, the SEC staff discussed with several financial guaranty industry participants the difference in loss reserve recognition practices in the industry. In June 2005, at the request of the SEC, the FASB added a project to their agenda to review and codify accounting standards for financial guaranty insurance contracts as they relate to loss reserving policies and later added a review of accounting policies in the financial guaranty insurance industry as they relate to premium recognition and deferred policy acquisition costs. Proposed guidance is expected to be released in the first half of 2007 with the final guidance expected to be issued later in the year. When the FASB issues final guidance, the financial guaranty insurance industry, including us, may have to change certain aspects of its relevant accounting policies. Until a final standard is released, we cannot predict how the FASB will resolve this issue and the resulting impact on our financial statements. Further, until the issue is resolved, the Company will continue to apply the accounting policies as disclosed in its audited financials statements as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004.
The following describes our consolidated financial results for the years ended December 31, 2006, 2005 and 2004 and our financial condition as of December 31, 2006 and 2005. In order to understand our consolidated financial results, we perform a detailed segment by segment analysis for our lines of business and therefore, to augment the segments discussion, the following consolidated discussion has been prepared to describe (1) revenue and expense items that are allocated to our four lines of business and (2) the results of our lines of business: Structured Credit, Public Finance, CDO Asset Management and Other.
Other. Other represented an immaterial portion of our net income in 2006 and 2005. We recognized large insured losses in 2004 in connection with certain transactions in businesses in which we are no longer active. Specifically, we incurred $20.3 million in losses on manufactured housing securitizations and $21.0 million on industry loss warranty contracts.
Within our statement of operations, we have income and expense items that are directly attributable to our lines of business and items that are indirectly attributable. Examples of items that are directly attributable to lines of business are gross premiums written, premiums earned, insured credit swap revenue, net realized and unrealized gains, losses on derivatives, losses and loss adjustment expenses and amortization and depreciation related to the consolidation of our CDOs. Certain operating expenses, including those related to personnel and other expenses dedicated to a line of business are allocated to that line of business. Remaining expenses are allocated to lines of business based on time and expense studies conducted annually. Due to its run-off status beginning in 2004, other operating expenses are not allocated to our Other line of business. Items allocated to lines of business include net investment income on the investment portfolio of ACA Financial Guaranty, net realized gains and losses on that portfolio, operating expenses, interest expense related to our corporate debt, depreciation and amortization and income taxes. The net investment income and net realized gains and losses on investments related to our CDO Asset Management and the Credit Fund are considered direct revenues. The following table summarizes the principal items in our consolidated statement of operations that are allocated for purposes of line of business reporting for the years ended December 31, 2006, 2005 and 2004. All other revenue and expense items included in the consolidated statement of operations are directly attributable to a specific line of business.
Income taxes. Income taxes are generally allocated to line of business based upon the overall corporate effective tax rate applied to pre-tax income. The increase in income taxes over the three-year period is a direct result of our increased profitability.
transactions with respect to this line of business have been recently conducted in the form of insured credit swaps. No new traditional insurance contracts were written in 2006 for this line of business and the decline relates to the expiration of contracts that were written in previous years. Our recent trend towards insured credit swap transactions is also evidenced in the 2005 to 2004 comparison of gross premiums written, whereby gross premiums written declined to $2.6 million in 2005 from $4.7 million in 2004.
Premiums Earned. The change in premiums earned over the three-year period was directly related to the change in gross premiums written described above.
The following table shows the components of net insured credit swap revenue for 2006, 2005 and 2004:
Net Investment Income. Net investment income was $8.7 million in 2006 compared to $0.8 million in 2005 and $0.5 million in 2004. Of the total net investment income of $8.7 million in 2006, $5.7 million related to the Credit Fund and $3.0 million related to allocated investment income. In 2005 and 2004, allocated investment income was $0.8 million and $0.5 million, respectively. Allocated investment income increased in 2006 due to growth within the overall ACA Financial Guaranty investment portfolio described in “-Results of Operations-Summary of Consolidated Results” above and due to an increase in the allocation percentage that we assigned to this line of business. The allocation increased in 2006 given the volume of business transacted. The following table shows the components of net investment income for 2006, 2005 and 2004:
Credit Fund in 2006 was $3.7 million. Allocated interest expense totaled $0.4 million in 2006, $0.1 million in 2005 and $0.1 million in 2004.
(Income) Loss of Minority Interest. (Income) loss of minority interest is related to our investment in the Credit Fund. While we consolidated the fund in 2006, we are not the sole equity investor in the fund. (Income) related to the portion of the Credit Fund not owned by us in 2006 was $(0.3) million.
The following table summarizes the operations of our Public Finance line of business for the years ended December 31, 2006, 2005 and 2004:
Premiums Earned. Premiums earned were $26.2 million in 2006, $23.9 million in 2005 and $13.9 million in 2004. Premiums earned from refundings were $9.4 million in 2006, $6.6 million in 2005 and $1.8
million in 2004. Essentially, premiums earned before refundings was flat when comparing 2006 to 2005 at approximately $17 million. The increase in premiums earned excluding refundings in 2005 compared to 2004 was due to the increase in recognition of premiums earned in respect of premiums written in 2004.
Net Insured Credit Swap Revenue. Net insured credit swap revenue was $0.5 million in 2006 and $13 thousand in 2005. We closed two transactions in the Public Finance line of business that were in the form of insured credit swaps, one in 2006 and the other in 2005. Because these transactions are in the form of insured credit swaps, they are marked to market. The unrealized gain or loss resulting from the fair valuation of these transactions is included in net insured credit swap revenue. An unrealized loss of $0.6 million was included in insured credit swap revenue in 2006. In 2005, the valuation was estimated at $0. We had no credit swaps in 2004.
Net Investment Income. Net investment income totaled $16.2 million in 2006, $13.9 million in 2005 and $8.8 million in 2004. The entire amount of net investment income for the Public Finance line of business is derived from the allocation of investment income from ACA Financial Guaranty’s investment portfolio. The increases in investment income are related to the growth in the ACA Financial Guaranty investment portfolio.
Other Income. In 2004, we recognized other income of approximately $3.7 million in connection with the one-time termination of our soft capital facility.
Provision for Loss and Loss Adjustment Expenses. The provision for loss and loss adjustment expenses was $6.5 million in 2006, $7.5 million in 2005 and $4.3 million in 2004. This provision includes amounts for case specific and loss adjustment expenses as well as non-specific reserves. The following table shows the components of the provision for loss and loss adjustment expenses for 2006, 2005 and 2004:
Net Policy Acquisition Costs. Net policy acquisition costs totaled $8.2 million in 2006, $7.0 million in 2005 and $2.2 million in 2004. Generally, such costs vary in accordance with the changes in premiums earned during each period. The increases from 2004 to 2005 and 2005 to 2006 were consistent with the increases in Public Finance premiums earned and the amortization of deferred expenses.
Interest Expense. Interest expense was $1.7 million in 2006, $1.7 million in 2005 and $1.0 million in 2004. Interest expense results from the allocated interest cost associated with corporate debt at our holding company.
Net Realized and Unrealized Gains (Losses) on Investments. Net realized gains (losses) are derived from our consolidated CDOs as well as allocated amounts. There are no unrealized gains or losses on investments for this line of business. The following table shows the components of net realized gains (losses) for 2006, 2005 and 2004.
Net realized gains (losses) from CDOs include losses from other than temporary impairments, or OTTI, in the amounts of $3.0 million in 2006, $1.9 million in 2005 and $6.9 million in 2004. OTTI is recognized when the fair value of investments in fixed maturity securities is reported below amortized cost for stated periods of time. In the case of asset-backed securities, of which the vast majority of our CDO portfolio is comprised, the market value decline is also coupled with a decline in future expected cash flows. OTTI write-downs in the three-year period were associated with certain mortgage-backed securities which experienced declines in value and projected cash flows.
Other Net Credit Swap Revenue. Other net credit swap revenue was $10.1 million in 2006, $4.2 million in 2005 and $11.0 million in 2004. As set forth in the table below, other net credit swap revenue is the sum of credit swap fees earned, net realized gains (losses) which may result from time to time result from any termination of such transactions and any credit events and unrealized gains (losses) resulting from the changes in fair value of these transactions. The vast majority of this revenue was credit swap fees from a partially funded consolidated synthetic CDO, in which the underlying instruments are credit swaps sold by the CDO to third parties. Also included as revenue in 2006 is an amount of $3.1 million of distributions to us as equity holder of two synthetic CDOs. In 2005, such distributions amounted to $1.4 million. No such distributions were received in 2004. The following table shows the components of other net credit swap revenue for 2006, 2005 and 2004:
In 2005, we incurred a realized loss in the amount of $3.3 million. This realized loss was in connection with a single credit swap included in our partially funded CDS CDO. Net unrealized losses related to changes in value were recorded in 2006 and 2005, while valuation or unrealized gains were recorded in 2004. These unrealized gains and losses were related to the then credit spread environment.
We have exposure to certain classes of residential mortgaged backed securities, or RMBS, through equity we own in our CDOs. In particular, we have equity exposure of $55.7 million to RMBS backed by subprime mortgages originated in 2006 in four of our mezzanine asset-backed CDOs that invest in RMBS rated below A-/A3. In December 2006, we made the decision to purchase credit protection in the form of two credit swaps referencing representative market indices to moderate impairments in that 2006 vintage subprime residential mortgage exposure. We did this in light of the recent negative developments that we have noted in this asset class. Specifically, the relaxed underwriting standards of certain sub-prime originators in 2006 have led to significantly higher early stage delinquencies. Market participants have speculated that these RMBS may ultimately represent the worst performing sub-prime bonds on record to date. While we have no current impairments in the 2006 vintage sub-prime bonds contained in the CDOs in which we have equity exposure, in light of the uncertainty in the market around this vintage of RMBS, we determined it prudent to purchase the credit swaps. The aggregate notional amount of credit protection purchased was $37 million. The annual expense for the protection will be approximately $0.9 million for future years, recorded in other net credit swap revenue. Additionally, we have equity exposure of $35.5 million to two CDOs which invest in RMBS rated at or above A-/A3.
established in connection with the expansion of our asset management business in Europe. Other operating expenses were relatively flat between 2005 and 2004.
All outstanding debt pays interest based on a floating rate above one or three month LIBOR. The increase in interest expense was primarily related to the rise in LIBOR over the three year period. No new debt was issued in 2006. Interest expense was $212.1 million in 2005 compared with $99.9 million in 2004, an increase of $112.2 million. This increase was a result of the full year effect of payments on consolidated CDO liabilities added in the fourth quarter of 2004 and the impact of rising short-term interest rates over the course of 2005. Interest expense also included interest expense on debt incurred to finance our CDO equity investments. We had $116.2 million of debt related to the financing of CDO equity and the allocation of interest payments in 2005 on debt issued to four trust preferred vehicles, and in 2004 on three of these trust preferred vehicles.
Depreciation and Amortization. Depreciation and amortization totaled $7.9 million in 2006, $7.7 million in 2005 and $6.2 million in 2004. Depreciation and amortization is comprised of the recognition of costs deferred in connection with our consolidated CDOs as well as allocated amounts. Depreciation and amortization related to consolidated CDOs totaled $7.3 million in 2006, $7.0 million in 2005 and $5.1 million in 2004. The increase in depreciation and amortization expenses for 2005 compared with 2004 was primarily the result of the full year of expense amortization related to the capitalized debt issuance costs of two consolidated CDOs closed in 2004.
(Income) Loss from Minority Interest. (Income) from minority interest totaled $(3.8) million in 2006, $(3.7) million in 2005 and $0.5 million in 2004. (Income) loss from minority income results from the fact that we consolidate two CDOs in which we own less than 100% of the equity. Minority interest reflected in the statement of operations represents the share of the (income) or loss of the CDO that represents the third party equity ownership. In 2006 and 2005, the two CDOs recognized net income and as a result we recorded minority interest (income) to reduce our net income. Conversely, in 2004, on a net basis, the two CDOs recorded a loss due to the termination of their associated warehouse facilities at a time when the valuation of the assets were less than the acquisition costs of such assets. As a result, we recorded minority interest loss in 2004 which increased our net income.
Consolidation of VIEs. From an accounting perspective, funded and partially funded CDOs are deemed to be issued out of Variable Interest Entities (VIEs). As such, each time a CDO is formed through the issuance of debt instruments to third parties and the purchase of investment assets, we perform an
analysis to determine whether we are the primary beneficiary and thus required to consolidate the CDO under the provisions of FIN 46(R). Prior to 2005, we retained all or most of the equity position in our CDOs, and these CDOs are therefore consolidated in our financial statements (a total of seven CDOs are consolidated). Although these VIEs are consolidated, we do not have the right to use the assets of the VIEs for general operations and the debt liabilities of the VIEs are without recourse to any assets other than those of the VIEs. Our investment exposure to our CDOs is therefore limited to our retained equity, which is the first loss position of the CDO. In the transactions in which we own less than 100% of the CDO VIE’s equity, but are deemed to be the primary beneficiary and thus consolidate the CDO VIE, we establish minority interests for the portion not owned. Total non-recourse debt of the CDOs included on our balance sheet at December 31, 2006 and 2005 were $4.7 billion and $4.8 billion, respectively. Fixed maturity securities, a guaranteed investment contract and cash related to consolidated CDOs included on our balance sheet at December 31, 2006 and 2005 were $5.0 billion and $5.1 billion, respectively.
Beginning in 2005, we have retained a lesser share of the equity position of our newly issued CDOs. Based on our analysis of FIN 46(R) we are not deemed to be the primary beneficiary and, as a result, these CDOs are not consolidated in our financial statements. Rather, our non-majority investment is recorded as an investment in a single fixed maturity security under the provisions of FAS 115 and EITF 99-20. During 2005 and 2006, we closed thirteen CDOs and purchased equity interests in eight. The fair value of our total investment in unconsolidated CDOs at December 31, 2006 was $23.8 million, not including synthetic CDOs in which we take derivative exposure but make no investment. We do not anticipate consolidating new CDOs in the future given our intention to buy minority portions.
CDOs can be issued in funded, unfunded or partially funded form. Funded CDOs issue debt instruments and purchase investment assets, while unfunded CDOs synthetically acquire assets and issue liabilities synthetically (i.e., assets and liabilities are in derivative form). Partially funded CDOs are a combination of these two forms. From an accounting perspective, funded and partially funded CDOs are deemed issued out of VIEs.
(2) Cash flow CDOs are generally callable once per quarter by a majority or greater vote of the equity holders on a specific date as negotiated, which is referred to as the First Optional Call Date.
(4) Tribune is comprised of 13 distinct trades some of which are denominated in Euros or Yen. For purposes of this chart, we have converted this amount to U.S. dollars at the prevailing currency exchange rates on December 31, 2006.
Accounting for a Consolidated CDO as Compared to an Unconsolidated CDO. When we consolidate a typical funded CDO, for accounting purposes, the CDO issuing vehicle is treated essentially as our wholly owned operating subsidiary. “Funded” means that at the CDO’s closing, it issues liabilities in the form of debt and equity and the assets are purchased out of a warehouse facility with the proceeds from the issuance. The following shows the balance sheet impact of consolidating a hypothetical $400 million asset-backed CDO at the closing date, assuming we purchase the entire equity position of $20 million for cash:
The presentation above would be proper from a U.S. GAAP reporting perspective. When management considers the financial performance of the CDO in relation to the economic benefit to the Company, management considers the income that the CDO generates in the following two component parts:
Management evaluates the revenue generation of our CDO Asset Management line of business on an unconsolidated basis as an alternative measure since management believes it is important to evaluate the revenue associated with each aspect of the business that relates to our investment or our contractual rights to payment and exclude those revenues that relate to other investors’ economic rights.
The table below sets forth the economic impact of our CDOs assuming all CDOs were unconsolidated for 2006, 2005 and 2004. Investors should neither place undue reliance on this presentation nor use it as a substitute for our segment financial statements which are prepared in accordance with U.S. GAAP. This presentation should be utilized only as a supplemental measure of financial performance in evaluating our CDO Asset Management line of business.
(2) Represents fees received during or at the end of the warehouse, or asset accumulation, phase of the CDO.
(4) Represents the sum of net unrealized gains and losses included in net insured credit swap revenue, net realized and unrealized gains (losses) on derivative instruments and other net credit swap revenue. This adjustment (subtracts) adds back mark to market gains (losses) on derivatives and realized gains (losses) on warehouse facilities because they represent non-cash adjustments that are expected to reverse themselves over time as the related contracts mature or expire.
expenses equal total segment expense less allocated amounts. Direct CDO expenses were $2.1 million in 2006, $2.7 million in 2005 and $2.1 million in 2004. When we consider the results related to our managed CDOs, allocated expenses are excluded and must be added back in order to reconcile to segment based income before taxes.
(5b) Represents a portion of our corporate debt interest expense allocated to this line of business. This allocated interest expense, combined with CDO debt-operating and CDO debt-non-recourse, equals total segment interest expense.
(5d) Represents a portion of our corporate realized (losses) gains allocated to this line of business. Direct realized losses including impairments were $2.8 million in 2006, $1.8 million in 2005 and $6.4 million in 2004. These direct realized losses are included above as a reduction of our equity return.
(6) Represents interest expense incurred in connection with the financing of our equity purchases. We view these costs as indirect costs of our CDO Asset Management business and exclude them when we consider direct results of this line of business. Therefore, management subtracts them to arrive at segment income before taxes.
The impact of a CDO on our financial statements depends on the structure of the CDO (fully funded, partially funded or unfunded), whether or not the CDO is consolidated and the nature of the underlying assets and liabilities.
Fully funded CDOs contain investments in interest bearing financial assets such as fixed maturity securities or guaranteed investment contracts. We have six fully funded consolidated CDOs and one partially funded consolidated CDO. The assets and liabilities of these CDOs are included on our balance sheets. The income generated by the investments is reflected in net investment income in the consolidated statements of operations. The debt liabilities issued in the form of notes pay interest that is included in interest expense in the consolidated statements of operations. A management fee is paid by the CDO to ACA Management but is eliminated in consolidation. Our return on our equity investment is the net of the CDO’s revenues (interest income) and expenses, including the management fee paid to ACA Management.
Partially funded synthetic, or CDS, CDOs sell credit protection on referenced assets by entering into credit swaps with various protection buyers in the market. The CDO also issues securities, both liabilities and equity, in order to use the proceeds from the sale of these securities to collateralize the CDO’s obligations under its credit swaps, except with respect to the most senior tranche of the CDO’s credit exposure, in connection with which a partially funded CDO typically purchases credit protection rather than issuing funded liability securities. The proceeds of the securities issued by the partially funded CDO are invested in a guaranteed investment contract, or GIC. We consolidate one partially funded CDS CDO. From this consolidated CDO, we consolidate investment income, relating to the return on the GIC, and interest expense in connection with the liability securities issued by the CDO. We also consolidate derivative income relating to net revenues from the fixed fees payable to the CDO under the terms of the credit swaps pursuant to which the CDS CDO sold credit protection on referenced assets and the fixed
We originated a fully synthetic, or unfunded, CDS CDO in each of 2002 and 2003. In these transactions, we act as asset manager, and, through ACA Financial Guaranty, insure the equity or first loss position of the CDO. No variable interest entities, or VIEs, exist in these structures; rather, the sponsoring investment bank acts as the counterparty to the various credit swaps that constitute the assets and liabilities of the synthetic CDO. CDOs that do not use VIEs are not subject to consolidation under FIN 46(R). For our various roles in the unfunded CDS CDOs, we receive structuring fees, management fees, premium and residual equity returns. On our consolidated statements of operations, these revenues are reflected as fee income, net insured credit swap revenue and other net credit swap revenue. Net insured credit swap revenue also includes the changes in fair value of the related credit swaps. Our combined equity position in our two unfunded CDS CDOs, which is the aggregate notional balance of our credit swaps insuring the equity tranches of these two CDOs, was $47.5 million at December 31, 2006 and 2005.
In certain funded CDOs, we issued liabilities in the form of notes in order to fund our equity purchases. These borrowings were accomplished through the issuance of non-recourse notes by our subsidiaries. These notes are insured as to the repayment of principal and interest by ACA Financial Guaranty. The premium on the policy insuring the notes payable to ACA Financial Guaranty is payable by our subsidiary that invested in the preferred shares. These subsidiaries and ACA Financial Guaranty are wholly owned by us and therefore this inter-company premium eliminates in consolidation.
In structuring our CDOs, we collaborate with sponsoring investment banks to develop the type of CDO, either fully funded, partially funded or unfunded, to meet the demand of market participants. At any given time, different types of CDOs may be attractive to different potential investors. Whether a CDO is consolidated is a function of the amount of our equity position in the CDO and the related accounting rules. See “-CDO Asset Management-Supplementary Information-Consolidation of VIEs.” Whether or not a CDO will be consolidated onto our financial statements is not a factor that we consider in determining the types of CDOs that we agree to manage.
Total Revenues. Total revenues primarily comprised of net premiums earned and net investment income, continue to decline for this line of business due to the fact that it has been in run-off since 2005. Premiums earned declined to $1.7 million in 2006 from $6.9 million in 2005 and $9.7 million in 2004. Our exposure in the trade credit business, a component of this line of business, continues to rapidly decline. Premiums earned for trade credit were $1.1 million in 2006, $4.3 million in 2005 and $2.4 million in 2004. Premiums earned for the other insurance contracts accounted for in this line of business also continue to decline. Our exposure to industry loss warranty contracts, a major component of premiums written and earned in 2004, had completely run-off in the first half of 2005. No revenue related to these contracts was received in 2006. We still continue to receive a small amount of installment premium for in-force asset-backed securitizations, principally manufactured housing, that were insured several years ago.
No loss activity has been recorded for industry warranty loss contracts since 2004, when losses incurred were $21.0 million. We no longer have exposure to these contracts.
In managing our business and assessing growth and profitability from a strategic and financial planning perspective, our management and Board of Directors consider U.S. GAAP net income results as well as a measurement called net economic income. We believe that net economic income enhances the understanding of our results of operations by highlighting income attributable to our ongoing operating performance. However, net economic income is not a measurement of financial performance or liquidity under U.S. GAAP. It should not be considered in isolation or as a substitute for net income, cash flows from operating, investing or financing activities, or any other measure calculated in accordance with U.S. GAAP.
We define net economic income as net income excluding the after-tax effects of:
We had after-tax unrealized gains (losses) of $2.9 million in 2006, $(3.7) million in 2005 and $4.0 million in 2004 on our insured credit swaps included in net insured credit swap revenue. We had after-tax unrealized gains of $5.0 million in 2006, $5.2 million in 2005 and $5.3 million in 2004 on our derivatives included in net realized and unrealized gains (losses) on derivative instruments. We had unrealized gains (losses) of $(0.1) million in 2006, $(0.8) million in 2005 and $1.4 million in 2004 on our credit swaps included in other net credit swap revenue. We had realized gains (losses) of $(0.7) million in 2006, $(0.6) million in 2005 and $(0.1) million in 2004 on our non-CDO investments. Lastly, we had after-tax expenses of $3.8 million in 2006, $4.3 million in 2005 and $4.3 million in 2004, which effectively constituted principal payments on our interest rate swaps.
As discussed above, one source of our liquidity, for the next 12 months and for the longer term, will be amounts paid by our operating subsidiaries as dividends to us. ACA Financial Guaranty is our principal subsidiary through which we operate all our lines of business. ACA Financial Guaranty is subject to restrictions under state insurance law on its ability to pay dividends. In May 2005, the Maryland Insurance Commissioner approved ACA Financial Guaranty’s request to pay a dividend in an amount equal to the interest payments on $40 million of the $80 million of our trust preferred issuance outstanding through the year ended December 31, 2005. In addition, the Maryland Insurance Commissioner approved ACA Financial Guaranty’s issuance of a $10 million surplus note to us. Accordingly, during 2005 ACA Financial Guaranty paid dividends of $2.1 million for the ultimate benefit of its parent, ACA Capital, and $0.5 million in interest on the surplus note. In December 2005, ACA Financial Guaranty received approval from the Maryland Insurance Commissioner to make dividend payments to ACA Capital in an amount equal to the interest due in 2006 on $40 million of trust preferred debt, the proceeds of which were initially contributed by ACA Capital into ACA Financial Guaranty. The Maryland Insurance Commissioner also approved interest payments by ACA Financial Guaranty on the $10 million surplus note due in the 2006 fiscal year. Approval of the Maryland Insurance Commissioner to make dividend and surplus note interest payments due in 2007 on the $40 million of trust preferred securities and the $10 million surplus note, respectively was received by us in December 2006. We have not received dividends from our operating subsidiaries other than ACA Financial Guaranty.
below a pre-agreed point, we are generally required to post collateral in an amount that is the lesser of the amount by which actual losses exceed this pre-agreed point and the amount of any negative mark to market value of the insured credit swap. If any of these events occurred, it could materially hurt our financial performance and liquidity and severely strain our capital resources. See “Part II,
ACA was originally incorporated in Delaware on January 3, 1997. On November 22, 2002, ACA changed its jurisdiction of incorporation from Delaware to Bermuda. During 2004, the Board of Directors determined that re-domesticating to Delaware would eliminate certain adverse consequences of remaining in Bermuda, facilitate ACA’s access to U.S. capital markets, simplify its tax filings, accounting and operations, and reduce the costs of compliance with two sets of filing obligations and laws (as ACA stockholders are U.S. entities and individuals). On September 15, 2004, therefore, ACA re-domesticated from Bermuda to Delaware through a process called a “discontinuation” under Bermuda law and “domestication” under Delaware law. As a result, it became a Delaware domiciled holding company and changed its name from American Capital Access Holdings, Ltd. to its current name.
Basis of Presentation-These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP. The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
The Company consolidates a VIE whose primary investment is a guaranteed investment contract (“GIC”). In the absence of readily ascertainable market value, GIC contracts are stated at fair value as determined by management. Management considers the GIC’s fair value to approximate contract value, as the interest rate is variable at LIBOR less 0.02% and resets on an annual basis. If, in the opinion of management, there were an impairment of value based on their credit risk assessment, such impairment
Other than Temporary Declines in Investments-The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These factors include (i) the duration of a significant decline in value, (ii) the liquidity, business prospects and overall financial condition of the issuer, (iii) the magnitude of the decline, (iv) the collateral structure and other credit support, as applicable, (v) the Company’s intent and ability to hold the investment until the values recover, and (vi) for asset backed securities, the estimated cash flows. When the analysis of the above factors results in a conclusion that a decline in fair values is other than temporary, the cost of the security is written down to fair value as of the reporting date and any previously unrealized loss is realized in the period such a determination is made (see Note 6).
Within the consolidated statements of operations, derivative contracts comprising insured credit swaps are reported as net insured credit swap revenue. Credit swaps issued out of consolidated CDOs or that are not insured by ACA Financial Guaranty are reported as other net credit swap revenue. Interest rate swaps and caps, entirely related to the CDO Asset Management segment, are reported as net realized and unrealized gains (losses) on derivative instruments.
The Company uses interest rate swaps to hedge the exposure to variable interest rates within the CDOs it structures and manages. To the extent cash flow hedges are properly designated and are highly effective, gains and losses on interest rate swaps are reported in accumulated other comprehensive income in stockholders’ equity, until earnings are affected by the variability in cash flows of the designated hedged item. Hedge effectiveness is assessed quarterly using the Volatility Reduction Measure, an accepted methodology for such analyses. Effective July 1, 2005, the Company met the documentation standards of FAS 133 to qualify these swaps as cash flow hedges for accounting purposes on a prospective basis. Based
Furniture and Equipment-Furniture and equipment are recorded at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from three to five years. Furniture and equipment held under capital leases and leasehold improvements are amortized over the shorter of the estimated lives of the assets or the related lease term. These items are reported in Other assets on the Company’s consolidated balance sheets.
Capitalization of Software-The Company accounts for the capitalization of certain internally developed software costs in accordance with Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” (“SOP 98-1”). These costs are amortized over their estimated useful life, which is five years, commencing upon the determination of the software being ready for its intended use.
Premiums Earned-Premiums on financial guaranty insurance products in the form of traditional insurance policies are typically received on an up front basis, although certain policies pay premium in periodic installments. The vast majority of the Company’s Public Finance business is conducted by the issuance of traditional policies. Traditional policies are those that meet the scope exception of the guidance of FAS 133, “Accounting for Derivative Instruments and Certain Hedging Activities,” paragraph 10d, as amended by FAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“FAS 149”). The scope exception provides that financial guaranty contracts are not subject to FAS 133, if they meet certain specified criteria. In general, premiums from insured municipal obligations are received on an up front basis. Installment premiums are earned over each installment period, which is generally one year or less. Up front premiums are earned in proportion to the expiration of risk, which is par. Premium is allocated to each par maturity (e.g., principal payment) included in an insured bond and earned on a straight-line basis for the period the related par is outstanding. Unearned premiums represent that portion of premiums which 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 unearned premiums, less any amount credited to a refunding issue insured by the Company, are recognized as earned premium. The amounts earned from refundings were approximately $9.4 million, $6.6 million and $1.8 million, in 2006, 2005 and 2004, respectively.
Net Insured Credit Swap Revenue-The Company’s net insured credit swap revenue is comprised of credit swap transactions in which the Company provides credit protection through the use of credit swaps that are insured by ACA Financial Guaranty. Net insured credit swap revenue includes insured credit swap premiums earned and realized and unrealized gains and losses on those credit swaps. Insured credit swap premiums are earned over the life of the transaction. Realized gains and losses occur due to the occurrence of termination events or credit events requiring payment to or by the Company under the credit swap. Unrealized gains and losses represent the changes in fair value of the instruments that are required to be recorded under FAS 133. Obtaining the fair value (as such term is defined in FAS 133) for such instruments requires the use of management judgment. These instruments are valued using pricing models based on the net present value of expected future cash flows and observed prices for other transactions bearing similar risk characteristics. The fair value of these instruments is included in derivative assets or derivative liabilities. The Company does not believe that its insured credit swaps meet the scope exception of FAS 133 paragraph 10d, as amended by FAS 149, because there is no contractual requirement that the protection purchaser be exposed to the underlying risk.
Other Net Credit Swap Revenue-Revenues from credit swap fees from CDS of a consolidated CDS CDO and other credit derivative fees are earned over the life of the underlying transactions and recognized in other net credit swap revenue. Other net credit swap revenue also includes related net realized gains and losses as well as net unrealized gains and losses resulting from the changes in fair value associated with these CDS (see Note 4).
Fee Income-The Company receives fees in connection with each of its businesses, although the vast majority comes from its CDO Asset Management business. As part of the CDO Asset Management business, the Company is paid management and structuring fees as well as warehouse income. Management fees represent remuneration for the Company’s role as asset manager of the CDO collateral and are typically received and earned on a quarterly basis. Structuring fees are payments for the Company’s role in structuring a CDO prior to its close. Structuring fees are typically contingent on the closing of the CDO and as such are earned upon the transaction close. Warehouse income represents remuneration for the selection and management of CDO collateral prior to a transaction closing. Warehouse income is earned over the life of the particular warehousing period.
With respect to its Public Finance business, the Company also collects fees in connection with waivers and consents granted to bond obligors as well as reimbursement of certain costs incurred with insuring municipal secondary-market transactions, primarily rating agency costs. These fees are recognized by the Company as fee income, while the associated costs are recognized as other operating expenses, when the transaction has been closed.
Losses and Loss Adjustment Expenses-Financial guaranty loss and loss adjustment expense reserves are established on the Company’s non-derivative exposure in an amount equal to the Company’s estimate of identified or case-specific reserves and non-specific reserves, including cost of settlement, on the obligations ACA Financial Guaranty has incurred. In determining its accounting policy for loss reserves, the Company relies primarily on FAS 60, “Accounting and Reporting by Insurance Enterprises” (“FAS 60”). However, FAS 60 was created when the financial guaranty industry was just beginning. As a result, FAS 60 did not contemplate the specific attributes of financial guaranty insurance as distinct from other forms of insurance. In particular, financial guaranty insurance is considered a short-duration insurance product, however, it has features that are more akin to long-duration contracts in that the term of some insured obligations can be as long as 30 years or more and the contracts are generally irrevocable. Under FAS 60, accounting for losses differs for short-duration and long-duration contracts. Because of this inconsistency, the Company also applies FAS 5, “Accounting for Contingencies” (“FAS 5”), in the determination of its loss reserves. Specifically, FAS 5 requires the establishment of reserves when it is probable that a liability has been incurred at the reporting date, but only to the extent the loss can be reasonably estimated. The Company understands that methods of determining non-specific reserves vary within the financial guaranty industry. FASB is considering whether additional accounting guidance is necessary to address the financial guaranty industry. It is possible that as a result of FASB’s deliberations, the financial guaranty industry, including the Company, may have to change aspects of its accounting policies in this regard. Any proposed and final documents are expected to be issued later in 2007.
Case specific reserves are those obligations identified as currently or likely to be in default, and represent the present value, discounted at the U.S. Treasury Note rate applicable to the term of the underlying insured obligations, of the expected loss and loss adjustment expense (“LAE”) payments, net of estimated recoveries (under salvage, subrogation or other recovery rights). Gross case-specific reserves, net of estimated recoveries, were $20.2 million and $17.7 million as of December 31, 2006 and 2005, respectively.
randomly selected, it forms one possible scenario and outcome. Together, these scenarios give a range of possible outcomes, some of which are more probable and some less probable. By definition, the average solution will give the most likely potential outcome. The Company’s risk management team typically runs at least 100,000 trials in order to determine future expected losses. The model uses the current ratings and default frequency (net of recovery) applied to each transaction with outstanding exposure to determine the expected probability distribution of loss. Default frequency and recovery amounts are published periodically by each of the major rating agencies. From the model output, the Company can estimate a range of expected loss. The amount of non-specific reserve recorded in the financial statements is based on the loss ratio resulting from the calculation of total losses, including past incurred losses and expected future losses divided by premium. For this purpose, premium is defined as ever to date written premium through December 31, 2006 plus future installment premium on closed transactions. This derived loss ratio is applied to ever to date earned premiums through December 31, 2006. Case specific reserves are subtracted from this amount to arrive at net non-specific reserves. At December 31, 2006 and 2005, non-specific reserves were $21.9 million and $16.6 million, respectively. These reserves were for our Public Finance insured exposure.
Management periodically evaluates the estimates for losses and LAE and any resulting changes are reflected in current year earnings. Management believes the reserving methodology and resulting reserves are adequate to cover the ultimate net cost of claims. However, the reserves are based upon estimates and there can be no assurance that any ultimate liability will not exceed such estimates.
Policy Acquisition Costs-Policy acquisition costs include those expenses that relate primarily to and vary with premium production. Such costs are comprised primarily of premium taxes, personnel and personnel-related expenses of individuals involved in marketing and underwriting, and certain rating-agency and legal fees for municipal and non-derivative structured finance business. The present value of anticipated claims and claim adjustment expenses are considered in determining the recoverability of acquisition costs (see Note 7). Net acquisition costs are deferred and amortized over the period in which the related premiums are earned. No costs are deferred in connection with the Company’s insured credit swap transactions.
Income Taxes-The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns.
Stock Compensation Plan-Effective January 1, 2006, the Company adopted FAS No. 123(R), “Share Based Payments” (“FAS 123(R)”). FAS 123(R) is a revision of FAS 123, “Accounting for Stock Based Compensation” (“FAS 123”) and supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), FAS 123(R) requires the Company to expense the grant date fair value of employee stock options and other forms of stock based compensation over the period that an employee provides service in exchange for the award. Effective January 1, 2006, the Company adopted the requirements of FAS 123(R) using the prospective application as permitted by FAS 123(R), accordingly, prior period amounts have not been restated. Under this application, the Company is required to record compensation expense for all awards granted after the date of adoption. Awards granted prior to the date of adoption of FAS 123(R) continue to be accounted for under APB 25, the Company’s prior accounting method for stock based compensation. For the year ended December 31, 2006, the Company recognized compensation expense under FAS 123(R) of $0.9 million related to stock options and $0.1 million related to restricted stock. For the years ended December 31, 2006, 2005 and 2004, the vested portion of the restricted stock granted to the Company’s president and chief executive officer on September 30, 2004 totaled $1.2 million, $1.2 million and $0.3 million, respectively, which was recognized under APB No. 25 in the Company’s consolidated statements of operations. The total value at the grant date of the restricted stock totaled $3.5 million. The restricted stock vests as follows: 33.33% vested on September 30, 2005; 33.33% will vest on September 30, 2006; and the remaining 33.34% will vest on September 30, 2007, provided he has been continuously employed by the Company or a subsidiary throughout the applicable vesting period (see Note 17).
Securities Purchased under Agreements to Resell and Securities Sold under Agreements to Repurchase-Securities purchased under agreements to resell and securities sold under agreements to repurchase are treated as collateralized financing transactions and are recorded at the amounts at which the securities were acquired or sold plus accrued interest. These items are related to the Company’s Credit Fund activities (the Company’s Credit Fund is defined and explained in more detail in Note 12). The Company’s policy is to take possession of securities purchased under agreements to resell. The market value of the underlying securities, which collateralize the related receivable on agreements to resell, is monitored to ensure that the market value exceeds contractually stated levels of principal at all times. If the seller defaults on its obligation to repay the Company, and the fair value of the collateral decline, realization of the collateral by the Company may be delayed or limited. Securities owned that are financed under repurchase agreements are carried at market value, with unrealized gains and losses reflected in net realized and unrealized gains (losses) on investments in the consolidated statements of operations. Obligations under securities sold under agreement to repurchase bear interest that approximates LIBOR and at December 31, 2006, had settlement dates less than 30 days.
In September 2005, Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance contracts”,
In February 2006, the FASB issued FAS 155, “Accounting for Certain Hybrid Financial Instruments” (“FAS 155”), an amendment of FAS 133 and FAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“FAS 140”). FAS 155 (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (ii) clarifies which interest-only strips and principal-only strips are not subject to the requirements of FAS 133, (iii) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (iv) amends FAS 140 to eliminate the exemption from applying the requirements of FAS 133 on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. Additionally, on November 8, 2006, the Derivatives Implementation Group of the FASB released Issue No. B40, “Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets.” This issue provides additional guidance on the implementation of FAS 155 as it relates to certain types of securitizations of prepayable financial assets. In December 2006, the FASB amended Issue No. B40 and revised the effective date of this Issue to instruments issued on June 30, 2007 or later. FAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Company will adopt FAS 155 on January 1, 2007. The implementation of this statement is not expected to have a material impact on the Company’s financial statements.
In March 2006, the FASB issued FAS 156, “Accounting for Servicing of Financial Assets” (“FAS 156”), an amendment of FAS 140. FAS 156 requires that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable, and permits for subsequent measurement using either fair value measurement with changes in fair value reflected in earnings or the amortization and impairment requirements of FAS 140. The subsequent measurement of separately recognized servicing assets and servicing liabilities at fair value eliminates the necessity for entities that manage the risks inherent in servicing assets and servicing liabilities with derivatives to qualify for hedge accounting treatment and eliminates the characterization of declines in fair value as impairments or direct write-downs. FAS 156 is effective for an entity’s first fiscal year beginning after September 15, 2006. The implementation of this statement is not expected to have a material impact on the Company’s financial statements.
FIN 48 is effective in fiscal years beginning after December 15, 2006. The provisions of FIN 48 are to be applied to all tax positions upon initial adoption, with the cumulative effect adjustment reported as an adjustment to the opening balance of retained earnings. Management expects that the adoption of FIN 48 will result in a decrease to stockholders’ equity as of January 1, 2007 of approximately $1.0 to $1.5 million.
In February 2007, the FASB issued FAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”). FAS 159 permits reporting entities to choose to remeasure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The fair value option may be applied instrument by instrument, is irrevocable and is applied only to entire instruments and not to portions of instruments. FAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. FAS 159 is effective for fiscal years that begin after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007 provided that the entity also elects to apply the provisions of FAS 157, which are described above. This early adoption election must be made within 120 days of the beginning of the fiscal year of adoption provided the entity has not yet issued interim period financial statements. Management is currently evaluating the potential impact, if any, which the adoption of FAS 159 will have on the Company’s financial statements.
In January and February 2005, the SEC staff discussed with several financial guaranty industry participants the difference in loss reserve recognition practices in the industry. In June 2005, at the request of the SEC, the FASB added a project to their agenda to review and codify accounting standards for financial guaranty insurance contracts as they relate to loss reserving policies and later added a review of accounting policies in the financial guaranty insurance industry as they relate to premium recognition and deferred policy acquisition costs. Proposed guidance is expected to be released in early 2007 with the final guidance expected to be issued later in the year. When the FASB issues final guidance, the financial guaranty insurance industry, including the Company, may have to change certain aspects of its relevant accounting policies. Until a final standard is released, the Company cannot predict how the FASB will resolve this issue and the resulting impact on its financial statements. Further, until the issue is resolved, the Company will continue to apply the accounting policies as disclosed in its audited financials statements as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004 (see Note 2).
The following table lists each of the Company’s CDOs outstanding as of December 31, 2006 (dollars in millions):
(3) Cash flow CDOs are generally callable once per quarter by a majority or greater vote of the equity holders following the conclusion of the reinvestment period, which is referred to as the First Optional Call Date.
(5) Tribune is comprised of 13 distinct trades some of which are denominated in Euros or Yen. For purposes of this chart, we have converted this amount to U.S. dollars at the prevailing currency exchange rates on December 31, 2006.
In connection with its engagement as asset manager, the Company typically retains a portion of the equity in such CDOs. Prior to June 2004, the Company retained the entire or the majority of the equity position in its funded CDOs and they are consolidated in the financial statements. A total of seven consolidated CDOs were issued in 2002 through 2004; comprised of six asset-backed securities (“ABS”) CDOs and one partially funded corporate credit swap CDO. The funded portions of this latter CDO are reflected as a guaranteed investment contract and debt in the Company’s consolidated financial statements, while the unfunded portions are treated as credit swaps or derivative contracts under FAS 133. CDO debt outstanding in the Company’s consolidated financial statements represents non-recourse debt to the Company that is supported only by the associated assets of the CDO. Likewise, the Company does not have the right to use VIE assets for general operations. The Company’s ultimate exposure in respect to losses on the assets purchased by a CDO is limited to the amount of its equity investment in that CDO. In those instances where the Company owns less than 100% of the CDO VIE’s equity, but is the primary beneficiary and thus consolidates the CDO VIE, it establishes minority interests for the un-owned portion. Two of the six ABS CDOs mentioned above include minority interests. The Company receives insurance premiums, asset management and structuring fees, and equity residual flows from the VIEs that are eliminated in consolidation.
As part of its CDO Asset Management business, the Company enters into warehouse facility agreements for the purpose of accumulating securities for potential CDO transactions. In general, though the specific structures may vary, the warehouse facility is a legal agreement designed to provide for CDO VIE purchases of the warehoused assets at their original cost from a third-party, plus the losses or minus the gains of any interest rate hedges on the fixed rate securities during the warehousing period, as applicable. The Company enters into these agreements to ensure that assets selected will ultimately be delivered with the desired credit spread to meet the return objectives of the CDO. On closure of the CDO transaction (and warehousing period), the VIE uses the proceeds from the issuance of notes to purchase the warehoused assets. The Company generally receives a fee for managing the warehoused assets. From an accounting perspective, when the Company is the primary beneficiary of the CDO VIE and thus required to consolidate it, the warehouse facility agreement represents a forward commitment to purchase assets that is marked to market under the provisions of FAS 133 and FAS 149. This does not apply when the Company is not deemed to be the primary beneficiary of the CDO VIE, which was applicable for all of the Company’s CDOs closed in 2006 and 2005. During 2004, the Company recognized net realized losses of $(0.6) million and net unrealized losses of $(0.6) million under warehouse facility agreements. No such gains or losses were recognized in either 2006 or 2005. Warehouse fees received by the Company totaled $5.0 million, $2.4 million and $1.4 million in 2006, 2005 and 2004, respectively, and are included in fee income.
The impact of a CDO on the Company’s consolidated financial statements depends on the structure of the CDO (fully funded, partially funded or unfunded), whether or not the CDO is consolidated and the nature of the underlying assets and liabilities.
5. NET INSURED CREDIT SWAP REVENUE AND OTHER NET CREDIT SWAP REVENUE
Net insured credit swap revenue includes insured credit swap premiums received for credit protection the Company has sold under its insured credit swaps as well as realized and unrealized gains and losses related to those transactions. Realized losses arise upon the occurrence of credit events requiring payment by the Company under the related credit swap and, additionally, realized gains or losses could occur if a transaction is terminated in advance of its scheduled termination date. Unrealized gains and losses represent the adjustments for changes in fair value that are recorded in each reporting period, under FAS 133. The fair value of the Company’s insured credit swaps are recorded as either derivative liabilities or derivative assets in the consolidated balance sheets.
The following table disaggregates net insured credit swap revenue into its component parts for the periods ended December 31, 2006, 2005 and 2004 (dollars in thousands):
The amortized cost and estimated fair value of fixed maturity securities were as follows (dollars in thousands):
The amortized cost and estimated fair value of fixed maturity securities at December 31, 2006, by contractual maturity, is shown below (dollars in thousands):
Total proceeds from the sale of fixed maturity securities available for sale during 2006, 2005 and 2004 were $154.0 million, $188.0 million, and $349.7 million, respectively; of these amounts $47.8 million, $20.2 million and $141.2 million, respectively, were VIE security sales. Total gross gains of $1.2 million, $0.5 million and $2.1 million and total gross losses of $2.3 million, $0.8 million and $1.2 million were realized on security sales in 2006, 2005 and 2004, respectively. Gross gains of $0.5 million, $0.1 million and $0.7 million and gross losses of $0.3 million, $0 million and $0.1 million, respectively, were related to VIE securities. In addition, the Company recognized approximately $3.0 million, $2.5 million, and $7.4 million in other than temporary declines during 2006, 2005 and 2004, respectively. Of these write-downs $3.0 million, $2.0 million and $6.9 million related to the Company’s VIE securities in 2006, 2005 and 2004, respectively.
The following table provides a reconciliation of the beginning and ending reserve balances for unpaid loss expenses (dollars in thousands):
Case reserves are recorded net of an adjustment for the time value of money. The Company discounts case reserves using the risk free rate that is closest to the term of the expected loss payments of the insured obligation at the date the case reserve is established. For this purpose, U.S. Treasury rates are used. At December 31, 2006, the weighted average discount factor used was 4.6% and the discount taken was $6.4 million. The $6.4 million is net of $13.2 million, which represents the discount related to expected reimbursements against projected future loss payments. At December 31, 2005, the weighted average discount factor used was also 4.6% and the discount taken was $16.9 million.
As of and for the years ended December 31, 2006, 2005 and 2004, amounts reinsured were as follows (dollars in thousands):
During 2006, 2005 and 2004, the Company reinsured a portion of its risk with other insurance companies under pro-rata, excess-of-loss, first loss and facultative reinsurance agreements.
Effective October 1, 2005, ACA Financial Guaranty entered into an excess of loss reinsurance agreement with HCC Reinsurance Company Limited whereby ACA Financial Guaranty cedes its first $50 million in excess of $490 million on non-derivative, non-investment grade municipal paid losses. This reinsurance agreement was amended effective February 1, 2006 to increase the Company’s retention to $525 million.
In 2004, the Company had a first loss and excess of loss reinsurance facility (the “Soft Capital Facility”) with ACE. In the aggregate, the Soft Capital Facility provided the Company with an additional $125 million for the payment of claims. The reinsurance facility provided first loss and excess of loss coverage.
The first loss coverage had an additional $50 million limit of liability and reinsured the Company’s in-force portfolio subject to the sub-limits of the reinsurer’s limit of liability (defined as $20 million in 2002 and increasing to $50 million in 2005 and thereafter) and upon the payment of a premium of $50 million. This $50 million in coverage was accounted for as a financing arrangement and no premiums or losses were recognized in the financial statements. In addition to the $50 million of first loss coverage, the reinsurer was liable for 100% of net paid losses in excess of $175 million and after the adjusted surplus, as defined, of the Company is less than $25 million, subject to a $75 million limit of liability.
In 2003, S&P revised its criteria for allowing financial guarantors to take credit for soft capital reinsurance facilities. As a result, the Soft Capital Facility no longer provided ACA Financial Guaranty with a significant benefit. Consequently during 2004, the Soft Capital Facility was cancelled. As a result of the cancellation, $5.6 million in ceded unearned premium reserve was returned to the Company and $2.4 million in deferred commission income was earned. The Company also reassumed a previously ceded case basis loss reserve in the amount of $1.1 million and recorded other income of $2.0 million in connection with the cancellation.
To the extent the Company cedes a portion of its business to other non-affiliated insurance and reinsurance companies, a contingent liability exists relating to such reinsurance in the event that the reinsurer becomes unable to meet their obligations under the terms of the reinsurance agreement; the Company would be liable for such defaulted amounts. The were no unpaid losses and loss adjustment expenses ceded to non affiliated insurance and reinsurance companies at December 31, 2006 and 2005. Unearned premiums ceded were $0.5 million and $0.8 million at December 31, 2006 and 2005, respectively.
Ceded earned premiums were $0.8 million, $0.3 million and $6.9 million in 2006, 2005 and 2004, respectively. Loss and loss adjustment expense payments ceded were $0 million in the years 2006, 2005 and 2004. Reinsurance recoverable on unpaid losses was $0.0 million at December 31, 2006, 2005 and 2004.
Debt outstanding at December 31, 2006 and 2005 consisted of the following (dollars in thousands):
In March 2005, a special purpose entity created by the Company, ACA Parliament, LLC (“ACA Parliament”), entered into an investment agreement with an investment trust (the “Investor”) pursuant to which the Investor deposited $99 million (net of $1 million in costs of issuance-see Note 19) (the “Deposit Amount”) in a deposit fund that is maintained and invested by ACA Parliament. Pursuant to the terms of the investment agreement, ACA Parliament is required to make quarterly interest payments to the Investor at a rate equal to the three-month LIBOR plus 125 basis points. The obligations of ACA Parliament to make such interest payments and to repay the Deposit Amount are guaranteed by financial guaranty insurance policies issued by ACA Financial Guaranty.
During 2006 and 2005, ACA Parliament loaned certain of the proceeds held by it under the investment agreement to certain ACA affiliates, which in turn were used by such affiliates either (i) to refinance existing funding notes or (ii) to finance the Company’s equity participation in the Company’s CDO asset management business. In particular, the Company’s equity position was refinanced in each of
During 2005, the Company entered into two promissory note agreements to finance its equity position in CDO deals. The first note had an original face of $4.5 million, has a maturity of 2013 and accrues interest payable quarterly at a rate of LIBOR plus a margin of 0.80%. The second note had an original face of $3.8 million, has a maturity of 2010 and accrues interest payable quarterly at a rate of LIBOR plus a margin of 0.75%.
As of December 31, 2006, Grenadier Funding Corp. and Zenith Funding Corp. had issued 30-90 day commercial paper notes with a weighted average maturity of 79 days and 80 days respectively. The rate on these notes is floating with a weighted average year end value of 5.32% and 5.38%. These notes are limited recourse debt obligations of the issuers, backed solely by collateral managed by the Company. The short-term nature of these notes is designed to correspond with the short term rates on the underlying collateral of the deals. The Zenith Funding Corp., ACA ABS 2004-1 Limited, Grenadier Funding Ltd., ACA ABS 2003-1 Limited, ACA ABS 2003-2 Limited, ACA CDS 2002-1 Limited and ACA ABS 2002-1 Limited tranched notes are issued and collateralized through a VIE pursuant to an indenture agreement. These notes are limited recourse debt obligations of the issuers backed solely by a pledge of collateral managed by the Company in the VIE. The notes may be redeemed prior to the scheduled maturity date at the option of the Company as issuer and collateral manager, or in connection with an event of default pursuant to the indenture agreement.
The Company entered into a credit agreement dated May 1, 2006 with J.P. Morgan Securities Inc., as Arranger, JPMorgan Chase Bank, N.A. as Administrative Agent, and various other lenders. The credit agreement provides for a 364-day senior unsecured revolving credit facility in an aggregate principal amount of up to $75 million. The Company may borrow cash under the revolving credit facility bearing interest based on the LIBOR, or the Federal Funds/Prime Rate. The Company pays a facility fee between 0.100% up to 0.175% per annum of the total commitments under the revolving credit facility. In addition, we also agreed to pay a utilization fee at a rate of 0.125% per annum on the average daily amount of the outstanding principal under the revolving credit facility, but only payable when such outstanding principal amount exceeds 50% of the commitments under the revolving credit facility. We had no indebtedness outstanding under this facility as of December 31, 2006.
The Company’s actual income tax expense for the years ended December 31, 2006, 2005 and 2004, differs from the expected amount computed by applying the statutory federal income tax rate of 35% to income before income taxes for the following reasons (dollars in thousands):
The tax effects of temporary differences that give rise to deferred tax assets and liabilities at December 31, 2006 and 2005, are presented below (dollars in thousands):
At December 31, 2006, the Company has federal net operating loss carryforwards of approximately $18.3 million that begin to expire in 2024 and are fully expired by 2026. Based on available evidence, it is more likely than not that the deferred tax assets relating to the net operating loss will not be fully realized. Accordingly, a valuation allowance was established in 2006 in the amount of $1.6 million relating to the portion of the tax benefits attributable to certain net operating losses.
In May 2006, the Company launched the Credit Fund to leverage its expertise in the capital and credit markets and as an asset manager. The fund invests in fixed income securities, particularly in the asset-backed sector. The Credit Fund had net assets under management of $25.6 million as of December 31, 2006. ACA Financial Products, Inc., a wholly owned indirect subsidiary of the Company, owned $17.0 million of equity in the Credit Fund at December 31, 2006. The remaining $8.6 million of equity was owned by third party investors. In addition to receiving a return on its investment in the Credit Fund, the Company is paid a management fee to select and manage the assets for the Credit Fund’s third-party investors. For accounting purposes, the Credit Fund is consolidated in the Company’s financial statements as of December 31, 2006 and its financial results are recorded in the Structured Credit line of business. As of December 31, 2006, the Credit Fund had assets of $264.6 million, including investments in fixed-maturity securities trading of $251.8 million, securities purchased under agreements to resell of $10.2 million and total liabilities and minority interest of $247.7 million, including securities sold under agreement to repurchase of $232.2 million and payable for securities purchased of $5.0 million, included in the Company’s consolidated balance sheet. The Company’s consolidated statement of operations included net realized and unrealized losses on the Credit Fund of $0.2 million, interest expense of $3.7 million and net investment income of $4.8 million for the year ended December 31, 2006.
During the ordinary course of business, the Company has become party to certain litigation. Other than with respect to the litigation described in Note 21 below, management believes all other matters will be resolved with no material impact on the Company.
In the event of a ratings downgrade of ACA Financial Guaranty under the terms of certain credit swap transactions entered into by various affiliates of the Company, whose obligations under the related credit swap transactions are insured by ACA Financial Guaranty, collateral is required to be posted for the benefit of the swap counterparty. The obligation to post collateral is that of the particular affiliate of ACA Financial Guaranty that entered into the swap. In the event the affiliate cannot satisfy its posting obligation, ACA Financial Guaranty may be required to make a termination payment to the counterparty based on the then current market value of the transaction.
Fixed Maturity Securities-The fair value for fixed maturity securities available-for-sale and trading shown in Note 6 is based on independent market quotations, broker quotes or valuation models when quotations are not available.
Securities Purchased under Agreements to Resell and Securities Sold under Agreements to Repurchase-Securities purchased under agreements to resell and securities sold under agreements to repurchase are treated as collateralized financing transactions and are recorded at the amounts at which the securities were acquired or sold plus accrued interest.
Cash and Cash Equivalents-The carrying amounts of these items are reasonable estimates of their fair value.
Unearned Premium Reserve-The fair value of the Company’s unearned premium reserve is based on the estimated cost of entering into a cession of the entire portfolio with third party reinsurers under current market conditions. This amount was determined by using the statutory basis unearned premium reserve, net of estimated ceding commissions.
Debt-Debt is primarily based on variable rates with fair value approximating carrying value.
Derivatives-The fair value derived from market information and appropriate valuation methodologies reflect the estimated amounts that the Company would receive or pay to terminate the transaction at the reporting date. The Company recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value.
Board of Directors approved the ACA Holdings, Inc. Amended and Restated 2004 Stock Incentive Plan effective September 30, 2004 (as amended on October 4, 2004, the “2004 Plan”) amending and restating the Prior Plan and increasing the total options available under the 2004 Plan (including those previously distributed under the Prior Plan) to 4,241,538. In August 2006, the Board of Directors approved the Amended and Restated 2006 Stock Incentive Plan, to become effective upon completion of the IPO (the “2006 Plan”) which increased the total options and shares available under the 2006 Plan, including all shares subject to existing awards there under pursuant to the Prior Plan and the 2004 Plan, to 6,327,972. The 2006 Plan became effective November 9, 2006. The 2006 Plan permits the grant of nonqualified and qualified stock options, incentive stock options, restricted stock, stock units, unrestricted stock, dividend equivalent and cash-based awards. As of December 31, 2006, the Company has issued stock options and restricted stock under the 2006 Plan. The objectives of the 2006 Plan are to optimize the profitability and growth of the Company through annual long-term incentives that are consistent and linked with the Company’s goals.
On August 3, 2006, the compensation committee granted in the aggregate to certain of the Company’s officers options to purchase 543,000 shares of common stock subject to the completion of the Company’s initial public offering. The options have an exercise price per share equal to the offering price per share of $13.00, have a term of ten years subject to earlier termination and vest in equal installments every six months over 42 months. The options were granted effective November 10, 2006.
Utilizing these assumptions, the weighted-average per-share fair value of stock options granted in 2006, 2005 and 2004 was $4.51, $2.41 and $1.14, respectively.
A summary of option activity for the years ended December 31, 2006, 2005 and 2004 is as follows:
During 2006, the Company purchased 499,971 shares of its common stock with an original cost basis of $5.1 million from a former employee for $6.6 million. The Company received a $2.3 million recourse note, which bears interest at 5.32%, from another former employee for the exercise of 221,220 stock options. Interest on this note compounds annually and all principal and interest on the note is due in June 2016. During 2005 and 2004, the Company purchased 7,128 shares and 174,372 shares, respectively, of its common stock from employees terminated during the year for a purchase price of $0.1 million and $2.2 million, respectively. The shares purchased were accounted for as treasury stock.
As of December 31, 2006, there was $5.0 million of total unrecognized compensation cost related to nonvested share-based compensation awards granted under the stock option plans. This cost is expected to be recognized over a weighted average period of 2.94 years.
Also, in August 2006, the compensation committee granted to certain of the Company’s officers and two of its independent directors 234,000 shares and 6,154 shares, respectively, of restricted common stock subject to the completion of the Company’s initial public offering. The officer’s shares vest in equal installments on each of the first four anniversaries of the grant date. The independent directors’ shares vest one-third per year over a three-year period. The shares were granted effective November 10, 2006 with a fair value of $13.00. The Company recognized FAS 123(R) compensation expense of $0.1 million in 2006 related to these restricted stock grants.
On September 30, 2004, the Company granted 335,214 restricted shares at a fair market value of $10.38 per share, to the Company’s president and chief executive officer (the “Executive”). The total value at the grant date of the restricted stock totaled $3.5 million. The restricted stock vests one-third per year over a three-year period provided the Executive has been continuously employed by the Company or a subsidiary throughout the applicable vesting period. In 2006, 2005 and 2004, the vested portion of the restricted stock totaled $1.2 million, $1.2 million and $0.3 million, respectively, which was recognized in the Company’s consolidated statements of operations (see Note 17)
The Company offers a defined contribution savings plan under Section 401(k) of the Internal Revenue Code. This plan covers substantially all employees who meet minimum age and service requirements and allows participants to defer a portion of their annual compensation on a pre-tax basis up to IRS limits. The Company may make discretionary contributions to the plan on behalf of employees. The Company contributed $1.0 million, $0.5 million and $0.6 million to the plan on behalf of employees for the years ended December 31, 2006, 2005 and 2004, respectively.
On November 9, 2006, ACA priced its initial public offering of common stock. The Company sold 6,875,000 shares of common stock in the offering, at $13.00 per share, with net proceeds to ACA of $79.3 million. The transaction closed on November 15, 2006. ACA is listed on the New York Stock Exchange under the symbol “ACA.” Upon the closing of its initial public offering of common stock, the Company converted 154 shares of senior convertible stock to 924,000 shares of common stock, 959 shares of convertible preferred stock converted to 5,754,000 shares of common stock and 2,785,769 shares of series B senior convertible preferred stock converted to 16,714,614 shares of common stock.
On August 3, 2006 the Company’s Board of Directors authorized a dividend in order to effect a six-for-one stock split on the Company’s outstanding shares of common stock and on each share of common stock to be issued upon conversion of the various classes of preferred stock of the Company. Each stockholder of record on August 3, 2006 has received five additional shares of common stock for each share of common stock held by such stockholder on that date. Additional funds have been reclassified from the additional paid in capital account to the common stock account to equal the amount of additional par value represented by the additional shares which have been issued under the stock split. Upon the conversion of the various classes of the Company’s preferred stock, each holder of convertible preferred stock, senior convertible preferred stock and series B senior convertible preferred stock was issued, in the case of convertible preferred stockholders and senior convertible preferred stockholders, 6,000 shares for each share of preferred stock held by such holder and, in the case of the series B senior convertible preferred stockholders, 6 shares of each share of preferred stock held by such holder. All earnings per share and related stock option information presented in these financial statements and accompanying footnotes have been retroactively adjusted to reflect the increased number of shares resulting from this action.
In April 2006, the Company issued 25 shares of senior convertible preferred stock to its existing stockholders representing the 5% “liquidation accretion” premium earned from the date of issuance through September 30, 2004. The transaction was accounted for as a dividend. A value of $2.0 million, based on the March 31, 2006 book value, was re-classified from retained earnings to senior convertible preferred stock to record the dividend.
The Maryland Insurance Administration (“MIA”), the insurance departments of certain other states and the rating agencies which rate ACA Financial Guaranty have various requirements relating to the maintenance of certain minimum statutory capital and reserves, single risk limits and limits on non-investment grade obligations.
Under Maryland insurance law, ACA Financial Guaranty may pay a dividend without the prior approval of the Commissioner of the MIA from earned surplus, as defined, subject to the maintenance of a minimum-capital requirement, and the dividend, which, together with all dividends declared or distributed by it during the preceding twelve months, may not exceed the lesser 10% of its policyholders’ surplus shown on its last filed statement, or net income, as defined, for such twelve-month period. Consistent with prior years, in 2007 based upon these restrictions, ACA Financial Guaranty will need the approval of the MIA to pay any dividends.
The MIA completed its five-year regulatory examination of ACA Financial Guaranty with respect to the period ended December 31, 2003. The Report on Examination was made available on the MIA’s website on January 19, 2007. There were no adjustments required to ACA Financial Guaranty’s 2006 statutory statements as a result of this report. All adjustments to ACA Financial Guaranty’s statutory statements required as a result of the examination were recorded in 2005.
The principal amount of insured public obligations as of December 31, 2006 and 2005, in the insured portfolio, net of amounts ceded, and the terms to final maturity were as follows (dollars in millions). Actual maturities could differ from final maturities because borrowers have the right to refund or prepay certain obligations.
Debt service on insured obligations for 2006 was approximately $51.0 billion. From its inception in 1997 through December 31, 2006, the Company has net paid and case-specific losses of $54.2 million on $202.3 million of net earned premium.
In 2002, the Company replaced one of its investment managers with Stephens Capital Management (“Stephens”) and incurred investment management fees of $0.7 million, $0.1 million and $0.2 million related to Stephens during 2006, 2005 and 2004, respectively. This investment manager is affiliated with SF Holding Corp. (f/k/a Stephens Group Inc.), which has a representative on the Company’s Board of Directors and is an investor in the Company. In January 2007, the investment management agreement with Stephens was terminated.
Pursuant to employment contracts approved by the Board of Directors, in 2001 key senior executives purchased in aggregate 2,493,828 shares of common stock of the Company in exchange for $4.2 million, 10-year promissory notes payable to the Company. The promissory notes accrue interest at the 10-year U.S. Treasury rate. The Company received principal payments in connection with these promissory notes of approximately $0 million and $0.1 million, during 2006 and 2005, respectively. In May 2004, the previous Chief Executive Officer’s promissory note of $2.2 million was cancelled in connection with the Company’s repurchase of his shares of the Company’s stock. The Company recorded interest income related to the promissory notes of $0.1 million, $0.1 million and $0.1 million, during 2006, 2005 and 2004, respectively. Interest receivable relating to the promissory notes was $0.0 million and $0.1 million at December 31, 2006 and 2005, respectively. Pursuant to the Amended and Restated Employment Agreements, effective September 30, 2004, the Company discharged one-third of the outstanding unpaid principal and interest
As mentioned in Note 6, ACA Financial Guaranty has assets on deposits with various regulatory authorities at December 31, 2006. Additionally, as mentioned in Note 2, in connection with its CDO Asset Management and Structured Credit businesses, the Company has on deposit $65.6 million for the benefit of various counterparties at December 31, 2006. These funds revert back to the Company upon the expiration of the related risk and in certain instances may be used to pay losses should they be incurred. The Company also holds $1.5 million in collateral at December 31, 2006, through one of its consolidated CDOs, for the benefit of the CDO debt holders. Restricted balances are recorded as restricted cash on the consolidated balance sheets.
(1) Structured Credit, which structures and sells credit protection, principally in the form of insured CDS, against a variety of asset classes in the institutional fixed income markets;
(2) Public Finance, which provides insurance guaranteeing the timely payment of ultimate principal and interest on municipal and other public finance obligations;
(4) Other, which primarily includes trade credit insurance business and financial guaranty insurance on certain other sectors, each of which the Company is no longer engaged in.
Where determinable, the Company specifically assigns assets to each segment, otherwise, the Company allocates assets based on estimates. In general, allocation percentages for assets are determined based on each line’s estimated capital utilization from a rating agency perspective.
As a result of the 2004 net loss, 4.74 million weighted average shares of participating convertible stock were excluded from the computation of basic earnings (loss) per share. Participating convertible stockholders do not participate in losses with the common stockholders. Additionally, 6.66 million and 0.24 million weighted average shares of dilutive potential common stock, resulting from convertible preferred stock and stock options, respectively, were not included in the computation of diluted earnings (loss) per share for the year ended December 31, 2004. In the absence of the net loss, diluted weighted average shares would have totaled 17.81 million.
The computation of diluted earnings per share for the quarters ended March 31, June 30, September 30 and December 31, 2006 did not include the effect of 1.0 million, 1.0 million, 1.1 million and 1.9 million, options, respectively, to purchase shares of common stock because their exercise prices were greater than the corresponding market value per share of our common stock and would have an anti-dilutive effect on the computation.
The computation of diluted earnings (loss) per share for the quarters ended March 31, June 30, September 30 and December 31, 2005 did not include the effect of 0.30 million options to purchase shares of common stock because their exercise prices were greater than the corresponding market value per share of our common stock and would have an anti-dilutive effect on the computation.