MBIA Corp. owns the 265,000 square foot office building on approximately 38 acres of property in Armonk, New York, in which the Company, MBIA Corp. and MBIA Asset Management have their headquarters. MBIA Corp. also has offices with 30,000 square feet of rental space in New York, New York, San Francisco, California, Paris, France, Madrid, Spain, Sydney, Australia, London, England, Milan, Italy, and Tokyo, Japan. MBIA Asset Management has 7,500 square feet of office space in Denver, Colorado. The Company believes that these facilities are adequate and suitable for its current needs.
MBIA’s municipal services operations consisted of the activities of MuniServices and Capital Asset. As a result of the sale of MuniServices and Capital Asset, the Company no longer reports municipal services operations and the assets, liabilities, revenues and expenses of these entities have been reported within discontinued operations for all years presented in accordance with Statement of Financial Accounting Standards No. (“SFAS”) 144, “Accounting for the Impairment or Disposal of Long-lived Assets.” See “Note 15: Discontinued Operations” in the Notes to Consolidated Financial Statements for information relating to the Company’s discontinued operations.
The Company’s results of operations for the years ended December 31, 2006, 2005 and 2004 are discussed in the “Results of Operations” section included herein.
The Company establishes two types of loss and LAE reserves for non-derivative financial guarantees: an unallocated loss reserve and case basis reserves. The unallocated loss reserve is established with respect to the Company’s entire non-derivative insured portfolio. The Company’s unallocated loss reserve represents the Company’s estimate of losses that have or are probable to occur as a result of credit deterioration in the Company’s insured portfolio but which have not yet been specifically identified and applied to specific insured obligations.
and in the Company’s actual recovery experience would likely increase the Company’s loss factor. Conversely, decreases in statistical
default rates relative to the Company’s insured portfolio and in the Company’s actual loss experience or increases in statistical recovery rates and in the Company’s actual recovery experience would likely decrease the Company’s loss factor. During the years ended December 31, 2006, 2005 and 2004, the Company calculated its provision for the unallocated loss reserve of $81 million, $84 million and $85 million, respectively. This provision represents loss and loss adjustment expenses as reported on the Company’s income statement.
In the years ended December 31, 2005 and 2004, the Company’s actual loss experience, one of the variables on which the loss factor is based, increased significantly above historical levels as case basis incurred activity exceeded the 12% loss factor used by the Company. Given the level of specific case basis losses recorded in 2005 and 2004, if none of the other variables used in deriving the loss factor had changed during this period, the Company’s loss factor would approximate 14% on a cumulative basis through December 31, 2006. Another variable that changed over the last several years, however, and that affects the determination of the loss factor is the mix of business among different sectors. During this period, the Company has ceased writing business in certain sectors in which loss experience has been high relative to its total portfolio, such as tax liens, lower rated high-yield collateralized bond obligations, manufactured housing and certain direct corporate obligations, which offset the impact that the higher case basis incurred activity would have on the loss factor. Excluding actual loss experience incurred in the sectors listed above, the Company’s cumulative loss factor through December 31, 2006 would approximate 9%. Also mitigating the impact of higher case basis incurred activity is the improvement in the overall credit quality of the insured portfolio, with a greater percentage of the insured portfolio rated A or above over the past few years, as well as a decline in the number of issues on the Company’s caution lists.
Considering all of the assumptions used in the assessment of the adequacy of the loss factor, including the higher case basis incurred activity in 2005 and 2004 and the offsetting effect of observed changes in the variables described above, the Company believes that its current loss factor of 12% continues to represent a reasonable estimate of losses that have or are probable to occur as a result of credit deterioration in the Company’s insured portfolio but which have not yet been specifically identified and applied to specific insured obligations. In addition, the Company believes that the amount of unallocated loss reserves recorded on its balance sheet at December 31, 2006 are adequate to cover specific losses that may develop from its existing insured portfolio. MBIA continually monitors its insured portfolio and actual loss experience in order to identify trends that would indicate a reasonably likely significant change to one or more of the variables on which the loss factor is based. If MBIA determines that any changes to one or more of these variables is likely to have an impact on the level of probable losses in its insured portfolio, the Company will increase or decrease its loss factor accordingly, which will result in an increase or decrease in its loss and loss adjustment expenses.
The Company establishes specific reserves in an amount equal to the Company’s estimate of identified or case basis reserves with respect to specific policies. A number of variables are taken into account in establishing specific case basis reserves for individual policies that depend primarily on the nature of the underlying insured obligation. 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. Factors that may affect the actual ultimate realized losses for any policy include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. The Company does not believe that changes to these factors would materially change the amount of the Company’s case basis loss reserves, with the exception of significant changes in salvage values of specific collateral. Changes in salvage values of specific collateral may occur over time and would directly affect the amount of case basis loss reserves established for individual insured obligations.
PREMIUM REVENUE RECOGNITION Upfront premiums are earned in proportion to the expiration of the related principal balance of an insured obligation. Therefore, for transactions in which the premium is received upfront, premium earnings are greater in the earlier periods when there is a higher amount of principal outstanding. The upfront premiums are apportioned to individual sinking fund payments of a bond issue according to an amortization schedule. After the premiums are allocated to each scheduled sinking fund payment, they are earned on a straight-line basis over the period of that sinking fund payment. Accordingly, deferred
premium revenue represents the portion of premiums written that is applicable to the unexpired risk of insured bonds and notes. When an MBIA-insured obligation is retired early, is called by the issuer, or is in substance paid in advance through a refunding accomplished by placing U.S. Government securities in escrow, the remaining deferred premium revenue is earned at that time since there is no longer risk to the Company. Installment premiums are earned on a straight-line basis over each installment period, generally one year or less. As the outstanding principal of an installment-based policy is paid down by the issuer of an MBIA-insured obligation, less premium is collected and recognized by the Company. Both upfront and installment premium recognition methods recognize premiums over the term of an insurance policy in proportion to the remaining outstanding principal balance of the insured obligation.
The effect of the Company’s upfront premium earnings policy is to recognize greater levels of upfront premiums in the earlier years of each policy insured, thus matching revenue recognition with exposure to the underlying risk. Recognizing premium revenue on a straight-line basis over the life of each policy without allocating premiums to the sinking fund payments would materially affect the Company’s financial results. Premium earnings would be more evenly recorded as revenue throughout the period of risk than under the current method, but the Company does not believe that the straight-line method would appropriately match premiums earned to the Company’s exposure to the underlying risk. Therefore, the Company believes its upfront premium earnings methodology is the most appropriate method to recognize its upfront premiums as revenue. The premium earnings methodology used by the Company is similar to that used throughout the financial guarantee industry. However, premium revenue recognition is subject to change as a result of the FASB project described in the “Losses and Loss Adjustment Expenses” section included herein.
MBIA regularly monitors its investments in which fair value is less than amortized cost in order to assess whether such a decline in value is other than temporary and, therefore, should be reflected as a realized loss in net income. Such an assessment requires the Company to determine the cause of the decline and whether the Company possesses both the ability and intent to hold the investment to maturity or until the value recovers to an amount at least equal to amortized cost. Additionally, this assessment requires management to exercise judgment as to whether an investment is impaired based on market conditions and trends and the availability of relevant data. See “Note 12: Investment Income and Gains and Losses” in the Notes to Consolidated Financial Statements for further information regarding other than temporary losses recorded in net income.
The Company’s exposure to derivative instruments is created through contracts into which it directly enters and through third-party contracts it insures. The majority of MBIA’s exposure to derivative instruments, measured by notional values, is related to certain synthetic collateralized debt obligations (“CDOs”) that it insures. These contracts meet the definition of a derivative under SFAS 133 but effectively represent an alternate form of financial guarantee execution. The fair values of the Company’s derivative instruments are estimated using various valuation models that conform to industry standards. The Company utilizes both vendor-developed and proprietary models, based on the complexity of transactions. Dealer market quotes are typically obtained for regularly traded contracts and provide the best estimate of fair value for those contracts. However, when reliable dealer market quotes are not available, the Company uses a variety of market data relative to the type and structure of derivative contracts entered into by the Company. Several of the more significant types of market and contract data that influence the Company’s valuation models include interest rates, credit spreads, credit quality ratings and correlation assumptions. The data is obtained from third-party sources and is reviewed for reasonableness and applicability to the Company’s derivative portfolio. The fair value of the Company’s derivative portfolio may be materially affected by changes in existing market data, the availability of new or improved market data, changes in specific contract data or enhancements to the Company’s valuation models resulting from new market practices.
In performing the impairment test for the investment management services operations, the fair value of a reporting segment is determined using a multiple of earnings before income tax, depreciation and amortization (“EBITDA”), as this is a common measure of fair value in the investment management industry. The multiple was determined based on a review of current industry valuation practices.
The Company performed its annual impairment testing of goodwill as of January 1, 2006 and January 1, 2007. On both dates, the fair values of the reporting segments exceeded their carrying values indicating that goodwill was not impaired. Alternate valuation methods would have likely produced different fair values. However, the Company believes that the valuation methods used provided the best estimates of fair value.
Consolidated revenues from continuing operations increased 18% to $2.7 billion in 2006 from $2.3 billion in 2005. Growth in insurance revenues resulted from an increase in net investment income and net realized gains from investment securities. An increase in investment management services’ interest income resulting from growth in asset/liability products was partially offset by a decrease in investment management services’ net gains on derivative instruments and foreign exchange. Consolidated expenses from continuing operations increased 23% to $1.6 billion in 2006 from $1.3 billion in 2005. This increase was principally due to an increase in investment management services and insurance interest expense, which was commensurate with the increase in interest income. Offsetting the increase in consolidated expenses was a reduction in corporate expenses resulting from $75 million of estimated penalties and disgorgement recorded in the third quarter of 2005 in connection with the settlement of regulatory investigations of the Company. Net income for 2006 of $819 million was up 15% from $711 million for 2005. Net income per diluted share was $5.99 for 2006 compared with $5.18 per diluted share for 2005, a 16% increase. The slightly larger percent increase in net income per diluted share compared with net income resulted from an approximately 526,000 decrease in the average number of diluted shares outstanding as a result of share repurchases the Company made in the first half of 2005.
Consolidated revenues from continuing operations increased 12% to $2.3 billion in 2005 from $2.1 billion in 2004. The growth in consolidated revenues was primarily due to a substantial increase in investment management services’ interest income resulting from growth in asset/liability products. Offsetting the increase in investment management services’ revenues was a decrease in insurance revenues resulting from a decline in net realized gains on investment securities. Consolidated expenses from continuing operations increased 45% to $1.3 billion in 2005 from $0.9 billion in 2004. This increase was principally due to an increase in investment management services’ interest expense, which was commensurate with the increase in interest income, and estimated penalties and disgorgement related to the settlement of regulatory investigations of the Company. Net income for 2005 of $711 million was down 16% from $843 million for 2004. Net income per diluted share was $5.18 for 2005 compared with $5.82 for 2004, an 11% decrease.
The municipal obligations that MBIA Corp. insures include tax-exempt and taxable indebtedness of states, counties, cities, utility districts and other political subdivisions, as well as airports, higher education and healthcare facilities and similar authorities and obligations issued by private entities that finance projects which serve a substantial public purpose. The asset-backed and structured finance obligations insured by MBIA Corp. typically consist of securities that are payable from or which are tied to the performance of a specified pool of assets that have an expected cash flow. Securities of this type include residential and commercial mortgages, a variety of consumer loans, corporate loans and bonds, trade and export receivables, aircraft, equipment and real property leases, and infrastructure projects.
In certain cases, the Company may be required to consolidate entities established as part of securitizations when it insures the assets or liabilities of those entities. These entities typically meet the definition of a VIE under FIN 46(R). We do not believe there is any difference in the risks and profitability of financial guarantees provided to VIEs compared with other financial guarantees written by the Company. Additional information relating to VIEs is contained in the “Variable Interest Entities” section included herein.
NPW, which represents gross premiums written net of premiums ceded to reinsurers, decreased 7% to $798 million in 2006 from $858 million in 2005. The decline in 2006 was a result of the decline in GPW, partially offset by a reduction in premiums ceded to reinsurers. Premiums ceded to reinsurers from all insurance operations as a percentage of GPW were 11% and 13% for 2006 and 2005, respectively. Reinsurance enables the Company to cede exposure and comply with its single risk and other credit guidelines, although the Company continues to be primarily liable on the insurance policies it underwrites.
In 2005, GPW decreased 12% compared with 2004, reflecting declines in both U.S and non-U.S. business. NPW decreased 10% compared with 2004, resulting from the decline in GPW, slightly offset by a reduction in premiums ceded to reinsurers. Premiums ceded to reinsurers from all insurance operations for 2005 declined to 13% of GPW from 14% for 2004. Net premiums earned declined 1% in 2005 compared with 2004 due to a 2% decrease in refunded premiums earned and a 1% decrease in scheduled premiums earned. The decrease in refunded premiums earned resulted from a modest slow down in refinancing activity in the municipal market from historically high levels.
MBIA evaluates the premium rates it charges for insurance guarantees through the use of internal and external rating agency quantitative models. These models assess the Company’s premium rates and return on capital results on a risk adjusted basis. In addition, market research data is used to evaluate pricing levels across the financial guarantee industry for comparable risks, when available. Although pricing has been acceptable in the last three years, the Company, along with the industry, experienced significant price increases over the period from 1998 through 2003. The Company’s pricing levels indicate continued acceptable trends in overall portfolio profitability under all models, and the Company believes the pricing charged for its insurance products produces results that meet its long-term return on capital targets.
Global public finance GPW decreased 10% in 2006 to $511 million from $569 million in 2005. This decrease was due to a 35% decline in U.S. business written resulting from lower debt issuance, weak market conditions and strong competition. Partially offsetting this decline was an 83% increase in non-U.S. business written primarily resulting from transportation and utility transactions in the Latin American and Australian markets. NPW decreased 7% in 2006 to $479 million from $514 million in 2005 as a result of the decrease in GPW and a lower cession rate. The global public finance cession rate for business written during 2006 was 6% compared with 10% during 2005. The decrease in the overall cession rate was due to a decline in both U.S. and non-U.S. business ceded. Global public finance net premiums earned increased 2% to $504 million in 2006 compared with $495 million in 2005. An 11% increase in refunded premiums earned was offset by a 2% decline in scheduled premiums earned. Refunded premiums earned increased as a result of the continued low interest rate environment in the U.S. and several international transactions that had significant unearned premium at the time of their refunding. Scheduled premiums earned have been adversely affected by high refunding levels in 2006 and prior years.
Global public finance net par insured rated A or above, before giving effect to the Company’s guarantee, represented 84% of global public finance business written by the Company during 2006, compared with 91% during 2005 and 87% during 2004. During 2006, a higher percentage of business was written in sectors that typically have a lower credit quality rating. At December 31, 2006, 82% of the outstanding global public finance book of business was rated A or above before the Company’s guarantee, down slightly from 83% at December 31, 2005.
Global structured finance GPW decreased 8% in 2006 to $385 million from $416 million in 2005, resulting primarily from a decrease in non-U.S. business written. The global structured finance sector continues to be adversely affected by increased competition, tight credit spreads and greater investor demand for uninsured transactions. NPW in 2006 decreased 7% to $319 million from $344 million due to the decrease in GPW offset by a slightly lower cession rate. The global structured finance cession rate for business written during 2006 was 17.0% compared with 17.4% for 2005. Global structured finance net premiums earned of $332 million in 2006 were 5% below 2005. The decrease in net premiums earned resulted from the decline in business written in 2006 and prepayments and maturities of business written in prior years.
In 2005, global structured finance GPW decreased 8% to $416 million from $451 million in 2004, resulting from decreases in U.S. and non-U.S. business written. Increased competition, tight spreads and greater investor demand for uninsured transactions had an adverse affect on business written in this sector. However, GPW was positively impacted by business from repeat issuers across all sectors. NPW decreased 8% in 2005 compared with 2004 due to the decrease in GPW. The global structured finance cession rate for business written during 2005 and 2004 was 17%. In 2005, global structured finance net premiums earned of $348 million were 2% below 2004 as a result of the decline in business written in 2005 and prepayments and maturities of insured issues.
INVESTMENT INCOME The Company’s insurance-related net investment income and ending asset balances at amortized cost for the last three years are presented in the following table:
The Company’s insurance-related net investment income, excluding net realized gains and losses, increased 16% to $598 million from $514 million in 2005. After-tax net investment income increased 15% in 2006 as the proportion of taxable investments remained relatively consistent with 2005. Growth in pre-tax investment income reflects an increase in consolidated VIE interest income of $34 million. VIE interest income is generated from interest bearing assets held by such entities and supports the payment of interest expense on debt issued by these entities. Additionally, pre-tax investment income for 2006 included $17 million related to Northwest Airlines’ enhanced equipment trust certificates, which the Company received in connection with a remediation, and $6 million related to non-recurring interest on reimbursed expenses received in connection with the remediation of a private label credit card securitization, with no comparable amounts recorded in 2005.
In 2006, fees and reimbursements increased 19% from 2005 to $33 million, primarily resulting from an increase in expense reimbursements associated with loss prevention efforts. In 2005, fees and reimbursements decreased 32% from 2004 to $28 million. The decrease in 2005 fees and reimbursements was primarily due to a decline in waiver and consent and commitment fees, as well as a decline in work fees reflecting fewer large complex transactions. Partially offsetting the decrease in such fees was an increase in expense reimbursements associated with loss prevention efforts. Fees earned when received represented 83% of total fees and reimbursements in 2006 compared with 72% in 2005 and 63% in 2004. Due to the transaction-specific nature inherent in insurance-related fees and reimbursements, these revenues can vary significantly from year to year.
NET GAINS AND LOSSES Net realized gains in the insurance operations were $6 million in 2006, compared with net realized losses of $3 million and net realized gains of $109 million in 2005 and 2004, respectively. The net realized gains in 2006 were largely due to the sale of investment securities, including the sale of the Company’s investment in RAM Holdings, Inc., the holding company of RAM Reinsurance Company Ltd., which generated an $11 million gain in the second quarter of 2006. Net realized gains in 2006 also included a $25 million impairment loss on a receivable the Company recorded through salvage and subrogation rights it obtained as a result of claim payments the Company previously made on an insured credit. In 2005, net realized losses were primarily due to $19 million of impairment losses on receivables the Company recorded through salvage and subrogation rights. Partially offsetting the impairment losses were net gains from sales of investment securities. Net realized gains in 2004 were largely due to a $77 million realized gain resulting from the sale of a common stock investment MBIA Corp. purchased in 2002 and a $41 million realized gain resulting from the termination of certain transactions that were accounted for as deposits. Realized gains in 2004 were partially offset by an $11 million realized loss resulting from an other-than-temporary impairment of a fixed-maturity security.
In the fourth quarter of 2006, the Company redeemed all of the remaining $117 million in principal outstanding of MBIA-insured notes backed by tax liens originated by Capital Asset. During 2006, the Company recorded $41 million in net losses related to this exposure. The Company no longer has any exposure to guaranteed tax lien securitizations originated by Capital Asset.
MBIA established a case loss reserve of $76 million in the fourth quarter of 2005 in connection with $686 million of net par exposure under four insured EETCs secured by 64 aircraft financed by Northwest Airlines. Northwest Airlines filed for bankruptcy protection in September 2005 and, subsequently, did not make scheduled payments on leases supporting outstanding senior debt for 31 aircraft in three of the four MBIA-insured EETCs. MBIA established the case loss reserve based on projected lower lease income related to these leases, the projected revenue from the potential redeployment of certain aircraft and estimated valuations for the aircraft subject to the defaulted leases. During the second quarter of 2006, the Company reduced its previously established case loss reserves relating to Northwest Airlines primarily as a result of claim payments it made, the sale of unsecured claims against Northwest Airlines, which provided unanticipated proceeds, the sale of selected collateral (aircraft) from one of the securitizations and an agreement to sell collateral from another securitization. The reduction of these case loss reserves, net of claim payments and salvage receipts, contributed $55 million to the Company’s unallocated loss reserve in 2006.
MBIA continues to closely monitor the manufactured housing sector, which has experienced stress during the last several years. MBIA ceased writing business in this sector, other than through certain CDO transactions, in 2000. At December 31, 2006, the Company had $21 million in case basis reserves, net of reinsurance, covering net insured par outstanding of $516 million on three credits within the manufactured housing sector. The Company had additional manufactured housing exposure of $1.6 billion in net insured par outstanding as of December 31, 2006, of which approximately 29% has been placed on the Company’s “Caution List-Medium” and “Caution List-High.” An explanation of the Company’s “Classified List” and “Caution Lists” is provided below.
When MBIA becomes entitled to the underlying collateral of an insured credit under salvage and subrogation rights as a result of a claim payment, it records salvage and subrogation as an asset. Such amounts are included in the Company’s balance sheet within
“Other assets.” As of December 31, 2006 and 2005, the Company had salvage and subrogation assets of $180 million and $143 million, respectively. The increase in salvage and subrogation assets was principally due to the expected recovery of a claim payment that the Company made in the fourth quarter of 2006 related to a multi-sector CDO. The amount the Company records as salvage and subrogation may be influenced by several factors during any period, such as the level of claim payments made for which the Company is entitled to reimbursements, amounts collected and impairment write-downs.
RISK MANAGEMENT In an effort to mitigate losses, MBIA is regularly involved in the ongoing remediation of credits that may involve, among other things, waivers or renegotiations of financial covenants or triggers, waivers of contractual provisions, the granting of consents, and the taking of various other remedial actions. The nature of any remedial action is based on the type of the insured issue and the nature and scope of the event giving rise to the remediation. In most cases, as part of any such remedial activity, MBIA is able to improve its security position and to obtain concessions from the issuer of the insured bonds. From time to time, the issuer of an MBIA-insured obligation may, with the consent of MBIA, restructure the insured obligation by extending the term, increasing or decreasing the par amount or decreasing the related interest rate with MBIA insuring the restructured obligation. If, as the result of the restructuring, MBIA estimates that it will incur an ultimate loss on the restructured obligation, MBIA will record a case basis loss reserve for the restructured obligation or, if it has already recorded a case basis loss reserve, it will re-evaluate the impact of the restructuring on the recorded reserve and adjust the amount of the reserve as appropriate.
REINSURANCE Reinsurance enables the Company to cede exposure for purposes of syndicating risk and increasing its capacity to write new business while complying with its single risk and credit guidelines. When a reinsurer is downgraded by one or more of the rating agencies, less capital credit is given to MBIA under rating agency models. Over the past several years, most of MBIA’s reinsurers have been downgraded and others remain under review. Any reduced capital credit associated with reinsurer downgrades has not and is not expected to have a material adverse effect on the Company. The Company generally retains the right to reassume the business ceded to reinsurers under certain circumstances, including rating downgrades of its reinsurers. Additionally, MBIA requires certain unauthorized reinsurers to maintain bank letters of credit or establish trust accounts to cover liabilities ceded to such reinsurers under reinsurance contracts. The Company remains liable on a primary basis for all reinsured risk, and although MBIA believes that its reinsurers remain capable of meeting their obligations, there can be no assurance of such in the future.
As of December 31, 2006, the aggregate amount of insured par ceded by MBIA to reinsurers under reinsurance agreements was $71.6 billion. Additionally, the Company has other reimbursement agreements not accounted for as reinsurance, primarily with a single-A rated reinsurer, covering $5.7 billion of insured par. The following table presents the percentage ceded to and reinsurance recoverable from reinsurers by rating levels:
MBIA will recognize a premium deficiency if the sum of the expected loss and loss adjustment expenses and unamortized policy acquisition costs exceed the related unearned premiums. If MBIA was to have a premium deficiency that is greater than unamortized acquisition costs, the unamortized acquisition costs would be reduced by a charge to expense and a liability would be established for any remaining deficiency. Although GAAP permits the inclusion of anticipated investment income when determining a premium deficiency, MBIA currently does not include this in making its determination.
Financial guarantee insurance companies use the expense ratio (expenses divided by net premiums earned) as a measure of expense management. The increases in the expense ratios presented in the preceding table are principally due to higher levels of operating expenses during 2006 and 2005.
INTEREST EXPENSE Interest expense from MBIA’s insurance operations, which primarily consists of interest related to debt issued by consolidated VIEs, the financing of the Northwest Airlines Pass Through Trust 2000-1G certificates and agreements accounted for as deposits, increased to $76 million in 2006 from $26 million in 2005. The increase primarily resulted from additional VIEs being consolidated by the Company during 2005 and the financing of the Northwest Airlines Pass Through Trust 2000-1G certificates in 2006. In 2005, interest expense decreased to $26 million from $34 million in 2004 as a result of a reduction in interest expense related to VIEs. Interest expense related to consolidated VIEs was $58 million, $25 million and $29 million in 2006, 2005 and 2004, respectively.
VARIABLE INTEREST ENTITIES The Company provides structured funding and credit enhancement services to global finance clients through the use of certain MBIA-administered, bankruptcy-remote special purpose vehicles (“SPVs”) and through third-party SPVs. Third-party SPVs are used in a variety of structures guaranteed or managed by MBIA, whereby the Company has risks analogous to those of MBIA-administered SPVs. The Company has determined that such SPVs fall within the definition of a VIE under FIN 46(R). Under the provisions of FIN 46(R), MBIA must determine whether it has a variable interest in a VIE and if so, whether that variable interest would cause MBIA to be the primary beneficiary. The primary beneficiary is the entity that will absorb the majority of the expected losses, receive the majority of the expected residual returns, or both, of the VIE and is required to consolidate the VIE.
December 31, 2006 and $1.3 billion at December 31, 2005. Revenues and expenses related to third-party VIEs are primarily recorded in “Net investment income” and “Interest expense”, respectively, on the Company’s statements of income and substantially net to zero. Consolidation of such VIEs does not increase MBIA’s exposure above that already committed to in its insurance policies.
The Company consolidated two VIEs in the third quarter of 2004 and a third VIE in the fourth quarter of 2006 that were established in connection with the securitizations of Capital Asset tax liens and to which the Company provided financial guarantees. In December 2006, the Company sold its interest in all of these consolidated VIEs. MBIA held a variable interest in these entities, which resulted from its insurance policies, and had determined that it was the primary beneficiary under FIN 46(R). MBIA has reported these VIEs as discontinued operations and included the assets of the securitizations, totaling $2.5 million at December 31, 2005, within “Other assets” on its consolidated balance sheet. Liabilities of the securitizations substantially represented amounts due to MBIA, which were eliminated in consolidation.
The Company’s investment management services operations provide an array of products and services to the public, not-for-profit and corporate sectors. Such products and services are provided primarily through wholly owned subsidiaries of MBIA Asset Management and include cash management, discretionary asset management and fund administration services and investment agreement, medium-term note and commercial paper programs related to funding assets for third-party clients and for investment purposes. The investment management services operations consist of three operating segments: asset/liability products, which include investment agreements and medium-term notes (“MTNs”) not related to the conduit programs; advisory services, which consist of third-party and related-party fee-based asset management; and conduit programs.
In 2005, investment management services’ total revenues of $910 million increased 69% compared with 2004. Excluding net realized gains or losses and net gains or losses on derivative instruments and foreign exchange, 2005 total revenues increased $314 million or 57%, compared with 2004 as a result of increased activity in asset/liability products and third-party management of CDO transactions in the advisory services segment. Total investment management services’ expenses in 2005 were $780 million, up 59% compared with 2004 due to higher interest expense from increased asset/liability products activity, which was consistent with the growth in revenues.
Net realized gains from investment securities in the investment management services operations were $6 million in 2006 compared with net realized gains of $1 million in 2005 and net realized losses of $4 million in 2004. Net realized gains and losses in the investment management services operations were generated from the ongoing management of its investment portfolios.
Asset/liability products’ pre-tax income, excluding realized gains and losses from investment securities and gains and losses on derivative instruments and foreign exchange, totaled $68.5 million in 2006, up 21% over 2005. At December 31, 2006, principal and accrued interest outstanding on investment agreement and medium-term note obligations and securities sold under agreements to repurchase totaled $20.3 billion compared to $15.7 billion at December 31, 2005. Assets supporting these agreements had market values of $20.5 billion and $15.9 billion at December 31, 2006 and December 31, 2005, respectively. These assets comprise high quality securities with an average credit quality rating of double-A. In 2005, asset/liability products’ pre-tax income, excluding net realized losses and foreign currency and derivative losses, totaled $56.5 million compared with $38.1 million in 2004, an increase of 48%.
In December of 2006, Moody’s published the findings of its previously disclosed review (Moody’s Evaluates Financial Guarantors’ Non-Core Businesses, Moody’s Special Comment, December 2006). Moody’s concluded that at its current level, MBIA’s non-core activities do not generate undue risk and do not present a threat to MBIA’s ratings. We do not expect projected growth in activities which Moody’s described as non-core to exceed the Moody’s materiality benchmarks in the foreseeable future.
The corporate operations consist of net investment income, net realized gains and losses, interest expense on MBIA Inc. debt and general corporate expenses. The corporate operations recorded losses of $81 million, $173 million and $84 million for the years ended 2006, 2005 and 2004, respectively.
The corporate operations incurred interest expense of $81 million, $91 million and $75 million for the years ended December 31, 2006, 2005 and 2004, respectively. The decrease in interest expense in 2006 compared with 2005 resulted from the retirement of $100 million of debt in the fourth quarter of 2005. The increase in interest expense in 2005 compared with 2004 primarily resulted from the issuance of $350 million of debt, partially offset by the retirement of $50 million of debt, in the fourth quarter of 2004.
Cash needs at the parent company level are primarily for dividends to its shareholders, interest payments on its debt and operating expenses. Sources of cash at the parent company level primarily consist of dividend payments from MBIA Corp. and MBIA Asset Management, investment income and the issuance of debt. Additionally, the parent company maintains excess cash and investments to ensure it is able to meet its ongoing short-term and long-term cash requirements.
The consolidated liquidity and operating cash requirements of the Company are met by cash flows generated from operations, which were more than adequate in the year ended December 31, 2006. The Company’s operating cash flows provided by continuing operations totaled $663.5 million for the year ended December 31, 2006 compared with $785.2 million for the year ended December 31, 2005. The majority of net cash provided by operating activities is generated from premium writings and investment income in the Company’s insurance operations. The decrease in cash flows principally resulted from an increase in loss payments, net of recovery collections, in the year ended December 31, 2006 compared with the year ended December 31, 2005. We believe that cash flows from operations will continue to be sufficient to meet the Company’s liquidity and operating cash requirements for the foreseeable future.
The decrease in the amortized cost of the insurance operations’ available-for-sale investments at December 31, 2006 compared with December 31, 2005 was the result of dividend payments to MBIA Inc. in December 2006 partially offset by positive cash flows from operations. The increase in the amortized cost of available-for-sale investments in the investment management services operations was the result of growth in the Company’s asset/liability products program. Corporate investments increased at December 31, 2006 compared with December 31, 2005 due to dividends received from the insurance operations.
MBIA’s consolidated investment portfolio includes investments that are insured by MBIA Corp. (“MBIA Insured Investments”). At December 31, 2006, MBIA Insured Investments, excluding conduit investments, at fair value represented $3.0 billion or 8% of total investments. Conduit investments represented $3.8 billion or 10% of total investments. Without giving effect to the MBIA guarantee of the MBIA Insured Investments in the consolidated investment portfolio, at December 31, 2006, based on the actual or estimated underlying ratings (i) the weighted-average rating of the investment portfolio would be in the Aa range, (ii) the weighted-average rating of just the MBIA Insured Investments in the investment portfolio would be in the A range and (iii) less than 1% of the investment portfolio would be rated below investment grade.
Typically, conduit programs involve the use of rating agencies in assessing the quality of asset purchases and in assigning ratings to the various programs funded through the conduits. All transactions currently funded in the conduits had an underlying rating of at least investment grade by Moody’s and S&P prior to funding. The weighted-average underlying rating for transactions currently funded in the conduits was A by S&P and A1 by Moody’s at the time such transactions were funded. MBIA estimates that the current weighted-average underlying rating of all outstanding conduit transactions was A+ by S&P and A1 by Moody’s at December 31, 2006.
The following table summarizes the Company’s contractual obligations as of December 31, 2006. For information on the Company’s financial guarantee exposure see “Note 20: Net Insurance In Force” in the Notes to Consolidated Financial Statements.
Investment agreements, commercial paper, medium-term notes, variable interest entity floating rate notes, securities sold under agreement to repurchase and long-term debt include accrued interest and exclude premiums or discounts and estimates of future interest payments. Gross insurance claim obligations represent the future value of payments MBIA expects to make, before estimated recoveries and reinsurance, under actual or probable insurance policy claims. The discounted value of such actual or estimated claims, after estimated recoveries, is reported as case basis reserves within “Loss and loss adjustment expense reserves” on the Company’s consolidated balance sheet.
Interest rate sensitivity can be estimated by projecting a hypothetical instantaneous increase or decrease in interest rates. As of December 31, 2006, a hypothetical increase in interest rates of 100, 200 and 300 basis points would have resulted in an after-tax decrease in the net fair value of the Company’s financial instruments of approximately $313.3 million, $630.3 million and $935.2 million, respectively. A decrease in interest rates of 100, 200 and 300 basis points would have resulted in an after-tax increase in the net fair value of the Company’s financial instruments of approximately $272.3 million, $605.8 million and $914.2 million, respectively.
We have completed integrated audits of MBIA Inc.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006 in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of MBIA Inc. and its subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2), present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
MBIA’s municipal services operations was sold in the fourth quarter of 2006 and related revenues and expenses have been reported as discontinued operations for all years presented in accordance with Statement of Financial Accounting Standards No. (“SFAS”) 144, “Accounting for the Impairment or Disposal of Long-lived Assets.” See “Note 15: Discontinued Operations” for additional information related to the Company’s discontinued operations.
The consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. As additional information becomes available or actual amounts become determinable, the recorded estimates are revised and reflected in operating results. Actual results could differ from those estimates.
Certain amounts have been reclassified in prior years’ financial statements to conform to the current presentation. This includes the reclassification of variable interest entity (“VIE”) interest expense from “Net investment income” to “Interest expense”, the reclassification of “Unearned compensation - restricted stock” to “Additional paid-in capital”, the reclassification of perpetual securities from “Fixed-maturity securities held as available-for-sale” to “Other investments” and the reclassification of amounts related to the Company’s discontinued operations, all of which had no effect on net income, total assets, total liabilities or shareholders’ equity as previously reported. See “Note 14: Business Segments” for information on changes in the Company’s segment reporting. In addition, the Company has revised its 2004 Consolidated Statements of Cash Flows to separately disclose the operating and investing portions of the cash flows attributable to discontinued operations. These amounts were previously reported on a combined basis.
The consolidated financial statements include the accounts of MBIA Inc., its wholly owned subsidiaries and all other entities in which the Company has a controlling financial interest. All significant intercompany balances have been eliminated and business segment results are presented net of all material intersegment transactions.
The Company determines whether it has a controlling financial interest in an entity by first evaluating whether an entity is a voting interest entity, a VIE or a qualifying special-purpose entity (“QSPE”) under GAAP.
QSPEs are passive entities accounted for in accordance with SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” SFAS 140 sets forth the criteria an entity must satisfy to be a QSPE. These criteria include the types of assets a QSPE may hold, limits on asset sales, the use of derivatives and financial guarantees, and the level of discretion a servicer may exercise in attempting to collect receivables. In accordance with SFAS 140 and FIN 46(R), the Company does not consolidate QSPEs.
Policy acquisition costs include those expenses that relate primarily to, and vary with, the acquisition of new insurance business. The Company periodically conducts a study to determine which operating costs have been incurred to acquire new insurance business and qualify for deferral. For business produced directly by MBIA Corp., such costs include compensation of employees involved in underwriting and policy issuance functions, certain rating agency fees, state premium taxes and certain other underwriting expenses, reduced by ceding commission income on premiums ceded to reinsurers. Policy acquisition costs, net of ceding commissions, related to non-derivative transactions are deferred and amortized over the period in which the related premiums are earned. Policy acquisition costs related to insured derivative transactions are expensed as incurred.
Goodwill represents the excess of the cost of acquiring a business enterprise over the fair value of the net assets acquired. Under SFAS 142, “Goodwill and Other Intangible Assets,” goodwill is tested for impairment at least annually. An impairment loss is triggered if the estimated fair value of an operating segment is less than its carrying value. See “Note 4: Goodwill” for an explanation of the Company’s annual impairment test.
Each quarter, the Company calculates its provision for the unallocated loss reserve as a fixed percent of scheduled net earned premium. This amount is recorded as “Losses and loss adjustment expense” on the consolidated statements of income. Annually, the Loss Reserve Committee evaluates the appropriateness of the fixed percent loss factor. In performing this evaluation, the Loss Reserve Committee considers the composition of the Company’s insured portfolio by municipal sector, structured asset class, remaining maturity and credit quality, along with the latest industry data, including historical default and recovery experience for the relevant sectors of the fixed-income market in order to determine if a trend is developing that indicates the loss factor should be increased or decreased. In addition, the Company considers its own historical loss activity and how those losses develop over time. The Loss Reserve Committee reviews the results of its annual evaluation over several years to determine whether any long-term trends are developing. Therefore, case basis reserves established in any year may be above or below the loss factor without requiring an increase or decrease to the loss factor. The Company’s additions to specific case basis reserves in the years ended December 31, 2005 and 2004 exceeded the 12% loss factor currently used by the Company. However, additions to specific case basis reserves in the year ended December 31, 2006 were less than the 12% loss factor. The Loss Reserve Committee is continuing to monitor any trends and evaluate whether an adjustment to the Company’s current loss factor is appropriate. During the years ended December 31, 2006, 2005 and 2004, the Company has calculated its provision for the unallocated loss reserve as 12% of scheduled net earned premium.
When a case basis reserve is established, MBIA reclassifies the estimated amount from its unallocated loss reserve in an amount equal to the specific case basis loss reserve. Therefore, the amount of available unallocated loss reserve at the end of each period is reduced
by the actual case basis reserves established in the same period. Such reclassification has no effect on the Company’s income statement as the unallocated loss reserve and specific case basis reserves, gross of recoveries from reinsurers, are reported as liabilities within “Loss and loss adjustment expense reserves” on the Company’s balance sheet. In the event that case basis reserves develop at a significantly faster or slower rate than anticipated by applying the loss factor to net scheduled earned premium, the Company will perform a qualitative evaluation with respect to the adequacy of the remaining unallocated loss reserve. In performing this evaluation, the Company considers the anticipated amounts of future transfers to existing case basis reserves, as well as the likeliness those policies for which case basis reserves have not been established will require case basis reserves at a faster or slower rate than initially expected.
A number of variables are taken into account in establishing specific case basis reserves for individual policies. These variables include the 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. Factors that may affect the actual ultimate realized losses for any policy include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. The methodology for determining when a case basis reserve is established may differ from other financial guarantee insurance companies, as well as from other property and casualty insurance enterprises.
The Company’s loss reserving policy, described above, is based on guidance provided in SFAS 60, “Accounting and Reporting by Insurance Enterprises,” SFAS 5, “Accounting for Contingencies” and analogies to Emerging Issues Task Force (“EITF”) 85-20, “Recognition of Fees for Guaranteeing a Loan.” SFAS 60 requires that, for short-duration contracts, a liability for unpaid claim costs relating to insurance contracts, including estimates of costs relating to incurred but not reported claims, be accrued when insured
Investment agreements, medium-term notes and commercial paper are recorded on the balance sheet at the time such agreements are executed. The liabilities for investment agreements and medium-term notes are carried at their face value, adjusted for any premiums or discounts, plus accrued interest. Interest expense is accrued at the contractual interest rate. Premiums and discounts related to investment agreements and medium-term notes are amortized on a constant yield basis as an adjustment to interest expense. Commercial paper is carried at face value adjusted for any discounts. Discounts related to commercial paper are amortized on a straight-line basis, which approximates a constant yield to maturity.
Securities Purchased Under Agreements to Resell And Securities Sold Under Agreements to Repurchase
Upfront premiums are earned in proportion to the expiration of the related principal balance of an insured obligation. Therefore, for transactions in which the premium is received upfront, premium earnings are greater in the earlier periods when there is a higher amount of principal outstanding. The upfront premiums are apportioned to individual sinking fund payments of a bond issue according to an amortization schedule. After the premiums are allocated to each scheduled sinking fund payment, they are earned on a straight-line basis over the period of that sinking fund payment. Accordingly, deferred premium revenue represents the portion of premiums written that is applicable to the unexpired risk of insured bonds and notes. When an MBIA-insured issue is retired early, is
The Company collects fees for services performed in connection with certain transactions. In addition, the Company may be entitled to reimbursement of third-party expenses that it incurs in connection with certain transactions. Depending upon the type of fee received and whether it is related to an insurance policy, the fee is either earned when it is received or deferred and earned over the life of the related transaction. Work, waiver and consent, termination, administrative and management fees are earned when the related services are completed and the fee is received. Structuring fees are earned on a straight-line basis over the life of the related insurance policy and commitment fees are earned on a straight-line basis over the commitment period. Expense reimbursements are recognized when received.
The Company follows the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation,” as revised by SFAS 123(R), “Share-Based Payment.” Under the modified prospective transition method selected by the Company under the provisions of SFAS 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” all equity-based awards granted to employees and existing awards modified on or after January 1, 2003 are accounted for at fair value with compensation expense recorded in net income. See “Note 24: Long-term Incentive Plans” for a further discussion regarding the methodology utilized in recognizing employee stock compensation expense.
In February 2007, the FASB issued SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 provides the Company an irrevocable option to report selected financial assets and liabilities at fair value with changes in fair value recorded in earnings. The option is applied, on a contract-by-contract basis, to an entire contract and not only to specific risks, specific cash flows or other portions of that contract. Upfront costs and fees related to a contract for which the fair value option is elected shall be recognized in earnings as incurred and not deferred. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. MBIA is currently evaluating the provisions of SFAS 159 and their potential impact on the Company’s financial statements.
In February 2006, the FASB issued SFAS 155, “Accounting for Certain Hybrid Financial Instruments,” which amends SFAS 133 and SFAS 140. SFAS 155 permits an entity to measure at fair value any financial instrument that contains an embedded derivative that would otherwise require bifurcation. The fair value designation may be applied on an instrument-by-instrument basis, however, the election to apply fair value accounting is irrevocable. For the Company, SFAS 155 is effective for those financial instruments acquired or issued on or after January 1, 2007. MBIA is currently evaluating the provisions of SFAS 155 and their potential impact on the Company’s financial statements.
In September 2006, the SEC issued Staff Accounting Bulletin No. (“SAB”) 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 requires that a registrant use both a balance sheet approach and an income statement approach when quantifying and evaluating the materiality of a misstatement. In addition, SAB 108 provides permitted transition methods for correcting and disclosing errors that existed prior to the application of SAB 108 when such errors are determined to be material to a registrant’s financial statements upon the application of SAB 108. SAB 108 is effective for the first fiscal year ending after November 15, 2006, with early adoption permitted in interim reports filed with the SEC. MBIA applied the provisions of SAB 108 in connection with the preparation of its financial statements for the year ended December 31, 2006. The application of SAB 108 did not have a material effect on the Company’s financial statements.
Goodwill totaled $79.4 million as of December 31, 2006 and 2005, of which $76.9 million was within the insurance reporting segment and $2.5 million was within the investment management services reporting segment.
The Company provides structured funding and credit enhancement services to global finance clients through the use of certain MBIA-administered, bankruptcy-remote special purpose vehicles (“SPVs”) and through third-party SPVs. The purpose of the MBIA-administered SPVs is to provide clients with an efficient source of funding, which may offer MBIA the opportunity to issue financial guarantee insurance policies. These SPVs purchase various types of financial instruments, such as debt securities, loans, lease receivables and trade receivables, and fund these purchases through the issuance of asset-backed short-term commercial paper or medium-term notes. The assets and liabilities within the medium-term note programs are managed primarily on a match-funded basis and may include the use of derivative hedges, such as interest rate and foreign currency swaps. By match-funding and hedging, the SPVs eliminate the risks associated with fluctuations in interest and foreign currency rates, indices and liquidity. Typically, programs involve the use of rating agencies in assessing the quality of asset purchases and in assigning ratings to the various programs. In general, asset purchases at the inception of a program are required to be investment grade by at least one major rating agency. The primary SPVs administered by MBIA are Triple-A One Funding Corporation (“Triple-A”), Meridian Funding Company, LLC (“Meridian”) and Polaris Funding Company, LLC (“Polaris”) (collectively, the “Conduits”). Third-party SPVs are used in a variety of structures guaranteed or managed by MBIA, whereby the Company has risks analogous to those of MBIA-administered SPVs. The Company has determined that such SPVs fall within the definition of a VIE under FIN 46(R).
In the fourth quarter of 2006, MBIA Asset Management sold $922.2 million of fixed-income investments, including debt issued by investment grade financial institutions and asset-backed securities, to Hudson-Thames Capital Limited, a Jersey-domiciled public company with limited liability. MBIA recorded an immaterial loss on the sale. Hudson-Thames Capital Limited, together with its co-issuer Hudson-Thames LLC, a Delaware limited liability company, (collectively, “Hudson-Thames”) is a structured investment vehicle investing in high quality investments and derivatives under various programs and funding its investments and derivatives by issuing capital notes, Euro and U.S. commercial paper and medium-term notes. Hudson-Thames carries program ratings of Aaa/P-1 from Moody’s and AAA/A-1+ from S&P. MBIA Asset Management holds an interest in Hudson-Thames through the purchase of $8.7 million in Hudson-Thames capital notes and by providing asset management services to Hudson-Thames. The Company has determined that Hudson-Thames meets the definition of a VIE and that MBIA is not the primary beneficiary and, therefore, does not consolidate these entities. The obligations issued by Hudson-Thames are not guaranteed by MBIA and MBIA’s creditors do not have any rights to the assets of Hudson-Thames.
The investment management services operations have entered into derivative transactions primarily consisting of interest rate, cross currency, credit default and total return swaps and principal protection guarantees. Interest rate swaps are entered into to hedge the risks associated with fluctuations in interest rates or fair values of certain contracts. Cross currency swaps are entered into to hedge the variability in cash flows resulting from fluctuations in foreign currency rates. Credit default swaps are entered into to hedge credit risk or to replicate investments in cash assets consistent with the Company’s risk objectives and credit guidelines for its investment management business. The maximum amount of future payments the Company may be required to make under credit default swap contracts, should a full credit event occur on all of its outstanding contracts, is $1.4 billion. These credit default swaps reference credits with an average quality of Aa3/AA- and have a maturity range of up to 5 years, with an average life of approximately 1.4 years. In accordance with SFAS 133, the fair values of these credit default swaps at December 31, 2006 are recorded on the consolidated balance sheet as assets and liabilities, representing gross gains and losses, of $2.8 million and $0.3 million, respectively. Total return swaps are entered into to enable the Company to earn returns on certain obligations without directly owning the underlying obligations. The Company has also provided loss protection on certain MBIA Municipal Investor Service Corporation (“MBIA-MISC”) managed municipal pools that invest in highly rated short-term fixed-income securities. Such protection is accounted for as a derivative under SFAS 133 and is included as part of the Company’s principal protection guarantees.
Certain interest rate and cross currency swaps qualify as cash flow hedges and fair value hedges under SFAS 133. The cash flow hedges mitigate or offset fluctuations in cash flows arising from variable rate assets or liabilities. The unrealized gains and losses relating to the cash flow hedges are reported in accumulated other comprehensive income and will be reclassified into earnings as interest revenue and expense are recognized on the hedged assets and liabilities. The fair value hedges are used to protect against changes in the market value of the hedged assets or liabilities. The gains and losses relating to the fair value hedges are recorded directly in earnings. Cash flow and fair value hedges are hedging existing assets, liabilities or forecasted transactions. During 2006, the Company recorded losses of $2.2 million (net of tax) and gains of $0.2 million (net of tax) in earnings within net gains (losses) on derivative instruments and foreign exchange due to the ineffectiveness of fair value and cash flow hedges, respectively.
The Conduits primarily enter into interest rate and cross currency swaps as economic hedges against interest rate and currency risks. The cross currency swaps qualify as fair value hedges of foreign currency risk under SFAS 133. During 2006, the Company recorded losses of $2.5 million (net of tax) in earnings due to the ineffectiveness of these hedges. The Company also recorded losses of $0.5 million (net of tax) on economic hedges that did not qualify for hedge accounting under SFAS 133.
Cash flow hedges related to the investment management services operations resulted in an aggregate net unrealized gain of $0.4 million (net of tax) in accumulated other comprehensive income at December 31, 2006. The aggregate net unrealized gain is composed of both positive and negative future cash flows. The Company expects that approximately $0.9 million of unrealized gains (net of tax) will migrate from accumulated other comprehensive income into earnings during 2007 and the remaining amount over the term of the contracts.
The corporate operations have entered into a cross currency swap to hedge foreign exchange risks related to the issuance of certain MBIA long-term debt in accordance with the Company’s risk management policies. The cross currency swap has been designated as a cash flow hedge and hedges the variability arising from currency exchange rate movements on the foreign denominated fixed rate debt. Changes in the fair value of the cross currency swap are recorded in accumulated other comprehensive income. As the debt is revalued at the spot exchange rate in accordance with SFAS 52, “Foreign Currency Translation,” an amount that will offset the
related transaction gain or loss arising from the revaluation will migrate each period from accumulated other comprehensive income into earnings. This cash flow hedge was 100% effective during 2006.
The cross currency swap resulted in an aggregate unrealized gain of $0.5 million (net of tax) remaining in accumulated other comprehensive income at December 31, 2006. The Company expects that approximately $0.7 million of unrealized losses (net of tax) will migrate from accumulated other comprehensive income into earnings during 2007 and the remaining balance over the term of the contract.
The notional values of the derivative instruments by business operations at December 31, 2006 and 2005 are as follows:
The Company manages counterparty credit risk on an individual counterparty basis through master netting agreements covering derivative transactions in the investment management services and corporate operations. These agreements allow the Company to contractually net amounts due from a counterparty with those amounts due to such counterparty when certain triggering events occur. The Company only executes swaps under master netting agreements, which typically contain mutual credit downgrade provisions that generally provide the ability to require assignment or termination in the event either MBIA or the counterparty is downgraded below a specified credit rating. If the Company were to settle all transactions covered under netting agreements as of December 31, 2006, the amount required to be paid to counterparties would have been reduced by $259.8 million as a result of its contractual right to offset amounts due from such counterparties. The Company has chosen not to net receivables due from counterparties with payables due to counterparties in its balance sheet, but instead report these amounts on a gross basis as assets and liabilities.
As of December 31, 2006 and 2005, the Company held derivative assets of $521.3 million and $326.9 million, respectively, and derivative liabilities of $400.3 million and $384.6 million, respectively, which are shown separately on the consolidated balance sheets. The following tables display the amount of the derivative assets and liabilities by business operations for the years ended December 31, 2006 and 2005.
The income statement impact for all derivative transactions for 2006 was an after-tax increase in net income of $84.2 million. The impact of all derivative transactions for 2005 and 2004 was an after-tax increase in net income of $83.5 million and $37.3 million, respectively. The income statement impact of derivative activity is broken down into revenues, net realized gains (losses), net gains (losses) on derivative instruments and foreign exchange and expenses. Interest and fee income, including premiums received on insured derivatives, and interest on derivatives, are recorded within revenues and expenses. For derivatives that have been designated as qualifying hedges, income and expense are recorded as an adjustment to those of the hedged items. The following tables display the impact described above on the 2006, 2005 and 2004 income statements by business operation of all derivative transactions.
The fair value of the Company’s derivative instruments is estimated using various valuation models that conform to industry standards. The Company utilizes both vendor-developed and proprietary models, based on the complexity of transactions. Dealer market quotes are typically obtained for regularly traded contracts and provide the best estimate of fair value. However, when reliable dealer market quotes are not available, the Company uses a variety of market and portfolio data relative to the type and structure of contracts. Several of the more significant types of data that influence the Company’s valuation models include interest rates, credit spreads, credit quality ratings and correlation assumptions. This data is obtained from highly recognized sources and is reviewed for reasonableness and applicability to the Company’s derivative portfolio.
The Company enters into securities borrowing and lending contracts in connection with MBIA’s collateralized investment agreement and repurchase agreement activities and to invest short-term cash balances or provide liquidity to the Company’s asset/liability programs. Such contracts are only transacted with high quality dealer firms. It is the Company’s policy to take possession of securities borrowed under these contracts. The Company minimizes the credit risk of counterparties to transactions that might be unable to fulfill their contractual obligations by monitoring customer credit exposure and collateral value and requiring additional collateral to be deposited with the Company when deemed necessary.
The Company may receive or pledge collateral in connection with certain derivative contracts when the current market value of such contracts exceeds exposure thresholds. See “Note 6: Derivative Instruments” for a further discussion on collateralized derivative transactions.
Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects the dilutive effect of all stock options and other items outstanding during the period that could potentially result in the issuance of common stock. As of December 31, 2006, 2005 and 2004 there were 1,716,828, 2,837,793 and 2,294,297 stock options, respectively, that were not included in the diluted earnings per share calculation because they were antidilutive.
The following table presents the computation of basic and diluted earnings per share for the years ended December 31, 2006, 2005 and 2004:
Note 10: Premiums Earned from Refunded, Called and Terminated Insured Obligations
The following tables present the amortized cost and fair value of the available-for-sale fixed-maturity, short-term and other investments included in the consolidated investment portfolio of the Company as of December 31, 2006 and 2005:
Fixed-maturity investments carried at fair value of $13.0 million and $12.9 million as of December 31, 2006 and 2005, respectively, were on deposit with various regulatory authorities to comply with insurance laws.
A portion of the obligations under investment agreements require the Company to pledge securities as collateral. As of December 31, 2006 and 2005, the fair value of securities pledged as collateral with respect to these obligations approximated $5.6 billion and $4.6 billion, respectively.
Investments that are held-to-maturity are reported on the Company’s balance sheet at amortized cost. These investments, which relate to the Company’s Conduit program and consolidated VIEs, primarily consist of asset-backed securities and loans issued by major national and international corporations and other structured finance clients. As of December 31, 2006, the amortized cost and fair value of held-to-maturity investments totaled $5.5 billion. There were no unrecognized gross gains and unrecognized gross losses were $27.1 million. As of December 31, 2005, the amortized cost and fair value of held-to-maturity investments totaled $5.8 billion. Unrecognized gross gains were $0.9 million and unrecognized gross losses were $31.8 million. The following table presents the distribution of held-to-maturity investments by contractual maturity at amortized cost and fair value at December 31, 2006.
Included in the preceding tables are investments that have been insured by MBIA Corp. (“MBIA Insured Investments”). These investments are rated triple-A by nationally recognized rating agencies as a result of MBIA’s financial guarantee. At December 31, 2006, MBIA Insured Investments, at fair value, represented $6.8 billion or 18% of the total portfolio, of which $3.8 billion or 10% relate to Conduit investments. Without giving effect to the MBIA guarantee of the MBIA Insured Investments, the underlying ratings (those given to an investment without the benefit of MBIA’s guarantee) of the MBIA Insured Investments as of December 31, 2006 are reflected in the following table. Amounts represent the fair value of such investments including the benefit of the MBIA guarantee. The ratings in the table below are the lower underlying rating assigned by S&P or Moody’s when an underlying rating exists from either rating service, or when an external underlying rating is not available, the underlying rating is based on the Company’s best estimate of the rating of such investment.
It is MBIA’s policy to obtain an underlying rating from both Moody’s and S&P for each new Conduit transaction prior to the execution of such transactions. All transactions currently funded in the Conduits had an underlying rating of investment grade by Moody’s and S&P prior to funding. The weighted-average underlying rating for transactions currently funded in the Conduits was A by S&P and A1 by Moody’s at the time such transactions were funded. MBIA estimates that the weighted-average underlying rating of all outstanding Conduit transactions was A+ by S&P and A1 by Moody’s as of December 31, 2006.
As of December 31, 2006 and 2005, the Company’s available-for-sale fixed-maturity, equity and held-to-maturity investment portfolios’ gross unrealized losses totaled $192.5 million and $167.3 million, respectively. The weighted-average contractual maturity of securities in an unrealized loss position as of December 31, 2006 and 2005 was 13 years and 11 years, respectively. As of December 31, 2006, there were 543 securities that were in an unrealized loss position for a continuous twelve-month period or longer with aggregate unrealized losses of $153.5 million. Of the 543 securities, 32 securities had unrealized losses in which their book value exceeded market value by more than 5%. As of December 31, 2005, there were 244 securities that were in an unrealized loss position for a continuous twelve-month period or longer with aggregate unrealized losses of $63.5 million. Of the 244 securities, 2 securities had unrealized losses in which their book value exceeded market value by more than 5%.
The following table includes total investment income from all operations. Net realized gains (losses) from fixed-maturity investment security sales are generated as a result of the ongoing management of the Company’s investment portfolios. Other investment net realized gains of $24 million in 2006 were primarily due to the sale of a common stock investment in RAM Holdings, Inc., the holding company of RAM Reinsurance Company, Ltd., which generated a realized gain of $11 million. Other investment net realized gains in 2005 of $11 million were primarily due to sales of perpetual securities. Other investment net realized gains in 2004 were largely due to the sale of a common stock investment the Company purchased in 2002, which resulted in a $77 million gain. Other net realized losses of $22 million in 2006 include a $25 million write-down of a salvage receivable. Other net realized losses of $25 million in 2005 include $16 million of impairment losses on receivables the Company recorded through salvage and subrogation rights it obtained as a result of claim payments it previously made on insured credits. Other net realized gains of $41 million in 2004 resulted from the termination of certain transactions that were accounted for as deposits. Additionally, in 2005 and 2004, the Company recognized net realized losses of $3 million and $11 million, respectively, due to other-than-temporary impairments of taxable fixed-maturity investments.
The tax effects of temporary differences that give rise to deferred tax assets and liabilities at December 31, 2006 and 2005 are presented in the following table:
As it is the Company’s practice and intent to permanently reinvest the earnings of MBIA Assurance, S.A., MBIA UK Insurance Limited and MBIA Euro Asset Acquisitions Ltd., no U.S. deferred income taxes have been provided with respect to the undistributed earnings of these entities. The cumulative amounts of such untaxed earnings were $206.1 million, $147.2 million and $106.5 million at December 31, 2006, 2005 and 2004, respectively.
The insurance operations is a reportable segment and provides an unconditional and irrevocable guarantee of the payment of principal and interest on insured obligations when due. MBIA issues financial guarantees for municipal bonds, asset-backed and mortgage-backed securities, investor-owned utility bonds, bonds backed by publicly or privately funded public-purpose projects, bonds issued by sovereign and sub-sovereign entities, obligations collateralized by diverse pools of corporate loans and pools of corporate and asset-backed bonds, both in the new issue and secondary markets. Additionally, MBIA insures credit default swaps on pools of collateral, which it considers part of its core financial guarantee business. This segment includes all activities related to global credit enhancement services provided principally by MBIA Corp.
The Company’s conduit segment administers three multi-seller conduit financing vehicles through MBIA Asset Finance, LLC. The conduits provide funding for multiple customers through special purpose vehicles that issue primarily commercial paper and medium-term notes.
The Company’s corporate operations are a reportable segment and include revenues and expenses that arise from general corporate activities and that consist of net investment income, gains and losses from the sale of investment securities, interest expense on MBIA Inc. debt and general corporate expenses.
Reportable segment results are presented net of material intersegment transactions. The following table summarizes the Company’s operations for the years ended December 31, 2006, 2005 and 2004:
The following table summarizes the segments within the investment management services operations for the years ended December 31, 2006, 2005 and 2004:
Represents the sum of interest income, investment management services fees and other fees.
A significant portion of premiums reported within the insurance segment is generated outside the U. S. The following table summarizes net premiums earned by geographic location of risk for years ended December 31, 2006, 2005 and 2004.
In December 2006, MBIA completed the sale of Capital Asset, a servicer of delinquent tax liens, to a third party company that is engaged in tax lien servicing and collection and that had been overseeing the servicing operations of Capital Asset since July 2006. The sale of Capital Asset also included three VIEs established in connection with the securitization of Capital Asset tax liens, which were consolidated within the Company’s insurance operations in accordance with FIN 46(R). The sale of Capital Asset and the related VIEs resulted in an after-tax loss of $0.6 million.
In May 2004, the Company completed the sale of the assets of 1838, a full service equity-focused asset management firm, to the management of 1838 together with an investor group led by Orca Bay Partners. The sale of 1838 resulted from the Company’s decision to exit the equity advisory market and focus on fixed-income asset management. 1838 comprised the equity advisory services segment of the Company’s investment management services operations. The Company recorded an after-tax gain of $3.2 million on the sale of the assets of 1838.
The following table presents the major classes of asset and liabilities related to discontinued operations that have been included in “Other assets” and “Other liabilities” on the Company’s consolidated balance sheet at December 31, 2005:
In 2006 and 2005, MBIA Corp. declared and paid dividends of $339 million and $95 million, respectively, to MBIA Inc. without the need for special approval by the NYSID. In the fourth quarter of 2006, MBIA Corp. received approval from the NYSID to pay a total dividend of $500 million, which MBIA Corp. declared and paid to MBIA Inc. in December 2006.
In February 2007, the Company’s Board of Directors authorized the repurchase of common stock up to $1 billion under a new share repurchase program, which superseded the previously authorized program. The Company’s ability to repurchase common stock is largely dependent on the amount of dividends paid by MBIA Corp. to MBIA Inc. Repurchases of common stock will be made from time to time in the open market or in private transactions as permitted by securities laws and other legal requirements. Share repurchases increase the Company’s treasury stock. Treasury stock is carried at cost and is a component of stockholders’ equity.
During 2006, 959,381 shares were purchased by the Company for settling awards under the Company’s long-term incentive plans.
The Company’s long-term debt is subject to certain restrictive covenants, none of which significantly restrict the Company’s operating activities or dividend-paying ability. At December 31, 2006 and December 31, 2005, the Company was in compliance with all debt covenants.
MBIA Corp. has access to $400 million of Money Market Committed Preferred Custodial Trust securities (“CPCT securities”) issued by eight trusts, which were created for the primary purpose of issuing CPCT securities and investing the proceeds in high
Note 18: Short-Term Debt, Long-Term Debt and Other Borrowing Arrangements (continued)
The Company has $19.8 million of outstanding letters of credit for MBIA-MISC that are intended to support the net asset value of certain investment pools managed by MBIA-MISC. These letters of credit can be drawn upon in the event that the liquidation of such assets is required and the proceeds are less than the cost. In addition, the Company has issued commitments to three pooled investment programs managed or administered by MBIA-MISC and its subsidiary. These commitments cover losses in such programs should the net asset values per share decline below specified per share values. At December 31, 2006, the maximum amount of future payments that the Company would be required to make under these commitments was $3.7 billion. These commitments shall be in effect so long as MBIA-MISC and its subsidiary remain as manager or administrator and each program remains in compliance with its respective investment objectives and policies.
Note 19: Investment Agreement, Commercial Paper and Medium-Term Note Obligations (continued)
MBIA Corp. may hold recourse provisions with third parties in derivative transactions through both reinsurance and subrogation rights. MBIA Corp.’s reinsurance arrangements provide that should MBIA Corp. pay a claim under a guarantee of a derivative contract, then MBIA Corp. could collect amounts from any reinsurers that have reinsured the guarantee on either a proportional or non-proportional basis, depending upon the underlying reinsurance agreement. MBIA Corp. may also have recourse through subrogation rights whereby if MBIA Corp. makes a claim payment, it is entitled to any rights of the insured counterparty, including the right to any assets held as collateral.
MBIA Corp. has also issued guarantees of certain obligations issued by its investment management affiliates that are not included in the previous tables. These guarantees take the form of insurance policies issued by MBIA Corp. on behalf of the investment management affiliates. Should one of these affiliates default on its insured obligations, MBIA Corp. will be required to pay all scheduled principal and interest amounts outstanding. As of December 31, 2006, the maximum amount of future payments that MBIA Corp. could be required to make under these guarantees, should a full default occur, is $20.8 billion. These guarantees have a maximum maturity range of 1-58 years, were entered into on an arm’s length basis and are fully collateralized by marketable securities. MBIA Corp. has both direct recourse provisions and subrogation rights in these transactions. If MBIA Corp. is required to make a payment under any of these affiliate guarantees, it would have the right to seek reimbursement from such affiliate and to liquidate any collateral to recover amounts paid under the guarantee.
Amounts deducted from gross insurance in force for reinsurance ceded by MBIA Corp. and its subsidiaries were $104.8 billion and $106.7 billion as of December 31, 2006 and 2005, respectively. The distribution of ceded insurance in force by geographic location is presented in the following table:
While Channel Re continues to be a triple-A rated reinsurer of MBIA Corp, S&P reaffirmed its negative outlook on Channel Re during the second quarter of 2006. MBIA does not expect S&P’s outlook on Channel Re to have a material negative impact on the Company’s financial condition or results of operations. MBIA continues to own a 17.4% equity interest in Channel Re.
In February 2004, MBIA Corp. and Channel Re entered into treaty and facultative reinsurance arrangements whereby Channel Re agreed to provide committed reinsurance capacity to MBIA Corp. through June 30, 2008, subsequently extended to June 30, 2009, and subject to renewal thereafter. Under these reinsurance arrangements, MBIA Corp. agreed to cede to Channel Re and Channel Re agreed to assume from MBIA Corp. varying percentages of designated policies issued by MBIA Corp. The amount of any policy subject to the committed reinsurance arrangements is based on the type of risk insured and on other factors. Additionally, the reinsurance arrangements provide Channel Re with certain preferential terms, including those related to ceding commissions.
The components of net premiums written and earned, including premiums assumed from and ceded to other companies, are presented in the following table:
In addition to the above plans, the Company maintains a non-qualified deferred compensation plan. Contributions to the above qualified plans that exceed limitations established by federal regulations are then contributed to the non-qualified deferred compensation plan. The non-qualified contributions included in the above stated pension and profit-sharing/401(k) expense and contribution amounts totaled $3.1 million, $2.7 million and $2.9 million for the pension plan, and $0.4 million, $1.5 million and $1.6 million for the profit-sharing/401(k) plan for the years ended December 31, 2006, 2005 and 2004, respectively. In addition, the interest credited to the non-qualified deferred compensation plans totaled $3.0 million, $2.6 million and $2.9 million for the years ended December 31, 2006, 2005, and 2004, respectively.
In November 2006, the Company’s Board of Directors approved new voluntary retirement benefits which will provide certain benefits to eligible employees of the Company upon retirement. A description of these benefits is included in the Company’s proxy statement.
Under the restricted stock component of the Omnibus Plan, certain employees are granted restricted shares of the Company’s common stock. These awards have a restriction period lasting three, four or five years depending on the type of award, after which time the awards fully vest. During the vesting period these shares may not be sold. Restricted stock grants are typically granted from the vice president level up to and including the chief executive officer. Some of the awards made in 2006 and 2005 are linked to growth in the book value of the Company including certain adjustments (“modified book value”) over a three-year period following the grant date. Actual shares issued at the vesting date will be determined based on the growth in modified book value. If modified book value grows by 30% or more over the three year period, then 100% of the award will vest. If the growth in modified book value over the three year period is lower than 30%, then the amount of restricted shares issued will be adjusted downward in proportion to the amount by which actual growth in modified book value is below 30%.
In November 2006, the Company’s Board of Directors approved new voluntary retirement benefits as discussed in “Note 23: Pension and Profit Sharing Plans.” One of the components of the retirement program for those employees that are retirement eligible is to immediately vest all outstanding stock options granted prior to the approval of the program and to immediately vest all outstanding time-based restricted share grants. SFAS 123(R) requires compensation costs for those employees to be recognized from the date of grant through the retirement eligible date. Accelerated expense relating to this retirement benefit for both stock option awards and restricted stock awards is included in compensation expense.
In May 2002, the MBIA Inc. Board of Directors approved the “MBIA Inc. Annual and Long-Term Incentive Plan” (the “Incentive Plan”). The Incentive Plan has been superseded by the Omnibus Plan. The Incentive Plan included a stock option component and a compensation component linked to the growth in modified book value over a three-year period following the grant date. Target levels for the Incentive Plan awards were established as a percentage of total salary and bonus, based upon the recipient’s position. Awards under the Incentive Plan typically were granted from the vice president level up to and including the chief executive officer. Actual amounts to be paid are adjusted upward or downward depending on the growth of modified book value versus a baseline target, with a minimum growth of 8% necessary to receive any payment and an 18% growth necessary to receive the maximum payment. Awards under the Incentive Plan were divided equally between the two components, with approximately 50% of the award to be given in stock options and approximately 50% of the award to be paid in cash or shares of Company stock. Payments are made at the end of each three-year measurement period. During 2006, 2005 and 2004, $4.3 million, $8.5 million and $25.1 million, respectively, was recorded as an expense related to modified book value awards. The tax benefit related to modified book value awards was $1.5 million, $3.0 million and $8.8 million for the years ended December 31, 2006, 2005 and 2004, respectively.
The fair value for stock option awards is estimated at the date of grant using the Black-Scholes option pricing model. This model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. The number of significant options granted and the assumptions used for valuing such option grants during the last three years are shown in the following table:
Employee stock option compensation expense, net of estimated forfeitures, for the years ended December 31, 2006, 2005, and 2004 totaled $16.6 million, $18.6 million and $16.7 million, respectively. The tax benefit related to the stock option awards exercised during 2006, 2005 and 2004 was $7.3 million, $2.5 million and $7.8 million, respectively. The excess tax benefit related to the stock option awards during 2006, 2005 and 2004 was $2.4 million, $1.0 million and $4.7 million, respectively. As of December 31, 2006, there was $16.5 million of total unrecognized compensation cost related to nonvested stock options. This amount is expected to be recognized as expense over a weighted-average period of 1.71 years.
The following table summarizes information about outstanding stock options at December 31, 2006:
Trusts for the benefit of employees, such as pension and profit-sharing trusts, that are managed by or under the trusteeship of management.
From time to time the Company may enter into transactions with related parties that the Company deems immaterial or which occur in the normal course of business and are deemed to be transacted at “arm’s length” by management. Since 1989, MBIA Corp. has executed five surety bonds to guarantee the payment obligations of the members of the Municipal Bond Insurance Association (the “Association”), a voluntary unincorporated association of insurers writing municipal bond and note insurance as agent for the member insurance companies that had their S&P claims-paying rating downgraded from AAA on their previously issued Association policies. In the event that the Association does not meet their policy payment obligations, MBIA Corp. will pay the required amounts directly to the paying agent. The aggregate outstanding exposure on these surety bonds as of December 31, 2006 is $340 million.
MBIA Inc., through its subsidiaries, is responsible for providing investment advisory and certain related administrative services to the MBIA Capital/Claymore Managed Duration Investment Grade Municipal Fund and, prior to the sale of 1838 in May 2004, provided such services to the 1838 Bond-Debenture Trading Fund and the 1838 Investment Advisors Funds (collectively, the “Funds”). Additionally, MBIA, Inc., through its subsidiaries, earned investment management, accounting, administration and service fees related to the Funds, which aggregated $0.4 million, $0.7 million and $0.9 million for the years ended December 31, 2006, 2005 and 2004, respectively, and are included in investment management services revenues in the Company’s consolidated statements of income.
During 2006, the Company structured two investment companies, Hudson-Thames and East-Fleet Finance Limited, along with its co-issuer, East-Fleet Finance LLC, which are not consolidated into the financial statements of the Company. MBIA, through its subsidiaries, provides asset management and administrative services to these companies. The Company will earn fees related to these services, which will be included in investment management services’ revenues in the Company’s consolidated statement of income. Additionally, MBIA has invested in the capital notes of Hudson-Thames as described in “Note 5: Variable Interest Entities.”
The Company owns investments, included in other investments, which are recorded in the Company’s financial statements using the equity method of accounting. These investments comprise equity interests in limited partnerships and in Channel Re. All material transactions between MBIA and these entities have been eliminated in MBIA’s consolidated financial statements. During 2006 and 2005, premiums ceded to Channel Re totaled $47.0 million and $61.4 million, respectively, and ceding commissions received from Channel Re totaled $11.0 million and $14.2 million, respectively. See “Note 21: Reinsurance” for information regarding the terms of the reinsurance arrangements between MBIA Corp. and Channel Re.
The Company had no loans outstanding to any executive officers or directors during 2006.
OTHER INVESTMENTS-Other investments consist of the Company’s interest in equity-oriented and equity method investments, including investments in perpetual securities. The fair value of these investments is based on quoted market prices, investee financial statements or cash flow modeling.
CASH AND CASH EQUIVALENTS, ACCRUED INVESTMENT INCOME, REINSURANCE RECOVERABLE ON UNPAID LOSSES, RECEIVABLE FOR INVESTMENTS SOLD, SHORT-TERM DEBT AND PAYABLE FOR INVESTMENTS PURCHASED-The carrying amounts of these items are reasonable estimates of their fair values as they are short-term in nature.
PREPAID REINSURANCE PREMIUMS-The fair value of the Company’s prepaid reinsurance premiums is based on the estimated proceeds from entering into an assumption of the entire portfolio with third-party reinsurers under current market conditions.
DEFERRED PREMIUM REVENUE-The fair value of the Company’s deferred premium revenue is based on the estimated cost of entering into a cession of the outstanding portfolio with third-party reinsurers under current market conditions.
INVESTMENT AGREEMENTS AND MEDIUM-TERM NOTES-The fair values of investment agreements and medium-term notes are estimated using discounted cash flow calculations based upon interest rates currently being offered for similar agreements and notes with maturities consistent with those remaining for the investment agreements and medium-term notes being valued.
In the normal course of operating its business, the Company may be involved in various legal proceedings.
In July 2002, MBIA Corp. filed suit against Royal Indemnity Company (“Royal”) in the United States District Court for the District of Delaware, to enforce insurance policies that Royal issued on certain vocational student loan transactions that MBIA Corp. insured. To date, claims in the amount of approximately $355 million have been made under the Royal policies with respect to loans that have defaulted. MBIA Corp. expects that there will be additional claims made under the policies with respect to student loans that may default in the future. Royal had filed an action seeking a declaration that it is not obligated to pay on its policies. In October 2003, the court granted MBIA Corp.’s motion for summary judgment and ordered Royal to pay all claims under its policies. Royal appealed the order, and, in connection with the appeal, pledged $403 million of investment grade collateral to MBIA Corp. to secure the entire amount of the judgment, with interest, and has agreed to post additional security for future claims and interest.
If the collateral is released and Royal is unable to make payments on the Royal policies, MBIA Corp. would incur substantial losses under its policies. MBIA Corp. does not believe, however, that any such losses will have a material adverse effect on its financial condition.
On January 29, 2007, the Company announced that it and its principal operating subsidiary MBIA Corp. (together with MBIA, the “Companies”) had concluded civil settlements with the SEC, the NYAG, and the NYSID with respect to transactions entered into by the Companies in 1998 following defaults on insured bonds issued by AHERF.
The terms of the settlements, under which the Companies neither admit nor deny wrongdoing, include:
The Companies’ consent to a cease and desist order with respect to future violations of securities laws;
The Company was named as a defendant in private securities actions consolidated as In re MBIA Inc. Securities Litigation; (Case No. 05 CV 03514(LLS); S.D.N.Y.) (filed October 3, 2005). Joseph W. Brown, the Company’s Chairman and former Chief Executive Officer, Gary C. Dunton, the Company’s Chief Executive Officer, Nicholas Ferreri, the Company’s former Chief Financial Officer, Neil G. Budnick, a Vice President of the Company and the Company’s former Chief Financial Officer and Douglas C. Hamilton, the Company’s Controller were also named as defendants in the suit, as were former Chairman and Chief Executive Officer David H. Elliott and former Executive Vice President, Chief Financial Officer and Treasurer Juliette S. Tehrani. The plaintiffs asserted claims under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act. The lead plaintiffs purport to be acting as representatives for a class consisting of purchasers of the Company’s stock during the period from August 5, 2003 to March 30, 2005 (the “Class Period”).
The allegations contained in the lawsuit included, among other things, violations of the federal securities laws arising out of the Company’s allegedly false and misleading statements about its financial condition and the nature of the arrangements entered into by MBIA Corp. in connection with the AHERF loss, and about the effectiveness of the Company’s internal controls. The plaintiffs alleged that, as a result of these misleading statements or omissions, the Company’s stock traded at artificially inflated prices throughout the Class Period.
The defendants, including the Company, filed motions to dismiss this lawsuit on various grounds. On February 13, 2007, the Court granted those motions, and dismissed the lawsuit in its entirety, on the grounds that these claims are barred by the applicable statute of limitations. The Court did not reach the other grounds for dismissal argued by the Company and the other defendants. The Company does not expect the outcome of the private securities litigation to have a material adverse affect on its financial condition, although the outcome is uncertain and no assurance can be given that the Company will not suffer a loss.
A Special Litigation Committee of three independent directors of MBIA Inc. has determined after a good faith and thorough investigation that pursuit of the Orton Litigation is not in the best interests of MBIA and its shareholders, and has moved to dismiss the action.