(2)Amounts for 2001 and 2002 represent the amortization of goodwill, which arose from ACE's acquisition of Capital Re Corporation as of December 31, 1999. Beginning January 1, 2002, goodwill is no longer amortized, but rather is evaluated for impairment at least annually in accordance with FAS No. 142, "Goodwill and Other Intangible Assets". During 2004, a goodwill impairment of $1.6 million was recognized for the trade credit business which the Company exited as part of its IPO strategy. No such impairment was recognized in the years ended December 31, 2003 and 2002.
(7)Combined policyholders' surplus represents the addition of our combined U.S. based statutory surplus and our Bermuda based statutory surplus.
We are a Bermuda-based holding company providing, through our operating subsidiaries, credit enhancement products to the public finance, structured finance and mortgage markets. We apply our credit expertise, risk management skills and capital markets experience to develop insurance, reinsurance and credit derivative products that meet the credit enhancement needs of our customers. We market our products directly and through financial institutions. We serve the U.S. and international markets.
Our financial results include three operating segments: financial guaranty direct, financial guaranty reinsurance and mortgage guaranty. For financial reporting purposes, we have a fourth segment, which we refer to as other. The other segment consists of a number of businesses that we have exited including equity layer credit protection, trade credit reinsurance, title reinsurance, life, accident and health reinsurance ("LA&H") and auto residual value reinsurance. Because we exited some of these businesses after December 31, 2003, our results of operations for the year ended December 31, 2004 will reflect the results of operations of these businesses through the date as of which we exited them.
Unrealized gains and losses on derivative financial instruments are a function of changes in the estimated fair value of our credit derivative contracts. We expect these unrealized gains and losses to fluctuate primarily based on changes in credit spreads and the credit quality of the referenced entities. We generally hold these derivative contracts to maturity. Where we hold a derivative contract to maturity, the cumulative unrealized gains and losses will net to zero if we incur no credit losses on that contract.
expense represents payments made to ceding companies generally based on the profitability of the business reinsured by us. Acquisition costs are related to the production of new business. Certain acquisition costs are deferred and recognized over the period in which the related premiums are earned. Operating expenses consist primarily of salaries and other employee-related costs. These costs do not vary with the amount of premiums written. Interest expense is a function of outstanding debt and the contractual interest rate related to that debt. Income taxes are a function of our profitability and the applicable tax rate in the various jurisdictions in which we do business.
Reserves for losses and loss adjustment expenses for non-derivative transactions in our financial guaranty direct, financial guaranty assumed reinsurance and mortgage guaranty business include case reserves and portfolio reserves. See the "Valuation of Derivative Financial Instruments" of the Critical Accounting Estimates section for more information on our derivative transactions. Case reserves are established when there is significant credit deterioration on specific insured obligations and the obligations are in default or default is probable, not necessarily upon non- payment of principal or interest by an insured. Case reserves represent the present value of expected future loss payments and LAE, net of estimated recoveries, but before considering ceded reinsurance. This reserving method is different from case reserves established by traditional property and casualty insurance companies, which establish case reserves upon notification of a claim and establish incurred but not reported ("IBNR") reserves for the difference between actuarially estimated ultimate losses and recorded case reserves. Financial guaranty insurance and assumed reinsurance case reserves and related salvage and subrogation, if any, are discounted at 6%, which is the approximate taxable equivalent yield on our investment portfolio in all periods presented.
We record portfolio reserves in our financial guaranty direct, financial guaranty assumed reinsurance and mortgage guaranty business. Portfolio reserves are established with respect to the portion of our business for which case reserves have not been established. Portfolio reserves are not established for quota share mortgage insurance contract types, all of which are in run-off, rather IBNR reserves have been established for these contracts.
Portfolio reserves are not established based on a specific event, rather they are calculated by aggregating the portfolio reserve calculated for each individual transaction. Individual transaction reserves are calculated on a quarterly basis by multiplying the par in-force by the product of the ultimate loss and earning factors without regard to discounting. The ultimate loss factor is defined as the frequency of loss multiplied by the severity of loss, where the frequency is defined as the probability of default for each individual issue. The earning factor is inception to date earned premium divided by the estimated ultimate written premium for each transaction. The probability of default is estimated from historical rating agency data and is based on the transaction's credit rating, industry
The chart below demonstrates the portfolio reserve's sensitivity to frequency and severity assumptions. The change in these estimates represent management's estimate of reasonably possible material changes and are based upon our analysis of historical experience. Portfolio reserves were recalculated with changes made to the default and severity assumptions. In all scenarios, the starting point used to test the portfolio reserve's sensitivity to the changes in the frequency and severity assumptions was the weighted average frequency and severity of our insured portfolio. Overall the weighted average default frequency was 0.65% and the weighted average severity was 28.8% at December 31, 2004. For example, in the first scenario where the frequency was increased by 5.0%, each transaction's contribution to the portfolio reserve was recalculated by adding 0.03% (i.e. 5.0% multiplied by 0.65%) to the individual transaction's default frequency.
On January 1, 2001, we adopted FAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"), which established accounting and reporting standards for derivative instruments. FAS 133 requires recognition of all derivatives on the balance sheet at fair value.
We issue credit derivative financial instruments, which prior to 2004 included a few index-based derivative financial instruments, that we view as an extension of our financial guaranty business but which do not qualify for the financial guaranty insurance scope exception under FAS 133 and therefore are reported at fair value, with changes in fair value included in our earnings.
The fair value of these instruments depends on a number of factors including credit spreads, changes in interest rates, recovery rates and the credit ratings of referenced entities. Where available, we use quoted market prices to determine the fair value of these credit derivatives. If the quoted prices are not available, particularly for senior layer CDOs and equity layer credit protection, the fair value is estimated using valuation models for each type of credit protection. These models may be developed by third parties, such as rating agencies, or developed internally based on market conventions for similar transactions, depending on the circumstances. These models and the related assumptions are continuously reevaluated by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely market information. The majority of our single name credit derivatives are valued using third-party market quotes. Our exposures to CDOs are typically valued using a combination of rating agency models and internally developed models.
As of December 31, 2004, 2003 and 2002, we had total investments of $2.1 billion, $2.2 billion and $2.1 billion, respectively. The fair values of all of our investments are calculated from independent market quotations.
Unearned premium reserves represent the portion of premiums written that is applicable to the unexpired amount at risk of insured bonds.
In our reinsurance businesses, we estimate the ultimate written and earned premiums to be received from a ceding company at the end of each quarter and the end of each year because some of our ceding companies report premium data anywhere from 30 to 90 days after the end of the relevant period. Written premiums reported in our statement of operations are based upon reports received by ceding companies supplemented by our own estimates of premium for which ceding company reports have not yet been received. As of December 31, 2004, the assumed premium estimate and related ceding commissions included in our consolidated financial statements are $30.4 million and $9.7 million, respectively. Key assumptions used to arrive at management's best estimate of assumed premium are premium amounts reported historically and informal communications with ceding companies. Differences between such estimates and actual amounts are recorded in the period in which the actual amounts are determined. Historically, the differences have not been material. We do not record a provision for doubtful accounts related to our assumed premium estimate. Historically there have not been any material issues related to the collectibility of assumed premium. For the year ended December 31, 2002, we recorded a provision for doubtful accounts related to our premium receivable of $0.3 million. No such provision was recorded for 2004 or 2003.
We organize our business around four financial reporting segments: financial guaranty direct, financial guaranty reinsurance, mortgage guaranty and other. There are a number of lines of business that we have exited, which are included in the other segment. However, the results of these businesses are reflected in the above numbers. These businesses include equity layer credit protection, trade credit reinsurance, title reinsurance, LA&H and auto residual value reinsurance.
Net income was $182.8 million, $214.5 million and $72.6 million for the years ended December 31, 2004, 2003 and 2002, respectively. The decrease of $31.7 million in 2004 compared with 2003 is primarily due to a $45.9 million decrease in unrealized gains on derivative financial instruments coupled with the accelerated vesting of stock awards at the IPO date of $11.3 million. This was partially offset by an increase of $46.4 million in our underwriting gain in 2004, compared with 2003. The increase of $141.9 million in 2003 compared with 2002 is primarily the result of a significant increase in unrealized gains on derivative financial instruments due to the tightening of credit spreads on our derivative financial instruments. Unrealized gains on derivative financial instruments increased from an after-tax loss of $48.9 million in 2002 to an after-tax gain of $83.4 million in 2003, an increase of $132.3 million. In addition, underwriting income increased to $50.6 million in 2003 from $39.2 million in 2002. Most of this increase is attributable to the growth and improved profitability of the financial guaranty direct segment.
Net earned premiums for the year ended December 31, 2003 increased by $63.5 million, or 26%, compared with the year ended December 31, 2002. The increase of $26.3 million in the financial guaranty direct segment is primarily due to the growth in our structured finance portfolio. In the financial guaranty reinsurance segment, net earned premiums increased from $79.3 million to $92.9 million due to public finance refunding activity and an increase in par insured outstanding. The increase in the other segment is mainly attributable to our decision to exit the LA&H business, which resulted in a reduction in earned premiums of $32.2 million in 2002 as a result of transferring this book of business to an affiliate of ACE. Net earned premiums declined in the mortgage segment to $27.6 million in 2003 from $45.3 million in 2002 related to a reduction in our treaty book of business.
Net realized investment gains, principally from the sale of fixed maturity securities, were $12.0 million, $5.5 million and $7.9 million for the years ended December 31, 2004, 2003 and 2002, respectively. The increase in 2004 compared with 2003 is due to realized gains of $6.0 million in the second quarter of 2004 as a result of investments sold in connection with a commutation settlement of a residual value transaction. Also included in net realized gains for 2004 is a write down of $1.3 million related to the Company's exited title reinsurance business. The investment related to this write down is included in other assets on our balance sheet. The Company had no write downs of investments for other than temporary impairment losses in 2004 compared with $0.1 million and $5.8 million of other than temporary impairment losses for the years ended December 31, 2003 and 2002, respectively. Net realized investment gains, net of related income taxes, were $7.7 million, $3.8 million and $5.8 million for the years ended December 31, 2004, 2003 and 2002, respectively.
Loss and LAE for the year ended December 31, 2004 were $(32.0) million, a decrease of $176.6 million, or 122%, compared with the year ended December 31, 2003. Our other segment declined $153.6 million in 2004, compared with 2003 as a result of exiting those lines of business mentioned previously. Our financial guaranty direct results include $12.3 million related to the closing out of transaction types that we do not expect to underwrite in the future. The financial guaranty reinsurance segment decreased in 2004 compared with 2003 as 2003 included $20.4 million in case reserve activity associated with CDOs assumed through treaties. This was partially offset by a $3.7 million addition in portfolio reserves in 2004 as a result of some credit downgrades. In addition, during 2004 management updated its loss estimates for the mortgage guaranty segment resulting in a release of reserves, as a result of changes in our statistical assumptions driven by the completion of a rating agency review of our book of business during the year coupled with favorable loss development related to older experience rated quota share contracts, which are running off.
$9.6 million decline in loss and loss adjustment expenses in the mortgage guaranty segment is due to favorable loss development on older contracts. The $9.1 million decline in the financial guaranty direct segment is due to the improved credit environment as compared with 2002. See "-Segment Results of Operations" for further explanations of these changes.
Acquisition costs primarily consist of ceding commissions, brokerage fees and operating expenses that are related to the acquisition of new business. Acquisition costs that vary with and are directly related to the acquisition of new business are deferred and are amortized in relation to earned premium. For the years ended December 31, 2004, 2003 and 2002, acquisition costs were $50.9 million, $64.9 million and $48.4 million, respectively. The decrease of $14.0 million in 2004 is partially related to the financial guaranty reinsurance segment, as we have negotiated lower ceding commission rates in 2004 compared with prior year. Additionally, acquisition costs in our other segment have decreased due to exiting certain lines of business, particularly the trade credit business which historically incurred an acquisition ratio of 30-35%. The increase of $16.5 million in 2003 compared with 2002 is consistent with the increase in earned premium.
For the years ended December 31, 2004, 2003 and 2002, other expenses were $12.3 million, $5.7 million and $10.6 million, respectively. The increase in 2004 is due to interest expense of $8.2 million related to the issuance of our 7% Senior Notes in May 2004 and the $1.6 million write off of goodwill in our other segment. This amount is related to the trade credit business which we exited as part of the IPO. The $4.9 million decrease in 2003 compared with 2002 is due to the reduction in interest expense related to the repayment of $100.0 million of debt in 2002.
Our financial results include three operating segments: financial guaranty direct, financial guaranty reinsurance and mortgage guaranty. For financial reporting purposes, we have a fourth segment, which we refer to as other. Management uses underwriting gains and losses as the primary measure of each segment's financial performance. Underwriting gain (loss) includes net premiums earned, loss and loss adjustment expenses, profit commission expense, acquisition costs and other operating expenses that are directly related to the operations of our insurance businesses. This measure excludes certain revenue and expense items, such as investment income, realized investment gains and losses, unrealized gains and losses on derivative financial instruments, and interest expense, that are not directly related to the underwriting performance of our insurance operations, but are included in net income. For the year ended December 31, 2004 our segment results exclude $11.3 million of operating expenses related to the accelerated vesting of stock awards at the IPO date.
For the years ended December 31, 2004, 2003 and 2002, net written premiums were $77.7 million, $70.0 million and $46.3 million, respectively. The growth in net written premiums is primarily due to growth in gross written premiums as we typically retain a substantial portion of this business.
Net earned premiums for the years ended December 31, 2004, 2003 and 2002, were $88.8 million, $70.2 million and $43.9 million, respectively, an increase of $18.6 million, or 27%, in 2004, and $26.3 million, or 60%, in 2003. This increase in 2004 compared with 2003 is attributable to the recognition of $24.1 million of net earned premiums in first quarter 2004 related to the close out of transaction types in which we no longer participate, offset by the runoff of our single name swap book of business. The increase in net earned premiums in 2003 compared with 2002 reflects the amortization of upfront premiums and the growing volume of installment premiums generated in the growing book of contracts.
Loss and loss adjustment expenses were $14.8 million, $16.3 million and $25.4 million, respectively, for the years ended December 31, 2004, 2003 and 2002. Our loss and loss adjustment expenses are affected by changes in the mix, size and credit trends in our book of business, and by changes in our reserves for loss and loss adjustment expenses for prior periods. Our loss ratio is principally affected by the mix of business in our net earned premiums, credit events in our net par outstanding, market credit spreads and premium rates, among other factors. The loss ratios for the years ended December 31, 2004, 2003 and 2002 were 16.7%, 23.2% and 57.9%, respectively. The decline in the loss ratio in 2004 as compared with 2003 reflects the release of portfolio reserves due to the maturing of CDO exposures and the continued runoff of our single name CDS business. Offsetting these releases are increased portfolio reserves for our other business in this segment as management further refined its loss reserving methodology. This reflects our normal ongoing portfolio review process and additional stress factors considered for our closely monitored credit list. The decline in the loss ratio in 2003 compared with 2002 was due to an improvement in the credit environment. Additionally, in 2003 we substantially reduced the new single name corporate credit derivatives business we wrote; this business generates a higher loss ratio than our other financial guaranty direct businesses.
Operating expenses for the years ended December 31, 2004, 2003 and 2002 were $15.8 million, $8.9 million and $5.5 million, respectively. The increase during 2004 compared with 2003 was primarily due to the increase in holding company expenses discussed earlier. Operating expenses are allocated
In our financial guaranty reinsurance business, we assume all or a portion of risk undertaken by other insurance companies that provide financial guaranty protection. The financial guaranty reinsurance business consists of structured finance and public finance reinsurance lines. Premiums on public finance are typically written upfront and earned over the life of the policy, and premiums on structured finance are typically written on an installment basis and earned ratably over the installment period.
Gross written premiums for our financial guaranty reinsurance segment include upfront premiums on transactions underwritten during the period, plus installment premiums on business primarily underwritten in prior periods. Consequently, this amount is affected by changes in the business mix between public finance, which tends to be upfront premium, and structured finance, which tends to be installment premium. For the years ended December 31, 2004 and 2003, 68% of gross written premiums in this segment were upfront premiums and 32% were installment premiums. For the year ended December 31, 2002, 56% of gross written premiums in this segment were upfront premiums and 44% were installment premiums.
For the years ended December 31, 2004, 2003 and 2002, gross written premiums in our structured finance line of business were $41.4 million, $46.0 million and $36.5 million, respectively. The decrease of $4.6 million in gross written premiums in 2004 compared with 2003 and the $9.5 million increase in gross written premiums from 2003 compared with 2002 was due to changes in the business mix and volume of installment premiums received in these periods.
Growth in our net earned premiums over the period has been driven by growth in both the public and structured finance lines of business, as evidenced by the growth in net par outstanding, unearned premium reserves and the net present value of installment premiums in-force. However, the public finance business's contribution also includes an increase in refunding premiums, which reflect the unscheduled pre-payment or refundings of underlying public bonds due to lower interest rates. These unscheduled refunding premiums are sensitive to market interest rates and we evaluate our net earned premiums both including and excluding these premiums.
For the years ended December 31, 2004, 2003 and 2002, net earned premiums were $114.4 million, $92.9 million and $79.3 million, respectively, an increase of $21.5 million, or 23%, in 2004 compared with 2003, and $13.6 million, or 17%, in 2003 compared with 2002. In 2004, structured finance earned
Loss and LAE were $15.4 million, $25.7 million and $5.3 million, respectively, for the years ended December 31, 2004, 2003 and 2002. Our loss and LAE ratios for the years ended December 31, 2004, 2003 and 2002 were 13.5%, 27.7% and 6.7%, respectively. While loss and LAE decreased in 2004 compared with 2003, in 2004 we actually increased portfolio reserves, which are established based on statistical estimates. Credit downgrades and a refined loss reserving methodology resulted in an increase to portfolio reserves. These amounts reflect our normal ongoing portfolio review process and additional stress factors considered for our closely monitored credit list. However 2003 included an increase in losses and LAE incurred in the structured finance line of business due to credit deterioration in collateralized debt obligations assumed through reinsurance treaties. Case reserves related to these collateralized debt obligations were increased in the fourth quarter after completion of risk management's credit analysis, which included discussions with ceding companies.
Gross written premiums for the years ended December 31, 2004 and 2003 remained consistent at $24.4 million for both years, while 2002 gross written premium were $47.6 million. The decline in gross written premiums from 2003 to 2002 is due to the continued runoff of our quota share business, as well as significant refinancing activity due to the low interest rate environment. Results for 2002 include $10.4 million of gross written premiums from one non-recurring transaction.
For the years ended December 31, 2004, 2003 and 2002, net earned premiums were $33.7 million, $27.6 million and $45.3 million, respectively. The increase in net earned premiums for 2004 compared with 2003 is due to an $8.8 million release of unearned premium reserves related to the commutation of an excess of loss reinsurance contract offset by a decline in our quota share treaty business. 2003 net earned premiums decreased compared with 2002 due to the runoff of our quota share business. In 2002, this runoff was offset by the non-recurring transaction described above, which generated $10.4 million of earned premium.
Operating expenses for the years ended December 31, 2004, 2003 and 2002 were $8.3 million, $4.2 million and $5.7 million, respectively. Operating expenses in 2004 increased by $4.1 million as compared with 2003 as a result of the increase in holding company expenses discussed earlier. Operating expenses are allocated based on total net earned premiums, excluding the net earned premium of retroactive reinsurance agreements entered into with subsidiaries of ACE as part of the IPO. The increase in the expense ratio in 2003 from 2002 is primarily due to the steady level of operating expenses required to support the business, as compared with a declining earned premium base, as discussed above.
Our other segment consists of certain non-core businesses that we have exited prior to, or in connection with, the IPO including equity layer credit protection, trade credit reinsurance, title reinsurance, LA&H reinsurance and auto residual value reinsurance. Also included in the 2003 and 2002 other segment results are the impact of the affiliate reinsurance transactions described below. These reinsurance contracts were purchased for the benefit of all of our operating segments. We do not allocate the costs or the related benefits of these transactions to each of the segments but rather record the impact of these transactions in the other segment.
•AGRI Affiliate Reinsurance Transaction: On December 31, 2001, AGRI entered into an excess of loss reinsurance contract with a subsidiary of ACE. Under the terms of this reinsurance contract, AGRI paid $125.0 million for 25 years of reinsurance coverage. This coverage provided a $400.0 million aggregate limit, a $50.0 million per risk limit and a $5.0 million per risk deductible. The cost and benefit from this contract are included in the other segment. We terminated this agreement effective December 31, 2003 and recorded a receivable of $131.9 million consisting of ceded unearned premium of $115.0 million and reinsurance recoverables on paid losses of $16.9 million. This amount was received in 2004. There was no earnings impact from the termination of this contract.
The following table provides details of net earned premiums and underwriting results by line of business:
LA&H had net earned premiums of negative $32.2 million in 2002 due to our exiting the LA&H business in 2002. The underwriting losses of $0.6 million in 2003 and $1.3 million in 2002 were related to the litigation and settlement of a disputed contract.
Net earned premiums related to affiliate reinsurance were negative $7.7 million and $10.3 million, for the years ended December 31, 2003 and 2002, respectively, and primarily represent the cost of the AGC Affiliate Reinsurance Transaction and AGRI Affiliate Reinsurance Transaction for these periods. As a result of losses of $14.4 million and $15.0 million ceded under these contracts in 2003 and 2002, respectively, affiliate reinsurance generated an underwriting gain of $8.2 million and $5.6 million, respectively. There were no affiliate reinsurance transactions during 2004.
Net cash flows (used in) provided by operating activities were $(44.6) million, $200.0 million and $277.7 million during the years ended December 31, 2004, 2003 and 2002, respectively. The cash flows used in operating activities in 2004 were due to the unwinding of certain transactions related to the IPO which generated approximately $146.0 million of cash outflows. Since July 1, 2004, we have
Net cash flows provided by (used in) investing activities were $22.3 million, $(145.3) million and $(267.0) million during the years ended December 31, 2004, 2003 and 2002, respectively. These investing activities were primarily net sales (purchases) of fixed maturity investment securities during 2004, 2003 and 2002. In addition, during 2004 Assured Guaranty Re Overseas Ltd., an indirect subsidiary of Assured Guaranty Ltd., sold 100% of the common stock of its subsidiary, ACE Capital Title Reinsurance Company, to ACE Bermuda Insurance Ltd., a subsidiary of ACE, for $39.8 million. There was no gain or loss associated with the sale.
Net cash flows provided by (used in) financing activities were $6.1 million, $(35.0) million and $(6.0) million during the years ended December 31, 2004, 2003 and 2002, respectively. On May 18, 2004, Assured Guaranty US Holdings Inc., a subsidiary of the Company, issued $200.0 million of 7.0% Senior Notes due in 2034. The proceeds of the offering were used to repay a $200.0 million promissory note, established as part of the IPO related formation transactions, issued to a subsidiary of ACE prior to the IPO in April 2004. The coupon on the Senior Notes is 7.0%, however, the effective rate will be approximately 6.4% due to a treasury hedge executed by the Company in March 2004. These senior notes are fully and unconditionally guaranteed by Assured Guaranty Ltd. We expect to have the capacity to repay and/or refinance the notes as they come due. During the years ended December 31, 2004, 2003 and 2002, ACE contributed capital of $78.9 million, $3.7 million and $84.2 million, respectively, to us. These capital contributions were utilized to pay interest and principal on long-term debt. The capital contribution in 2002 also included $75.0 million for the purpose of the repayment of our long-term debt. In all years, these were non-cash contributions (see Note 14 to the consolidated financial statements).
(2)Lease payments are subject to escalations in building operating costs and real estate taxes.
The Company entered into a $250.0 million unsecured credit facility ("$250.0 million credit facility") on April 29, 2004, with a syndicate of banks, for which ABN AMRO Incorporated and Bank of America (an affiliate of Banc of America Securities LLC) are acting as co-arrangers to which each of Assured Guaranty, AGC and Assured Guaranty (UK) Ltd., a subsidiary of Assured Guaranty organized under the laws of the United Kingdom, is a party, as borrower.
The $250.0 million credit facility replaced a $140.0 million credit facility ("$140.0 million credit facility") with seven banks including Bank of America and Citibank N.A. that provided a one-year term loan provision. The $140.0 million credit facility was available to AGC for general corporate purposes,
including the payment of claims, and was guaranteed by ACE. As of December 31, 2003, no amounts were outstanding under this facility. AGC had no borrowings under the life of this facility. This facility's financial covenants required that AGC: (1) maintain as of the end of each quarter, a consolidated debt to total capital ratio of not more than 35%, (2) not permit statutory capital to be less than 80% of statutory capital as of the fiscal quarter of AGC prior to the closing date of the facility, (3) not permit its ratio of net par to statutory capital to exceed 150:1, and (4) not permit the aggregate value of all property of AGC subject to a lien given to secure payment of credit derivative guaranties to exceed 11% of the sum of the total capitalization plus the aggregate value of all collateral provided for the benefit of the lending banks. AGC was in compliance with all of these financial covenants during the life of the facility. In addition, during any period in which AGC had outstanding borrowings under the credit facility, AGC's ability to declare dividends was limited to (a) dividends payable to its material subsidiaries or (b) dividends payable not in excess of $15.0 million in any fiscal year.
On November 8, 2004 the Company, AGRI and AGRO entered into a standby letter of credit agreement (the "LOC Agreement") with KeyBank National Association ("KeyBank"). Under the LOC Agreement, KeyBank will issue up to $50.0 million in letters of credit on our behalf. The obligations of the Company, AGRI and AGRO under the LOC Agreement are joint and several. The letters of credit will be used to satisfy AGRI's or AGRO's obligations under certain reinsurance agreements and for general corporate purposes. The LOC Agreement expires April 28, 2005, but its term may be extended with the consent of KeyBank under certain circumstances. The LOC Agreement contains covenants that limit debt, liens, guaranties, loans and investments, dividends, liquidations, mergers, consolidations, acquisitions, sales of assets or subsidiaries and affiliate transactions. Most of these restrictions are subject to certain minimum thresholds and exceptions. The LOC Agreement also contains financial covenants that require the Company: (i) to maintain the ratio of consolidated debt to total capitalization at not greater than 0.30 to 1.0; (ii) to maintain consolidated net worth of at least seventy-five percent (75%) of its consolidated net worth as of June 30, 2004; and (iii) to maintain the consolidated interest coverage ratio for any test period ending on the last day of a fiscal quarter at not less than 2.50 to 1.0. In addition, the LOC Agreement provides that the obligations of KeyBank to issue letters of credit may be terminated, and our obligations under the agreement may be accelerated, upon an event of default. As of December 31, 2004, no amounts were payable under any letter of credit issued under this facility.
AGC participated in a liquidity facility established for the benefit of ACE and certain of its subsidiaries. The overall facility was a 364-day credit agreement in the amount of $500.0 million with a syndicate of banks. AGC had a $50.0 million participation in the facility. AGC did not utilize the facility. As of April 29, 2004, this facility was replaced with the $250.0 million credit facility.
ACE Bermuda made available to AGRI a $50.0 million credit line and ACE INA Holdings made available to AGC a $75.0 million credit line. Neither AGRI nor AGC utilized these lines. As of April 29, 2004, theses lines were replaced with the $250.0 million credit facility.
The following table summarizes our investment portfolio as of December 31, 2004:
The following table summarizes our investment portfolio as of December 31, 2003:
The amortized cost and estimated fair value of our available for sale fixed maturity securities as of December 31, 2004 and 2003, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
As of December 31, 2004 and 2003, our investment portfolio did not contain any securities that were not rated or rated below investment grade.
values of our pledged securities totaled $1.9 million as of December 31, 2004 and $154.8 million as of December 31, 2003.
Market risk represents the potential for losses that may result from changes in the value of a financial instrument as a result of changes in market conditions. The primary market risks that impact the value of our financial instruments are interest rate risk, basis risk, such as taxable interest rates relative to tax-exempt interest rates, and credit spread risk. Each of these risks and the specific types of financial instruments impacted are described below. Senior managers in our risk management department are responsible for monitoring risk limits and applying risk measurement methodologies. The estimation of potential losses arising from adverse changes in market conditions is a key element in managing market risk. We use various systems, models and stress test scenarios to monitor and manage market risk. These models include estimates made by management that use current and historic market information. The valuation results from these models could differ materially from amounts that actually are realized in the market. See "-Critical Accounting Estimates-Valuation of Investments."
In December 2004, the FASB issued FAS No. 123 (revised 2004), "Share-Based Payment" ("FAS 123R"). FAS 123R replaces FAS No.123, "Accounting for Stock-Based Compensation" ("FAS 123") and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). As permitted by FAS 123, the Company currently accounts for share-based payments to employees using APB 25's intrinsic value method and, as such, generally recognizes no compensation expense for employee stock options. Accordingly, the adoption of FAS 123R's fair value method will have a significant impact on our result of operations, although it will have no impact on our overall financial position. The impact of adoption of FAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted FAS 123R in prior periods, the impact of that standard would have approximated the impact of FAS 123 as described in the disclosure of pro forma net income and earnings per share in Note 2 to our consolidated financial statements. FAS 123R also requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were $5.4 million, $5.7 million and $3.5 million in 2004, 2003 and 2002, respectively.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and comprehensive income, of shareholders' equity and of cash flows present fairly, in all material respects, the financial position of Assured Guaranty Ltd. and its subsidiaries (collectively referred to as "the Company") as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 5 to the consolidated financial statements, the Company changed its method of accounting for goodwill in 2002.
On April 28, 2004, subsidiaries of ACE Limited ("ACE"), completed an initial public offering ("IPO") of 49,000,000 of their 75,000,000 common shares, par value $0.01 per share, of Assured Guaranty Ltd. (the "Company"), formerly AGC Holdings Ltd. Assured Guaranty Ltd.'s common shares are traded on the New York Stock Exchange under the symbol "AGO". The IPO raised approximately $840.1 million in net proceeds, all of which went to the selling shareholders. As part of the IPO, Assured Guaranty Ltd. and ACE entered into various agreements which govern various settlement issues. As part of these agreements all pre-IPO intercompany receivables and payables were settled with ACE on June 10, 2004. In connection with the IPO, the following transactions took place:
Financial guaranty insurance provides an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due. Financial guaranty insurance may be issued to the holders of the insured obligations at the time of issuance of those obligations, or may be issued in the secondary market to holders of public bonds and structured securities. A loss event occurs upon existing or anticipated credit deterioration, while a payment under a policy occurs when the insured obligation defaults. This requires the Company to pay the required principal and interest when due in accordance with the underlying contract. The principal types of obligations covered by our financial guaranty direct and financial guaranty assumed reinsurance businesses are structured finance obligations and public finance obligations. Because both businesses involve similar risks, we analyze and monitor our financial guaranty direct portfolio and financial guaranty assumed reinsurance portfolio on a combined basis.
Mortgage guaranty insurance is a specialized class of credit insurance that provides protection to mortgage lending institutions against the default of borrowers on mortgage loans that, at the time of the advance, had a loan to value in excess of a specified ratio. Reinsurance in the mortgage guaranty insurance industry is used to increase the insurance capacity of the ceding company, to assist the ceding company in meeting applicable regulatory and rating agency requirements, to augment the financial strength of the ceding company, and to manage the ceding company's risk profile. The Company provides mortgage guaranty protection on an excess of loss basis.
The Company has participated in several lines of business that are reflected in its historical financial statements but that the Company has exited or is exiting, including equity layer credit protection, trade credit reinsurance, title reinsurance, life, accident and health and auto residual value reinsurance. These lines of business make up the Company's other segment.
The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"), which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Amounts presented prior to April 28, 2004, the IPO date, were prepared on an historical combined basis, since Assured Guaranty Ltd. and its subsidiaries were included in the results of ACE. However, since the entities are the same for all periods presented, the financial statements have been prepared and reported on a consolidated basis. This presentation has no impact on the Company's results of operations or financial condition. Certain expenses reflected in the combined financial statements include allocations of corporate expenses incurred by ACE, related to general and administrative services provided to the Company, including tax consulting and preparation services, internal audit services and liquidity facility costs. These expenses were allocated based on estimates of the cost incurred by ACE to provide these services to the Company and are mainly reflected in 2003 and 2002 amounts. All intercompany accounts and transactions have been eliminated. Certain items in the prior year financial statements have been reclassified to conform with the current year presentation.
Premiums are received either upfront or in installments. Upfront premiums are earned in proportion to the expiration of the amount at risk. Each installment premium is earned ratably over its installment period, generally one year or less. For insured bonds for which the par value outstanding is
If the Company believes a decline in the value of a particular investment is temporary, the decline is recorded as an unrealized loss on the balance sheet in "accumulated other comprehensive income" in shareholders' equity. If the Company believe the decline is "other than temporary," the Company will write down the carrying value of the investment and record a realized loss in its consolidated statements of operations and comprehensive income. The Company's assessment of a decline in value includes management's current assessment of the factors noted above. If that assessment changes in the future, the Company may ultimately record a loss after having originally concluded that the decline in value was temporary.
value reinsurance and trade credit reinsurance within our other segment. The other segment represents lines of business we have exited or sold prior to the IPO.
Certain of the Company's assumed and ceded reinsurance contracts are funds held arrangements. In a funds held arrangement, the ceding company retains the premiums instead of paying them to the reinsurer and losses are offset against these funds in an experience account. Because the reinsurer is not in receipt of the funds, the reinsurer earns interest on the experience account balance at a predetermined credited rate of interest. The Company generally earns interest at fixed rates of between 4% and 6% on its assumed funds held arrangements and generally pays interest at fixed rates of between 4% and 6% on its ceded funds held arrangements. The interest earned or credited on funds held arrangements is included in net investment income. In addition, interest on funds held arrangements will continue to be earned or credited until the experience account is fully depleted, which can extend many years beyond the expiration of the coverage period.
ended December 31, 2004 the Company recognized a goodwill impairment of $1.6 million for the trade credit business which the Company exited as part of its IPO strategy. No such impairment was recognized in the years ended December 31, 2003 or 2002. See Note 5. Goodwill, for more information.
The Company accounts for stock-based compensation plans in accordance with Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations. No compensation expense for options is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of the grant. Pro forma information regarding net income and earnings per share is required by FAS No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"). In December 2002, the FASB issued FAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" ("FAS 148"). FAS 148 amends the disclosure requirements of FAS 123 to require prominent disclosure in both annual and interim financial statements regarding the method of accounting for stock-based compensation and the effect of the method used on reported results.
In December 2004, the FASB issued FAS No. 123 (revised 2004), "Share-Based Payment" ("FAS 123R"). FAS 123R replaces FAS No.123, "Accounting for Stock-Based Compensation" and supersedes APB 25. As permitted by FAS 123, the Company currently accounts for share-based payments to employees using APB 25's intrinsic value method and, as such, generally recognizes no compensation expense for employee stock options. Accordingly, the adoption of FAS 123R's fair value method will have a significant impact on the Company's results of operations, although it will have no impact on its overall financial position. The impact of adoption of FAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted FAS 123R in prior periods, the impact of that standard would have approximated the impact of FAS 123 as described in the disclosure of pro forma net income and earnings per share in Note 2 to the Company's consolidated financial statements. FAS 123R also requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after
adoption. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were $5.4 million, $5.7 million, and $3.5 million in 2004, 2003 and 2002, respectively.
actual experience may differ from the estimates reflected in the Company's consolidated financial statements, and the differences may be material.
Goodwill of $94.6 million arose from ACE's acquisition of Capital Re Corporation as of December 31, 1999 and was being amortized over a period of twenty-five years. On January 1, 2002, the Company ceased amortizing goodwill as part of its adoption of FAS 142 and now evaluates it for impairment at least annually in accordance with FAS 142.
The following table details goodwill by segment as of December 31, 2004 and 2003:
In the year ended December 31, 2004 the Company recognized a goodwill impairment of $1.6 million for its trade credit business which the Company exited as part of its IPO strategy. No such impairment was recognized in the years ended December 31, 2003 and 2002.
These consolidated financial statements are prepared on a GAAP basis, which differs in certain respects from accounting practices prescribed or permitted by the insurance regulatory authorities, including the Maryland Insurance Administration, the New York State Insurance Department as well as the statutory requirements of the Minister of Finance of Bermuda.
The Company's U.S. domiciled insurance companies prepare statutory financial statements in accordance with accounting practices prescribed or permitted by the National Association of Insurance Commissioners ("NAIC") and their respective Insurance Departments. Prescribed statutory accounting practices are set forth in the NAIC Accounting Practices and Procedures Manual. The combined capital and statutory surplus of the Company's U.S. domiciled insurance companies was $265.8 million (unaudited) and $307.9 million as of December 31, 2004 and 2003, respectively. The statutory combined net income of the Company's U.S. domiciled insurance companies was $107.5 million (unaudited), $70.2 million and $50.8 million for the years ended December 31, 2004, 2003 and 2002, respectively.
Assured Guaranty Re International Ltd. ("AGRI") prepares its statutory financial statements in conformity with the accounting principles set forth in Bermuda in The Insurance Act 1978, amendments thereto and Related Regulations. The statutory capital and surplus of AGRI was $635.2 million (unaudited) and $603.4 million as of December 31, 2004 and 2003, respectively. The statutory net income of AGRI was $73.1 million (unaudited), $91.3 million and $34.7 million for the years ended December 31, 2004, 2003 and 2002, respectively.
The portfolio contained exposures in each of the 50 states and abroad. The distribution of net financial guaranty par outstanding by geographic location is set forth in the following table:
Premiums earned include $17.4 million, $19.2 million and $14.0 million for 2004, 2003 and 2002, respectively, related to refunded and called bonds.
The following table summarizes the Company's aggregate investment portfolio as of December 31, 2003:
The amortized cost and estimated fair value of available-for-sale fixed maturity securities as of December 31, 2004, by contractual maturity, are shown below. Expected maturities will differ from
Proceeds from the sale of available-for-sale fixed maturity securities were $780.3 million, $619.6 million and $965.5 million for the years ended December 31, 2004, 2003 and 2002, respectively.
During 2002, the Company determined that the decline in value related to WorldCom bonds held in its investment portfolio was "other than temporary." Accordingly, the Company recorded a write-down of the carrying value of these bonds in the amount of $5.8 million. During 2002, the Company sold all of its investments in WorldCom.
The following table summarizes, for all securities in an unrealized loss position as of December 31, 2004, the aggregate fair value and gross unrealized loss by length of time the amounts have continuously been in an unrealized loss position.
The following table provides a reconciliation of the beginning and ending balances of the reserve for losses and LAE:
In 2002, the Company transferred to an affiliate its LA&H book of business. This transfer had no impact on net income and resulted in a $28.8 million reduction of reserves related to the prior year with a corresponding reduction in premiums earned and deferred acquisition costs (see Note 14 for further details).
Losses and loss adjustment expenses paid, net of recoveries, were $241.6 million, $99.8 million and $89.8 million, respectively, for the years ended December 31, 2004, 2003 and 2002. Of the total net loss payments, $56.2 million, $77.1 million and $36.4 million, respectively, related to equity layer CDO losses paid in 2004, 2003 and 2002. In addition, during 2002, $11.6 million of losses were paid for a single name credit derivative and $13.3 million of losses were paid for a financial guaranty contract.
The Company's Bermuda subsidiaries are not subject to any income, withholding or capital gains taxes under current Bermuda law. The Company has received an undertaking from the Minister of Finance in Bermuda that, in the event of any taxes being imposed, the Bermuda subsidiaries will be exempt from taxation in Bermuda until March 2016.
The Company's U.S. subsidiaries are subject to income taxes imposed by U.S. authorities and file U.S. tax returns.
In connection with the IPO, the Company and ACE Financial Services Inc. ("AFS") entered into a tax allocation agreement, whereby the Company and AFS will make a "Section 338 (h)(10)" election that will have the effect of increasing the tax basis of certain affected subsidiaries tangible and intangible assets to fair value. Future tax benefits that the Company derives from the election will be payable to AFS when realized by the Company.
As a result of the election, the Company has adjusted its net deferred tax liability, to reflect the new tax basis of the Company's affected assets. The additional basis is expected to result in increased future income tax deductions and, accordingly, may reduce income taxes otherwise payable by the
Company. Any tax benefit realized by the Company will be paid to AFS. Such tax benefits will generally be calculated by comparing the Company's affected subsidiaries' actual taxes to the taxes that would have been owed by those subsidiaries had the increase in basis not occurred. After a 15-year period, to the extent there remains an unrealized tax benefit, the Company and AFS will negotiate a settlement of the unrealized benefit based on the expected realization at that time.
The Company has recorded a $49.0 million reduction of its existing deferred tax liability, based on an estimate of the ultimate resolution of the Section 338(h)(10) election. Under the tax allocation agreement, the Company will pay $20.9 million to AFS and accordingly has established this amount as a liability, which is included in other liabilities on the balance sheet. The difference, which is attributable to the change in the tax basis of certain liabilities for which there is no associated step-up in the tax basis of its assets and no amounts due to AFS, resulted in an increase to additional paid-in capital of $28.1 million.
As of December 31, 2004, AGRO had a standalone net operating loss carry-forward of $101.5 million, which is available to offset future U.S. federal taxable income through 2024. As a Section 953(d) company, any standalone net operating losses of AGRO are treated as dual consolidation losses and are not permitted to offset income of any other members of the consolidated group. Management believes it is more likely than not that $20.0 million of AGRO's $101.5 million net
In the event that any or all of the reinsurers are unable to meet their obligations, the Company would be liable for such defaulted amounts. Direct, assumed, and ceded reinsurance amounts were as follows:
subject to certain statutory provisions, which generally prohibit the payment of dividends in any twelve-month period in an aggregate amount exceeding the lesser of 10% of surplus or net investment income (at the preceding December 31) without prior approval of the Maryland Commissioner of Insurance. The amount available for distribution from the Company during 2005 with notice to, but without prior approval of, the Maryland Commissioner of Insurance under the Maryland insurance law is approximately $23.7 million (unaudited). During the years ended December 31, 2003 and 2002, AGC paid $10.0 million and $8.0 million, respectively, in dividends to ACE Financial. There were no such dividends paid in 2004. Under Maryland insurance regulations, AGC is required at all times to maintain a minimum surplus of $750,000.
AGMIC is a New York domiciled insurance company. Under the New York Insurance Law, AGMIC may declare or pay dividends only out of "earned surplus," which is defined as that portion of the company's surplus that represents the net earnings, gains or profits (after deduction of all losses) that have not been distributed to shareholders as dividends or transferred to stated capital, capital surplus or contingency reserves, or applied to other purposes permitted by law, but does not include unrealized appreciation of assets. Additionally, no dividend may be declared or distributed in an amount which, together with all dividends declared or distributed by it during the preceding twelve months, exceeds the lesser of 10% of AGMIC's statutory surplus as shown on its latest statutory financial statement on file with the New York Superintendent of Insurance, or 100% of AGMIC's adjusted net investment income during that period, unless, upon prior application, the Superintendent approves a greater dividend or distribution after finding that the company will retain sufficient surplus to support its obligations and writings. There were no amounts available during 2004, 2003 and 2002, respectively, for the payment of dividends by AGMIC which would not be characterized as "extraordinary dividends". AGMIC did not declare or pay any dividends during 2004.
In December 2001, AGRI entered into a 25 year portfolio cover with a $5.0 million per risk deductible, a $50.0 million per risk limit and a $400.0 million aggregate limit with ACE Bermuda. In December 2003, this agreement was cancelled and the unearned premium of $115.0 million and loss reserves of $16.9 million were returned to AGRI in January 2004. As of December 31, 2003, the Company recorded $115 million in due from affiliate and $16.9 million in reinsurance recoverables for the cancellation of this transaction. For the years 2003 and 2002, the Company ceded losses of $11.9 million and $5.0 million, respectively, under this cover.
In March 2001, the Company entered into a reinsurance agreement with an ACE affiliate, Westchester Fire Insurance Company, whereby the Company reinsured a portion of an auto residual value insurance contract. Losses and LAE incurred and premiums earned recorded at inception amounted to $84.8 million. The value of reinsurance business assumed recorded at the inception of the contract amounted to $31.5 million and represented the difference between the estimated ultimate amount of the losses assumed under the retroactive reinsurance contract of $116.3 million and the cash received of $84.8 million. As of December 31, 2003, the value of reinsurance business assumed was $14.2 million, and the reserves for losses and loss adjustment expenses were $116.3 million. In both 2003 and 2002 the Company recorded amortization of the value of reinsurance business assumed in the amount of $6.1 million This agreement was commuted in connection with the IPO. See Note 1 for more information.
In 2002, the Company transferred its LA&H business to several ACE affiliates. The transfer was retroactive and resulted in a reduction of net written and earned premiums of $40.2 million and $32.2 million, respectively, with a related reduction in losses and LAE incurred and acquisition costs of $28.8 and $3.4 million, respectively.
In 2001, AGRI and ACE Bermuda entered into a funding facility agreement pursuant to which ACE Bermuda agreed to purchase up to $150.0 million of non-investment grade fixed income securities selected by AGRI, and AGRI agreed to enter into a total rate of return swap in respect of each security purchased. The aggregate amount received by AGRI under this funding facility agreement, net of the funding fee paid by AGRI, for the years ended December 31, 2003 and 2002 were $4.8 million and $2.8 million, respectively. All securities purchased pursuant to this agreement were sold and this agreement was terminated in connection with the IPO.
During the time the Company was a subsidiary of ACE, it was party to a number of service agreements with subsidiaries of ACE under which either the Company provided services to subsidiaries of ACE, or they provided services to the Company. Since the IPO, many of these service agreements have been terminated, though some still remain in place. A summary of the service agreements is summarized below:
The Company provided a variety of administrative services to ACE American Insurance Company, ACE Asset Management Inc. and ACE Financial Services, including human resources, legal, data processing, accounting, tax and financial planning. The aggregate fees recorded under these services agreements for the years ended December 31, 2004, 2003 and 2002 were $0.1 million, $3.4 million and $1.8 million, respectively. As of the IPO, these agreements have been terminated.
The Company and its subsidiaries are party to various lease agreements. As of December 31, 2004, future minimum rental payments under the terms of these operating leases for office space are
On January 18, 2002, World Omni Financial Corp. ("World Omni") filed an action against AG Intermediary Inc., a subsidiary of the Company, in the United States District Court for the Southern District of New York entitled World Omni Financial Corp. v. ACE Capital Re Inc., Case No. 02 CV 0476 (RO). On September 20, 2002, World Omni amended its complaint to add Assured Guaranty Re Overseas Ltd. ("AGRO") as a defendant. The dispute arises out of a quota share reinsurance agreement between AGRO and JCJ Insurance Company ("JCJ"), an affiliate of World Omni, and an underlying residual value insurance policy issued by JCJ to World Omni, which insured residual value losses of World Omni with respect to a portfolio of automobile leases. Subject to the terms and conditions of the policy, the residual value insurance policy insures World Omni against losses (as defined in the policy) resulting from the value of leased vehicles at the end of the applicable lease term being less than what such value was assumed to have been at the inception of the applicable lease term. In the District Court action, World Omni sought a declaratory judgment regarding AGRO's coverage obligations, if any, for such alleged losses, as well as damages for breach of contract based upon AGRO's refusal to pay claims asserted by World Omni. World Omni sought $157.0 million, which is the limit of liability under the quota share reinsurance agreement, plus interest.
World Omni formally commenced the arbitration against AGRO on March 11, 2004. By agreement, AGRO's retrocessionaire, Royal Indemnity Company, also is a defendant in the arbitration. The parties have completed written discovery and document production, and depositions of fact witnesses are currently underway. All discovery is scheduled to be completed in July 2005. The arbitration hearing is scheduled to commence in November 2005.
Various other lawsuits have arisen in the ordinary course of the Company's business. It is the opinion of the Company's management, based upon the information available, that the expected outcome of these matters, individually or in the aggregate, will not have a material adverse effect on the Company's financial position, results of operations or liquidity, although an adverse resolution of a
The Company is party to reinsurance agreements with all of the major monoline primary financial guaranty insurance companies. The Company's facultative and treaty agreements are generally subject to termination (i) upon written notice (ranging from 90 to 120 days) prior to the specified deadline for renewal, (ii) at the option of the primary insurer if the Company fails to maintain certain financial, regulatory and rating agency criteria which are equivalent to or more stringent than those the Company is otherwise required to maintain for its own compliance with state mandated insurance laws and to maintain a specified financial strength rating for the particular insurance subsidiary or (iii) upon certain changes of control of the Company. Upon termination under the conditions set forth in (ii) and (iii) above, the Company may be required (under some of its reinsurance agreements) to return to the primary insurer all statutory unearned premiums, less ceding commissions, attributable to reinsurance ceded pursuant to such agreements. Upon the occurrence of the conditions set forth in (ii) above, whether or not an agreement is terminated, the Company may be required to obtain a letter of credit or alternative form of security to collateralize its obligation to perform under such agreement or it may be obligated to increase the level of ceding commission paid.
During the first quarter of 2005 the Company recovered $6.8 million relating to a reinsurance claim incurred in 1998 and 1999. This recovery was received in connection with the completion of two settlements. Recovery efforts relating to this and other claims are continuing.
The Company's client base includes all of the major monoline primary financial guaranty insurance companies, many banks and several European insurance and reinsurance companies. No client represented more than 10% of the Company's total gross premiums written for the years ended December 31, 2004, 2003 and 2002, except as indicated below. Of the Company's total gross premiums written for the year ended December 31, 2004, 41.8%, 19.6% and 14.8% came from Financial Security Assurance Inc. ("FSA"), Ambac Assurance Corporation and Municipal Bond Investors Assurance Company ("MBIA"), respectively, three of the four monoline primary financial guaranty insurance companies. Of the Company's total gross premiums written for the year ended December 31, 2003, 25.3% and 10.8% came from FSA and MBIA, respectively. For the year ended December 31, 2002, 10.9% came from Dresdner Bank, an investment bank.
Since the Company was a subsidiary of ACE during 2003 and 2002, management has determined that disclosing common stock related to those years would not be meaningful, as the Company was recapitalized due to IPO.
On November 4, 2004, the Board of Directors authorized a $25.0 million share stock repurchase program with no scheduled date to expire. The Company has spent approximately $6.0 million to repurchase approximately 0.3 million shares of its Common Stock at an average price of $18.61 through December 31, 2004.
Prior to the IPO, Assured Guaranty's officers and employees participated in ACE's long-term incentive plans providing options to purchase shares and restricted share unit awards.
Upon completion of the IPO, any unvested options to purchase ACE ordinary shares granted to the Company's officers or employees under the ACE employee long term incentive plan immediately vested and any unvested restricted ACE ordinary shares were forfeited. These officers and employees generally had 90 days from the date of the IPO to exercise any vested options to acquire ACE ordinary shares. The acceleration of vesting of options to purchase ordinary shares resulted in a pre-tax charge to the Company of approximately $3.5 million. Based upon a price of $42.79 per ACE ordinary share, the Company incurred a pre-tax charge of $7.8 million and contributed cash in the same amount to fund a trust, with a trustee, for the value of the restricted ACE ordinary shares forfeited by all of the Company's officers and employees. These pre-tax charges took place during Second Quarter 2004 and are included in other operating expenses on the consolidated statements of operation and comprehensive income. The trust purchased common shares of Assured Guaranty Ltd. and allocated to each such individual common shares having the approximate value of the ACE ordinary shares forfeited by such individual. Based on the initial public offering price of $18.00 per common share, the trust purchased approximately 436,000 common shares. This transaction is reported in shareholders' equity as treasury stock and unearned stock grant compensation. The common shares will be deliverable to each individual on the 18-month anniversary of the IPO so long as during that 18-month period the individual was not employed, directly or indirectly, by any designated financial guaranty company. (The forfeiture restriction has been waived for one former employee of the Company.) Any forfeited common shares will be delivered to us. The trustees do not have any beneficial interest in the trust. Since completion of the IPO, the Company's officers and employees are no longer eligible to participate in ACE's employee long-term incentive plans. In connection with these events, Assured
Guaranty received $4.5 million from ACE, for the book value of unrestricted compensation, which it recorded in unearned stock grant compensation, which is included in shareholders' equity.
As of April 27, 2004, the Company adopted the Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (the "Incentive Plan"). The number of common shares that may be delivered under the Incentive Plan may not exceed 7,500,000. In the event of certain transactions affecting the Company's common shares, the number or type of shares subject to the Incentive Plan, the number and type of shares subject to outstanding awards under the Incentive Plan, and the exercise price of awards under the Incentive Plan, may be adjusted.
Since the Company was a subsidiary of ACE during 2003 and 2002, management has determined that disclosing amounts related to those years would not be meaningful, as the information determined under FAS 123 would be based on ACE's ordinary shares. Following is a summary of Assured Guaranty Ltd. options issued and outstanding for the year ended December 31, 2004:
The following table summarizes the range of exercise prices for outstanding options as of December 31, 2004:
Under the Company's Incentive Plan 1,088,292 restricted common shares were awarded during the year ended December 31, 2004 to employees and non-employee directors of the Company. These shares vest at various dates through 2008.
United States and Bermuda officers and employees generally have been covered by benefit plans established by the Company, although Bermuda officers and employees continued to be covered by ACE health and welfare plans until December 31, 2004. Employees located in the United Kingdom continued to participate in the ACE benefit plans in which they participated prior to the IPO until December 31, 2004 and now participate in plans maintained by the Company.
(1)Since the shares held as treasury stock are required to be settled by delivery of employer stock, those shares are included in the calculation of basic and diluted EPS.
The fair value of the Company's $200 million of Senior Notes is determined by calculating the midpoint of quoted bid/ask prices over the U.S. Treasury yield at the year-end date and the appropriate credit spread for the similar debt instruments.
The Company does not segregate certain assets and liabilities at a segment level since management reviews and controls these assets and liabilities on a consolidated basis. The Company allocates operating expenses to each segment based on each segment's percentage of total earned premiums. The other segment received proportional share of operating expenses up to the IPO date. From the IPO date, the other segment was not allocated operating expenses. Management uses underwriting gains and losses as the primary measure of each segment's financial performance.
The Company's other segment consists of certain non-core lines of business that the Company has stopped, or intends to stop, writing, including equity layer credit protection, trade credit reinsurance, title reinsurance, LA&H reinsurance and auto residual value reinsurance. Also included in the other segment is the impact of the affiliate reinsurance transactions, that were purchased by management for the benefit of all of the Company's reporting segments. The Company does not allocate the cost nor the related benefit of these transactions to the reporting segments but rather records the impact of these transactions in the other segment (See Note 14). The Company manages these exited lines of business by focusing on the net earned premiums and the underwriting gain/(loss).
The following table provides underwriting gain/(loss) by line of business for the other segment.
(1)Basic and diluted EPS for the first quarter 2004 and each quarter of 2003 are based on shares outstanding immediately prior to the IPO.