(c)Total claims-paying resources is a term used by Moody's to evaluate adequacy of claims-paying resources and credit ratings. Moody's uses its judgment in making adjustments to some of the measures. The Company provides the adjusted balances. This term represents the sum of statutory capital, statutory unearned premium reserve, present value of future net installment premiums, statutory loss reserve, credit available under standby line of credit facility and money market committed preferred trust securities.
In this Annual Report, the Company has included statements that may constitute "forward-looking statements" within the meaning of the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. Words such as "believes," "anticipates," "expects," "intends" and "plans" and future and conditional verbs such as "will," "should," "would," "could" and "may" and similar expressions are intended to identify forward looking statements but are not the exclusive means of identifying such statements. The Company cautions that a number of important factors could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in forward-looking statements made by the Company. Important factors that could cause its results to differ, possibly materially, from those indicated in the forward-looking statements include, but are not limited to, those discussed under "Item 1. Business-Forward-Looking Statements" and "Item 1A. Risk Factors."
Financial Security Assurance Holdings Ltd. ("FSA Holdings" or, together with its consolidated subsidiaries, the "Company") operates in two business segments: financial guaranty insurance and financial products ("FP"). The financial guaranty segment includes the insurance operations of Financial Security Assurance Inc. ("FSA") and its subsidiaries, which provide financial guaranty insurance for public finance and asset-backed obligations. The FP segment is composed of non-insurance company subsidiaries that borrow funds by issuing either guaranteed investment contracts ("GICs") issued by certain subsidiaries of FSA Holdings (the "GIC Subsidiaries") or debt issued by certain consolidated variable interest entities (the "VIEs"). The Company invests the proceeds of FP segment debt issuances in fixed-income securities that satisfy the Company's investment criteria, with the objective of generating a positive net interest margin ("NIM"). The GIC Subsidiaries are consolidated by FSA Holdings, and the VIEs are consolidated by FSA. In both segments, the Company is affected by conditions in the financial markets and general economic conditions, primarily in the United States and also, to a growing extent, abroad.
A number of FSA's competitors in the financial guaranty industry announced sharp increases in projected losses on insured transactions in the last quarter of 2007 and were subsequently placed on negative outlook or review for downgrade by rating agencies. These guarantors generally had significant exposure to collateralized debt obligations ("CDOs") of asset-backed securities ("ABS"), which include CDOs of CDOs (also referred to as CDO squared). Some were downgraded by one or more rating agencies in the first quarter of 2008, after rating agencies recalibrated their models in light of the deteriorating credit performance in the mortgage sector. FSA's Triple-A ratings were reaffirmed with a stable outlook by Fitch Ratings ("Fitch"), Moody's Investors Service, Inc. ("Moody's") and Standard & Poor's Ratings Services ("S&P"). FSA's ratings were reaffirmed without consideration of a subsequently announced contribution of $500 million of additional capital to the Company by Dexia Holdings, Inc., the Company's parent. These developments have reduced FSA's competition from other financial guarantors, at least in the short term, and created opportunity for the Company, as illustrated by the increase in FSA's share of the U.S. municipal bond insurance market since November of 2007.
The deterioration of market perception of the financial guaranty industry presents an important challenge for FSA, as well as the entire industry. Concerns regarding the capital adequacy of Triple-A guarantors drew attention not only from rating agencies but also state regulators, the federal government and financial institutions concerned about their own exposure to monolines. In February
2008, the Superintendent of Insurance of the State of New York (the "New York Superintendent") stated his intention to propose new regulations for financial guaranty insurers, potentially including limitations or prohibitions on insuring credit default swaps ("CDS") and certain structured finance obligations, such as CDOs of ABS. Additionally, vocal short-sellers put pressure on the stock valuations of publicly traded monolines. The cost of buying protection in the CDS market on monoline names rose markedly.
Management believes the stresses on the financial guaranty industry do not point to a systemic failure of the monoline business model but to a single product area-CDOs of ABS backed by residential mortgage-backed securities ("RMBS"). However, the resolution of these recent developments and their long-term impact on the Company's competitive position and industry concentration remains uncertain. New regulatory limits on financial guaranty insurance business may limit FSA's business opportunities going forward.
The Company has direct exposure to other monolines through secondary wraps of previously insured securities, reinsurance and investments. These exposures are detailed in "-Financial Guaranty Segment-Insured Portfolio Summary," below. The Company does not foresee material credit losses associated with these exposures, but downgrades of other monolines could cause mark-to-market losses in the Company's investment portfolios. Additionally, such downgrades could reduce the credit for reinsurance that rating agencies assign in their capital adequacy models, increasing the capital charges in those models for certain previously insured transactions. See "Item 1A. Risk Factors-Downgrade or default of one or more of the Company's reinsurers could reduce the Company's capital adequacy and return on equity."
At this stage, management cannot predict how the situation will be resolved for the Company or its competitors, or what competitive, regulatory and rating agency environments may emerge, but it sees near-term conditions as providing increased opportunities, especially in the U.S. municipal market, at a time when FSA is well positioned within its industry and able to command higher premiums than its peers. The Company has no restructuring plans and will maintain its underwriting discipline and capital adequacy while communicating with the public, regulators and other interested parties.
losses and market concerns related to their exposure to CDOs of ABS that contain a high percentage of subprime RMBS.
Except for projected losses in 2007 on insured HELOC transactions of $65.0 million, the Company's insured RMBS portfolio has generally performed within the loss tolerances structured into the transactions. Nearly all of the Company's exposure to subprime mortgages, excluding net interest margin securities ("NIMs"), is rated Triple-A, although some transactions have now been put on credit watch by one or more rating agencies. The exceptions are certain older transactions with $103 million in net par outstanding that were insured in the 1990s and 2000, and one 2007 transaction with $263 million in net par outstanding that was originally insured at Triple-A and recently internally downgraded to Double-A. For more detail on the Company's RMBS exposure see "-Financial Guaranty Segment-Results of Operations-Losses."
As of December 31, 2007, approximately 67% of the FP Investment Portfolio was invested in non-agency RMBS, 92% of which were rated Triple-A and 8% rated Double-A. Three assets in the FP Investment Portfolio were deemed other-than-temporarily impaired ("OTTI") during 2007, and an $11.1 million pre-tax loss was charged through the consolidated statements of operations and comprehensive income. Based on observed market indicators through February 2008, management expects additional significant negative unrealized mark-to-market adjustments in the FP Investment Portfolio in the first quarter of 2008. Management has not completed its quarterly analysis of possible other-than-temporary impairments for the first quarter of 2008. Performance data received to date do not indicate that OTTI is likely, but if positions were to be deemed OTTI the adverse effect on income could be significant.
The full extent of credit losses in the mortgage sector, and the extent to which they may affect the Company, will not be known for several years. The Company is also closely monitoring the consumer and corporate sectors for signs of deepening economic stress.
In the first quarter of 2008, the current market turmoil has also resulted in disruptions in the domestic public finance market, evidenced by auction failures for auction rate municipal bonds, higher rates on variable rate demand notes and historic high yields for tax-exempt municipal bonds compared with U.S. government treasury securities. In the short-term, these conditions present the Company with new business opportunities, but if they persist for an extended period of time, the Company's own insured obligations could experience increased losses because, in extreme cases, higher borrowing costs could lead to defaults of FSA-insured securities.
While credit problems were largely confined to the mortgage market during 2007, the concerns they generated led to a contraction of liquidity across the capital markets. This resulted in reduced new-issue volume, particularly in the residential mortgage and collateralized loan obligation ("CLO") markets. Credit spreads widened during the year and may continue to widen. Wider spreads generally mean that a financial guarantor has more opportunities and can sell insurance at higher premium rates. The Company's new business production reached a record level in 2007 partly because of spread widening. For more information, see "-New Business Production." However, wider spreads also necessitate unrealized negative fair-value (mark-to-market) adjustments through income for insured derivatives and through equity for certain FP investments, under accounting principles generally accepted in the United States ("GAAP").
For more information about risks to the Company see "Item 1A. Risk Factors."
(1)Economic hedge ineffectiveness remains in operating earnings. See following table for a more detailed presentation of fair-value adjustments for economic hedges.
outstanding and PV NIM outstanding, which represent future revenue and cash flows not recorded on the balance sheet under GAAP. ABV deducts the effect of deferred acquisition costs ("DAC"), which represents costs incurred to acquire the future premium revenue flows, and fair-value adjustments that are expected to sum to zero by each contract's maturity, barring a credit event. Any credit deterioration indicating a realized loss would be recognized in book value and ABV at such time that a loss is probable and reasonably estimable. ABV is reconciled to book value in the table that follows.
The Company employs the non-GAAP measure present value originations ("PV originations") to describe the present value of all the Company's originations in a given period.
•the present value of premiums originated ("PV premiums originated"), defined as estimated future installment premiums discounted to their present value, as well as upfront premiums (see "-Financial Guaranty Segment-PV Premiums Originated" and "-Non-GAAP Measures-Present Value of Premiums Originated"), and
2007 vs. 2006: In the financial guaranty segment, higher invested assets in the General Investment Portfolio, resulting partially from record premiums received in 2007, produced higher net investment income. New business originations also contributed to earned premiums. Refundings (net of amortization) were up 14%. Non-recurring realized foreign exchange gains accounted for a $10.6 million pre-tax increase year over year. These increases were offset, in part, by increased interest expense, loss expense and other operating expenses. Interest expense increased due to the issuance of $300 million in hybrid debt in the fourth quarter of 2006. Loss expense rose due primarily to an increase in the experience factor used in calculating the non-specific reserve and higher originations in the international public finance sector, which carry higher loss reserve charges in the non-specific reserving methodology. Higher operating expenses were caused by higher compensation expenses, which vary with production and growth in ABV, and lower deferral rates.
2006 vs. 2005: In the financial guaranty segment, higher invested assets in the General Investment Portfolio resulting from premiums received in 2006 produced higher net investment income. Refundings (net of amortization) were down 9%, and premium earnings excluding refundings were down 3%. 2006 pre-tax realized gains were $7.6 million lower than in 2005, and operating expenses increased, due primarily to lower deferral rates.
Net premiums earned are broken down into three major categories: premiums earned on insured derivatives, premiums earned on refundings and premiums earned on non-derivative insured obligations. Refundings may vary significantly from year to year as they are affected by the current interest rate environment. In periods of declining interest rates, issuers generally seek to refinance their obligations. In cases where an issuer defeases or calls an outstanding obligation insured by the Company, all unearned premiums are accelerated and recognized in current earnings. Over the past several years, the Company has limited its originations of ABS due to management's avoidance of CDOs of ABS and restraint in other RMBS sectors. Generally, asset-backed transactions in FSA's insured portfolio have an average life of approximately 4.3 years. As transactions originated in earlier years rolled off, they were not being replaced with the same volume of new originations, resulting in a decline in asset-backed earnings. During much of the last three years, tightening credit spreads combined with a competitive market environment resulted in the Company foregoing opportunities to
Premium collections are invested in the General Investment Portfolio, which consists primarily of municipal tax-exempt bonds. The Company's invested balances have been rising over the past several years, increasing net investment income. The Company's year-to-date effective tax rate on investment income (excluding the effects of realized gains and losses) was 12.4%, 12.2% and 13.2% for 2007, 2006 and 2005, respectively.
The following table sets forth certain information concerning the securities in the Company's General Investment Portfolio based on amortized cost and fair value.
fair value of that contract will change in part solely from the passage of time as premiums are received. Absent any claims under the Company's guaranty, any "losses" recorded in marking a guaranty to fair value will be reversed by an equivalent "gain" at or prior to the expiration of the guaranty, and any "gain" recorded will be reversed by an equivalent "loss" over the remaining life of the transaction, with the cumulative changes in the fair value of the CDS summing to zero by the time of each contract's maturity.
(1)As of January 1, 2007, the Company implemented Statement of Financial Accounting Standards No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS 155"), which resulted in a mark-to-market loss of $2.7 million in 2007 related to insured NIM securitizations originated in 2007. The change in fair value was a function of the market's adverse perception of RMBS products. The tables below show the fair value at December 31, 2007 and 2006 and the changes in fair value of the Company's insured CDS portfolio for 2007, 2006 and 2005.
•FSA-insured CDS contracts are neither held for trading purposes nor used as hedging instruments.
•The liquidity risk present in most non-insured CDS contracts is not present in most FSA-insured CDS contracts, since the terms of the insured CDS contract are designed to replicate the payment provisions of financial guaranty contracts in that (a) losses, if any, are generally paid over time, and (b) FSA is not required to post collateral to secure its obligation under the insured CDS contract.
Pooled Corporate CDS Valuation: A pooled corporate CDS contract is a contract that insures the default risk of a pool of referenced corporate entities. As there is no observable exchange trading of bespoke pooled corporate CDS, the Company values these contracts using an internal pricing model that uses published third-party indexes as inputs to its pricing model, principally the Dow Jones CDX for domestic corporate CDS and iTraxx for European corporate CDS. Each such index provides price quotes for standard attachment and detachment points (or "tranches") for contracts with maturities of three, five, seven and ten years. Prices quoted for these tranches do not represent perfect pricing references, but are the only relevant market-based information available for this type of non-traded contract. The recent market volatility in the index tranches has had a significant impact on the estimated fair value of the Company's portfolio of pooled corporate CDS.
CDS of Funded CDOs and CLO Valuations: As with pooled corporate CDS, there is no observable exchange trading of CDS of funded CDOs and CLOs. The Company estimates the market price with reference to the all-in LIBOR spread in the current published JP Morgan High Yield CLO Triple-A Index, which includes a credit and funding component. Depending on the absolute value of the LIBOR spread, the Company may also apply a factor to the spread as a means of estimating the credit enhancement component.
Insured derivatives in the asset-backed portfolio represent 67% of total asset-backed par outstanding. The tables below summarize the credit rating, net par outstanding and remaining average lives for the primary components of the Company's insured CDS portfolio. While most of the Company's insured CDS are pooled corporate exposures, there are also some insured CDS in other sectors, including $223.9 million in RMBS categories.
Where the Company refinanced underperforming insured obligations, the underlying assets or obligations are carried on the consolidated financial statements and earn income. The Company then manages such assets or sells them in order to maximize recoveries. The Company has not refinanced a transaction since 2004, and the related assets have either been sold or continue to run off and therefore the income contribution of these assets has been declining since 2005.
Other income includes income and fair-value adjustments on assets of the deferred compensation plans ("DCP") and supplemental executive retirement plans ("SERP"), foreign exchange gains or losses and other miscellaneous income items. The changes in fair value of DCP and SERP assets may vary significantly from period to period and are offset by changes in the related liability, which are recorded in other operating expenses.
The following table shows activity in the liability for losses and loss adjustment expense reserves, which consists of case and non-specific reserves.
The following table shows the gross and net par outstanding on transactions with case reserves, the gross and net case reserves recorded and the number of transactions comprising case reserves.
During 2006, the Company charged $23.3 million to loss expense, consisting of $17.8 million for originations of new business and $5.5 million related to accretion on the reserve for in-force business. Net case reserves decreased $0.7 million, due primarily to loss payments and some improvement in CBO transactions, offset in part by the establishment of a new case reserve for a municipal health care transaction.
During 2005, the Company charged $25.4 million to loss expense, consisting of $20.4 million for originations of new business and $5.0 million related to accretion on the reserve for in-force business. The non-specific reserve increased $16.4 million in 2005, primarily due to loss expense of $25.4 million, partially offset by transfers from the non-specific reserve to case reserves of $10.5 million. Case reserves increased $8.5 million due primarily to deterioration of specific CBO risks.
Since case and non-specific reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates. The Company will continue, on an ongoing basis, to monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company's revised estimate of loss, its actual loss experience, mix of business and economic conditions.
Given the broad diversification of FSA's insured portfolio, management believes that it is necessary to look at particular sectors when examining the sensitivity of the insured portfolio to changes in underlying loss assumptions. Management believes that different analyses are required for the two broad sectors of the insured portfolio, public finance credits and asset-backed obligations.
Management believes that, in contrast to the public finance insured portfolio, the primary determinant of loss in the asset-backed insured portfolio is default frequency, although severity is also considered. Since introducing a non-specific reserve in 1993, actual aggregate losses have been reasonably consistent with management's expectation in the majority of asset-backed categories, including insured obligations collateralized by automobile loans or residential mortgage debt of non-prime borrowers. The one exception involved senior bonds issued in 1998 and 1999 in connection with CDOs. In CDOs, the bonds insured by FSA are in "second-loss" positions, meaning that there are uninsured, subordinate bondholders or equity investors who must lose all of their investment outstanding at the time of default or earlier trigger event before the FSA-insured bonds become subject to loss. These transactions were structured to FSA's requirement that the "first-loss" position provide FSA an investment-grade level of protection. The underlying assets supporting the insured obligations were pools of corporate bonds individually rated below investment grade. In this structure, multiple credits must fail before claims are triggered. In 2002, credit quality deteriorated across a broad spectrum of the corporate market, which led to projected claims on these transactions and charges to the Company's consolidated statements of operations and comprehensive income, as well as an increase in the Company's loss experience rate. However, the severity of the largest single loss was relatively modest.
In a volatile mortgage market, future HELOC reserves or actual future losses could vary from the current estimate of loss. In particular, the deterministic models used to establish case reserves for HELOCs are affected by multiple variables, including default rates, the rates at which new borrowings ("draws") under the HELOCs are funded, prepayment rates and the spread between LIBOR and Prime interest rates. Management believes the key determinants of loss are default rates and draw rates. In setting its reserves, management assumed a conditional default rate curve that began at the then-current one-month value and rose over six months to a stress conditional default rate of 8%, 10% or 15% (annualized), depending on the transaction, remained there for 12 months, then decreased over 12 months to twice the "normal" conditional default rate.
Interest expense in the financial guaranty segment represents interest on corporate debt and intersegment interest on notes payable to GIC Subsidiaries related to the funding of the refinancing transactions. The table below shows the composition of the interest expense. The increase in interest expense is primarily due to the issuance of $300 million in hybrid debt in the fourth quarter of 2006.
The GAAP measure "gross premiums written" captures financial guaranty premiums collected or accrued in a given period, whether collected for business originated in the period or in installments for business originated in prior periods. It is not a precise measure of current-period originations because a significant portion of the Company's premiums are collected in installments. Therefore, management calculates the non-GAAP measure PV premiums originated as a measure of current-period premium production. To do so, management combines the following for business closed in the reporting period: (1) gross present value of premium installments and (2) premiums received upfront. The actual installment premiums received could vary from the amount estimated at the time of origination based on variances in the actual versus estimated outstanding debt balances and foreign exchange rate fluctuations. As a result, the realization of PV premiums originated could be greater or less than the amount reported.
The following table reconciles gross premiums written to PV premiums originated.
The following table represents the ratings distribution at origination for 2007.
Full-year 2007 estimated U.S. municipal market volume was 10% higher than in 2006 and the highest market volume on record. This followed a 5% decline in 2006 from 2005. Insurance penetration was approximately 47% in 2007, 49% in 2006 and 57% in 2005. FSA insured approximately 25% of the par amount of insured new U.S. municipal bond issues sold during 2007, compared with 24% in 2006 and 26% in 2005.
During the fourth quarter of 2007, municipal market volume declined, as issuers scaled back borrowing in response to market volatility, wider credit spreads and concerns about certain bond insurers. By December, a growing preference for FSA bond insurance had developed, and FSA's share of the insured market exceeded 50% in that month. Under these conditions in U.S. public finance, FSA's fourth-quarter 2007 PV premiums originated increased 50%, despite a 1% decline in par originated. Approximately 91% of the U.S. municipal bonds that FSA insured in the fourth quarter had an underlying credit quality of Single-A or higher. Although management believes it will continue to hold a dominant market position and achieve attractive pricing across sectors for a period of time, the length of that period will depend on market reaction to the recapitalization and possible reorganization
of certain major competitors, the entry of one or possibly more new competitors, and any material regulatory changes.
A summary of FSA's insured portfolio and distribution of ratings as of December 31, 2007 is shown below. Exposure amounts are expressed net of first-loss, quota share and excess-of-loss reinsurance.
Distribution of Insured Portfolio by Ratings based on Net Par Outstanding
In addition to amounts shown in the tables above, the Company had outstanding commitments to provide guarantees of $11,731.6 million as of December 31, 2007. These commitments are typically short term and principally relate to primary and secondary public finance debt issuances. Commitments are contingent on the satisfaction of all conditions set forth in the commitments. These commitments may expire unused or be cancelled at the counterparty's request. Therefore, the total commitment amount does not necessarily reflect actual future guaranteed amounts.
HELOCs: HELOCs represent 6% of total asset-backed par outstanding. Most of the Company's insured HELOCs were originated by mortgage finance companies, which, prior to 2007, had experienced historical lifetime losses of between 1% and 3% of original par. At underwriting and at originally expected net prepayment speeds, a typical finance company-originated HELOC pool would have sufficient protection to withstand losses of approximately 15% of original par. Prepayment speeds have exceeded expectations in a number of transactions, reducing excess spread available to cover losses. Default rates on several FSA-insured HELOC pools recently have risen to historically unprecedented levels, resulting in net FSA claim payments of $47.6 million through December 31, 2007 across six finance-company transactions, some of which are expected to be fully reimbursed. The Company has reduced its internal credit rating on seven HELOCs to below investment grade. As of December 31, 2007, the Company projects present value cumulative lifetime losses of $65.0 million across five HELOCs.
Subprime U.S. RMBS: Subprime U.S. RMBS represent 4% of total asset-backed par outstanding. Nearly all subprime US RMBS transactions insured by FSA are rated Triple-A, although some issues have been put on credit watch subsequent to year end by one or more rating agencies. The exceptions are certain transactions insured in the 1990s and 2000 with net par outstanding of $103 million, which are reviewed quarterly for reserve sufficiency, and one 2007 transaction originally insured at Triple-A and recently internally downgraded to Double-A, with net par outstanding of $263 million. At origination, typical FSA-insured subprime RMBS transactions contain approximately 20% overcollateralization and subordination plus excess spread typically estimated at 7% versus an original FSA loss expectation of 10% (22% defaults at 45% loss severity). If loss severity increased to 60%, more than 45% of all borrowers would have to default for the Company to pay a claim.
Option Adjustable Rate Mortgages: Option adjustable rate mortgage loan ("Option ARMs") securitizations represent 2% of total asset-backed par outstanding. All FSA-insured Option ARM transactions are currently rated Triple-A and are senior in the capital structures. These transactions are prepaying at moderate speeds and building overcollateralization. Although delinquencies are rising, there are few mortgage losses to date.
The Company obtains reinsurance to increase its policy-writing capacity on both an aggregate-risk and a single-risk basis; to meet rating agency, internal and state insurance regulatory limits; to diversify risk; to reduce the need for additional capital; and to strengthen financial ratios. The Company reinsures portions of its risks with affiliated and unaffiliated reinsurers under quota share, first-loss and excess-of-loss treaties and on a facultative basis. For balances recorded in the consolidated financial statements for related party reinsurance transactions, see Note 21 to the consolidated financial statements in Item 8.
(1)The Company has structural collateral agreements satisfying the Triple-A credit requirement of S&P and/or Moody's.
(3)Downgraded by Moody's (A3/review for downgrade) in March 2008 and S&P (A-/credit watch negative) in February 2008. The Company had a letter of credit from XLFA for $211.5 million as of December 31, 2007.
(6)Downgraded by Moody's (A3/review for downgrade) and S&P (A/credit watch negative) in February 2008.
(7)All risks reinsured by ACA Financial Guaranty Corporation are domestic public finance obligations.
(8)Includes Federal Insurance Company, Security Life of Denver International Ltd., PMI Mortgage Insurance Company, Assured Guaranty Re Overseas Ltd., Munich Reinsurance Company, Partner Reinsurance Company Ltd, Radian Insurance Inc. and XL Insurance (Bermuda) Ltd. 84% in the Double-A rating category by S&P, and 51% rated Aa2 and 34% rated Aa3 by Moody's.
2007 vs. 2006: Despite an OTTI charge of $11.1 million pre-tax, FP Segment NIM increased as the average aggregate balance of the GIC book of business grew from $14.5 billion in 2006 to $17.6 billion in 2007, and as a result of realized gains. The GIC balance stabilized at $18.8 million in the fourth quarter of 2007 due to management's decision to build liquidity in the FP Investment Portfolio. FP Segment NIM is reconciled below.
2006 vs. 2005: The FP Segment NIM increased primarily due to growth in the average aggregate GIC balance, which increased from $11.3 billion in 2005 to $14.5 billion in 2006.
The Company is cooperating with the Department of Justice and the Securities and Exchange Commission in connection with their investigations of bid-rigging of awards of municipal GICs and brokers of municipal GICs. See "Item 1A. Risk Factors-The Company has received Department of Justice and SEC subpoenas and been named in class action lawsuits related to the municipal GIC industry."
Like installment premiums, the PV NIM originated is expected to be earned and collected in future periods. The non-GAAP measure PV NIM originated represents the difference between the present value of estimated interest to be received on investments and the present value of estimated interest to be paid on liabilities issued by the FP Segment, net of transaction expenses, the expected results of derivatives used to hedge interest rate risk and the estimated effect of adverse changes in the expected lives of FP liabilities. In the first quarter of 2007, based on experience, management reduced its estimate of the adverse effect of transaction and hedging costs and changes in expected lives of FP liabilities. The Company's future positive interest rate spread estimate generally relates to contracts or security instruments that extend for multiple years. More detail on this Non-GAAP measure can be found in "-Non-GAAP Measures-Present Value of Financial Products Net Interest Margin Originated."
For the year, PV NIM originated declined 27% due primarily to the accumulation of liquidity and reduced investment activity in the last quarter. Although the Company issued $1.5 billion of new GICs in the fourth quarter of 2007, it limited new asset acquisitions in order to build additional liquidity in response to volatile market conditions. The increase in 2006 reflected the growth in the GIC book of business.
•the FP Investment Portfolio, consisting of the investments supporting the GIC liabilities; and
The Company's management believes that the assets held in the VIE Investment Portfolio are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership.
Management uses judgment in reviewing the specific facts and circumstances of individual securities and uses estimates and assumptions of expected default rates, loss severity and prepayment speeds to determine expected loss in its evaluation of OTTI. It uses both proprietary and third-party models to analyze the underlying collateral of ABS and the cash flows generated by the collateral to determine whether a security's performance is consistent with the view that all payments of principal and interest will be made as contractually required. Each mortgage-backed security in the FP Investment Portfolio was evaluated for OTTI as of December 31, 2007 by applying projected default assumptions to various delinquency categories, starting with 30 days past due, in order to create a measure of loss coverage. Once default rate assumptions were applied by delinquency category, management applied a 50% severity rate to projected gross losses. The result of this calculation was then compared with the hard credit enhancement embedded in each asset. As of December 31, 2007, all assets in the FP Investment Portfolio passed this test.
collateralization ratios. The analysis for the selected Alt-A and subprime securities used Intex, a third party vendor, because of its cash flow modeling capabilities as well as its detailed performance information. Management developed assumptions regarding conditional default rates, severity of loss and prepayment rates, which resulted in projected cumulative lifetime net losses by transaction ranging from 9.4% to 17.8% as a percentage of the original collateral balances for Alt-A securities. Subprime projected cumulative lifetime net losses ranged from 14.2% to 24.3%. The default, prepayment and severity of loss assumptions were modeled for each of the selected transactions to determine if those assumptions would result in a loss to the security held in the FP Investment Portfolio. If there were no projected ultimate losses to the security held in the FP Investment Portfolio, the security was deemed to perform. If the modeling results had indicated a collateral shortfall, the security value would have been deemed OTTI, which could have resulted in an OTTI charge being recorded through the consolidated statements of operations and comprehensive income. As of December 31, 2007, each Alt-A and subprime security passed the above test and therefore was expected to perform. Therefore, no Alt-A or subprime securities in the FP Investment Portfolio were considered other-than-temporarily impaired as of that date.
Given the market stress in the subprime and Alt-A sectors, management further stressed these securities by increasing the default curve and applying its modeled peak default rate for a more extended period of time resulting in an increase in projected cumulative lifetime net losses for each of the securities stressed. There are 14 Alt-A security positions, representing approximately $320 million of amortized cost, that are considered most vulnerable to further performance deterioration and would be the positions most likely to trigger an OTTI charge in the future. See "-Liquidity and Capital Resources-Summary of Invested Assets-FP Investment Portfolio" for information regarding the FP Investment Portfolio.
The following table indicates the Company's par value of debt outstanding with respect to municipal and non-municipal GICs as well as VIEs:
GICs issued by the Company may be withdrawn based upon certain contractually established conditions. While management follows the performance of each contract carefully, in some cases withdrawals may occur substantially earlier than originally projected. In response, the Company has been enhancing the liquidity available in its FP Investment Portfolio by investing newly originated GIC proceeds into short-term investments.
The primary component of expenses is employee compensation, which represented 65%, 59% and 65% of total expenses in each of the last three years, net of deferrals. The table below shows other operating expenses with and without compensation expense related to DCP and SERP plans, which include mark-to-market adjustments and other expenses. These expenses are offset by amounts in other income arising from assets held to economically defease such obligations. The DCP and SERP liabilities are matched with assets.
Compensation expense consists largely of bonus and equity participation plan expenses, which are driven by the performance of the Company. The Company defines success by the level of operating earnings, growth in ABV and origination volume. Two of the last three years have been record origination years at FSA, with operating earnings and ABV also growing. Lower deferral rates have also increased operating expenses over the last three years. The overall deferral rate for 2007 was 53%, versus 57% in 2006 and 63% in 2005.
The Company adopted Financial Accounting Standards Board ("FASB") Interpretation No.48 ("FIN 48") as of January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes in an entity's financial statements pursuant to FASB Statement No. 109, "Accounting for Income Taxes" and provides thresholds for recognizing and measuring benefits of a tax position taken or expected to be taken in a tax return. Consequently, the Company recognizes tax benefits only on tax positions where it is "more likely than not" to prevail. There was no impact on the Company's financial statements from adopting FIN 48. See Note 11 to the consolidated financial statements in Item 8.
The tables below summarize the exposure to each financial guaranty monoline insurer by exposure category and the underlying ratings of the Company's insured risks.
(1)Represents transactions with second-to-pay FSA insurance that were previously insured by other monolines.
(3)Excludes $39 million in redeemable preferred shares of XLFA, which are not rated.
(4)Subsequent to December 31, 2007, ratings were downgraded or outlooks were revised downward by one or more rating agencies. Special Purpose Entities
Asset-backed and, to a lesser extent, public finance transactions insured by the Company may employ special purpose entities for a variety of purposes. A typical asset-backed transaction, for example, employs a special purpose entity as the purchaser of the securitized assets and as the issuer of the insured obligations. The Company's participation is typically requested by the sponsor of the special purpose entity or the underwriter, either via a bid process or on a sole-source basis. Special purpose entities are typically owned by transaction sponsors or charitable trusts, although the Company may have an ownership interest in some cases. The Company maintains certain contractual rights and exercises varying degrees of influence over special purpose entity issuers of FSA-insured obligations.
The Company's underwriting policy is to insure only obligations that are otherwise investment grade. In addition, the special purpose entity typically pays a periodic premium to the Company in consideration of the issuance by the Company of its insurance policy, with the special purpose entity's assets typically serving as the source of such premium, thereby providing some of the "rewards" of the special purpose entity's assets to the Company. Special purpose entities are also employed by the Company in connection with "repackaging" of outstanding securities into new securities insured by FSA and with refinancing underperforming, non-investment-grade transactions insured by FSA.
The degree of influence exercised by the Company over these special purpose entities varies from transaction to transaction, as does the degree to which "risks and rewards" associated with asset
On November 22, 2006, FSA Holdings issued $300.0 million principal amount of Junior Subordinated Debentures with a scheduled maturity date of December 15, 2036 and a final repayment date of December 15, 2066. The final repayment date of December 15, 2066 may be automatically extended up to four times in five-year increments provided certain conditions are met. The debentures are redeemable, in whole or in part, at any time prior to December 15, 2036 at their principal amount plus accrued and unpaid interest to the date of redemption or, if greater, the make-whole redemption price. Interest on the debentures will accrue from November 22, 2006 to December 15, 2036 at the annual rate of 6.40%. If any amount of the debentures remains outstanding after December 15, 2036, then the principal amount of the outstanding debentures will bear interest at a floating interest rate equal to one-month LIBOR plus 2.215% until repaid. FSA Holdings may elect at one or more times to defer payment of interest on the debentures for one or more consecutive interest periods that do not exceed ten years. In connection with the completion of this offering, FSA Holdings entered into a replacement capital covenant for the benefit of persons that buy, hold or sell a specified series of FSA Holdings long-term indebtedness ranking senior to the debentures. Under the covenant, the debentures will not be repaid, redeemed, repurchased or defeased by FSA Holdings or any of its subsidiaries on or before the date that is 20 years prior to the final repayment date, except to the extent that FSA Holdings has received proceeds from the sale of replacement capital securities. The proceeds from this offering were used to pay a dividend to the shareholders of FSA Holdings.
On November 26, 2002, FSA Holdings issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt. FSA Holdings used a portion of the proceeds of this issuance to redeem in whole FSA Holdings' $130.0 million principal amount of 7.375% Senior QUIDS due September 30, 2097.
In its financial guaranty business, premiums and investment income are the Company's primary sources of funds to pay its operating expenses, insured losses and taxes. FSA's primary uses of funds are to pay operating expenses and to pay dividends to its parent FSA Holdings. FSA's funds are also required to satisfy claims under insurance policies in the event of default by an issuer of an insured obligation and the unavailability or exhaustion of other payment sources in the transaction, such as the cash flow or collateral underlying the obligations. FSA seeks to structure asset-backed transactions to address liquidity risks by matching insured payments with available cash flow or other payment sources. Insurance policies issued by FSA guaranteeing payments under bonds and other securities provide, in general, that payments of principal, interest and other amounts insured by FSA may not be accelerated by the holder of the obligation but are paid by FSA in accordance with the obligation's original payment schedule or, at FSA's option, on an accelerated basis. Payments made in settlement of the Company's obligations in its insured portfolio may, and often do, vary significantly from year to year depending primarily on the frequency and severity of payment defaults and its decisions regarding whether to exercise its right to accelerate troubled insured transactions in order to mitigate future losses. In each of the three years reported, the Company has not drawn on any alternative sources of liquidity to meet its obligations. In prior years, the Company has refinanced certain transactions using funds raised through its GIC Subsidiaries.
Insurance policies issued by FSA guaranteeing payments under CDS may provide for acceleration of amounts due upon the occurrence of certain credit events subject to single-risk limits specified in the insurance laws of the State of New York ("the New York Insurance Law"). These policy provisions prohibiting or limiting acceleration of certain claims are mandatory under Article 69 of the New York Insurance Law and serve to reduce FSA's liquidity requirements. See "Item 1. Business-Insurance Regulatory Matters." Management believes that FSA's expected operating liquidity needs, on both a short- and long-term basis, can be funded from its operating cash flow.
FSA may repurchase shares of its common stock from its shareholder subject to the New York Superintendent's approval. The New York Superintendent has approved the repurchase by FSA of up
In February 2008, FSA Holdings contributed $500 million of additional capital to FSA to provide additional capacity to insure new financial guaranty business. The contribution increased FSA's excess rating agency capital.
In its FP segment, the Company relies on net interest income to fund its net interest expense and operating expenses. Management believes that the FP segment's operating cash flow and the maturity of its investments provide sufficient liquidity to pay its obligations. Uncertainties remain regarding the timing of withdrawals of GICs associated with the CDOs of ABS. If additional liquidity is needed or cash flow from operations significantly decreases, the Company can sell investment assets, although the Company has the ability and management has the intent to hold these investments to maturity. To support this intent, as well as the Company's ability to hold the investments to maturity, the Company has been increasing short-term liquidity positions in the FP Investment Portfolio, which amounted to $1.9 billion as of December 31, 2007, and may raise additional funds through the issuance of GICs or medium term notes or by entering into repurchase agreement transactions. Under stress scenarios, the FP segment may be required to access additional funds through the issuance of GICs at higher credit spreads reflective of the current market environment or other avenues that would be costly to the Company.
(1)Amounts represent the undiscounted estimated claim payments, net of recoveries. Negative amounts are shown for years in which management expects recoveries of claims paid in prior years. Excludes non-specific reserves.
(2)Amounts include future implied interest accretion on zero-coupon obligations and future interest payments. Foreign amounts are calculated using spot rates as of December 31, 2007. Future interest payments are assumed to be at the rates in effect as of December 31, 2007 for floating rate debt.
The Company's cash flows from operations are heavily dependent on market conditions, the competitive environment and the mix of business originated. The following table summarizes cash flow from operations, investing and financing activities at the FSA Holdings consolidated level.
$728.6 million in 2006. In 2007, excluding trading portfolio asset purchases, the decrease in cash flow from operations was primarily due to an increase in losses paid, as well as increases in interest paid on notes payable and taxes paid. Excluding trading portfolio asset purchases, the increase in cash flow from operations between 2005 and 2006 is attributable primarily to an increase in net interest received from the FP segment and a reduction in taxes paid, partially offset by the decrease in premiums.
Net investment income from the General Investment Portfolio has been increasing over the past three years, largely due to increased investment balances as premiums received are generally invested in long-term assets. Investment income received on assets acquired in refinancing transactions declines as those assets pay down or are sold. Losses paid increased significantly in 2007 due primarily to claim payments on insured HELOC obligations. Interest on notes payable increased from $27.0 million in 2005 and $26.9 million in 2006 to $47.3 million in 2007 due to the issuance of $300.0 million of hybrid debt in the fourth quarter of 2006. Operating expenses paid increased in each of the last two years, due primarily to increased bonus and share performance payments to employees. Net cash flow from FP interest income and expense increased from 2005 to 2006 as the FP debt and FP Investment Portfolios grew. The decrease in 2007 from 2006 was due to an increase in prepaid derivative payments and lower margins.
In 2006, cash flow from financing activities included net cash inflow of $295.8 million related to the issuance of hybrid debt and cash outflow of $530.0 million for dividends paid to shareholders, including a $400.0 million extraordinary dividend.
(1)Ratings are based on the lower of Moody's or S&P ratings available as of December 31, 2007.
Management has determined that the unrealized losses in fixed-income securities at December 31, 2007 are primarily attributable to the current interest rate environment and has concluded that these unrealized losses are temporary in nature based upon: (a) the lack of principal and interest payment defaults on these securities; (b) the creditworthiness of the issuers; and (c) FSA's ability and current intent to hold these securities until maturity. As of December 31, 2007 and 2006, 100% of the securities that were in a gross unrealized loss position were rated investment grade.
(2)Stated maturities for asset-backed securities of one to 15 years as of December 31, 2007 and of one to 28 years as of December 31, 2006. The weighted average maturity of the fixed-income securities in the General Investment Portfolio as of December 31, 2007 was approximately 12 years.
Mortgage-backed securities differ from traditional fixed-income bonds because they are subject to prepayments at par value without penalty when the underlying mortgage loans are prepaid at the borrower's option. Prepayment rates on mortgage-backed securities are influenced primarily by the general level of prevailing mortgage interest rates, with prepayments increasing when prevailing loan interest rates are lower than the rates on the underlying mortgage loans, and by the terms of the loans. When prepayments occur, the proceeds must be reinvested at then-current market rates, which may be below the yield on the prepaid securities.
The Company carries debt securities designated as "available-for-sale" on its balance sheet at fair value in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The Company records the difference between the book value and fair value of these securities (the "unrealized gains and losses") net of deferred tax, as a component of accumulated other comprehensive income. In the FP Investment Portfolio, after-tax unrealized losses of $922.1 million as of December 31, 2007 were recorded in other comprehensive income and resulted from the general widening of credit spreads and liquidity premium in the mortgage-backed and asset-backed securities markets. In 2007 and 2006, unrealized after-tax gains of $9.1 million and $2.3 million, respectively, were recorded in the consolidated statements of operations and comprehensive income related to its trading portfolio. For a discussion of these unrealized losses, as well as the risks inherent in the FP Investment Portfolio, see "
Consolidated Statements of Cash Flows for the Years Ended December 31, 2007, 2006 and 2005
Financial Security Assurance Holdings Ltd. ("FSA Holdings") is a holding company incorporated in the State of New York. The Company, through its insurance company subsidiaries, is primarily engaged in providing financial guaranty insurance on public finance and asset-backed obligations in domestic and international markets including Europe, the Asia Pacific region and elsewhere in the Americas. The financial strength of the Company's insurance company subsidiaries is rated "Triple-A" by the major securities rating agencies and obligations insured by them are generally awarded "Triple-A" ratings by reason of such insurance. The Company's principal insurance company subsidiary is Financial Security Assurance Inc. ("FSA"), a wholly owned New York insurance company. FSA was the first insurance company organized to insure non-municipal obligations and has been a major insurer of asset-backed and other non-municipal obligations since its inception in 1985. FSA expanded the focus of its business in 1990 to include financial guaranty insurance of municipal obligations and has since become a major insurer of municipal and other public finance obligations. In addition, the Company offers FSA-insured guaranteed investment contracts and other investment agreements ("GICs") through other consolidated entities. References to the "Company" are to Financial Security Assurance Holdings Ltd. together with its subsidiaries.
Asset-backed obligations insured by the Company are generally issued in structured transactions and are backed by pools of assets such as residential mortgage loans, consumer or trade receivables, securities or other assets having an ascertainable cash flow or market value. The Company insures synthetic asset-backed obligations that generally take the form of credit default swap ("CDS") obligations or credit-linked notes that reference asset-backed securities or pools of securities or other obligations, with a defined deductible to cover credit risks associated with the referenced securities or loans.
Commencing in the fourth quarter of 2007, major financial institutions, including financial guaranty insurers, became subject to increasing stress. This has led to ratings downgrades and negative outlooks for a number of the Company's competitors, as well as increased scrutiny from regulatory authorities and rating agencies. FSA and the Company's other insurance company subsidiaries remain rated Triple-A/stable by Moody's Investors Service, Inc. ("Moody's"), Standard & Poor's Ratings Services ("S&P") and Fitch Ratings ("Fitch"). However, the impact of recent developments on the financial guaranty insurance industry and the Company remains uncertain, and could include decreased demand
The Company refinanced certain defaulted transactions by employing refinancing vehicles to raise funds. These refinancing vehicles are also consolidated and considered part of its financial guaranty business.
The Company conducts its GIC business through its consolidated affiliates FSA Capital Management Services LLC ("FSACM"), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the "GIC Subsidiaries"). FSACM has conducted substantially all of the Company's GIC business since April 2003, following the receipt of an exemption from the requirements of the Investment Company Act of 1940. The GIC Subsidiaries lend the proceeds from their sales of GICs to FSA Asset Management LLC ("FSAM"), which invests the funds, generally in obligations that qualify for FSA insurance. FSAM wholly owns FSA Portfolio Asset Limited ("FSA-PAL"), a U.K. Company that invests in non-U.S. securities.
and the deferral and amortization of policy acquisition costs and taxes. Actual results may differ from those estimates.
•the VIE Investment Portfolio, consisting of the investments supporting the VIE liabilities, which were entirely designated as available-for-sale as of December 31, 2007;
•the assets acquired in refinancing FSA-insured transactions, which are designated as available-for-sale; and
qualify as fair-value hedges is recorded in the consolidated statements of operations and comprehensive income in net interest income on FP segment.
Variable rate demand notes ("VRDNs") are included in bonds in the General Investment Portfolio. Auction rate securities ("ARS") are included in bonds in the FP Segment Investment Portfolio.
The gains and losses relating to derivatives not designated as fair-value hedges are included in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income. The gains and losses related to derivatives designated as fair-value hedges are included in either net interest income or net interest expense from the FP segment, as appropriate, along with the offsetting change in the fair value of the risk being hedged.
Fair value is defined as the price at which an asset or liability could be bought or sold in a current transaction between willing parties. Fair value is determined based on quoted market prices, if available. If quoted market prices are not available, as is the case with most of the Company's insured CDS contracts because these contracts are not traded, then the determination of fair value is based on internally developed estimates that employ credit-spread algorithms. These algorithms are unique to each insured CDS category and utilize various publicly available indices, depending on the types of assets referenced by the insured CDS contract and the length of the contract. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, performance of underlying assets, changes in internal credit assessments or rating agency-based shadow ratings, and, for its insured obligations, the level at which the deductible has been set. Estimates generated from the Company's valuation process may differ materially from values that may be realized in market transactions. The following is a description of the market pricing information that the Company utilizes in determining the fair value for significant categories of its insured CDS portfolio.
A pooled corporate CDS contract is a contract that insures the default risk of a pool of reference corporate entities. As there is no observable exchange trading of bespoke pooled corporate CDS the Company values these contracts using an internal pricing model that uses published third-party indexes as inputs to its pricing model, principally the Dow Jones CDX for domestic corporate CDS and iTraxx for European corporate CDS. Each such index provides price quotes for standard attachment and detachment points (or "tranches") for contracts with maturities of three, five, seven and ten years. Prices quoted for these tranches do not represent perfect pricing references but are the only relevant market-based information available for this type of non-traded contract. The recent market volatility in the index tranches has had a significant impact on the estimated fair value of the Company's portfolio of pooled corporate CDS.
The Company's valuation process for the pooled corporate CDS portfolio involves stratifying the investment-grade and high-yield contracts by remaining term to maturity, consistent with the reference indexes. Within maturity bands, further distinction is made for contracts that have higher attachment points. As index prices are quoted for standard attachment and detachment points (or tranches), the Company calibrates the quoted index price to the typical attachment points for its individual CDS contracts in order to derive the appropriate value, which is then validated by comparing it with relevant recent market transactions, if available.
As with pooled corporate CDS, there is no observable exchange trading of CDS of funded collateralized debt obligations ("CDOs") and collateralized loan obligations ("CLOs"). The Company estimates the market price with reference to the all-in London Interbank Offered Rate ("LIBOR") spread in the current published JP Morgan High Yield CLO Triple-A index, which includes a credit
and funding component. Depending on the absolute value of the LIBOR spread, the Company may also apply a factor to the spread as a means of estimating the credit enhancement component.
The Company determines fair value of insured CDS of European residential mortgage loan portfolios with reference to the recent auction prices of KfW Bankengruppe, the German development bank, when available. For CDS for which observable market value information is not available, management applies its best judgment to estimate the appropriate current fair value.
Securities Purchased under Agreements to Resell and Securities Sold under Agreements to Repurchase
Securities purchased under agreements to resell and securities sold under agreements to repurchase are accounted for as collateralized transactions and are recorded at contract value plus accrued interest. It is the Company's policy to take possession of securities borrowed under agreements to resell.
The financial guaranty industry has emerged over the past 35 years. Management believes that existing insurance accounting under Statement of Financial Accounting Standards ("SFAS") No. 60, "Accounting and Reporting by Insurance Enterprises" ("SFAS 60"), does not specifically address financial guaranty insurance. Accordingly, the accounting for loss and loss adjustment expenses within the financial guaranty insurance industry has developed based on analogy to the most directly comparable elements of existing literature, including sections of SFAS 60, SFAS No. 5, "Accounting for
Case reserves for financial guaranty insurance companies differ from those of traditional property and casualty insurance companies. The primary difference is that traditional property and casualty case reserves include only claims that have been incurred and reported to the insurance company. In a traditional property and casualty company, claims are incurred when defined events occur such as an auto accident, home fire or storm. Unlike traditional property and casualty claims, financial guaranty losses arise from the extension of credit protection and occur as the result of the credit deterioration of the issuer or underlying assets of the insured obligations over the lives of those insured obligations. Such deterioration and ultimate loss amounts can be projected based on historical experience in order to estimate probable loss, if any. Accordingly, specific loss events that require case reserves include (1) policies under which claim payments have been made and additional claim payments are expected and (2) policies under which claim payments are probable and reasonably estimable, but have not yet been made.
The Company establishes a non-specific reserve on its portfolio of credits because management believes that a portfolio of insured obligations will deteriorate over its life and that the existence of inherent loss can be proven statistically by data such as that published by rating agencies. The
Management believes that existing accounting literature does not address the unique attributes of financial guaranty insurance. As an insurance enterprise, the Company initially refers to the accounting and financial reporting guidance in SFAS 60. In establishing loss liabilities, the Company relies principally on SFAS 60, which prescribes differing treatment depending on whether a contract is a short-duration contract or a long-duration contract. Financial guaranty insurance does not fall clearly within the definition of either short-duration or long-duration contracts. Therefore, the Company does not believe that SFAS 60 alone provides sufficient guidance for financial guaranty claim liability recognition.
Deferred acquisition costs comprise expenses primarily related to the production of business, including commissions paid on reinsurance assumed, compensation and related costs of underwriting, certain rating agency fees, premium taxes and certain other underwriting expenses, reduced by ceding commission received on premiums ceded to reinsurers. Deferred acquisition costs are amortized over the period in which the related premiums are earned. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred acquisition cost is recognized. A premium deficiency would be recognized if the present value of anticipated losses and loss adjustment expenses exceeded the sum of deferred premium revenue and estimated installment premiums.
Monetary assets and liabilities denominated in foreign currencies are translated at the spot rate at the balance sheet date. Non-monetary assets and liabilities are translated at historical rates. Revenues and expenses denominated in foreign currencies are translated at average rates prevailing during the year. Unrealized gains and losses on available-for-sale securities resulting from translating investments denominated in foreign currencies are recorded in accumulated other comprehensive income. Gains and losses from transactions in foreign currencies are recorded in other income. The Company recorded $13.4 million in 2007, $2.8 million in 2006 and $8.4 million in 2005, respectively, related to transaction gain recorded in other income.
The Company adopted FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109" ("FIN 48") as of January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes in an entity's financial statements pursuant to SFAS No. 109, "Accounting for Income Taxes" ("SFAS 109") and provides thresholds for recognizing and measuring benefits of a tax position taken or expected to be taken in a tax return. Consequently, the Company recognizes tax benefits only on tax positions where it is "more likely than not" to prevail. There was no effect on the Company's statements of operations and comprehensive income from adopting FIN 48.
FIN 46-R addresses consolidation of SPEs that are deemed to be VIEs. A VIE is an entity that has one or both of the following characteristics: (a) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity; and (b) the equity investors lack the direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights and do not have the obligation to absorb the expected losses of the entity if they occur or the right to receive the expected residual returns of the entity if they occur. In analyzing variable interests that FSA holds in SPEs, as described above, the Company considers reinsurance to be an implicit variable interest. Where the Company determines it is required to consolidate the SPE, the outstanding exposure is excluded from Note 10.
The Company adopted SFAS No. 123, "Share-Based Payment" (revised 2004) ("SFAS 123 (R)") in 2006. SFAS 123 (R) did not have a material impact on the consolidated statements of operations and comprehensive income. Under SFAS 123 (R), $1.2 million and $1.0 million in additional after-tax expense related to the Dexia Employee Share Plans in 2007 and 2006, respectively.
reporting entities to choose to measure at fair value many financial instruments and certain other items that are not currently required to be measured at fair value. The fair-value option may be applied instrument by instrument, is irrevocable and is applied only to entire instruments and not to portions of instruments. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The effect of adopting SFAS 159 as of January 1, 2008 was a $53.2 million, after-tax, reduction of retained earnings.
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, "Noncontrolling interests in consolidated financial statements, an amendment of ARB No. 51" ("SFAS 160"). SFAS 160 requires reporting entities to present noncontrolling (minority) interests as equity (as opposed to liability or mezzanine equity) and provides guidance on the accounting for transactions between an entity and noncontrolling interests. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. FSA is currently evaluating the provisions of SFAS 160 and their potential impact on the Company's financial statements.
On April 18, 2007, the FASB issued an Exposure Draft entitled "Accounting for Financial Guarantee Insurance Contracts," an interpretation of SFAS 60 (the "Exposure Draft"). The Exposure Draft addresses premium revenue and claim liabilities recognition, as well as related disclosures. The proposed recognition approach for a claim liability would require the Company to recognize a claim liability when there is an expectation that a claim loss will exceed the unearned premium revenue (liability) on a policy basis based on the present value of expected cash flows. Under the Exposure Draft, the premium earnings methodology would also change significantly. Additionally, the Exposure Draft would require the Company to provide expanded disclosures relating to factors affecting the recognition and measurement of financial guaranty contracts.
Based on the comment letter responses to the Exposure Draft, the FASB reopened deliberations on some of the proposed guidance of the draft. The final statement is expected to be issued in the first quarter of 2008. Until final guidance is issued by the FASB, the Company will continue to apply its existing policies with respect to the establishment of both case and non-specific loss reserves and the recognition of premium revenue.
In the third quarter of 2007, management identified errors relating to the calculation of foreign currency transaction gains (losses) and the valuation of derivatives relating to FSA Global. The derivatives are used to economically hedge interest rate and foreign currency risk on debt and investments in FSA Global's portfolio. The Company does not apply hedge accounting to the risks these swaps are hedging; however, the hedges are economically effective and therefore the misstatement had no economic effect on the Company's financial position or FSA's claims paying ability, which is a metric used by the rating agencies. The misstatement does not affect any trends in the Company's financial statements, management's compensation, or cash flows and did not affect any loan covenants or regulatory matters. Management has evaluated the effect of the misstatement and concluded that the effect on a quantitative and qualitative basis is not material to the current or prior periods. As a result, in 2007, management recorded a $22.4 million after-tax charge to correct the cumulative errors, affecting the following items on the consolidated statements of operations and comprehensive income: net interest income from FP segment ($0.5 million gain); net interest expense from FP segment ($2.2 million expense); foreign currency gain (loss) from FP segment ($12.2 million gain); net realized and unrealized gain (loss) on derivatives ($45.0 million loss); and taxes ($12.1 million benefit).
Net investment income generated by the General Investment Portfolio consisted of the following:
The General Investment Portfolio includes bonds insured by FSA ("FSA-Insured Investments"). Of the bonds included in the General Investment Portfolio, 7.5% were Triple-A by virtue of insurance provided by FSA, and 28.1% were insured by other monolines (see Note 25). 100% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments, which is the rating without giving effect to the FSA insurance, was in the Double-A range.
The amortized cost and fair value of the securities in the General Investment Portfolio were as follows:
(1)The majority of foreign securities are government issues and they are denominated primarily in British pounds.
The amortized cost and fair value of fixed-income investments in the General Investment Portfolio as of December 31, 2007 and 2006, by contractual maturity, are shown below. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
earned by SPS from certain of its mortgage servicing activities. The Company recorded an asset of $12.6 million representing this contingent payment asset. Under the sale documents, the Company's subsidiary that owned the SPS investment made customary representations and warranties to, and undertook specified indemnification obligations for the benefit of, the purchaser. As of December 31, 2005, the Company recorded a $5.1 million liability related to this indemnification, representing the expected liability. Based on an estimate of the assets retained and liabilities assumed, the Company recorded a $0.4 million loss on the sale of SPS. The Company has received amounts in excess of the original estimated receivable. As of December 31, 2007, the carrying value of the asset was zero and the carrying value of the liability was $1.4 million. The Company recorded income related to SPS receipts of $5.3 million pre-tax in 2007, $0.5 million pre-tax in 2006. The Company has finalized an agreement with the purchaser that will result in a net cash payment to the Company of $1.7 million by March 31, 2008 and a release of all remaining liabilities.
The FP Investment Portfolio and VIE Investment Portfolio together constitute the "FP Segment Investment Portfolio." Within the FP Investment Portfolio, the Company classifies all securities as available-for-sale, except for five securities classified as trading securities. The assets in the trading portfolio are bonds denominated in foreign currencies. There have been no dispositions of assets held in the trading portfolio since inception. The VIE Investment Portfolio is classified as available-for-sale at December 31, 2007.
The following tables set forth certain information concerning the FP Investment Portfolio based on amortized cost:
(1)Ratings are based on the lower of Moody's or S&P ratings available at December 31, 2007. Since that date, many of these securities have had their ratings placed on review for possible downgrades and in some cases have been downgraded. The FP Investment Portfolio includes FSA-Insured Investments. Of the bonds included in the FP Investment Portfolio as of December 31, 2007, 4.4% were rated Triple-A by virtue of insurance provided by FSA. As of that date, 99% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments, which is the rating without giving effect to the FSA insurance, was in the Triple-B range. Of the bonds included in the FP Investment Portfolio, 19.4% were insured by other monoline guarantors (see Note 25).
The following tables show the gross unrealized losses and fair values of the available-for-sale bonds in the FP Investment Portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.
In addition to this test, management selected what it believed to be the 20 worst performing investments from each of the Alt-A and subprime investment categories for further analysis. The Alt-A sector was identified because this sector demonstrated the worst relative performance in terms of overcollateralization ratios. The analysis for the selected Alt-A and subprime securities used Intex, a third-party vendor, because of its cash flow modeling capabilities as well as its detailed performance information. Management developed assumptions regarding conditional default rates, severity of loss and prepayment rates, which resulted in projected cumulative lifetime net losses by transaction ranging from 9.4% to 17.8% as a percentage of the original collateral balances. Subprime projected cumulative lifetime net losses ranged from 14.2% to 24.3%. The default, prepayment and severity of loss assumptions were modeled for each of the selected transactions to determine if those assumptions would result in a loss to the security FP Investment Portfolio. If there were no projected ultimate losses to the security held in the FP Investment Portfolio, the security was deemed to perform. If the modeling results had indicated a collateral shortfall, the security value would have been deemed OTTI, which could have resulted in an OTTI charge being recorded through the consolidated statements of operations and comprehensive income. As of December 31, 2007, each Alt-A and subprime security passed the above test and therefore was expected to perform. Therefore, no Alt-A or subprime securities in the FP Investment Portfolio were considered other-than-temporarily impaired as of that date.
As part of the Company's review of OTTI in the FP Investment Portfolio, the Company reviewed all the investments in the portfolio, with particular attention to subprime and Alt-A investments, given the market stress in these sectors. Subjecting both subprime and Alt-A securities to further stress by increasing the expected default curve and applying its modeled peak default rate for a more extended period of time would result in an increase in projected cumulative lifetime net losses for each of the securities stressed. There are 14 Alt-A security positions, representing approximately $320 million of amortized cost that are considered most vulnerable to further performance deterioriation and would be the positions most likely to trigger an OTTI charge in the future.
The amortized cost and fair value of the available-for-sale securities in the FP Investment Portfolio are shown below by contractual maturity. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
As of December 31, 2006, there was one held-to-maturity investment in the VIE Investment Portfolio with a carrying value of $157.8 million, which was recorded in other assets.
Securities purchased under agreements to resell are eligible to be pledged to certain interest rate swap counterparties. In general, under the terms of each of these counterparty-specific derivative agreements, the Company and its counterparty may be required to pledge collateral or transfer assets as a result of changes in the fair value of those derivative agreements. The timing and amount are
generally dependent on which entity is exposed, as well as the credit rating of the party in the payable position. The Company and the counterparty typically have identical rights and obligations to pledge and rehypothecate collateral according to the terms included within each of the counterparty-specific derivative agreements. At December 31, 2007, $16.3 million of the assets held in the FP Investment Portfolio and related accrued interest were pledged as collateral to margin accounts. FSA Global, under the terms of its derivative agreements, is not required to pledge collateral. Its counterparties, however, may be required to pledge collateral or transfer assets to FSA Global.
The Company has rights under certain of its financial guaranty insurance policies and indentures that allow it to accelerate the insured notes and pay claims under its insurance policies upon the occurrence of predefined events of default. To mitigate financial guaranty insurance losses, the Company may elect to purchase the outstanding insured obligation or its underlying collateral. Generally, refinancing vehicles reimburse FSA in whole for its claims payments in exchange for assignments of certain of FSA's rights against the trusts. The refinancing vehicles obtain their funds from the proceeds of FSA-insured GICs issued in the ordinary course of business by the GIC Subsidiaries. The refinancing vehicles are consolidated into the Company's financial statements.
The following table presents the balance sheet components of the assets acquired in refinancing transactions:
The accretable yield on the securitized loans at December 31, 2007, 2006 and 2005 was $148.8 million, $157.3 million and $149.7 million, respectively. The cash flows on the securitized loans, net of reinsurance, are monitored and the effective yield modified prospectively to reflect any change in the cash flow estimate. Since the notes represent 100% of the debt capitalization of the trusts and since FSA maintains all the risk of further asset decline (except as provided by reinsurance) and maintains control over key decisions regarding the trusts (such as removal of the servicer, sale of the assets and liquidation of the entity), the trusts were consolidated with the Company.
The refinanced asset portfolio had seven thousand dollars of gross unrealized losses as of December 31, 2007 and no gross unrealized losses as of December 31, 2006.
(1)There were no HELOC reserves in 2006. The table below presents certain assumptions inherent in the calculations of the case and non-specific reserves:
During 2007, the Company charged $31.6 million to loss expense, consisting of $25.8 million for originations of new business and $5.8 million related to accretion on the reserve for in-force business. Net case reserves increased $45.1 million in 2007 due primarily to the establishment of new case reserves for HELOC and public finance transactions, offset in part by the settlement of several pooled corporate collateralized bond obligations ("CBOs"), which were accrued for in prior years. HELOC transactions in the asset-backed portfolio have experienced some deterioration. Credit support for the HELOC transactions is primarily provided by excess spread. Generally, once the overcollateralization is exhausted, the Company pays a claim if losses in a period exceed excess spread for the period, and to the extent excess spread exceeds losses, the Company is reimbursed for any losses paid to date. As of December 31, 2007, an estimated ultimate loss (discounted to present value) of $65.0 million on HELOC transactions had been transferred from the non-specific reserve to case reserves, which increased the experience factor. Such estimate of loss is net of reinsurance and anticipated recoveries and is reevaluated on a quarterly basis. In the second half of 2007, the Company paid a total of $47.6 million in HELOC claims, of which $39.5 million represented what the Company deems to be recoverable and is recorded as salvage and subrogation recoverable as of December 31, 2007.
During 2005, the Company charged $25.4 million to loss expense, consisting of $20.4 million for originations of new business and $5.0 million related to accretion on the reserve for in-force business. The non-specific reserve increased $16.4 million in 2005, due primarily to loss expense of $25.4 million, partially offset by transfers from the non-specific reserve to case reserves of $10.5 million. Net reserves increased $8.5 million due primarily to deterioration of specific CBO risks.
The Company also assigns each credit to one of five designated surveillance categories to facilitate appropriate allocation of resources to loss mitigation efforts and to communicate efficiently the relative credit condition of each risk exposure, as well as the overall health of the insured portfolio. Such categorization is determined in part by the risk of loss and in part by the level of routine involvement required and monitoring cycle deemed appropriate. The surveillance categories are organized as follows:
FP segment debt consists of GIC and VIE debt. The obligations under GICs issued by the GIC Subsidiaries may be called at various times prior to maturity based on certain agreed-upon events. As of December 31, 2007, interest rates were between 1.91% and 6.07% per annum on outstanding GICs and between 1.98% and 6.22% per annum on VIE debt. Payments due under GICs are based on expected withdrawal dates, which are subject to change, and include accretion of $1,039.8 million. VIE debt includes $996.7 million of future interest accretion on zero-coupon obligations. The following table presents the combined principal amounts due under FP segment debt for 2008 and each of the next four years ending December 31, and thereafter:
Contractual Terms to Maturity of Net Par Outstanding of Insured Obligations
In addition, the Company and its subsidiaries or branches file separate tax returns in various states and local and foreign jurisdictions, including the United Kingdom, Japan and Australia. With limited exceptions, the Company and its subsidiaries are no longer subject to income tax examinations for its 2003 and prior tax years for U.S. federal, state and local, or non-U.S. jurisdictions.
The cumulative balance sheet effects of deferred federal tax consequences are as follows:
Management believes it is more likely than not that the tax benefit of the deferred tax assets will be realized. Accordingly, no valuation allowance was necessary at December 31, 2007 or 2006.
In 2007, the Company recognized a tax benefit of $4.2 million, which includes the benefit of $0.7 million of interest from the expiration of the statute of limitations for the 2003 tax year.
discussed in Note 13. A reconciliation of the effective tax rate (before minority interest and equity in earnings of unconsolidated affiliates) with the federal statutory rate follows:
A reconciliation of the beginning to ending unrecognized tax benefits follows:
If recognized, the entire amount of unrecognized benefits would favorably affect the effective tax rate.
The Company recognizes interest and penalties related to unrecognized tax benefits as part of income tax expense. For 2007, the Company recognized an expense of approximately $0.4 million in interest and penalties. The Company had approximately $2.3 million of accrued interest and penalties at December 31, 2007.
The Dexia restricted stock component is a fixed plan, where the Company purchases Dexia shares and establishes a prepaid expense for the amount paid, which is amortized over 2.5-year and 3.5-year vesting periods. In 2007 and 2006, FSA purchased shares that economically defeased its liability for $4.7 million and $4.6 million, respectively. These amounts are being amortized to expense over the employees' vesting periods. For the years ended December 31, 2007, 2006 and 2005, the after-tax amounts amortized into income were $2.7 million, $1.9 million and $0.9 million, respectively.
Performance shares granted under the 1993 Equity Plan and 2004 Equity Plan are as follows:
At December 31, 2007, 349,533 outstanding performance shares were fully vested, with a value of $46.6 million. These amounts were paid in the first quarter of 2008. At December 31, 2007, the total compensation cost related to non-vested performance shares not yet recognized was $130.2 million. This amount is expected to be recognized as an expense over the next three years, with approximately 50% being expensed in 2008 and the remainder in 2009 and 2010.
The estimated final cost of these performance shares is accrued over the performance period. The after-tax expense for the performance shares was $40.0 million, $37.3 million and $35.4 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The components of net realized and unrealized gains (losses) on derivative instruments are shown in the table below:
The Company's insured portfolio includes contracts accounted for as derivatives, namely: FSA-insured CDS; insured IR swaps entered into in connection with the issuance of certain public finance obligations; and insured NIM securitizations issued in connection with certain RMBS financings. The Company considers all such agreements to be a normal part of its financial guaranty insurance business, although, for accounting purposes, these contracts are deemed to be derivative instruments and therefore must be recorded at fair value, with changes in fair value recorded in the consolidated statements of operations and comprehensive income in the line item "realized and unrealized gains (losses) on derivative instruments," along with the results of other derivatives held at FSA Holdings. The Company receives a premium in return for its obligation to make payment in the event of an insured loss (default or non-payment by the obligor), which is recorded in the consolidated statements of operations and comprehensive income as earned premium. The Company recorded net earned premiums from insured CDS and NIM securitizations of $102.8 million, $87.2 million and $89.2 million for the years ended 2007, 2006 and 2005, respectively. The Company's net par outstanding of $84.3 billion and $74.7 billion relating to insured CDS and NIM securitizations at December 31, 2007 and 2006, respectively, is included in the balances in Note 10.
the transaction, with the cumulative changes in the fair value of the CDS summing to zero by the time of each contract's maturity. See Note 2 for a discussion of the Company's valuation methodology.
The tables below show the fair value at December 31, 2007 and 2006 and the changes in fair value of the Company's insured CDS portfolio for 2007, 2006 and 2005.
The negative fair-value adjustments in 2007 resulted from an unusual and severe widening of credit spreads during the year. Despite the structural protections associated with the Company's CDS, the significant widening of credit spreads on pooled corporate CDS and funded CDOs and CLOs, as with other structured credit products, during the second half of 2007, resulted in a decline in fair value of these contracts. Funding costs for domestic and European CLOs as well as pooled corporate CDS were at their widest levels during the fourth quarter. As a result, Triple-A spreads to LIBOR continued to widen in the fourth quarter and resulted in the significant adverse mark reflected in the CDS fair-value results.
(4)Amounts include transactions previously wrapped by other monolines. See Note 25.
In order for a derivative to qualify for hedge accounting, it must be highly effective at reducing the risk associated with the exposure being hedged. An effective fair-value hedge is defined as one whose periodic change in fair value is 80% to 125% correlated with the change in fair value of the hedged item. The difference between a perfect hedge (i.e., the change in fair value of the hedge and hedged item offset one another so that there is zero effect on the consolidated statements of operations and comprehensive income, referred to as being "100% correlated") and the actual correlation within the 80% to 125% effectiveness range is the ineffective portion of the hedge. A failed hedge is one whose correlation falls outside of the 80% to 125% effectiveness range. The table below presents the net gain (loss) related to the ineffective portion of the Company's fair-value hedges and net gain (loss) related to failed hedges.
(1)Includes the changes in value of hedging instruments related to the passage of time, which have been excluded from the assessment of hedge effectiveness. The inception-to-date net unrealized gain on derivatives (excluding accrued interest) in the FP segment of $560.4 million and $487.3 million at December 31, 2007 and 2006, respectively, is recorded in other assets or other liabilities and minority interest, as applicable.
In 1998, the Company and XL Capital Ltd. ("XL"), a major Bermuda-based insurance holding company, entered into a joint venture, establishing two Bermuda-domiciled financial guaranty insurance companies: FSA International and XLFA. At December 31, 2004, XL owned a minority interest in FSA International, and the Company owned a minority interest in XLFA. In October 2005, FSA purchased all the preferred shares of FSA International owned by XL Insurance (Bermuda), Ltd. for a cash purchase price of $39.1 million in anticipation of the repatriation of earnings and profits of FSA International. Giving effect to such purchase, FSA International became an indirect, wholly owned subsidiary of the Company. The preferred shares were Cumulative Participating Voting Preferred Shares that, in total, had a minimum fixed dividend of $1.5 million per annum. In 2005, FSA International paid preferred dividends of $16.3 million to XL. For the year ended December 31, 2005, the Company recognized minority interest of $6.9 million.
The detailed balances that comprise other assets and other liabilities and minority interest are as follows:
In connection with its financial guaranty business, the Company had outstanding commitments to provide guarantees of $11,731.6 million as of December 31, 2007. These commitments are typically short term and principally relate to primary and secondary public finance debt issuances. Commitments are contingent on the satisfaction of all conditions set forth in the contract. These commitments may expire unused or be cancelled at the counterparty's request. Therefore, the total commitment amount does not necessarily reflect actual future guaranteed amounts.
On November 15, 2006, the Company received a subpoena from the Antitrust Division of the U.S. Department of Justice issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs. On November 16, 2006, FSA received a subpoena from the SEC related to an ongoing industry-wide investigation concerning the bidding of municipal GICs. The subpoenas requested that the Company furnish to the DOJ and SEC records and other information with respect to the Company's municipal GIC business.
See Note 26 for subsequent events relating to the Company's legal proceedings. There are no other material legal proceedings pending to which the Company is subject.
2007, $140.0 million in 2006 and $87.0 million in 2005. Based upon FSA's statutory statements for December 31, 2007, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the following 12 months would be approximately $162.9 million.
FSA has a standby line of credit commitment in the amount of $350.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $350.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $1,471.4 million at December 31, 2007. The obligation to repay loans made under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a term expiring on April 30, 2015 and contains an annual renewal provision, commencing April 30, 2008, subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2007.
Certain FSA Global debt issuances contain provisions that could extend the stated maturities of those notes. To ensure FSA Global will have sufficient cash flow to repay its funding requirements in such transactions, it entered into several liquidity facilities with Dexia and other counterparties for amounts totaling $760.9 million.
The Company operates in two business segments: financial guaranty and financial products. The financial guaranty segment is primarily in the business of providing financial guaranty insurance on public finance and asset-backed obligations. The FP segment includes the GIC operations of the Company, which issues GICs to municipalities and other market participants and the VIEs' operations. See Note 1 for description of business. The following tables summarize the financial information by segment as of and for the years ended December 31, 2007, 2006 and 2005:
The amount of SFAS 133 fair-value adjustments for insured derivatives is a reconciling item between pre-tax segment operating earnings and net income. In addition, management subtracts the effect of economic hedges when analyzing the segments. Marking the derivatives to fair value but not marking the hedged assets or liabilities causes one-sided accounting. By removing its effect, in the view of management, the measure more closely reflects the underlying economic performance of segment operations.
The GIC Subsidiaries and VIEs in the FP segment pay premiums to FSA. In addition, management of FSA provides management, oversight and administrative support services ("indirect FP expenses") to the entities in the FP segment. The Company's management evaluates the FP segment based on the separate results of operations of the GIC Subsidiaries and FSAM, excluding the premium paid to FSA and including the indirect FP expenses. For the VIEs, the premium paid approximates the indirect expenses incurred by FSA.
The Company enters into various related party transactions, primarily with Dexia and XL. The primary related party transactions between the Company and Dexia are as follows:
•The Company enters into transactions with various affiliates of Dexia, in which Dexia acts as the counterparty in swap contracts, primarily in the FP segment. The interest income and expense as well as the fair-value adjustments for those derivative contracts are recorded in the statement of operations and comprehensive income.
•The Company has loans receivable from Dexia recorded in other assets.
XLFA had an equity interest in FSA International until 2005, at which time the Company repurchased shares in FSA International held by XLFA. The Company has a preferred stock investment in XLFA, which is redeemable in 2008 with a carrying amount of $39.0 million. The Company's management holds two positions on the Board of Directors of XLFA. The primary related party transactions with XL are as follows.
•The Company receives dividends on its preferred stock investment in XLFA, which is recorded in the consolidated statements of operations and comprehensive income.
(2)The Company ceded business to XL Insurance (Bermuda) Ltd. ("XLI"), which owned an interest in FSA International prior to October 2005 and XLFA. The Company maintains an investment in XLFA, which was an indirect subsidiary of XL prior to 2007.
•For short-term investments in the General Investment Portfolio and the FP Segment Investment Portfolio, which are those investments with a maturity of less than one year at time of purchase, the carrying amount is fair value. Changes in fair value of short-term investments are due to changes in foreign exchange rates.
•For cash, the carrying amount is the same as a fair value.
•Other assets include the receivable for securities sold and derivatives. Other liabilities and minority interest include the payable for securities purchased and derivatives. For receivable for securities sold and payable for securities purchased, the carrying amount is cost, which approximates fair value because of the short maturity. For fair-value adjustments on derivatives, the carrying amount represents fair value. The Company uses quoted market prices when available, but if quoted market prices are not available, management uses internally developed estimates (see Note 2).
•For notes payable, the carrying amount represents the principal amount due at maturity. The fair value is based on the quoted market price or other third party sources.
•For installment premiums, consistent with industry practice, there is no carrying amount. Similar to the treatment of deferred premium revenue, the fair value of installment premiums is the estimated cost to cede the portfolio to third-party reinsurers under current market conditions.
•For losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses, the carrying amount is equal to the present value of the expected cash flows for specifically identified claims plus statistical losses representing the inherent losses in the Company's insured portfolio. Management believes the carrying amount is a reasonable proxy for fair value.
•non-insurance company subsidiaries do not prepare accounts applying statutory accounting standards.
(1)Amounts revised from those reported in Form 10-Q for March 31, June 30 and September 30, 2007 to reflect a reclassification of fair-value adjustments on trading portfolio assets to other income.
(4)Subsequent to December 31, 2007, ratings were downgraded or outlooks were revised downward by one or more rating agencies. 26. SUBSEQUENT EVENTS
Subsequent to December 31, 2007, credit spreads have widened significantly with respect to the Company's insured derivative portfolio and FP Investment Portfolio. Unless market conditions improve,
management expects to record material negative fair-value adjustments relating to its insured derivative portfolio and its FP Investment Portfolio in the first quarter of 2008.