MBIA Corp. owns the 265,000 square foot office building on approximately 15.5 acres of property in Armonk, New York, in which the Company and MBIA Corp. have their headquarters. The Company has over the past several years added approximately 18 additional acres adjacent to its current headquarters in order to provide an ability to expand its headquarters as needed. The Company also has rental space in New York, New York, San Francisco, California, Paris, France, Madrid, Spain, Sydney, Australia, London, England, Milan, Italy, Tokyo, Japan and the Republic of Singapore. The Company believes that these facilities are adequate and suitable for its current needs.
The Company has restated its previously issued consolidated financial statements for 1998 and subsequent years to correct the accounting treatment for two reinsurance agreements entered into in 1998 with Converium Reinsurance (North America) Inc., (formerly known as Zurich Reinsurance (North America), Inc.) (Converium). The restatement adjustments resulted in a cumulative net reduction in shareholders’ equity of $59.2 million, or 1%, as of December 31, 2001 and an increase to previously reported net income of $22 thousand for the year ended December 31, 2002. For the year ended December 31, 2003, the restatement adjustments resulted in an increase to previously reported net income of $2.3 million.
In 1998, the Company incurred a $170 million loss related to $265 million of MBIA-insured bonds issued by Allegheny Health, Education and Research Foundation (AHERF). At that time, the Company entered into an excess of loss reinsurance agreement with Converium, which reimbursed the Company $70 million. This $70 million reimbursement was recorded as an offset to the $170 million AHERF related loss. At the same time that MBIA Corp. arranged the excess of loss reinsurance agreement, it entered into a separate quota share reinsurance agreement with Converium that obligated the Company to cede $102 million of premiums to Converium over a six-year period ending October 1, 2004.
The following information presented in Management’s Discussion and Analysis of Financial Condition and Results of Operations gives effect to the restatement. See “Note 2: Restatement of Consolidated Financial Statements” in the Notes to Consolidated Financial Statements for additional information.
Significant changes to any variables on which the 12% loss factor is based, over an extended period of time, would likely result in an increase or decrease in the Company’s loss factor with a corresponding increase or decrease in the amount of the Company’s loss and loss adjustment expense provision. For example, as external and internal statistical data are applied to the various sectors of the Company’s insured portfolio, a shift in business written toward sectors with high default rates would likely increase the loss factor, while a shift toward sectors with low default rates would likely decrease the loss factor. Additionally, increases in statistical default rates relative to the Company’s insured portfolio and in the Company’s actual loss experience or decreases in statistical recovery rates and in the Company’s actual recovery experience would likely increase the Company’s loss factor. Conversely, decreases in statistical default rates relative to the Company’s insured portfolio and in the Company’s actual loss experience or increases in statistical recovery rates and in the Company’s actual recovery experience would likely decrease the Company’s loss factor. During the years ended December 31, 2004, 2003 and 2002, the Company calculated its provision for the unallocated loss reserve of $82 million, $74 million and $62 million, respectively, as 12% of scheduled net earned premium. This provision represents loss and loss adjustment expenses as reported on the Company’s income statement.
The Company establishes specific reserves in an amount equal to the Company’s estimate of identified or case basis reserves with respect to specific policies. A number of variables are taken into account in establishing specific case basis reserves for individual policies that depend primarily on the nature of the underlying insured obligation. These variables include the nature and creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured and the expected recovery rates on the insured obligation, the projected cash flow or market value of any assets that support the insured obligation and the historical and projected loss rates on such assets. Factors that may affect the actual ultimate realized losses for any policy include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. The Company does not believe that changes to these factors would materially change the amount of the Company’s case basis loss reserves, with the exception of significant changes in salvage values of specific collateral. However, the Company does not believe that significant changes in salvage values of specific collateral are reasonably likely to occur.
PREMIUM REVENUE RECOGNITION Upfront premiums are earned in proportion to the expiration of the related risk while installment premiums are earned over each installment period, generally one year or less. Therefore, for transactions in which the premium is received upfront, premium earnings are greater in the earlier periods when there is a higher amount of exposure outstanding. The upfront premiums are apportioned to individual sinking fund payments of a bond issue according to an amortization schedule. After the premiums are allocated to each scheduled sinking fund payment, they are earned on a straight-line basis over the period of that sinking fund payment. Accordingly, deferred premium revenue represents the portion of premiums written that is applicable to the unexpired risk of insured bonds and notes. When an MBIA-insured issue is retired early, is called by the issuer, or is in substance paid in advance through a refunding accomplished by placing U.S. Government securities in escrow, the remaining deferred premium revenue is earned at that time since there is no longer risk to the Company.
MBIA regularly monitors its investments in which fair value is less than amortized cost in order to assess whether such a decline in value is other than temporary and, therefore, should be reflected as a realized loss in net income. Such an assessment requires the Company to determine the cause of the decline and whether the Company possesses both the ability and intent to hold the investment to maturity or until the value recovers to an amount at least equal to amortized cost. As of December 31, 2004, MBIA determined that unrealized losses on its investments were temporary in nature because there was no material indication of credit deterioration and the Company has the ability and intent to hold the investments to maturity or until the fair value increases to an amount equal to amortized cost. This assessment requires management to exercise judgment as to whether an investment is impaired based on market conditions and trends and the availability of relevant data.
The Company’s exposure to derivative instruments is created through contracts into which it directly enters and through third-party contracts it insures. The majority of MBIA’s exposure to derivative instruments is related to certain synthetic collateralized debt obligations (CDOs) that it insures. These contracts meet the definition of a derivative under SFAS 133 but effectively represent an alternate form of financial guarantee execution. The fair values of the Company’s derivative instruments are estimated using various valuation models that conform to industry standards. The Company utilizes both vendor-developed and proprietary models, based on the complexity of transactions. Dealer market quotes are typically obtained for regularly traded contracts and provide the best estimate of fair value for those contracts. However, when reliable dealer market quotes are not available, the Company uses a variety of market data relative to the type and structure of derivative contracts entered into by the Company. Several of the more significant types of market and contract data that influence the Company’s valuation models include interest rates, credit quality ratings, credit spreads, default probabilities and diversity scores. The data is obtained from third-party sources and is reviewed for reasonableness and applicability to the Company’s derivative portfolio. The fair value of the Company’s derivative portfolio may be materially affected by changes in existing market data, the availability of new or improved market data, changes in specific contract data or enhancements to the Company’s valuation models resulting from new market practices.
MBIA expects to hold all derivative instruments to their contractual maturity. Upon maturity of a contract, the unrealized value recorded in the Company’s financial statements will be zero. However, in the unlikely event circumstances require the termination and settlement of a contract prior to maturity, any unrealized gain or loss will be realized.
The Company has dedicated resources to the development and ongoing review of its valuation models and has instituted procedures for the approval and control of data inputs. In addition, regular reviews are performed to ensure that the Company’s valuation models are appropriate and produce values reflective of the current market environment. See “Note 27: Fair Value of Financial Instruments” in the Notes to Consolidated Financial Statements for additional information on the various types of instruments entered into by MBIA and a comparison of carrying values as reported in the Company’s balance sheet to estimated fair values.
The Company completed its transitional impairment testing on its existing goodwill as of January 1, 2002 in accordance with SFAS 142. As of January 1, 2002, goodwill in the insurance reporting segment totaled $76.9 million. SFAS 142 requires a two-step approach in determining any impairment of goodwill. Step one entails evaluating whether the fair value of a reporting segment exceeds its carrying value. In performing this evaluation, the Company determined that the best measure of the fair value of the insurance reporting segment is its book value adjusted for the after-tax effects of net deferred premium revenue less deferred acquisition costs, and the present value of installment premiums to arrive at an adjusted book value. Adjusted book value is a common measure used by analysts to determine the value of financial guarantee companies. As of January 1, 2002, the insurance reporting segment’s adjusted book value significantly exceeded its carrying value, and thus management concluded that there was no impairment of its existing goodwill.
Total goodwill for the segments within the investment management services operations was $13.1 million as of January 1, 2002. In performing step one of the impairment testing, the fair values of the reporting segments were determined using a multiple of earnings before income tax, depreciation and amortization (EBITDA), as this is a common measure of fair value in the investment management industry. The multiple was determined based on a review of current industry valuation practices. As of January 1, 2002, the fair values of the investment management services’ reporting segments exceeded their carrying values indicating that goodwill was not impaired.
Consolidated revenues for 2004 were $2.0 billion compared with $1.9 billion in 2003, an 8% increase. The growth in consolidated revenues was primarily due to increases in insurance premium earnings and investment income, investment management services medium-term note program revenues and the full-year impact of the consolidation of conduit revenues. Consolidated expenses for 2004 were $871 million compared with $708 million in 2003, a 23% increase. This increase was primarily due to an increase in investment management services medium-term note program interest and operating expenses and the full year impact of the consolidation of conduit expenses. Net income for 2004 of $815 million was down slightly from $816 million in 2003. Net income per share was flat compared with the prior year.
The Company’s insurance operations are principally comprised of the activities of MBIA Insurance Corporation and its subsidiaries (MBIA Corp.) MBIA Corp. issues financial guarantees for municipal bonds, asset-backed and mortgage-backed securities, investor-owned utility bonds, bonds backed by publicly or privately funded public purpose projects, bonds issued by sovereign and sub-sovereign entities, obligations collateralized by diverse pools of corporate loans and credit default swaps and pools of corporate and asset-backed bonds, both in the new issue and secondary markets.
Revenues from insurance operations were $1.42 billion in 2004 and $1.39 billion in 2003, reflecting a 3% increase. The growth in insurance operations revenues was due to increases of 11% in earned premiums, 8% in net investment income and 61% in net realized gains offset by decreases of 30% in advisory fee income and 93% in net gains on derivative instruments. Insurance expenses, which consist of loss and loss adjustment expenses, amortization of deferred acquisition costs and operating expenses, increased 8% in 2004 compared with 2003. Loss and loss adjustment expenses and the amortization of deferred acquisition costs both increased 11%, in line with the increase in earned premiums. Operating expenses increased 5%, principally due to higher compensation costs, premiums related to the renewal of directors’ and officers’ liability insurance and loss prevention costs. Gross insurance expenses (expenses before the deferral or amortization of acquisition costs) for 2004 increased 1% compared with 2003.
In 2003, insurance operations revenues of $1.39 billion increased 37% compared with 2002. The large growth in revenues was principally due to net gains on derivative instruments, as well as increases of 25% in premiums earned and 18% in advisory fee income. Insurance operations expenses increased 20% in 2003, which is in line with the increase in insurance revenues for the same period. However, operating expenses increased as a result of a change in expense allocation methodology between business operations, expenses related to the formation of Toll Road Funding, Plc. (TRF), and a one-time cost to replace split-dollar life insurance policies terminated by the Company.
GPW reflects premiums received and accrued for the period and does not include the present value of future cash receipts expected from installment premium policies originated during the year. GPW was $1.1 billion in 2004, down 12% from 2003, reflecting a 15% decrease in U.S. business and a 7% decrease in non-U.S. business. Upfront and installment GPW decreased 21% and 2%, respectively.
NPW, which represents gross premiums written net of premiums ceded to reinsurers, decreased 8% to $970 million from $1.1 billion in 2003. The smaller decrease in NPW relative to GPW reflects a decline in premiums ceded to reinsurers, including the effects of reassuming previously ceded business to reinsurers. Business reassumed from reinsurers is discussed in the “Reinsurance” section included herein. Premiums ceded to reinsurers from all insurance operations were $147 million, $219 million and $182 million for 2004, 2003 and 2002, respectively. Reinsurance enables the Company to cede exposure and comply with its single risk and credit guidelines, although the Company continues to be primarily liable on the insurance policies it underwrites.
Net premiums earned include scheduled premium earnings as well as premium earnings from refunded issues. Net premiums earned in 2004 of $822 million increased 11% over 2003 due to an 11% increase in scheduled premiums earned and a 10% increase in refunded premiums earned. The increase in scheduled premiums earned was a result of strong growth in new business written in past years, as well as a decline in the use of reinsurance. The increase in refunded premiums earned resulted from high levels of refinancing activity due to the sustained low interest rate environment.
MBIA evaluates the premium rates it receives for insurance guarantees through the use of internal and external rating agency quantitative models. These models assess the Company’s premium rates and return on capital results on a risk adjusted basis. In addition, market research data is used to evaluate pricing levels across the financial guarantee industry for comparable risks. Although pricing has not been as robust in 2004, the Company, along with the industry, experienced significant price increases over the period from 1998 through 2003. The Company’s pricing levels indicate continued acceptable trends in overall portfolio profitability under all models, and the Company believes the pricing charged for its insurance products produces results that meet its long-term return on capital targets.
Global structured finance GPW increased 3% in 2004, to $451 million from $436 million in 2003, resulting from an increase in non-U.S. business written. The global structured finance sector continues to be adversely impacted by tight spreads and greater investor demand for uninsured transactions. NPW for 2004 increased 16% due to the increase in GPW and lower cession rates on both U.S. and non-U.S. business written. The 2004 cession rate on total global structured finance business written was 20%, which declined from a 28% cession rate in 2003. In 2004, global structured finance net premiums earned of $340 million increased 7% over 2003. This increase was driven by higher levels of new non-U.S. business written over the last two years and a declining cession rate.
Global structured finance GPW increased 2% in 2003, to $436 million from $426 million in 2002, resulting from an increase in non-U.S. business. NPW for 2003 increased 4% due to the increase in non-U.S. business activity coupled with a lower cession rate on that business. Premiums written in 2003 were adversely impacted by generally unattractive market pricing and credit terms in the mortgage and consumer asset-backed sectors. In 2003, global structured finance net earned premiums of $318 million increased 14% over 2002.
The credit quality of MBIA’s global structured finance insured business written rated A or above, before giving effect to the Company’s guarantee, was 64% in 2004, down from 71% in 2003 and 77% in 2002. At December 31, 2004, 77% of the outstanding global structured finance book of business was rated A or above before giving effect to the Company’s guarantee, up from 74% at December 31, 2003.
The Company’s insurance-related net investment income, excluding net realized gains, increased 8% to $474 million in 2004, up from $438 million in 2003. After-tax net investment income also increased 8% compared with 2003 as the proportion of taxable investments remained stable. The increase in investment income for 2004 was principally the result of an increase in invested assets due to premium collections and reinvested interest. Since the fourth quarter of 2003, a portion of MBIA-administered conduit investment income has been reported as insurance-related net investment income. Excluding investment income related to MBIA-administered conduits, after-tax insurance-related investment income would have increased 6% from 2003.
In 2003, insurance-related pre-tax net investment income of $438 million increased 1% over 2002. The modest growth in 2003 was due to the low-yield environment, despite an 11% growth in the average invested asset base at amortized cost. After-tax insurance-related net investment income decreased 2% in 2003 as the Company increased its concentration of taxable investments. Excluding investment income related to the Conduits, after-tax insurance-related investment income would have decreased 3% from 2002.
The duration of the investment portfolio at December 31, 2004 and December 31, 2003 was 5.3 years and at December 31, 2002 was 6.9 years. The reduction in 2003 was a result of the Company’s decision to shorten the duration of the investment portfolio to approximately 5 years in order to preserve economic capital embedded in the investment portfolio as a result of the low interest rate environment. The effect of shortening the investment portfolio duration, which largely occurred in 2003, was an increase in realized gains and a reduction in net investment income.
In 2004, advisory fee revenues decreased 30% to $41.5 million, from $59.7 million in 2003. This decrease was primarily due to a decline in work fees, resulting from fewer large and complex transactions, and waiver and consent and structuring fees. In 2003, advisory fee revenues increased 18% to $59.7 million, from $50.7 million in 2002. This increase was driven by higher work fees related to complex transactions and waiver and consent fees related to the surveillance and remedial activities of the Company’s Insured Portfolio Management Department (IPM), partially offset by lower administrative fees. Fees that are earned when due totaled 63% and 75% of 2004 and 2003 advisory fee income, respectively. Due to the transaction-specific nature inherent in such fees, advisory fee income can vary significantly from period to period.
Net gains (losses) on derivative instruments and foreign exchange from insurance operations, which primarily represent changes in the market value of the Company’s insured credit derivative portfolio, were net gains of $7 million and $100 million in 2004 and 2003, compared with a net loss of $74 million in 2002. The 2004 net gain was primarily due to an increase in the value of the Company’s insured credit derivatives portfolio, reflecting a tightening credit spread environment. In past years, gains or losses on derivatives have been largely due to movements in credit spreads affecting the insurance operations insured portfolio of synthetic CDOs. Insurance operations represent the majority of the derivatives when measured by notional values. However, credit spreads did not move significantly in 2004 relative to 2003 or 2002.
The Company recorded $82 million in loss and loss adjustment expenses in 2004, an 11% increase compared with $74 million in 2003. This increase was a direct result of growth in scheduled net earned premium, which is the base upon which the 12% loss factor is applied. At December 31, 2004, the Company had $292 million in unallocated loss reserves, which represent the Company’s estimate of losses associated with credit deterioration that has occurred in the Company’s insured portfolio and are available for future case-specific activity. During 2004, the unallocated loss reserve was increased by reserves of $32 million related to the agreement with Asian Securitization & Infrastructure Assurance (Pte) Ltd (ASIA Ltd). Additional information related to the agreement with ASIA Ltd is provided in the following Reinsurance section.
On June 30, 2004, in order to reduce ongoing carrying and other costs, a clean-up call was exercised for the Capital Asset Research Funding Series 1997A and Series 1998A tax lien securitizations. The clean-up call provisions permitted the issuer of the bonds to buy back any remaining tax liens when the principal amount of the bonds fell below ten percent of the original principal amount. In connection with the clean-up calls, MBIA paid $51.5 million (net of reinsurance) under its policies to the trustee for the securitizations, which defeased its remaining exposure to these transactions. MBIA did not record any additional losses in connection with its payment during the second quarter.
Another area that MBIA is monitoring closely is the manufactured housing sector, which has experienced significant stress. MBIA ceased writing business in this sector, other than through certain CDO transactions, in 2000. In the fourth quarter of 2004, the Company established a case basis reserve of $10 million relating to a specific manufactured housing exposure and placed this exposure on its “Classified List.” As of December 31, 2004, net insured par outstanding on this exposure was $563 million. The Company had additional manufactured housing exposure of $2.2 billion in net insured par outstanding as of December 31, 2004, of which approximately 44% has been placed on the Company’s “Caution List-Medium” and “Caution List-High.” An explanation of the Company’s “Classified List” and “Caution Lists” is provided below.
The Company does not establish any case basis reserves for issues that are listed as “Caution List-Low,” “Caution List-Medium” or “Caution List-High” until such issues are placed on the Company’s “Classified List.”
Included in the Company’s case basis reserves are both loss reserves for insured obligations for which a payment default has occurred and MBIA has already paid a claim and also for which a payment default has not yet occurred but a claim is probable and estimable in the future, as follows:
When MBIA becomes entitled to the underlying collateral of an insured credit under salvage and subrogation rights as a result of a claim payment, it records salvage and subrogation as an asset. Such amounts are included in the Company’s balance sheet within “Other assets.” As of December 31, 2004 and 2003, the Company had salvage and subrogation of $154 million and $125 million, respectively. During the third quarter of 2004, MBIA acquired $42 million of tax liens, which were acquired as a result of payments made on policies related to the Philadelphia Authority for Industrial Development “PAID” 6.488% Tax Claim Collateralized Revenue Bonds Series 1997 and the Capital Asset Research Funding Series 1997A and Series 1998A tax lien securitizations. The balance of these tax liens at December 31, 2004 was $34.9 million, which the Company expects to collect as a result of future redemptions. Additionally, the payment made by the Company related to the Capital Asset Research Funding Series 1997A and Series 1998A tax lien securitizations resulted in MBIA consolidating the securitizations in its financial statements. Information related to the consolidation of these securitizations is provided in the following Variable Interest Entities section.
REINSURANCE Reinsurance enables the Company to cede exposure for purposes of increasing its capacity to write new business while complying with its single risk and credit guidelines. The rating agencies continuously review reinsurers providing coverage to the financial guarantee industry. Many of MBIA’s reinsurers have been downgraded over the past two years, and others remain under review. As of December 31, 2002, reinsurers rated Double-A and above represented 90% of MBIA’s ceded par. As a result of downgrades during 2003, this percentage as of December 31, 2003 was 56%; however, it then increased to 88% as of December 31, 2004. The increase from December 31, 2003 was principally due to cessions to Channel Reinsurance Ltd. (Channel Re), a Triple-A rated reinsurer, and to a lesser extent, the reassumption of portfolios throughout 2004. When a reinsurer is downgraded, less capital credit is given to MBIA under rating agency models. The reduced capital credit has not and is not expected to have a material adverse effect on the Company. The Company generally retains the right to reassume the business ceded to reinsurers under certain circumstances, including the downgrade of the reinsurers. The Company remains liable on a primary basis for all reinsured risks, and although the Company believes that its reinsurers remain capable of meeting their obligations, there can be no assurance that the reinsurers will be able to meet these obligations.
On January 31, 2004, the Company reassumed portfolios of previously ceded transactions from Axa Re Finance S.A. (Axa Re) and Radian Reinsurance Inc. (Radian Re). On February 29, 2004, the Company reassumed portfolios of previously ceded transactions from American Re-Insurance Company (American Re) and Partner Reinsurance Company Ltd. (Partner Re). The Company received total proceeds from these transactions of $138.1 million consisting of unearned premium reserves of $181.2 million and case reserves of $15.4 million less return ceding commissions of $58.5 million. Insured par reassumed from these transactions totaled $31.6 billion.
exposures from ASIA Ltd with an outstanding par balance of $37.5 million, and CapMAC reassumed twenty exposures it previously reinsured with ASIA Ltd with an outstanding par balance of $331.7 million. MBIA Corp. and CapMAC received proceeds of $60.9 million representing $8.8 million of unearned premium reserves, $19.4 million of case basis reserves and $32.7 million of unallocated reserves associated with the assumed portfolios.
In 1998, three reinsurers, AXA Re Finance S.A. (ARF), Converium and Muenchener Rueckversicherungs-Gesellshaft (Munich Re) reimbursed the Company $170 million for losses incurred with respect to $265 million of MBIA-insured bonds issued by AHERF under three separate reinsurance agreements (the AHERF Reinsurance Agreements). The AHERF Reinsurance Agreements were structured as three successive excess-of-loss facilities that aggregated to $170 million. Under the excess of loss reinsurance agreements, Converium reimbursed the Company $70 million of it’s $170 million loss and Munich Re and ARF each reimbursed MBIA $50 million.
At the same time that the Company arranged the AHERF Reinsurance Agreements, it entered into several separate quota share reinsurance agreements with the same reinsurers. Under these quota share reinsurance agreements, the Company agreed to cede on a quota share basis to the three reinsurers new business written with an aggregate par sufficient to generate $297 million in gross premiums over a six year period ending October 1, 2004. Of the $297 million in premium to be ceded under the quota share arrangements, the Company agreed to cede to Converium cash premiums equal to $102 million, to ARF adjusted gross premiums of $98 million and to Munich Re adjusted gross premiums of $97 million over this period. The aggregate insured par ceded to these reinsurers under these quota share agreements totaled over $45 billion.
Under separate agreements, to which the Company was not a party, Converium reinsured directly and indirectly to ARF (the Converium-ARF Retrocession Agreements) the risk that it assumed from the Company under its quota share agreements with the Company for losses in excess of $13.1 million. ARF contended that, in connection with its agreement to assume this risk from Converium under the Converium-ARF Retrocession Agreements, there was an oral agreement with MBIA under which MBIA would replace ARF as a reinsurer to Converium by no later than October 2005.
In October 2004, the Company commuted and assumed from ARF the policies that ARF had reinsured directly under its quota share reinsurance agreements with the Company discussed above (the MBIA-ARF Reinsurance Agreements). At the same time, the Company also assumed from ARF all of the risk that ARF assumed from Converium under the Converium-ARF Retrocession Agreements. AXA RE, S.A (AXA RE), ARF’s parent, in turn agreed to reinsure the Company for all losses in excess of $96.9 million assumed by the Company from ARF under the Converium-ARF Retrocession Agreements up to an aggregate amount of $90 million.
ARF paid the Company $10 million for assuming from it the risk under the Converium-ARF Retrocession Agreements, and the Company paid AXA RE $1 million for reinsuring the Company for all losses in excess of $96.9 million assumed by the Company from ARF under the Converium-ARF Retrocession Agreements up to an aggregate amount of $90 million.
In October 2004, the Company’s management recommended that the Audit Committee of the Company’s Board of Directors undertake an investigation of the AHERF Reinsurance Agreements, including whether an oral agreement existed between MBIA
Corp. and ARF that the Company would assume the risk that Converium retroceded to ARF under the Converium-ARF Retrocession Agreements. The Audit Committee retained outside counsel and initiated an investigation in October 2004. The outside counsel’s investigation has been substantially completed. While the investigation has not conclusively determined whether an oral agreement in fact existed, the Company has been advised, however, that it appears likely that such an agreement or understanding with ARF was made in 1998. Based on the investigation and other considerations, on March 8, 2005, the Company announced that it decided to restate its financial statements for 1998 and subsequent years to correct the accounting treatment for the MBIA Reinsurance Agreement and quota share agreement entered into with Converium as discussed in the preceding Restatement of Consolidated Financial Statements section.
On March 9, 2005, the Company received a subpoena from the U.S. Attorney’s Office for the Southern District of New York seeking information related to the reinsurance agreements it entered into in connection with the AHERF loss. The Company intends to cooperate fully with the U.S. Attorney’s Office.
Financial guarantee insurance companies use the expense ratio (expenses divided by net premiums earned) as a measure of expense management. The Company’s 2004 expense ratio of 22.0% is slightly below the 2003 ratio of 22.8% and the 2002 ratio of 23.5%. The decrease in the ratio from 2003 and 2002 is the result of an increase in net premiums earned.
As a result of the clean-up call exercised for the Capital Asset Research Funding Series 1997A and Series 1998A tax lien securitizations, these securitizations no longer meet the conditions of a qualifying special purpose entity under SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” MBIA holds a variable interest in these entities, which resulted from its insurance policies, and has determined that it is the primary beneficiary under FIN 46R. In the third quarter of 2004, MBIA acquired the assets of the securitizations and has reported such assets, totaling $16.8 million as of December 31, 2004, principally within “Other assets” on its consolidated balance sheet. Liabilities of the securitizations substantially represented amounts due to MBIA, which were eliminated in consolidation.
Third-party VIEs are used in a variety of structures insured or managed by MBIA. Under FIN 46R, MBIA’s guarantee of the assets or liabilities of a VIE constitutes a variable interest and requires MBIA to assess whether it is the primary beneficiary. Additionally, the Company’s management of VIEs under asset management agreements may subject the Company to consolidation of such entities. Consolidation of such VIEs does not increase MBIA’s exposure above that already committed to in its insurance
policies. VIE assets and liabilities consolidated in the Company’s financial statements at December 31, 2004 and 2003 are primarily reported in “Investments held-to-maturity” and “Variable interest entity floating rate notes,” respectively, on the face of the Company’s balance sheet and totaled approximately $600 million each.
Investment management services 2004 total revenues of $542 million increased 29% compared with 2003. Excluding net realized losses of $4 million and losses on derivative instruments and foreign exchange of $6 million, total revenues increased $148 million, or 37% over 2003. The growth is primarily attributable to increased activity in the structured product businesses, particularly the asset/liability products and third-party management of CDO transactions. In addition, 2004 results include twelve months of Conduit activities, which were not consolidated by the Company in the first nine months of 2003. Profitability in the pooled investment business declined compared with 2003 due to lower fees and an unfavorable geographic mix. Excluding net realized gains or losses and net gains or losses on derivative instruments and foreign exchange, 2003 total investment management services revenues increased $16 million, or 4%, compared with 2002.
Fixed-income ending assets under management as of December 31, 2004, which do not include Conduit assets, were $39.1 billion, 14% above the 2003 year-end level and 29% above the 2002 year-end level. Conduit assets are held to their contractual maturity and are originated and managed differently from those held as available-for-sale by the Company or those managed for third parties. The following table summarizes the consolidated investment management services results and assets under management over the last three years:
The asset/liability products segment is comprised of the activities of IMC, GFL and EAAL. IMC provides customized investment agreements, guaranteed by MBIA Corp., for bond proceeds and other public funds for such purposes as construction, loan origination, escrow and debt service or other reserve fund requirements. It also provides customized products for funds that are invested as part of asset-backed or structured product issuances. GFL raises funds through the issuance of medium-term notes with varying maturities (GFL MTNs), which are in turn guaranteed by MBIA Corp. GFL lends the proceeds of these GFL MTN issuances to the Company (GFL Loans). Under an agreement between the Company and MBIA Corp., the Company invests the proceeds of the GFL Loans in eligible investments (the GFL Investments), which consist of securities with a minimum Double-A credit quality rating. The GFL Investments are pledged to MBIA Corp. EAAL primarily purchases foreign assets as permitted under the Company’s investment guidelines.
Asset/liability products pre-tax income, excluding realized gains, foreign currency and derivative losses, totaled $38.1 million in 2004 compared with $31.3 million in 2003, resulting in an increase of 22%. At December 31, 2004, principal and accrued interest outstanding on investment agreement and medium-term note obligations and securities sold under agreements to repurchase totaled $12.5 billion, compared with $9.3 billion at December 31, 2003. Assets supporting these agreements had market values of $12.6 billion and $9.4 billion at December 31, 2004 and December 31, 2003, respectively. These assets are comprised of high-quality securities with an average credit quality rating of Double-A. In 2003, asset/liability products pre-tax income, excluding net realized gains, foreign currency and derivative losses, totaled $31.3 million compared with $18.4 million in 2002, resulting in an increase of 70%.
CMC specializes in fixed-income management for institutional funds and provides investment management services to IMC’s investment agreement portfolio, GFL’s medium-term note and investment agreement portfolio, MBIA-MISC’s municipal cash management programs, the Company’s insurance and corporate investment portfolios and third-party clients. CMC is a SEC-registered investment adviser and National Association of Securities Dealers member firm. At December 31, 2004, 2003 and 2002, the market values of CMC’s third-party assets under management were $4.1 billion, $3.1 billion and $2.6 billion, respectively. The market values of assets related to the Company’s insurance and corporate investment portfolio managed by CMC as of December 31, 2004, 2003 and 2002 were $10.3 billion, $9.8 billion and $8.7 billion, respectively.
AM-UK was formed in November 2004 to provide investment management services to foreign branches of the Company, its affiliates and third-party clients and is included in the fixed-income advisory services segment. AM-UK is a United Kingdom Financial Services Authority (FSA)-regulated investment adviser.
The Conduits enter into derivative instruments primarily as economic hedges against interest rate and currency risks. It is expected that any change in the market value of the derivative instruments will be offset by a change in the market value of the hedged assets or liabilities. However, since the investments are accounted for as held-to-maturity, the change in market value, with the exception of the change in value of foreign currency assets due to changes in foreign currency rates, is not recorded in the financial statements. Derivative instruments entered into by the Conduits are not accounted for as interest rate hedges under SFAS 133 and, therefore, changes in market value are recorded as gains or losses in MBIA’s consolidated income statement.
Typically, Conduit programs involve the use of rating agencies in assessing the quality of asset purchases and in assigning ratings to the various programs funded through the Conduits. An underlying rating is the implied rating for the transaction without giving consideration to the MBIA guarantee. All transactions currently funded in the Conduits had an underlying rating of at least investment grade by Moody’s and S&P prior to funding. The weighted-average underlying rating for transactions currently funded in the Conduits was A by S&P and A2 by Moody’s at the time such transactions were funded. MBIA estimates that the current weighted-average underlying rating of all outstanding Conduit transactions was A- by S&P and A2 by Moody’s as of December 31, 2004.
MBIA’s municipal services operation is consolidated under MuniServices Company (MBIA MuniServices) and provides revenue enhancement services and products to public-sector clients nationwide, consisting of discovery, audit, collections/recovery and information (data) services. The municipal services operations also include Capital Asset Holdings GP, Inc. and certain affiliated entities (Capital Asset), a servicer of delinquent tax certificates.
On June 30, 2004, MBIA paid $51.5 million (after reinsurance) to the trustees for two of the securitizations as part of a clean-up call, which defeased the Company’s remaining exposure to these transactions. MBIA continues to insure the third securitization. Additional information related to MBIA’s payment and the impact on its consolidated financial statements is provided under Losses and Loss Adjustment Expenses in the Insurance Operations section included herein.
The corporate operations incurred $75 million of interest expense in 2004 compared with $68 million in 2003, a 9% increase. The increase in interest expense primarily resulted from the issuance of $350 million of debt, partially offset by the retirement of $50 million of debt, in the fourth quarter of 2004. In 2003, interest expense increased 17% compared with 2002 as a result of the issuance of an additional $200 million of debt in the third quarter of 2002.
On October 22, 2004, The American Jobs Creation Act of 2004 (the Act) was introduced and signed into law. The Act has a provision which allows for a special one-time dividends received deduction of 85% on the repatriation of certain foreign earnings to the U.S. parent with limitations. Although the Company is currently evaluating the applicability and the effects of the repatriation provision, the Company does not believe that the impact of the special dividend received deduction, if claimed, will have a material effect on its financial position or results of operations.
preferred stock that will be held by the trusts. The trusts are vehicles for providing MBIA Corp. the opportunity to access new capital at its sole discretion through the exercise of the put options. The trusts are rated AA and Aa2 by S&P and Moody’s, respectively. To date, MBIA Corp. has not exercised its put options under any of these arrangements.
Under New York State insurance law, without prior approval of the superintendent of the state insurance department, financial guarantee insurance companies can pay dividends from earned surplus subject to retaining a minimum capital requirement. In MBIA Corp.’s case, dividends in any twelve-month period cannot be greater than 10% of policyholders’ surplus as shown on MBIA Corp.’s latest filed statutory financial statements. In 2004, MBIA Corp. declared and paid regular dividends of $372 million to MBIA Inc.
As a result of the payment of the special dividend in the fourth quarter and under the formula applicable to the payment of dividends, MBIA Corp. may not pay any dividends without prior approval by the New York State Department of Insurance until the
The investment portfolio provides a high degree of liquidity, since it is comprised of readily marketable high-quality fixed-income securities and short-term investments. At year-end 2004, the fair value of the consolidated investment portfolio was $30.6 billion, as shown in the following table:
The fair value of the Company’s investments is based on quoted market prices, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Differences between fair value and amortized cost arise primarily as a result of changes in interest rates occurring after a fixed-income security is purchased, although other factors influence fair value, including credit-related actions, supply and demand forces and other market factors. When the Company holds its available-for-sale investments to maturity, unrealized gains or losses currently recorded in accumulated other comprehensive income in the shareholders’ equity section of the balance sheet will decrease over time as the investments approach maturity. As a result, the Company expects to realize a value substantially equal to amortized cost. However, when investments are sold prior to maturity, the Company will realize any gains or losses in current net income. The Conduit portfolios are considered held-to-maturity, as the Company has the ability and intent to hold these investments to their contractual maturity. Therefore, these portfolios are reported at amortized cost and are not adjusted to reflect unrealized changes in fair value.
The underlying ratings of the MBIA Insured Investments as of December 31, 2004 are reflected in the following table. Amounts represent the fair value of such investments including the benefit of the MBIA guarantee. The ratings in the table below are the lower underlying rating assigned by S&P or Moody’s when an underlying rating exists from either rating service, or when an external underlying rating is not available, the underlying rating is based on the Company’s best estimate of the rating of such investment.
Interest rate sensitivity can be estimated by projecting a hypothetical instantaneous increase or decrease in interest rates. As of December 31, 2004, a hypothetical increase in interest rates of 100 and 300 basis points would have resulted in an after-tax decrease in the net fair value of the Company’s financial instruments of approximately $276.2 million and $827.7 million, respectively. A decrease in interest rates of 100 basis points would have resulted in an after-tax increase in the net fair value of the Company’s financial instruments of approximately $256.5 million.
MBIA Inc. (MBIA or the Company) was incorporated in the state of Connecticut on November 12, 1986 as a licensed insurer and, through a series of transactions during December 1986, became the successor to the business of the Municipal Bond Insurance Association (the Association), a voluntary unincorporated association of insurers writing municipal bond and note insurance as agent for the member insurance companies. The Company operates its insurance business primarily through its wholly owned subsidiary, MBIA Insurance Corporation (MBIA Corp.) and MBIA Corp.’s wholly owned French subsidiary, MBIA Assurance, S.A. (MBIA Assurance).
MBIA Assurance writes financial guarantee insurance in the international market, and pursuant to a reinsurance agreement with MBIA Corp., a substantial amount of the risks insured by MBIA Assurance are reinsured by MBIA Corp. In addition, the Company manages books of business through two other subsidiaries wholly owned by MBIA Corp., MBIA Insurance Corp. of Illinois (MBIA Illinois), acquired in December 1989, and Capital Markets Assurance Corporation (CMAC), acquired in February 1998 when the Company merged with CapMAC Holdings, Inc. (CapMAC). The net book of business of these two subsidiaries is 100% reinsured by MBIA Corp. In 2004, MBIA UK Insurance Limited (MBIA UK), a wholly owned subsidiary of MBIA Corp. incorporated in the United Kingdom, was established to write financial guarantee insurance in the international markets. Pursuant to a reinsurance agreement between MBIA UK and MBIA Corp., a substantial amount of the risks insured by MBIA UK will be reinsured by MBIA Corp. As of December 2004, MBIA UK had not commenced writing business.
The Company also provides investment services through several of its subsidiaries, which are wholly owned by MBIA Asset Management LLC (MBIA-AML). MBIA-AML, formed in 1998 and converted to a limited liability corporation in December 2000, is a wholly owned subsidiary of MBIA Inc. MBIA Municipal Investors Service Corporation (MBIA-MISC) operates cooperative cash management programs for school districts and municipalities. In May 2000, MBIA-MISC merged with another subsidiary, American Money Management Associates, Inc. (AMMA), which provides investment and treasury management consulting services to municipal and quasi-public sector clients. MBIA Investment Management Corp. (IMC) provides customized investment agreements for bond proceeds and other public funds, as well as for funds that are invested as part of asset-backed or structured product issuances. MBIA Capital Management Corp. (CMC) provides fixed-income investment management services for the Company, its affiliates and third-party institutional clients. 1838 Investment Advisors, LLC (1838), a full service equity-focused asset management firm wholly owned by MBIA-AML, was sold in May 2004. The sale of 1838 resulted from the Company’s decision to exit the equity advisory market and focus on fixed-income asset management.
The Company also provides municipal services through its municipal services operations’ subsidiaries, which are wholly owned by MBIA MuniServices Company (MBIA MuniServices) which was formed in 1996. Municipal Resources Consultants (MRC) is a revenue audit and information services firm and also provides tax compliance services to state and local governments. Municipal Tax Collection Bureau Inc. (MTB) provides tax compliance services to state and local governments. MTB’s activities have been transferred to MBIA MuniServices and MRC and, as of December 31, 2004, only one service contract remained in MTB. Capital Asset Holdings, Inc. and subsidiaries (Capital Asset) service and manage delinquent municipal tax liens.
LaCrosse Financial Products, LLC (LaCrosse), formerly King Street Financial Products, LLC, was created in December 1999 to offer clients structured derivative products, such as credit default, interest rate and currency swaps. While MBIA does not have a direct ownership interest in LaCrosse, it is consolidated in the financial statements of the Company on the basis that LaCrosse is controlled by MBIA and substantially all risks and rewards are borne by MBIA.
MBIA Global Funding, LLC (GFL) was formed as a wholly owned subsidiary of the Company in May 2002. GFL issues medium-term notes for the purpose of funding financial assets within the Company’s asset management business.
In May 2003, the Company sponsored the formation of Toll Road Funding, Plc. (TRF), a public company limited by shares and incorporated in Ireland under the Irish Companies Act. TRF was established to acquire a loan participation related to the financing of an Italian toll road. TRF is a variable interest entity (VIE), of which MBIA is the primary beneficiary. Therefore, while MBIA does not have a direct ownership interest in TRF, it is consolidated in the financial statements of the Company in accordance with Financial Accounting Standards Board (FASB) Interpretation Number (FIN) 46 “Consolidation of Variable Interest Entities,” subsequently revised as FIN 46(R). In June 2004, the loan in which TRF participated was repaid in full. At that time, TRF repaid all of its outstanding debt obligations.
In September 2003, MBIA purchased the equity and acquired all controlling interests of Triple-A One Funding Corporation (Triple-A), Meridian Funding Company, LLC (Meridian) and Polaris Funding Company, LLC (Polaris) (collectively the Conduits) through Asset Finance. The Conduits fall within the scope of FIN 46(R) and are consolidated by the Company under its requirements. See Note 6 for additional disclosures related to the consolidation of the Conduits.
In October 2004, the Company’s management recommended that the Audit Committee of the Company’s Board of Directors undertake an investigation of the reinsurance agreements related to AHERF, including whether an oral agreement existed between the Company and AXA Re Finance S.A. (ARF) that the Company would assume the risk from ARF that MBIA ceded to Converium and Converium retroceded to ARF. The Audit Committee retained outside counsel and initiated an investigation in October 2004. The outside counsel’s investigation has been substantially completed. While the investigation has not conclusively determined whether an oral agreement in fact existed, the Company has been advised, however, that it appears likely that such an agreement or understanding was made in 1998. Based on this information, the Company could no longer be certain that for financial reporting purposes, insurance risk was transferred to Converium with respect to the excess of loss and quota share reinsurance agreements. Therefore, the Company has corrected its accounting for these agreements by recording the $70 million received from Converium under the excess of loss agreement as a deposit and recorded subsequent premium cessions to Converium under the quota share agreement as a repayment of the deposit with imputed interest.
Information presented in the Notes to Consolidated Financial Statements gives effect to the restatement unless otherwise indicated.
The consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States of America (GAAP). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. As additional information becomes available or actual amounts become determinable, the recorded estimates are revised and reflected in operating results. Actual results could differ from those estimates. The Company’s significant accounting policies are as follows:
INVESTMENTS The Company classifies its fixed-maturity investments as either available-for-sale or held-to-maturity, as defined by Statement of Financial Accounting Standards (SFAS) 115, “Accounting for Certain Investments in Debt and Equity Securities.” Available-for-sale investments are reported in the financial statements at fair value, with unrealized gains and losses, net of deferred taxes, reflected in accumulated other comprehensive income in shareholders’ equity. Bond discounts and premiums are amortized using the effective yield method over the remaining term of the securities. For pre-refunded bonds, the remaining term is determined based on the contractual refunding date. Investment income is recorded as earned. Realized gains or losses on the sale of investments are determined by specific identification and are included as a separate component of revenues.
Short-term investments are carried at amortized cost, which approximates fair value, and include all fixed-maturity securities with a remaining effective term to maturity of less than one year.
MBIA regularly monitors its investments in which fair value is less than amortized cost in order to assess whether such a decline in value is other-than-temporary and, therefore, should be reflected as a realized loss in net income. Such an assessment requires the Company to determine the cause of the decline and whether the Company possesses both the ability and intent to hold the investment to maturity or until the value recovers to an amount at least equal to amortized cost. This assessment requires management to exercise judgment as to whether an investment is impaired based on market conditions and trends and the availability of relevant data.
POLICY ACQUISITION COSTS Policy acquisition costs include those expenses that relate primarily to, and vary with, premium production. The Company periodically conducts a study to determine which operating costs vary with, and primarily relate to, the acquisition of new insurance business and qualify for deferral. For business produced directly by MBIA Corp. and its subsidiaries, such costs include compensation of employees involved in underwriting and policy issuance functions, certain rating agency fees, state premium taxes and certain other underwriting expenses, reduced by ceding commission income on premiums ceded to reinsurers. Policy acquisition costs are deferred and amortized over the period in which the related premiums are earned.
GOODWILL Goodwill represents the excess of the cost of acquiring business enterprises over the fair value of the net assets acquired. Effective January 1, 2002 the Company adopted SFAS 142, “Goodwill and Other Intangible Assets.” Under SFAS 142, goodwill is no longer amortized but rather is tested for impairment at least annually. See Note 5 for an explanation of the impact of adoption of this Statement on the Company’s financial statements.
PROPERTY AND EQUIPMENT Property and equipment consists of land, buildings, furniture and fixtures, computer equipment and software and leasehold improvements. All property and equipment is recorded at cost and, except for land, is depreciated over the appropriate useful life of the asset using the straight-line method. Maintenance and repairs are charged to current earnings as incurred. The useful lives of each class of assets are as follows:
DERIVATIVES The FASB issued, then subsequently amended, SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” which was effective for the Company on January 1, 2001. Under SFAS 133, as amended, all derivative instruments are recognized on the balance sheet at their fair value, and changes in fair value are recognized immediately in earnings unless the derivatives qualify as hedges. If the derivatives qualify as hedges, depending on the nature of the hedge, changes in the fair value of the derivatives are either offset against the change in fair value of assets, liabilities, or firm commitments through earnings, or are recognized in accumulated other comprehensive income until the hedged item is recognized in earnings. Any ineffective portion of a derivative’s change in fair value is recognized immediately in earnings. If circumstances or events arise that require the termination and settlement of a derivative contract prior to maturity, any unrealized gain or loss will be recognized immediately in earnings. If the underlying hedged item ceases to exist, all changes in the fair value of the derivative are recognized in earnings each period until the derivative matures or terminates.
LOSSES AND LOSS ADJUSTMENT EXPENSES The financial guarantees issued by MBIA Corp. insure scheduled payments of principal and interest due on various types of financial obligations against a payment default on such payments by the issuers of the obligations. Loss and loss adjustment expense (LAE) reserves are established by the Company’s Loss Reserve Committee, which is comprised of members of senior management, and require the use of judgment and estimates with respect to the occurrence and
amount of a loss on an insured obligation. As discussed below, the accounting for non-derivative financial guarantee loss reserves is possibly subject to change.
If, after establishing case basis reserves for the period, the Company determines that the remaining unallocated loss reserve is not sufficient to cover its estimate of losses not yet specifically identified in its insured portfolio, additional unallocated loss reserves will be accrued at such time which, as a result, will reduce the Company’s earnings for the period. Conversely, if the Company determines that the remaining unallocated loss reserve is in excess of the amount needed to cover its estimate of unidentified losses, the Company will reverse the excess at such time which, as a result, will increase the Company’s earnings for the period.
SECURITIES BORROWED OR PURCHASED UNDER AGREEMENTS TO RESELL AND SECURITIES LOANED OR SOLD UNDER AGREEMENTS TO REPURCHASE Securities borrowed or purchased under agreements to resell and securities loaned or sold under agreements to repurchase are accounted for as collateralized transactions and are recorded at contract value plus accrued interest, subject to the provisions of SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” It is the Company’s policy to take possession of securities borrowed or purchased under agreements to resell. Securities borrowed or loaned are primarily entered into to obtain securities that are repledged as part of MBIA’s collateralized investment and repurchase agreement activity and are only transacted with high quality dealer firms. In addition, securities sold under agreements to repurchase provide liquidity to the Company’s investment agreement and medium-term note programs.
PREMIUM REVENUE RECOGNITION Upfront premiums are earned in proportion to the expiration of the related risk. Therefore, for transactions in which the premium is received upfront, premium earnings are greater in the earlier periods when there is a higher amount of exposure outstanding. The upfront premiums are apportioned to individual sinking fund payments of a bond issue according to an amortization schedule. After the premiums are allocated to each scheduled sinking fund payment, they are earned on a straight-line basis over the period of that sinking fund payment. Accordingly, deferred premium revenue represents the portion of premiums written that is applicable to the unexpired risk of insured bonds and notes. When an MBIA-insured issue is retired early, is called by the issuer, or is in substance paid in advance through a refunding accomplished by placing U.S. Government securities in escrow, the remaining deferred premium revenue is earned at that time since there is no longer risk to the Company. Installment premiums are earned over each installment period, generally one year or less.
ADVISORY FEE REVENUE RECOGNITION The Company collects advisory fees in connection with certain transactions. Depending upon the type of fee received and whether it is related to an insurance policy, the fee is either earned when it is due or deferred and earned over the life of the related transaction. Work, waiver and consent, termination, administrative and management fees are earned when the related services are completed. Structuring fees are earned on a straight-line basis over the life of the related insurance policy and commitment fees are earned on a straight-line basis over the commitment period.
MUNICIPAL SERVICES OPERATIONS Municipal services results are comprised of the net investment income, operating revenues, expenses and gains and losses of MBIA MuniServices, MTB, MRC and Capital Asset. Operating revenues primarily consist of fees, which are recognized in earnings as the related services are performed.
In September 2004, the Emerging Issues Task Force (EITF) issued Issue 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1,” “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” which delayed the guidance in paragraphs 10-20 of EITF 03-1. The disclosure requirements required by EITF 03-1 issued in December 2003 remain in effect. EITF 03-1 requires the Company to disclose certain information about unrealized losses on its investment portfolio that have not been recognized as other-than-temporary impairments. The requirements were effective for fiscal years ending after December 15, 2003, and required the Company to make disclosures in its financial statements about investments in debt or marketable equity securities with market values below carrying values. See Note 12 for disclosures required by EITF 03-1.
adopted as of January 1, 1995. Thus, the fair value of any options vesting in the current year that were granted subsequent to January 1, 1995 will be included in expense. However, restatement of prior years is not required. The Retroactive Restatement Method is identical to the Modified Prospective Method in that the fair value of all options vesting in the current year for grants made after January 1, 1995 are included in expense. However, this method also requires that all periods presented in the financial statements be restated to reflect stock option expense. Restatement of periods prior to those presented is permitted but not required.
SFAS 148 also required additional disclosure in the “Summary of Significant Accounting Policies” footnote of both annual and interim financial statements. MBIA chose to report its stock option expense under the Modified Prospective Method. See Note 25 for further information about the effect of adoption on the Company’s financial statements.
The Company provides structured funding and credit enhancement services to global finance clients through the use of certain MBIA-administered, bankruptcy-remote special purpose vehicles (SPVs) and through third-party SPVs. The purpose of the MBIA-administered SPVs is to provide clients with an efficient source of funding, which may offer MBIA the opportunity to issue financial guarantee insurance policies. These SPVs purchase various types of financial instruments, such as debt securities, loans, lease receivables and trade receivables, and fund these purchases through the issuance of asset-backed short-term commercial paper or medium-term notes. The assets and liabilities within the medium-term note programs are managed primarily on a match-funded basis and may include the use of derivative hedges, such as interest rate and foreign currency swaps. By match-funding, the SPVs eliminate the risks associated with fluctuations in interest and foreign currency rates, indices and liquidity. Typically, programs involve the use of rating agencies in assessing the quality of asset purchases and in assigning ratings to the various programs. In general, asset purchases at the inception of a program are required to be at least investment grade by at least one major rating agency. The primary SPVs administered by MBIA are Triple-A, Meridian, Polaris and TRF. Third-party SPVs are used in a variety of structures guaranteed or managed by MBIA, whereby the Company has risks analogous to those of MBIA-administered SPVs. The Company has determined that such SPVs fall within the definition of a VIE under FIN 46(R).
It is MBIA’s policy to obtain an underlying rating from both Moody’s Investors Service (Moody’s) and Standard & Poor’s (S&P) for each new transaction prior to the execution of such transactions within the Conduits. An underlying rating is the implied rating for the transaction without giving consideration to the MBIA guarantee. All transactions currently funded in the Conduits have an underlying rating of at least investment grade by Moody’s and S&P prior to funding. The weighted-average underlying rating for transactions currently funded in the Conduits was A by S&P and A2 by Moody’s at the time such transactions were funded. MBIA estimates that the weighted-average underlying rating of all outstanding Conduit transactions was A- by S&P and A2 by Moody’s as of December 31, 2004.
As a result of having to adhere to MBIA’s underwriting standards and criteria, Conduit transactions have, in general, the same underlying ratings that similar non-Conduit transactions guaranteed by MBIA have at the time they are closed. Like all credits underwritten by MBIA, the underlying ratings on Conduit transactions may be downgraded or upgraded by either one or both rating agencies after they are closed. In general, the underlying ratings on Conduit transactions have been downgraded no more frequently than similar non-Conduit transactions guaranteed by MBIA.
In May 2003, the Company sponsored the formation of TRF, a public company incorporated in Ireland under the Irish Companies Act. TRF is a conduit established to acquire a loan participation related to the financing of an Italian toll road. Assets supporting the repayment of the debt were comprised of the loan participation and high quality, liquid investments. Assets and liabilities of TRF are primarily included within “Investments held-to-maturity” and “Medium-term notes,” respectively, on the Company’s balance sheet. TRF is a VIE, of which MBIA is the primary beneficiary. Therefore, while MBIA does not have a direct ownership interest in TRF, it is consolidated in the financial statements of the Company in accordance with FIN 46. At December 31, 2003, TRF had $1.5 billion of debt outstanding. In June 2004, the loan in which TRF participated was repaid in full. At that time, TRF repaid all of its outstanding debt obligations.
In addition to MBIA-administered SPVs, MBIA must determine whether it has variable interests in third-party VIEs and if so, whether those variable interests would cause MBIA to be the primary beneficiary and, therefore, consolidate such entities. Under FIN 46(R), MBIA’s guarantee of the assets or liabilities of a VIE constitute a variable interest and require MBIA to assess whether it is the primary beneficiary. Consolidation of such VIEs does not increase MBIA’s exposure above that already committed to in its insurance policies. In 2003, the Company consolidated a third-party VIE as a result of guarantees provided by its insurance operations. Third-party VIE assets and liabilities are primarily reported in “Investments held-to-maturity” and “Variable interest entity floating rate notes”, respectively, on the face of the Company’s balance sheet and totaled $600.5 million and $600.3 million at December 31, 2004 and 2003, respectively. Third-party VIE creditors do not have recourse to the general assets of MBIA outside of the financial guarantee policy provided to the VIE.
MBIA enters into derivative transactions as an additional form of financial guarantee and for purposes of hedging risks associated with existing assets and liabilities and forecasted transactions. In 2004, MBIA Corp. received approval for a derivative use plan from the New York State Insurance Department (NYSID). The derivative use plan authorizes MBIA Corp. to hedge certain risks through the use of derivative instruments. The Company accounts for derivative transactions in accordance with SFAS 133, which requires that all such transactions be recorded on the Company’s balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings within net gains (losses) on derivative instruments and foreign exchange or in shareholders’ equity within accumulated other comprehensive income, depending on whether the derivative is designated as a hedge, and if so designated, the type of hedge.
INSURANCE The Company has entered into derivative transactions that it views as an extension of its core financial guarantee business but do not qualify for the financial guarantee scope exception under SFAS 133 and, therefore, must be stated at fair value. The insurance operations, which represent the majority of the Company’s derivative exposure, have insured derivatives primarily consisting of structured pools of credit default swaps that the Company intends to hold for the entire term of the contract. The insurance operations have also provided guarantees on the value of certain structured closed-end funds, which meet the definition of a
INVESTMENT MANAGEMENT SERVICES The investment management services operations have entered into derivative transactions primarily consisting of interest rate, cross currency, credit default and total return swaps and principal protection guarantees. Interest rate swaps are entered into to hedge the risks associated with fluctuations in interest rates or fair values of certain contracts. Cross currency swaps are entered into to hedge the variability in cash flows resulting from fluctuations in foreign currency rates. Credit default swaps are entered into to hedge credit risk or to replicate investments in cash assets consistent with the Company’s risk objectives and credit guidelines for its investment management business. The maximum amount of future payments the Company may be required to make under these contracts, should a full credit event occur, is $1.1 billion. These credit default swaps reference credits with an average quality of AA-/Aa3 and have a maturity range of 1-6 years. In accordance with SFAS 133, the fair values of these credit default swaps at December 31, 2004 are recorded on the consolidated balance sheet as assets and liabilities, representing gross gains and losses, of $6.3 million and $0.1 million, respectively. Total return swaps are entered into to enable the Company to earn returns on certain obligations without directly owning the underlying obligations. The Company has also provided loss protection on certain MBIA-MISC managed municipal pools that invest in highly rated short-term fixed-income securities. Such protection is accounted for as a derivative under SFAS 133 and is included as part of the Company’s principal protection guarantees.
The Conduits primarily enter into interest rate and foreign currency swaps as economic hedges against interest rate and currency risks. The cross currency swaps qualify as fair value hedges of foreign currency risk under SFAS 133. The Company recognizes the earnings impact of cross currency swaps designated as fair value hedges upon the recognition of the foreign exchange gain or loss on the translation to U.S. dollars of the hedged item. During 2004, the Company recorded losses of $6.3 million (net of tax) in earnings due to the ineffectiveness of these hedges. This was offset by gains of $5.4 million (net of tax) on economic hedges that did not qualify for hedge accounting under SFAS 133.
The cross currency swap resulted in an aggregate unrealized gain of $1.5 million (net of tax) remaining in accumulated other comprehensive income at December 31, 2004. The Company expects that approximately $0.4 million of unrealized losses (net of tax) will migrate from accumulated other comprehensive income into earnings during 2005 and the remaining balance over the term of the contract.
only executes swaps under master netting agreements, which typically contain mutual credit downgrade provisions that generally provide the ability to require assignment or termination in the event either MBIA or the counterparty is downgraded below a specified credit rating. If the Company were to settle all transactions covered under netting agreements as of December 31, 2004, the amount required to be paid to counterparties would have been reduced by $137.2 million as a result of its legal right to offset amounts due from such counterparties. The Company has chosen not to net receivables due from counterparties with payables due to counterparties in its balance sheet, but instead report these amounts on a gross basis as assets and liabilities.
FINANCIAL STATEMENT IMPACT As of December 31, 2004 and 2003, the Company held derivative assets of $288.8 million and $256.7 million, respectively, and derivative liabilities of $528.6 million and $437.7 million, respectively, which are shown separately on the consolidated balance sheet. The following tables display the amount of the derivative assets and liabilities by business operations for the years ended December 31, 2004 and 2003.
The income statement impact for all derivative transactions for 2004 was an after-tax increase in net income of $33.6 million. The impact for all derivative transactions for 2003 and 2002 was an after-tax increase in net income of $96.8 million and an after-tax reduction in net income of $38.4 million, respectively. The income statement impact of derivative activity is broken down into revenues, net realized gains (losses), net gains (losses) on derivative instruments and foreign exchange and expenses. Interest and fee income, including premiums received on insured derivatives, and interest and fee expense on derivatives are recorded within revenues and expenses. For derivatives that have been designated as qualifying hedges, income and expense are recorded as an adjustment to those of the hedged items. The change in the fair value of derivatives is recorded within net gains (losses) on derivative instruments and foreign exchange. The following tables display the impact described above on the 2004, 2003 and 2002 income statements by business operation of all derivative transactions.
* Includes premiums earned, advisory fees and losses incurred in the insurance operations and interest income and expenses in the investment management services and corporate operations.
At December 31, 2004, the Company reported an accumulated unrealized gain of $3.1 million in other comprehensive income related to the fair value of the cash flow hedges compared to a $6.7 million unrealized loss at December 31, 2003. The change resulted from an $11.1 million after-tax unrealized gain in the fair value of the cash flow hedges and the transfer of $1.3 million of after-tax income to earnings as a result of scheduled interest payments and receipts on the cash flow hedges. At December 31, 2004, the maximum term of derivative instruments that hedge forecasted transactions was approximately 14 years.
fixed-maturity investments are generally reported at amortized cost rather than fair value;
deferred income tax balances, representing future tax consequences of events that have been recognized in the financial statements, are included as surplus adjustments. Under GAAP, the Company’s net deferred income tax balance is reported as either an asset or liability;
The NYSID adopted the Codification guidance effective January 1, 2001. However, the NYSID did not adopt the Codification rules on deferred taxes until December 31, 2002. The deferred tax effect of adoption on the statutory surplus of MBIA Corp. and its subsidiaries reduced surplus by $10.8 million. In addition, the NYSID does not allow goodwill to be admitted as an asset while the NAIC requires goodwill recognition.
Premiums earned, after reinsurance, include $140.1 million, $126.9 million and $74.9 million for 2004, 2003 and 2002, respectively, related to refunded and called MBIA-insured bonds.
The following tables set forth the amortized cost and fair value of the available-for-sale fixed-maturity and short-term investments included in the consolidated investment portfolio of the Company as of December 31, 2004 and 2003:
Fixed-maturity investments carried at fair value of $13.8 million and $13.9 million as of December 31, 2004 and 2003, respectively, were on deposit with various regulatory authorities to comply with insurance laws.
A portion of the obligations under investment agreements requires the Company to pledge securities as collateral. As of December 31, 2004 and 2003, the fair value of securities pledged as collateral with respect to these obligations approximated $3.6 billion and $3.3 billion, respectively.
Investments that are held-to-maturity are reported on the Company’s balance sheet at amortized cost. These investments, which relate to the Company’s Conduit program and a consolidated VIE, primarily consist of asset-backed securities and loans issued by major national and international corporations and other structured finance clients. The following table sets forth the distribution of held-to-maturity investments by contractual maturity at amortized cost and fair value at December 31, 2004.
Included in the preceding tables are investments that have been insured by MBIA Corp. (MBIA Insured Investments). At December 31, 2004, MBIA Insured Investments, at fair value, represented $11.8 billion or 38% of the total portfolio, of which $6.9 billion or 23% relate to Conduit investments. Without giving effect to the MBIA guarantee of the MBIA Insured Investments, the underlying ratings (those given to an investment without the benefit of MBIA’s guarantee) of the MBIA Insured Investments as of December 31, 2004 are reflected in the following table. Amounts represent the fair value of such investments including the benefit of the MBIA guarantee. The ratings in the table below are the lower underlying rating assigned by S&P or Moody’s when an underlying rating exists from either rating service, or when an external underlying rating is not available, the underlying rating is based on the Company’s best estimate of the rating of such investment.
Net unrealized gains, including related deferred income taxes, reported in accumulated other comprehensive income within shareholders’ equity consist of:
The Company believes that its deferred tax assets will be fully recognized in future periods and, therefore, has not established a valuation allowance with respect to such assets.
As it is the Company’s practice and intent to permanently reinvest the earnings of MBIA Assurance and MBIA UK, no U.S. deferred income taxes have been provided with respect to the undistributed earnings of these entities. The cumulative amounts of such untaxed earnings were $101.8 million, $64.7 million and $28.2 million at December 31, 2004, 2003 and 2002, respectively.
The insurance operations provide an unconditional and irrevocable guarantee of the payment of principal and interest on insured obligations when due. MBIA issues financial guarantees for municipal bonds, asset-backed and mortgage-backed securities, investor-owned utility bonds, bonds backed by publicly or privately funded public- purpose projects, bonds issued by sovereign and sub-sovereign entities, obligations collateralized by diverse pools of corporate loans and credit default swaps and pools of corporate and asset-backed bonds, both in the new issue and secondary markets. The Company views its insurance operations as a reportable segment. This segment includes all activities related to global credit enhancement services provided principally by MBIA Corp. and its subsidiaries.
(a) Represents the sum of net premiums earned, net investment income, advisory fees, investment management fees and other fees.
(b) At December 31, 2004, there were no assets associated with the Company’s discontinued operations. Identifiable assets relating to the Company’s discontinued operations were $25.0 million and $30.3 million at December 31, 2003 and 2002, respectively.
(a) Represents the sum of interest income, investment management services fees and other fees.
An increasingly significant portion of premiums reported within the insurance segment is generated outside the United States. The following table summarizes net premiums earned by geographic location of risk for years ended December 31, 2004, 2003 and 2002.
In May 2004, the Company completed the sale of the assets of 1838, a full service equity-focused asset management firm, to the management of 1838 together with an investor group led by Orca Bay Partners, which resulted in a $3.2 million after-tax gain. The sale of 1838 resulted from the Company’s decision to exit the equity advisory market and focus on fixed-income asset management. 1838 comprised the equity advisory services segment of the Company’s investment management services operations.
The Company’s short-term debt consists of floating rate certificates issued as part of Tender Option Bond (TOB) trades. A TOB trade is a repackaging of municipal bonds, effectively providing MBIA with leveraged securitized financing of long-term bonds at short-term tax-exempt rates. At December 31, 2004 and 2003, floating rate certificates related to the TOB trades included in short-term debt totaled $58.7 million and $57.3 million, respectively. The aggregate
In November 2004, the Company completed a $350 million debt offering of 30-year senior notes, which carry a coupon rate of 5.7%. These notes are redeemable at the Company’s option, in whole or in part, at any time prior to maturity. Part of the proceeds from this offering were used to redeem the Company’s $50 million 6.95% Senior Quarterly Income Debt Securities (“Senior QUIDS”) due November 1, 2038, in December 2004. The Senior QUIDS were redeemed at a price equal to one hundred percent of the principal amount plus accrued and unpaid interest thereon to the date of redemption. The remainder of the proceeds will be used for general corporate purposes.
In connection with the 7.56% Notes due 2010, MBIA entered into a swap transaction that met the criteria for cash flow hedge accounting. The swap transaction converts the interest rate from a fixed Swiss franc debt rate of 4.5% to a fixed U.S. dollar rate of 7.56% and converts the Swiss franc principal amount due at maturity to a fixed U.S. dollar amount of approximately $99.3 million.
The aggregate maturity of long-term debt obligations, excluding accrued interest and premiums or discounts, as of December 31, 2004 for each of the next five years and thereafter commencing in 2005 was:
MBIA Corp. has a limited recourse standby line of credit facility in the amount of $700 million with a group of major Triple-A rated banks to provide loans to MBIA Corp. This facility can be drawn upon if MBIA Corp. incurs cumulative losses (net of expected recoveries) on its insured public finance obligations, after certain adjustments, in excess of the greater of $900 million or 5% of average annual debt service of the covered obligations. MBIA’s obligation to repay loans made under this agreement is limited recourse payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations, including certain installment premiums and other collateral. This commitment has a seven-year term expiring on October 31, 2010.
MBIA Inc. also maintained two ten-year annually renewable facilities maturing in 2011 and 2012 for $100 million and $50 million, respectively. These facilities allowed the Company to issue subordinated securities and could be drawn upon if the Company incurred cumulative losses (net of any recoveries) above an annually adjusted attachment point. The $50 million facility was terminated in the fourth quarter of 2003 due to a rating downgrade of the related provider and the $100 million facility was terminated in the second quarter of 2004.
The Company and MBIA Corp. maintain two short-term bank liquidity facilities totaling $500 million. These bank lines are maintained with a group of highly rated global banks and are currently comprised of a renewable $167 million facility with a term of 364 days and a $333 million facility with a five-year term, maturing in April 2009. As of December 31, 2004, there were no borrowings outstanding under these agreements.
Medium-term note obligations are recorded as liabilities on the Company’s balance sheet based upon proceeds received, net of unamortized discounts and premiums, plus unpaid accrued interest at the balance sheet date. Medium-term notes are issued by GFL as part of MBIA’s asset/liability program and by Meridian, Triple-A and Polaris as part of MBIA’s Conduit program. In 2004, GFL issued 1.6 billion of U.S. dollar and 190.0 million of Euro-denominated medium-term notes, and Meridian issued 1.3 billion of U.S. dollar medium-term notes. The rates of the medium-term notes are fixed or are indexed to the London Interbank Offered Rate (LIBOR), Constant Maturity Swap or the effective Federal Funds rate. As of December 31, 2004, the annual interest rates of the medium-term notes ranged from 0.09% to 5.98% and the weighted-average interest rate was 3.09%. As of December 31, 2003, the annual interest rates of the medium-term notes ranged from 1.09% to 5.98% and the weighted-average interest rate was 2.74%. Principal payments due under medium-term note obligations based on their contractual maturity dates are as follows:
As of December 31, 2004, insurance in force, net of cessions to reinsurers and other reimbursement arrangements, had an expected maturity range of 1-45 years. Other reimbursement arrangements that have been netted from the Company’s insurance in force as reported below relate to contracts under which the Company is entitled to reimbursement of losses on its insured portfolio but which do not qualify as reinsurance under GAAP. The distribution of net insurance in force by geographic location, excluding $12.7 billion and $9.7 billion relating to transactions guaranteed by MBIA Corp. on behalf of various investment management services’ affiliated companies in 2004 and 2003, respectively, is set forth in the following table:
The insurance operations have entered into certain guarantees of derivative contracts, included in the preceding tables, which do not qualify for the financial guarantee scope exception under SFAS 133. MBIA Corp. generally guarantees the timely payment of principal and interest related to these derivatives upon the occurrence of a credit event with respect to a referenced obligation. The maximum amount of future payments that MBIA Corp. may be required to make under these guarantees, should a full credit event occur, is $81.4 billion. This amount is net of cessions to reinsurers of $17.0 billion. MBIA Corp.’s guarantees of derivative contracts have a legal maximum maturity range of 1-74 years. A small number of guaranteed credit derivative contracts have long maturities to satisfy regulatory requirements imposed on MBIA’s counterparties. However, the expected maturities of such contracts are much shorter due to amortizations and prepayments in the underlying collateral pools. In accordance with SFAS 133, the fair values of these guarantees at December 31, 2004 are recorded on the balance sheet as assets and liabilities, representing gross gains and losses, of $40.0 million and $26.4 million, respectively. These derivative contracts are discussed further in Note 7.
MBIA Corp. has also issued guarantees of certain obligations issued by its investment management affiliates that are not included in the previous tables. These guarantees take the form of insurance policies issued by MBIA Corp. on behalf of the investment management affiliates. Should one of these affiliates default on its insured obligations, MBIA Corp. will be required to pay all scheduled principal and interest amounts outstanding. As of December 31, 2004, the maximum amount of future payments that MBIA Corp. could be required to make under these guarantees, should a full default occur, is $12.7 billion. These guarantees have a maximum maturity range of 1-42 years. These guarantees were entered into on an arm’s length basis and are fully collateralized by marketable securities. MBIA Corp. has both direct recourse provisions and subrogation rights in these transactions. If MBIA Corp. is required to make a payment under any of these affiliate guarantees, it would have the right to seek reimbursement from such affiliate and to liquidate any collateral to recover all or a portion of the amounts paid under the guarantee.
The distribution of ceded insurance in force by type of bond is set forth in the following table:
In February 2004, MBIA Corp. and Channel Re, a Triple-A rated financial guarantee reinsurance company in which MBIA holds a 17.4% ownership interest, entered into treaty and facultative reinsurance arrangements whereby Channel Re agreed to provide committed reinsurance capacity to MBIA Corp. through June 30, 2008 and subject to renewal thereafter. Under these reinsurance arrangements, MBIA Corp. agreed to cede to Channel Re and Channel Re agreed to assume from MBIA Corp. varying percentages of designated policies issued by MBIA Corp. The amount of any policy subject to the committed reinsurance arrangements is based on the type of risk insured and on other factors. Additionally, the reinsurance arrangements provide Channel Re with certain preferential terms, including those related to ceding commissions.
Ceding commissions received from reinsurers, before deferrals and net of return ceding commissions, were $31.6 million, $62.9 million and $49.7 million in 2004, 2003 and 2002, respectively.
(2) Represents the amount of losses and LAE incurred that have been eliminated in proportion to MBIA’s ownership interest in Channel Re, which is carried on an equity method accounting basis.
(3) Represents reserves associated with the assumption of portfolios from ASIA Ltd.
Total case basis activity was $126 million, $60 million and $49 million in 2004, 2003 and 2002, respectively. Case basis activity during 2004 primarily consisted of loss reserves for insured obligations issued by Fort Worth Osteopathic Hospital, MBIA’s guaranteed tax lien portfolios, AHERF, an older vintage collateralized debt obligation (CDO) and a manufactured housing exposure.
During 2003, case basis activity included reserves for MBIA’s guaranteed tax lien portfolios and losses associated with the guarantee of an older vintage CDO and a Trenwick America Corp. debt obligation. During 2002, case basis activity included reserves for MBIA’s guaranteed tax lien portfolios, AHERF and a structured finance transaction.
The Company has a non-contributory, defined contribution pension plan to which the Company contributes 10% of each eligible employee’s annual compensation. Annual compensation consists of base salary, bonus and commissions, as applicable, for determining such contributions. Pension benefits vest over a five-year period with 60% vesting after three years and 20% in years four and five. Pension expense for the years ended December 31, 2004, 2003 and 2002 was $9.7 million, $10.1 million and $10.1 million, respectively.
The Company also has a profit-sharing/401(k) plan. The plan is a voluntary contributory plan that allows eligible employees to defer compensation for federal income tax purposes under Section 401(k) of the Internal Revenue Code of 1986, as amended. Employees may contribute through payroll deductions up to 10% of eligible compensation. The Company matches employee contributions up to the first 5% of such compensation with MBIA Inc. common stock. The benefit of the Company’s contributions vests over five years with 60% vesting after three years and then 20% in years four and five. Generally, a participating employee is entitled to distributions from the plan upon termination of employment, retirement, death or disability. Participants who qualify for distribution may receive a single lump sum, transfer the assets to another qualified plan or individual retirement account, or receive a series of specified installment payments. Company contributions to the profit-sharing/401(k) plan aggregated $5.3 million, $5.1 million and $3.4 million for the years ended December 31, 2004, 2003 and 2002, respectively.
The stock option grants, which may continue to be awarded every year, provide the right to purchase shares of common stock at the fair value of the stock on the date of the grant. In 2004, 1,057,515 options were awarded under the 2000 plan. These options vest over four or five years depending on the level of the recipient.
In December 1995, the MBIA Inc. board of directors approved the “MBIA Long-Term Incentive Program” (the incentive program). The incentive program includes a stock option component (described above) and a compensation component linked to the growth in book value per share, including certain adjustments, of the Company’s stock (modified book value) over a three-year period following the grant date. Target levels for the incentive program awards are established as a percentage of total salary and bonus, based upon the recipient’s position. Awards under the incentive program typically are granted from the vice president level up to and including the executive chairman. Actual amounts to be paid are adjusted upward or downward depending on the growth of modified book value versus a baseline target, with a minimum growth of 8% necessary to receive any payment and an 18% growth necessary to receive the maximum payment. Awards under the incentive program are divided equally between the two components, with approximately 50% of the award to be given in stock options and approximately 50% of the award to be paid in cash or shares of Company stock. Payments are made at the end of each three-year measurement period. During 2004, 2003 and 2002, $25.1 million, $21.8 million and $18.8 million, respectively, were recorded as an expense related to modified book value awards.
In 1992, CapMAC adopted an Employee Stock Ownership Plan (ESOP) to provide its employees the opportunity to obtain beneficial interests in the stock of CapMAC through a trust (the ESOP Trust). The ESOP Trust purchased 525,938 shares of the Company’s stock. The ESOP Trust financed its purchase of common stock with a loan from the Company in the amount of $10 million, which was fully repaid in 2001. An amount representing unearned employee compensation, equivalent in value to the unpaid balance of the ESOP loan, is recorded as “Unallocated ESOP shares” and is shown as a separate component of shareholders’ equity.
The following table displays the total number of options granted during the last three years. The proxy officers represent the seven most highly compensated officers in 2004 while in 2003 and 2002 there were five disclosed in the Company’s proxy statement.
A summary of the Company’s stock option plan as of December 31, 2004, 2003 and 2002, and changes during the years ending on those dates, is set forth in the following table:
The following table summarizes information about the plan’s stock options at December 31, 2004:
Affiliates of the Company: An affiliate is a party that directly or indirectly controls, is controlled by or is under common control with the Company. Control is defined as having, either directly or indirectly, the power to direct the management and policies of the Company through ownership, by contract or otherwise.
From time to time the Company may enter into transactions with related parties that the Company deems immaterial or which occur in the normal course of business and are deemed to be transacted at “arm’s length” by management. Since 1989, MBIA Corp. has executed five surety bonds to guarantee the payment obligations of the members of the Association that had their S&P claims-paying rating downgraded from Triple-A on their previously issued Association policies. In the event that they do not meet their Association policy payment obligations, MBIA Corp. will pay the required amounts directly to the paying agent. The aggregate outstanding exposure on these surety bonds as of December 31, 2004 is $340 million.
MBIA Inc., through its subsidiaries, is responsible for providing investment advisory and certain related administrative services to the MBIA Capital/Claymore Managed Duration Investment Grade Municipal Fund and, prior to the sale of 1838, provided such services to the 1838 Bond-Debenture Trading Fund and the 1838 Investment Advisors Funds (collectively, the “Funds”). Additionally, MBIA, Inc., through its subsidiaries, earned investment management, accounting, administration and service fees related to the Funds, which aggregated $0.9 million, $1.4 million and $1.7 million for the years ended December 31, 2004, 2003 and 2002, respectively, and are included in investment management services revenues in the Company’s income statement.
PREPAID REINSURANCE PREMIUMS-The fair value of the Company’s prepaid reinsurance premiums is based on the estimated cost of entering into an assumption of the entire portfolio with third-party reinsurers under current market conditions.
DEFERRED PREMIUM REVENUE-The fair value of the Company’s deferred premium revenue is based on the estimated cost of entering into a cession of the entire portfolio with third-party reinsurers under current market conditions.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES-The carrying amount is composed of the present value of the expected cash flows for specifically identified claims combined with an estimate for unidentified claims. Therefore, the carrying amount is a reasonable estimate of the fair value of the reserve.