The principal executive offices of the Company and FSA are located at 31 West 52nd Street, New York, New York, 10019, and consist of approximately 110,000 square feet of office space.
Net premiums earned increased 2.3% in 2005 and 10.8% in 2004. Excluding the effects of refundings and prepayments, net premiums earned decreased 0.2% in 2005 and increased 7.9% in 2004. Refundings and prepayments result from interest-rate movements and other factors outside the Company’s control, and no assurance can be given that refundings and prepayments will continue at the recent level. The recent slower growth rate in earned premiums is a function of the relatively higher contribution from U.S. municipal originations, which generally have longer maturities and therefore slower earnings, and a decline in asset-backed earned premiums.
Viewed at a policy level, installment premiums are generally calculated as a fixed premium rate multiplied by the insured debt outstanding as of dates established by the terms of the policy. Because the actual installment premiums received could vary from the amount estimated at the time of origination based on variances in the actual outstanding debt balances as of the pre-established dates, the realization of PV premiums originated could be greater or less than the amount reported.
PV premiums originated reflects estimated future installment premiums discounted to their present value, as well as upfront premiums, but only for business originated during the period. To calculate PV premiums originated, management discounts an estimate of all future installment premium receipts. The Company calculates the discount rate for PV premiums originated as the average pre-tax yield on its insurance investment portfolio for the previous three years. This rate serves as a proxy for the return that could be achieved if the premiums had been received upfront. The estimated installment premium receipts are determined based on each installment policy’s projected par balances outstanding multiplied by its premium rate. The Company’s Transaction Oversight Groups estimate the relevant schedule of future par balances outstanding for each insurance policy with installment premiums. At the time of origination, projected debt schedules are generally based on good faith estimates developed and used by the parties negotiating the transaction.
Year-to-year comparisons of PV premiums originated are affected by the application of a different discount rate each year. The discount rate employed by the Company for this purpose was 5.30% for 2005 originations, 5.62% for 2004 originations and 5.91% for 2003 originations. Management intends to revise the discount rate in future years according to the same methodology, in order to reflect specific return results realized by the Company.
Driven by steady new-money issuance and high levels of refundings, the U.S. municipal new-issue market reached approximately $408.4 billion in 2005, on a sale-date basis, a 13.4% increase from $360.1 billion in 2004 and a 6.4% increase from the record level of $383.7 billion in 2003. Insurance penetration was approximately 56%, compared with 54% in 2004 and 50% in 2003. In all three years, low interest rates, strong demand for refundings and continuing needs for infrastructure investment drove high levels of municipal borrowing. Of the insured par amount of municipal bonds sold each year, FSA guaranteed approximately 26% in 2005, 24% in 2004 and 27% in 2003.
The Company’s U.S. asset-backed gross par insured decreased 49.7% in 2005 and rose 211% in 2004. The Company’s associated PV premiums originated decreased 16.6% in 2005 and rose 31.9% in 2004. In 2005, PV premiums originated declined less than par originated due to a shift toward longer duration transactions in the mix of business. Declines in PV premiums from high-premium net interest margin mortgage-backed transactions, which are generally designed to securitize excess cash flow generated by an issuer’s residential mortgage loan securitizations, and other residential mortgage transactions represented most of the decrease in PV premiums originated. Consumer finance and CDO PV premiums originated increased. In 2004, PV premiums originated did not grow as much as par insured because most of the growth in par volume came from pooled corporate and residential mortgage transactions of Triple-A underlying credit quality. Such high-quality transactions tend to have relatively low premium rates but tend to achieve good returns on equity.
GICs are issued at or converted into LIBOR-based floating-rate obligations, with proceeds invested in or converted into LIBOR-based floating-rate investments intended to result in profits from a higher investment rate than borrowing rate. The difference between the current-year investment revenue and borrowing cost is the FP NIM.
The non-GAAP measure PV NIM represents the difference between the present value of estimated interest to be received on the investments and the present value of estimated interest to be paid on liabilities issued in the form of GICs, net of the expected results of derivatives used to hedge interest-rate risk. The Company’s future positive interest-rate spread can be reasonably estimated and generally relates to contracts or security instruments that extend for multiple years.
2. FSA-insured credit default swaps (“CDS”) that have investment-grade underlying credit quality and that must be marked to fair value under SFAS 133.
Periodic unrealized gains and losses related to economic interest-rate hedges arise in both the financial guaranty and financial products business segments, caused primarily by the one-sided mark-to-
market derivative valuations prescribed by SFAS 133 for derivatives that do not qualify for “hedge-accounting treatment” under GAAP. Under the Company’s definition of operating earnings, the economic effect of these hedges is recognized, which, for interest rate swaps, generally results in any cash paid or received being recognized ratably as an expense or revenue over the hedged item’s life. Futures contracts used to hedge interest-rate risk include both the embedded current net interest paid or received, as well as the value of the future net interest cash flow. Therefore, to reflect the equivalent of any cash paid or received being recognized ratably as an expense or revenue over the hedged item’s life, the current interest accretion amount embedded in the mark-to-market value of open futures positions is added back to operating earnings.
Operating earnings are subject to certain general and specific limitations that investors should carefully consider. For example, as stated above, unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting. The Company’s operating earnings are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. Unlike GAAP, the Company’s operating earnings presentation does not represent a comprehensive basis of accounting. Investors, therefore, should not compare the Company’s performance with that of other financial guaranty companies based upon operating earnings. Operating earnings results are only meant to supplement GAAP results by providing additional information regarding the operational and performance indicators that are most closely used by management, the Company’s Board of Directors and rating agencies to assess performance.
Other limitations arise from the specific adjustments that management makes to GAAP results to derive operating earnings results. For example, in reversing the unrealized gains and losses that result from application of SFAS 133 to derivatives that do not qualify for hedge accounting, management focuses on the long-term economic effectiveness of those instruments relative to the underlying hedged item and isolates the effects of interest-rate volatility and changing credit spreads on the fair value of such instruments during the period. Under GAAP, the effects of these factors on the fair value of the derivative instruments (but not the underlying hedged item) tend to show more volatility in the short term. While the Company believes that its presentation presents the economic substance of its FP Segment and the business of FSA Global Funding Limited (“FSA Global”), a variable interest entity (“VIE”) whose results are consolidated with those of the Company, the presentation understates GAAP earnings volatility.
(1) See following table for a more detailed presentation of fair-value adjustments for economic interest-rate hedges.
5. elimination of the effect of fair-value adjustments for insured CDS;
6. elimination of the fair-value adjustments for economic interest-rate hedges; and
source of future earnings. Certain of the Company’s compensation formulas are based, in part, on the ABV growth rate.
The limitations of the ABV metric are that it reflects the accelerated realization of certain assets and liabilities through equity and relies on an estimate of the amount and timing of the receipt of installment premiums and future net interest margin. Actual installment premium receipts could vary from the amount estimated due to differences between actual and estimated insured debt balances outstanding. Actual net interest margin results could vary from the amount estimated based on sales of investments prior to maturity and variances in the actual timing and amount of repayment associated with flexible-draw GICs that the Company issues. ABV excludes the fair-value adjustments of investment-grade insured CDS and the fair-value adjustments of derivatives that hedge interest-rate risk but do not qualify for hedge accounting under SFAS 133.
Shareholders’ equity was $2.8 billion and non-GAAP ABV was $3.9 billion at December 31, 2005. During 2005, ABV grew 14.0%.
The following table reconciles book value to non-GAAP ABV for the years presented:
The gross and net par amounts outstanding on transactions with case reserves were $612.7 million and $519.5 million, respectively, at December 31, 2005. Net case reserves consisted primarily of seven CDO transactions and one municipal transaction, which collectively accounted for approximately 94% of the total net case reserve. The remaining 11 exposures were in various sectors.
Case and non-specific reserves for losses and loss adjustment expenses are discounted when established using the risk-free rate appropriate for the term of the insured obligation at the time the reserve is established.
During 2005, the Company charged $25.4 million to loss expense, consisting of $20.4 million for originations of new business and $5.0 million related to accretion on the reserve for in-force business. Case reserves increased $8.3 million, primarily due to deterioration of specific CDO risks. See Note 16 to the Consolidated Financial Statements in Item 8.
diversified within that asset type. Due to characteristically low default frequency, losses on insured asset-backed transactions have been manageable, in management’s view, despite variability.
A material adverse change from management’s current estimate of loss for municipal transactions with case reserves is considered unlikely because the only such case reserve is set near the full policy amount.
The Company is aware that there are differences regarding the method of measurement of the non-specific reserve among participants in the financial guaranty industry. Other financial guarantors may not establish a non-specific reserve in the manner described above, may call their non-specific reserve by a different name, such as, but not limited to “unallocated losses,” “active credit reserves” and “portfolio reserves,” or may use different statistical techniques from those the Company uses to determine loss at a given point in time. Management and the industry expect accounting literature specific to the financial guaranty industry to evolve; however, management cannot predict or estimate the scope of the guidance or potential impact on the Company’s financial statements at this time. See Note 2 to the Consolidated Financial Statements in Item 8.
At December 31, 2005, the reinsurance recoverable on unpaid losses from reinsurers and ceded par outstanding, by S&P rating levels, were as follows:
Both the federal government and the executive and legislative branches of the affected states have considered or are expected to consider proposals or legislation to assist the municipalities and facilitate recovery. An example of such an enactment at the federal level is the Community Disaster Loan Act of 2005, under which the federal government has begun to make loans to affected municipalities.
FP operating NIM, a non-GAAP measure, is defined as the FP Segment net interest margin excluding fair-value adjustments for economic interest-rate hedges. Management uses FP operating NIM as a key performance measure of the Company’s financial products business. FP operating NIM was $40.5 million in 2005, $23.5 million in 2004 and $8.9 million in 2003. The increases in FP operating NIM were related primarily to the increase in the book of GIC business since the FP Segment commenced operations at the end of 2001. Prior-year balances have been reclassified to conform to the current-year presentation.
NIM shown in accordance with classifications required under GAAP on the consolidated statements of operations and comprehensive income (“Total NIM”) is calculated as net interest income from financial products and VIEs, plus financial products net realized gains (losses), less net interest expense from financial products and VIEs. Total NIM was negative $11.2 million for 2005, negative $70.7 million for 2004 and negative $37.1 million for 2003, and primarily represents fixed-rate liabilities (which are swapped to a floating-rate obligation) funding floating-rate assets. The differences between Total NIM and FP
operating NIM relate primarily to the presentation of periodic interest income and expense on derivatives, intersegment transactions and VIE NIM, as discussed further below.
Intersegment income relates primarily to intercompany notes held in the FP bond portfolio. In connection with the Company’s refinancing transactions, FSA obtains funds from the FP operations to fund claim payments, as discussed further in Note 22 to the Consolidated Financial Statements in Item 8, creating an interest-bearing intercompany note. This intercompany note is included in the assets of the FP Segment, with the related net interest income added to FP operating NIM, but is eliminated from the consolidated Total NIM.
FSA’s business includes insurance of CDS referencing diversified pools of obligations. The net par outstanding was $66.6 billion relating to these transactions at December 31, 2005 and $66.0 billion at December 31, 2004. Many of these transactions require periodic accounting adjustments to reflect an estimate of fair value (or the replacement cost of the Company’s financial guaranty contract) under SFAS 133. These transactions have generally been underwritten with Triple-A or higher levels of credit protection provided by significant deductibles that must be exhausted prior to claims under FSA’s guaranty. Adjustments required by SFAS 133 resulted in pre-tax income of $11.1 million for 2005, $56.4 million for 2004 and $34.8 million for 2003. The benefits during 2005, 2004 and 2003 resulted primarily from tightening credit spreads in the CDS market. None of these adjustments indicate any material improvement or deterioration in the underlying credit quality of FSA’s insured CDS portfolio. The gain or loss created by estimated fair-value adjustments will rise or fall each quarter based on estimated market pricing of highly rated swap guarantees and is not expected to be an indication of potential claims under FSA’s guaranty. Fair value is defined as the price at which an asset or a liability could be bought or sold in a current transaction between willing parties. The fair value is determined based on quoted market prices, if available. If quoted market prices are not available, as is the case primarily with CDS on pools of assets, then the determination of fair value is based on internally developed estimates. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, performance of underlying assets, changes in internal shadow ratings, the level at which the deductible has been set and FSA’s ability to obtain reinsurance for its insured obligations. Due to changes in these factors, the gain or loss from derivative instruments may vary substantially from period to period. Absent any claims under FSA’s guaranty, any “losses” recorded in marking a guaranty to fair value will be reversed by an equivalent “gain” at or prior to the expiration of the guaranty, and any “gain” recorded will be reversed by an equal “loss” over the remaining life of the transaction. The average remaining life of these contracts is 3.2 years. The inception-to-date pre-tax gain on the CDS portfolio was $57.7 million at December 31, 2005 and $46.6 million at December 31, 2004. Given the very high credit quality of FSA’s insured CDS portfolio and the Company’s intent to hold to maturity, management believes that “losses” or “gains” attributable to marking these exposures to fair value do not reflect on the profitability of the Company in a meaningful way.
The Company utilizes interest-rate derivatives to hedge against fluctuations in interest rates and foreign currency derivatives to hedge against fluctuations in exchange rates. All gains and losses from changes in the fair-value of derivatives that do not qualify for hedge accounting under SFAS 133 are recognized immediately in the consolidated statements of operations and comprehensive income under the caption net unrealized and realized gains (losses) on derivatives. Hedge accounting is applied to derivatives designated as hedging instruments in a fair-value hedge, provided certain criteria are met.
Total equity in earnings of unconsolidated affiliates was a pre-tax gain of $1.2 million in 2005, a pre-tax loss of $3.3 million in 2004 and pre-tax income of $5.5 million in 2003.
In October 2005, the Company sold its investment in SPS to an unaffiliated third party. For its interest in SPS, the Company was paid $42.9 million in cash at closing and expects to receive additional amounts, from time to time through March 31, 2008, out of income earned by SPS through December 31, 2007 from certain of its mortgage servicing activities. Under the sale documents, the Company’s subsidiary that owned the SPS investment made customary representations and warranties to, and undertook specified indemnification obligations for the benefit of, the purchaser. Based on an estimate of the assets retained and liabilities assumed, the Company recorded a $0.4 million loss on the sale of SPS. Under the terms of the agreement, the Company will receive cash payments through the first quarter of 2008 from a residual interest in mortgage servicing assets. The Company recorded an asset of $12.6 million representing this contingent payment asset. The Company and other prior shareholders indemnified the buyer for certain liabilities relating to SPS’s operations, including litigation and regulatory actions. The maximum indemnification obligation for SPS’s operations will not exceed approximately $34.0 million. The Company’s portion of this obligation is 37.4% or $12.7 million. As of December 31, 2005, the Company recorded a $5.1 million liability related to this indemnification representing the expected liability. The Company will continue to evaluate the appropriate carrying value of the liabilities assumed and whether the assets are impaired.
FSA’s 13% investment in preferred shares of XLFA, a financial guaranty insurance subsidiary of XL, is redeemable by XLFA at a price equal to the fair market value of the preferred shares, subject to a cap defined as the internal rate of return of 19% per annum from the date of the investment through the date of redemption, plus accrued dividends as if 100% of current-year earnings were distributed. Based on this formula, the Company carries this investment at the lesser of the current calculated redemption value or the redemption value as of the next January first, which would exclude its share of accrued current-year earnings to the extent the cap had been otherwise met. Consistent with this policy, in the third quarter of 2004, the Company charged a pre-tax amount of $11.7 million to equity in earnings of unconsolidated affiliates and reduced its carrying value in this investment to $56.4 million.
The degree of influence exercised by FSA over these VIEs varies from transaction to transaction, as does the degree to which “risks and rewards” associated with asset performance are assumed by FSA. While all transactions insured by FSA are included in the Company’s outstanding exposure, and losses under these obligations are reflected in the Notes to Consolidated Financial Statements, the assets and liabilities of these VIEs, except for refinanced transactions discussed below and in Note 22 to the Consolidated Financial Statements in Item 8, have not been consolidated with those of the Company for financial reporting purposes because the Company is not the primary beneficiary.
The Company consolidates FSA Global, Canadian Global and Premier. The Company’s adoption of FIN 46 on July 1, 2003 resulted in a $1.9 billion aggregate increase in total assets and total liabilities. The differences upon consolidation were reflected as a cumulative effect of a change in accounting principle. The cumulative effect of a change in accounting principle for Canadian Global resulted in additional income of $4.8 million, net of income tax in 2003. During the third quarter of 2004, the majority of the assets of Canadian Global were liquidated and its liabilities satisfied. There was no income statement effect from consolidating FSA Global and Premier. FSA Global is managed as a “matched funded vehicle,” in which the proceeds from the issuance of FSA-guaranteed notes are invested in obligations having cash flows substantially matched to those of, and maturing prior to, such notes. In certain cases, investments of FSA Global consist of GICs issued by the GIC Affiliates. In each such case, the Company’s GIC liability and GIC asset are eliminated in consolidation. At December 31, 2005, $1,142.1 million was eliminated as a result of such consolidation.
The Company’s effective tax rates were 27.3% in 2005, 19.0% in 2004 and 22.2% in 2003. The 2005 rate differs from the statutory rate of 35%, primarily due to tax-exempt interest income, minority interest, the Company’s reorganization of Financial Security Assurance International Ltd. (“FSA International”) and its intention to repatriate FSA International’s future earnings. In 2004 and 2003, the rates differed from the statutory rate of 35% primarily due to tax-exempt interest, income from FSA International, and minority interest, with the White Mountains indemnity payment (see below) and the expected repatriation of earnings of FSA International in 2005 also having an effect.
The American Jobs Creation Act of 2004 (the “Act”), enacted on October 22, 2004, added Section 965 to the Internal Revenue Code. Section 965 provides for the repatriation of dividends from a controlled foreign corporation to its U.S. shareholder at an effective tax rate of 5.25%, provided that proceeds from the repatriation are utilized for qualified domestic investment activities. The U.S. Treasury Department issued Notice 2005-10, which provides guidance on acceptable investment activities. The Company believes it qualifies for the beneficial treatment under Section 965 and accordingly accrued a tax liability and expense of $5.3 million at December 31, 2004. This amount approximated the tax effect on FSA International’s tax dividend distribution made in the fourth quarter of 2005.
In December 2005, the Company repatriated earnings from FSA International to avail itself of the reduced effective tax rate of 5.25% (compared with the normal effective tax rate of 35%) applicable to certain earnings and profits of offshore subsidiaries repatriated during the current tax year and invested in the United States pursuant to a qualifying reinvestment plan in accordance with the Act. In connection with such repatriation, the Company recapitalized FSA International in October of 2005 to become a wholly owned subsidiary and declared that it no longer intends to leave future earnings of that subsidiary permanently offshore, with the effect that 2005 and future income from FSA International have become subject to an increased effective U.S. tax rate. The impact on earnings reflects (1) a tax liability of $15.1 million in respect of earnings of FSA International that have previously been recognized for GAAP but not yet for tax and (2) $14.2 million related to 2005 earnings.
for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, the Company has agreed to share 50% of the deferred tax benefit with White Mountains Insurance Group under certain circumstances, but did not satisfy the standards for recording a liability for accounting purposes as of December 31, 2005.
Like other financial guarantors, the Company has received comments from the staff of the Securities and Exchange Commission (“SEC”) regarding its accounting for fixed income investments that are insured by FSA (“FSA-Insured Investments”). The Company cannot predict how the SEC staff will resolve this issue or the resulting effect on the Company’s consolidated financial statements. See “Item 1. Business-Investments Insured by the Company.”
The Company’s consolidated invested assets at December 31, 2005, net of unsettled security transactions, were $17,372.2 million, compared with the December 31, 2004 balance of $12,227.2 million. These balances include the change in the market value of the Company’s various portfolios, which had an unrealized gain position of $236.2 million at December 31, 2005, compared with an unrealized gain position of $294.5 million at December 31, 2004. These balances exclude (1) the effect of any economic interest-rate derivatives’ hedging and (2) assets in the VIE bond portfolio and assets acquired under refinancing transactions that the Company’s management believes are beyond the reach of the Company and its creditors. Included in these balances are short-term investments of $182.6 million at December 31, 2005 and $119.7 million at December 31, 2004. Cash and cash equivalents were $20.1 million at December 31, 2005 and $14.4 million at December 31, 2004.
FSA’s ability to pay dividends depends, among other things, upon FSA’s financial condition, results of operations, cash requirements and compliance with rating agency requirements for maintaining its Triple-A ratings, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York (the “New York Insurance Law”), FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (a) 10% of policyholders’ surplus as of its last statement filed with the New York Superintendent or (b) adjusted net investment income during this period. Based on FSA’s statutory statements for 2004, and considering dividends that can be paid by its subsidiary, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the 12 months following December 31, 2005 is approximately $153.8 million. FSA paid dividends of $87.0 million in 2005 and $30.0 million in 2004 and paid none in 2003.
FSA International paid preferred dividends to XL Capital Ltd, its minority interest owner, of $6.9 million in 2005, $7.0 million in 2004 and $3.3 million in 2003.
Management believes that the Company’s expected operating liquidity needs, on both a short- and long-term basis, can be funded from its operating cash flow. In addition, the Company has a number of sources of liquidity available to pay claims on a short- and long-term basis: cash flow from premiums written, FSA’s investment portfolio and earnings thereon, reinsurance arrangements with third-party reinsurers, new borrowings through its GIC Affiliates, liquidity lines of credit with banks and capital market transactions.
FSA has a credit arrangement aggregating $150.0 million, provided by commercial banks and intended for general application to transactions insured by FSA. If FSA is downgraded below Aa3 and AA-, the lenders may terminate the commitment and the commitment commission becomes due and payable. If FSA is downgraded below Baa3 and BBB-, any outstanding loans become due and payable. At
FSA has a standby line of credit in the amount of $350.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $350.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $1,220.0 million at December 31, 2005. The obligation to repay loans under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a ten-year term expiring on April 30, 2015 and contains an annual renewal provision, commencing April 30, 2008, subject to approval by the banks. A ratings downgrade of FSA would result in an increase in the commitment fee. No amounts have been utilized under this commitment as of December 31, 2005.
In June 2003, $200.0 million of money market committed preferred trust securities (the “CPS Securities”) were issued by trusts created for the primary purpose of issuing the CPS Securities, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the “Preferred Stock”) of FSA. If FSA were to exercise a put option, the applicable trust would transfer the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $1.3 million for 2005 and $1.3 million for 2004 and was recorded as other operating expense in the Company’s Consolidated Financial Statements. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts under FIN 46 because it does not retain the majority of the residual benefits or expected losses.
FSA-insured GICs subject the Company to risk associated with unexpected withdrawals of principal allowed by the terms of the GICs. The majority of municipal GICs insured by FSA relate to debt service reserve funds and construction funds in support of municipal bond transactions. Debt service reserve fund GICs may be drawn unexpectedly upon a payment default by the municipal issuer. Construction fund GICs may be drawn unexpectedly when construction of the underlying municipal project does not proceed as expected. In addition, most FSA-insured GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below Aa3 by Moody’s or AA- by S&P, unless the GIC provider posts collateral or otherwise enhances its credit. Some FSA-insured GICs also allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below A3 by Moody’s or A- by S&P, with no right of the GIC provider to avoid such withdrawal by posting collateral or otherwise enhancing its credit. The Company manages this risk through the maintenance of liquid collateral and bank liquidity facilities.
FSA Asset Management LLC (“FSAM”) has a $100.0 million line of credit with UBS Loan Finance LLC, which expires December 8, 2006, unless extended. This line of credit provides an additional source of liquidity should there be unexpected draws on GICs issued by the GIC Affiliates. There were no borrowings under this arrangement at December 31, 2005. Borrowings under this agreement are conditioned on FSA having a Triple-A rating by either S&P or Moody’s, and on neither S&P nor Moody’s having issued a rating to FSA below AA+ or Aa1, respectively.
S&P, Moody’s and Fitch Ratings periodically assess the credits insured by FSA, and the reinsurers and other providers of capital support to FSA, to confirm that FSA continues to satisfy the rating agencies’ capital adequacy criteria necessary to maintain FSA’s Triple-A ratings. Capital adequacy assessments by the rating agencies are generally based on FSA’s qualified statutory capital, which is the aggregate of
policyholders’ surplus and contingency reserves determined in accordance with statutory accounting principles.
II Condensed Financial Statements of Financial Security Assurance Holdings Ltd. as of
December 31, 2005 and 2004 and for the Years Ended December 31, 2005, 2004 and 2003
As discussed in Note 25 to the consolidated financial statements, in 2003 the Company changed its method of accounting for its interest in certain variable interest entities.
The Company expects to continue to emphasize a diversified insured portfolio characterized by insurance of both municipal and asset-backed obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. The Company’s insured portfolio consists primarily of municipal and asset-backed obligations originated in the United States of America, but the Company has also written and continues to pursue business in Europe and the Asia Pacific region.
The Company issues guaranteed investment contracts (“GICs”) through its consolidated affiliates: FSA Capital Management Services LLC (“FSACM”), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the “GIC Affiliates”). FSACM has conducted substantially all of the Company’s GIC business since April 2003, following the receipt of an exemption from the requirements of the Investment Company Act of 1940. The GIC Affiliates lend the proceeds from their sales of GICs to FSA Asset Management LLC (“FSAM”), which invests the funds, generally in obligations that qualify for FSA insurance. The GIC Affiliates and FSAM are collectively referred to as the “FP Segment.”
FSA Global is a special purpose funding vehicle owned 29% by a subsidiary of the Company. FSA Global issues FSA-insured medium term notes and invests the proceeds from the sale of its notes in FSA-insured obligations with a view towards realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. The majority of Canadian Global’s assets were liquidated and its liabilities satisfied during the third quarter of 2004. Premier is principally engaged in debt defeasance for lease transactions.
On July 5, 2000, the Company completed a merger in which Financial Security Assurance Holdings Ltd. (“FSA Holdings”) became a direct subsidiary of Dexia Holdings, Inc. (“Dexia Holdings”), which, in turn, is owned 90% by Dexia Crédit Local S.A. (“Dexia Crédit Local”) and 10% by Dexia S.A. (“Dexia”), a Belgian corporation whose shares are traded on the Euronext Brussels and Euronext Paris markets, as well as on the Luxembourg Stock Exchange. Dexia Crédit Local is a wholly owned subsidiary of Dexia. At December 31, 2005, Dexia Holdings owned approximately 99% of the Company’s outstanding shares; the only other holders of the Company’s common stock were an affiliate of White Mountains Insurance Group, Ltd. (“White Mountains”) and certain directors of the Company who owned shares of the Company’s common stock or economic interests therein under the Director Share Purchase Program (see Note 10).
The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), which, for the insurance company subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 5). 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 in the Company’s consolidated balance sheets at December 31, 2005 and 2004, the reported amounts of revenues and expenses in the statements of operations and comprehensive income during the years ended December 31, 2005, 2004 and 2003 and disclosure of contingent assets and liabilities. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses, fair value of financial instruments and the deferral and amortization of policy acquisition costs. Actual results may differ from those estimates. Significant accounting policies under GAAP are as follows:
The Consolidated Financial Statements include the accounts of FSA Holdings and its direct and indirect subsidiaries, principally including FSA, FSA Insurance Company, Financial Security Assurance International Ltd. (“FSA International”), Financial Security Assurance (U.K.) Limited, the GIC Affiliates, FSAM, FSA Portfolio Management Inc., Transaction Services Corporation, FSA Services (Australia) Pty Limited and FSA Services (Japan) Inc. (collectively, the “Subsidiaries”). The Consolidated Financial Statements also include the accounts of certain VIEs as described in Note 1. All intercompany accounts and transactions have been eliminated. Certain prior-year balances have been reclassified to conform to the current-year presentation.
Bond discounts and premiums are amortized on the effective yield method over the remaining terms of the securities acquired. For mortgage-backed securities and any other holdings for which prepayment risk may be significant, assumptions regarding prepayments are evaluated periodically and revised as necessary. Any adjustments required due to the resulting change in effective yields are recognized in current income. Short-term investments, which are those investments with a maturity of less than one year at time of purchase, are carried at cost, which approximates fair value. Amounts deposited in money market funds and investments with a maturity at time of purchase of three months or less and are included in short-term investments.
The Company has also insured a number of CDS agreements that it intends, in each case, to hold for the full term of the agreement. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred.
Changes in fair value are recorded in net realized and unrealized gains (losses) on derivative instruments and in other assets or other liabilities, as appropriate. The Company uses quoted market prices, when available, to determine fair value. If quoted prices are not available, management uses internally developed estimates of fair value. Due to a lack of a quoted market for the CDS obligations written by the Company, estimates generated from the Company’s valuation process may differ materially from values that may be realized in market transactions.
Securities purchased under agreements to resell and securities sold under agreements to repurchase are accounted for as collateralized transactions and are recorded at contract value plus accrued interest, subject to the provisions of Statement of Financial Accounting Standards No. 140, “Accounting for Transfer and Servicing of Financial Assets and Extinguishment of Liabilities.” It is the Company’s policy to take possession of securities borrowed under agreements to resell.
Gross and ceded premiums received in upfront payouts are earned in proportion to the expiration of the related risk. For upfront premium transactions, premium earnings are greater in the earlier periods when there is a higher amount of exposure outstanding. The amount of risk outstanding is equal to the sum of the par amount of debt insured over the expected period of coverage. Deferred premium revenue and prepaid reinsurance premiums represent the portion of gross and ceded premium, respectively, that is applicable to coverage of risk to be provided in the future on policies in force. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred premium revenue and prepaid reinsurance premium, less any amount credited to a refunding issue insured by the Company, are recognized.
For premiums received on an installment basis, the Company earns the premium over each installment period, typically less than one year, throughout the period of coverage. Typically, installment premiums are applicable to insured transactions that involve CDS or special purpose vehicles (“SPVs”) structured to finance pools of assets such as auto loans or mortgage loans. Premiums on such transactions are typically paid in installments because premium is paid from the interest spread available to the SPV (i.e. the difference in interest rate between the yield on its assets and the yield on its liabilities). The nature of the assets financed can have uncertain debt service schedules due to prepayments. When the Company, through its ongoing credit review process, identifies transactions where premiums are paid on an installment basis and certain default triggers have been breached, the Company ceases to earn premiums on such transactions.
Financial guaranty insurance generally provides an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due. Upon a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other amounts due in accordance with the obligation’s original payment schedule or, at its option, to pay such amounts on an accelerated basis.
The financial guaranty industry has emerged over the past thirty-four years. Management believes that existing insurance accounting under Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”), does not specifically address financial guaranty insurance. Accordingly, the accounting for loss and loss adjustment expenses within the financial guaranty insurance industry has developed based on analogy to the most directly comparable elements of existing
literature, including sections of SFAS 60, Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS 5”) and Emerging Issues Task Force Issue 85-20, “Recognition of fees for guaranteeing a loan” (“EITF 85-20”).
The Company records a non-specific reserve to reflect the credit risks inherent in its portfolio. The non-specific and case reserves together represent the Company’s estimate of total reserves. Generally, when an insured credit deteriorates to a point where claims are expected, a case reserve is established. The establishment of a non-specific reserve for credits that have not yet defaulted is a common practice in the financial guaranty industry, although there are differences in the specific methodologies applied by other financial guarantors in establishing and measuring these reserves.
(“S&P”), together with qualitative factors such as overall credit quality trends resulting from economic and political conditions, recent loss experience in particular segments of the portfolio and changes in underwriting policies and procedures. The factors used to establish reserves are evaluated periodically by comparing the statistically computed loss amount with the incurred losses as represented by case reserve activity to develop an experience factor that is updated and applied to current-year originations. The process results in management’s best estimate of inherent losses associated with providing credit protection at each balance sheet date.
The product of the current-year statistical calculation multiplied by the current-year experience factor represents the present value of loss amounts calculated for current-year originations. The experience factor is based on the Company’s inception-to-date historical losses (starting from 1993, when the Company established the non-specific reserve methodology). The experience factor is calculated by dividing cumulative inception-to-date actual losses incurred by the Company by the cumulative inception-to-date losses determined by the statistical calculation. The experience factor that applies to the whole portfolio is reviewed and, where appropriate, updated periodically, but no less than annually.
The present value of loss amounts calculated for the current-year originations is established at inception of the policy, and there is no subsequent change unless significant adverse or favorable loss experience is observed. In the event that the experience factor is either increased or decreased based on adverse or favorable loss experience, an analysis is performed of the non-specific reserve balance with particular emphasis on the asset class, if any, driving the experience factor adjustment. The objective of such analysis is to quantify the appropriate adjustment to the overall non-specific reserve balance for the change in experience. The adjustment that increases or decreases the non-specific reserve is charged or credited to loss expense.
As a result, the Company also analogizes to SFAS 5, which requires the establishment of liabilities when a loss is both probable and reasonably estimable. The Company also relies by analogy on EITF 85-20, which provides general guidance on the recognition of losses related to guaranteeing a loan. In the absence of a comprehensive accounting model provided by SFAS 60, industry participants, including the Company, have looked to such other guidance referred to above to develop their accounting policies for the establishment and measurement of loss liabilities. The Company believes that its financial guaranty loss reserve policy is appropriate under the applicable accounting literature, and that it best reflects the fact that a portfolio of credit-based insurance, comprising irrevocable contracts that cannot be unilaterally changed by the insurer and that match the maturity terms of the underlying insured obligation, contains probable and reasonably estimable losses.
Monetary assets and liabilities denominated in foreign currencies are translated at the spot rate at the balance sheet date. Non-monetary assets and liabilities are translated at historical rates. Revenues and expenses denominated in foreign currencies are translated at average rates prevailing during the year. Unrealized gains and losses on available-for-sale securities, net of deferred taxes, resulting from translating investments denominated in foreign currencies are recorded in shareholders’ equity. Gains and losses from transactions in foreign currencies are recorded in income.
Bonds and short-term deposits at amortized cost of $9.9 million and $9.7 million at December 31, 2005 and 2004, respectively, were on deposit with state regulatory authorities as required by insurance regulations.
Consolidated net investment income attributable to the Investment Portfolio consisted of the following (in thousands):
The credit quality of bonds in the Investment Portfolio at December 31, 2005 was as follows:
Of the bonds included in the Investment Portfolio, 6.8% were Triple-A by virtue of insurance provided by FSA (“FSA-Insured Investments”). Over 95% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments, which is the rating without giving effect to the FSA insurance, was in the Double-A range.
The following table shows the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands):
The amortized cost and fair value of bonds in the Investment Portfolio at December 31, 2005, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
Of the bonds included in the FP Investment Portfolio, 7.0% were Triple-A by virtue of insurance provided by FSA. Over 90% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments was in the Single-A range.
The following table shows the gross unrealized losses and fair value for the FP Investment Portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005 (in thousands):
The amortized cost and fair value of the FP Investment Portfolio, at December 31, 2005, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
Proceeds from sales of bonds held in the FP Investment Portfolio during 2005, 2004 and 2003 were $293.0 million, $91.7 million and $190.7 million, respectively. Proceeds from maturities of bonds for the FP Investment Portfolio during 2005, 2004 and 2003 were $6,764.3 million, $2,485.8 million and $1,032.0 million. Gross gains of $0.4 million and gross losses of $7.9 million were realized on sales in 2005. Gross gains of $2.2 million were realized on sales in 2004. Gross gains of $10.9 million were realized on sales in 2003.
· upfront premiums are recognized as earned when related principal and interest have expired rather than over the expected coverage period;
2) for all policies written on or after July 1, 1989, an amount equal to the greater of 50% of premiums written for each category of insured obligation or a designated percentage of principal guaranteed for that category. These amounts are provided each quarter as either 1/60th or 1/80th of the total required for each category, less permitted reductions;
· deferred tax assets are generally admitted to the extent reversals of existing temporary differences in the subsequent year can be recovered through carry back;
· VIEs and refinancing vehicles are not consolidated under statutory accounting standards;
Reconciliations of net income for the years ended 2005, 2004 and 2003 and shareholders’ equity at December 31, 2005 and 2004, reported by the Company on a GAAP basis, to the amounts reported by the insurance company subsidiaries on a statutory basis, are as follows (in thousands):
Dexia Holdings and the Company and its Subsidiaries, except FSA International, file a consolidated federal income tax return. A tax-sharing agreement between them provides that each member’s tax benefit or expense is calculated on a separate-return basis and that any credits or losses available to the Company are allocated among the members based on each member’s taxable income. At December 31, 2004, the Company and its Subsidiaries received benefits from utilizing Dexia Holdings’ credits and losses of $1.3 million. The Company and its Subsidiaries did not receive any such benefits in 2005. These amounts
Except as described below, federal income taxes were not provided on all of the undistributed earnings of FSA International, since it was the Company’s practice and intent to reinvest such earnings in the operations of this subsidiary. The cumulative amount of such untaxed earnings was $22.6 million and $86.7 million at December 31, 2004 and 2003, respectively.
In December 2005, the Company repatriated earnings from FSA International to avail itself of the reduced effective tax rate of 5.25% (compared with the normal effective tax rate of 35%). In connection with such repatriation, the Company recapitalized FSA International in October of 2005 to become a wholly owned subsidiary and declared that it no longer intends to leave future earnings of that subsidiary permanently offshore. As a result, FSA International is subject to an increased effective U.S. tax rate on its 2005 and future income. The impact on earnings reflects (1) a tax liability of $15.1 million in respect of earnings of FSA International that have previously been recognized for GAAP but not yet for tax purposes and (2) $14.2 million related to 2005 earnings.
Following a change in SPS’s investors in 2002, the Company determined that it would be appropriate to apply the 80% dividend-received deduction allowed by the Internal Revenue Service when accounting for the tax on its equity earnings from SPS, based on management’s expectation that it would realize its gain on such investment through dividend distributions rather than through sale of its investment. For 2004 and 2003, equity in earnings from SPS was taxed at an effective rate of 7.0%. In the first quarter of 2005, due to the pending sale of its investment in SPS Holding Corp. (“SPS”) (formerly, Fairbanks Capital Holding Corp.), the Company eliminated the assumption that accumulated earnings of SPS would be distributed in the form of dividends eligible for a dividend-received deduction. The net effect of this was to provide additional taxes on SPS’s accumulated earnings of approximately $1.6 million.
In connection with Dexia’s acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains. While the Company had no legal liability in connection with the indemnity payment, the payment should be treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, the Company has agreed to share 50% of the deferred tax benefit with White Mountains under certain circumstances, but did not satisfy the standards for recording a liability for accounting purposes as of December 31, 2005.
FSA’s ability to pay dividends depends on FSA’s financial condition, results of operations, cash requirements, rating agency capital adequacy and other related factors, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York, FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (a) 10% of policyholders’ surplus as of its last statement filed with the Superintendent of Insurance of the State of New York or (b) adjusted net investment income during this period. FSA paid $87.0 million of dividends in 2005 and $30.0 million in 2004. Based upon FSA’s statutory statements for December 31, 2005, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the following 12 months would be approximately $153.8 million.
FSAM has a $100.0 million line of credit with UBS Loan Finance LLC, which expires December 8, 2006, unless extended. This line of credit provides an additional source of liquidity should there be unexpected draws on GICs issued by the GIC Affiliates. There were no borrowings under this agreement at December 31, 2005. Borrowings under this agreement are conditioned on FSA having a Triple-A rating by either S&P or Moody’s, and on neither S&P nor Moody’s having issued a rating to FSA below AA+ or Aa1, respectively.
In June 2003, $200.0 million of money market committed preferred trust securities (the “CPS Securities”) were issued by trusts created for the primary purpose of issuing the CPS Securities, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the “Preferred Stock”) of FSA. If FSA were to exercise a put option, the applicable trust would transfer the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $1.3 million and $1.3 million for 2005 and 2004, respectively, and was recorded within other operating expenses. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts because it does not retain the majority of the residual benefits or expected losses.
On July 31, 2003, the Company issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the notes. In September 2003, the Company called for redemption, on November 1, 2003, $100.0 million of its 6.95% Senior Quarterly Income Debt Securities (“Senior QUIDS”) due November 1, 2098 and delivered to the trustee sufficient collateral to legally defease the 6.95% Senior QUIDS. Unamortized debt issuance costs of $3.2 million for the 6.95% Senior QUIDS were charged to interest expense in 2003. Subsequently, the trustee used the defeasance collateral to redeem all of the 6.95% Senior QUIDS.
The estimated final cost of these performance shares is accrued over the performance period. The expense for the performance shares was $55.8 million, $73.3 million and $63.1 million for the years ended December 31, 2005, 2004 and 2003, respectively.
In the event that any or all of the reinsuring companies are unable to meet their obligations, or contest such obligations, the Company would be unable to recover such defaulted amounts. Certain of the reinsuring companies have provided collateral to secure their reinsurance obligations.
Amounts of ceded and assumed business were as follows (in thousands):
The Company’s policies insure the scheduled payments of principal and interest on municipal and asset-backed (including FSA-insured CDS) obligations. The gross amount of financial guarantees in force (principal and interest) was $668.2 billion at December 31, 2005 and $622.6 billion at December 31, 2004. The net amount of financial guarantees in force was $480.2 billion at December 31, 2005 and $444.5 billion at December 31, 2004.
The net par outstanding as of December 31, 2005 and 2004 and the contractual terms to maturity are as follows (in millions):
The Company limits its exposure to losses from writing financial guarantees by underwriting investment-grade obligations, diversifying its portfolio and maintaining rigorous collateral requirements on asset-backed obligations, as well as through reinsurance. The net par outstanding of insured obligations in the asset-backed insured portfolio includes the following amounts by type of collateral (in millions):
(1) Excludes intercompany insurance of $13,463 million in 2005 and $7,143 million in 2004 relating to FSA-insured GICs issued by the GIC Affiliates.
For the years ended December 31, 2005, 2004 and 2003, the Subsidiaries ceded premiums of $31.6 million, $35.2 million and $48.8 million, respectively, to subsidiaries of XL Capital Ltd (“XL”), a major Bermuda-based insurance holding company, which owned an interest in FSA International prior to October 2005, when it redeemed its interest in exchange for $39.1 million. During 2005, 2004 and 2003, the Company paid dividends to XL of $16.3 million, $7.0 million and $3.3 million, respectively. The amounts included in prepaid reinsurance premiums at December 31, 2005 and 2004 for reinsurance ceded to subsidiaries of XL were $84.4 million and $70.3 million, respectively. The amounts of reinsurance recoverable for unpaid losses at December 31, 2005 and 2004 for reinsurance ceded to subsidiaries of XL were $1.8 million and $8.2 million, respectively.
The Subsidiaries earned premiums of $28.0 million, $28.0 million and $20.5 million for the years ended December 31, 2005, 2004 and 2003, respectively, relating to business with affiliates of Dexia. Deferred premium revenue relating to those transactions was $19.5 million and $17.0 million at December 31, 2005 and 2004, respectively. Gross par outstanding relating to those transactions was $21.5 billion and $24.0 billion at December 31, 2005 and 2004, respectively. The Company also paid Dexia a fee of $0.7 million in 2003 relating to business in which both Dexia and the Company were involved. No payments were made in 2004 and 2005. For the year ended December 31, 2005, the Company recorded a pre-tax loss of $12.0 million, and for the years ended December 31, 2004 and 2003, the Company recorded pre-tax income of $97.6 million and $52.9 million, respectively, relating to swaps where Dexia was the counterparty. The Company recorded other assets of $323.5 million and other liabilities of $13.9 million in 2005 and recorded other assets of $353.1 million and other liabilities of $17.2 million in 2004, primarily
For short-term investments, including the FP short-term investment portfolio and the VIE short-term investments, the carrying amount is cost, which approximates fair market value due to the short maturity of the instruments.
For deferred premium revenue, net of prepaid reinsurance premiums, the carrying amount represents the Company’s future premium revenue, net of reinsurance, on policies where the premium was received at the inception of the insurance policy. The fair value of deferred premium revenue, net of prepaid reinsurance premiums, is an estimate of the statutory premiums that would be paid under a reinsurance agreement with a third party to transfer the Company’s financial guaranty risk, net of that portion of the premiums retained by the Company to compensate it for originating and servicing the insurance contract.
The table below shows the carrying amount and fair value of the Company’s financial instruments (in thousands):
Activity in the liability for losses and loss adjustment expenses, which consists of the case and non-specific reserves, is summarized as follows (in millions):
The Company monitors its exposure to Hurricanes Katrina and Rita in Louisiana and Mississippi and has determined that no case reserve is required. Of the 11 credits with significant risk of loss, the Company has identified two high-priority risks. These risks are perpetual obligations, on which the Company may have to pay claims of up to $44.0 million in a worst-case scenario. However, in these two cases the Company expects that, so long as the population returns in adequate numbers, it would suffer only the lost interest income on any claims paid until the issuer repaid the Company at some point in the future.
investment in SPS made by the Company in 2004 funded a portion of the $40.0 million payment that was required to be made to the FTC under the terms of the FTC’s settlement agreement with SPS.
In October 2005, the Company sold its investment in SPS to an unaffiliated third party. For its interest in SPS, the Company was paid $42.9 million in cash at closing and expects to receive additional amounts, from time to time through March 31, 2008, out of income earned by SPS through December 31, 2007 from certain of its mortgage servicing activities. Under the sale documents, the Company’s subsidiary that owned the SPS investment made customary representations and warranties to, and undertook specified indemnification obligations for the benefit of, the purchaser. Based on an estimate of the assets retained and liabilities assumed, the Company recorded a $0.4 million loss on the sale of SPS. The Company will continue to evaluate the appropriate carrying value of the liabilities assumed and whether the assets are impaired.
FSA’s 13% investment in preferred shares of XL Financial Assurance Ltd (“XLFA”), a financial guaranty insurance subsidiary of XL, is redeemable by XLFA at a price equal to the fair market value of the preferred shares, subject to a cap defined as the internal rate of return of 19% per annum from the date of the investment through the date of redemption, plus accrued dividends as if 100% of current-year earnings were distributed. Based on this formula, in 2004, the Company adopted a policy of carrying this investment at the lesser of the current calculated redemption value or the redemption value as of the next January first, which would exclude its share of accrued current-year earnings to the extent the cap had been otherwise met. Consistent with this policy, in the third quarter of 2004, the Company charged $11.7 million to equity in earnings of unconsolidated affiliates and reduced its carrying value in this investment to $56.4 million.
In 1998, the Company and XL entered into a joint venture, establishing two Bermuda-domiciled financial guaranty insurance companies-FSA International and XLFA. At December 31, 2004, XL owned a minority interest in FSA International and the Company owned a minority interest in XLFA. In October 2005, FSA purchased all the preferred shares of FSA International owned by XL Insurance (Bermuda), Ltd. for a cash purchase price of $39.1 million in anticipation of the repatriation of earnings and profits of FSA International. Giving effect to such purchase, FSA International became an indirect wholly owned subsidiary of the Company. The preferred shares were Cumulative Participating Voting Preferred Shares that, in total, had a minimum fixed dividend of $1.5 million per annum. In 2005, 2004 and 2003, FSA International paid preferred dividends of $16.3 million, $7.0 million and $3.3 million, respectively, to XL. For the years ended December 31, 2005, 2004 and 2003, the Company recognized minority interest of $6.9 million, $7.0 million and $9.3 million, respectively.
Changes in the fair value of CDS, which were gains of $11.1 million, $56.4 million and $34.8 million for the years ended December 31, 2005, 2004, and 2003, respectively, were recorded in net realized and unrealized gains on derivative instruments in the statements of operations and comprehensive income. The Company included net par outstanding of $66.6 billion and $66.0 billion relating to these CDS transactions at December 31, 2005 and December 31, 2004, respectively, in the asset-backed balances in Note 13. The gains or losses recognized by recording these contracts at fair value are determined each quarter based on
The Company enters into derivative contracts to manage interest-rate and foreign currency exposure in its FP Investment Portfolio, GICs, VIE debt and VIE Portfolio. The derivative contracts are recorded at fair value. These derivatives generally include interest-rate futures and interest-rate and currency swap agreements, which are primarily utilized to convert fixed-rate debt and investments into U.S. dollar floating-rate debt and investments. The gains and losses related to the fair value of derivatives are included in net realized and unrealized gains (losses) on derivative instruments. The inception-to-date net unrealized loss on derivatives used to hedge GIC liabilities and the financial products bond portfolio of $56.9 million and $2.2 million at December 31, 2005 and December 31, 2004, respectively, is recorded in other assets or accrued expenses and other liabilities, as applicable. The inception-to-date net unrealized gain on the outstanding derivatives used to economically hedge the VIE debt and VIE bond portfolio of $433.7 million and $570.8 million at December 31, 2005 and December 31, 2004, respectively, are recorded in other assets and accrued expenses and other liabilities, as applicable.
The credit quality of bonds within the refinanced asset portfolio at December 31, 2005 was as follows:
(1) Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2005.
The amortized cost and fair value of equities held within the refinanced asset portfolio were as follows (in thousands):
The amortized cost and fair value of fixed-income assets within the refinanced asset portfolio at December 31, 2005, are shown below by contractual maturity (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
At December 31, 2005, there were no securities in an unrealized loss position for a continuous 12-month period or longer. The Company determined that there were six securities considered other-than-temporarily impaired. For 2005, a $4.5 million impairment was recorded in the consolidated statements of operations and comprehensive income.
The Company operates in two business segments: financial guaranty and financial products. The financial guaranty segment is primarily in the business of providing financial guaranty insurance on municipal and asset-backed obligations. It also includes the results of the VIEs that were consolidated for the first time in the third quarter of 2003. The FP Segment includes the GIC operations of the Company, which issues GICs to municipalities and other market participants. GICs provide for the return of principal and the payment of interest at pre-specified rates. The following tables summarize the financial
The SFAS 133 fair-value adjustments for CDS are a reconciling item between pre-tax segment operating earnings and net income. In addition, management subtracts the impact of interest-rate derivatives when analyzing the segments, as it believes that, by removing the effect of the one-sided accounting caused by marking the derivatives, but not the hedged assets or liabilities, to fair value, the measure will more closely reflect the underlying performance of segment operations.
The detailed balances that comprise other assets and accrued expenses and other liabilities at December 31, 2005 and 2004 are as follows (in thousands):
In January 2003, the FASB issued FIN 46, which addresses consolidation of VIEs that have one or both of the following characteristics: (a) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity; and (b) the equity investors lack the direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights, the obligation to absorb the expected losses of the entity if they occur or the right to receive the expected residual returns of the entity if they occur. In December 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities, an interpretation of ARB 51” (“FIN 46R”). FIN 46R replaced FIN 46 and is effective for public companies for periods after December 15, 2003. The Company has identified three SPEs that satisfy the consolidation requirements.
FIN 46R requires that, upon consolidation, the Company initially measure the VIE’s assets, liabilities and minority interest at their carrying amounts under existing GAAP as if the entity had been consolidated from the time the Company was considered its primary beneficiary (or parent). The increase in total assets and total liabilities related to the consolidation of these entities was $1.9 billion at July 1, 2003, when they were first consolidated. The difference upon consolidation was reflected as a cumulative effect of a change in accounting principle at July 1, 2003. The cumulative effect of a change in accounting principle for Canadian Global resulted in additional income of $4.8 million, net of income tax. There were no cumulative income statement effects from consolidating FSA Global and Premier. The following table presents the impact of consolidation of the VIEs.
(1) Asset-backed securities consist of floating-rate assets, which are valued using readily available quoted market prices or at amortized cost if there is no readily available valuation. Management believes that amortized cost closely approximates fair value for these securities.
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments (“SFAS 155”). SFAS 155 provides guidance with respect to bifurcation of embedded credit risk in a special purpose entity. The adoption of SFAS 155 is not expected to have a material impact on the Company’s financial position or results of operations.
In November 2005, the FASB issued FASB Staff Position (“FSP”) 115-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” which supersedes certain requirements of EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” and amends SFAS 115 and Accounting Principles Board Opinion (“APB”) 18, “The Equity Method of Accounting for Investments in Common Stocks.” FSP 115-1 outlines a three-step model to identify investment impairments in each reporting period. First, for each reporting period, individual securities are determined to be impaired if the fair value of a security is less than its cost. Second, impaired securities are evaluated as to whether the impairment is other than temporary based on existing applicable guidance. Lastly, if the impairment is other than temporary, an impairment loss is recognized in earnings equal to the difference between the investment’s cost and fair value as of the reporting date. Under FSP 115-1, 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
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123-R, “Share-Based Payment” (“SFAS 123-R”). This Statement is a revision of SFAS 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. SFAS 123-R requires entities to recognize compensation cost for all equity-classified awards after the effective date using the fair-value measurement method. SFAS 123-R is effective for annual periods beginning after June 15, 2005. The adoption of SFAS 123-R is not expected to have a material impact on the Company’s financial position or results of operations.