FSA or its subsidiaries also maintain leased office space in San Francisco, Dallas, Hamilton (Bermuda), London (England), Madrid (Spain), Mexico City (Mexico), Paris (France), Singapore, Sydney (Australia) and Tokyo (Japan). The Company and its subsidiaries do not own any material real property.
The Company’s telephone number at its principal executive offices is (212) 826-0100.
(d) Total claims-paying resources is a term used by Moody’s to evaluate adequacy of claims-paying resources and credit ratings. Moody’s uses its judgment in making adjustments to some of the measures. The Company provides the adjusted balances. This term represents the sum of statutory capital, statutory unearned premium reserve, present value of future net installment premiums, statutory loss reserve, credit available under standby line of credit facility and money market committed preferred trust securities.
Management’s principal business objective is to grow the intrinsic value of the Company over the long term. To this end, it seeks to accumulate an insured portfolio of conservatively underwritten public finance and asset-backed obligations and attractively priced guaranteed investment contracts (“GICs”), in order to produce a reliable, predictable earnings stream. Strategically, the Company seeks to maintain balanced capabilities across domestic and international public finance and asset-backed markets in order to allow the flexibility to pursue the most attractive opportunities available at any point in the business cycle. References to the “Company” are to Financial Security Assurance Holdings Ltd. together with its subsidiaries.
To reflect accurately how management evaluates the Company’s operations and progress toward long-term goals, this discussion employs both measures promulgated in accordance with accounting principles generally accepted in the United States of America (GAAP measures) and measures not so promulgated (non-GAAP measures). Although the measures identified as non-GAAP in this discussion should not be considered substitutes for GAAP measures, management considers them key performance indicators and employs them in determining compensation. Non-GAAP measures therefore provide investors with important information about the way management analyzes its business and rewards performance.
Net premiums earned decreased 3.8% in 2006 and increased 2.3% in 2005. Excluding the effects of refundings and prepayments, net premiums earned decreased 2.8% in 2006 and 0.2% in 2005. 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 decline in net premiums earned reflects a decrease in asset-backed premiums, offset in part by an increase in public finance earned premiums.
For each accounting period, the Company estimates the present value of originations (“PV originations”). This non-GAAP measure consists of the total present value of premiums originated (“PV premiums originated”) by Financial Security Assurance Inc. and its subsidiaries (“FSA”) and the present value of future net interest margin (“PV NIM”) originated by the Company’s financial products (“FP”) business (the “FP Segment”). The Company generated PV originations of $910.2 million in 2006, $1,014.0 million in 2005 and $927.2 million in 2004. Management believes that by disclosing the components of PV originations in addition to premiums written, the Company provides investors with a more comprehensive description of its new business activity in a given period.
Installment premiums are not recorded in the financial statements until due, which is a function of the terms of each insurance policy. Future installment premiums are not captured in premiums earned or premiums written, the most comparable GAAP measures. Management therefore uses PV premiums originated to evaluate current business production.
PV premiums originated reflects estimated future installment premiums discounted to their present value, as well as upfront premiums, for business originated during the reporting 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.
The Company’s U.S. asset-backed gross par insured increased 17.0% in 2006 and decreased 49.7% in 2005. The Company’s associated U.S. PV premiums originated decreased 42.0% in 2006 and 16.6% in 2005. Throughout 2006, the asset-backed market was characterized by tight credit spreads, excess market liquidity and aggressive uninsured structures, which had a negative impact on pricing. Additionally, 2006 originations had shorter average lives. 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 securitization, and other residential mortgage transactions represented most of the decrease in PV premiums originated.
The FP Segment, in which the Company conducts business through affiliates (the “GIC Affiliates”) and variable interest entities (“VIEs”) produces net interest margin (“FP NIM”) rather than insurance premiums. Like installment premiums, the PV NIM originated is expected to be earned and collected in future periods.
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.
Net interest income and net interest expense are reflected in the statements of operations and comprehensive income but are limited to current-year earnings. As GIC contracts extend beyond the current period, management considers the non-GAAP measure PV NIM to be a useful indicator of future FP NIM to be earned and includes it in the non-GAAP measure adjusted book value (“ABV”) as an element of intrinsic value that is not found in GAAP book value.
with the result that the actual timing and amount of repayments may differ from the original estimates, which in turn would affect the realization of the estimate of PV NIM originated in a given accounting period.
In addition to evaluating the Company’s GAAP financial information, management evaluates the Company’s business under certain non-GAAP performance measures that management refers to as operating earnings and ABV. Management uses these two metrics to measure the Company’s performance and to calculate long-term incentive compensation and the annual bonus pool. Management refers to this information in its presentations with rating agencies and the Board of Directors. While these metrics are not substitutes for reported results under GAAP, management regards operating earnings and ABV as meaningful indicators of operational performance that supplement the information available from GAAP measures. While GAAP provides a uniform comprehensive basis of accounting, management believes that operating earnings are an important additional measure for providing a more complete understanding of the Company’s results of operations.
The Company defines operating earnings as net income before the effects of fair-value adjustments for two items:
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, the presentation understates GAAP earnings volatility.
Operating earnings also do not reflect earnings variability related to CDS fair-value adjustments. A significant percentage of the Company’s CDS exposures subject to fair-value adjustments are considered Triple-A or Super Triple-A, and the Company does not intend to trade these highly rated, highly structured contracts. Accordingly, management believes it is probable that the financial impact of the fair-value adjustments for the insured CDS will sum to zero over the finite terms of the exposures, which are typically five to ten years at inception. For this reason, management believes that the market volatility of credit-spread pricing, the primary driver of the Company’s change in fair-value results, should not influence a measure of the Company’s operating performance and therefore excludes CDS fair-value adjustments from operating earnings.
1. addition of unearned premium revenues, net of amounts ceded to reinsurers;
3. addition of the present value of future net interest margin;
Management considers ABV an operating measure of the Company’s intrinsic value. Book value reflects an estimate of loss for all insured risks made at the time of contract origination. ABV adds back certain GAAP liabilities and deducts certain GAAP assets (adjustments 1, 4, 5, 6 and 7 in the calculation above) and also captures the estimated value of future contractual cash flows related to transactions in force as of the balance sheet date (adjustments 2 and 3 in the calculation above) because installment payment contracts, whether in the form of premiums or NIM, are generally non-cancelable and represent a claim to future cash flows. Beginning in 2006, ABV also reflects certain IFRS adjustments in order to better align the interests of employees with the interests of Dexia S.A. (“Dexia”), the Company’s principal shareholder, whose accounts are maintained under IFRS. An investor attempting to evaluate the Company using GAAP measures alone would not have the benefit of this information. In addition, investors may consider the growth of ABV to be a performance measure indicating the degree to which management has succeeded in building a reliable source of future earnings. Certain of the Company’s compensation formulas are based, in part, on the ABV growth rate or ABV growth rate before IFRS adjustments.
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 for investment-grade insured CDS and the effective portion of fair-value adjustments for derivatives that hedge interest rate risk but do not qualify for hedge accounting under SFAS 133.
As discussed above under “New Business Production-Financial Products Originations,” the Company calculates PV NIM originated (adjustment 3) because net interest income and net interest expense reflected in the statements of operations and comprehensive income are limited to current-year earnings. The Company’s future positive interest rate spread from outstanding GIC business can be estimated and generally relates to contracts or security instruments that extend for multiple years. Management therefore includes it in ABV as another element of intrinsic value not found in GAAP book value.
Activity in the liability for losses and loss adjustment expenses, which consists of case and non-specific reserves, is summarized as follows:
offset by transfers from the non-specific reserve to case reserves of $10.5 million. Case reserves increased $8.5 million due primarily to deterioration of specific CDO risks.
is likely to be in a stress scenario. FSA addresses the severity risk in this sector through internal policies that limit exposure to any single credit.
A material adverse change from management’s current estimate of loss for public finance transactions with case reserves is considered unlikely because the largest such case reserve is set near the full policy amount. The additional estimated loss, assuming 75% loss severity, for the health care case reserve is included in the estimated loss above.
FSA management believes that the liability it carries for losses and loss expenses is adequate to cover the net cost of claims. However, the loss liability is based on assumptions regarding the insured portfolio’s
The sensitivities described above are hypothetical and should be used with caution. The effect of variation in a particular assumption is calculated without changing any other assumption; in reality, changes in one factor may result in, or be accompanied by, changes in another, which might magnify or counteract the sensitivities.
In addition, to provide relief to local governments facing difficulties meeting debt service obligations during this recovery period, the State of Louisiana issued an aggregate of $400 million of Gulf Tax Credit and matching State General Obligation Bonds on July 19, 2006. The bond proceeds funded a State Debt Service Assistance Fund to provide loans to help qualifying local governments meet debt service obligations for the next several years. All of the qualifying entities are located in the New Orleans metropolitan area.
Asset-backed transactions insured by FSA, backed by pools of geographically diverse assets, show no unusual concentrations in the affected areas.
Other operating expenses increased 33.1% in 2006, compared with a decrease of 5.5% in 2005. Excluding compensation expenses related to the Company’s deferred compensation and supplemental executive retirement plans, other operating expenses were $110.2 million in 2006, $91.4 million in 2005 and $80.8 million in 2004. The increases in 2006 and 2005 relate primarily to a reduction in deferral rates and increases in personnel costs and premises and equipment expense as a result of the move to the Company’s new headquarters. The Company purchases assets selected by participants in the deferred compensation and supplemental executive retirement plans to economically defease the Company’s liability under these plans. Deferred compensation and supplemental executive retirement plan expenses are recorded in other operating expenses, and the related income on the assets is recorded in other income. Such expenses and income therefore have no effect on net income.
FP spread portfolio NIM, a non-GAAP measure, is defined as the FP Segment net interest margin excluding variable interest entities net interest margin (“VIE NIM”) and fair-value adjustments for economic interest rate hedges. Management uses FP spread portfolio NIM as a key performance measure of the Company’s growing FP business. FP spread portfolio NIM was $68.8 million in 2006, $40.5 million in 2005 and $23.5 million in 2004. The increases in FP spread portfolio NIM were related primarily to growth in the GIC portfolio. FP spread portfolio NIM is comparable to FP operating NIM, which the Company reported for periods prior to December 31, 2006. Beginning in the fourth quarter of 2006, FP Segment reporting includes the results of VIEs, which formerly were reported in the financial guaranty segment.
Net realized interest income and expense associated with economic interest rate hedges are recorded in realized and unrealized gains and losses on derivative instruments and are added back to calculate FP spread portfolio NIM. Derivatives that qualify for hedge accounting are classified in the consolidated statements of operations and comprehensive income with the underlying item being hedged. Gains and losses on derivatives that do not qualify for hedge accounting are shown under the caption net realized and
Intersegment income relates primarily to intercompany notes held in the FP Investment 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 5 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 Segment NIM, but is eliminated from the consolidated Total NIM.
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. Fair value is determined based on quoted market prices, if available. If quoted market prices are not available, as is primarily the case 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 unrealized 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
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. Hedge accounting is applied to certain interest rate swaps used to hedge the GIC liabilities.
Income from assets acquired in refinancing transactions, excluding realized gains or losses, was $24.7 million in 2006, $35.2 million in 2005 and $31.6 million in 2004. The increase in 2005 reflects the impact of a full year of income from transactions that were refinanced at various times during 2004, while 2006 reflects lower invested balances due to paydowns and dispositions of assets within this portfolio.
$11.2 million related to this asset and liability. The Company will continue to evaluate the appropriate carrying value of the liabilities assumed.
FSA has an investment in TheMuniCenter with a fair value of $3.2 million at December 31, 2006 and $6.0 million at December 31, 2005. The Company wrote down the value of TheMuniCenter in the third quarter of 2006 by $3.0 million. The MuniCenter is an electronic municipal bond trading platform though which FSA provides secondary-market bond insurance.
The Company’s effective tax rates were 28.8% in 2006, 27.3% in 2005 and 19.0% in 2004. The 2006 rate differs from the statutory rate of 35% due primarily to tax-exempt interest and minority interest. In 2005, the rate differed from the statutory rate of 35% due primarily to tax-exempt interest, minority interest, the Company’s reorganization of Financial Security Assurance International Ltd. (“FSA International”) and its intention to repatriate FSA International’s future earnings. The 2004 rate differed from the statutory rate of 35% primarily due to tax-exempt interest, income from FSA International, minority interest, the White Mountains indemnity payment (see below) and the expected repatriation of earnings of FSA International in 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 2005 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 (a) 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 (b) $14.2 million related to 2005 earnings.
(2) Amounts include future implied interest accretion on zero-coupon obligations and future interest payments. Foreign amounts are calculated using spot rates as of December 31, 2006. Future interest payments are assumed to be at the rates in effect as of December 31, 2006 for floating rate debt.
Downgrades of FSA’s Triple-A financial strength ratings would adversely affect FSA’s ability to compete for business. Credit ratings are an important component of a financial institutions’ ability to compete in the financial guaranty, derivative, investment agreement and structured transaction markets. If FSA were downgraded, FSA might be required to post incremental collateral to its investment agreement
and derivative counterparties, introducing liquidity risk. In addition, most investment agreements provide certain remedies for the investment agreement purchaser in the event of a downgrade of FSA’s credit rating, typically below Aa3 by Moody’s or AA- by S&P. Such remedies include termination of the investment agreement contract. In most cases FSA is permitted to post collateral or otherwise enhance its credit prior to an actual termination of the investment agreement.
On November 22, 2006, FSA Holdings issued $300.0 million principal amount of Junior Subordinated Debentures with a scheduled maturity date of December 15, 2036 and a final repayment date of December 15, 2066. The final repayment date of December 15, 2066 may be automatically extended up to four times in five-year increments provided certain conditions are met. The debentures are redeemable, in whole or in part, at any time prior to December 15, 2036 at their principal amount plus accrued and unpaid interest to the date of redemption. Interest on the debentures will accrue from November 22, 2006 to December 15, 2036 at the annual rate of 6.40%. If any amount of the debentures remains outstanding after December 15, 2036, then the principal amount of the outstanding debentures will bear interest at a floating interest rate equal to one-month LIBOR plus 2.215% until repaid. FSA Holdings may elect at one or more times to defer payment of interest on the debentures for one or more consecutive interest periods that do not exceed ten years. In connection with the completion of this offering, FSA Holdings entered into a replacement capital covenant for the benefit of persons that buy, hold or sell a specified series of FSA Holdings long-term indebtedness ranking senior to the debentures. Under the covenant, the debentures will not be repaid, redeemed, repurchased or defeased by FSA Holdings or any of its subsidiaries on or before the date that is 20 years prior to the final repayment date, except to the extent that FSA Holdings has received proceeds from the sale of replacement capital securities. The proceeds from this offering were used to pay a dividend to the shareholders of FSA Holdings.
On November 26, 2002, FSA Holdings issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt. FSA Holdings used a portion of the proceeds of this issuance to redeem in whole FSA Holdings’ $130.0 million principal amount of 7.375% Senior QUIDS due September 30, 2097.
On December 19, 2001, FSA Holdings issued $100.0 million of 67¤8% Quarterly Income Bond Securities due December 15, 2101, which are callable without premium or penalty on or after December 19, 2006. Debt issuance costs of $3.3 million are being amortized over the life of the debt.
FSA’s primary uses of funds are to pay operating expenses and to pay dividends to, or pay interest or principal on surplus notes held by, its parent FSA Holdings. FSA’s funds are also required to satisfy claims under insurance policies in the event of default by an issuer of an insured obligation and the unavailability or exhaustion of other payment sources in the transaction, such as the cash flow or collateral underlying the obligations. FSA seeks to structure asset-backed transactions to address liquidity risks by matching insured payments with available cash flow or other payment sources. Insurance policies issued by FSA guaranteeing payments under bonds and other securities provide, in general, that payments of principal, interest and other amounts insured by FSA may not be accelerated by the holder of the obligation but are paid by FSA in accordance with the obligation’s original payment schedule or, at FSA’s option, on an accelerated basis. Insurance policies issued by FSA guaranteeing payments under CDS may provide for acceleration of amounts due upon the occurrence of certain credit events subject to single-risk limits specified in the New York Insurance Law. These policy provisions prohibiting or limiting acceleration of certain claims are mandatory under Article 69 of the New York Insurance Law and serve to reduce FSA’s liquidity requirements.
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 $1,328.3 million at December 31, 2006. 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, 2006.
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 $1.0 million for 2006 and $1.3 million for 2005 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 Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (revised December 2003) (“FIN 46-R”) 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 Investors Service, Inc. (“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.
any time. In recent years, a number of Triple-A rated reinsurers employed by FSA have been downgraded by S&P. Downgrade of these reinsurers by S&P to the Double-A category resulted in a decline in the credit allowed for reinsurance by S&P from 100% to 70% or 65% under present criteria. While a downgrade by S&P of all reinsurers to the Double-A category would not impair FSA’s Triple-A ratings, it would reduce the “margin of safety” by which FSA would survive a theoretical catastrophic depression modeled by S&P. A reduction by S&P in credit for reinsurance used by FSA would also be expected ultimately to reduce the Company’s return on equity to the extent that ceding commissions paid to FSA by such reinsurers were not increased to compensate for such reduction. FSA employs considerable reinsurance in its business to manage its single-risk exposures on insured credits. Any material increase in capital charges by S&P on FSA’s insured portfolio would likewise be expected to have an adverse effect on FSA’s margin of safety under the S&P capital adequacy model and, ultimately, the Company’s return on equity. The Company may seek to raise additional capital to replenish capital eliminated by any of the rating agencies in their assessment of FSA’s capital adequacy.
The Company incurred approximately $3.4 million in capital expenditures in 2006 for leasehold improvements, furniture and fixtures, which were funded from cash flows from operations.
The Company received no tax benefits in 2006 or 2005 and received tax benefits of $1.2 million in 2004 from its parent company, which was recorded as a capital contribution. See Note 12 for disclosure of non-cash transactions relating to restricted treasury stock transactions.
Financial guaranty insurance written by the Company guarantees scheduled payments on an issuer’s obligation. In the case of 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.
(revised December 2003) (“FIN 46-R”). The Company also consolidates Premier as a result of obtaining control rights.
On July 5, 2000, the Company completed a merger in which 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, 2006, Dexia Holdings owned over 99% of FSA Holdings outstanding shares; the only other holders of FSA Holdings common stock were certain current and former directors of FSA Holdings who owned shares of FSA Holdings common stock or economic interests therein under the Director Share Purchase Program (see Note 12). During 2006, Dexia purchased all the shares previously owned by an affiliate of White Mountains Insurance Group, Ltd. (“White Mountains”).
Variable rate demand notes (“VRDNs”) are included in bonds in the General Investment Portfolio. Auction rate securities (“ARS”) are included in bonds in the FP Segment Investment Portfolio. The FP Segment Investment Portfolio consists of investments supporting GIC liabilities (“FP Investment Portfolio”) and investments supporting VIE liabilities (“VIE Investment Portfolio”). The FP Investment Portfolio includes securities classified as trading securities.
VRDNs are long-term bonds that bear floating interest rates and provide investors with the option to tender or put the bonds at par, generally on a daily, weekly or monthly basis. ARS are long-term securities with interest rate reset features and are traded in the marketplace through a bidding process. The cash flows related to these securities are presented on a gross basis in the consolidated statements of cash flows.
Mortgage loans are carried at the lower of cost or market on an aggregate basis. Realized gains or losses on sale of investments are determined on the basis of specific identification. Investment income is recorded as earned. Other-than-temporary impairments are reflected in earnings as a realized loss.
Investments in unconsolidated affiliates are based on the equity method of accounting (see Note 3). The Company records its share of unrealized gains or losses of unconsolidated affiliates, net of applicable deferred taxes, in other comprehensive income.
The Company enters into derivative contracts to manage interest rate and foreign currency risks associated with the Company’s GIC and VIE debt and FP Segment Investment Portfolio. The derivatives are recorded at fair value and generally include interest rate futures and interest rate and currency swap agreements, which are primarily utilized to convert the Company’s fixed rate GIC and VIE debt and FP Segment Investment Portfolio into U.S.-dollar floating rate assets and liabilities. The gains and losses relating to derivatives not designated as fair-value hedges are included in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income.
The 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 record earned premiums over the installment period, 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 either 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, as is generally the case, management uses internally developed estimates of fair value. 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 the Company’s ability to obtain reinsurance for its insured obligations. 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. It is the Company’s policy to take possession of securities borrowed under agreements to resell.
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 Company establishes a case reserve for the present value of the estimated loss, net of subrogation recoveries, when, in management’s opinion, the likelihood of a future loss on a particular insured obligation is probable and reasonably estimable at the balance sheet date. When an insured obligation has met the criteria for establishing a case reserve and that transaction pays a premium in installments, those premiums, if expected to be received prospectively, are considered a form of recovery and are no longer earned as premium revenue. A case reserve is determined using cash flow or similar models that represent the Company’s estimate of the net present value of the anticipated shortfall between (1) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (2) anticipated cash flow from and proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries. The estimated loss, net of recovery, on a transaction is discounted using the risk-free rate appropriate for the term of the insured obligation at the time the reserve is established and is not subsequently adjusted.
The non-specific reserve established considers all levels of protection (e.g., reinsurance and overcollateralization). Net par outstanding for policies originated in the current period is multiplied by loss frequency and severity factors, with the resulting amounts discounted at the risk-free rates using the treasury yield curve (the “statistical calculation”). The discount rate does not change and is used to accrete the loss for the life of each policy. The loss factors used for the calculation are the product of default frequency rates obtained from Moody’s and severity factors obtained from S&P. Moody’s is chosen for default frequency rates due to its credibility, large population, statistical format and reliability of future update. The Moody’s default information is applied to all credit sectors or asset classes as described below. In its publication of default rates for bonds issued from 1970-2005, Moody’s tracks bonds over a 20-year horizon by credit rating at time of issuance. For the purpose of establishing appropriate severity factors, the Company’s methodology segregates the portfolio into asset classes, including health care transactions, all other public finance transactions, pooled corporate transactions, commercial real estate, and all other asset-backed transactions. The severity factors are derived from capital charge assessments provided by S&P. S&P capital charges project loss levels by asset class and are incorporated into their capital adequacy stress scenario analysis.
The present value of loss amounts calculated for the current-year originations is established at inception of each 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.
Since the non-specific reserve contains the inherent losses of the portfolio, when a case reserve adjustment is deemed appropriate, whether the result of adverse or positive credit developments, accretion or the addition of a new case reserve, a full transfer is made between the non-specific reserve and the case reserve balances with no effect to income. The adequacy of the non-specific reserve balance is reviewed periodically and at least annually. Such analyses are performed to quantify appropriate adjustments that may be either charges or benefits on the consolidated statements of operations and comprehensive income, as occurred in 2004.
The table below presents the significant assumptions inherent in the calculations of the case and non-specific reserves.
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 obligations, contains probable and reasonably estimable losses.
Deferred acquisition costs comprise expenses primarily related to the production of business, including commissions paid on reinsurance assumed, compensation and related costs of underwriting and marketing personnel, certain rating agency fees, premium taxes and certain other underwriting expenses, reduced by ceding commission received on premiums ceded to reinsurers. Deferred acquisition costs are amortized over the period in which the related premiums are earned. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred acquisition cost is recognized. A premium deficiency would be recognized if the present value of anticipated losses and loss adjustment expenses exceeded the sum of deferred premium revenue and estimated installment premiums.
reported amounts in the financial statements that will result in deductible or taxable amounts in future years when the reported amounts of assets and liabilities are recovered or settled.
The degree of influence exercised by FSA over these special purpose entities varies from transaction to transaction, as does the degree to which “risks and rewards” associated with asset performance are assumed by FSA.
FIN 46-R 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 and do not have the obligation to absorb the expected losses of the entity if they occur or the right to receive the expected residual returns of the entity if they occur. In analyzing special purpose entities described above, the Company considers reinsurance to be an implicit variable interest. Where the Company determines it is required to consolidate the special purpose entity, the outstanding exposure is excluded from Note 10.
On September 15, 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), which addresses how companies should measure fair value when required to use fair value measures for recognition or disclosure purposes under GAAP. SFAS 157 adopted an “exit price” approach to determining fair value and established a three-level fair value hierarchy to prioritize the inputs used in valuation techniques. Level 1 is the highest priority and is defined as observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 is defined as inputs other than quoted prices included in Level 1 that are observable for the asset or liability through corroboration with observable market data. Level 3 is the lowest priority and is defined as a valuation based on unobservable inputs such as a company’s own data. Prioritization of inputs, as well as other considerations, determine the level of disclosure required. SFAS 157 is applicable to financial statements issued for fiscal years beginning after November 15, 2007 and for interim periods within those fiscal years. The Company is in the process of evaluating the impact of SFAS 157 on its financial statements.
In February 2007, The FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits reporting entities to choose to measure at fair value many financial instruments and certain other items that are not currently required to be measured at fair value. The fair value option may be applied instrument by instrument, is irrevocable and is applied only to entire instruments and not to portions of instruments. SFAS 159 is effective for fiscal years beginning after November 15, 2007. Early adoption is permitted, under certain circumstances, provided the provisions of SFAS 157 are also applied. The Company is currently evaluating the implication of SFAS 159 for its financial statements.
Bonds and short-term deposits at an amortized cost of $10.5 million and $9.9 million at December 31, 2006 and 2005, respectively, were on deposit with state regulatory authorities as required by insurance regulations.
The amortized cost and fair value of the bonds in the General Investment Portfolio were as follows:
At December 31, 2006, there were 451 investments in fixed-income securities for which amortized cost exceeded fair value; the aggregate amount of the excess over fair value was $9.8 million, or 1.5%. At December 31, 2005, there were 616 such investments, for which the aggregate amount of the excess over fair value was $17.9 million, or 1.8%. Management has determined that the unrealized losses in fixed income securities at December 31, 2006 are primarily attributable to the current interest rate environment and has concluded that these unrealized losses are temporary in nature based upon (a) no principal and interest payment defaults on these securities; (b) analysis of the creditworthiness of the issuer; and (c) FSA’s ability and current intent to hold these securities until a recovery in fair value or maturity. There were no individual securities with material unrealized losses as of December 31, 2006 and 2005. As of December 31, 2006 and 2005, 100% of the securities that were in a gross unrealized loss position were rated investment grade.
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
FSA’s investment in preferred shares of XL Financial Assurance Ltd (“XLFA”), a financial guaranty insurance company and indirect 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.
Of the bonds included in the FP Investment Portfolio, 4.4% were Triple-A by virtue of insurance provided by FSA. Over 97% 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 Triple-B 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, 2006:
Proceeds from sales of bonds held in the FP Investment Portfolio during 2006, 2005 and 2004 were $4,512.5 million, $5,635.3 million and $2,511.8 million, respectively. Proceeds from maturities of bonds for
the FP Investment Portfolio during 2006, 2005 and 2004 were $4,485.1 million, $1,422.0 million and $65.7 million, respectively. Gross gains of $0.1 million were realized on sales in 2006. 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.
On April 28, 2006, the Company increased its ownership of the ordinary shares of FSA Global from 29% to 49% through an acquisition of shares from an unaffiliated third party. Immediately thereafter, FSA Global’s charter documents were amended to create a new class of non-voting preference shares, all of which were issued to the Company. Holders of such preference shares have exclusive rights to any future dividends and, upon any winding up of FSA Global, all net assets available for distribution to shareholders (after a distribution of $250,000 to the ordinary shares). As a result of the issuance of such preference shares, (a) a substantive sale and purchase of an interest took place between the ordinary shareholders of FSA Global and the Company, resulting in an assessment and recording of the fair value of the assets and liabilities sold and purchased at the time of such transaction, and (b) the Company’s minority interest liability associated with FSA Global was eliminated. In the second quarter of 2006, the Company realized a pre-tax gain of $1.8 million as a result of this transaction.
The amortized cost and fair value of bonds in the VIE Investment Portfolio were as follows:
(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.
The amortized cost and fair value of bonds in the VIE Investment Portfolio at December 31, 2006, by contractual maturity, are shown below. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
In the normal course of business, the Company may hold securities purchased under agreements to resell. A portion of these securities may be pledged to the Company’s investment agreement counterparties (including counterparties with agreements structured as investment repurchase agreements). However, such securities generally may not be rehypothecated by the investment agreement counterparty. The Company also pledges investments held in the FP Investment Portfolio to investment agreement counterparties. At December 31, 2006, $4.7 billion of the assets held in its FP Investment Portfolio and related accrued interest were pledged as collateral to investment agreement counterparties. In addition, substantially all the assets of FSA Global are pledged to secure the repayment, on a pro rata basis, of FSA Global’s notes and its other obligations.
Securities purchased under agreements to resell are eligible to be pledged to certain interest rate swap counterparties. In general, under the terms of each of these counterparty-specific derivative agreements, the Company and its counterparty may be required to pledge collateral or transfer assets as a result of changes in the fair value of those derivative agreements. The timing and amount are generally dependent on which entity is exposed as well as the credit rating of the party in the payable position. The Company and the counterparty typically have identical rights and obligations to pledge and rehypothecate collateral according to the terms included within each of the counterparty-specific derivative agreements. At December 31, 2006, $7.3 million of the assets held in the FP Investment Portfolio and related accrued interest were pledged as collateral to margin accounts. FSA Global, under the terms of its derivative agreements, is not required to pledge collateral. Its counterparties, however, may be required to pledge collateral or transfer assets to FSA Global. FSA Global is not permitted to rehypothecate any such collateral or assets.
The amortized cost and fair value of equities held within the refinanced asset portfolio were as follows:
Activity in the liability for losses and loss adjustment expenses, which consists of the case and non-specific reserves, is summarized as follows:
The gross and net par amounts outstanding on transactions with case reserves were $483.4 million and $399.6 million, respectively, at December 31, 2006. The net case reserve consisted primarily of five CDO risks and two municipal risks, which collectively accounted for approximately 94.9% of the total net case reserve. The remaining eight risks were in various sectors.
During 2006, the Company charged $23.3 million to loss expense, consisting of $17.8 million for originations of new business and $5.5 million related to accretion on the reserve for in-force business. Net case reserves decreased $0.7 million due primarily to loss payments and some improvement in the CDO transactions, offset in part by the establishment of a new case reserve for a municipal health care transaction.
During 2005, the Company charged $25.4 million to loss expense, consisting of $20.4 million for originations of new business and $5.0 million related to accretion on the reserve for in-force business. The non-specific reserve increased $16.4 million in 2005, due primarily to loss expense of $25.4 million, partially offset by transfers from the non-specific reserve to case reserves of $10.5 million. Net reserves increased $8.5 million due primarily to deterioration of specific CDO risks.
During 2004, the Company charged $20.6 million to loss expense, consisting of $20.4 million for originations of new business, $4.6 million for accretion related to prior years and $3.2 million related to reassumptions of previously ceded business, offset by reserve releases related primarily to a large refinancing transaction in 2004.
In September 2004, FSA exercised its rights to have the collateral of a defaulted collateralized bond obligation liquidated at a public sale, in which the Company offered the highest bid. The Company acquired the collateral to gain control of the portfolio in order to mitigate future losses. The previously established case reserve was drawn down to reflect the excess of the purchase amount over the fair value of the collateral. The remaining $9.5 million balance in the case reserve related to this transaction was returned to the non-specific reserve. After reevaluating its requirements for the CDO portion of the non-specific reserve, the Company then reduced the non-specific reserve by $9.5 million, which was partially offset by normal reserve additions. The net amount transferred from case reserves to the non-specific reserve was $1.4 million, which also included a transfer from the non-specific reserve to a case reserve for a municipal utility transaction. The CDO portfolio continues to perform within the expectations reflected in previously recorded provisions for CDOs.
Since case and non-specific reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates. The Company will continue, on an ongoing basis, to monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company’s actual loss experience, its future mix of business and future economic conditions.
FSA-insured bonds are protected by various sources of support that would be invoked before FSA would incur losses. These sources include access to pledged taxes or revenues, reserve funds, property and casualty insurance and state and federal monies. The issuers of these insured bonds have generally continued to improve financially and management does not expect that FSA will sustain permanent losses.
The loss estimation process involves the exercise of considerable judgment and therefore FSA’s ultimate 2005 hurricane-related losses may be materially different from the current estimate and may affect future operating results.
The obligations under GICs issued by the GIC Affiliates may be called at various times prior to maturity based on certain agreed-upon events. As of December 31, 2006, interest rates were between 1.6% and 6.1% per annum on outstanding GICs and between 1.98% and 6.20% per annum on VIE debt. Payments due under GICs are based on expected withdrawal dates and exclude negative hedge accounting adjustments and prepaid interest of $77.6 million, and include accretion of $899.5 million. VIE debt excludes fair-value adjustments of $146.3 million and includes $1,042.1 million of future interest accretion on zero-coupon obligations. The following table presents the combined principal amounts due under GICs and VIE debt for 2007 and each of the next four years ending December 31, and thereafter:
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.
The net par outstanding as of December 31, 2006 and 2005 and the contractual terms to maturity are as follows:
(2) Excludes intercompany insurance of $16,558 million in 2006 and $13,463 million in 2005 relating to FSA-insured GICs issued by the GIC Affiliates.
The net par outstanding of insured obligations in the public finance insured portfolio includes the following amounts by type of issue:
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 at December 31, 2004.
In 2004, the Company adopted the 2004 Equity Participation Plan (the “2004 Equity Plan”), which continues the incentive compensation program formerly provided under the Company’s 1993 Equity Participation Plan. The 2004 Equity Plan provides for performance share units comprised 90% of performance shares (which provide for payment based upon the Company’s performance over two specified three-year performance cycles) and 10% of shares of Dexia restricted stock. Performance shares have generally been awarded on the basis of two sequential three-year performance cycles, with one-third of each award allocated to the first cycle, which commences on the date of grant, and two-thirds of each award allocated to the second cycle, which commences one year after the date of grant. The total number of performance shares authorized under this plan was 3.3 million. At December 31, 2006, 2.7 million performance shares remained available for distribution.
At December 31, 2006, 364,510 outstanding performance shares were fully vested, with a value of $61.9 million. These amounts were paid in the first quarter of 2007. At December 31, 2006, the total compensation cost related to non-vested performance shares not yet recognized was $73.9 million. This amount is expected to be recognized as an expense over a weighted-average period of 1.14 years.
The estimated final cost of these performance shares is accrued over the performance period. The after-tax expense for the performance shares was $39.2 million, $36.3 million and $47.6 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Awards of Dexia restricted stock remain restricted for an additional six months after the end of the last year of each vesting period. Shares of Dexia restricted stock purchased under the 2004 Equity Plan are as follows:
In the fourth quarter of 2000, the Company purchased 304,757 shares of its common stock from Dexia Holdings for $24.0 million. Additional purchases are intended to fund obligations relating to the Company’s Director Share Purchase Program (“DSPP”), which enables its participants to make deemed investments in the Company’s common stock under the Deferred Compensation Plan and Supplemental Executive Retirement Plan. Under the DSPP, the deemed investments in the Company’s stock are irrevocable, settlement of the deemed investments must be in stock and, after receipt, the participants must generally hold the stock for at least six months. Restricted treasury stock is distributed to a director as a DSPP payout at the end of applicable restriction periods.
The Company purchased and distributed shares of its common stock under the DSPP in the following amounts:
Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” did not have any impact on the consolidated statements of operations and comprehensive income.
FSA has insured a number of CDS with the expectation that these transactions will not be subject to a market value termination for which the Company would be liable. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes and therefore are recorded at fair value. The Company recorded $87.2 million, $89.2 million and $69.1 million of net earned premium under these agreements for the years ended 2006, 2005 and 2004, respectively.
Changes in the fair value of CDS, which were gains of $31.8 million, $11.1 million and $56.4 million for the years ended December 31, 2006, 2005, and 2004, respectively, were recorded in net realized and unrealized gains on derivative instruments in the consolidated statements of operations and comprehensive income. The Company’s net par outstanding of $74.7 billion and $66.6 billion relating to these CDS transactions at December 31, 2006 and December 31, 2005, respectively, are included in the asset-backed insured balances in Note 10. The Company does not believe that the fair-value adjustments are an indication of potential claims under FSA’s guarantees or an indication of potential gains to be realized from the derivative transactions. The average remaining life of these contracts at December 31,
2006 was 3.1 years. The inception-to-date gain on the balance sheet was $89.2 million at December 31, 2006 and $57.4 million at December 31, 2005, and was recorded in other assets.
The Company enters into various other derivative contracts that do not qualify for hedge accounting treatment. These derivatives include swaptions, caps and other derivatives, which are used principally as protection against large interest rate movements. Gains and losses on these derivatives are reflected in net realized and unrealized gains (losses) on derivative instruments in the statements of operations and comprehensive income.
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 and 2004, FSA International paid preferred dividends of $16.3 million and $7.0 million, respectively, to XL. For the years ended December 31, 2005 and 2004, the Company recognized minority interest of $6.9 million and $7.0 million, respectively.
The detailed balances that comprise other assets and accrued expenses, other liabilities and minority interest at December 31, 2006 and 2005 are as follows:
Rent expense was $10.7 million in 2006, $10.1 million in 2005 and $7.8 million in 2004. Rent expense in 2005 includes a $1.2 million lease termination fee related to the Company’s former headquarters.
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 (the “New York Superintendent”) or (b) adjusted net investment income during this period. FSA paid $140.0 million of dividends in 2006, $87.0 million in 2005 and $30.0 million in 2004. Based upon FSA’s statutory statements for December 31, 2006, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the following 12 months would be approximately $156.6 million.
FSA Holdings paid dividends of $530.0 million in 2006, $71.1 million in 2005 and $22.9 million in 2004.
FSA has a credit arrangement aggregating $150.0 million that is provided by commercial banks and intended for general application to insured transactions. 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 December 31, 2006, there were no borrowings under this arrangement, which expires on April 21, 2011, if not extended.
FSA has a standby line of credit commitment in the amount of $350.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $350.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $1,328.3 million at December 31, 2006. The obligation to repay loans made under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a term expiring on April 30, 2015 and contains an annual renewal provision, commencing April 30, 2008, subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2006.
The Company operates in two business segments: financial guaranty and financial products. The financial guaranty segment is primarily in the business of providing financial guaranty insurance on public finance and asset-backed obligations. The FP Segment includes the GIC operations of the Company, which issues GICs to municipalities and other market participants. GICs provide for the return of principal and the payment of interest at pre-specified rates. Reflecting the Company’s management of the VIEs’ operations, the results of the VIEs are included in the FP Segment beginning in 2006. Prior-year disclosures have been reclassified to conform to the 2006 presentation. The following tables summarize the financial information by segment as of and for the years ended December 31, 2006, 2005 and 2004:
The following tables present reconciliations of segments’ pre-tax operating earnings to net income.
The amount of SFAS 133 fair-value adjustments for CDS is a reconciling item between pre-tax segment operating earnings and net income. In addition, management subtracts the impact of economic interest rate hedges when analyzing the segments. By removing the effect of the one-sided accounting caused by marking the derivatives to fair value, but not the hedged assets or liabilities, the measure will more closely reflect the underlying performance of segment operations.
The table below summarizes amounts included in the financial statements and outstanding exposures resulting from various types of transactions executed with related parties:
(1) The Company ceded business to XL Capital Ltd. (“XL”), a major Bermuda-based insurance holding company that owned an interest in FSA International prior to October 2005. The Company maintains an investment in XLFA, an indirect subsidiary of XL.
For bonds and equity securities in the General Investment Portfolio and the FP Segment Investment Portfolio, the carrying amount represents fair value. The fair value is generally based on quoted market price or, in the case of the Company’s investment in XLFA, redemption value.
For short-term investments, including the FP short-term investment portfolio and the VIE short-term investments, the carrying amount 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 inception. 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 the premiums retained by the Company to compensate it for originating and servicing the insurance contract.
For installment premiums, consistent with industry practice, there is no carrying amount. Similar to the treatment of deferred premium revenue, the fair value of installment premiums is the estimated present value of the future contractual premium revenues that would be received from reinsurers assuming
the Company’s financial guaranty risk, net of the premium retained by the Company to compensate it for originating and servicing the insurance contract.
For GICs and VIE debt, the fair value is the present value of the expected cash flows as of the reporting date.
The table below shows the carrying amount and fair value of the Company’s financial instruments:
· certain assets designated as “non-admitted assets” are charged directly to statutory surplus but are reflected as assets under GAAP;
· deferred tax assets are generally admitted to the extent reversals of existing temporary differences in the subsequent year can be recovered through carryback;
· bonds are carried at amortized cost rather than fair value;
· non-insurance company subsidiaries do not prepare accounts applying statutory accounting standards.