The Company's operations during 2000 began well as Commercial Guaranty Assurance wrote $4 million in gross premiums during the first quarter. However, on March 7, 2000, Fitch announced the intended acquisition of Duff & Phelps Credit Rating Co. and completed it on April 12, 2000. The companies were subsequently merged, with Fitch as the surviving company. Although Duff & Phelps rated Commercial Guaranty Assurance's claims paying ability "AAA", Fitch did not previously rate Commercial Guaranty Assurance. On June 2, 2000, Fitch placed Commercial Guaranty Assurance's "AAA" rating on general review for possible downgrade, on the basis that Commercial Guaranty Assurance did not meet Fitch's minimum capital requirements of $500 million for a "AAA" rating. This announcement significantly curtailed Commercial Guaranty Assurance's ability to write new business.
CGA Group commenced efforts to raise the requisite incremental capital, engaging the investment banking firm of Credit Suisse First Boston Corporation to act as its exclusive financial advisor. In December 2000, CGA Group entered into a letter of intent with a major U.S. financial institution as lead investor, pursuant to which that lead investor agreed, subject to the terms and conditions set out in the letter of intent, to invest along with other investors sufficient incremental capital to meet Fitch's requirements for Commercial Guaranty Assurance to maintain its AAA financial strength rating. On March 13, 2001, this lead investor advised Commercial Guaranty Assurance and Fitch that it did not intend to proceed with the proposed transaction. As a result, Fitch downgraded Commercial Guaranty Assurance's financial strength rating to AA on March 14, 2001. Commercial Guaranty Assurance's rating from Fitch remains on "Rating Watch Negative".
In its press release announcing the downgrade, Fitch stated that " . . . [t]he lead investor told Fitch that market conditions were the reasons for its decision, and not anything to do with [Commercial Guaranty Assurance]. However, without the lead investor's involvement, the likelihood at this time of the deal going forward is sufficiently uncertain to warrant a downgrade of [Commercial Guaranty Assurance's] insurer financial strength rating to `AA'. [Commercial Guaranty Assurance] remains on Rating Watch Negative. While the downgrade of Commercial Guaranty Assurance to below `AAA' triggers the funding of a $60 million capital commitment by its owners within 45 days, the company must now develop an operating and capital plan consistent with an `AA' rated financial guarantor. Fitch is particularly concerned with [CGA Group's] capital structure, which includes [Series A Preferred Stock] that is currently scheduled to receive annual cash dividend payments of approximately $17.5 million per year beginning in June 2002. Over the next several months, one of the focal points of Fitch's review will be on [Commercial Guaranty Assurance's] plan to maintain capital adequacy consistent with an `AA' rated financial guarantor, which could include a restructuring of the [Series A Preferred Stock]".
The Company will continue to work with its financial advisor, Credit Suisse First Boston, to attempt to structure a financial transaction that will either warrant an upgrade of Commercial Guaranty Assurance's financial strength rating from Fitch back to `AAA', or that will at least satisfy Fitch's concerns regarding the Company's Series A Preferred Stock dividend structure and permit Commercial Guaranty Assurance to operate as a `AA' rated financial guarantor going forward. As of the date of this report, no assurance can be given as to whether or not the Company will be successful in these efforts. See "Liquidity and Capital Resources" below.
Also during 2000, CGA Investment Management was successful in completing a repackaging of securities totaling $439.4 million that had previously been financed with credit facilities guaranteed by Commercial Guaranty Assurance. This repackaging resulted in the elimination of short-term debt on the books of the insured clients and replaced it with financing that matched the lives of the repackaged securities. This repackaging provides liquidity to Commercial Guaranty Assurance's clients and will continue to provide revenue to the Company.
The net premiums earned in 1999 of $12.2 million were derived from $16.3 million of gross premiums written, of which $2.0 million were ceded under reinsurance agreements, and offset by a $2.1 million change in unearned premiums. Ceded premiums in 1999 were affected by approximately $1.0 million of charges due to the recognition of prepaid reinsurance premiums related to Commercial Financial Services securities. As a result of claims paid in 1999 related to the Commercial Financial Services securities by Commercial Guaranty Assurance's reinsurer, the reinsured exposure decreased from approximately $154 million to approximately $58 million, thereby requiring early recognition of the $1.0 million charge. Commercial Guaranty Assurance paid an up-front premium of $1.3 million for the reinsurance in October 1998. Most of the increase in unearned premiums during 1999 was from one transaction for which Commercial Guaranty Assurance received an up-front premium of approximately $1.8 million, of which only $11 thousand was earned in 1999. Net premiums earned increased by approximately $3 million, or 32% for 1999 compared to 1998. The increase was primarily the result of a 43% increase in insurance in force as of December 31, 1999 compared to December 31, 1998.
The decrease in investment management fees earned as a percentage of assets under management is attributable to clients of CGA Investment Management having resecuritized approximately $1.5 billion in assets over the period between September 1998 and September 2000. The asset management fees earned from these resecuritization transactions are lower than the asset management fees earned while these assets remained in such clients' investment portfolios. In addition, at the request of certain clients, during 1999, CGA Investment Management reduced the amount of the asset management fee by 60% from 25 basis points to 10 basis points to assist them with the liquidity difficulties discussed above.
"AAA" ........................ 4% 4% 4% "AA" ......................... 14% 2% 3% "A" .......................... 26% 25% 12% "BBB" ........................ 45% 58% 67% "BB" ......................... 10% 9% 11% Not rated .................... 1% 2% 3% ---- ---- ---- Total ........................ 100% 100% 100% ==== ==== ====
The credit quality of the portfolio improved slightly during 2000 and 1999 as non-investment grade exposure decreased from 14% at December 31, 1998 to 11% at December 31, 1999 and 2000. Exposure to securities rated "A" or better increased to 44% of the portfolio at December 31, 2000 from 31% at December 31, 1999.
Net investment income was $9.3 million for the year ended December 31, 2000, $8.6 million for 1999, and $8.5 million for the period ended December 31, 1998. Net investment income is presented after deducting the cost of external investment management and custodial fees that totaled $0.2 million in 2000, $0.1 million for 1999 and $0.3 million for 1998. Commencing in September 1998, Commercial Guaranty Assurance modified its investment strategy to have the investment portfolio closely match the returns of a "Double-A" or better three to five year Eurodollar bond index. This strategy results in a less actively managed portfolio, which resulted in the management fee being reduced by approximately twenty basis points per annum.
During 2000, realized losses of $2.0 million resulted from selling securities with maturities of approximately two years or less. The proceeds were used to buy longer dated securities to maintain the three to five year average life of the portfolio. The new strategy also resulted in above normal turnover of the portfolio in 1998 and contributed to the realized gains of $2.8 million during 1998. The total market value of the investment portfolio, other investments, cash and accrued interest receivable at December 31, 2000, was $167 million compared to $163.5 million at December 31, 1999. Cash used for operations, including $10.3 million for claims paid, offset increases in such balances from
Commercial Guaranty Assurance established general loss reserves of $1.6 million in 2000, $3.3 million in 1999, and $2.0 million in 1998. Commercial Guaranty Assurance established case basis reserves, net of reinsurance, of $2.6 million in 2000, $15.3 million in 1999 and $20.8 million in 1998.
In December 1998, Commercial Financial Services Inc., a credit-card debt collection company and certain affiliates filed a petition for relief under Chapter 11 of the United States Bankruptcy Code. Commercial Guaranty Assurance previously had guaranteed approximately $212 million face amount of certain asset backed securities issued by various trusts established and serviced by CFS (the "CFS Securities"), and had reinsured approximately $162 million of this exposure, so that its original net exposure was $50 million. As of December 31, 2000, Commercial Guaranty Assurance has made claim payments under its guarantees in respect of the insured CFS Securities in an aggregate amount of approximately $150.7 million, of which $115.2 million was covered by reinsurance. In connection with these claim payments, Commercial Guaranty Assurance and its reinsurer acquired a corresponding face amount of the underlying securities, which have no readily determinable market value and have not been recorded on the books of Commercial Guaranty Assurance. All payments received on the underlying securities so acquired by Commercial Guaranty Assurance are being used to purchase additional securities from Commercial Guaranty Assurance's clients, until Commercial Guaranty Assurance has no further exposure in respect of these securities.
As a result of the claim payments described above and interim principal repayments, Commercial Guaranty Assurance's gross remaining potential exposure in respect of these securities has been reduced to $30.7 million as of December 31, 2000, of which $23.5 million is covered by reinsurance, leaving Commercial Guaranty Assurance with a remaining net exposure of $7.2 million. Commercial Guaranty Assurance does not anticipate that it will have to pay any further claims in respect of these securities and accordingly, no additional case basis reserves have been established.
Commercial Guaranty Assurance and various other plaintiffs have commenced legal proceedings against Commercial Financial Services, certain of its officers and shareholders, its auditors, and its legal and financial advisors, alleging various counts of federal and state securities law violations and common law fraud. Management
believes that it is too early to predict what, if anything, Commercial Guaranty Assurance may ultimately recover out of these legal proceedings, or from Commercial Financial Services estate in bankruptcy.
In April 2000, Commercial Guaranty Assurance paid a $2.6 million claim in connection with a $20 million face amount "Triple-B" rated tranche of a home equity loan securitization held by one of the St. George companies. Based on its ongoing surveillance of the St. George portfolio, CGA Investment Management was concerned about the deteriorating credit quality of the collateral pool underlying this security, and believed that it would mitigate the potential losses to Commercial Guaranty Assurance if the security were divested. CGA Investment Management accordingly recommended the divestiture of the security to Commercial Guaranty Assurance which, as insurer of St. George's liabilities and after reviewing CGA Investment Management's analysis and recommendations, directed CGA Investment Management, as investment adviser to St. George, to sell the security. The sale resulted in a shortfall of $2.6 million, which was included in Commercial Guaranty Assurance's case basis reserve at March 31, 2000. Commercial Guaranty Assurance made the claim payment of $2.6 million on April 27, 2000. As a result of this claim payment, Commercial Guaranty Assurance is entitled under the transaction documentation to share in a portion of the monthly cash flow from the underlying assets to partially mitigate the loss. For the year ended December 31, 2000, Commercial Guaranty Assurance recovered approximately $289,000 under these provisions. As the subrogation amounts to be received cannot be estimated with any degree of certainty, management is currently recording these recoveries as reported.
Surveillance for transactions in the St. George and Cobalt companies is currently performed by CGA Investment Management of behalf of Commercial Guaranty Assurance pursuant to a surveillance contract. In accordance with the provisions of this agreement, CGA Investment Management monitors each asset owned by St. George and Cobalt and provides detailed surveillance reports to Commercial Guaranty Assurance on a monthly or quarterly basis, depending on asset type. As part of its ongoing surveillance procedures, Commercial Guaranty Assurance maintains and regularly updates a watchlist of those credits which Management believes are showing poor or worsening credit characteristics, or are otherwise showing trends that could indicate worsening credit performance in the future. These watchlist credits are ranked in categories, ranging from those that are subject to heightened scrutiny, to those which Management believes have a materially higher risk of ultimately resulting in a claim. As of December 31, 2000, there were two asset backed securities, both collateralized debt or loan obligations totaling $36 million in principal amount, and one corporate default swap in the principal amount of $5 million, in the lowest category of the watchlist. As Management does not believe that a loss in respect of any of these securities is both "probable and determinable", Commercial Guaranty Assurance has not posted case basis reserves in respect of these exposures. Management will continue to monitor these securities carefully, and may establish case basis reserves against these exposures in the future, to the extent their credit performance deteriorates further.
For the year ended December 31, 2000 the pay-in-kind dividends on preferred stock and accretion on preferred stock totaled $13.9 million compared to $15.0 million for 1999 and $20.9 million for 1998. The decreases result from the conversion of all outstanding Series B preferred stock into common stock on March 31, 1999.
The table below presents financial information for each of the operating segments.
On a consolidated basis, CGA Group used $3.1 million of cash for operating activities during 2000 compared to using $15.8 million during 1999 and providing $1.2 million in 1998. CGA Group applied $4.7 million of net cash to investing activities in 2000 compared to $23.9 million of net cash during 1999 and $5.8 million in 1998. Cash flows from financing activities in 1999 resulted from the sale of Series C preferred stock, which raised net proceeds of $49.9 million.
CGA Group does not expect to pay cash dividends to its shareholders. Commercial Guaranty Assurance's Board of Directors has passed a resolution that Commercial Guaranty Assurance will not declare or pay cash dividends before June 2002. After June 2002, Commercial Guaranty Assurance intends to comply with dividend restrictions, if any, imposed by Fitch subject to covenants contained in the subscription agreements for the various classes of CGA Group's stock. In addition, Commercial Guaranty Assurance's dividend payments are subject to certain limitations under Bermudian insurance regulations that require minimum solvency margins and liquidity ratios.
If Fitch were to further downgrade Commercial Guaranty Assurance's financial strength rating, there would be further adverse consequences for Commercial Guaranty Assurance. A downgrade to below "Double A" would trigger the acceleration of certain liabilities of St. George and Cobalt that have been guaranteed by Commercial Guaranty Assurance. To the extent that St. George or Cobalt were unable to repay these liabilities in full, which could result if the securities collateralizing the obligations could not be sold for a price at least equal to the outstanding principal balance of the related liability plus accrued and unpaid interest thereon, Commercial Guaranty Assurance would be liable under its guarantees for the amount of any repayment shortfall. Although the Company believes that Commercial Guaranty Assurance's claims-paying resources currently are adequate to cover the amount of any such shortfalls and still provide adequate protection for outstanding policies, a decline in the market value of these securities would result in an equivalent increase in the size of the shortfall required to be paid by Commercial Guaranty Assurance. At this time, the Company has not completed its assessment of the likely amounts and timings of such shortfalls. In addition, as well as further decreasing the volume of new insurance Commercial Guaranty Assurance could write and the amount of premiums it could charge for its insurance, certain other occurrences would be triggered in the event of a downgrade, which may, or may not, have a material adverse effect upon the Company, depending upon timing of the occurrence. However, a downgrade to below "Double A" would severely jeopardize Commercial Guaranty's business prospects and could raise substantial doubt about its ability to continue as a going concern.
At December 31, 2000, Commercial Guaranty Assurance's claims paying resources were $247.3 million, compared to $238.6 million at December 31, 1999.
On October 31, 2000, Standard & Poor's, a major rating agency, announced that it had acquired Canadian Bond Rating Service, and that it would work to "harmonize" outstanding ratings from Canadian Bond Rating Service with those of Standard & Poor's. Although Canadian Bond Rating Service currently rates Commercial Guaranty Assurance's claims paying ability as "A++" (triple-A), Commercial Guaranty Assurance is not rated by Standard & Poor's. It is currently unclear what rating would be assigned to Commercial Guaranty Assurance by Standard & Poor's as a result of this harmonization process, or what action Commercial Guaranty Assurance might take in connection therewith. Commercial Guaranty Assurance expects that it will, in the near future, either request that Canadian Bond Rating Service withdraw its rating of Commercial Guaranty Assurance's claims-paying ability or work with Standard & Poor's to clarify Commercial Guaranty Assurance's ratings from Canadian Bond Rating Service. Pending clarification of the status of Commercial Guaranty Assurance's rating from Canadian Bond Rating Service and, in light of the Fitch downgrade, Dominion Bond Rating Service, Commercial Guaranty Assurance's ability to provide credit enhancement for Canadian transactions will be significantly curtailed, at least until such time as the status of Commercial Guaranty Assurance's ratings from these two Canadian rating agencies is clarified.
In late March 2001, Commercial Guaranty Assurance was made aware of four collateralized debt obligation transactions owned by its clients on which interest payments are being deferred or are expected by Management to be deferred in the near future due to these transactions failing certain of their coverage tests. The aggregate principal balance of these four securities is $91 million. Collateralized debt and loan obligations are securities issued in securitization transactions that are backed by pools of high yield bonds and loans. These transactions are typically structured with overcollateralization, debt service coverage and other tests. When these tests are breached, transaction cash flow (including interest payments on the underlying bonds and loans) that would otherwise be used to pay interest on the more junior classes of securities issued in the transaction are used instead to prepay principal on the most senior outstanding tranche of securities issued in the transaction. Because the principal balance of these senior securities is now being prepaid out of interest payments on the underlying bonds, this results in a smaller principal amount of securities outstanding that are now supported by a proportionately larger pool of collateral, which ultimately benefits all of the transaction's securityholders. The unpaid interest on the junior tranches of securities is deferred and added to the outstanding principal amount of these securities. Once enough of the senior securities are repaid so that the transaction is once again in compliance with all applicable coverage tests, normal interest payments on all classes of the transaction's securities are resumed. The deferred interest is ultimately repaid as the underlying bonds pay down.
As a result of interest payments not being made on these securities, Commercial Guaranty Assurance expects that its clients will therefore have insufficient funds to pay certain of its liabilities, and that Commercial Guaranty Assurance will have to make such payments under its guarantees. Commercial Guaranty Assurance believes that these payments will aggregate approximately $3 million in each of 2001, 2002 and 2003. However, Commercial Guaranty Assurance expects that each of these securities will resume paying cash interest in 2004 and thereafter, and that the payments made by Commercial Guaranty Assurance will be fully reimbursed over a period of approximately 7-8 years.