FSA or its subsidiaries also maintain leased office space in San Francisco, Dallas, Hamilton (Bermuda), London (England), Madrid (Spain), Paris (France), Singapore, Sydney (Australia) and Tokyo (Japan). The Company and its subsidiaries do not own any material real property.
(b)VIE balances are included beginning July 1, 2003 due to the adoption of Financial Accounting Standards Board Interpretation No. 46, "Consolidation of Variable Interest Entities, an interpretation of ARB No. 51."
As explained in detail below, 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. ("FSA") and the present value of net interest margin originated ("PV NIM originated") in the financial products segment. The Company generated PV originations of $927.2 million in 2004, $894.6 million in 2003 and $881.8 million in 2002. 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.
The GAAP measure "gross premiums written" captures premiums collected in a given period, whether collected for business originated in the period, or in installments for business originated in prior periods. It is not a precise measure of current-period originations because a significant portion of the Company's premiums are collected in installments. Therefore, to measure current-period premium production, management calculates the gross present value of premium installments originated in the accounting period and combines it with premiums received upfront in the accounting period, which produces the non-GAAP measure PV premiums originated.
Installment premiums are not recorded in the financial statements until due, which is a function of the terms of each insurance policy. Future non-cancelable 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.
Year-to-year comparisons of PV premiums originated are affected by the application of a different discount rate each year. The discount rate employed by the Company for this purpose was 5.62% for 2004 originations and 5.91% for 2003 originations. Management intends to revise the discount rate in future years according to the same methodology, in order to reflect specific return results realized by the Company.
The tables below show the PV premiums originated and gross par amount insured by FSA in its three major business sectors.
New-issue volume in the U.S. municipal bond market totaled approximately $360.2 billion, on a sale date basis, a 6.1% decline from the record level of $383.7 billion in 2003 and slightly more than the $358.8 billion in 2002. Insurance penetration was approximately 54%, compared with 50% in both 2003 and 2002. In all three years, low interest rates, strong demand for refundings and continuing needs for infrastructure investment drove high levels of municipal borrowing. FSA guaranteed approximately 24% of the insured par amount of municipal bonds sold in 2004, and approximately 27% of the insured par amount of municipal bonds sold in 2003 and 2002.
The Company's U.S. asset-backed gross par insured rose 211% in 2004. The Company's associated PV premiums originated, which increased 31.9%, did not grow as much as par insured because most of the growth in par volume came from pooled corporate and residential mortgage transactions of Triple-A underlying credit quality. Such high-quality transactions tend to have relatively low premium rates but tend to achieve good returns on equity. In 2003, par originated in FSA's U.S. asset-backed business declined
56.2%, while PV premiums originated declined 9.4%. Compared with 2002 activity, the Company's asset-backed business reflected a shift away from large Super Triple-A CDSs, Triple-A tranches of residential mortgage-backed securities and auto loan transactions toward higher premium types of transactions, including Triple-A collateralized loan obligations ("CLOs") and certain residential mortgage and consumer finance issues.
Full-year international par insured for 2004 approximated that of the prior year, and international PV premium originations decreased 2.1%. FSA had expected to insure a greater number of infrastructure transactions during the year, but some significant transactions were postponed. In 2003, the 4.8% decline in international PV premiums originated was less than the 48.0% decline in gross par insured, largely because of a shift from Super Triple-A pooled corporate CDS to a broader range of transactions, including CLOs, synthetic residential mortgage securitizations and other structured financings. Infrastructure financings contributed the largest share of international premium production in 2003. PV premiums for international originations are translated into U.S. dollars using month-end currency exchange rates. Actual premiums received could differ from this amount due to exchange-rate fluctuations.
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 Adjusted Book Value as another element of intrinsic value, not found in GAAP book value. PV NIM represents the difference between the estimated interest to be received on the investments and the estimated interest to be paid on liabilities issued in the form of GICs, net of expected hedge derivative results. PV NIM is calculated after giving effect to swaps and other derivatives that convert substantially all fixed-rate assets and liabilities to floating rates. At the time of origination, all interest-rate hedges are assumed to be completely effective.
Management uses two key metrics to measure company performance and to calculate long-term incentive compensation and the annual bonus pool. These two metrics-operating earnings and adjusted book value ("ABV")-are both non-GAAP measures.
•must be marked to fair value under Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133").
CDS contracts are generally non-cancelable prior to maturity, and the Company views insured CDS risks as comparable to other insured risks. In a typical CDS transaction, the Company, in exchange for an upfront or periodic premium, indemnifies the insured for economic losses related to specified reference obligations, primarily pools of corporate debt securities or bank loans, structured such that the risk insured is investment grade without the benefit of the credit protection provided by the Company. In the event a CDS were to migrate below investment grade, the fair-value impact would be fully reflected in operating earnings.
The Company discloses operating earnings to inform investors of a key measure used by both management and the Board of Directors to assess the Company's consolidated operating performance and to calculate its employees' long-term incentive compensation payments. The limitations of the operating earnings metric are the lack of comparability to operating earnings of other companies that may define it differently and the exclusion of 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 (defined as credit quality based on loss protection which is greater than 1.3 times the Triple-A
As discussed above under "New Business Production-Financial Products Originations," the Company calculates PV NIM (adjustment 3) because net interest income and net interest expense reflected in the statement of operations are limited to current-year earnings. The Company's future positive interest rate spread from outstanding GIC business can be reasonably 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 U.S. GAAP book value.
Shareholders' equity was $2.5 billion and non-GAAP ABV was $3.7 billion at December 31, 2004. During 2004, ABV grew 16.8% excluding realized and unrealized capital gains and losses in the investment portfolio and 16.9% including such gains and losses.
(1)Includes the effect of after-tax unrealized gains in the investment portfolio, which were $177.8 million at December 31, 2004 and $147.4 million at December 31, 2003.
Net investment income increased 11.7% in 2004, primarily due to higher invested balances arising from new business writings, partially offset by lower reinvestment rates stemming from the low interest-rate environment during the year. Net investment income increased 10.7% in 2003 from that of the prior year, primarily due to higher invested balances arising from new business writings. For further discussion, see "Liquidity and Capital Resources," below.
The gross and net par amounts outstanding on transactions with case reserves were $791.4 million and $752.8 million, respectively, at December 31, 2004. The net case reserve consisted primarily of six CDO transactions and one municipal transaction, which collectively accounted for approximately 95% of the total net case reserve. The remaining 11 exposures were in various sectors.
Reserves for losses and loss adjustment expenses are discounted when established at the then current risk-free rates. The cumulative amount of net discount taken was approximately $59.5 million at December 31, 2004, $65.9 million at December 31, 2003 and $44.7 million at December 31, 2002.
At June 30, 2002, this analysis produced a present value of expected losses of $51.5 million, net of reinsurance recoveries and net of unearned premiums and future ceding commissions. Management addressed this net present value of expected loss ($51.5 million) through (i) an increase in the Company's non-specific reserve ($31.0 million) and (ii) amounts already existing in its non-specific reserve ($20.5 million), including non-specific reserve amounts reallocated to case reserves ($11.3 million). The $31.0 million increase in the Company's non-specific reserve resulted in a corresponding increase to losses and loss adjustment expenses in the Statements of Operations and Comprehensive Income of $31.0 million. An additional adjustment of $10.1 million was made in the fourth quarter of 2002 as a result of further deterioration of the CDO portfolio, resulting in an increase to loss expense and a corresponding increase to the non-specific reserve. Management established a methodology of recording case reserves on CDO transactions based on the extent to which the overcollateralization ratio (non-defaulted collateral at par value divided by the debt insured) has fallen below 100%, since management believes that claims on such transactions are probable and that the amount of the undercollateralization is a reasonable estimate of such claims. Such transactions may benefit from excess cash flow attributable in part to higher interest rates on the underlying collateral than on the insured securities. In addition, such transactions generally require insured payments of principal only at the ultimate maturity of such transactions. As a result, the Company does not expect to be required to pay claims on these transactions for several years, but may elect to do so at earlier dates at its discretion. In some cases since 2002, the Company has elected to pay claims earlier than required. Application of this methodology resulted in recording $68.8 million in gross case reserves and $29.8 million in reinsurance recoverable on unpaid losses, resulting in a $39.0 million increase in net case reserves in 2002. Management, beginning in the second quarter of 2002, has refined the loss factor it applies to its net par underwritten when calculating the non-specific reserve in order to reflect its recent adverse experience. As a result, the non-specific reserve accrual for the year ended December 31, 2002 was $65.6 million, rather than the approximately $14.9 million that would have been accrued using the prior assumptions.
During 2002, the Company increased its non-specific reserve by $65.6 million, of which $41.1 million related to the CDO portfolio discussed above, $21.1 million was for origination of new business and $3.4 million was for accretion of the discount on prior years' reserves. Also during 2002, the Company transferred to the non-specific reserve $0.8 million representing recoveries received on prior-year transactions and transferred $45.8 million from the non-specific reserve to case reserves.
The primary estimates affecting the statistical calculation are (a) probability of default and (b) severity of loss given default. The Company applies its experience factor to the statistical calculation to reflect actual loss experience in terms of both frequency and severity. Historically, defaults on guaranteed obligations have been infrequent, but the size of resulting claims have varied widely due to both the differing sizes of the obligations guaranteed and the significant variability of the severity experienced. Severity represents the magnitude of loss, which is calculated as par guaranteed minus total recoveries, expressed as a percentage of par guaranteed. Recoveries include salvage value of assets and amounts due from reinsurers. Actual claim frequency and severity experience may evolve over time, affected by many factors, including changes in the insured portfolio's distribution across sectors and underlying ratings, as well as changes in the economy and the political environment. The Company's loss reserving methodology is designed to reflect these factors. Changes in the sectors and underlying credit quality of the transactions are captured in the formula directly, while changes in the economy and political environment are captured in the experience factor.
Asset-backed obligations insured by FSA are secured by pools of assets. While the assets in a given transaction are generally of one type (such as automobile loans, residential mortgage loans, etc.), they are diversified within that asset type. Due to characteristically low default frequency, losses on insured asset-backed transactions have been manageable in management's view, despite variability.
Management believes severity is not the primary determinant of possible loss in a portfolio of insured asset-backed obligations. Since introducing a non-specific reserve in 1993, actual aggregate losses have been reasonably consistent with management's expectation in the majority of asset-backed categories, including insured obligations collateralized by automobile loan or residential mortgage debt of non-prime borrowers. The one exception involved senior bonds issued in 1998 and 1999 in connection with structured CDOs. In such a structure, the bonds insured by FSA are in second-loss positions, meaning that there are uninsured, subordinate bondholders or equity investors who must lose all of their investment outstanding at the time of default or earlier trigger event before the FSA-insured bonds become subject to loss. These transactions were structured to FSA's requirement that the first-loss position provide FSA an investment-grade level of protection. The underlying assets supporting the insured obligations were pools of corporate bonds individually rated below investment grade. In this structure, multiple credits must fail before claims are triggered. In 2002, credit quality deteriorated across a broad spectrum of the corporate market, which led to projected claims on these transactions and charges to FSA's income statement, as well as an increase in the Company's loss experience rate. Yet even under this unprecedented stress scenario, the severity of the largest single loss was relatively modest.
Accordingly, management considers default frequency the relevant factor driving adverse loss experience in the asset-backed sector and believes that a reasonably possible adverse change in default frequencies would not result in a material adverse adjustment to the non-specific loss reserve.
Carlo average default rate, actual losses would exceed the current estimate. Applying a higher frequency of default, observed at the 90% confidence level, would result in additional present value loss of $30 million.
To assess sensitivity to changes in loss assumptions in the municipal insured portfolio, management believes that categories of municipal risk other than the health care sector should not result in a material adverse change to the estimate of loss under a reasonably possible scenario. Management believes that a material adverse change in loss is reasonably possible to occur in the health care sector. While the Company has not experienced a loss in this sector, the potential severity of health care losses is comparatively high. Hospital facilities are single-purpose assets and a failing health care issuer is likely to be liquidated or acquired. If there is collateral associated with a health care credit, it is generally in the form of a hospital facility, the value of which is primarily driven by the community's need for that facility. The more hospitals competing in a community, the more fragile the value of the hospital collateral 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 municipal transactions with case reserves is considered unlikely because the only such case reserve is set near the full policy amount.
FSA management believes that the liability it carries for losses and loss expenses are adequate to cover the net cost of claims. However, the loss liability is based on assumptions regarding the Company's probability of default and its severity of loss and there can be no assurance that the liability for losses will not exceed such estimates.
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 changes in another, which might magnify or counteract the sensitivities.
The Company is aware that there are differences regarding the method of measurement of the non-specific reserve among participants in the financial guaranty industry. Other financial guarantors may not establish a non-specific reserve in the manner described above, may call their non-specific reserve by a different name, such as, but not limited to "unallocated losses," "active credit reserves" and "portfolio reserves," or may use different statistical techniques than the Company uses to determine loss at a given point in time. Management and the industry expect accounting literature specific to the financial guaranty industry to evolve; however, management cannot predict or estimate the scope of the guidance or potential impact on the financial statements at this time. See Note 2 to the Consolidated Financial Statements in Item 8.
At December 31, 2004, the reinsurance recoverable on unpaid losses from reinsurers and ceded par outstanding, by Standard & Poor's Ratings Services ("S&P") rating levels, are as follows:
For the financial products segment, FP NIM was $22.8 million in 2004, $5.1 million in 2003 and $7.6 million in 2002. The increases in FP NIM are primarily related to an increasing book of GIC business since commencing operations at the end of 2001. FP NIM was adversely affected in 2003 by SFAS 133 adjustments. Prior-year balances have been reclassified to conform to the current-year presentation.
(1)VIE NIM represents the impact of consolidation of the VIEs on the Total NIM. Derivative gains and losses are included in the FP NIM whether or not they are designated hedges. GAAP requires that derivatives designated as hedges be classified in the Statements of Operations and Comprehensive Income with the underlying item being hedged. Gains and losses on undesignated hedges are shown under the caption net realized and unrealized gains (losses) on derivative instruments.
VIE NIM and FP NIM are combined on the Statements of Operations and Comprehensive Income. VIE NIM pertains to the net interest margin derived from transactions executed by FSA Global Funding Limited ("FSA Global"), Canadian Global Funding Corporation ("Canadian Global") and Premier International Funding Co. ("Premier"). See Note 25 to the Consolidated Financial Statements in Item 8.
During the first half of 2002, FSA's insured portfolio contained a portfolio of CDS on 100 corporate names (each rated investment grade at inception of the swap), with $10 million of exposure per name, for which the Company had first-loss exposure. This "single-name CDS program" was the only transaction of its kind in the insured portfolio. In the third quarter of 2002, the Company terminated its exposure under this program in exchange for paying termination costs of $43.0 million. The charge was included in net realized and unrealized gains (losses) on derivative instruments in the Consolidated Statements of Operations and Comprehensive Income during 2002.
On November 12, 2003, the FTC announced a settlement with SPS, resolving the FTC's civil allegations against SPS. Pursuant to that settlement, SPS paid $40.0 million to the FTC to compensate consumers who suffered harm. The settlement enjoins SPS from future law violations and imposes restrictions on SPS's business practices. A related settlement of numerous class action lawsuits against SPS has been approved by a federal district court in Massachusetts. In the second quarter of 2004, the Company made a $10.3 million additional equity investment in SPS to fund a portion of the $40.0 million payment that was required to be made to the FTC under the terms of the FTC's settlement agreement with SPS.
In the third quarter of 2004, the Company determined that its $7.6 million of goodwill associated with its investment in SPS was impaired as a result of challenges encountered by SPS in acquiring new business, despite servicer ratings of "Average." While management believes book value approximates fair value, the Company will continue to monitor the value of its investment in SPS. The Company and the other owners of SPS have entered into a binding Summary of Terms relating to the potential sale to an unaffiliated third party of their respective interests in SPS pursuant to an option, exercisable on or before July 31, 2005. The sale is subject to several conditions, including, among other things, execution of definitive agreements.
FSA's 13% investment in preferred shares of XLFA, a financial guaranty insurance subsidiary of XL, is redeemable by XLFA at a price equal to the fair market value of the preferred shares, subject to a cap defined as the internal rate of return of 19% per annum from the date of the investment through the date of redemption, plus accrued dividends as if 100% of current-year earnings were distributed. Based on this formula, the Company recently 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.
For the first three quarters of 2004 and all prior years, equity in earnings of unconsolidated affiliates included the results of XLFA. In accordance with EITF 02-14, "Whether an Investor Should Apply the Equity Method of Accounting for Investments Other Than Common Stock," the Company no longer accounts for its investment in XLFA under the equity method of accounting. Effective October 1, 2004, the Company's 15% investment in XLFA is included in equity securities as an available-for-sale security. The fair value of the investment at December 31, 2004 was $54.3 million.
Company and its creditors, even in bankruptcy or other receivership. All intercompany insured amounts between FSA and FSA Global or Canadian Global are excluded from the Notes to the Consolidated Financial Statements for the years ended December 31, 2004 and 2003. In addition, the Company refinances certain defaulted transactions by employing refinancing vehicles to raise funds for the refinancings. These refinancing vehicles are also consolidated. See Note 22 to the Consolidated Financial Statements in Item 8.
The effective tax rates were 21.8% in 2004, 24.1% in 2003 and 16.2% in 2002, which differ from the statutory rate of 35% due primarily to tax-exempt interest income and income from Financial Security Assurance International Ltd. ("FSA International"), with the White Mountains indemnity payment (see below) being an additional difference in 2004. In addition, the effective tax rate was affected by the expected repatriation of earnings of Financial Security Assurance International Ltd. ("FSA International") in 2005.
In the third quarter of 2002, the Company changed its method of taxing its equity in earnings from SPS, an unconsolidated affiliate of the Company. Prior to 2002, the Company taxed 100% of its equity in earnings from SPS at the statutory rate of 35%. Following a change in SPS's investors, the Company determined that it would be appropriate to apply the 80% dividend-received deduction allowed by the Internal Revenue Service when calculating the tax on its equity in earnings from SPS, based on management's expectation that it would realize its gain on such investment through dividend distributions rather than through sale of its investment. In 2002, the Company recorded a cumulative-to-date benefit of $4.0 million.
The Company's critical accounting policies are described in Note 2 to the Consolidated Financial Statements in Item 8.
The Company's consolidated invested assets at December 31, 2004, net of unsettled security transactions, were $12,227.2 million, compared with the December 31, 2003 balance of $7,942.7 million. These balances include the change in the market value of the Investment Portfolio, which had an unrealized gain position of $262.8 million at December 31, 2004, compared with an unrealized gain position of $226.7 million at December 31, 2003. These balances exclude the assets in the VIE bond portfolio, which the Company's management believes are beyond the reach of the Company and its creditors.
(1)Amounts represent the undiscounted estimated claim payments. (2)Amounts include future accretions on zero coupon obligations.
At December 31, 2003, Financial Security Assurance Holdings Inc. (as a separate holding company, "FSA Holdings") held $152.9 million of surplus notes of FSA. During 2004, FSA repaid $44.0 million of those surplus notes. At December 31, 2004, FSA Holdings held $108.9 million of FSA surplus notes. Payments of principal or interest on such notes may be made only with the approval of the Superintendent of Insurance of the State of New York (the "New York Superintendent"). FSA Holdings employs surplus
note purchases in lieu of capital contributions in order to allow it to withdraw funds from FSA through surplus note payments without reducing earned surplus, thereby preserving dividend capacity of FSA.
FSA Holdings paid dividends of $22.9 million in 2004 and $11.7 million in 2002. It did not pay dividends in 2003.
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. Unamortized debt issuance costs of the retired debt of $4.1 million were charged to interest expense in 2002.
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 has a standby line of credit in the amount of $325.0 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 $325.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $1,067.0 million at December 31, 2004. 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 seven-year term that will expire on April 30, 2011 and contains an annual renewal provision 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, 2004.
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 a put option were to be exercised by FSA, the applicable trust would use the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, and transfer such proceeds to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $1.3 million for 2004 and $3.6 million for 2003 and was recorded in equity. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts under FIN 46 because it does not retain the majority of the residual benefits or expected losses.
Capital adequacy is one of the financial strength measures under Moody's financial guarantor model. The model includes a penalty for risk concentration and recognizes a benefit for diversification. The published results reflect four metrics of financial strength relating to the insured portfolio's credit quality, correlation risk, concentration of risk and capital adequacy. Moody's assesses capital adequacy by comparing FSA's claims-paying resources to a Moody's-derived probability of potential credit losses. Moody's loss distribution reflects FSA's current distribution of risk by sector (asset-backed and municipal), the credit quality of insured exposures, correlations that exist between transactions, the credit quality of FSA's reinsurers, and the term to maturity of FSA's insured portfolio. The published results compare levels of theoretical loss in the tail of this distribution to various measures of FSA's claims-paying resources.
The Company plans to incur approximately $30 million, net of lease incentives, in capital expenditures through the second quarter of 2005 for leasehold improvements, furniture and fixtures related to its new corporate headquarters. The Company expects to fund these capital expenditures out of cash flows from operations. For additional information see "Item 2 - Properties."
On July 1, 2003, the Company consolidated $1.9 billion in assets and $1.9 billion in liabilities relating to variable interest entities with no corresponding cash movement. The Company received tax benefits of $1.2 million in 2004 and $0.3 million in 2003 from its parent company, which were recorded as capital contributions. See Note 10 for disclosure of non-cash transactions relating to restricted treasury stock transactions.
Financial Security Assurance Holdings Ltd. (together with its consolidated entities, the "Company") is a holding company incorporated in the State of New York. The Company is principally engaged, through its insurance company subsidiaries, in providing financial guaranty insurance on asset-backed and municipal obligations. Its primary insurance company subsidiary is Financial Security Assurance Inc. ("FSA"). The Company's underwriting policy is to insure asset-backed and municipal obligations that it determines would be of investment-grade quality without the benefit of the Company's insurance. The asset-backed obligations insured by the Company are generally issued in structured transactions and are backed by pools of assets, such as residential mortgage loans, consumer receivables, securities or other assets having an ascertainable cash flow or market value. The Company also insures synthetic asset-backed obligations that generally take the form of credit default swap ("CDS") obligations or credit-linked notes that reference pools of securities or loans, with a defined deductible to cover credit risks associated with the referenced securities or loans. The municipal obligations insured by the Company consist primarily of general obligation bonds that are supported by the issuers' taxing power and of special revenue bonds and other special obligations of states and local governments that are supported by the issuers' ability to impose and collect fees and charges for public services or specific projects. Municipal obligations include obligations backed by the cash flow from leases or other revenues from projects serving a substantial public purpose, including government office buildings, toll roads, healthcare facilities and utilities. 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.
FSA Global is a special purpose funding vehicle owned 29% by the Company. FSA Global issues FSA-insured medium term notes and invests the proceeds from the sale of its notes in FSA-insured obligations with a view towards realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. At December 31, 2004, the consolidated VIEs had $2.4 billion principal amount of outstanding notes, after elimination of intercompany transactions. The majority of Canadian Global's assets were liquidated and its liabilities satisfied during the third quarter of 2004. Premier is principally engaged in debt defeasance for lease transactions.
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"), which, for the insurance company subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 5). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities in the Company's consolidated balance sheets at December 31, 2004 and 2003 and the reported amounts of revenues and expenses in the consolidated statements of operations and comprehensive income during the years ended December 31, 2004, 2003 and 2002. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses, fair value of financial instruments and the deferral and amortization of policy acquisition costs. Actual results may differ from those estimates. Significant accounting policies under GAAP are as follows:
The consolidated financial statements include the accounts of FSA Holdings and its direct and indirect subsidiaries, principally including FSA, FSA Insurance Company, Financial Security Assurance International Ltd. ("FSA International"), Financial Security Assurance (U.K.) Limited, the GIC Subsidiaries, FSAM, FSA Portfolio Management Inc., Transaction Services Corporation, FSA Services (Australia) Pty Limited and FSA Services (Japan) Inc. (collectively, the "Subsidiaries"). The consolidated financial statements also include the accounts of certain VIEs as described in Note 1. All intercompany accounts and transactions have been eliminated. Certain prior-year balances have been reclassified to conform to the 2004 presentation.
Investments in debt and equity securities designated as available for sale are carried at fair value. The unrealized gain or loss on the investments that are not hedged is reflected as a separate component of
shareholders' equity, net of applicable deferred income taxes. The unrealized gain or loss on the investments that qualify as fair-value hedges is recorded in income currently.
Derivative instruments, which are primarily designated as fair-value hedges, are entered into to manage the interest-rate and currency exchange-rate exposure of the Company's GIC and VIE debt, GIC bond portfolio, and VIE bond portfolio and are recorded at fair value. These derivatives generally include interest-rate futures and interest-rate and currency swap agreements, which are primarily utilized to convert the Company's fixed-rate obligations on its GIC and VIE debt, GIC bond portfolio and VIE bond portfolio into U.S.-dollar floating-rate obligations. The gains and losses relating to these fair-value hedges, including any ineffective portion, are included in financial products and variable interest entities net interest income, and financial products and variable interest entities net interest expense, as appropriate, along with the offsetting change in fair value of the hedged item attributable to the risk being hedged, on the consolidated statements of operations and comprehensive income. Gains and losses relating to derivatives that fail hedge effectiveness are recorded at fair value through earnings and included in net interest income from financial products and variable interest entities and net interest expense from financial products and variable interest entities, as appropriate.
The Company has also insured a number of CDS agreements that it intends, in each case, to hold for the full term of the agreement. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred. Changes in fair value are recorded in net realized and unrealized gains (losses) on derivative instruments and in other assets or other liabilities, as appropriate. The Company uses quoted market prices, when available, to determine fair value. If quoted prices are not available, management uses internally developed estimates of fair value. Due to a lack of a quoted market for the CDS obligations written by the Company, estimates generated from the Company's valuation process may differ materially from values that may be realized in market transactions.
Securities purchased under agreements to resell and securities sold under agreements to repurchase are accounted for as collateralized transactions and are recorded at contract value plus accrued interest, subject to the provisions of Statement of Financial Accounting Standards No. 140, "Accounting for Transfer and Servicing of Financial Assets and Extinguishment of Liabilities." It is the Company's policy to take possession of securities borrowed under agreements to resell.
Financial guaranty as an industry has emerged over the past thirty years. Management believes that existing insurance accounting under Statement of Financial Accounting Standards No. 60, "Accounting and Reporting by Insurance Enterprises" ("SFAS 60"), does not specifically address financial guaranty insurance. Accordingly, the accounting for loss and loss adjustment expenses within the financial guaranty insurance industry has developed based on analogy to the most directly comparable elements of existing literature including sections of SFAS 60, Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies" ("SFAS 5") and Emerging Issues Task Force Issue 85-20, "Recognition of fees for guaranteeing a loan ("EITF 85-20").
The Company establishes loss liabilities based on its estimate of specific and non-specific losses. The Company also establishes liabilities for loss adjustment expenses ("LAE"), consisting of the estimated cost of settling claims, including legal and other fees and expenses associated with administering the claims process.
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 estimated 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 (i) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (ii) 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 Company establishes non-specific reserves on its entire portfolio of credits because management believes that a portfolio of insured obligations will deteriorate over its life and that the existence of inherent loss can be proven statistically by data such as rating agency publications. The establishment of these reserves is a systematic process that considers this quantitative, statistical information obtained primarily from Moody's Investors Service, Inc. ("Moody's") and Standard & Poor's Ratings Services ("S&P"), together with qualitative factors such as overall credit quality trends resulting from economic and political conditions, recent loss experience in particular segments of the portfolio and changes in underwriting policies and procedures. The factors used to establish reserves are evaluated periodically by comparing the statistically computed loss amount to the incurred losses as represented by case reserve activity to develop an experience factor, which is updated and applied to future originations. The process results in management's best estimate of inherent losses associated with providing credit protection at each balance sheet date.
The non-specific reserve amount 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 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 from 1970-2003, Moody's tracks bonds over a twenty-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 municipal 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 product of the current-year statistical calculation multiplied by the current-year experience factor represents the present value of loss amounts calculated for current-year originations. The experience factor is based on the Company's inception-to-date historical losses (starting from 1993, when the Company established the non-specific reserve methodology). The experience factor is calculated by dividing cumulative inception-to-date actual losses incurred by the Company by the cumulative inception-to-date losses determined by the statistical calculation. The experience factor that applies to the whole portfolio is reviewed and, where appropriate, updated periodically, but no less than annually.
The present value of loss amounts calculated for the current-year originations plus an amount representing the accretion of discount pertaining to prior-year originations are charged to loss expense, and increase the non specific loss reserve after adjustments that may be made to reflect observed favorable or adverse experience. The entire non-specific reserve is available to absorb probable losses inherent in the portfolio. As there are no specific losses provided in the non-specific reserve there is no identifiable reinsurance recoverable. At the time that a case reserve is identified, the gross loss liability is recognized along with the reinsurance recoverable, if any. The amount of reinsurance recoverable depends on the policy ceded and the reinsurance agreements covering such policy. Management cannot predict the specific policies that will emerge as case-basis losses from the portfolio and is not entitled to recovery from the reinsurer in advance of producing a case reserve.
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 based on a review of the Company's inception-to-date cumulative case based losses divided by the total inception-to-date cumulative net par underwritten. This inception-to-date result is compared with the product of the non specific reserves divided by the net par outstanding as of the balance sheet date. In the event that such ratios are not in line, then further analysis is performed to quantify appropriate adjustments that may be either income statement charges or benefits, as occurred in 2002, 2003 and 2004 as described in Note 16.
The Company does not defer acquisition costs relating to GICs issued by the GIC Subsidiaries, except for GIC commissions paid to third parties, which are included in other assets. The amortization of these commissions is recorded in net interest expense from financial products and VIEs.
Monetary assets and liabilities denominated in foreign currencies are translated at the spot rate. Non-monetary assets and liabilities are translated at historical rates. Revenues and expenses denominated in foreign currencies are translated at average rates prevailing during the year. Unrealized gains and losses on available-for-sale securities, net of deferred taxes, resulting from translating investments denominated in foreign currencies are recorded in shareholders' equity. Gains and losses from transactions in foreign currencies are recorded in income.
Bonds at amortized cost of $9.7 million and $8.9 million at December 31, 2004 and 2003, respectively, were on deposit with state regulatory authorities as required by insurance regulations.
The credit quality of bonds in the Investment Portfolio at December 31, 2004 was as follows:
(1)Ratings are based on the lower of Moody's or S&P ratings available at December 31, 2004. Of the bonds included in the Investment Portfolio, 12.9% were AAA by virtue of insurance provided by FSA. Without giving effect to the FSA guaranty, the weighted-average rating of the FSA-insured investments was in the A+ range, and all of these investments were investment grade.
The amortized cost and fair value of bonds in the Investment Portfolio were as follows (in thousands):
Proceeds from sales of bonds for the investment portfolio during 2004, 2003 and 2002 were $770.5 million, $948.3 million and $772.0 million, respectively. Gross gains of $5.2 million, $12.6 million and $30.5 million and gross losses of $5.7 million, $7.5 million and $1.3 million were realized on sales in 2004, 2003 and 2002, respectively.
In 2002, the Company purchased foreign currency call options. These calls were marked to market through earnings and, for the years ended December 31, 2004, 2003 and 2002, resulted in net unrealized gains of $0.9 million, $0.3 million and $0.2 million, respectively.
The following table shows the gross unrealized losses and fair value for the GIC Portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004 (in thousands):
The Company periodically monitors the GIC Portfolio for individual investments in an unrealized loss position in order to assess whether that investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2004, there were 14 securities that were in an unrealized loss position for a continuous 12-month period or longer. None of the 14 securities had an unrealized loss that exceeded book value by 14% at December 31, 2004. At December 31, 2004, the Company determined that no investments were considered other-than-temporarily impaired.
The amortized cost and fair value of the GIC Portfolio, at December 31, 2004, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
Proceeds from sales of bonds held in the GIC Portfolio during 2004, 2003 and 2002 were $91.7 million, $190.7 million and $274.1 million, respectively. Gross gains of $2.6 million were realized on sales in 2004, offset by $0.4 million of unrealized losses on derivatives used to hedge the securities that were sold. Gross gains of $10.5 million were realized on sales in 2003, offset by $11.5 million of unrealized losses on derivatives used to hedge the securities that were sold. Gross losses of $0.2 million were realized on sales in 2002.
Reconciliations of net income for the years ended 2004, 2003 and 2002 and shareholders' equity at December 31, 2004 and 2003, reported by the Company on a GAAP basis, to the amounts reported by the insurance company subsidiaries on a statutory basis, are as follows (in thousands):
Dexia Holdings, Inc. ("Dexia Holdings") and the Company and its Subsidiaries, except FSA International, file a consolidated federal income tax return.
Except as described below, federal income taxes have not been provided on all of the undistributed earnings of FSA International, since it has been the Company's practice and intent to reinvest such earnings in the operations of this subsidiary. The cumulative amount of such untaxed earnings was $86.7 million and $57.1 million at December 31, 2003 and 2002, respectively.
The American Job Creation Act of 2004 (the "Act") was enacted on October 22, 2004, which added Section 965 to the Internal Revenue Code. Section 965 provides for the repatriation of dividends from a controlled foreign corporation to its U.S. shareholder at an effective tax rate of 5.25%, provided that proceeds from the repatriation are utilized for qualified domestic investment activities. The U.S. Treasury Department issued Notice 2005-10, which provided guidance on acceptable investment activities. The Company believes it qualifies for the beneficial treatment under Section 965 and has accordingly accrued a deferred tax liability and expense of $5.3 million at December 31, 2004. This amount represents the tax effect on FSA International's tax dividend distribution capability at December 31, 2004. To the extent FSA International generates additional tax earnings and profits in 2005, it is probable that the Company will distribute such amounts and, accordingly, provide taxes on such earnings as they accrue during 2005.
The Act provides special tax treatment only for tax dividends. Tax dividends can be made only to the extent of earnings and profits that have a different basis of calculation from that of GAAP earnings. At December 31, 2004, GAAP earnings exceeded tax earnings and profits by approximately $22.6 million. It is the Company's intention to repatriate only earnings that qualify for the special tax treatment under the Act.
In connection with Dexia's acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. ("WMH"). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains Insurance Group for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains Insurance Group. While the Company had no legal liability in connection with the indemnity payment, the payment should be treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, under certain circumstances, which are not probable, the Company expects to agree to share 50% of the deferred tax benefit with White Mountains Insurance Group.
A reconciliation of the effective tax rate with the federal statutory rate follows:
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, 2004, there were no borrowings under this arrangement, which expires on April 22, 2005, if not extended.
FSA has a standby line of credit commitment in the amount of $325.0 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 $325.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $1,067.0 million at December 31, 2004. 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
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 a put option were to be exercised by FSA, the applicable trust would use the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, and transfer such proceeds to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $1.3 million and $3.6 million for 2004 and 2003, respectively, and was recorded in equity. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts under FIN 46 because it does not retain the majority of the residual benefits or expected losses.
On November 26, 2002, the Company 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. The Company used a portion of the proceeds of this issuance to redeem in whole the Company's $130.0 million principal amount of 7.375% Senior QUIDS due September 30, 2097. Unamortized debt issuance costs of the retired debt of $4.1 million were charged to interest expense in 2002.
The Company maintains both qualified and non-qualified non-contributory defined contribution pension plans for the benefit of eligible employees. Contributions are based on a fixed percentage of employee compensation. Pension expense, which is funded annually, amounted to $5.8 million, $4.9 million and $5.1 million for the years ended December 31, 2004, 2003 and 2002, respectively.
The Company applies APB Opinion 25 and related Interpretations in accounting for its performance shares. The estimated final cost of these performance shares is accrued over the performance period. The expense for the performance shares was $73.3 million, $63.1 million and $58.9 million for the years ended December 31, 2004, 2003 and 2002, respectively.
For obligations under the Company's Deferred Compensation Plan ("DCP") and Supplemental Executive Retirement Plan ("SERP"), the Company generally purchases investments expected to perform similarly to the tracking investments chosen by the participants under the plans.
During the ordinary course of business, the Company and its Subsidiaries become parties to certain litigation. The Company is not subject to any material pending legal proceedings.
In the event that any or all of the reinsuring companies are unable to meet their obligations, or contest such obligations, the Company would be liable for such defaulted amounts. Certain of the reinsuring companies have provided collateral to secure their reinsurance obligations.
The Company's policies insure the scheduled payments of principal and interest on asset-backed (including FSA-insured CDS) and municipal obligations. The gross amount of financial guarantees in force (principal and interest) was $622.6 billion at December 31, 2004 and $558.2 billion at December 31, 2003. The net amount of financial guarantees in force was $444.5 billion at December 31, 2004 and $403.1 billion at December 31, 2003.
(2)Excludes intercompany insurance of $7,143 million in 2004 and $4,474 million in 2003 relating to FSA-insured GICs issued by the GIC Subsidiaries. The par amount ceded as of December 31, 2004 and 2003 and the terms to maturity are as follows (in millions):
The Company limits its exposure to losses from writing financial guarantees by underwriting investment-grade obligations, diversifying its portfolio and maintaining rigorous collateral requirements on
(1)Excludes intercompany insurance of $7,143 million in 2004 and $4,474 million in 2003 relating to
municipalities located therein issued an aggregate of 2% or more of the Company's net par amount outstanding (in millions) of insured municipal securities as of December 31, 2004:
The Subsidiaries earned premiums of $28.0 million, $20.5 million and $17.3 million for the years ended December 31, 2004, 2003 and 2002, respectively, relating to business with affiliates of Dexia. Deferred premium revenue relating to those transactions was $17.0 million and $6.9 million at December 31, 2004 and 2003, respectively. Gross par outstanding relating to those transactions was $24.0 billion and $16.8 billion at December 31, 2004 and 2003, respectively. The Company also paid Dexia a fee of $0.7 million in 2003 and $3.3 million in 2002 relating to business in which both Dexia and the Company were involved. For the years ended December 31, 2004, 2003 and 2002 the Company recorded pre-tax income (loss) of $97.6 million, $52.9 million and $(3.7) million, respectively, relating to swaps where Dexia was the counterparty. At December 31, 2004 and 2003, the Company recorded other assets of $373.1 million and other liabilities of $17.2 million, primarily relating to swaps where Dexia was the counterparty. In addition, at December 31, 2004 and 2003, the Company had $163.0 million and $154.3 million in VIE debt, respectively, relating to debt issued by the Company and purchased by Dexia. During 2004 and 2003, the Company recorded $8.8 million and $3.3 million, respectively, in VIE net interest expense relating to such debt.
For bonds, equity securities, GIC bond portfolio, GIC bond portfolio pledged as collateral and VIE bond portfolio, the carrying amount represents fair value. The fair value is based on quoted market price or redemption value for the Company's investment in XLFA.
For assets acquired under refinancing transactions, the fair value is either the present value of the expected cash flows or quoted market prices as of the reporting date.
For deferred premium revenue, net of prepaid reinsurance premiums, the carrying amount represents the Company's future premium revenue, net of reinsurance, on policies where the premium was received at the inception of the insurance policy. The fair value of deferred premium revenue, net of prepaid reinsurance premiums, is an estimate of the premiums that would be paid under a reinsurance agreement with a third party to transfer the Company's financial guaranty risk, net of that portion of the premiums retained by the Company to compensate it for originating and servicing the insurance contract.
For losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses, the carrying amount is net present value of the expected cash flows for specifically identified claims and inherent losses in the Company's insured portfolio, which management believes is a reasonable proxy for fair value.
The table below shows the carrying amount and fair value of the Company's financial instruments (in thousands):
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 the case reserves to the non-specific reserve was $1.4 million, which also included a transfer from the non-specific to the case reserves for a municipal utility transaction. The CDO portfolio continues to perform within the expectations reflected in previously recorded provisions for CDOs.
The Company made equity investments in SPS Holding Corp. ("SPS") (formerly, Fairbanks Capital Holding Corp.) of $10.3 million and $13.4 million in 2004 and 2002, respectively, and did not make any equity investments in 2003. At December 31, 2004, the Company had a 34.1% interest in SPS. The Company's investment in SPS is accounted for using the equity method of accounting. Amounts recorded by the Company in connection with SPS at December 31, 2004, 2003 and 2002 were as follows (in thousands):
At December 31, 2004 and 2003, the Company's retained earnings included $4.0 million and $3.5 million, respectively, of accumulated undistributed earnings of SPS.
At December 31, 2003, the Company's retained earnings included $25.7 million of accumulated undistributed earnings of XLFA.
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. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred. The Company recorded $69.1 million, $57.7 million and $35.0 million of net earned premium under these agreements for the years ended 2004, 2003 and 2002, respectively.
Changes in the fair value of CDS, which were gains of $56.4 million and $34.8 million for the years ended December 31, 2004 and 2003, respectively, and losses of $50.2 million in 2002, were recorded in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income. The Company included net par outstanding of $66.0 billion and $63.8 billion relating to these CDS transactions at December 31, 2004 and December 31, 2003, respectively, in the asset-backed balances in Note 13. The gains or losses recognized by recording these contracts at fair value are determined each quarter based on quoted market prices, if available. If quoted market prices are not available 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 the Company's ability to obtain reinsurance for its insured obligations. The Company does not believe that the fair value adjustments are an indication of potential claims under FSA's guarantees. The average life of these contracts is 2.9 years. The inception to date gain (loss) on the CDS portfolio was $46.6 million at December 31, 2004 and $(9.8) million at December 31, 2003.
In order for a derivative to qualify for hedge accounting, it must be highly effective at reducing the risks associated with the exposure being hedged. An effective hedge is defined as a hedge that falls within an 80% to 125% correlation range. The difference between a perfect hedge (i.e., one that correlates exactly 100%) and the actual correlation within the 80% to 125% range is the ineffective portion of the
The Company generally has rights under its financial guaranty insurance policies and indentures that allow it to accelerate the insured notes and pay claims under its insurance policies upon the occurrence of predefined events of default. To mitigate future losses, the Company may elect to purchase the outstanding insured obligation or its underlying collateral. Generally, refinancing vehicles reimburse FSA in whole for its claims payments in exchange for assignments of certain of FSA's rights against the trusts. The refinancing vehicles obtain their funds from the proceeds of FSA-insured GICs issued in the ordinary course of business by the GIC Subsidiaries. The refinancing vehicles are consolidated into the Company's financial statements. The Company maintains its reinsurance on these transactions.
Securitized loans are carried at cost, net of losses at the date of purchase. Income is recorded based on the effective yield method. The cash flows on the securitized loans, net of reinsurance, are monitored and the effective yield modified to reflect any change in the cash flow estimate on a prospective basis (see Note 26). Since the notes represent 100% of the debt capitalization of the trusts and since FSA maintains all the risk of further asset decline (except as provided by reinsurance) and maintains control over key decisions regarding the trusts (such as removal of the servicer, sale of the assets and liquidation of the entity), the trusts were consolidated with FSA for accounting purposes. FSA also consolidated the refinancing vehicles.
The intersegment assets consist of (1) intercompany notes issued by FSA and held within the GIC Portfolio and (2) GICs issued by the GIC Subsidiaries and held within the VIE Portfolio. The intersegment revenues and expenses relate to interest income and interest expense on intercompany notes and GICs.
FIN 46R requires that, upon consolidation, the Company initially measure the VIE's assets, liabilities and minority interest at their carrying amounts under existing GAAP as if the entity had been consolidated from the time the Company was considered its primary beneficiary (or parent). The increase in total assets and total liabilities, at July 1, 2003, related to the consolidation of these entities was $1.9 billion. The difference upon consolidation was reflected as a cumulative effect of a change in accounting principle at July 1, 2003. The cumulative effect of a change in accounting principle for Canadian Global resulted in additional income of $4.8 million, net of income tax. There were no cumulative income statement effects from consolidating FSA Global and Premier. The following table presents the impact of consolidation of the VIEs.
All bonds in the VIE Portfolio are insured by FSA. The credit quality of the VIE Portfolio, without the benefit of FSA's insurance, at December 31, 2004 was as follows:
The amortized cost and fair value of bonds in the VIE Portfolio were as follows (in thousands):
The amortized cost and fair value of bonds in the VIE Portfolio at December 31, 2004, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-3: "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3"). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to
SOP 03-3 requires that the investor recognize the excess of all cash flows expected at acquisition over the investor's initial investment in the loan as interest income on a level-yield basis over the life of the loan. SOP 03-3 prohibits investors from displaying differences from expected cash flows in the balance sheet. Subsequent increases in cash flows expected to be collected generally should be recognized prospectively through adjustment of the loan's yield over its remaining life. Decreases in cash flows expected to be collected should be recognized as an impairment.
SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004. For loans acquired in fiscal years beginning on or before December 15, 2004 and that fall within the scope of Practice Bulletin 6 as it applies to decreases in cash flows expected to be collected, SOP 03-3 should be applied prospectively for fiscal years beginning after December 15, 2004. Management believes that the implementation of SOP 03-3 will not have a material effect on the Company's financial position, results of operations or cash flows.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123-R, "Share-Based Payment" ("SFAS 123-R"). This Statement is a revision of SFAS 123, "Accounting for Stock-Based Compensation" and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees," and its related implementation guidance. SFAS 123-R requires entities to recognize compensation cost for all equity-classified awards after the effective date using the fair-value measurement method. SFAS 123-R is effective for interim or annual periods beginning after June 15, 2005. The adoption of SFAS 123-R is not expected to have a material impact on the Company's financial position or results of operations.