The following table presents our selected consolidated financial and operating data. The financial data set forth below for the years ended December 31, 2007, 2006, 2005, 2004 and 2003 are derived from our Consolidated Financial Statements. The financial data as of December 31, 2007, 2006 and 2005 and for the years ended December 31, 2007, 2006, 2005 and 2004 have been audited. The information set forth below should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in
Each of Moody’s, Fitch and S&P has reassessed our historical triple-A ratings in light of recent market conditions resulting in downgrades and continued monitoring. On January 23, 2008, Fitch downgraded the IFS rating of XLCA, XLCA-UK and XLFA to “A” (Rating Watch Negative) from “AAA.” Fitch has announced that, based on its model, SCA has a capital shortfall of more than $2 billion at the “AAA” rating threshold. On February 25, 2008, S&P downgraded the IFS, credit enhancement and issuer credit ratings of XLCA, XLCA-UK and XLFA to "A-" from “AAA” and
each remains on CreditWatch with negative implications. S&P stated that under its capital adequacy model, XLCA’s, XLCA-UK’s and XLFA’s margin of safety falls in the “A” category and the CreditWatch Negative designation reflects potential that our strategic plan may not be successful. S&P also announced that under its updated theoretic bond insurance stress case scenario, XLCA’s and XLFA’s total after-tax net loss on their guarantees of RMBS and CDOs are estimated by it to be approximately $2.8 billion, which, we believe, would result in a capital shortfall of approximately $1.8 billion at S&P’s “AAA” ratings level. On March 4, 2008, Moody’s placed the “A3” IFS ratings of XLCA, XLCA-UK and XLFA on review for possible downgrade. Previously, on February 7, 2008, Moody’s downgraded the IFS rating of XLCA, XLCA-UK and XLFA to “A3” (Negative Outlook) from “Aaa” at which time Moody’s noted that, under its analysis, the capitalization required to cover losses at the “Aaa” target level would exceed $6 billion compared to Moody’s estimate of SCA’s current claims paying resources of $3.6 billion. In addition to these downgrades of our IFS ratings, Moody’s, S&P and Fitch have recently downgraded our debt and other ratings.
As a result of this review, we have developed a strategic plan focused on: (i) mitigating the risk of non-compliance with regulatory solvency requirements and risk limits, (ii) maintaining or enhancing our liquidity, (iii) increasing the amount of capital available to support our ratings and (iv) mitigating uncertainty in regard to adverse loss reserve development. The primary elements of our strategic plan include:
exploring the commutation of assumed reinsurance agreements or entering into new ceded reinsurance agreements to reduce the capital that we are required to maintain in support of our ratings by rating agencies;
continuing to investigate longer term strategic alternatives, including the restructuring of our business to facilitate the creation or raising of new capital.
On February 22, 2008 and March 6, 2008, we issued notices terminating seven CDS contracts with a certain counterparty under which we had agreed to make payments to the counterparty on the occurrence of certain credit events pertaining to particular ABS CDOs referenced in the agreements. We issued each of the termination notices on the basis of the counterparty’s repudiation of certain contractual obligations under each of the agreements. We have been advised by the counterparty that it disputes the effectiveness of the terminations. We intend to vigorously enforce the terminations. The notional amount of the credit default swaps at December 31, 2007 aggregated $3.1 billion before reinsurance ($3.0 billion after reinsurance). For the year ended December 31, 2007, we recorded a charge of $632.3 million relating to these CDS contracts, of which $215.0 million represents a net unrealized loss and is reflected in our consolidated statement of operations in the caption entitled “Net realized and unrealized losses on credit derivatives,” and $417.3 million represents the provision of case basis reserves for losses and loss adjustment expenses and is reflected in our consolidated statement of operations in the caption entitled, “Net losses and loss adjustment expenses.” At December 31, 2007, we recorded a derivative liability and reserves for losses and loss adjustment expenses associated with these credit default swap contracts of $222.8 million and $498.8 million before reinsurance ($215.0 million and $417.3 million after reinsurance), respectively.
We were formed as an indirect wholly owned Bermuda based subsidiary of XL Capital on March 17, 2006. On July 1, 2006, XL Capital contributed all its ownership interests in its financial guarantee insurance and financial guarantee reinsurance operating businesses to us. These businesses consisted of: (i) XLCA and its wholly-owned subsidiary, XLCA-UK and (ii) XLFA. XLCA was an indirect wholly owned subsidiary of XL Capital and all of XLFA was owned by XL Capital except for a preferred stock interest which is owned by FSAH, an entity which is otherwise not related to XL Capital or us. On August 4, 2006, we completed our IPO from which we received net proceeds of $341.3 million. We contributed $298.1 million of the proceeds to XLFA and $25.0 million to XLCA to support their business operations and retained $18.2 million for general corporate purposes. In addition, XL Capital sold a portion of its shares in the IPO reducing its ownership to approximately 63% economic interest in SCA, adjusted for restricted share awards to our employees and management made at the effective date of the IPO. In June 2007, XL Capital sold an additional 10,627,422 common shares of SCA further reducing its ownership to approximately 46% voting and economic interest in SCA, adjusted for restricted share awards to our employees and management outstanding as of such date. XL Capital’s voting interest in SCA is subject to limitations contained
The financial guarantee business is significantly affected by economic cycles. For example, a robust economy featuring a good or improving credit environment is beneficial to the in-force portfolios of financial guarantee insurers and reinsurers. Historically, however, when such conditions have existed for an extended period, credit spreads tend to narrow and pricing and demand for financial guarantee insurance and reinsurance tend to decline. A weakening economic and credit environment, in contrast, is typically marked by widening credit spreads and increasing pricing for financial guarantee products. However, a prolonged period of weak or declining economic activity could stress in-force financial guarantee insured portfolios and result in claims or could adversely impact capital adequacy due to deterioration in the credit quality of in-force insured portfolios.
Over the past several quarters, credit spreads across most bond sectors have widened reflecting widely published concerns in regard to potential credit erosion in the U.S. residential mortgage and corporate credit sectors. This trend has affected, or could affect, many companies such as ours which have exposure to the securities which have been issued over the years to finance the housing industry, such as RMBS and ABS CDOs. Specifically, in the current environment, transactions within our insured RMBS and ABS CDO portfolios have been or may be downgraded, placed on watch or subject to other actions by the three rating agencies. Such ratings actions could in turn require us to maintain a material amount of additional capital to support the exposures we have guaranteed. Among other things, this could cause us to: (i) have to raise additional capital, if available, on terms, and under conditions, that may be unfavorable which among other things could increase our cost of capital, (ii) curtail the production of new business, or (iii) pay to reinsure or otherwise transfer certain of our risk exposure. See “-Overview-General-Review of Strategic Options” above.
Premiums are accounted for as written when due; therefore when we enter into policies that provide for upfront premium, all of the premium on the policy is accounted for as written generally when the policy commences. The portion of the upfront premium that has been written but has not yet been earned is carried on our balance sheet as deferred premium revenue. When we enter into policies that provide for installment premium, only that installment of the premium that is then due (generally the current monthly, quarterly or semiannual installment) is accounted for as written. Future premium installments during the remainder of the life of the installment-based policy are not reflected on our financial statements. Therefore, the amount of total premiums written that we
Unrealized gains and losses on CDS contracts and insurance policies that we account for as derivative contracts are a function of changes in the estimated fair value of those contracts. These unrealized gains and losses fluctuate primarily based on changes in credit spreads, the credit quality of the referenced securities, rates of return and various other factors. See “-Critical Accounting Policies and Estimates-Valuation of Credit Default Swaps” and Note 3 to the Consolidated Financial Statements for additional information.
We evaluate our periodic sales performance based on a non-GAAP measure known as adjusted gross premiums. Adjusted gross premiums for any period equals the sum of: (i) upfront premiums written in such period, (ii) current installment premiums on business written in such period and (iii) expected future installment premiums on contracts written during such period that remain in force and for which there is a binding obligation on the part of the insured to pay the future installment premiums, discounted to present value at 7%, which we refer to as the present value of future installment premiums (“PVFIP”) on business written during such period. The 7% discount rate was established when our subsidiaries first started reporting adjusted gross premiums based upon the view that 7% was the appropriate discount for these future premiums and that rate has not been changed in order to preserve comparability among periods. This measure adjusts for the fact, as described above, that upfront premiums are recorded in full as total premiums written at inception of the contract but future installment premiums are not, even though the volume of insured business we are writing is essentially the same. PVFIP is not reflected on our Consolidated Financial Statements. PVFIP can be negatively affected by prepayments and refundings, early terminations, credit losses or other factors impacting our in-force book of business.
We also measure our performance by excluding from net income: (i) net realized gains (losses) on investments and net realized and unrealized (losses) gains on credit derivatives and (ii) earned premiums from refundings. Management believes that net income adjusted to exclude these items provides a better measure of the operating performance of its business, as such items are largely not subject to management discretion or control.
As of December 31, 2007, our total net direct exposure to RMBS aggregated approximately $9.6 billion, representing approximately 5.9% of our total in-force guaranteed net par outstanding at such date. The RMBS exposure consisted of various collateral types as set forth in the chart below. The tables below also set forth our internal ratings, as well as the ratings of the rating agencies of the insured transactions at December 31, 2007. During the year ended December 31, 2007, we recorded a provision for losses and loss adjustment expenses of $216.7 million before reinsurance ($37.2 million after reinsurance) on certain guarantees supported by HELOC and closed-end second (“CES”) mortgage collateral. See “-Critical Accounting Policies and Estimates-Reserves for Losses and Loss Adjustment Expenses.”
Set forth below is certain additional information in regard to our exposure to RMBS and CDOs.
The following table presents the net par outstanding for our insured RMBS portfolio by type of collateral as of December 31, 2007:
An “Alt-A” loan means a loan which is ineligible for purchase by Fannie Mae or Freddie Mac.
Subprime (1st lien) mortgage loans are secured by first liens on residential properties to non-prime borrowers. The underwriting standards used to underwrite subprime mortgage loans are less stringent than the standards applied to the most creditworthy borrowers and less stringent than the standards generally acceptable to Fannie Mae and Freddie Mac with regard to the borrower’s credit standing and repayment ability.
The following table presents the net par outstanding for our insured RMBS portfolio by year of origination (year the guarantee was underwritten and issued) as of December 31, 2007:
Our internal ratings are based on our independent credit assessment of each transaction taking into account the overall credit strengths and weaknesses, transaction structure and the trends in the asset sector. We base our analysis on information received from the trustees or from the issuer, as well as on-site visits to issuers, servicers, collateral managers and project sites. If updated modeling has been performed, modeling results are also considered. We also take into consideration the rating agencies’ rationale for their ratings, and, accordingly, our ratings are typically consistent with the rating agencies. However, variations exist as we make independent conclusions that may result in different ratings.
The following table presents the net notional exposure for our guaranteed CDOs by type of referenced asset as of December 31, 2007:
An ABS CDO is a CDO that is collateralized by, or synthetically references, a pool of asset backed securities, though mostly RMBS.
CDOs secured primarily by “AAA,” “AA,” and “A” rated RMBS collateral at inception.
The following table presents the net notional exposure for our ABS CDO portfolio by referenced asset type as of December 31, 2007:
Prime RMBS includes securities with a weighted average FICO score at or above 700 per third party data sources. Midprime RMBS includes securities with a weighted average FICO score below 700 but above 640 per third party data sources.
Other ABS includes credit card, student loan, small business loan and other non-mortgage securitizations.
The following table presents the net notional exposure of the referenced assets underlying our ABS CDO portfolio by rating as of December 31, 2007:
Ratings represent the lower of ratings by S&P or Moody’s as of February 15, 2008.
SCA internal ratings as of March 12, 2008. "BIG" indicates a rating of below investment grade.
S&P, Moody’s and Fitch ratings as of March 12, 2008. The symbol "/*-" indicates rating is on review for downgrade.
The following table presents our CDO squared exposure as of December 31, 2007:
Case basis reserves on financial guarantee insurance business written are established by us with respect to a specific policy or contract upon receipt of a claim notice or when management determines that (i) a claim is probable in the future based on specific credit events that have occurred and (ii) the amount of the ultimate loss that we will incur can be reasonably estimated. As specific case basis reserves are established we consider whether any changes are required to the assumptions underlying the calculation of unallocated reserves (which are discussed below) as a result of such activity. The amount of the case basis reserve is based on the net present value of the expected ultimate loss and loss adjustment expense payments that we expect to make, net of expected recoveries under salvage and subrogation rights. Case basis reserves are determined using cash flow or similar models to estimate 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 the proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries. A number of quantitative and qualitative factors are considered when determining or assessing the need for a case basis reserve. These factors may include the creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured, the projected cash flow or market value of any assets that collateralize or secure the insured obligation, and the historical and projected loss rates on such assets. Other factors that may affect the actual ultimate loss include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. Case basis reserves are generally discounted at a rate reflecting the yield on our investment portfolio during the period the case basis reserve is established. We believe this yield is an appropriate rate to discount our reserves because it reflects the rate of return on the assets supporting such business. When a case basis reserve is established for a guaranteed obligation whose premium is paid on an upfront basis, we continue to record premium earnings on such policy over its remaining life, unless we have recorded a full limit loss with respect to such policy, in which case the remaining deferred premium revenue relating
Case basis reserves on financial guarantee reinsurance assumed are generally established by us upon notification from ceding companies. Based on our evaluation of the loss activity reported to us from our ceding companies, as well as the results from our periodic reviews of our ceding companies’ underwriting and surveillance procedures, we may, in management’s judgment, establish case reserves greater than those reported by the ceding companies.
Our initial selection of an IELR (and subsequent periodic updates thereof) is based on management’s judgment and considered: (i) the characteristics of our in-force financial guarantee insurance and reinsurance business (e.g., principally the mix of our in-force financial guarantee insurance and reinsurance business between public finance and structured finance business; however, we also considered the various bond sectors comprising our insured and reinsured in-force business which are discussed in detail in Note 13 to our Consolidated Financial Statements included elsewhere herein, as well as the credit profile of our insured and reinsured portfolio of business), (ii) our actual loss experience, (iii) the characteristics, as discussed above in relation to our in-force
Our methodology applies the initial expected loss ratio to earned premium during the period from our entire in-force book of business (after exclusion of the effect on earned premium of refunding and full limit losses because no more risk exists on these related policies). Significant changes to any variables on which our initial expected loss ratio is based, over an extended period of time, will likely result in an increase or decrease in such ratio. For example, a shift in business written for sectors with high default rates would likely increase our expected loss ratio, while a shift for sectors with low default rates would likely decrease our expected loss ratio. Additionally, increases in default rates relative to our insured portfolio and in our actual loss experience or decreases in statistical recovery rates and in our actual recovery experience would increase our expected loss ratio, while the inverse would likely decrease our expected loss ratio.
During 2004 we adjusted our initial expected loss ratio to 20% from 25%, which was utilized since the adoption of our unallocated reserve methodology in recognition of the cumulative experience of our business to that point in time, as well as the increasing percentage of our in-force business from public finance insurance. This change resulted in approximately a $15.0 million decrease in unallocated loss reserves, which decrease was substantially offset by a change in the estimated expected loss emergence pattern of our in-force business due to the availability of more detailed information as a result of the implementation in 2004 of a new automated information system. Management also considered its industry studies described above as supportive of management’s change in the initial expected loss ratio in 2004, for the reasons described above. Our updated analyses in 2005 and 2006 indicated that no change was necessary in our expected loss ratio of 20% from that in 2004. As discussed above, we have not changed the IELR in 2007 because of our view that the losses recorded by us and others in the industry are concentrated in our residential mortgage exposures which are not correlated to the rest of our in-force business. Nevertheless, management continues to review conditions in the market which could affect the performance of all exposures in our in-force business and could decide later to increase the IELR if events warrant.
For example, underperformance in the early periods of a consumer-asset-backed security is generally of particular concern from the standpoint of potential loss manifestation. However, early underperformance does not necessarily predict that an incurred loss will result and, in certain instances, a restructuring of the transaction can mitigate a loss event. Conversely, if structured finance deals perform more or less as expected in the early stages, collateral protection multiples usually increase with time and, accordingly, the loss propensity decreases. Similarly, municipal default statistics demonstrate a propensity toward increased relative defaults in the early years and less in the later years. Once a municipality has established its revenue flows to meet its debt borrowing obligations and these are performing as expected, it becomes increasingly unlikely that the existing debt burden cannot be adequately serviced in the future from the same revenue base. Management believes it is reasonable to estimate the loss emergence pattern by reflecting the proportionate mix of municipal versus structured finance.
For the purposes of the following example, we assume a 15-year financial guarantee contract with a $1,000 upfront premium that is earned in proportion to the expiration of related risk, as described in “-Critical Accounting Policies and Estimates-Premium Revenue Recognition”. The example below assumes the guarantee contract was written in 2005 and shows how premiums would be earned, as well as how unallocated reserves are calculated and amortized over the loss emergence pattern. The application of the methodology set forth in this example is indicative of how this methodology applies to our entire in-force business. The assumed loss emergence pattern represented by the “Fraction of Loss Exposure Exhausted” (column (3) and the selected initial expected loss ratio of 20%, is shown in the calculation in column (4). For purposes of this example we applied the selected initial expected loss ratio of 20% on a policy level; however, we apply in practice the selected initial expected loss ratio on a portfolio-wide basis to earned premium during the period from our entire in-force book of business. The first table below illustrates the establishment of the unallocated reserve and run-off of such reserve as the par at risk of the insured obligation in the example amortizes. The second table below is the same as the first table except that a column is added to illustrate the periods in which the model assumes case reserve and paid loss activity to occur and the related amounts. In accordance with our methodology, as management establishes case basis reserves and pays claims it may, based on its judgment, reduce or increase the ultimate expected loss ratio used to determine unallocated reserves to reflect its best estimate of expected ultimate loss experience. We have described above the interrelationship of unallocated reserves, case basis reserves and cumulative paid losses to date as well as the methodology for selecting our initial expected loss ratio. As previously stated, the process of establishing unallocated reserves and periodically revising such reserves to reflect the underlying par risk amortization and management’s current best estimate of ultimate losses will ultimately cause the cumulative loss experience over the life of a particular underwriting year’s business to equal the cumulative inception-to-date actual paid losses on such business. The third table below illustrates by an example the impact of actual loss experience different from that assumed in the second table.
Our total reserves for losses and loss adjustment expenses represent a small percentage of our insured and reinsured in-force par outstanding. We believe that our reserves are adequate to cover our expected ultimate losses. However, due to the inherent uncertainties of estimating reserves for loss and loss adjustment expenses, actual experience may differ from the estimates reflected in our Consolidated Financial Statements, and the differences may be material. Differences exist within the financial guarantee industry with regard to the methodology and measurement of such reserves. While we believe that the principles we apply are the most appropriate for our business and have applied them consistently within the periods presented, alternate methods may produce different estimates as compared to the current methodology we use. See “Risk Factors-Risks Related to Our Company-Rules relating to certain accounting practices in the financial guarantee insurance and reinsurance industry are currently being reviewed by applicable regulatory bodies and any changes required by that review could have a material adverse effect on the reported operating results and financial condition of the industry or particular market participants, including us.”
Our surveillance department focuses its review on monitoring the lower-rated bond sectors and potentially troubled sectors. It tracks performance monthly to try to ensure that covenants have not been breached. Once a covenant is breached we may have the right to put the transaction into rapid amortization so that all cash flow generated from that transaction is used to pay down principal and stay current with interest. Typically, we review periodically servicing and trustee reports to help track coverage levels, enhancement levels, delinquency levels, loss frequency, loss severity and total losses and compare these performance metrics with the metrics that were made available at the time the transaction was closed. If losses are above projections we will analyze the reasons for the deviation. In some cases it may be an indication of servicing problems where loans are delinquent and are not put into foreclosure in time to maximize recovery. Periodically, we audit servicers of loans and other assets supporting our insured obligations to better understand their servicing practices and to identify potential servicing problems, if any. Management believes that this is an important safeguard, as servicers are required to indemnify us against failure to adhere to the servicing standards set forth in the servicing agreements.
As discussed above, the IELR selected by management to determine our unallocated reserves is based on historical financial guarantee insurance industry loss experience, based on management’s judgment, adjusted for the risk inherent in our in-force business, as compared to that of the industry, and our actual loss experience. Based upon the actual historical industry loss experience considered in establishing our unallocated reserves, we believe it is reasonably likely that the industry loss ratio could vary within a range of plus or minus 5 percentage points of its current mean. However, determining the variability in management’s IELR that could be considered to be reasonably likely requires the application of further management judgment. In this regard, after considering the variability of industry loss experience that would be reasonably likely, management applied its judgment to consider whether its own experience and the composition of our in-force business would suggest that another range of variability would be more appropriate for measuring the reasonably likely variability of our unallocated reserves. In addition, management considered the change in our unallocated reserves, implied by our selection of a reasonably likely range of variability, relative to the insured risks on our flag lists noted above. Based on the convergence of the mix of our in force business with that of the industry, our cumulative experience to date, and the insured risks on our flag lists compared to our selected range, management concluded that the selected industry historical range of loss reserve variability would also represent an appropriate range around our current IELR. Accordingly, increasing our IELR by 5 percentage points would increase our net unallocated reserves by approximately $21.0 million or 22.7% more than that recorded at December 31, 2007. Similarly, decreasing our IELR by 5 percentage points, which would be indicative of a robust economy would decrease our net unallocated reserves by $20.0 million or 21.5% less than that recorded at December 31, 2007. Please see “-Key Factors Affecting Profitability.”
At December 31, 2007, the loss list consisted of 21 credits. Gross case basis reserves at December 31, 2007 were $1.1 billion, or $706.9 million net of ceded reinsurance. Thirteen credits are related to ABS CDO exposures, five credits are related to HELOC exposures, one credit is related to CES exposure and the remaining two transactions are a single-structured risk project financing and a third-party reinsured international transportation credit. See Note 14 to the Consolidated Financial Statements included elsewhere herein for additional information.
During the year ended December 31, 2007, the Company recorded a provision for losses before reinsurance of approximately $838.6 million ($651.5 million after reinsurance) with respect to guarantees of ABS CDOs, representing the net present value of losses expected to be incurred in the future with respect to 13 of its 25 guarantees of ABS CDOs. Such losses represent the net present value of all expected claims, less the net present value of expected recoveries and future installment premiums due by the counterparties to such guarantees. The remaining notional/par guaranteed by the Company with respect to these transactions net of carried case basis reserves, but before reinsurance, aggregated approximately $9.4 billion ($8.6 billion after reinsurance) at December 31, 2007. The estimate of loss was based on assumptions and estimates extending over many years into the future. Such estimates are subject to the inherent limitation on our ability to predict the aggregate course of future events. Accordingly, the actual emergence of losses and loss adjustment expenses may vary, perhaps materially, from any estimate. There is currently no payment default with respect to these transactions. Management continues to monitor the exposure and will revise its loss estimate if necessary, as new information becomes available. See “-Exposure to Residential Mortgage Market” above for additional information on our exposure to, and reserves for losses on, ABS CDOs.
The case basis loss reserves on our ABS CDO portfolio were determined based on detailed cash flow modeling of expected monthly cash flows for all loans that are referenced in the 25 ABS CDOs. ABS CDOs we guarantee are highly complex structured transactions, the performance of which depends on a wide variety of factors outside of our control. Our estimate of losses on these transactions was based on sophisticated financial models, generated internally and supplemented by models generated by third parties, to estimate future credit performance of the underlying assets, and to evaluate structures, rights and our potential obligations over time. The modeling of multi-sector CDOs requires analysis of both direct ABS as well as CDO collateral within the multi-sector CDOs, known as “inner securitizations,” and we do not consistently have access to all the detailed information necessary to project every component of each inner securitization. Therefore, in some cases we put greater reliance on the models and analysis of third party market participants and are not able to fully, independently and precisely verify each data point. In addition, many of these financial models include, and rely on, a number of assumptions, many of which are difficult to determine and are subject to change, and even small alterations in the underlying assumptions of the model can have a significant impact on its results. Moreover, the performance of the securities we insure depends on a wide variety of factors which are outside our control, including the liquidity and performance of the collateral underlying such securities, the correlation of assets within collateral pools, the performance or non-performance of other transaction participants (including third-party servicers) and the exercise of control or other rights held by other transaction participants.
Loan risk factors (option adjustable rate mortgages (“ARM”), negative amortization, investor property, second home, and second lien)
The roll rate projections of defaults for loans that are currently delinquent in the pool.
We generally determined the expected performance of each RMBS security owned by the CDO as follows:
The base default rate was then adjusted upwards, based on management judgment, to reflect the additional risk associated with certain types of loans, including: Option ARMs, second lien, stated income, low or no documentation, investor property, etc., as well as loans with high CLTV.
For each RMBS security, different loss curves were assigned based on fixed or floating rate collateral composition.
These assumptions were input into cash flow models created for each RMBS security by a third party vendor (Intex). The Intex model generated monthly cash flows for each of the CUSIP level securities owned by the CDO.
Next, we developed cash flow projections for the direct holdings of CDO collateral (“Inner CDOs”). The majority of the Inner CDOs are tranches of other ABS CDOs. For each RMBS owned by an Inner CDO we went through the same steps as described above for our direct RMBS holdings in order to assign loan loss projections, CPR and constant default rate (“CDR”) curves. Each of the RMBS pools were then run through the Intex model to calculate the total par loss or principal write-down on the tranche owned by the Inner CDO.
Some of the Inner CDOs also hold investments in other ABS CDOs, which we refer to as 3rd level CDOs. Our assumption was that these investments would experience a 75% loss.
The only other assets we encountered in any significant amount in our ABS CDOs are CMBS securities. We assume that these bonds pay interest and principal over their WAL in most cases.
During the year ended December 31, 2007, we recorded a provision for losses before reinsurance of approximately $216.7 million ($37.2 million after reinsurance), representing the net present value of losses expected to be incurred in the future with respect to 6 of our 15 HELOC or CES transactions. The total remaining par guaranteed by us with respect to these 6 transactions net of carried case basis reserves, but before reinsurance, aggregated approximately $2.4 billion ($2.2 billion after reinsurance) at December 31, 2007. Through December 31, 2007, we have paid claims aggregating $7.5 million on our guarantees of obligations supported by HELOCs, $5.0 million of which relates to transactions for which we have established a case basis reserve at December 31, 2007. Through February 15, 2008, we have paid claims aggregating $39.2 million, $28.4 million of which relates to transactions for which we have established a case basis reserve at December 31, 2007. The estimate of losses was based on assumptions and estimates extending over many years into the future. Such estimates are subject to the inherent limitation on our ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of losses and loss adjustment expenses will vary, perhaps materially, from any estimate. Among other things, the assumptions could be affected by an increase in unemployment, increase in consumer costs, lower advance rates by lenders or other parties, lower than expected revenues or other external events. Our estimate was determined based on an analysis of results of a cash flow model. The gross provision for losses and corresponding case basis reserve represents the net present value of all claims expected to be paid after December 31, 2007 less the net present value of expected recoveries and future installment premiums due to the Company for the policies.
The cash flow model projects expected cash flows from the underlying mortgage notes. The model output is dependent on, and sensitive to, the key input assumptions, including assumptions regarding default rates, prepayment rates and the rate of new draws on the HELOCs. On the HELOC transactions, it also projects expected new collateral to be created by the funding of new HELOC draws. The cash flow from the mortgages is then run through the “waterfall” as set forth in the indenture for each transaction. Claims in respect of principal result when the outstanding principal balance of the mortgages is less than the outstanding principal balance of the insured notes. Recoveries result when cash flow from the mortgages is available for repayment, typically after the insured notes are paid off in full.
The Company based its default assumptions on recent observed default rates and the current pipeline of delinquent loans. The Company generally assumes that the default rates will increase for the next nine months and then ramp down over another nine months, at which point the default rate will stabilize at a rate nearer, but still above, historical default rates. A 1% increase in the default rate on all deals would result in an increase to our reserve of approximately $40 million. Net losses may be greater if the time it takes the mortgage performance to stabilize is longer than expected. If the time it takes for the market to stabilize is 24 months instead of 18 months, our reserve would increase by approximately $32 million.
In 2002, we insured $325 million of notes issued to finance the construction costs for a group of projects in connection with a structured project financing (the “Projects”). Concurrent with our provision of insurance on the notes we entered into a reinsurance arrangement with XLI, whereby XLI reinsured the entire subordinate tranche and a portion of the mezzanine tranche of the insured notes. The reinsurance was structured in senior, mezzanine, and subordinate tranches of notes. Funds for the payment of debt service on the notes come solely from net revenues produced from operating the Projects. Our insurance provides an irrevocable guarantee to the holders of such notes of the timely payment of principal and interest on the notes pursuant to its indenture. During the year ended December 31, 2004, we recorded a loss of approximately $42.1 million, representing, in management’s judgment, the present value of the loss, discounted at 3.43%, expected to be incurred in the future with respect to the subordinate tranche of the notes. This loss was fully reinsured by XLI and, accordingly, there was no net impact on our results of operations from this loss provision. During 2005, we recorded an additional provision for loss relating to the mezzanine tranche of the notes of $16.7 million (which reduced our operating results by $8.7 million after reinsurance to XLI), representing the present value of the loss discounted at 4.2%, to reflect certain adverse developments occurring during 2005. During 2006, the Company again recorded an additional provision for loss relating to the transaction of $15.2 million, which was fully covered under an indemnification discussed above and, accordingly, resulted in no net impact on the Company’s results of operations in 2006. There has been no change in the reserve during 2007. The total remaining par insured by the Company in connection with this transaction (net of applicable carried case reserves before reinsurance), which amortizes over the next 11 years, aggregated approximately $204.6 million at December 31, 2007. After the reinsurance indemnity provided by subsidiaries of XL Capital and the $8.7 million net case basis reserve carried on the Company’s books discussed above the Company has no remaining net exposure to this transaction. The estimate of loss was based on assumptions and estimates extending over many years into the future. There is currently no payment default with respect to this transaction. Management continues to monitor the exposure and will revise its loss estimate if necessary, as new information becomes available.
were rated (based on S&P ratings) “AAA,” with 7% rated at or above investment-grade and less than 1% rated below investment-grade.
The fair value of our in-force portfolio of CDS contracts represents our best estimate of the premium that would be required by a market participant to assume the risks in our credit derivative portfolio as of the measurement date. Fair value is defined as the price at which an asset or a liability could be bought or transferred in a current transaction between willing parties. Fair value is determined based on quoted market prices, if available. Quoted market prices are available only on a limited portion of our in-force portfolio of CDS contracts. If quoted market prices are not available, fair value is estimated based on the use of valuation techniques involving management judgment. In determining the fair value of our CDS contracts, we use various valuation approaches with priority given to observable market prices when they are available. Market prices are generally available for traded securities and market standard credit default swaps but are less available or unavailable for highly-customized CDS contracts. Most of the derivative contracts we insure are structured credit derivative transactions that are not traded and do not have observable market prices.
Typical market CDS contracts are standardized, liquid instruments that reference tradable securities such as corporate bonds that also have observable prices. These market standard CDS contracts also involve collateral posting and, upon a default of the reference bond, can be settled in cash. In contrast, our guaranteed CDS contracts do not contain the typical CDS market standard features as described above but have been customized to replicate our financial guarantee insurance policies. Our guaranteed CDS contracts provide protection on specified obligations, such as those described above, with a deductible or subordination level. We are not required to post collateral and, upon default, we generally make payments over time (i.e. “pay-as-you-go” basis) after the subordination in a transaction is exhausted.
Our guaranteed CDS contracts are generally structured to prevent large one-time claims upon an event of default and almost always allow for payments on a “pay as you go” basis or at final maturity. Also, our guaranteed CDS contracts are generally governed by a single transaction
International Swaps and Derivatives Association, Inc. (“ISDA”) Master Agreement relating only to that particular transaction/contract. There is no requirement for mark-to-market termination payments, under most monoline standard termination provisions, upon the early termination of the guaranteed CDS contract. However, certain of our CDS contracts have mark-to-market termination payments following the occurrence of events that are in our control, as well as events that are outside our control, such as our insolvency or a regulator taking control of our primary insurance subsidiary. An additional difference between our CDS contracts and the typical market standard CDS contract is that, except in the limited circumstances noted above, there is no current acceleration of the payment to be made under our guaranteed CDS contract unless we elect to accelerate at our option. Furthermore, by law, our guarantees are unconditional and irrevocable, and cannot be transferred by us to most other capital market participants as they are not licensed to write such business. Through reinsurance, the risk of loss (but not counterparty risk) on these contracts can be transferred to other financial guarantee insurance and reinsurance companies.
Historically there has not been a market for the transfer of such highly structured guaranteed CDS contracts, in part because of the contractual differences noted above. As a result, we believe there are no relevant third party “exit value” market observations for these contracts. If we were to effect a transfer of these contracts, we believe the most likely counterparties would be other financial guarantee insurers and reinsurers or credit derivative products companies.
estimates of rates of return which would be required by market participants to assume the risks in our CDS contracts in the current market environment;
the amount of subordination in our CDS contracts before liability attaches that would be required by a market participant in order for it to assume the risks in our contracts;
the actual amount of subordination in our CDS contracts before liability attaches;
the market perception of risk associated with asset classes referenced in our CDS contracts;
At December 31, 2007, the net fair value of our credit derivatives was a liability of $1.5 billion. Because this amount reflects management’s best estimate of the premium we would have to pay a counterparty to transfer the risks in our portfolio of credit derivatives in one or more hypothetical transactions in excess of that which we charged for such risk, it is reflected in our balance sheet as a liability. A parallel shift in the rates of return used by management to value the portfolio at December 31, 2007 by 2.5% would cause a change in the fair value of our credit derivative liability by approximately $30.4 million. In addition, a parallel shift in the discount rate of 1.0% used to estimate the present value of cash flows under our CDS contracts would cause a change in the fair value of our credit derivative liability by approximately $12.8 million.
All of our investments in debt securities and short-term investments are considered available-for-sale and accordingly are carried at fair value. As of December 31, 2007 and 2006, the carrying value of such investments was $2.4 billion and $2.0 billion, respectively. The fair values of our investments are based upon quoted market prices from nationally recognized pricing services or, in the absence of quoted market prices, dealer quotes or matrix pricing. Adverse credit market conditions during the second half of 2007 caused some markets to become relatively illiquid, thus reducing the availability of certain data used by the independent pricing services and dealers.
As of December 31, 2007, based on fair value, approximately 89% of our investments were long-term debt securities, and our portfolio had an average duration of 3.3 years, compared with 80% and 3.1 years as of December 31, 2006. Changes in interest rates affect the value of our investment portfolio. As interest rates fall, the fair value of debt securities increases, and as interest rates rise, the fair value of debt securities decreases. The following table summarizes the estimated change in fair value net of related income taxes of our investments in debt securities and short-term investments as of December 31, 2007 based upon an assumed parallel shift in interest rates across the entire yield curve:
Our process for identifying declines in the fair value of investments that are other-than-temporary involves consideration of several factors. These factors include (i) the time period during which there has been a significant decline in value, (ii) an analysis of the liquidity, business prospects and financial condition of the issuer, (iii) the significance of the decline, (iv) an analysis of the capital structure and other credit support, as applicable, of the securities in question and (v) our intent and ability to hold the investment for a sufficient period of time for the value to recover. Where our analysis of the above factors results in the conclusion that declines in fair values are other-than-temporary, the cost of the security is written down to fair value and such write down is reflected as a realized loss in the period that such determination is made.
For the year ended December 31, 2007, we recorded other-than-temporary impairment charges of $1.2 million. We did not record any other-than-temporary declines in the fair value of debt securities or short-term investments for the years ended December 31, 2006 or 2005.
The following table summarizes the unrealized losses on debt securities and short-term investments in our investment portfolio by type of security and the length of time such securities have been in a continuous unrealized loss position as of December 31, 2007 and 2006:
Of the non-U.S. government securities in a continuous unrealized loss position for 12 months or more (which excludes $0.7 million of unrealized losses on securities issued by the Government National Mortgage Association (“GNMA”), Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”) which are included in “Mortgage and Asset-Backed Securities” in the above table), 71.4%, 86.8%, and 100% are rated “AAA,” “AA-” or better or “A-” or better, respectively, of the total unrealized loss in such category. In addition, of the non-government securities in a continuous unrealized loss position for 12 months or more, securities aggregating 82% of the total unrealized loss in such category have a price decline of less than 6% from their amortized cost and 18% have a price decline greater than 6% but less than 8% of their amortized cost as of December 31, 2007.
Of the non-U.S. government securities in a continuous unrealized loss position for 12 months or more (which excludes $2.7 million of unrealized losses on securities issued by the GNMA, FNMA and FHLMC) which are included in “Mortgage and Asset-Backed Securities” in the above table), 59.2%, 75.1%, and 100% are rated “AAA”, “AA-” or better or “A-” or better, respectively, of the total unrealized loss in such category. In addition, of the non-government securities in a continuous unrealized loss position for 12 months or more, securities aggregating 87% of the total unrealized loss in such category have a price decline of less than 6% from their amortized cost and 13% have a price decline greater than 6% but less than 9% of their amortized cost as of December 31, 2006.
early, is called by the issuer or is in substance paid in advance through a refunding accomplished by placing U.S. Government securities in escrow, the remaining deferred premium revenue is earned at that time. Premiums earned for the years ended December 31, 2007, 2006 and 2005 include $14.7 million, $27.4 million, and $14.7 million, respectively, related to refunded and called bonds.
Acquisition costs incurred that vary with and are directly related to the production of new insurance and reinsurance business are deferred and amortized to expense in relation to earned premiums. These costs include direct and indirect expenses such as compensation costs of underwriting and marketing personnel and ceding commissions paid on assumed business. As of December 31, 2007 and 2006, we had deferred acquisition costs of $108.1 million and $93.8 million, respectively. Management uses its judgment in determining the amount of costs that should be deferred. Each year we conduct a study to determine the amount of operating costs that vary with, and are directly related to, the acquisition of new business and therefore qualify for deferral. The amount of expenses that qualify for deferral is dependent on the level of new business production, the level of ceding commissions negotiated with primary insurers, management’s judgment as to what costs and the percentages thereof that are deferrable. Ceding commissions received on premiums we cede to other reinsurers reduce acquisition costs. Such commissions are earned in relation to earned premium. In determining the recoverability of our deferred acquisition costs we consider expected losses and loss adjustment expenses, maintenance costs, unearned premiums, the anticipated present value of future premiums under installment contracts written, and anticipated investment income. Acquisition costs associated with credit derivative products are expensed as incurred. For policies reinsured with third parties we receive ceding commissions to compensate for acquisition costs incurred. We net ceding commissions received against deferred acquisition costs and earn these ceding commissions over the period in which the related premiums are earned.
For the year ended December 31, 2007, we recorded a $137.6 million charge to establish a valuation allowance for our net deferred tax assets. The valuation allowance was calculated in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”), which places primary importance on our operating results in the most recent three-year period when assessing the need for a valuation allowance. Our cumulative loss in the most recent three-year period, including the net loss reported for the year ended December 31, 2007, represented negative evidence sufficient to require a full valuation allowance under the provisions of SFAS 109. We intend to maintain a full valuation allowance for our net deferred tax assets until sufficient positive evidence exists to support reversal of all or a portion of the valuation allowance. Until such time, except for state, local and foreign tax provisions, we will have no net deferred tax assets.
As of December 31, 2006, our Consolidated Financial Statements reflected a deferred federal income tax asset of $18.2 million, resulting from the operations of the SCA Holdings U.S. Inc. group which are subject to U.S. federal income taxes. Such deferred tax assets were net of a valuation allowance of $1.9 million.
On April 5, 2007, we consummated the sale of $250 million of SCA Series A Preference Shares which were offered for sale pursuant to a private placement. Gross proceeds from the offering were $250.0 million, offering costs were $3.4 million, and net proceeds were $246.6 million. The SCA Series A Preference Shares are perpetual securities with no fixed maturity date and, if declared by the Board of SCA, will pay a fixed dividend, on a semi-annual basis during the first and third quarters of each fiscal year, at the annualized rate of 6.88% until September 30, 2017. After such date, the Series A Preference Shares, if declared by the Board of SCA, will pay dividends, on a quarterly basis, at a floating rate based on three- month LIBOR plus 2.715%. Dividends on the SCA Series A Preference Shares are non-cumulative. The SCA Series A Preference Shares have a liquidation preference of $1,000 per preference share. See “-Liquidity and Capital Resources-Capital Resources.” On December 19, 2007, we completed an exchange offer for up to 250,000 of the SCA Series A Preference Shares whereby 100% of the shares were exchanged for shares with the same terms and conditions that are registered under the Securities Act pursuant to a registration statement on Form S-4.
31, 2007, as compared to 2006, was primarily driven by: (i) higher net unrealized losses on credit derivatives of $682.5 million, resulting primarily from widening credit spreads on assets referenced in our in-force credit derivative portfolio, particularly subprime mortgage loan assets, which exist in our guarantees of ABS CDOs (ii) higher net losses and loss adjustment expenses of $705.6 million primarily due to an increase in case and unallocated reserves for a group of ABS CDO and HELOC transactions, due to a rapid deterioration in the fourth quarter of 2007 in credit quality of the collateral underlying these contracts, (iii) higher operating expenses of $19.9 million resulting primarily from higher costs for compensation, legal and advisory services and public company expenses, (iv) an increase in income taxes of $13.3 million primarily driven by a write-down of our net deferred tax asset due to cumulative net operating losses in XLCA, (v) the semi-annual dividend of $8.4 million on our Series A perpetual non-cumulative preference shares, which was issued in April 2007, (vi) an increase in acquisition costs of $3.7 million primarily driven by a write-off of deferred acquisition costs of $3.1 million related to certain guarantees of obligations supported by HELOC and CES mortgage loan collateral on which we have recognized losses, as well as higher premium taxes resulting from growth in our in-force business and (vii) a decrease in fee income of $2.2 million. These adverse factors were offset in part by (i) an increase in net investment income of $43.0 million reflecting a period over period increase in average invested assets (due to our issuance of Series A Perpetual Non-Cumulative Preference Shares in April 2007 and operating cash flow), as well as higher yields on new money investments, (ii) higher earned premiums of $32.6 million due to the continued growth of our in-force business (in particular, our book of installment premium business written in prior periods), (iii) a decrease in net realized losses on investments of $13.7 million, and (iv) a decrease of $4.4 million in dividends on our redeemable preferred shares.
Net premiums earned for the year ended December 31, 2007 were $215.7 million and included $14.7 million of earnings from the early retirement of certain guaranteed obligations (“refundings”) (or $12.0 million, net of accelerated amortization of deferred acquisition costs related to the earnings from such refundings). For the year ended December 31, 2006, net earned premiums were $183.1 million and included $27.4 million of refundings (or $25.2 million, net of accelerated amortization of deferred acquisition costs related to the earnings from such refundings). The year over year increase in earned premiums (excluding earned premiums from refundings) resulted from the continued growth in our in force book of business and business assumed from third-party primary companies. Our business production as measured by adjusted gross premiums (“AGP”) (which includes upfront premiums written in the period, current installment premiums due on business written in the period and expected future installment premiums on business written during the period discounted at 7.0%) totaled $549.1 million for the year ended December 31, 2007, a 1.3% decrease from $556.1 million in 2006. For a reconciliation of AGP to premiums written see “-Other Measures Used by Management to Evaluate Operating Performance.” Also, as a result of the recent downgrade of our ratings, we have suspended writing substantially all new business. See “-Overview” for further information.
The increase in our net income of $36.9 million for the year ended December 31, 2006, as compared to 2005, was primarily driven by: (i) significant growth in net premiums earned of $31.3 million, which was largely due to refunding activity, the effect of the transfer of certain business to XLFA from an affiliate in connection with our IPO, and the growth of our insured in force business, (ii) an increase in investment income of $26.6 million reflecting an increase in average invested assets and higher yields on new money investments, and (iii) lower net losses and loss adjustment expenses of $11.1 million. These factors were offset in part by (i) higher net realized losses on
investments of $13.0 million which primarily resulted from a $15.1 million impairment charge recorded during 2006 on investments acquired in satisfaction of a claim, (ii) higher net realized and unrealized losses on credit derivatives of $1.7 million due primarily to higher mark to market losses on insured interest rate swaps resulting from lower long-term interest rates and the addition of interest rate swaps to the portfolio, (iii) higher net acquisition costs of $4.0 million primarily reflecting the effect of the aforementioned refunding activity and growth in our in force business, (iv) an increase in operating expenses of $11.4 million, which resulted primarily from an increase in compensation costs associated with certain employees whose compensation prior to the IPO was partially charged to other affiliates of XL Capital, as well as certain expenses associated with SCA being a standalone public company, which prior to the IPO we did not incur, and (v) an increase in income tax expense of $4.4 million resulting from higher profitability in the Company’s operations in the United States.
All our gross premiums written are from our financial guarantee insurance segment. Gross premiums written during the period include: (i) premiums received upfront on policies or contracts written during the period, (ii) installment premiums received during the period on in-force policies or contracts that were written prior to the period, and (iii) installment premiums received during the period on policies and contracts written during the period. Gross premiums written during the period do not include installment premiums due in future periods. Accordingly, our premiums written during any period are a function of the type of contracts we write (upfront versus installment), as well as prevailing market prices. Factors affecting market prices include credit spreads, interest rates, competition and new issuance and refunding volume. Generally, financial guarantee insurers are able to charge higher premiums when credit spreads widen. Also, as a result of the recent downgrade of our ratings, we have suspended writing substantially all new business. See “-Overview” for further information. The following table presents, for the years ended December 31, 2007, 2006 and 2005, the amount of gross premiums written attributable to upfront and installment policies and contracts.
by the increase of $28.9 million in installment premiums written in the CDO and asset backed securities sector. See “-Key Factors Affecting Profitability” for a discussion of the accounting for installment premium business and the reason why installment premium reported in any period is not indicative of new installment business production, and “-Other Measures Used by Management to Evaluate Operating Performance” for information management reviews to evaluate new business production.
Gross premiums written were $353.7 million in 2006, an increase of $120.4 million or 51.6%, from $233.3 million recorded in 2005. The increase was primarily due to a $109.3 million increase in upfront premiums written resulting from growth in premiums written in the public finance infrastructure and utilities sectors, and an $11.1 million increase in installment premiums written resulting from growth in the CDO and the infrastructure financing portfolios partially offset by the decrease in installment premiums written in the asset backed securities sector.
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Other Measures Used by Management to Evaluate Operating Performance” for information management reviews to evaluate new business production.
All our reinsurance premiums assumed are from our financial guarantee reinsurance segment. The majority of our financial guarantee reinsurance business is assumed from affiliates of FSA. Also, as a result of our recent ratings downgrades, we may be required to return all or a portion of our unearned premium on such business, as determined in accordance with accounting practices prescribed or permitted by the State of New York (“SAP”). See “-Liquidity and Capital Resources-Capital Resources-Recent Developments” for information regarding our downgrades and “-Liquidity and Capital Resources-Liquidity Resources-Letter of Credit and Liquidity Facility” for more information with regard to the amount of unearned premium that may be required to be returned to our reinsurers.
The following table presents, for the years ended December 31, 2007, 2006 and 2005, the amount of reinsurance premiums assumed from affiliates of FSA, XLI, and other third-party primary companies:
Reinsurance premiums assumed in 2007 were $56.4 million, an increase of $1.1 million or 2.0%, as compared to $55.3 million recorded in 2006. The increase is the result of upfront deals assumed from FSA and a new business relationship with a third party primary company. The amount of reinsurance ceded to us from year to year by affiliates of FSA and other third-party primary companies depends upon the type and amount of insurance that they write, their capital needs and other factors.
Reinsurance premiums assumed in 2006 were $55.3 million, an increase of $3.1 million or 5.9%, as compared to $52.2 million recorded in 2005. The increase resulted primarily from premiums assumed in connection with the transfer of business from XLI in connection with certain transactions entered into concurrent with our IPO.
The following table presents, for the years ended December 31, 2007, 2006 and 2005, the amount of gross reinsurance premiums assumed by principal market:
We manage our in-force business based on single-risk limits to avoid concentration in single names and to mitigate event risk. For transactions that exceed these limits, we cede the excess to subsidiaries of XL Capital or third-party reinsurers. Through these cessions, we gain greater flexibility to manage large single risks and reduce concentration in specific bond sectors and geographic regions. Since our IPO, we have focused on reducing reinsurance to XLI and increase our third-party reinsurance relationships. To the extent that we cede a portion of our exposure to one or more reinsurance companies, we can reduce our concentration to particular issuers and help to control the diversification of our in-force business. In addition, use of reinsurance can increase our capacity to write new business and strengthen our financial ratios.
All our ceded premiums are from our financial guarantee insurance segment. Ceded premiums in 2007 were $72.3 million, an increase of $59.2 million as compared to $13.1 million in 2006. The increase was largely attributable to the transfer of certain business back to XLFA from XLI in connection with our IPO in 2006, offset in part by a decrease in cessions to XL RE AM in connection with the management of XLCA’s single risk limits. Also, XLFA ceded certain business to XLI in 2007 as part of overall capital management which resulted in XLFA ceding $21.5 million of premiums to XLI.
The following tables present net investment income, average invested assets, and the effective yield on our average invested assets for the years ended December 31, 2007, 2006 and 2005, and the average duration of our invested assets as of December 31, 2007 and 2006:
Net realized and unrealized losses on credit derivatives were $690.9 million, $8.4 million and $6.7 million for the years ended December 31, 2007, 2006 and 2005, respectively. The loss in 2007 was primarily attributable to our guarantees of ABS CDOs, which have significant exposure to the residential mortgage market, offset in part by an unrealized gain on the put option in the XLFA Capital Facility. See “-Critical Accounting Policies-Valuation of Credit Default Swaps,” “-Critical Accounting Policies-Exposure to Residential Mortgage Market” and “-Liquidity and Capital Resources.” The losses in 2006 and 2005 were primarily attributable to insured interest rate swaps, which are accounted for at fair value. Volatility in long term interest rates resulted in an increase in the derivative liability of these contracts.
Net losses and loss adjustment expenses include current year net losses incurred and adverse or favorable development of prior year net loss and loss adjustment expenses reserves. See “-Critical Accounting Policies and Estimates-Reserves for Losses and Loss Adjustment Expenses.”
Net losses and loss adjustment expenses in 2006 were $15.0 million, a decrease of $11.0 million or 42.3%, as compared to $26.0 million recorded in 2005. The decrease in net losses and loss adjustment expenses was primarily attributable to lower net losses and loss adjustment expenses in the financial guarantee insurance segment of $12.7 million, offset in part by higher net losses and loss adjustment expenses in the financial guarantee reinsurance segment of $1.7 million. Lower net losses and loss adjustment expenses in the financial guarantee insurance segment resulted from lower case reserves of $14.2 million, offset in part by a higher provision for unallocated reserves of $1.5 million. During 2006 there was a nominal case reserve provision for losses and loss adjustment expenses, whereas 2005 included case basis reserve provisions aggregating $12.2 million, of which $12.1 million related to two insured obligations. See Note 14(c) and 14(d) to the Consolidated Financial Statements elsewhere herein for details. Higher net losses and loss adjustment expenses in the financial guarantee reinsurance segment was primarily attributable to a net increase in the net case reserve provision of $0.5 million in 2006 as compared to a net decrease in the case reserve provision for losses and loss adjustment expenses in 2005 of $2.0 million. The net decrease in the 2005 provision was primarily related to the reduction in certain case reserves on transactions assumed from FSA, offset in part by an increase in the case provision of loss adjustment expenses in 2005 relating to certain business which we reinsured from XLI and which was cancelled in 2006 in connection with our IPO.
Also, during 2006 we recorded a $15.2 million increase in our gross case reserve relating to an insured project financing, as well as a $5.0 million gross case reserve in connection with an insured transaction supported by loans to medical providers. See Note 14(c) and 14(d) of our Consolidated Financial Statements, respectively, included elsewhere herein for further details of these two insurance transactions. These increases in case reserves in 2006 had no effect on our results of operations due to reinsurance and indemnities provided to us by XL Capital in connection with our IPO. In addition, during 2006 one of the two insured transactions discussed in Note 14(e) to our Consolidated Financial Statements included elsewhere herein was retired pursuant to rights exercised by the sponsor of the obligation. As a result thereof, we recorded a reduction in our net case reserves of $1.1 million in the financial guarantee insurance segment. This reduction was offset by a $1.3 million increase in case reserves relating to the other insured transaction discussed in Note 14(e) to the Consolidated Financial Statements resulting from the cancellation of reinsurance protection on the transaction which we had purchased from a third-party financial guarantee company.
rating agency fees and legal costs associated with the production of new business. Such capitalized acquisition costs are reduced by ceding commission income on premiums ceded to reinsurers.
Amortization of acquisition costs in the financial guarantee insurance segment was $19.5 million for the year ended December 31, 2007, an increase of $2.8 million, as compared to $16.7 million in 2006 (which included $0.8 million and $2.1 million, respectively, of accelerated amortization of deferred acquisition costs due to refundings in 2007 and 2006). Excluding the impact of refundings, calls and other accelerations, the increase of $4.1 million primarily reflects a write-off of deferred acquisition costs of $3.1 million related to certain guarantees of obligations supported by HELOC and CES mortgage loan collateral on which we have recognized losses, as well as higher premium taxes resulting from growth in our in-force business.
Acquisition costs in the financial guarantee reinsurance segment represent commissions paid to acquire assumed business, as well as fees for letters of credit to secure our obligations to primary companies so that they can take credit for our reinsurance in filings with their insurance regulators. Amortization of acquisition costs in the financial guarantee reinsurance segment was $7.8 million for the year ended December 31, 2007, an increase of $2.1 million, as compared to $5.7 million in 2006. The increase was primarily the result of an increase in net premiums earned in the financial guarantee reinsurance segment and an increase in letter of credit fees of $0.4 million.
Amortization of acquisition costs in the financial guarantee insurance segment was $16.7 million for the year ended December 31, 2006, an increase of $4.3 million, as compared to $12.4 million in 2005 (which included $2.1 million and $1.1 million, respectively, of accelerated amortization of deferred acquisition costs due to refundings, calls and other accelerations in 2006 and 2005). Excluding the impact of refundings, calls and other accelerations, the increase of $3.3 million primarily reflects higher acquisition costs resulting from the growth in our in-force business.
Operating expenses were $98.9 million in 2007, an increase of $19.9 million or 25.2% as compared to $79.0 million in 2006. The increase in operating expenses in 2007, as compared to 2006, was primarily attributable to: (i) higher corporate expenses of $12.5 million reflecting a full year as a public company, as compared to 2006, (ii) higher operating expenses in the financial guarantee insurance segment of $5.1 million, and (iii) higher operating expenses in the financial guarantee reinsurance segment of $2.1 million. The overall increase in operating expenses in 2007, as compared to 2006, was primarily due to a $7.8 million increase in professional fees incurred during 2007, a $7.6 million increase in compensation costs reflecting the fact that in 2006 a portion of certain of our employees compensation prior to the IPO was charged to other affiliates of XL Capital, as well as the increase in corporate expenses previously discussed.
For the year ended December 31, 2007, we reported income tax expense of $16.4 million, an increase of $13.3 million, as compared to income tax expense of $3.1 million reported in 2006. We have concluded that future income forecasted to be generated is insufficient to cause the realization of our deferred tax assets within a reasonable period, thus a valuation allowance has been established against the entire deferred tax asset at December 31, 2007. For the year ended December 31, 2006, we reported income tax expense of $3.1 million, an increase of $4.4 million, as compared to a net income tax benefit of $1.3 million reported in 2005. The increase was primarily attributable to higher pre-tax income at our U.S. insurance subsidiaries in 2006 compared to pre-tax losses in 2005, as well as a valuation allowance of $1.9 million established against net unrealized losses on investments and realized capital loss carry forwards in the U.S. See Note 15 to the Consolidated Financial Statements included elsewhere herein for further details.
Dividends on XLFA’s Series A Redeemable Preferred Shares were $3.5 million for year ended December 31, 2007, a decrease of $4.5 million, as compared to $8.0 million in 2006.
The decrease in dividends on XLFA’s Series A Redeemable Preferred Shares during the year ended December 31, 2007, as compared to 2006 was due to an amendment of the terms of the preferred shares pursuant to an agreement with the holders of such securities in February of 2007 which resulted in the payment of an extraordinary dividend on March 30, 2007 of $15.0 million and a change in the stated value of such securities from $54.0 million to $39.0 million. As a result of the reduction in stated value, dividends on XLFA’s Series A Redeemable Preferred Shares will be approximately $0.8 million quarterly subsequent to March 31, 2007 compared to $1.1 million quarterly prior to the amendment. See “-Liquidity and Capital Resources-Liquidity Resources-XLFA Redeemable Preferred Shares Extraordinary Dividend and Redemption.”
Subsequently, all three rating agencies took the negative rating actions, described below, which have caused us to suspend writing substantially all new business resulting in the loss of future incremental earnings and cash flow.
On March 4, 2008, Moody’s placed the “A3” IFS ratings of XLCA, XLCA-UK and XLFA on review for possible downgrade. Previously, on February 7, 2008, among other actions, Moody’s downgraded the IFS ratings of XLCA, XLCA-UK and XLFA to “A3” (Negative Outlook) from “Aaa.” Moody’s also noted that, under its analysis, the capitalization required to cover losses at the “Aaa” target level would exceed $6 billion compared to Moody’s estimate of SCA’s current claims paying resources of $3.6 billion.
The amount of new capital that we may need to raise, and other plans that we may need to implement, to address the ratings agencies’ requirements to restore our ratings may be significant. We have been exploring strategic options with our advisors, regulators, potential investors and counterparties to preserve and potentially enhance our capital resources, address the rating agencies requirements and eventually restore our ratings to a level sufficient to permit us to recommence writing new business; however, we cannot provide any assurance when and if we can successfully address the rating agencies requirements or that we will be able to recommence writing new business in the near term or at all.
We believe our liquidity resources are sufficient to fund our obligations and to comply with our regulatory solvency and regulatory risk limit requirements for at least the next twelve months, notwithstanding the suspension of writing substantially all new business, the downgrades of our ratings by the rating agencies, the significant reserves for losses and loss adjustment expenses that we have recorded on our guarantees of obligations supported by mortgage loan collateral, and the dislocation in the credit markets that we operate in.
We manage our in-force portfolio of guaranteed obligations based on, and to comply with, regulatory and rating agency single-risk limits and internal credit guidelines. Single-risk limits are designed to avoid concentration in single names and to mitigate event risk and are calculated as a percentage of capital. For transactions that exceed these limits or guidelines, we will cede the excess to XLI, XL RE AM, or other third-party reinsurers. Generally, all such reinsurance is structured as facultative quota share reinsurance in which the reinsurer is liable to us for its quota share of the applicable policies that we issue, regardless of when the loss occurs. Accordingly, related loss reserves, including unallocated loss reserves, are ceded in accordance with such contracts. Through these facultative cessions, we gain greater flexibility to manage large single risks and reduce concentration in specific bond sectors and geographic regions. To the extent that we cede a portion of our exposure to one or more reinsurance companies, we can reduce our concentration to particular issuers and help to control the diversification of our credit portfolio. In addition, use of reinsurance can increase our capacity to write new business and strengthen our capital adequacy ratios.
As of December 31, 2007 and December 31, 2006, we had $432.5 million and $70.8 million in reinsurance recoverables from our reinsurers relating to specific case reserves. The following table presents, by reinsurer, the amount of our in-force principal exposure ceded to reinsurers as of December 31, 2007 and 2006:
on negative watch by the rating agencies, and as a consequence, the rating agency capital credit we receive from two of our reinsurers has been reduced from 80% to 25% and for another reinsurer the rating agency capital credit we receive has been reduced from 80% to 60%. This has resulted in higher amounts of capital we are required to maintain by the rating agencies to support our ratings. Further declines in the rating of these insurers and declines in the ratings of other reinsurers, may result in even higher amounts of capital we are required to maintain. For example, absent a posting of collateral by a reinsurer, should the rating of a reinsurer decline below “A” we would receive zero rating agency capital credit for reinsurance.
On December 19, 2007 we completed an offer to exchange up to $250.0 million of our unregistered privately placed SCA Series A Preference Shares (the “Initial Shares”) for SCA Series A Preference Shares, with the same terms and conditions, registered under the Securities Act whereby 100% of the Initial Shares, were tendered prior to the expiration of the exchange offer on December 19, 2007 and were accepted for exchange by the Company.
We define liquidity resources to include our investments in debt securities, short-term investments, cash and cash equivalents, accrued investment income, the capacity for revolving credit loans under our letter of credit and liquidity facility (see “-Letter of Credit and Liquidity Facility” below for details), and with respect to XLFA, our soft capital credit facility (see “-XLFA Capital Facility” below for details). At December 31, 2007 and December 31, 2006 our total liquidity resources on a consolidated basis were $3.2 billion and $2.6 billion, respectively. At December 31, 2007, approximately $2.0 billion of our liquidity resources was deposited in a trust for the benefit of XLCA. Adverse developments in our case basis reserves for losses and loss adjustment expenses would require XLFA to deposit additional collateral (marketable securities or cash) in this trust. This could reduce the amount of our resources that are available to satisfy our other obligations.
As a holding company, our cash flow consists of dividends from our insurance subsidiaries (XLCA and XLFA), if declared and paid, and investment income on our invested assets, offset by expenses incurred for employee compensation and other expenses consisting primarily of costs incurred as a stand-alone public company, including: board of directors fees, directors and officers liability insurance, independent auditor fees, stock registrar and listing fees, legal and other advisory fees, and annual report and proxy production and distribution costs.
In the ordinary course of business, we evaluate our liquidity resource needs in light of our expenses, our dividend policy, and the dividend paying ability of our insurance subsidiaries. Based on our liquidity resources (as described above) as of December 31, 2007, which aggregated $273.8 million (consisting of $250 million under our revolving credit facility described below and $23.8 million of cash) at Security Capital Assurance Ltd. on a stand-alone basis, and the income we expect to receive from such liquidity resources, we believe that our holding company will have sufficient
In direct financial guarantee business underwritten by XLCA, our general practice is not to agree to ratings-based triggers which require the mandatory posting of collateral or which would otherwise have a material adverse impact on our liquidity position. The transactions which have ratings-based triggers usually require downgrades of several notches before such triggers are breached. Typical consequences for breach of such ratings-based triggers may include (a) loss or
The inwards reinsurance agreements XLFA has with primary insurers generally contain ratings-based triggers whereby if XLFA is downgraded to a level of “AA+” to “A+” (which given the downgrades of XLFA, subject to the applicable cure provisions in the agreements, have been triggered), depending upon the reinsurance agreement, the primary insurer has the right, but not the obligation, to terminate the agreement and take back generally all or a fixed percentage of all transactions under a given reinsurance agreement. XLFA may generally, but is not obligated to, provide collateral to an extent which gives the primary insurer the ability to obtain full financial credit for our reinsurance. If the primary insurer elects to terminate the reinsurance agreement on a cut-off basis and depending upon the reinsurance agreement, XLFA may be required to pay to the primary insurer the statutory unearned premiums on the policies and XLFA would forgo any future installment premiums for which reinsurance is terminated. If all third-party reinsurance agreements, including those with FSA, were terminated on a cut-off basis, we would have to return U.S. statutory unearned premium, net of ceding commissions, of approximately $138.7 million as of December 31, 2007. In addition, the primary insurer may also have the option to increase the ceding commission to a prearranged level in line with the rating of XLFA after the downgrade and any such increases will reduce cash flow from operations. Other termination triggers also exist such as: (i) decline in our policyholders’ surplus of more than 25% from one quarter to the next, (ii) insolvency, (iii) illegality and other standard termination provisions. The primary insurer typically has the option as to whether policies are terminated on a run-off or cut-off basis.
Cash Flows. XLCA reported net cash provided by operating activities of $20.0 million for the year ended December 31, 2007 compared to $81.7 million of net cash provided by operating activities in 2006. Net cash provided by operating activities decreased by $61.7 million. The decrease in XLCA’s cash flow from operations is primarily due to: (i) slightly lower business production (particularly in the public finance sector), as compared to the prior year, and (ii) a higher proportion of installment business, as compared to upfront business, during the year ended December 31, 2007, as compared to 2006, offset in part by (iii) XLCA’s higher retention of business resulting from the change in its quota share arrangement with XLFA, whereby effective July 1, 2006 XLCA began ceding up to 75% of its business to XLFA, as compared with 90% prior thereto.
XLCA reported net cash used in investing activities was $116.6 million and $56.4 million for the years ended December 31, 2007 and 2006, respectively. Cash used in investing activities is primarily a result of investing cash generated from operating activities. See “-Liquidity Resources” above.
XLCA may be required to repay these amounts should the assets in XLAF’s investment portfolio prove insufficient or should XLAF otherwise fail to perform its obligations thereunder. Although XLAF is a wholly owned subsidiary of XL Capital, XL Capital is not contractually obligated to support XLAF’s obligations under the program agreements or the GICs. XL Capital has, however, communicated to XLCA and publicly disclosed its intent to settle all such liabilities and its expectation to do so for substantially all GICs by the end of March 2008. Accordingly, XLCA does not expect to incur any claims under its insurance of XLAF’s GICs. The aggregate face amount of XLAF’s GICs outstanding at December 31, 2007 and 2006 which were guaranteed by XLCA was $4.0 billion and $3.9 billion, respectively. As of February 29, 2008, the remaining aggregate face amount outstanding of such GICs was approximately $2.0 billion.
XLFA reported net cash provided by financing activities was $76.5 million and $185.1 million for the years ended December 31, 2007 and 2006, respectively. The current year net inflow reflects the contribution of $225.0 million of net proceeds from the issuance of SCA Series A Preference Shares, partially offset by dividends paid to SCA and dividends paid to holders of the redeemable preferred shares of XLFA.
On August 1, 2006, we and certain of our subsidiaries entered into an aggregate $500 million, five-year letter of credit and revolving credit facility (the “Facility”) with a syndicate of banks, for which Citibank N.A. is the administrative agent. The Facility provides for letters of credit of up to $250 million and up to $250 million of revolving credit loans with the aggregate amount of outstanding letters of credit and revolving credit loans thereunder not to exceed $500 million. On December 26, 2007, we entered into Amendment No. 1 to the Facility. The Amendment was technical and did not represent substantive changes to the Facility.
As of December 31, 2007, XLFA had letters of credit outstanding under the Facility of $233.0 million, which were established for the benefit of primary insurance companies reinsured by us, as explained below. No revolving loans have been drawn by us under the Facility since its inception. For the year ended December 31 2007, and the period from August 1, 2006 through December 31, 2006, we incurred expenses of $0.6 million and $0.2 million, respectively, under the Facility. Prior to August 1, 2006, XL Capital had drawn letters of credit under its credit facility with a syndicate of commercial banks for the benefit of primary companies reinsured by us. For the period from January 1, 2006 through July 31, 2006 and the year ended December 31, 2005, we incurred expenses of $0.3 million and $1.6 million, respectively, related to letters of credit drawn by XL Capital for the benefit of primary companies reinsured by us.
In December 2004, XLFA entered into a put option agreement and an expense reimbursement agreement (the “Asset Trust Expense Reimbursement Agreement”) with Twin Reefs Asset Trust (the “Asset Trust”). The put option agreement provides XLFA with the irrevocable right to require the Asset Trust at any time and from time to time to purchase XLFA’s non-cumulative perpetual Series B preferred shares with an aggregate liquidation preference of up to $200 million. There is no limit to the number of times that XLFA may exercise the put option, redeem the Series B preferred shares from the Asset Trust and exercise the put option again. XLFA is obligated to reimburse the Asset Trust for certain fees and ordinary expenses. To the extent that any Series B preferred shares are put to the Asset Trust and remain outstanding, a corresponding portion of such fees and ordinary expenses will be payable by XLFA pursuant to the asset trust expense reimbursement agreement. The put option agreement is perpetual but would terminate on delivery of notice by XLFA on or after December 9, 2009, or under certain defined circumstances, such as the failure of XLFA to pay the put option premium when due or bankruptcy. The premium payable by XLFA is
the sum of certain trustee and investment managers expenses, the distribution of income paid to holders of the pass-through trust securities, less the investment yield on the eligible assets purchased using the proceeds originally raised from the issuance of the pass-through securities. The eligible securities (which are generally high-grade investment securities) are effectively held in trust to be used to fund the purchase of any Series B preferred shares upon exercise of the put.
XLFA’s Series B preferred Shares were created in conjunction with the establishment of the Asset Trust. The Series B Preferred Shares are non-cumulative redeemable perpetual preferred shares with a par value of $120 per share. The Series B Preferred Shares rank prior to XLFA’s common and Series A Redeemable Preferred Shares (see Note 5 to the Consolidated Financial Statements located elsewhere herein) and have a liquidation preference of $100,000 each. In the event that XLFA exercises its put option to the Asset Trust and the Series B preferred shares are issued, the holders of outstanding Series B Preferred Shares shall be entitled to receive, in preference to the holders of XLFA’s common and Series A Redeemable Preferred Shares, cash dividends at a percentage rate per Series B Preferred Share as follows:
On February 11, 2008, XLFA exercised the put option, for the first time since the inception of the facility, to issue $200 million of non-cumulative perpetual Series B preferred shares which, if declared, by XLFA’s Board of Directors, will pay monthly dividends as discussed above. On February 26, 2008, XLFA declared dividends on the Series B preferred shares at the applicable rate for the next three monthly periods.
The following table presents our long-term contractual obligations and related payments as of December 31, 2007, due by period:
The timing and amounts of actual claims payments related to these reserves vary based on many factors. The ultimate amount of the claims payments could differ materially from our estimated amounts. For information regarding the estimates for unpaid loss and loss expenses as well as factors affecting potential payment patterns of reserves for actual and potential claims related to our different lines of business, see “-Critical Accounting Policies and Estimates” above.
Does not include contractual payments required under: (i) preferred shares issued by XLFA, and (ii) XLFA’s soft capital facility. See details above and in notes to our Consolidated Financial Statements included elsewhere herein.
As of December 31, 2007 and 2006, we did not have any off-balance sheet arrangements that were not accounted for or disclosed in the Consolidated Financial Statements. See “-Liquidity and Capital Resources-XLFA Soft Capital Facility” above and Notes 7 and 13 to our Consolidated Financial Statements.
On April 18, 2007, the FASB issued Proposed SFAS, Accounting for Financial Guarantee Insurance Contracts-an interpretation of SFAS 60, “Accounting and Reporting by Insurance Enterprises.” This proposed Statement would clarify how SFAS 60 applies to financial guarantee insurance contracts. The FASB Board concluded redeliberations of the proposed Statement on January 30, 2008 and expects to issue a final Statement sometime in 2008. This proposed Statement, among other things, would change current industry practices with respect to the recognition of premium revenue and claim liabilities. Under the proposed Statement, a claim liability on a financial guarantee insurance contract would be recognized when the insurance enterprise expects that a claim loss will exceed the unearned premium revenue (liability) for that contract based on expected cash flows. The discount rate used to measure the claim liability would be based on the risk-free market rate and updated each quarter. Premium revenue recognition, under the proposed Statement, will be based on applying a fixed percentage of the premium to the amount of outstanding exposure at each reporting date (referred to as the level-yield approach). In addition, in regard to financial guarantee insurance contracts where premiums are received in installments the proposed Statement requires that an insurance enterprise should recognize an asset for the premium receivable and a liability for the unearned premium revenue at inception of a financial guarantee insurance contract and, that such recognition should be based on the following:
the expected term of the financial guarantee insurance contract if (1) prepayments on the insured financial obligation are probable, (2) the timing and amount of prepayments can be
the discount rate used to measure the premium receivable (asset) and the unearned premium revenue (liability) should be the risk-free rate.
We expect that the initial effect of applying the provisions of the Statement as currently proposed will be material to our financial statements. In particular, we expect that implementation of this guidance as currently proposed would cause us to de-recognize our reserves for unallocated losses and loss adjustment expenses and preclude us from providing such reserves in the future.
The final Statement will be effective for financial statements issued for fiscal years beginning after December 15, 2008, and for interim periods within those fiscal years. In addition, beginning the first quarter after issuance of the final Statement, an insurance enterprise will be required to make certain disclosures describing our guarantees which we are closely monitoring as a result of deterioration or other adverse developments.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 provides us an irrevocable option to report selected financial assets and liabilities at fair value with changes in fair value recorded in earnings. The option is applied, on a contract-by-contract basis, to an entire contract and not only to specific risks, specific cash flows or other portions of that contract. Upfront costs and fees related to a contract for which the fair value option is elected shall be recognized in earnings as incurred and not deferred. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We will adopt the provisions of SFAS 159 on January 1, 2008. The adoption of SFAS 159 will not have a material effect on our financial statements.
Proposed FASB Staff Position EITF 03-6-a, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities”
Changes in the valuation of our invested assets reflect changes in interest rates (for example, changes in the level, slope and curvature of yield curves, volatility of interest rates, mortgage prepayment speeds and credit spreads) and credit quality. Market risk therefore arises due to the uncertainty surrounding the future valuations of these different assets, the factors that impact their values and the impact that this could have on our earnings.
Our fixed-income portfolio is exposed to credit and interest rate risk. At December 31, 2007, the fair value of our fixed-income portfolio was approximately $2.7 billion, as compared to approximately $2.2 billion as of December 31, 2006.
the outcome of the ongoing rating assessments for all bond insurers, including us, by Fitch, Moody’s and S&P, the outcome of our discussions with Fitch, Moody’s and S&P, and our ability to successfully address any capital requirements within required timeframes;
the impact of the recent ratings actions on us announced on March 4, 2008 by Moody’s, February 25, 2008 by S&P, and January 23, 2008 by Fitch, including the downgrades of the IFS ratings of XLCA, XLCA-UK and XLFA;
higher risk of loss in connection with obligations guaranteed by us due to recent deterioration in the credit markets stemming from the poor performance of subprime residential mortgage loans;
increased competition on the basis of pricing, capacity, terms or other factors;
greater frequency or severity of claims and loss activity including in excess of our loss reserves, including as a result of natural or man-made catastrophic events, than our underwriting, reserving or investment practices anticipate based on historical experience or industry data;
changes in the availability, cost or quality of reinsurance or retrocessions, including a material adverse change in the ratings of our reinsurers or retrocessionaires;
On March 17, 2006, XL Capital Ltd (“XL Capital”) formed Security Capital Assurance Ltd (“SCA”), as a wholly owned Bermuda based subsidiary holding company. SCA is a publicly-traded company with shares traded on the New York Stock Exchange (“NYSE”) under the symbol “SCA.” On July 1, 2006, XL Capital contributed all its ownership interests in its financial guarantee insurance and financial guarantee reinsurance operating businesses to SCA. The aforementioned operating businesses consisted of: (i) XL Capital Assurance Inc. (“XLCA”) and its wholly-owned subsidiary, XL Capital Assurance (U.K.) Limited (“XLCA-UK”) and (ii) XL Financial Assurance Ltd. (“XLFA”). XLCA was an indirect wholly owned subsidiary of XL Capital and all of XLFA was owned by XL Capital, except for a preferred stock interest which is owned by Financial Security Assurance Holdings Ltd. (“FSAH”), an entity which is otherwise not related to XL Capital or SCA. See Note 6. SCA, XLCA, XLFA and all other subsidiaries of SCA are hereafter collectively referred to as the “Company.”
XLCA and XLCA-UK are primarily engaged in providing credit protection through the issuance of financial guarantee insurance policies and guarantees of credit default swap (“CDS”) contracts. Financial guarantee insurance provides an unconditional and irrevocable guarantee to the holder of a debt obligation of full and timely payment of principal and interest. In the event of a default under the obligation, the insurer has recourse against the issuer and/or any related collateral (which is more common in the case of insured asset-backed obligations or other non-municipal debt) for amounts paid under the terms of the policy. CDS contracts are derivative contracts which offer credit protection relating to a particular security or pools of specified securities. Under the terms of a CDS contract, the seller of credit protection makes a specified payment to the buyer of credit protection upon the occurrence of one or more specified credit events with respect to a referenced security. Credit derivatives typically provide protection to a buyer rather than credit enhancement of
an issue as in traditional financial guarantee insurance. The companies’ underwriting policies limit the companies to providing credit protection only on obligations or referenced securities that it determines would be of investment-grade quality without the benefit of credit enhancement provided by the companies through their issuance of insurance policies and the guarantees of CDS contracts.
XLFA is primarily engaged in the business of providing reinsurance of financial guarantee insurance policies and CDS contracts issued by XLCA, subsidiaries of FSAH (see Note 6), and certain other non-affiliated triple-A-rated financial guarantee primary insurance companies.
Establishment of case basis reserves for losses and loss adjustment expenses requires the use and exercise of significant judgment by management, including estimates regarding the likelihood of occurrence and amount of a loss on an insured obligation. Actual experience may differ from estimates and such difference may be material, due to the fact that the ultimate dispositions of claims are subject to the outcome of events that have not yet occurred and, in certain cases, will occur over many years in the future. Examples of these events include changes in the level of interest rates, credit deterioration of insured obligations, and changes in the value of specific assets supporting insured obligations. Both qualitative and quantitative factors are used in establishing such reserves. In determining the reserves, management considers all factors in the aggregate, and does not attribute the reserve provisions or any portion thereof to any specific factor. Any estimate of future costs is subject to the inherent limitation on management’s ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of losses and loss adjustment expenses will vary, perhaps materially, from any estimate.
Status of Regulatory Compliance and Other Factors to Consider in Regard to Risk and Uncertainties
As of December 31, 2007, the Company was in compliance, in all material respects, with regulatory requirements it is subject to in all jurisdictions in which it operates.
Based on its current statutory projections management believes that the Company could incur adverse case basis loss reserve development subsequent to 2007 up to 80% of its established case basis reserves at December 31, 2007, after giving effect to reinsurance, and still maintain compliance with its regulatory solvency and risk limit requirements. Actual experience may differ from estimates and such differences may be material.
The Company believes its liquidity resources are sufficient to fund its obligations and to comply with its regulatory solvency and regulatory risk limit requirements for at least the next twelve months.
Management’s Current Strategic Plan Responding to Recent Developments, Risks and Uncertainties
In response to the recent developments and the risks and uncertainties noted above, the Company has been exploring strategic options with its advisors, regulators, potential investors and counterparties to preserve and potentially enhance its capital resources, address the rating agencies requirements, and eventually restore the Company’s ratings to a level sufficient to permit it to recommence writing new business. However, management cannot provide any assurance that the Company can successfully address the rating agencies’ requirements or when, and if, the Company will be able to recommence writing new business.
The Company has developed a strategic plan focused on: (i) mitigating the risk of non-compliance with regulatory solvency requirements and risk limits, (ii) maintaining or enhancing the Company’s liquidity, (iii) increasing the amount of capital available to support its ratings, and (iv) mitigating uncertainty in regard to adverse loss reserve development. The primary elements of the Company’s strategic plan include:
realigning the Company’s cost structure to reflect current business conditions, including staff reductions;
There can be no assurance that the Company’s strategic plan will not evolve or change over time, will be successfully implemented or when and if it will address the requirements of the rating agencies. In addition, there can be no assurance that the Company will be able to recommence
The accompanying Consolidated Financial Statements present the historical consolidated financial position, results of operations and cash flows of the Company. These Consolidated Financial Statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could, and likely will, differ from those estimates. Accounting policies requiring significant estimates consist of those relating to the Company’s credit derivative contracts, deferred acquisition costs, investments, and reserves for losses and loss adjustment expenses, as discussed in this note.
All of the Company’s investments in debt securities are considered available-for-sale and accordingly are carried at fair value. The fair value of investments is based on quoted market prices received from nationally recognized pricing services or, in the absence of quoted market prices, dealer quotes or matrix pricing. Adverse credit market conditions during the second half of 2007 caused some markets to become relatively illiquid, thus reducing the availability of certain data used by the independent pricing services and dealers. The net unrealized appreciation or depreciation on investments, net of deferred income taxes, is included in accumulated other comprehensive income (loss). Any unrealized depreciation in value considered by management to be other-than- temporary is charged to income in the period that such determination is made.
At the end of each accounting period, the Company reviews unrealized losses on its investment securities to identify declines in fair value that are other-than-temporary. This review involves consideration of several factors including: (i) the time period during which the security has been in a continuous unrealized loss position, (ii) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (iii) the significance of the decline, (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question and (v) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company concludes that a decline in fair value is other-than-temporary, the cost of the security is written down to fair value and a corresponding loss is realized in the period such determination is made.
The Company’s accounting policies for the recognition of ceded premiums, ceding commissions and ceded losses and loss adjustment expenses under its ceded reinsurance contracts mirror the policies described herein for premium revenue recognition, deferred ceding commissions, and reserves for losses and loss adjustment expenses.
In addition, when an insured issue is retired early, is called by the issuer or is in substance paid in advance through a refunding accomplished by placing U.S. government securities in escrow, the remaining deferred premium revenue is earned at that time since there is no longer risk to the Company.
The Company collects advisory and structuring fees in connection with certain transactions. Depending upon the type of fee received, the fee is either earned when services are rendered or deferred and earned over the life of the related transaction. Termination fees are earned when due and are included in the accompanying statements of operations under the caption “Fee Income and Other.” Structuring, waiver and consent, and commitment fees are included in the accompanying consolidated statements of operations as premiums and earned on a straight-line basis over the life of the related transaction.
The financial guarantees that the Company issues insure guaranteed scheduled payments of principal and interest due on various types of financial obligations against default by the issuers of such obligations. The Company establishes reserves for losses and loss adjustment expenses on such business based on its best estimate of the ultimate expected incurred losses. The Company’s estimated ultimate expected incurred losses are comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. Establishment of such reserves requires the use and exercise of significant judgment by management, including with respect to estimates regarding the occurrence and amount of a loss on an insured obligation. Actual experience may differ from estimates and such difference may be material due to the fact that the ultimate dispositions of claims are subject to the outcome of events that have not yet occurred. Examples of these events include changes in the level of interest rates, credit deterioration of insured obligations, and changes in the value of specific assets supporting guaranteed obligations. Both qualitative and quantitative factors are used in establishing such reserves. In determining the reserves, management considers all factors in the aggregate, and does not attribute the reserve provisions or any portion thereof to any specific factor. Any estimate of future costs is subject to the inherent limitation on the Company’s ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of losses and loss adjustment expenses will vary, perhaps materially, from any estimate.
Case basis reserves on financial guarantee insurance business written are established by the Company with respect to a specific policy or contract upon receipt of a claim notice or when management determines that: (i) a claim is probable in the future based on specific credit events that have occurred and (ii) the amount of the ultimate loss that the Company will incur can be reasonably estimated. As specific case basis reserves are established, the Company considers whether any changes are required to the assumptions underlying the calculation of unallocated reserves (which are discussed below) as a result of such activity. The amount of the case basis reserve is based on the net present value of the expected ultimate loss and loss adjustment expense payments that the Company expects to make, net of expected recoveries under salvage and subrogation rights. Case basis reserves are determined using cash flow or similar models to estimate 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 the proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries. A number of quantitative and qualitative factors are considered when determining or assessing, in management’s judgment, the need for a case basis reserve. These variables may include the creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured, the projected cash flow or market value of any assets that collateralize or secure the insured obligation,
under its in-force insured and reinsured policies less outstanding case basis reserves and cumulative paid claims to date on such policies. The Company’s unallocated reserves are estimated by management based upon an actuarial reserving analysis. The actuarial methodology applied by the Company is in accordance with Actuarial Standards of Practice No. 36, Determination of Reasonable Provision. The methodology applied is based on the selection of an initial expected loss ratio, as well as an expected loss emergence pattern (i.e., the expected pattern of the expiration of risk on insured and reinsured in-force policies). Salvage and subrogation recoveries are implicit in the Company’s selected expected ultimate loss ratio as such ratio is derived from industry loss experience, which is net of salvage and subrogation recoveries (i.e., from the liquidation of supporting or pledged collateral assets). The implicit inclusion of salvage and subrogation recoveries in the Company’s selected expected ultimate loss ratio is consistent with the Company’s explicit consideration of collateral support in the establishment of its case basis reserves.
The Company updates its estimates of losses and loss adjustment expense reserves quarterly and any resulting changes in reserves are recorded as a charge or credit to earnings in the period such estimates are changed. In connection therewith, the Company’s unallocated reserves are adjusted each period to reflect (i) any revisions to management’s estimate of expected ultimate losses, if any, and (ii) the underlying par risk amortization (or “loss development”) of the related insured and reinsured in-force business (i.e., loss emergence pattern). As stated above, the Company’s estimated ultimate expected incurred losses comprise: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. As the Company establishes case basis reserves and pays claims it may, based on its judgment, reduce or increase the ultimate expected loss ratio used to determine unallocated reserves to reflect its best estimate of expected ultimate loss experience. In addition, under the Company’s accounting policy the Company may, based on its judgment, reduce unallocated reserves in response to significant case basis reserve and/or paid loss activity. The Company would only expect such reductions to occur in limited instances, such as economic events generating significant loss activity across a broad cross-section of its in-force portfolio. The Company has not viewed its case basis reserve and paid loss activity to date to warrant a reduction of its unallocated reserves. While material case basis reserves were established by the Company in 2007, these reserves were concentrated in certain sectors of the financial guarantee portfolio and were associated with unprecedented credit-market events. As such, these events did not alter the Company’s perspective of the expected loss ratio associated with the remainder of the portfolio and the required level of unallocated reserves. Each quarterly period there is an interplay between case basis reserves, unallocated reserves and cumulative paid losses to date, such that the aggregate thereof represents management’s best estimate of the ultimate losses it expects to incur on the Company’s in- force business. The process of establishing unallocated reserves and periodically revising such reserves to reflect the underlying par risk amortization and management’s current best estimate of ultimate losses will ultimately cause the cumulative loss experience over the life of a particular underwriting year’s business to equal the cumulative inception-to-date actual paid losses on such business.
The Company’s initial selection of an initial expected loss ratio (and subsequent periodic updates thereof) was based on management’s judgment and considered the characteristics of its in-force financial guarantee insurance and reinsurance business (e.g. principally the mix of the Company’s in-force financial guarantee insurance and reinsurance business between public finance and structured finance business; however, the Company also considered the various bond sectors comprising the Company’s insured and reinsured in-force business which are discussed in detail in Note 13 to the Consolidated Financial Statements, as well as the credit profile of the Company’s insured and reinsured portfolio of business), as well as the Company’s actual loss experience, the characteristics of the insured in-force business of companies comprising the financial guarantee industry and the actual loss experience of companies comprising the industry from the Company’s analysis referred to above. Other factors affecting market default levels and the assumptions important to the Company’s reserving methodology are implicit in its initial expected loss ratio. Such
factors may include interest rates, inflation, taxes, industry trends in the valuation of certain asset classes and the overall credit environment. Based on this comparison, the Company adjusts its expected loss ratio as considered necessary to ensure that such ratio continues to be appropriate for the risks inherent in the Company’s in-force business.
The Company’s total reserves for losses and loss adjustment expenses represent a small fraction of the Company’s insured and reinsured in-force par outstanding, which reflects the nature of the business the Company underwrites, which is consistent with that of the financial guarantee insurance industry and the loss experience of the industry. The Company believes that its reserves are adequate to cover its expected ultimate losses. However, due to the inherent uncertainties of estimating reserves for losses and loss adjustment expenses, actual experience may differ from the estimates reflected in the Company’s Consolidated Financial Statements, and the differences may be material. While the Company believes that the underlying principles applied to loss reserving are consistent across the financial guarantee industry, differences may exist with regard to the methodology and measurement of such reserves. While the Company believes that the principles it applies are the most appropriate for the Company’s business and have been applied consistently within the periods presented, alternate methods may produce different estimates as compared to the current methodology used by the Company.
The Company believes its loss reserving policy reflects the requirements of applicable accounting literature, as well as the fact that financial guarantee losses occur over time as a result of credit deterioration, operational difficulties of the insured obligor or fraud, which may not be specifically detected when they occur but which can be generally estimated across a portfolio of insured obligations based on the credit quality and nature of the portfolio and historical default data. The Company does, however, recognize premium revenue and policy acquisition costs in a manner consistent with the guidance provided in SFAS 60 for short-duration contracts. If the Company and the rest of the financial guarantee industry were required to classify its insurance contracts as either short-duration or long-duration or if new specific guidance for financial guarantee insurance emerges, different methods of accounting could apply with respect to loss reserving and
The Company recognizes a premium deficiency if the sum of expected losses and loss adjustment expenses, maintenance costs and unamortized policy acquisition costs exceeds the related unearned premiums, the anticipated present value of future premiums under installment contracts written, and anticipated investment income. When the Company has a premium deficiency that is greater than unamortized acquisition costs, the unamortized acquisition costs are reduced by a charge to expense, and a liability (if necessary) would be established for any remaining deficiency. For policies reinsured with third parties the Company receives ceding commissions to compensate for acquisition costs incurred. The Company nets ceding commissions received against deferred acquisition costs and earns these ceding commissions over the period in which the related premiums are earned.
Intangible assets comprise licenses to conduct financial guarantee insurance business in 45 states of the United States. The recoverability of the carrying value of these intangible assets is evaluated at least annually for impairment. The Company has not recorded any adjustments to the carrying value of its intangible assets since their acquisition.
The Company utilizes the asset and liability method of accounting for income taxes. Deferred federal income taxes are provided for temporary differences between the tax and financial reporting basis of assets and liabilities that will result in deductible or taxable amounts in future years when the reported amounts of the assets or liabilities are recovered or settled. A valuation allowance is recorded when it is more likely than not that all, or some portion, of the benefits related to deferred tax assets will not be realized.
The Company issues and reinsures CDS contracts and certain other credit derivatives. Under the terms of its CDS contracts the Company is generally required to make payments to its counterparty in the event of specific credit events relating to assets referenced in the contracts after exhaustion of various first-loss protection levels.
Assets referenced in the Company’s in-force CDS contracts include structured pools of obligations, such as ABS CDOs, CLOs, investment-grade corporate CDOs, CDOs of CDOs and CMBS. Such pools were awarded investment-grade ratings at the deals’ inception. At December 31, 2007, the notional amount outstanding of the Company’s in-force CDS contracts was $65.3 billion ($59.6 billion net of reinsurance) and the weighted average term of such contracts was 8.6 years. In addition, based on such notional amount, as of December 31, 2007 approximately 93% of referenced assets underlying such in-force contracts were rated (based on Standard & Poor’s ratings) “AAA”, with 7% rated at or above investment-grade and less than 1% rated below investment-grade.
Pursuant to the terms of the Company’s CDS contracts, the Company is precluded from transferring such contracts to other market participants without the consent of the counterparty. In addition, the Company’s policy is to hold its CDS contracts to maturity and not to manage such contracts to realize gains or losses from periodic market fluctuations. However, in certain circumstances, the Company may choose to enter into an off-setting position, terminate or restructure a credit derivative prior to maturity for risk management or other purposes (for example, upon a deterioration in underlying credit quality or for the purposes of managing rating agency capital requirements). With the exception of two transactions which occurred in 2004 and 2003, respectively, there have been no such terminations since the Company’s inception.
As derivative financial instruments, CDS contracts are required to be reported at fair value in accordance with GAAP, with changes in fair value during the period included in earnings. The principal drivers of the fair value of the Company’s CDS contracts include: (i) general market credit spreads for the type(s) of assets referenced in CDS contracts, (ii) the specific quality and performance of the actual assets referenced in the contracts, (iii) the amount of subordination in the transaction before liability attaches, (iv) the quality of the asset manager of the transaction, if applicable, (v) other customized structural features of such contracts (e.g. terms, conditions, covenants), (vi) the rating agency capital charge for the transaction, (vii) supply and demand factors, including the volume of new issuance and financial guarantee market penetration, as well as the level of competition in the marketplace, and (viii) in certain circumstances, the market perception of the Company’s ability to meet its obligations under its CDS contracts which may be implied by the cost of buying credit protection on XLCA.
cash. In contrast, the Company’s guaranteed CDS contracts do not contain the typical CDS market standard features as described above but have been customized to replicate the Company’s financial guarantee insurance. The Company’s guaranteed CDS contracts provide protection on specified obligations, such as those described above, or the CDS contracts contain a deductible or subordination level. The Company is not required to post collateral, and upon default, the Company generally makes payments on a “pay-as-you-go” basis after the subordination in a transaction is exhausted.
Historically, there has not been a market for the transfer of such highly structured guaranteed CDS contracts, in part because of the contractual differences noted above. As a result, the Company believes there are no relevant third party “exit value” market observations for these contracts. If the Company were to affect a transfer of these contracts, it believes the most likely counterparties would be other financial guarantee insurers and reinsurers or other derivative products companies.
estimates of rates of return which would be required by market participants to assume the risks in the Company’s CDS contracts in the current market environment,
prices of guarantees issued in the Company’s retail market or commutations of contracts the Company has executed in proximity to the measurement date.
Because it is the Company’s policy to consider all available relevant evidence in forming its best estimate of the fair value of its CDS contracts, as new information becomes available, or existing information becomes more or less available, the Company may consider new or different factors than those listed above and change its estimates in the future.
in instances where the Company was in substantive discussions with market participants to transfer the risk in specific CDS contracts, management’s estimate of the fair value of such contracts was largely based on the price discovery it obtained from such discussions,
Because management views the credit derivative contracts that the Company issues and reinsures as an extension of the Company’s financial guarantee business, management believes that the most meaningful presentation of these derivatives is to reflect: (i) fees that the Company receives from the issuance of such contracts in the line item captions in the consolidated statement of operations entitled “gross premiums written,” “reinsurance premium assumed,” “net premiums written” and “net premiums earned,” as appropriate, (ii) losses from actual and expected payments to counterparties under such contracts in the line item caption in the consolidated statement of operations entitled “net losses and loss adjustment expenses” and (iii) changes in the fair value of such instruments which are attributable to market factors in the line item caption in the consolidated statement of operations entitled “net realized and unrealized losses on credit derivatives.”
The aggregate fair value of the Company’s derivative financial instruments at December 31, 2007 resulted in a net liability of $1.4 billion, which was comprised of a net liability of $1.5 billion relating to credit derivatives issued by the Company and a derivative asset of $107.0 million relating to the Company’s put option under XLFA’s Capital Facility (see Note 7). Of its net liability relating to credit derivatives at December 31, 2007, 47.1%, 2.3%, 48.8% and 1.8%, respectively, reflects estimates based primarily on price discovery resulting from discussions and negotiations to commute certain of the Company’s CDS contracts, market indices, management’s judgment in regard to the rate of return required by a market participant to transfer the risk, as discussed above, and other factors.
The Company insures obligations issued by variable interest entities (“VIEs”) in the ordinary course of the Company’s business. The Company provides financial guarantee insurance of structured transactions backed by pools of assets of specified types, municipal obligations supported by the issuers’ ability to charge fees for specified services or projects, and corporate risk obligations including essential infrastructure projects and obligations backed by receivables from future sales of commodities and other specified services. The obligations related to these transactions are often securitized through VIEs. In synthetic transactions, the Company guarantees payment obligations of counterparties, including VIEs, through CDS contracts referencing asset portfolios. The Company only provides financial guarantee insurance of these VIEs for premiums at market rates but does not hold any equity positions or subordinated debt in these off-balance sheet arrangements. These financial guarantee contracts represent variable interests held by the Company in VIEs.
In underwriting financial guarantees, the Company generally requires that guaranteed obligations be investment-grade prior to the provision of credit enhancement. Typically, in the case of ABS and other structured obligations, such investment grade ratings are based upon subordination, cash reserves and other structural protections. Consequently, the Company has determined that it is not the primary beneficiary of any VIEs in which it holds a variable interest. Accordingly, these VIEs are not consolidated by the Company.
(iii) certain tax benefits when the award generates a tax deduction. However, the calculation of diluted loss per share excludes the dilutive effect of stock option and restricted stock awards outstanding because it would otherwise have an anti-dilutive effect on net loss per share.
of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”), and addresses issues raised in SFAS 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” The primary objectives of SFAS 155 are: (i) with respect to SFAS 133, to address the accounting for beneficial interests in securitized financial assets and (ii) with respect to SFAS 140, to eliminate a restriction on the passive derivative instruments that a qualifying special purpose entity may hold. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Company adopted SFAS 155 on January 1, 2007 and it had no effect on the Company’s financial condition or results of operations.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 on January 1, 2007 and it had no effect on the Company’s financial condition or results of operations.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 provides the Company an irrevocable option to report selected financial assets and liabilities at fair value with changes in fair value recorded in earnings. The option is applied, on a contract-by-contract basis, to an entire contract and not only to specific risks, specific cash flows or other portions of that contract. Upfront costs and fees related to a contract for which the fair value option is elected shall be recognized in earnings as incurred and not deferred. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company will adopt the provisions of SFAS 159 on January 1, 2008. The adoption of SFAS 159 will not have a material effect on the Company’s financial statements.
In October 2006, the FASB issued proposed FASB Staff Position EITF 03-6-a, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities”. This FASB Staff Position (FSP) addresses whether instruments granted in share-based payment transactions may be participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing basic earnings per share (“EPS”) pursuant to the two-class method described in paragraphs 60 and 61 of FASB Statement No. 128, “Earnings Per Share.” A share- based payment award that contains a non-forfeitable right to receive cash when dividends are paid to common shareholders irrespective of whether that award ultimately vests or remains unvested shall be considered a participating security as these rights to dividends provide a non-contingent transfer of value to the holder of the share-based payment award. Accordingly, these awards should be included in the computation of basic EPS pursuant to the two-class method. The guidance in this proposed FSP would be effective in the first reporting period beginning after the FASB posts the final FSP to its website. All prior period EPS data will have to be adjusted retrospectively to reflect the provisions of the FSP. Under the terms of the Company’s restricted stock awards, grantees are entitled to the right to receive dividends on the unvested portions of their awards. There is no requirement to return such dividends in the event the unvested awards are forfeited in the future. Accordingly, this FSP will have an effect on the Company’s EPS calculations should the FASB issue the proposed guidance as final during 2008. The Company will continue to evaluate the effect of this guidance.
In June 2007, the FASB ratified the consensus reached by the EITF on Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards.” EITF Issue No. 06-11 requires that the tax benefit with respect to dividends or dividend equivalents for non-vested restricted shares or restricted share units that are paid to employees be recorded as an increase to additional paid-in-capital. EITF Issue No. 06-11 is to be applied prospectively for tax benefits on dividends declared in fiscal years beginning after December 15, 2007, with early adoption permitted. The Company does not believe that the adoption of EITF Issue No. 06-11 will have a material impact on its consolidated financial statements.
Proceeds from sales of debt securities for the years ended December 31, 2007, 2006 and 2005 were $91.5 million, $384.5 million and $589.0 million, respectively.
The amortized cost and fair value of bonds at December 31, 2007 and 2006 by contractual maturity are shown below. Actual maturity may differ from contractual maturity because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
The Company has gross unrealized losses on securities which it considers to be temporary impairments. Such individual security positions have been evaluated by management, based on specific criteria, to determine if these impairments should be considered other-than-temporary. These criteria include assessment of the severity and length of time securities have been impaired, along with management’s ability and intent to hold the securities to recovery (which considers the Company’s liquidity position), among other factors.
Of the non-U.S. government securities in a continuous unrealized loss position for 12 months or more at December 31, 2006 (which excludes $2.7 million of unrealized losses on securities issued by the GNMA, FNMA and FHLMC which are included in “Mortgage- and Asset-Backed Securities” in the above table), 59.2%,75.1%, and 100% are rated “AAA”, “AA-” or better or “A-” or better, respectively, of the total unrealized loss in such category. In addition, of the non-government securities in a continuous unrealized loss position for 12 months or more, securities aggregating 87% of the total unrealized loss in such category have a price decline of less than 6% from their amortized cost and the remaining 13% have a price decline greater than 6% but less than 9% of their amortized cost as of December 31, 2006.
For the year ended December 31, 2007, the Company recorded other-than-temporary impairment charges of $1.2 million. The Company did not record any other-than-temporary declines in the fair value of debt securities or short-term investments for the years ended December 31, 2006 or 2005.
The Company’s business activities are organized and managed in two operating segments: financial guarantee insurance and financial guarantee reinsurance. These segments are managed separately because they provide different products or services to different customers, are subject to different regulation, require different strategies and have different technology requirements. Products comprising the financial guarantee insurance segment primarily include financial guarantee insurance of public finance and structured finance debt securities and CDS contracts. Products comprising the reinsurance segment primarily include reinsurance of financial guarantee insurance products issued by financial guarantee insurance companies. Refer to Note 1 and Note 13 for additional information with regard to the products offered by the Company’s operating segments.
Prior to April, 2006 the redemption price of the Series A Preferred Shares was estimated at the end of each reporting period and changes in the redemption value were accreted over the period from the date of issuance to the earliest redemption date using the interest method. Pursuant to resolution of XLFA’s shareholders on April 2006, XLFA restructured the terms of its Series A Redeemable Preferred Shares and changed its bye-laws accordingly. In accordance with the resolution, the participating dividend of the preference shares was eliminated, the stated value of the preferred shares held by FSAH and its subsidiaries was increased to $54.0 million, and the fixed dividend rate was increased from 5% to 8.25%.
For the year ended December 31, 2006, the Company recorded $8.0 million of “minority interest-dividends on redeemable preferred shares” which reflects the effect of the restructured terms of the Series A Preferred Shares referred to above. For the year ended December 31, 2005 the Company recorded $8.8 million of fixed and participating dividends and accreted redemption value.
On February 27, 2007, the board of directors of XLFA approved: (i) an extraordinary dividend of $15.0 million on its Series A Redeemable Preferred Shares, and (ii) a reduction in the stated value of the remaining outstanding Series A Redeemable Preferred Shares by a corresponding amount. Payment of the extraordinary dividend and the reduction in the stated value of the Series A Redeemable Preferred Shares were made in March 2007. There was no change in the voting interest of the holders of the Series A Redeemable Preferred shares as a result of the extraordinary dividend and reduction in the stated value of the Series A Redeemable Preferred Shares. As a result of the reduction in stated value, dividends on the redeemable preferred shares were $0.8 million quarterly subsequent to March 31, 2007.
XLFA’s Series B Preferred Shares were created in conjunction with the establishment of the Asset Trust. The Series B Preferred Shares are non-cumulative redeemable perpetual preferred shares with a par value of $120 per share. The Series B Preferred Shares rank prior to XLFA’s common and Series A Redeemable Preferred Shares (see Note 6) and have a liquidation preference of $100,000 each. In the event that XLFA exercises its put option to the Asset Trust and the Series B preferred shares are issued, the holders of outstanding Series B Preferred Shares shall be entitled to receive, in preference to the holders of XLFA’s common and Series A Redeemable Preferred Shares, cash dividends at a percentage rate per Series B Preferred Share as follows:
for any Dividend Period ending on or prior to December 9, 2009, One-Month LIBOR plus 1.00% per annum, calculated on an Actual/360 Basis; and
The holders of the Series B Preferred Shares will not be entitled to any voting rights as shareholders of XLFA and their consent will not be required for taking any corporate action. Subject to certain requirements, the Series B Preferred Shares may be redeemed, in whole or in part, at the option of XLFA at any time or from time to time after December 9, 2009 for cash at a redemption price equal to the liquidation preference per share plus any accrued and unpaid dividends thereon to the date of redemption without interest on such unpaid dividends.
The Company maintains a qualified defined contribution pension plan for the benefit of all eligible employees and a non-qualified deferred compensation plan for the benefit of certain employees (collectively, the “SCA Plans”). Prior to the IPO, XL America, Inc (“XLA”) maintained plans, with substantially the same terms, which employees of the Company participated in (the “XLA Plans”). Discretionary contributions to the SCA Plans and XLA Plans are based on a fixed percentage of employee contributions and compensation, as defined in the aforementioned plans. For the years ended December 31, 2007, 2006, and 2005, the Company incurred costs under the aforementioned plans aggregating $5.2 million, $2.7 million, and $2.2 million, respectively, which are reflected in “operating expenses” in the accompanying consolidated statements of operations.
Effective August 4, 2006, certain subsidiaries of XL Capital indemnified the Company for all losses and loss adjustment expenses incurred in excess of its retained reserves at the effective date of the agreement relating to an insured project financing described in Note 14(c). In consideration for the aforementioned indemnifications the Company is obligated to pay such affiliates approximately $9.8 million on an installment basis over the life of the aforementioned project financing. As this premium is due irrespective of any early termination of the underlying insurance transaction, the Company recorded a liability of approximately $7.0 million at the effective date of the indemnifications (representing the present value of the obligation discounted at 5.0%, which reflects the rate on treasury obligations with a term to maturity commensurate with that of the liability) and a corresponding deferred cost, which are reflected in the accompanying consolidated balance sheet in “reinsurance premiums payable” and “prepaid reinsurance premiums”, respectively.
for any costs arising out of any litigation or future claim in connection with the aforementioned insurance policy. See Note 14(d) for further information regarding amounts recovered or recoverable by SCA under the indemnity.
On August 4, 2006, XLFA terminated a facultative quota share reinsurance treaty with XLI that had been effective since 2001. As a result of the termination, XLI returned $26.5 million of premiums to XLFA, XLFA returned ceding commissions of $7.8 million to XLI, and XLI paid XLFA $18.7 million.
Effective November 1, 2002 and as amended and restated as of March 1, 2007, XLCA is party to a facultative reinsurance arrangement (the “XL Re Treaty”) with XL RE AM. Under the terms of the XL Re Treaty, XL RE AM agrees to reinsure risks insured by XLCA under financial guarantee insurance policies up to the amount necessary for XLCA to comply with single risk limitations set forth in Section 6904(d) of the New York Insurance Laws. Such reinsurance was on an automatic basis prior to the effective date of the IPO and is on a facultative basis on and after the effective date of the IPO. The reinsurance provided by XL RE AM may be on an excess of loss or quota share basis. The Company is allowed up to a 30% ceding commission (or such other percentage on an arm’s-length basis) on ceded premiums written under the terms of this agreement.
guaranteed by XLI. Effective upon the IPO, the guarantee was terminated with respect to all new business assumed by XLFA under such arrangement, but the guarantee remains in effect with respect to cessions under the agreement prior to the IPO. Premiums assumed by XLFA under its reinsurance arrangements with FSA represented 78%, 70%, and 66% of the Company’s total reinsurance premiums assumed for the years ended December 31, 2007, 2006, and 2005, respectively.
XLFA has guaranteed certain of XLI’s obligations in connection with certain transactions where XLI’s customer required such credit enhancement. Each of these transactions has a “double trigger” structure, meaning that XLFA does not have to pay a claim unless both the underlying transaction and XLI default. For each of these transactions, XLFA has entered into a reimbursement agreement with XLI, pursuant to which XLI pays XLFA a fee for providing its guarantee and XLI grants XLFA a security interest in a portion of the payments received by it from its client. As of December 31, 2007 and 2006, XLFA’s aggregate net par outstanding relating to such guarantees was $511.1 million and $522.8 million, respectively.
Deferred acquisition costs, net of deferred ceding commission revenue, as well as related amortization, as of and for the years ended December 31, 2007, 2006 and 2005 are as follows:
During the year ended December 31, 2007, the Company recorded a premium deficiency by accelerating the amortization of $3.1 million of deferred acquisition costs relating to its guarantees of obligations supported by HELOCs and CES transactions. There have been no premium deficiencies recorded by the Company prior to 2007.
Accelerated amortization of deferred acquisition costs due to refundings was $2.7 million, $2.2 million and $1.5 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company enters into ceded reinsurance arrangements principally to increase aggregate capacity, manage its risk guidelines and to reduce the risk of loss on business written or assumed. This reinsurance includes the reinsurance arrangements with affiliates that are discussed in Note 8, as well as reinsurance arrangements with non-affiliated reinsurers. Reinsurance does not relieve the Company of its obligations under its guarantees. Accordingly, the Company is still liable under its guarantees in the event reinsuring companies do not meet their obligations to the Company under reinsurance agreements. The Company regularly monitors the financial condition of its reinsurers. For the years ended December 31, 2007, 2006, and 2005 there were no amounts provided by the Company for uncollectible reinsurance recoverable. The following tables set forth certain amounts ceded to affiliate and non-affiliate reinsurers as of and for the years ended December 31, 2007, 2006, and 2005.
On August 1, 2006, the Company entered into an aggregate $500 million, five-year letter of credit and revolving credit facility (the “Facility”) with a syndicate of banks, for which Citibank N.A. is the administrative agent. The Facility provides for letters of credit of up to $250 million and up to $250 million of revolving credit loans with the aggregate amount of outstanding letters of credit and revolving credit loans thereunder not to exceed $500 million.
The Facility contains financial covenants that require that the Company at any time (a) prior to August 1, 2008, maintain a minimum consolidated net worth (defined as total shareholders’ equity before accumulated other comprehensive income and excluding the effect of any adjustments required under Statement of Financial Accounting Standards No. 133) of $857.4 million, (b) on or after August 1, 2008, maintain a minimum consolidated net worth (as defined above) equal to the greater of (1) $857.4 million or (2) an amount equal to 65% of the consolidated net worth (as defined above) as of the end of the then most recent fiscal year or fiscal quarter of the Company for which financial statements shall have been delivered, and (c) maintain a maximum total funded debt-to- total capitalization ratio of 30%. At December 31, 2007, consolidated net worth (as defined above), as calculated by the Company in accordance with the Facility, was $1,091.0 million and there was no debt outstanding. The Facility also contains certain covenants, including restrictions on mergers, acquisitions and other business consolidations; the sale of assets; incurrence of indebtedness; liens on assets; and transactions with affiliates. In addition, the Facility contains certain customary provisions regarding events of default, including payment defaults, breaches of representations and warranties, covenant defaults, cross-default and cross-acceleration to certain other indebtedness, certain events of bankruptcy and insolvency, material judgments, certain events under the Employee
Retirement Income Security Act of 1974, as amended, and changes of control. The Facility also requires that the Company deliver audited financial statements without a “going concern” or like qualification or exception and without any qualification or exception as to the scope of such audit.
Financial guarantee insurance policies issued by the Company and assumed pursuant to reinsurance arrangements guarantee the timely payment of principal and interest on insured obligations. CDS contracts issued by the Company guarantee the payment of the notional amounts of referenced securities. The net exposure retained on any risk guaranteed or reinsured by the Company is subject to the Company’s underwriting guidelines and regulatory risk limitations. The Company’s in-force business is diversified both domestically and internationally, across multiple industries and by type of obligations guaranteed. The Company’s total exposure, before reinsurance, to principal (or “par”) amounts insured and notional amounts guaranteed as of December 31, 2007 and 2006 was $183.7 billion and $125.3 billion, respectively. The Company’s total exposure, before reinsurance, to principal and interest amounts insured and notional amounts guaranteed as of December 31, 2007 and 2006 was $285.4 billion and $195.4 billion, respectively.
The par amounts insured as of December 31, 2007 and 2006 and the terms of maturity are as follows:
The Company seeks to limit its exposure to losses by maintaining a surveillance function which monitors such transactions throughout their lives. Additionally, the Company seeks to mitigate credit risk by only underwriting investment-grade transactions, diversifying its portfolio and maintaining collateral requirements on asset-backed obligations, as well as through reinsurance.
As of December 31, 2007 and 2006, the Company’s in-force portfolio of guaranteed risks was diversified by type of obligation as shown in the following table:
In addition, the Company seeks to maintain a diversified portfolio of guaranteed obligations designed to spread its risk across a number of geographic areas. Set forth below is the distribution of the Company’s par and notional exposures by geographic location as of December 31, 2007 and 2006:
Set forth below is the Company’s par exposure from the issuance of financial guarantee insurance policies and its notional exposure from the issuance of CDS contracts as of December 31, 2007 and 2006:
The following table presents the net notional exposure of the referenced assets underlying the Company’s CDO of ABS portfolio by rating as of December 31, 2007:
Amount is net of $95.1 million, representing the net present value of future installment premiums at December 31, 2007 with regard to certain of the Company’s guarantees on which case reserves are recorded at December 31, 2007.
Set forth below is a discussion of certain case basis reserves established by the Company. The Company has been indemnified with respect to loss development relating to the insurance transactions described under “(c)” and “(d)” below by affiliates of XL Capital in connection with SCA’s IPO. As a result of such indemnifications, all adverse loss development on such insurance transactions subsequent to the effective date of the IPO, which is in excess of the Company’s carried reserves for such transactions at the date of the IPO, will be absorbed by the aforementioned affiliates of XL Capital. Such protection does not relieve the Company of its obligations under the aforementioned insurance transactions. Accordingly, the Company is still liable under the insurance transactions in the event that the affiliates of XL Capital do not meet their obligations under the indemnifications. For further information with respect to the indemnifications, see Note 8.
representing the net present value loss expected to be incurred in the future with respect to 13 of its 25 guarantees of ABS CDOs. The net present value loss represents: (i) all claims paid through December 31, 2007, plus the net present value of claims expected be paid subsequent thereto, less (ii) recoveries received through December 31, 2007, the net present value of expected recoveries subsequent thereto, and the net present value of installment premiums due by the counterparties to such guarantees subsequent to December 31, 2007. There have been no claims paid on these transactions to date. The total remaining notional/par guaranteed by the Company with respect to these 13 transactions net of carried case basis reserves, but before reinsurance, aggregated approximately $9.4 billion ($8.6 billion after reinsurance) at December 31, 2007. The estimate of loss was based on assumptions and estimates extending over many years into the future. Such estimates are subject to the inherent limitation on the Company’s ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of losses and loss adjustment expenses will vary, perhaps materially, from any estimate. There is currently no payment default with respect to these transactions. Management continues to monitor the exposure and will revise its loss estimate if necessary, as new information becomes available.
The case basis loss reserves on the Company’s ABS CDO portfolio were determined based on detailed cash flow modeling of expected monthly cash flows for all loans that are referenced in the 25 ABS CDOs. ABS CDOs that the Company guarantees are highly complex structured transactions, the performance of which depends on a wide variety of factors outside of its control. The Company’s estimate of losses on these transactions was based on sophisticated financial models, generated internally and supplemented by models generated by third parties, to estimate future credit performance of the underlying assets, and to evaluate structures, rights and its potential obligations over time. The modeling of multi-sector CDOs requires analysis of both direct ABS as well as CDO collateral within the multi-sector CDOs, known as “inner securitizations,” and the Company does not consistently have access to all the detailed information necessary to project every component of each inner securitization. Therefore, in some cases the Company puts greater reliance on the models and analysis of third party market participants and are not able to fully, independently and precisely verify each data point. In addition, many of these financial models include, and rely on, a number of assumptions, many of which are difficult to determine and are subject to change, and even small alterations in the underlying assumptions of the model can have a significant impact on its results. Moreover, the performance of the securities the Company insures depends on a wide variety of factors which are outside its control, including the liquidity and performance of the collateral underlying such securities, the correlation of assets within collateral pools, the performance or non-performance of other transaction participants (including third-party servicers) and the exercise of control or other rights held by other transaction participants.
After the occurrence of a rapid amortization event, the HELOC transactions generally benefit by the funding of the new HELOC draws by a third-party. This benefit will be diminished in the event that the third-party is not legally required, or is unable or unwilling,
to fund the draws, or if the lender suspends credit lines under certain circumstances legally permitted.
During 2006, the reinsurance of the aforementioned two residential mortgage transactions was cancelled in settlement of a dispute with the reinsurer. As a result of the cancellation, all ceded premium (which was on an installment basis and consequently fully earned) aggregating $0.4 million, was returned to the Company and the Company’s net reserve increased by approximately $1.7 million. Also, during 2006, one of the insured debt obligations was retired early as a result of the exercise of a clean-up call by the entity which transferred the underlying mortgages to the special purpose issuer. As a result of the aforementioned retirement, the Company reduced the related case reserve by approximately $1.9 million. The Company’s earnings for 2006 were increased by approximately $0.6 million as a result of the aforementioned returned premium, cancellation, and early retirement. As of December 31, 2006, the Company carried a case basis reserve for this transaction of $3.3 million (none of which was reinsured). During 2007, the insured obligation was retired as a result of the exercise of a clean-up call by the sponsor of the securitization thereby eliminating the Company’s exposure without loss. Accordingly, the Company recorded a reduction in its provision for losses and loss adjustment expenses during 2007 of $3.3 million resulting from the elimination of the aforementioned reserve.
During 2007, the Company recorded a provision for loss of $9.5 million representing the net present value of claims expected to be incurred with respect to two related reinsured international transportation project financings. Because this loss represented a full limit loss, the remaining deferred premium revenue pertaining to the transactions, which aggregated approximately $5.5 million, was fully earned resulting in a net loss of approximately $4.0 million. No loss payments have been made to date with respect to the transactions. The transactions are expected to be terminated in 2008.
In accordance with the Company’s accounting policy discussed in Note 3, the Company’s net provision for unallocated reserves is a function of applying the initial expected loss ratio to earned premium each period (after exclusion of the effect on earned premium of refunding and full limit losses because no more risk exists on those related policies) and the expected loss emergence pattern. For the years ended December 31, 2007, 2006, and 2005, the Company recorded a net provision for unallocated reserves of $17.5 million, $14.3 million and $13.6 million, respectively. The Company’s unallocated loss reserve is established on an undiscounted basis and represents management’s best estimate of losses that the Company will incur in the future as a result of credit deterioration in the Company’s in-force business but which have not yet been specifically identified. As management establishes case basis reserves and pays claims it may, based on its judgment, reduce or increase the ultimate expected loss ratio used to determine unallocated reserves to reflect its best estimate of expected ultimate loss experience. In addition, under the Company’s accounting policy management may, based on its judgment, reduce unallocated reserves in response to significant case basis reserve or paid loss activity. Management would only expect such reductions to
occur in limited instances, such as economic events generating significant loss activity across a broad cross-section of the portfolio. Management has not viewed the Company’s case basis reserve or paid loss activity to date to warrant such a reduction of the Company’s unallocated reserves. While material case basis reserves were established in 2007 by the Company, these reserves were concentrated in certain sectors of its financial guarantee portfolio and were associated with unprecedented credit-market events. As such, these events did not alter management’s perspective of the expected loss ratio associated with the remainder of the portfolio and the required level of unallocated reserves.
XLCA is subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations. The U.S. federal income tax liability is determined in accordance with the principles of the consolidated tax provisions of the Internal Revenue Code and Regulations. XLCA has operations in subsidiary and branch form in certain international jurisdictions that are subject to relevant taxes in those jurisdictions.
With few exceptions, the Company is no longer subject to tax examinations by tax authorities in the major jurisdictions in which the Company operates for years prior to 2003 in the U.S. and 2002 in the UK.
The Company’s income tax provisions for the years ended December 31, 2007, 2006, and 2005 are as follows:
Reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate for the years ended December 31, 2007, 2006 and 2005 is provided below:
The weighted average expected tax provision or benefit has been calculated using the pre-tax accounting income or loss in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. The expected and actual tax benefit or expense for each of the years ending December 31, is primarily attributable to the taxable income or loss in the United States. XLCA has a facultative quota share reinsurance treaty with XLFA. Under the terms of this treaty, XLFA agrees to reinsure up to 75% of the guaranty business written by the Company. As a result, the pre-tax income earned by XLFA, which is a Bermuda company, is not subject to U.S. income tax.
Management has concluded that future income forecasted to be generated is insufficient to offset net operating loss carry forwards and cause the realization of the deferred tax assets within a reasonable period, thus a valuation allowance has been established against the entire deferred tax
In the ordinary course of business, the Company is subject to litigation or other legal proceedings. It is the opinion of management, after consultation with legal counsel and based upon the information available, that the expected outcome of any outstanding litigation, individually or in the aggregate, will not have a material adverse effect on the Company’s financial position, results of operations or liquidity. The Company intends to vigorously defend itself in the litigation discussed below.
In the ordinary course of business, the Company also receives subpoenas and other information requests from regulatory agencies or other governmental authorities. Although no action has been initiated against the Company, it is possible that one or more regulatory agencies or other governmental authorities may pursue action against the Company. If such an action is brought, it could materially adversely affect the Company’s business, results of operations and financial condition.
SCA is a Bermuda corporation and, except as described below, neither it nor its non-United States subsidiaries have paid United States corporate income taxes on the basis that they are not engaged in a trade or business or otherwise subject to taxation in the U.S. However, because definitive identification of activities which constitute being engaged in a trade or business in the United States is not provided by the Internal Revenue Code of 1986, regulations or court decisions, there could be no assurance that the Internal Revenue Service would not contend that the Company or its non-United States subsidiaries are engaged in a trade or business or otherwise subject to taxation in the U.S. If the Company or its non-United States subsidiaries were considered to be engaged in a trade or business in the United States (and, if the Company or such subsidiaries were to qualify for the benefits under the income tax treaty between the United States and Bermuda and other countries in which the Company operates, such business were attributable to a “permanent establishment” in the U.S.), the Company or such subsidiaries could be subject to United States tax at regular tax rates on its taxable income that is effectively connected with its United States trade or business plus an additional 30% “branch profits” tax on such income remaining after the regular tax.
The Company’s lease commitments comprise primarily office premise leases at 1221 Avenue of the Americas, New York, New York, 25 Copthall Ave-London, Merritt 7 Corporate Park, Norwalk, Connecticut and office space lease commitments it assumed from an affiliate, Global Credit Analytics, Inc. (“GCA”), with respect to office space at 250 Park Avenue, New York, New York. In addition, the Company is liable under an information technology outsourcing agreement that it entered into with International Business Machines Corporation (“IBM”) on October 1, 2006. Pursuant to the agreement IBM will: (i) provide the Company with all its information technology hardware, (ii) provide all support services to maintain such hardware and provide for efficient disaster recovery, (iii) develop a transition plan for the Company’s systems from its existing hardware to new hardware, and (iv) maintain the Company’s technology at a level that allows the Company to take advantage of technological advances. In consideration for these services the Company is obligated to pay IBM approximately $4.0 million per annum for the five year term of the contract. The Company incurred expenses of $4.6 million under this agreement for the year ended December 31, 2007.
The following estimated fair values have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret the data used to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
Installment premiums: The fair value of installment premiums is estimated based on the present value of the future contractual premium revenues, net of reinsurance, that would be paid under a reinsurance agreement with a third party to transfer the Company’s financial guarantee risk, net of that portion of the premium retained by the Company to compensate it for originating and servicing the insurance contract. The fair value is derived by calculating the present value of the estimated future cash flow stream (net premium and ceding commissions) discounted at 4.5% and 4.8% at December 31, 2007 and 2006, respectively.
The ability of XLCA to declare and pay SCA a dividend is governed by the Insurance Law of the State of New York (the “Insurance Law”). Under the Insurance Law XLCA is permitted to pay dividends each calendar year, without the prior approval of the superintendent of the insurance department, in an amount equal to the lesser of ten percent of its policyholders’ surplus as of the end of the preceding calendar year or its net investment income for the preceding calendar year, as determined in accordance with Statutory Accounting Practices prescribed or permitted by the Insurance Department of the State of New York. The Insurance Law also provides that XLCA may distribute dividends to its shareholders in excess of the aforementioned amount only upon giving notice of its intention to declare such dividend, and the amount thereof, to the New York Superintendent. Moreover, a New York-domiciled insurer may not declare or distribute any dividends except out of earned surplus. The New York Superintendent may disapprove such distribution if he finds that the financial condition of XLCA does not warrant such distribution.
For the years ended December 31, 2007, 2006, and 2005, XLCA reported statutory-basis net (loss) income of $(191.1) million, $0.1 million, and $(0.4) million, respectively, and statutory-basis capital and surplus of $192.0 million and $207.0 million as of December 31, 2007 and 2006, respectively.
In connection with the Company’s IPO, XLCA and XLFA each passed resolutions that provided that, until the second anniversary of the IPO, each will not declare or grant dividends on its common stock, other than to fund certain parent holding company operating expenses and debt service requirements and, to fund dividends on SCA’s preferred stock and “nominal” dividends on its common stock. Subsequently, XLFA passed a superseding resolution for purposes of capital reallocation between the operating entities permitting the payment of a dividend in the amount of $130 million, the proceeds of which were ultimately contributed to the capital of XLCA.
Among other requirements, Article 69 of the New York Insurance Law provides that financial guarantee insurance companies maintain minimum capital and surplus and limits both the aggregate and individual risks that XLCA may guarantee on a net basis based on the type of obligations guaranteed. As of December 31, 2007, XLCA was in compliance with all such regulatory requirements.
XLFA is subject to Bermuda regulatory constraints that will affect its ability to pay dividends on its common shares and to make other payments to SCA. Under Bermuda’s Insurance Act 1978, as amended, and related regulations (the “Insurance Act”), XLFA is required to maintain a minimum solvency margin and minimum liquidity ratio and is prohibited from declaring or paying dividends if such payment would result in its non-compliance with these requirements. In addition, under the Companies Act 1981 of Bermuda, as amended (the “Companies Act”), XLFA may not declare or pay a dividend, or make a distribution out of its contributed surplus, if there are reasonable grounds for believing that (1) it is, or would after the payment be, unable to pay its liabilities as they become due; or (2) the realizable value of its assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts (as such terms are defined in the Companies Act). Furthermore, in order to reduce its total statutory capital by 15% or more, XLFA would require the prior approval of the Bermuda Monetary Authority.
XLFA is required, with respect to its general business, to maintain a minimum solvency margin equal to the greatest of:
20% of net premiums written up to $6,000,000 plus 15% of net premiums written over $6,000,000, and
In connection with the sale of the SCA Series A Preference Shares, the Company entered into a Replacement Capital Covenant (the “Replacement Capital Covenant”), whereby the Company agreed for the benefit of holders of one or more designated series of its long-term debt securities that the Company may issue in the future that (i) the Company will not redeem, exchange or purchase the SCA Series A Preference Shares and (ii) none of the Company’s subsidiaries will purchase or exchange the SCA Series A Preference Shares, except, subject to certain limitations, to the extent that the applicable redemption, exchange or purchase price does not exceed a specified amount of cash proceeds from the sale of certain specified qualifying replacement capital securities raised during the period commencing on the 180th calendar day prior to the date of notice of the redemption or the date of purchase. The Company has made no decision as to whether, or when, it would issue debt securities that would have the benefit of that covenant. While such provisions are in effect, there could be circumstances where the Company would wish to redeem, exchange or purchase some or all of the SCA Series A Preference Shares but be restricted from doing so. The Replacement Capital Covenant may be terminated if (i) holders of at least a majority by principal amount of the then-effective series of covered debt consent or agree in writing to terminate the Replacement Capital Covenant, (ii) the Company no longer has outstanding any indebtedness that qualifies as covered debt or (iii) the Company no longer has any outstanding SCA Series A Preference Shares. In addition, if not earlier terminated, the Replacement Capital Covenant will terminate on September 30, 2047; provided, however, that the September 30, 2047 termination date may be extended at the Company’s option.
Prior to the IPO, certain employees of the Company participated under XL Capital’s stock-based and long-term compensation plans and expense relating thereto was reflected in the Company’s results of operations. Subsequent to the IPO, SCA adopted its own stock-based and long-term incentive plan and certain awards to employees of the Company under XL Capital’s stock-based compensation and long-term incentive plans were converted to SCA’s plans. Expense relating to awards to employees of the Company under XL Capital plans that were not so converted and remain outstanding continues to be recognized in the Company’s financial statements. See also Note 8.
The stock options awarded under the Plan in 2006 had a weighted average grant-date fair value of $6.06 and the restricted stock had a weighted average grant-date fair value of $20.50. During the year ended December 31, 2006, the Company recognized approximately $0.7 million of compensation expense, net of tax, related to its stock option Awards.
The risk free interest rate is based on U.S. Treasury rates. The expected lives are estimated using the exercise behavior of grant recipients.
There were approximately 4.5 million options available for grant as of December 31, 2007 irrespective of the form of the Award (e.g. SAR’s, restricted shares, restricted share units, performance shares, performance units, dividend equivalents, and other share-based awards).
For the years ended December 31, 2007 and 2006 SCA recognized approximately $6.2 million and $1.2 million of compensation expense related to its restricted stock awards, respectively.
Total unrecognized stock based compensation expense related to non-vested restricted stock was approximately $22.5 million at December 31, 2007, which is expected to be recognized over a weighted-average period of 3.25 years.
In connection with the IPO, XL Capital and the Company offered eligible employees of the Company the opportunity to exchange all of their outstanding unvested restricted Class A Ordinary Shares of XL Capital and options to purchase Class A Ordinary Shares of XL Capital, which were awarded to such employees under XL Capital Plans prior to the IPO, for a long term incentive plan award (the “LTIP Award”) from SCA to be granted under SCA’s Plan (the “Exchange Offer”).
Restricted stock awards issued under the 1991 Performance Incentive Program vest as set forth in the applicable award agreements. These shares contained certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability.
Total expense recognized by the Company with respect to plan awards to employees of the Company by XL Capital was $0.8 million, $2.1 million and $2.4 million in 2007, 2006 and 2005, respectively.
For the years ended December 31, 2006 and 2005, the Company recognized approximately $2.5 million, and $2.7 million of compensation expense related to such Awards, respectively. There was no unrecognized compensation expense at December 31, 2006 related to the aforementioned deferred cash and deferred bonus awards as a result of the involuntary conversion of such Awards to SCA plans as discussed above.
The following table sets forth the computation of basic and diluted earnings (loss) per share:
For the year ended December 31, 2005, earnings (loss) per share was based on 46,127,245 shares outstanding immediately prior to the IPO. In July 2006, a stock split of the Company’s outstanding common shares was effected. As a result, there were 46,127,245 shares of the Company’s common stock issued and outstanding just prior to the offering. The accompanying financial statements and share amounts have been retroactively adjusted for the effects of such stock split.
The increase, as compared to prior quarters, relates to the provisions for case basis reserves discussed in Note 14(a), (b) and (f).
The loss recorded during the fourth quarter of 2007 is primarily the result of provisions for case basis reserves discussed in Note 14(a), (b) and (f), as well as the change in the estimate of the fair value of the Company’s CDS contracts, which is discussed in Note 3.