(2) Amount for 2005 represents investment banking fees and put option premiums associated with Assured Guaranty Corp.’s $200.0 million committed capital securities. Amounts for 2001 and 2002 represent the amortization of goodwill, which arose from ACE’s acquisition of Capital Re Corporation as of December 31, 1999. Beginning January 1, 2002, goodwill is no longer amortized, but rather is evaluated for impairment at least annually in accordance with FAS No. 142, “Goodwill and Other Intangible Assets.” During 2004, a goodwill impairment of $1.6 million was recognized for the trade credit business which the Company exited as part of its IPO strategy. No such impairment was recognized in the years ended December 31, 2005, 2003 and 2002.
(4) The loss and loss adjustment expense ratio is calculated by dividing loss and loss adjustment expenses by net earned premiums.
(6) Under U.S. statutory accounting principles, financial guaranty and mortgage guaranty insurers are required to establish contingency reserves based on a specified percentage of premiums. A contingency reserve is an additional liability established to protect policyholders against the effects of adverse economic developments or cycles or other unforeseen circumstances.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and accompanying notes which appear elsewhere in this Form 10-K. It contains forward-looking statements that involve risks and uncertainties. Please see “Forward-Looking Statements” for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the headings “Investment Considerations” and “Forward-Looking Statements.”
Assured Guaranty Ltd. is a Bermuda-based holding company which provides, through its operating subsidiaries, credit enhancement products to the public finance, structured finance and mortgage markets. We apply our credit expertise, risk management skills and capital markets experience to develop insurance, reinsurance and credit derivative products that meet the credit enhancement needs of our customers. We market our products directly and through financial institutions. We serve the U.S. and international markets.
Our expenses consist primarily of losses and loss adjustment expenses (“LAE”), profit commission expense, acquisition costs, operating expenses, interest expense and income taxes. Losses and LAE are a function of the amount and types of business we write. Losses and LAE are based upon estimates of the ultimate aggregate losses inherent in the portfolio. The risks we take have a low expected frequency of loss and are investment grade at the time we accept the risk. Prior to the IPO, the majority of the risks we underwrote were investment grade, however some risks accepted were below investment grade. Profit commission expense represents payments made to ceding companies generally based on the profitability of the business reinsured by us. Acquisition costs are related to the production of new business. Certain
acquisition costs that vary with and are directly attributable to the production of new business are deferred and recognized over the period in which the related premiums are earned. Operating expenses consist primarily of salaries and other employee-related costs, various outside service providers, rent and related costs and other expenses related to maintaining a holding company structure. These costs do not vary with the amount of premiums written. Interest expense is a function of outstanding debt and the contractual interest rate related to that debt. Income taxes are a function of our profitability and the applicable tax rate in the various jurisdictions in which we do business.
Portfolio reserves are not established based on a specific event, rather they are calculated by aggregating the portfolio reserve calculated for each individual transaction. Individual transaction reserves are calculated on a quarterly basis by multiplying the par in-force by the product of the ultimate loss and earning factors without regard to discounting. The ultimate loss factor is defined as the frequency of loss multiplied by the severity of loss, where the frequency is defined as the probability of default for each individual issue. The earning factor is inception to date earned premium divided by the estimated ultimate written premium for each transaction. The probability of default is estimated from historical rating agency
data and is based on the transaction’s credit rating, industry sector and time until maturity. The severity is defined as the complement of historical recovery/salvage rates gathered by the rating agencies of defaulting issues and is based on the industry sector.
Portfolio reserves are recorded gross of reinsurance. To date our reinsurance programs have been made up of excess of loss contracts. We have not ceded any amounts under these contracts, as our recorded portfolio reserves have not exceeded our contractual retentions.
In addition to analyzing the sensitivity of our portfolio reserves to possible changes in frequency and severity, we have also performed a sensitivity analysis on our financial guaranty and mortgage guaranty case reserves. Case reserves may change from our original estimate due to changes in severity factors. An actuarial analysis of the historical development of our case reserves shows that it is reasonably possible that our case reserves could develop by as much as ten percent. This analysis was performed by separately evaluating the historical development by comparing the initial case reserve established to the subsequent development in that case reserve, excluding the effects of discounting, for each sector in which we currently have significant case reserves, and estimating the possible future development. Based on this analysis, it is reasonably possible that our current financial guaranty and mortgage guaranty case reserves of $38.6 million could reasonably increase by approximately $3.0 million to $4.0 million in the future. This would cause an increase in incurred losses on our statement of operations and comprehensive income.
(1) These ratings represent the Company’s internal assessment of the underlying credit quality of the insured obligations. Our scale is comparable to that of the nationally recognized rating agencies.
Our surveillance department is responsible for monitoring our portfolio of credits and maintains a list of closely monitored credits. The closely monitored credits are divided into four categories: Category 1 (low priority; fundamentally sound, greater than normal risk); Category 2 (medium priority; weakening credit profile, may result in loss); Category 3 (high priority; claim/default probable, case reserve established); Category 4 (claim paid, case reserve established for future payments). The closely monitored credits include all below investment grade (“BIG”) exposures where there is a material amount of exposure (generally greater than $10.0 million) or a material risk of the Company incurring a loss greater than $0.5 million. The closely monitored credits also include investment grade (“IG”) risks where credit quality is deteriorating and where, in the view of the Company, there is significant potential that the risk quality will fall below investment grade. The closely monitored credits include approximately 96% of our BIG exposure, and the remaining BIG exposure of $55.2 million is distributed across 103 different credits. Other than those excluded BIG credits, credits that are not included in the closely monitored credit list are categorized as fundamentally sound risks.
The following table provides financial guaranty net par outstanding by credit monitoring category as of December 31, 2005 and 2004:
(1) As of December 31, 2005, Category 1 contains 4 credits with net par outstanding of $44.8 million and Category 2 contains 7 credits with net par outstanding of $80.6 million related to Hurricane Katrina.
The Company is aware that there are certain differences regarding the measurement of portfolio loss liabilities among companies in the financial guaranty industry. In January and February 2005, the Securities and Exchange Commission (“SEC”) staff had discussions concerning these differences with a number of industry participants. Based on those discussions, in June 2005, the Financial Accounting Standards Board (“FASB”) staff decided additional guidance is necessary regarding financial guaranty contracts. When the FASB staff reaches a conclusion on this issue, which is expected during the first half of 2006, the Company and the rest of the financial guaranty industry may be required to change some aspects of their loss reserving policies, but the Company cannot currently assess how the FASB or SEC staffs’ ultimate resolution of this issue will impact our reserving policy or other balances, i.e., premiums and DAC. Until the issue is resolved, the Company intends to continue to apply its existing policy with respect to the establishment of both case and portfolio reserves.
The fair value adjustment recognized in our statement of operations for the year ended December 31, 2005 was a $3.5 million loss compared with a $52.5 million gain for the year ended December 31, 2004 and a $98.4 million gain for the year ended December 31, 2003. The change in fair value is related to many factors but primarily due to run-off of deals and changes in credit spreads. For example, the 2005 loss of $3.5 million primarily relates to the run-off of deals and a slight widening in investment grade corporate spreads over that period, the 2004 gain of $52.5 million primarily relates to an approximate 15-20% tightening in credit spreads, and the 2003 gain of $98.4 million primarily relates to an approximate 60-65% tightening in credit spreads.
As of December 31, 2005, 2004 and 2003, we had total investments of $2.2 billion, $2.1 billion and $2.2 billion, respectively. The fair values of all of our investments are calculated from independent market quotations.
As of December 31, 2005, approximately 95% of our investments were long-term fixed maturity securities, and our portfolio had an average duration of 4.4 years, compared with 92% and 5.0 years as of December 31, 2004. Changes in interest rates affect the value of our fixed maturity portfolio. As interest rates fall, the fair value of fixed maturity securities increases and as interest rates rise, the fair value of fixed maturity securities decreases. The following table summarizes the estimated change in fair value net of related income taxes on our investment portfolio as of December 31, 2005 based upon an assumed parallel shift in interest rates across the entire yield curve:
· a decline in the market value of a security by 20% or more below amortized cost for a continuous period of at least six months;
The following table summarizes the unrealized losses 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 the dates indicated:
Premiums are received either upfront or in installments. Upfront premiums are earned in proportion to the expiration of the related risk. Each installment premium is earned ratably over its installment period, generally one year or less. For the years ended December 31, 2005, 2004 and 2003, approximately 49%, 66% and 34%, respectively, of our gross written premiums were received upfront, and 51%, 34% and 66%, respectively, were received in installments. For the financial guaranty direct and financial guaranty reinsurance segments, earned premiums related to upfront premiums are greater in the earlier periods of an upfront transaction when there is a higher amount of risk outstanding. The premiums are allocated in accordance with the principal amortization schedule of the related bond issue and are earned ratably over the amortization period. 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
Acquisition costs incurred, other than those associated with credit derivative products, that vary with and are directly related to the production of new business are deferred and amortized in relation to earned premiums. These costs include direct and indirect expenses such as ceding commissions, brokerage expenses and the cost of underwriting and marketing personnel. As of December 31, 2005 and 2004, we had deferred acquisition costs of $193.4 million and $186.4 million, respectively. Ceding commissions paid to primary insurers are the largest component of deferred acquisition costs, constituting 72.6% and 79.2% of total deferred acquisition costs as of December 31, 2005 and 2004, respectively. Management uses its judgment in determining what types of costs should be deferred, as well as what percentage of these costs should be deferred. We annually conduct a study to determine which operating costs vary with, and are directly related to, the acquisition of new business and qualify for deferral. Ceding commissions received on premiums we cede to other reinsurers reduce acquisition costs. Anticipated losses, LAE and the remaining costs of servicing the insured or reinsured business are considered in determining the recoverability of acquisition costs. Acquisition costs associated with credit derivative products are expensed as incurred. When an insured issue is retired early, as discussed in the Premium Revenue Recognition section of these Critical Accounting Estimates, the remaining related deferred acquisition cost is expensed at that time.
As of December 31, 2005, Assured Guaranty Re Overseas Ltd. (“AGRO”) had a stand-alone NOL of $59.2 million, which is available to offset its future U.S. taxable income. The Company has $38.5 million of
this NOL available through 2017; $20.7 million available through 2023. AGRO’s stand-alone NOL is not permitted to offset income of any other members of AGRO’s consolidated group due to certain tax regulations. Under applicable accounting rules, we are required to establish a valuation allowance for NOLs that we believe are more likely than not to expire before utilized. Management believes it is more likely than not that $20.0 million of AGRO’s $59.2 million NOL will not be utilized before it expires and has established a $7.0 million valuation allowance related to the NOL deferred tax asset. The valuation allowance is subject to considerable judgment, is reviewed quarterly and will be adjusted to the extent actual taxable income differs from estimates of future taxable income that may be used to realize NOLs.
these businesses are reflected in the above numbers. These businesses include equity layer credit protection, trade credit reinsurance, title reinsurance, LA&H and auto residual value reinsurance.
Gross written premiums for the year ended December 31, 2005 were $252.1 million compared with $190.9 million for the year ended December 31, 2004, an increase of $61.2 million, or 32%. Gross written premiums from our financial guaranty operations decreased $45.6 million in 2005 compared with 2004. The financial guaranty direct segment increased $15.4 million in 2005 compared with 2004 primarily due to a $16.1 million increase in public finance transactions. This increase was offset by decreased business in our financial guaranty reinsurance segment attributable to one cedant relationship that was terminated and business from a second cedant that was decreased, effective July 1, 2004 and to Financial Security Assurance Inc. (“FSA”) reassuming from Assured Guaranty Re Ltd. (“AG Re”) $18.4 million of healthcare related business (“FSA transaction”) during 2005. Offsetting the decreased gross written premium from our financial guaranty operations was an increase of $106.8 million in 2005 compared with 2004 in our other segment. The increase was due to $25.8 million in gross written premium in 2005, which was immediately retroceded to an ACE subsidiary, as part of a pre-IPO reinsurance agreement under which we provided reinsurance to CGA Group Ltd. (“CGA”) and retroceded 100% of this exposure to that ACE subsidiary. In addition, 2004 gross premiums written were reduced $97.8 million, as part of the IPO due to the unwinding of equity layer credit protection products.
Gross written premiums for the year ended December 31, 2004 were $190.9 million compared with $349.2 million for the year ended December 31, 2003, a decrease of $158.3 million, or 45%. Gross written premiums from our financial guaranty operations increased $6.9 million in 2004 compared with 2003 due to the recognition of $10.4 million of gross premiums written in the financial guaranty direct segment from the closing out of transaction types in which we no longer participate. Offsetting the increased financial
Net earned premiums for the year ended December 31, 2005 increased by $10.8 million, or 6%, compared with the year ended December 31, 2004. Financial guaranty net earned premiums decreased $38.1 million in 2005 compared with 2004, due to a $14.3 million decline in the financial guaranty direct segment, which included $24.2 million of net earned premium related to the unwinding of a transaction in 2004 and a $15.1 million decrease in our mortgage guaranty segment, reflecting the run-off of our quota share treaty business. This decrease was offset by an increase of $48.9 million in our other segment, in 2004 attributable to the retrocession in 2004 of lines of business that we no longer underwrite.
Net earned premiums for the year ended December 31, 2004 decreased by $123.0 million, or 40%, compared with the year ended December 31, 2003. Financial guaranty net earned premiums increased $46.1 million in 2004 compared with 2003, due to the recognition of $24.2 million of net earned premiums in the financial guaranty direct segment in 2004 related to the close out of transaction types in which we no longer participate and an increase of $21.5 million in our financial guaranty reinsurance segment primarily attributable to our structured finance business which increased $16.7 million, compared with 2003, due to timing on installment earnings reported by our ceding companies. These increases were offset by our other segment which declined $169.1 million in 2004 compared with 2003 as a result of exiting certain lines of business in connection with the IPO.
down is included in other assets on our balance sheet. The Company had no write downs of investments for other than temporary impairment losses in 2005 or 2004 compared with $0.1 million of other than temporary impairment losses for the year ended December 31, 2003. Net realized investment gains, net of related income taxes, were $1.8 million, $7.7 million and $3.8 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Derivative financial instruments are recorded at fair value as required by FAS 133 and FAS 149. However, as explained under “-Critical Accounting Estimates,” we record part of the change in fair value in the loss and LAE reserves as well as in unearned premium reserves. The fair value adjustment for the year ended December 31, 2005 was a $3.5 million loss compared with a $52.5 million gain for the year ended December 31, 2004 and a $98.4 million gain for the same period in 2003. The change in fair value is related to many factors but primarily due to run-off of deals and changes in credit spreads. For example, the 2005 loss of $3.5 million primarily relates to the run-off of deals and a slight widening in investment grade corporate spreads over that period. The 2004 gain of $52.5 million primarily relates to an approximate 15-20% tightening in credit spreads. The 2003 gain of $98.4 million primarily relates to an approximate 60-65% tightening in credit spreads.
Loss and LAE for the year ended December 31, 2004 decreased $176.6 million, or 122%, compared with the year ended December 31, 2003. Our financial guaranty direct results include $12.3 million related to the closing out of transaction types that we no longer underwrite. The financial guaranty reinsurance segment decreased in 2004 compared with 2003 as 2003 included $20.4 million in case reserve activity associated with CDOs assumed through treaties. This was partially offset by a $3.7 million addition in portfolio reserves in 2004 as a result of credit downgrades. In addition, during 2004 management updated its loss estimates for the mortgage guaranty segment resulting in a release of reserves, as a result of changes in our statistical assumptions driven by the completion of a rating agency review of our book of business during the year coupled with favorable loss development related to older experience rated quota share contracts, which are running off. See “-Segment Results of Operations” for further explanations of these changes. Our other segment declined $153.6 million in 2004, compared with 2003 as a result of exiting those lines of business mentioned previously.
Profit commissions, which are primarily related to our mortgage guaranty segment, allow the ceding company to share favorable experience on a reinsurance contract due to lower than expected losses. For the years ended December 31, 2005, 2004 and 2003 profit commissions were $12.9 million, $15.5 million and $9.8 million, respectively. Favorable loss development generates increased profit commission expense, while the inverse occurs on unfavorable loss development. The decrease in profit commission expense for 2005 compared with 2004 is primarily due to the run-off of mortgage guaranty experience rated quota share treaties, which have a large profit commission component. The increase in profit commission expense for 2004 is due to favorable loss development on experience rated quota share treaties. Portfolio reserves are not a component of these profit commission calculations. This balance is expected to increase in future years due to the profit commission component on the FSA transaction.
For the years ended December 31, 2005, 2004 and 2003, operating expenses were $59.0 million, $67.8 million and $41.0 million, respectively. The decrease for 2005 compared with 2004 was primarily due to the accelerated vesting of $11.3 million of employee stock awards which occurred as part of the IPO, offset by expenses associated with maintaining a holding company platform during all of 2005. The holding company was not activated until April 28, 2004, the date of the IPO. The increase for 2004 was primarily due to $11.3 million of accelerated employee stock awards vesting, which occurred as part of the IPO, in addition to various expenses incurred as a result of the establishment of a holding company.
For the years ended December 31, 2005, 2004 and 2003, other expenses were $17.3 million, $12.3 million and $5.7 million, respectively. The increase in 2005 includes $3.7 million of investment banking fees and put option premiums associated with Assured Guaranty Corp.’s (“AGC”) $200.0 million committed capital securities and increased interest expense related to the issuance of our 7% Senior Notes in May 2004 as they have been outstanding for the entire year. The coupon on the Senior Notes is 7.0%, however, the effective rate will be approximately 6.4%, taking into account the effect of a cash flow hedge executed by the Company in March 2004. The increase in 2004 is due to interest expense of $8.2 million related to the issuance of our 7% Senior Notes in May 2004 and the $1.6 million write off of goodwill in our other segment. This amount is related to the trade credit business which we exited as part of the IPO.
For the years ended December 31, 2005, 2004 and 2003, income tax expense was $41.2 million, $50.5 million and $31.7 million and our effective tax rate was 17.9%, 21.7% and 12.9% for the years ended December 31, 2005, 2004 and 2003, respectively. Our effective tax rates reflect the proportion of income recognized by each of our operating subsidiaries, with U.S. subsidiaries taxed at the U.S. marginal corporate income tax rate of 35%, UK subsidiaries taxed at the UK marginal corporate tax rate of 30%, and no taxes for our Bermuda holding company and subsidiaries. Accordingly, our overall corporate effective tax rate fluctuates based on the distribution of taxable income across these jurisdictions.
Our financial results include four principal business segments: financial guaranty direct, financial guaranty reinsurance, mortgage guaranty and other. Management uses underwriting gains and losses as the primary measure of each segment’s financial performance. Underwriting gain (loss) includes net premiums earned, loss and loss adjustment expenses, profit commission expense, acquisition costs and other operating expenses that are directly related to the operations of our insurance businesses. This measure excludes certain revenue and expense items, such as investment income, realized investment gains and losses, unrealized gains and losses on derivative financial instruments, and interest expense, that are not directly related to the underwriting performance of our insurance operations, but are included in net income. For the year ended December 31, 2004 our segment results exclude $11.3 million of operating expenses related to the accelerated vesting of stock awards at the IPO date.
The financial guaranty direct segment contributed $96.2 million, $80.8 million and $71.1 million to overall gross written premiums, for the years ended December 31, 2005, 2004 and 2003, respectively. The $15.4 million increase in 2005 compared with 2004 is primarily due to a $16.1 million increase in public finance transactions, reflecting the execution of our direct business plan. The $9.7 million increase in 2004 compared with 2003, was attributable to $17.8 million written as financial guaranty insurance, offset by a $8.1 million decrease in premiums written as credit derivatives.
Net earned premiums for the years ended December 31, 2005, 2004 and 2003, were $74.5 million, $88.8 million and $70.2 million, respectively. The decrease of $14.3 million in net earned premiums in 2005 compared with 2004 is due to $24.2 million of net earned premiums in first quarter 2004 related to the close out of a transaction in which we no longer participate, offset by new business. The increase of $18.6 million in 2004 compared with 2003 is attributable to the recognition of $24.2 million of net earned premiums mentioned above, offset by the runoff of our single name swap book of business.
Loss and loss adjustment expenses were $(2.2) million, $14.8 million and $16.3 million, respectively, for the years ended December 31, 2005, 2004 and 2003. Our loss and loss adjustment expenses are affected by changes in the mix, size and credit trends in our book of business, and by changes in our reserves for loss and loss adjustment expenses for prior periods. The loss ratios for the years ended December 31, 2005, 2004 and 2003 were (2.9)%, 16.7% and 23.2%, respectively. 2005 portfolio reserves were reduced $7.0 million, attributable to changes in credit quality and from continued runoff from maturing CDO exposures, as well as management updating its loss reserving data, as part of our normal portfolio reserve process, to include the most current rating agency default studies. Primarily offsetting this portfolio reserve decrease was an addition of $4.5 million in case reserves for a specific mortgage transaction executed in 2002, consisting of sub-prime mortgages originated in 2000.
The decline of $1.5 million in the loss and loss adjustment expenses in 2004 as compared with 2003 reflects the release of portfolio reserves due to the maturing of CDO exposures and the continued runoff of our single name CDS business. Offsetting these releases were increased portfolio reserves for our other business in this segment as management further refined its loss reserving methodology. This reflected our normal ongoing portfolio review process and additional stress factors considered for our closely monitored credit list.
Operating expenses for the years ended December 31, 2005, 2004 and 2003 were $36.9 million, $31.7 million and $8.9 million, respectively. During 2005 the Company implemented a new operating expense methodology to more closely apply expenses to the individual operating segments starting with 2004, the year of the IPO. This new methodology was based on a comprehensive cost study. The prior allocation was based on segment net earned premium. Basing the allocation on earned premium for 2005 and 2004 would have caused the financial guaranty reinsurance and mortgage guaranty segments to receive a disproportionate amount of the expenses. 2004 amounts have been adjusted to reflect this new allocation. The earned premium allocation methodology was kept for 2003, as the current business strategy of focusing on direct business was not in place in 2003 and thus the net earned premium allocation methodology allocated an appropriate amount of operating expense to the segments. The increase during 2005 compared with 2004 was primarily due to salary and related expenses as the Company has increased staffing levels to meet its business needs. The increase during 2004 compared with 2003 is due to the direct segment receiving an increased share of operating expenses attributable to the updated operating expense
methodology discussed above and additional holding company expenses associated with the Company’s IPO in April 2004.
Gross written premiums for the years ended December 31, 2005, 2004 and 2003 were $98.0 million, $160.3 million and $163.1 million, respectively. 2005 decreased $62.3 million, or 39%, compared with 2004, while 2004 decreased $2.8 million, or 2%, compared with 2003. These decreases are primarily due to one cedant relationship that was terminated and business from a second cedant that was decreased, effective July 1, 2004. Further reducing 2005 gross written premium is the FSA transaction of $18.4 million discussed earlier.
For the years ended December 31, 2005, 2004 and 2003, net written premiums were $97.8 million, $160.1 million and $162.1 million, respectively. These differences are consistent with the changes in gross written premium described above.
For the years ended December 31, 2005, 2004 and 2003, net earned premiums were $105.6 million, $114.4 million and $92.9 million, respectively, a decrease of $8.8 million, or 8%, in 2005 compared with 2004, and an increase of $21.5 million, or 23%, in 2004 compared with 2003. The $8.8 million decrease in 2005 net earned premiums compared with 2004 was primarily caused by $5.3 million of reduced refundings in our public finance business which reflects the unscheduled pre-payment or refundings of underlying public bonds due to lower interest rates. These unscheduled refunding premiums are sensitive to market interest rates and we evaluate our net earned premiums both including and excluding these premiums. In addition, the FSA transaction reduced net earned premiums by $3.0 million, while the termination of one cedant relationship and decreased business from a second cedant, effective July 1, 2004, also contributed to the decline. The $21.5 million increase in 2004 compared with 2003 was primarily attributable to our structured finance business which increased $16.7 million, compared with 2003, due to timing on installment earnings reported by our ceding companies.
Loss and LAE were $(61.3) million, $15.4 million and $25.7 million, respectively, for the years ended December 31, 2005, 2004 and 2003. Our loss and LAE ratios for the years ended December 31, 2005, 2004 and 2003 were (58.1)%, 13.5% and 27.7%, respectively. 2005 includes $71.0 million in loss recoveries from a third party litigation settlement agreement, with two parties, relating to a reinsurance claim incurred in 1998 and 1999. This recovery was offset by an addition to loss reserves of $6.0 million, consisting of a $10.4 million addition to case reserves and a reduction of $4.4 million to portfolio reserves due to a reinsurance client ceding losses on two Northwest Airlines Enhanced Equipment Trust Certificate (EETC) credits with net par outstanding of $66.1 million. In addition, portfolio reserves were increased $2.8 million , due to credit downgrades causing movements in our closely monitored credit list and increased exposure to Hurricane Katrina. While loss and LAE decreased in 2004 compared with 2003, in 2004 we actually increased portfolio reserves, which are established based on statistical estimates. Credit downgrades and a
refined loss reserving methodology resulted in the increase to portfolio reserves. These amounts reflect our normal ongoing portfolio review process and additional stress factors considered for our closely monitored credit list. However, 2003 included an increase in losses and LAE incurred in the structured finance line of business due to credit deterioration in collateralized debt obligations assumed through reinsurance treaties. Case reserves related to these collateralized debt obligations were increased after completion of risk management’s credit analysis, which included discussions with ceding companies.
For the years ended December 31, 2005, 2004 and 2003, acquisition costs were $36.9 million, $38.8 million and $33.6 million, respectively. The changes in acquisition costs over the periods are directly related to the changes in net earned premium.
Gross written premiums for the year ended December 31, 2005 were $25.7 million, while 2004 and 2003 gross written premiums were both $24.4 million. The increase of $1.3 million in 2005 from 2004 is primarily related to a single transaction executed during 2005 which contributed $16.3 million to gross written premiums. Likewise, the year 2004 included a single transaction which contributed $9.5 million to gross written premiums. Excluding these items, gross written premiums decreased $5.5 million due to the run-off of our quota share treaty business.
Loss and loss adjustment expenses were $(3.7) million, $(11.9) million and $(0.7) million, respectively, for the years ended December 31, 2005, 2004 and 2003. The loss and loss adjustment expense ratios for the years ended December 31, 2005, 2004 and 2003 were (19.9)%, (35.2)% and (2.5)%, respectively. The 2005 amount is due to an IBNR release of $4.4 million, offset by an increase in portfolio reserves of $0.7 million. The IBNR reduction is offset by increased profit commission expense discussed below. In 2004, the decrease in the loss and loss adjustment expense ratio was primarily due to a decrease of $5.5 million of portfolio reserves, as a result of changes in our statistical assumptions driven by the completion of a rating agency review of our book of business during the year coupled with favorable loss development related to older experience rated quota share contracts, which are running off. This reduction in loss and loss adjustment expense was partially offset by increased profit commission expense discussed below. The negative loss ratio for 2003 is primarily a result of favorable loss experience related to older contracts, which are running off, mentioned above.
Profit commission expense for the years ended December 31, 2005, 2004 and 2003 was $8.0 million, $14.1 million and $7.3 million, respectively. The decrease in profit commission expense in 2005 compared with 2004 is due to the run-off of mortgage guaranty quota share treaties, which have a large profit commission component. The increase in profit commission expense in 2004 compared with 2003 was due to more favorable loss development on experience rated quota share treaties. Loss development can fluctuate from period to period. Portfolio reserves are not a component of these profit commission calculations.
Operating expenses for the years ended December 31, 2005, 2004 and 2003 were $2.7 million, $3.8 million and $4.2 million, respectively. During 2005 the Company implemented a new operating expense methodology to more closely apply expenses to the individual operating segments starting with 2004, the year of the IPO. This new methodology was based on a comprehensive cost study. The prior allocation was based on segment net earned premium. Basing the allocation on earned premium for 2005 and 2004 would have caused the financial guaranty reinsurance and mortgage guaranty segments to receive a disproportionate amount of the expenses. 2004 amounts have been adjusted to reflect this new allocation. The earned premium allocation methodology was kept for 2003, as the current business strategy of focusing on direct business was not in place in 2003 and thus the net earned premium allocation methodology allocated an appropriate amount of operating expense to the segments. The decrease during 2005 compared with 2004 was due to the mortgage guaranty segment receiving a declining allocation of operating expenses as fewer resources are focused on this segment compared to prior year. The decrease during 2004 compared with 2003 is due to the mortgage segment receiving a decreased share of operating expenses attributable to the updated operating expense methodology discussed above.
Our other segment consists of certain non-core businesses that we have exited in connection with the IPO, including equity layer credit protection, trade credit reinsurance, title reinsurance, LA&H reinsurance and auto residual value reinsurance. Also included in the 2003 other segment results are the impact of the affiliate reinsurance transactions described below. These reinsurance contracts were purchased for the benefit of all of our operating segments. We did not allocate the costs or the related benefits of these transactions to each of the segments but rather recorded the impact of these transactions in the other segment.
After entering the equity layer credit protection market in 2001, we ceased writing new equity layer credit protection business during 2003, and net earned premiums declined to $5.4 million for the year ended December 31, 2004 from $61.8 million for the year ended December 31, 2003. The underwriting gain of $2.4 million in 2005 was attributable to a salvage recovery received during 2005. The $3.1 million underwriting gain in 2004 is from the unwinding of this business. For the year ended December 31, 2003, the underwriting loss of $1.0 million was the result of the termination of three trades.
Trade credit reinsurance net earned premiums were negative $25.3 million in 2004 due to the 100% retrocession with an affiliate of ACE, whereby we ceded 100% of the unearned premium reserves and loss and LAE reserves. For the year ended December 31, 2003 net earned premiums were $51.2 million.
Our liquidity, both on a short-term basis (for the next twelve months) and a long-term basis (beyond the next twelve months), is largely dependent upon: (1) the ability of our operating subsidiaries to pay dividends or make other payments to us, (2) external financings and (3) investment income from our invested assets. Our liquidity requirements include the payment of our operating expenses, interest on our debt, and dividends on our common shares. We may also require liquidity to make periodic capital investments in our operating subsidiaries. In the ordinary course of our business, we evaluate our liquidity needs and capital resources in light of holding company expenses, debt-related expenses and our dividend policy, as well as rating agency considerations. Based on the amount of dividends we expect to receive from
our subsidiaries and the income we expect to receive from our invested assets, management believes that we will have sufficient liquidity to satisfy our needs over the next twelve months, including the ability to pay dividends on our common shares in accordance with our dividend policy. Total cash paid in 2005 and 2004 for dividends to shareholders was $9.0 million, or $0.12 per common share, and $4.6 million, or $0.06 per common share, respectively. During February 2006, the Board of Directors declared a quarterly dividend of $0.035 per common share, payable on March 8, 2006 to shareholders of record at the close of business on February 16, 2006. Beyond the next twelve months, the ability of our operating subsidiaries to declare and pay dividends may be influenced by a variety of factors including market conditions, insurance and rating agencies regulations and general economic conditions. Consequently, although management believes that we will continue to have sufficient liquidity to meet our debt service and other obligations over the long term, no guaranty can be given that we will not be required to seek external debt or equity financing in order to meet our operating expenses, debt service obligations or pay dividends on our common shares.
Liquidity at our operating subsidiaries is used to pay operating expenses, claims, payment obligations with respect to credit derivatives, reinsurance premiums and dividends to Assured Guaranty U.S. Holdings Inc. for debt service and dividends to us, as well as, where appropriate, to make capital investments in their own subsidiaries. In addition, certain of our operating companies may be required to post collateral in connection with credit derivatives and reinsurance transactions. Management believes that these subsidiaries’ operating needs generally can be met from operating cash flow, including gross written premium and investment income from their respective investment portfolios.
Net cash flows provided by (used in) operating activities were $175.8 million, $(44.6) million and $200.0 million during the years ended December 31, 2005, 2004 and 2003, respectively. 2005 operating cash flows were primarily provided by $203.7 million of net premiums received and loss recoveries of $71.0 million, partially offset by tax payments of $40.0 million and a $34.4 million payment of funds held.
Net cash flows (used in) provided by financing activities were $(31.9) million, $6.1 million and $(35.0) million during the years ended December 31, 2005, 2004 and 2003, respectively. During 2005, we paid dividends of $9.0 million, paid $3.9 million, net, under our option and incentive plans and paid $19.0 million to repurchase 1.0 million of our common shares under the Board of Directors authorized $25.0 million share stock repurchase program. Under the program we have repurchased a total of 1.3 million common shares, over a two year period, of Common Stock at an average price of $18.69. During 2004,
As of December 31, 2005 and 2004, the Company did not have any significant off-balance-sheet arrangements that were not accounted for or disclosed in the consolidated financial statements.
such facility and agreed that, if the Consolidated Assets (as defined in the related credit agreement) of AGC and its subsidiaries were to fall below $1.2 billion, it would, within 15 days, guarantee the obligations of AGC and AG (UK) under such facility and (iii) Assured Guaranty Overseas US Holdings Inc., as a Material Non-AGC Subsidiary (as defined in the related credit agreement), guaranteed the obligations of Assured Guaranty Ltd., AG Re and AGRO under such facility. Subsequently, AG Re and AGRO, as Material Non-AGC Subsidiaries, both guaranteed the obligations of the other and of Assured Guaranty Ltd. under such facility.
On April 29, 2004, Assured Guaranty Ltd. and certain of its subsidiaries entered into a $250.0 million unsecured credit facility (“$250.0 million credit facility”), with a syndicate of banks, for which ABN AMRO Incorporated and Bank of America, N.A. acted as co-arrangers. Each of Assured Guaranty, AGC and AG (UK), was a party, as borrower. The $250.0 million credit facility was terminated and replaced by the $300.0 million credit facility discussed above.
Agreement also contained financial covenants that required the Company: (i) to maintain the ratio of consolidated debt to total capitalization at not greater than 0.30 to 1.0; (ii) to maintain consolidated net worth of at least seventy-five percent (75%) of its consolidated net worth as of June 30, 2004; and (iii) to maintain the consolidated interest coverage ratio for any test period ending on the last day of a fiscal quarter at not less than 2.50 to 1.0. In addition, the LOC Agreement provided that the obligations of KeyBank to issue letters of credit may be terminated, and our obligations under the agreement may be accelerated, upon an event of default. As of December 31, 2004, no amounts were payable under any letter of credit issued under this facility. The LOC Agreement expired on April 28, 2005 and was replaced by the $300.0 million credit facility discussed above.
Pursuant to the Put Agreement, AGC will pay a monthly put premium to each Custodial Trust except (1) during any period when the AGC Preferred Stock that has been put to a Custodial Trust is held by that Custodial Trust or (2) upon termination of the Put Agreement. The put premium will equal the product of (A) the applicable distribution rate on the CCS Securities for the respective distribution period less the excess of (i) the Custodial Trust’s stated return on the Eligible Assets for such distribution period (including any fees and expenses of the Pass-Through Trust) (expressed as an annual rate) over (ii) the expenses of the Custodial Trust for such distribution period (expressed as an annual rate), (B) the aggregate face amount of the CCS Securities of the Custodial Trust outstanding on the date the put premium is calculated, and (C) a fraction, the numerator of which will be the actual number of days in such distribution period and the denominator of which will be 360. In addition, and as a condition to exercising the put option under a Put Agreement, AGC is required to enter into a Custodial Trust Expense Reimbursement Agreement with the respective Custodial Trust pursuant to which AGC agrees it will pay the fees and expenses of the Custodial Trust (which includes the fees and expenses of the Pass-Through Trust) during the period when such Custodial Trust holds AGC Preferred Stock.
As of December 31, 2005, the put option had not been exercised.
Following exercise of the put option during the Auction Rate Mode or at the end of any Flexed Rate Period, AGC may redeem the AGC Preferred Stock held by a Custodial Trust in whole or in part (x) on the final distribution payment date of the applicable Flexed Rate Period and (y) on any distribution payment date in the Auction Rate Mode, by paying a redemption price to the Custodial Trust in an amount equal to the liquidation preference amount of the AGC Preferred Stock to be redeemed (plus any accrued but unpaid dividends on such AGC Preferred Stock for the then current distribution period). If AGC partially redeems the AGC Preferred Stock held by a Custodial Trust, the redemption proceeds will be distributed pro rata to the holders of the CCS Securities and, if the Pass-Through Trust is the holder of CCS Securities, distributed by the Pass-Through Trust to holders of Pass-Through Securities (and a corresponding reduction in the aggregate face amount of CCS Securities and, if the Pass-Through Trust is the holder of CCS Securities, Pass-Through Trust Securities will be made); provided that AGC must redeem all of the AGC Preferred Stock if after giving effect to a partial redemption, the aggregate liquidation preference amount of the AGC Preferred Stock held by such Custodial Trust immediately following such redemption would be less than $20,000,000. If a Fixed Rate Distribution Event occurs, AGC may not redeem the AGC Preferred Stock for a period of two years from the date of such Fixed Rate Distribution Event.
Our investment portfolio consisted of $2,134.0 million of fixed maturity securities, $115.8 million of short-term investments and had a duration of 4.4 years as of December 31, 2005, compared with $1,965.1 million of fixed maturity securities, $175.8 million of short-term investments and a duration of 5.0 years as of December 31, 2004. Our fixed maturity securities are designated as available-for-sale in accordance with FAS No. 115 “Accounting for Certain Investments in Debt and Equity Securities” (“FAS 115”) Fixed maturity securities are reported at their fair value in accordance with FAS 115, and the change in fair value is reported as part of accumulated other comprehensive income. If we believe the decline in fair value is “other than temporary,” we write down the carrying value of the investment and record a realized loss in our statement of operations.
See Note 9 of the notes to our consolidated financial statements for more information on our available-for-sale fixed maturity securities as of December 31, 2005 and 2004.
Fair value of the fixed maturity securities is based upon quoted market prices provided by either independent pricing services or, when such prices are not available, by reference to broker or underwriter bid indications. Our investment portfolio does not include any non-publicly traded securities. For a detailed description of our valuation of investments see “-Critical Accounting Estimates.”
The following table summarizes the ratings distributions of our investment portfolio as of December 31, 2005 and 2004. Ratings are represented by the lower of the Moody’s and S&P classifications.
See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” for more information.
During 2005, FASB Staff Position (“FSP”) FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” was issued to replace the guidance set forth in paragraphs 10-18 of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairments and its Application to Certain Investments” (“EITF 03-1”), with references to existing other than temporary impairment guidance. FSP FAS 115-1 is to be applied prospectively from its effective date for periods beginning after December 15, 2005. The disclosure requirements of EITF 03-1 remain in effect and are included in Note 9. Investments. This pronouncement will not materially effect the Company’s results of operations or financial position.
* Counties designated by FEMA for both individual and public assistance as of October 7,
For informational purposes, the Company’s total public finance net par outstanding exposure in Louisiana, Mississippi and Alabama is $1,385.2 million, inclusive of the counties designated by FEMA for individual and public assistance, and is summarized in Table 4.
As of December 31, 2005, management has evaluated the effectiveness of the Company’s internal control over financial reporting based on the criteria established in “Internal Control-Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, we have concluded that Assured Guaranty Ltd.’s internal control over financial reporting was effective as of December 31, 2005.
PricewaterhouseCoopers LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Company included in this Annual Report, has also audited management’s assessment of the effectiveness of the Company’s internal control over financial reporting and the effectiveness of the Company’s internal controls over financial reporting as of December 31, 2005. The report, which expresses unqualified opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, is included in this Item under the heading “Report of Independent Registered Public Accounting Firm.”
The Company has participated in several lines of business that are reflected in its historical financial statements but that the Company exited in connection with the IPO, including equity layer credit protection, trade credit reinsurance, title reinsurance, life, accident and health (“LA&H”) and auto residual value reinsurance. These lines of business make up the Company’s other segment.
The 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 consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Premiums are received either upfront or in installments. Upfront premiums are earned in proportion to the expiration of the amount at risk. Each installment premium is earned ratably over its installment period, generally one year or less. For insured bonds for which the par value outstanding is declining during the insurance period, upfront premium earnings are greater in the earlier periods thus matching revenue recognition with the underlying risk. The premiums are allocated in accordance with the principal amortization schedule of the related bond issue and are earned ratably over the amortization period.
The Company accounts for its investments in fixed maturity securities in accordance with the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards (“FAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“FAS 115”). Management determines the appropriate classification of securities at the time of purchase. As of December 31, 2005 and 2004, all investments in fixed maturity securities were designated as available-for-sale and are carried at fair value with a corresponding adjustment to accumulated other comprehensive income. The fair values of all the Company’s investments are calculated from independent market quotations.
The amortized cost of fixed maturity securities is adjusted for amortization of premiums and accretion of discounts computed using the effective interest method. That amortization or accretion is included in net investment income. For mortgage-backed securities, and any other holdings for which there is prepayment risk, prepayment assumptions are evaluated and revised as necessary. Any necessary adjustments required due to the resulting change in effective yields and maturities are recognized in current income.
Realized gains and losses on sales of investments are determined using the specific identification method. Unrealized gains and losses on investments, net of applicable deferred income taxes, are included in accumulated other comprehensive income in shareholders’ equity. The Company has a formal review process for all securities in its investment portfolio, including a review for impairment losses. Factors considered when assessing impairment include:
Acquisition costs incurred, other than those associated with credit derivative products, that vary with and are directly related to the production of new business are deferred and amortized in relation to net earned premiums. These costs include direct and indirect expenses such as commissions, brokerage expenses and costs of underwriting and marketing personnel. The Company’s management uses judgment in determining what types of costs should be deferred, as well as what percentage of these costs should be deferred. The Company periodically conducts a study to determine which operating costs vary with, and are directly related to, the acquisition of new business and therefore qualify for deferral. Ceding commissions received on premiums ceded to other reinsurers reduce acquisition costs. Anticipated losses, loss adjustment expenses and the remaining costs of servicing the insured or reinsured business are considered in determining the recoverability of acquisition costs. Acquisition costs associated with credit derivative products are expensed as incurred. 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, as discussed above in the Premium Revenue Recognition section, the related deferred acquisition cost is expensed at that time.
Reserves for losses and loss adjustment expenses for non-derivative transactions in the Company’s financial guaranty direct, financial guaranty assumed reinsurance and mortgage guaranty business include case reserves and portfolio reserves. See Note 4. Derivatives, for more information on the Company’s derivative transactions. Case reserves are established when there is significant credit deterioration on specific insured obligations and the obligations are in default or default is probable, not necessarily upon non-payment of principal or interest by an insured. Case reserves represent the present value of expected future loss payments and loss adjustment expenses (“LAE”), net of estimated recoveries, but before considering ceded reinsurance. This reserving method is different from case reserves established by traditional property and casualty insurance companies, which establish case reserves upon notification of a claim and establish incurred but not reported (“IBNR”) reserves for the difference between actuarially estimated ultimate losses and recorded case reserves. Financial guaranty insurance and assumed reinsurance case reserves and related salvage and subrogation, if any, are discounted at 6%, which is the approximate taxable equivalent yield on the Company’s investment portfolio in all periods presented.
The Company records portfolio reserves in its financial guaranty direct, financial guaranty assumed reinsurance and mortgage guaranty business. Portfolio reserves are established with respect to the portion of the Company’s business for which case reserves have not been established. Portfolio reserves are not established for quota share mortgage insurance contract types, all of which are in run-off, rather IBNR reserves have been established for these contracts.
Portfolio reserves are recorded gross of reinsurance. To date the Company’s reinsurance programs have been made up of excess of loss contracts. The Company has not ceded any amounts under these contracts, as the Company’s recorded portfolio reserves have not exceeded its contractual retentions.
For all other mortgage guaranty transactions the Company records portfolio reserves in a manner consistent with its financial guaranty business. While other mortgage guaranty insurance companies do not record portfolio reserves, rather just case and IBNR reserves, the Company records portfolio reserves because the Company writes business on an excess of loss basis, while other industry participants write quota share or first layer loss business. The Company manages and underwrites this business in the same manner as its financial guaranty insurance and reinsurance business because they have similar characteristics as insured obligations of mortgage-backed securities.
FAS No. 60, “Accounting and Reporting by Insurance Enterprises” (“FAS 60”) is the authoritative guidance for an insurance enterprise. FAS 60 prescribes differing reserving methodologies depending on whether a contract fits within its definition of a short-duration contract or a long-duration contract. Financial guaranty contracts have elements of long-duration insurance contracts in that they are irrevocable and extend over a period that may exceed 30 years or more, but for regulatory purposes are reported as property and liability insurance, which are normally considered short-duration contracts. The short-duration and long-duration classifications have different methods of accounting for premium revenue and contract liability recognition. Additionally, the accounting for deferred acquisition costs (“DAC”) could be different under the two methods.
In the ordinary course of business, the Company’s insurance subsidiaries assume and retrocede business with other insurance and reinsurance companies. These agreements provide greater diversification of business and may minimize the net potential loss from large risks. Retrocessional contracts do not relieve the Company of its obligation to the reinsured. Reinsurance recoverable on ceded losses includes balances due from reinsurance companies for paid and unpaid losses and LAE that will be recovered from reinsurers, based on contracts in force, and is presented net of any provision for estimated uncollectible reinsurance. Any change in the provision for uncollectible reinsurance is included in loss and loss adjustment expenses. Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers relating to the unexpired terms of the reinsurance contracts in force.
Certain of the Company’s assumed and ceded reinsurance contracts are funds held arrangements. In a funds held arrangement, the ceding company retains the premiums instead of paying them to the reinsurer and losses are offset against these funds in an experience account. Because the reinsurer is not in receipt of the funds, the reinsurer earns interest on the experience account balance at a predetermined credited rate of interest. The Company generally earns interest at fixed rates of between 4% and 6% on its assumed funds held arrangements and generally pays interest at fixed rates of between 4% and 6% on its ceded funds held arrangements. The interest earned or credited on funds held arrangements is included in net investment income. In addition, interest on funds held arrangements will continue to be earned or credited
Goodwill is evaluated for impairment at least annually in accordance with FAS No. 142, “Goodwill and Other Intangible Assets”. In the year ended December 31, 2004 the Company recognized a goodwill impairment of $1.6 million for the trade credit business which the Company exited as part of its IPO strategy. No such impairment was recognized in the years ended December 31, 2005 or 2003. See Note 5. Goodwill, for more information.
Basic earnings per share is calculated using the weighted-average number of common shares outstanding during the year. For 2005 and 2004 this is calculated using the shares issued upon the formation of the Company, adjusted for shares issued or reacquired during the year. For 2003 the basic shares outstanding were assumed to be the common shares outstanding immediately prior to the IPO. All potentially dilutive securities, including unvested restricted stock and stock options are excluded from the basic earnings per share calculation. In calculating diluted earnings per share, the shares issued are increased to include all potentially dilutive securities. Basic and diluted earnings per share are calculated by dividing net income by the applicable number of shares as described above. See Note 20. Earnings Per Share, for more information.
Since the Company was a subsidiary of ACE during 2003, management has determined that disclosing amounts related to that period would not be meaningful, as the compensation expense determined under FAS 123 would be based on ACE’s ordinary share price. The amount of stock-based compensation expense included in reported net income, net of income tax, was $2.0 million for the year ended December 31, 2003.
The fair value of options issued is estimated on the date of grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions used for grants in 2005 and 2004:
In December 2004, the FASB issued FAS 123R. FAS 123R is effective January 1, 2006 and replaces FAS 123 and supersedes APB 25. As permitted by FAS 123, the Company currently accounts for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognizes no compensation expense for employee stock options, or its employee stock purchase plan. Accordingly, the adoption of FAS 123R’s fair value method will have a significant impact on the Company’s results of operations, although it will have no impact on its overall financial position. At December 31, 2005, unamortized compensation expense related to outstanding unvested options, as determined in accordance with FAS 123, that the Company expects to record during fiscal 2006 was approximately $2.0 million, before income taxes. The total impact of adoption of FAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted and shares purchased by employees under the employee stock purchase plan in the future. However, had the Company adopted FAS 123R in prior periods, the impact of that standard would have approximated the impact of FAS 123 as described in the
disclosure of pro forma net income and earnings per share in Note 2 to the Company’s consolidated financial statements. FAS 123R also requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were $4.1 million, $5.4 million and $5.7 million in 2005, 2004 and 2003, respectively.
Certain products (principally credit protection oriented) issued by the Company have been deemed to meet the definition of a derivative under FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”) and FAS No. 149,”Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“FAS 149”). These products consist primarily of credit derivatives. In addition, the Company issued a few index-based derivative financial instruments prior to 2004. FAS 133 and FAS 149 establish accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. FAS 133 and FAS 149 require that an entity recognize all derivatives as either assets or liabilities in the consolidated balance sheets and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a fair value, cash flow or foreign currency hedge. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. The Company had no derivatives that were designated as hedges, except as described in Note 17. Long Term Debt, during 2005, 2004 and 2003. The Company uses derivative instruments primarily to offer credit protection to others. The Company records these transactions at fair value. Where available, the Company uses quoted market prices to fair value these insured credit derivatives. If quoted prices are not available, particularly for senior layer collateralized debt obligations (“CDO”) and equity layer credit protection, the fair value is estimated using valuation models for each type of credit protection. These models may be developed by third parties, such as rating agency models, or may be developed internally, depending on the circumstances. These models and the related assumptions are continually reevaluated by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely market information. The fair value of derivative financial instruments reflects the estimated cost to the Company to purchase protection on its outstanding exposures and is not an estimate of expected losses incurred. Due to the inherent uncertainties of the assumptions used in the valuation models to determine the fair value of these derivative products, actual experience may differ from the estimates reflected in the Company’s consolidated financial statements, and the differences may be material.
The Company records premiums received from the issuance of derivative instruments in gross written premiums and establishes unearned premium reserves and loss reserves. These loss reserves represent the Company’s best estimate of the probable losses expected under these contracts and are calculated in the same manner as the Company’s financial guaranty business. See Note 2. Significant Accounting Policies,
Reserves for Losses and Loss Adjustment Expenses, for more information. Unrealized gains and losses on derivative financial instruments are computed as the difference between fair value and the total of the unearned premium reserves, losses and LAE reserve, premiums receivable, prepaid reinsurance premiums and reinsurance recoverable on ceded losses. Changes in unrealized gains and losses on derivative financial instruments are reflected in the consolidated statements of operations and comprehensive income. Cumulative unrealized gains are reflected as assets in the Company’s balance sheets. Unrealized gains and losses resulting from changes in the fair value of derivatives occur because of changes in interest rates, credit spreads, recovery rates, the credit ratings of the referenced entities and other market factors. In the event that the Company terminates a derivative contact prior to maturity as a result of a decision to exit a line of business or for risk management purposes, the unrealized gain or loss will be realized through premiums earned and losses incurred.
The Company recorded a pretax net unrealized loss on derivative financial instruments of $3.5 million for the year ended December 31, 2005, a pretax net unrealized gain on derivative financial instruments of $52.5 million for the year ended December 31, 2004, and a pretax net unrealized gain on derivative financial instruments of $98.4 million for the year ended December 31, 2003.
The following table details goodwill by segment as of December 31, 2005 and 2004:
The Company’s U.S. domiciled insurance companies prepare statutory financial statements in accordance with accounting practices prescribed or permitted by the National Association of Insurance Commissioners (“NAIC”) and their respective Insurance Departments. Prescribed statutory accounting practices are set forth in the NAIC Accounting Practices and Procedures Manual. There are no permitted accounting practices on a statutory basis The combined capital and statutory surplus of the Company’s U.S. domiciled insurance companies was $286.4 million and $265.8 million as of December 31, 2005 and 2004, respectively. The statutory combined net income of the Company’s U.S. domiciled insurance companies was $103.0 million, $107.5 million and $70.2 million for the years ended December 31, 2005, 2004 and 2003, respectively.
(1) These ratings represent the Company’s internal assessment of the underlying credit quality of the insured obligations. The Company’s scale is comparable to that of the nationally recognized rating agencies.
Approximately 28% and 26% of the Company’s total investment portfolio as of December 31, 2005 and 2004, respectively, was composed of mortgage-backed securities (“MBS”), including collateralized mortgage obligations and commercial mortgage-backed securities. As of December 31, 2005 and 2004, the weighted average credit quality of the Company’s entire investment portfolio was AAA and AA+, respectively.
Proceeds from the sale of available-for-sale fixed maturity securities were $728.6 million, $780.3 million and $619.6 million for the years ended December 31, 2005, 2004 and 2003, respectively.
The above balances include 207 and 123 fixed maturity securities as of December 31, 2005 and 2004, respectively. The Company has considered factors such as sector credit ratings and industry analyst reports in evaluating the above securities for impairment and has concluded that these securities are not other than temporarily impaired as of December 31, 2005 and 2004.
No material investments of the Company were non-income producing for the years ended December 31, 2005, 2004 and 2003.
The financial guaranty case basis reserves have been discounted using a rate of 6% in 2005, 2004 and 2003, resulting in a discount of $10.7 million, $18.4 million and $19.8 million, respectively.
The favorable prior year development in 2005 of $76.7 million is primarily due to $71.0 million in loss recoveries from a third party litigation settlement agreement, with two parties, relating to a reinsurance claim incurred in 1998 and 1999 as well as a $2.4 million recovery related to the equity layer credit protection business. Further contributing to the favorable prior year development is changes in credit quality and from continued runoff from maturing CDO exposures, as well as management updating its loss reserving data, as part of the Company’s normal portfolio reserve process, to include the most current rating agency default studies.
In 2004 the favorable prior year development of $81.3 million is primarily related to the reduction of loss reserves associated with the exiting of certain lines of business in connection with the IPO.
The prior year development in 2003 of $94.6 million is due in part to an increase of $25.0 million in case activity on the structured finance line of business due to credit deterioration in collateralized debt obligations assumed through reinsurance treaties. In addition, prior year development includes an increase in the case reserve on the World Omni transaction discussed earlier.
The Company initially recorded a $49.0 million reduction of its existing deferred tax liability, based on an estimate of the ultimate resolution of the Section 338(h)(10) election. Under the tax allocation agreement, the Company estimated that as of the IPO date, it would pay $20.9 million to AFS and accordingly has established this amount as a liability. The initial difference, which is attributable to the change in the tax basis of certain liabilities for which there is no associated step-up in the tax basis of its assets and no amounts due to AFS, resulted in an increase to additional paid-in capital of $28.1 million. During 2005, the Company paid AFS $0.8 million, reducing the liability to $20.1 million, which is included in other liabilities on the balance sheet.
AVIC, AGFP and AFP file a consolidated federal income tax return. Assured Guaranty Overseas US Holdings Inc. (“AGOUS”) and its subsidiaries, AGRO, Assured Guaranty Mortgage Insurance Company (“AGMIC”), ACE Capital Title Reinsurance (for the period ending April 15, 2004) and Assured Guaranty Inc., have historically filed a consolidated federal income tax return. AGRO, a Bermuda domiciled company, has elected under Section 953(d) of the Internal Revenue Code to be taxed as a U.S. domestic corporation. Each company, as a member of its respective consolidated tax return group, has paid its proportionate share of the consolidated federal tax burden for its group as if each company filed on a separate return basis with current period credit for net losses.
The following table presents the affiliated and third party reinsurance recoverable balances on ceded losses and provides Standard & Poors (“S&P”) ratings for individual reinsurers:
During Second Quarter 2005, AGC and AG Re, two of the Company’s subsidiaries, entered into a reinsurance agreement with Financial Security Assurance Inc. (“FSA”) pursuant to which substantially all of FSA’s financial guaranty risks previously ceded to AGC (the “Ceded Business”) were assumed by AG Re. This agreement is effective as of January 1, 2005. In connection with the transaction, AGC transferred liabilities of $169.0 million, consisting primarily of unearned premium reserves. All profit and loss related items associated with this transfer were eliminated in consolidation, with the exception of profit commission expense, certain other operating expenses, and provision for income taxes. Since this transaction transferred unearned premium reserve from AGC, a U.S. tax paying entity, to AG Re, a non-U.S. tax paying entity, the Company released a deferred tax liability related to differences between the book and tax carrying amounts of unearned premium reserves which resulted in a tax benefit. The total impact of all these items increased 2005 net income $3.7 million. FSA has released AGC from all liabilities with respect to the Ceded Business. AG Re has assumed substantially all of AGC’s liabilities with respect to the Ceded Business. FSA may receive a profit commission on the Ceded Business based on its future performance.
AG Re’s and AGRO’s dividend distribution are governed by Bermuda law. Under Bermuda law, dividends may only be paid if there are reasonable grounds for believing that the Company is, or would after the payment be, able to pay its liabilities as they become due and if the realizable value of its assets would thereby not be less than the aggregate of its liabilities and issued share capital and share premium accounts. Distributions to shareholders may also be paid out of statutory capital, but are subject to a 15% limitation without prior approval of the Bermuda Monetary Authority. Dividends are further limited by requirements that the subject company must at all times (i) maintain the minimum solvency margin required under the Insurance Act of 1978 and (ii) have relevant assets in an amount at least equal to 75% of relevant liabilities, both as defined under the Insurance Act of 1978. Under these restrictions, the maximum allowable dividend payout by AG Re without prior approval of the Bermuda Monetary Authority is $58.4 million as of December 31, 2005. During 2005, AG Re declared dividends of approximately $19.4 million and paid $38.4 million to its parent, Assured Guaranty Ltd. During 2004, AG Re declared dividends of approximately $32.0 million and paid $13.0 million to its parent, Assured Guaranty Ltd. During 2003, AG Re paid dividends of $25.0 million to its parent, ACE Bermuda.
AGC has committed to its rating agencies that it will not pay more than $10.0 million per year in dividends, without prior consultation.
AGMIC is a New York domiciled insurance company. Under the New York Insurance Law, AGMIC may declare or pay dividends only out of “earned surplus,” which is defined as that portion of the company’s surplus that represents the net earnings, gains or profits (after deduction of all losses) that have not been distributed to shareholders as dividends or transferred to stated capital, capital surplus or contingency reserves, or applied to other purposes permitted by law, but does not include unrealized appreciation of assets. Additionally, no dividend may be declared or distributed in an amount which, together with all dividends declared or distributed by it during the preceding twelve months, exceeds the lesser of 10% of AGMIC’s statutory surplus as shown on its latest statutory financial statement on file with the New York Superintendent of Insurance, or 100% of AGMIC’s adjusted net investment income during that period, unless, upon prior application, the Superintendent approves a greater dividend or distribution after finding that the company will retain sufficient surplus to support its obligations and writings. Any such dividend would be classified as an “extraordinary dividend”. There were no amounts available during 2005, 2004 and 2003, respectively, for the payment of dividends by AGMIC which would not be characterized as an extraordinary dividend. AGMIC did not declare or pay any dividends during 2005 and 2004.
The following table summarizes the activity with ACE subsidiaries (“affiliated”) and non-affiliated entities for each line item where applicable in the income statements:
In December 2001, AG Re entered into a 25 year portfolio cover with a $5.0 million per risk deductible, a $50.0 million per risk limit and a $400.0 million aggregate limit with ACE Bermuda. In December 2003, this agreement was cancelled and the unearned premium of $115.0 million and loss reserves of $16.9 million were returned to AG Re in January 2004. For 2003 the Company ceded losses of $11.9 million under this cover.
Assured Guaranty Finance Overseas Ltd. and Assured Guaranty (UK) Ltd. (“AG (UK)”) obtained staffing, payroll and related services from ACE INA Services (UK) Ltd. For the years ended December 31, 2004 and 2003, the Company incurred $1.1 million and $1.1 million, respectively, in employee related expenses. Effective December 31, 2004 this arrangement has been terminated.
The Company and its subsidiaries are party to various lease agreements. As of December 31, 2005, future minimum rental payments under the terms of these operating leases for office space are $2.7 million for each of the years 2006, 2007 and 2008, $1.2 million in 2009, $0.2 million in 2010 and none thereafter. These payments are subject to escalations in building operating costs and real estate taxes. Rent expense for the years ended December 31, 2005, 2004 and 2003 was approximately $3.1 million, $3.2 million and $3.4 million, respectively.
On January 18, 2002, World Omni Financial Corp. (“World Omni”) filed an action against AG Intermediary Inc., a subsidiary of the Company, in the United States District Court for the Southern District of New York entitled World Omni Financial Corp. v. ACE Capital Re Inc., Case No. 02 CV 0476 (RO). On September 20, 2002, World Omni amended its complaint to add Assured Guaranty Re Overseas Ltd. (“AGRO”) as a defendant. The dispute arose out of a quota share reinsurance agreement between AGRO and JCJ Insurance Company (“JCJ”), an affiliate of World Omni, and an underlying residual value insurance policy issued by JCJ to World Omni, which insured residual value losses of World Omni with respect to a portfolio of automobile leases. Subject to the terms and conditions of the policy, the residual value insurance policy insures World Omni against losses (as defined in the policy) resulting from the value of leased vehicles at the end of the applicable lease term being less than what such value was assumed to have been at the inception of the applicable lease term. In the District Court action, World Omni sought a declaratory judgment regarding AGRO’s coverage obligations, if any, for such alleged losses, as well as damages for breach of contract based upon AGRO’s refusal to pay claims asserted by World Omni. World Omni sought $157.0 million, which is the limit of liability under the quota share reinsurance agreement, plus interest.
During 2005 the Company recovered $71.0 million relating to a reinsurance claim incurred in 1998 and 1999. This recovery was received in connection with the completion of two settlements. See Note 10 for further information.
The Company’s client base includes all of the major monoline primary financial guaranty insurance companies, many banks and several European insurance and reinsurance companies. Of the Company’s total gross premiums written for the year ended December 31, 2005, 18.0% and 13.0% came from FSA and Ambac Assurance Corporation (“Ambac”), respectively, two of the four monoline primary financial guaranty insurance companies. In addition, 10.3% of the Company’s total gross premiums written came from CGA Group Ltd. (“CGA”). The entire amount related to CGA was retroceded to a subsidiary of ACE. Of the Company’s total gross premiums written for the year ended December 31, 2004, 41.8%, 19.6% and 14.8% came from FSA, Ambac and Municipal Bond Investors Assurance Company (“MBIA”), respectively, three of the four monoline primary financial guaranty insurance companies. Of the Company’s total gross premiums written for the year ended December 31, 2003, 25.3% and 10.8% came from FSA and MBIA, respectively. No other client represented more than 10% of the Company’s total gross premiums written for the years ended December 31, 2005, 2004 and 2003.
On May 18, 2004, Assured Guaranty US Holdings Inc., a subsidiary of the Company, issued $200.0 million of 7.0% Senior Notes due 2034 for net proceeds of $197.3 million. The proceeds of the offering were used to repay substantially all of a $200.0 million promissory note issued to a subsidiary of ACE in April 2004 as part of the IPO related formation transactions. The coupon on the Senior Notes is 7.0%, however, the effective rate will be approximately 6.4%, taking into account the effect of a cash flow hedge executed by the Company in March 2004. The Company recorded interest expense of $13.4 million and $8.4 million, including $0.6 million and $0.4 million of amortized gain on the cash flow hedge, for the years ended December 31, 2005 and 2004, respectively. These Senior Notes are fully and unconditionally guaranteed by Assured Guaranty Ltd.
As of December 31, 2003, the Company’s long-term debt included $75.0 million of cumulative monthly income preferred shares issued in 1994 through a former affiliate of the Company, Capital Re LLC, a limited liability company organized under the laws of Turks and Caicos Islands. The amount paid to preferred shareholders for the year ended December 31, 2003 was $5.7 million and is shown on the consolidated statements of operations and comprehensive income as interest expense. Upon completion of the IPO, Capital Re LLC and the obligation with respect to the $75.0 million cumulative monthly income preferred shares remained with ACE and the after-tax interest of $1.4 million was forgiven.
On April 15, 2005, Assured Guaranty Ltd. and certain of its subsidiaries entered into a $300.0 million three-year unsecured revolving credit facility (the “$300.0 million credit facility”) with a syndicate of banks, for which ABN AMRO Incorporated and Bank of America, N.A. acted as lead arrangers and KeyBank National Association (“KeyBank”) acted as syndication agent. Under the $300.0 million credit facility, each of AGC, AG (UK), a subsidiary of AGC organized under the laws of the United Kingdom, Assured Guaranty Ltd., AG Re and AGRO are entitled to request the banks to make loans to such borrower or to request that letters of credit be issued for the account of such borrower. The $300.0 million credit facility replaced (1) the $250.0 million credit facility and (2) the Letter of Credit Agreement, both discussed below.
The $300.0 million credit facility’s financial covenants require that Assured Guaranty Ltd. (a) maintain a minimum net worth of $1.2 billion, (b) maintain an interest coverage ratio of at least 2.5:1, and (c) maintain a maximum debt-to-capital ratio of 30%. In addition, the $300.0 million credit facility requires that AGC: (x) maintain qualified statutory capital of at least 80% of its statutory capital as of the
On April 29, 2004, Assured Guaranty Ltd. and certain of its subsidiaries entered into a $250.0 million unsecured credit facility (“$250.0 million credit facility”), with a syndicate of banks, for which ABN AMRO Incorporated and Bank of America, N.A. acted as co-arrangers. Each of Assured Guaranty Ltd., AGC and AG (UK), was a party, as borrower. The $250.0 million credit facility was terminated and replaced by the $300.0 million credit facility discussed above.
The Company has an authorized share capital of $5.0 million divided into 500,000,000 shares, par value $0.01 per share, of which 75,000,000 common shares were issued and outstanding and beneficially owned by ACE prior to the IPO. On April 28, 2004, subsidiaries of ACE completed the IPO of 49,000,000 of their 75,000,000 common shares of Assured Guaranty Ltd., with the remaining 26,000,000 common shares beneficially owned by ACE. Additional common shares were issued to the Company’s officers and employees in connection with the IPO - see Note 19. Except as described below, the Company’s common shares have no preemptive rights or other rights to subscribe for additional common shares, no rights of redemption, conversion or exchange and no sinking fund rights. In the event of liquidation, dissolution or winding-up, the holders of the Company’s common shares are entitled to share equally, in proportion to the number of common shares held by such holder, in the Company’s assets, if any remain after the payment of all the Company’s debts and liabilities and the liquidation preference of any outstanding preferred shares. Under certain circumstances, the Company has the right to purchase all or a portion of the shares held by a shareholder at fair market value. All of the common shares are fully paid and
Subject to the Company’s Bye-Laws and Bermuda law, the Company’s Board of Directors has the power to issue any of the Company’s unissued shares as it determines, including the issuance of any shares or class of shares with preferred, deferred or other special rights.
Under the Company’s Bye-Laws and subject to Bermuda law, if the Company’s Board of Directors determines that any ownership of the Company’s shares may result in adverse tax, legal or regulatory consequences to us, any of the Company’s subsidiaries or any of its shareholders or indirect holders of shares or its Affiliates (other than such as the Company’s Board of Directors considers de minimis), the Company has the option, but not the obligation, to require such shareholder to sell to the Company or to a third party to whom the Company assigns the repurchase right the minimum number of common shares necessary to avoid or cure any such adverse consequences at a price determined in the discretion of the Board of Directors to represent the shares’ fair market value (as defined in the Company’s Bye-Laws). See also Note 19 for common shares held in trust.
During 2005 and 2004 the Company paid dividends of $9.0 million, or $0.12 per common share, and $4.6 million, or $0.06 per common share, respectively. Any determination to pay cash dividends will be at the discretion of the Company’s Board of Directors, and will depend upon the Company’s results of operations and cash flows, its financial position and capital requirements, general business conditions, legal, tax, regulatory, rating agency and any contractual restrictions on the payment of dividends and any other factors the Company’s Board of Directors deems relevant. During February 2006, the Board of Directors declared a quarterly dividend of $0.035 per common share, payable on March 8, 2006 to shareholders of record at the close of business on February 16, 2006. For more information concerning regulatory constraints that will affect the Company’s ability to pay dividends, see Note 13.
Upon completion of the IPO, any unvested options to purchase ACE ordinary shares granted to the Company’s officers or employees under the ACE employee long term incentive plans immediately vested and any unvested restricted ACE ordinary shares were forfeited. These officers and employees generally had 90 days from the date of the IPO to exercise any vested options to acquire ACE ordinary shares. The acceleration of vesting of options to purchase ordinary shares resulted in a pre-tax charge to the Company of approximately $3.5 million. Based upon a price of $42.79 per ACE ordinary share, the Company incurred a pre-tax charge of $7.8 million and contributed cash in the same amount to fund a trust, with a trustee, for the value of the restricted ACE ordinary shares forfeited by all of the Company’s officers and employees. These pre-tax charges took place during Second Quarter 2004 and are included in other operating expenses on the consolidated statements of operation and comprehensive income. The trust purchased common shares of Assured Guaranty Ltd. and allocated to each such individual common shares having the approximate value of the ACE ordinary shares forfeited by such individual. Based on the initial public offering price of $18.00 per common share, the trust purchased approximately 436,000 common shares. This transaction is reported in shareholders’ equity as treasury stock and unearned stock grant compensation. The common shares were delivered to each individual that was not employed, directly or indirectly, by any designated financial guaranty company on October 28, 2005, the 18-month anniversary of the IPO. (The forfeiture restriction was waived for one former employee of the Company.) The trustees did not have any beneficial interest in the trust. Since completion of the IPO, the Company’s officers and employees are no longer eligible to participate in ACE’s employee long-term incentive plans. In connection with these events, Assured Guaranty received $4.5 million from ACE, for the book value of unrestricted compensation, which it recorded in unearned stock grant compensation, which is included in shareholders’ equity.
The Incentive Plan is administered by a committee of the Board of Directors. The Compensation Committee of the Board serves as this committee except as otherwise determined by the Board. The Board may amend or terminate the Incentive Plan.
Since the Company was a subsidiary of ACE during 2003, management has determined that disclosing amounts related to that year would not be meaningful, as the information determined under FAS 123 would be based on ACE’s ordinary shares. Following is a summary of Assured Guaranty Ltd. options issued and outstanding for the years ended December 31, 2005 and 2004:
The following table summarizes the range of exercise prices for outstanding options as of December 31, 2005:
Effective January 1, 2006, the Company will begin recognizing compensation expense for options in accordance with FAS 123R. See Note 3. Recent Accounting Pronouncements, for more information.
In Bermuda the savings incentive plan is available to all full-time employees upon their first date of employment. Eligible participants may contribute a percentage of their salary subject to a maximum of $14,000 for 2005. Contributions are matched by the Company at a rate of 100% up to 6% of the participant’s compensation, subject to IRS limitations. Eligible participants also receive a Company contribution equal to 6% of the participant’s compensation, subject to IRS limitations, without requiring the participant to contribute to the plan. Participants generally vest in Company contributions upon the completion of one year of service. With respect to those employees who are Bermudian or spouses of Bermudians and who must participate in the Bermuda national pension scheme plan maintained by the Company, a portion of the foregoing contributions are made to the Bermuda national pension scheme plan. If employee or employer contributions in the Bermuda savings incentive plan are limited by the tax-qualification rules of Code section 401(a), then contributions in excess of those limits are allocated to a nonqualified plan. The Company may contribute an additional amount to eligible employees’ Bermuda nonqualified plan accounts at the discretion of the Board of Directors. For the 2004 plan year, the Company made a discretionary contribution equal to 2% of the compensation of eligible participants to the Bermuda nonqualified plan. No such contribution was made for plan year 2005.
The Company contributed approximately $1.7 million in 2005, $1.7 million in 2004 and $1.3 million in 2003 in nondiscretionary contributions under all these plans. Total discretionary expense under all these plans amounted to approximately $0.9 million in 2005, $0.9 million in 2004 and $1.2 million in 2003.
In January 2005, the Company established the Assured Guaranty Ltd. Employee Stock Purchase Plan (the “Stock Purchase Plan”) in accordance with Internal Revenue Code Section 423. The Stock Purchase Plan was approved by shareholders at the 2005 Annual General Meeting. Participation in the Stock Purchase Plan is available to all eligible employees. Maximum annual purchases by participants are limited to the number of whole shares that can be purchased by an amount equal to 10 percent of the participant’s compensation or, if less, shares having a value of $25,000. Participants may purchase shares at a purchase price equal to 85 percent of the lesser of the fair market value of the stock on the first day or the last day of the subscription period. The Company reserved for issuance and purchases under the Stock Purchase Plan 100,000 shares of its common stock. Employees purchased 19,488 shares for aggregate proceeds of approximately $0.4 million in the year ended December 31, 2005. Effective January 1, 2006, the Company will begin recognizing compensation expense for its employee stock purchase plan in accordance with FAS 123R. See Note 3. Recent Accounting Pronouncements, for more information.
The carrying amount reported in the balance sheet for these instruments is cost, which approximates fair value due to the short-term maturity of these instruments.
The Company has four principal business segments: (1) financial guaranty direct, which includes transactions whereby the Company provides an unconditional and irrevocable guaranty that indemnifies the holder of a financial obligation against non-payment of principal and interest when due, and could take the form of a credit derivative; (2) financial guaranty reinsurance, which includes agreements whereby the Company is a reinsurer and agrees to indemnify a primary insurance company against part or all of the loss which the latter may sustain under a policy it has issued; (3) mortgage guaranty, which includes mortgage
guaranty insurance and reinsurance whereby the Company provides protection against the default of borrowers on mortgage loans; and (4) other, which includes several lines of business in which the Company is no longer active, including trade credit reinsurance, title reinsurance, auto residual value reinsurance and the credit protection of equity layers of CDOs, as well as life, accident and health reinsurance.
(1) Excludes $11.3 million of operating expenses, included in other operating expenses in the consolidated statements of operations and comprehensive income, related to the accelerated vesting of stock awards at the IPO date.
The following table summarizes the Company’s gross written premiums by geographic region. Allocations have been made on the basis of location of risk.
The following tables present the condensed consolidated financial information for Assured Guaranty Ltd., Assured Guaranty US Holdings Inc., of which AGC is a subsidiary and AG Re and other subsidiaries of Assured Guaranty Ltd. as of December 31, 2005 and 2004 and for the years ended December 31, 2005, 2004 and 2003.
* Due to the accounting for subsidiaries under common control, net income in the consolidating adjustment column will not equal parent company equity in earnings of subsidiaries, due to the FSA agreement discussed in Note 12.
The Company’s cash paid during the periods presented for federal income taxes and interest, and non-cash financing activities were as follows:
(2) Basic and diluted EPS for the first quarter 2004 are based on shares outstanding immediately prior to the IPO.
(3) Per share amounts for the quarters and the full years have each been calculated separately. Accordingly, quarterly amounts may not add to the annual amounts because of differences in the average common shares outstanding during each period and, with regard to diluted per share amounts only, because of the inclusion of the effect of potentially dilutive securities only in the periods in which such effect would have been dilutive.
The Company’s net par outstanding on public finance exposures in counties designated by the Federal Emergency Management Agency for both individual and public assistance in the states of Louisiana, Mississippi and Alabama totals $220.6 million, and of that amount $142.3 million is in Greater New Orleans (comprised of Orleans, St. Bernard and Jefferson parishes). Over 96% of that exposure comes through the Company’s reinsurance segment. As of December 31, 2005 the Company has recorded $1.3 million in portfolio reserves, but has not recorded any case reserves for this event, as no case reserves have been reported to the Company by any of its ceding company clients. In addition, only five claims have been paid, in the amount of $0.1 million, all of which were fully recovered. The Company has added 4 credits with net par outstanding of $44.8 million to Category 1 of its Closely Monitored Credits (“CMC”) list and 7 credits with net par outstanding of $80.6 million to Category 2 of the CMC list related to Hurricane Katrina. Nonetheless, significant uncertainty exists with regard to both the probability of defaults occurring and the loss severities that will apply to any defaults that do occur. The Company’s surveillance department is actively monitoring specific exposures in coordination with its reinsurance clients and will continue to assess the impact of Hurricane Katrina on the credit quality of the Company’s portfolio.