(a)Prepared in accordance with accounting principles generally accepted in the United States of America. Deferred premium revenue is shown net of prepaid reinsurance premiums. Losses and loss adjustment expenses are shown net of reinsurance recoverables on unpaid losses.
(c)Amounts are statutory data for FSA as a separate company and therefore include amounts relating to FSA-insured GICs issued by the GIC Subsidiaries, FSA Global investments insured by FSA and Canadian Global debt insured by FSA.
(d)The sum of statutory capital, statutory unearned premium reserve, present value of future net installment premiums, statutory loss reserve, credit available under standby line of credit facility and the money market committed preferred trust securities.
Management's principal objective is to increase the intrinsic value of the Company over the long term. To this end, it seeks to accumulate a book of conservatively underwritten financial guaranty insurance business to generate premiums that create a reliable, predictable earnings stream.
Strategically, the Company seeks to maintain balanced capabilities across domestic and international asset-backed and municipal markets in order to have the flexibility to pursue the most attractive opportunities available at any point in the business cycle.
To accurately reflect how management evaluates the Company's operations and progress toward long-term goals, this discussion employs both measures promulgated in accordance with accounting principles generally accepted in the United States of America (GAAP measures) and measures not so promulgated (non-GAAP measures). Although the measures identified as non-GAAP in this discussion should not be considered substitutes for GAAP measures, management and investors consider them important because of characteristics specific to the financial guaranty business.
The following tables reconcile gross premiums written to PV originations and summarize net earned and written premiums.
Financial Security Assurance Inc. (FSA) and the financial products operations generated PV originations of $894.6 million, $881.8 million and $696.5 million for the years ended December 31, 2003, 2002 and 2001, respectively. The tables below show the components of PV originations and the related insured par amounts.
International par insured by the Company in 2003 declined 48.0% from the previous year's result, while PV premiums declined only 4.8%. PV premiums declined less than par insured, largely because of a shift from Super Triple-A pooled corporate CDS to a broader range of transactions, including CLOs, synthetic residential mortgage securitizations and other structured financings. Infrastructure financings contributed the largest share of international premium production in 2003, driven by major transactions in the United Kingdom. In 2002, the Company's international par insured declined 6.3%, while its international PV premiums rose 65.6%, because Triple-A and Double-A shadow-rated CDO transactions, which tend to have low premiums relative to par, represented a smaller percentage of the business mix in 2002 than in 2001.
In the second quarter of 2002, as part of the Company's ongoing credit review process, management identified certain transactions not performing as expected in its portfolio of insured CDOs. As a result, management undertook a quantitative analysis of all CDO transactions in its insured portfolio that breached senior overcollateralization triggers, which were included in such transactions as one measure of adverse performance. A present value "deterministic" approach was utilized to estimate the loss inherent in this portfolio. The deterministic model takes the average cumulative default rate produced by a Monte Carlo simulation and applies those defaults to a cash flow model using (i) a timing sequence dependent on the portfolio's rating and maturity composition, (ii) an estimate of collateral recovery values for severity and (iii) the LIBOR forward curve as a predictor of interest rates. Management assumed that current default rates on CDO collateral would improve in a manner consistent with an economic recovery following a period of significant credit deterioration similar to that experienced in 1991/1992 and, as a result, management utilized the Moody's idealized default curve, adjusted by a factor consistent with the relationship between the 1992 cohort experience and the Moody's 30-year average default rate. The per-period default rate was calculated based on the Moody's weighted-average rating factor for each piece of surviving collateral. Recovery rates were judgmentally established by the Company. In considering the recovery rates to be utilized, management adjusted Moody's average recovery rates (observed since 1982) downward to reflect more recent adverse observations. At June 30, 2002, this analysis produced a present value of expected losses of $51.5 million, net of reinsurance recoveries and net of unearned premiums and future ceding commissions. Management addressed this net present value of expected loss ($51.5 million) through (i) an increase in the Company's general reserve ($31.0 million) and (ii) amounts already existing in its general reserve ($20.5 million), including general reserve amounts reallocated to case reserves ($11.3 million). The $31.0 million increase in the Company's general reserve resulted in a corresponding increase to losses and loss adjustment expenses in the income statement of $31.0 million. An additional adjustment of $10.1 million was made to the general reserve in the fourth quarter of 2002 as a result of further deterioration of the CDO portfolio. Management established a methodology
During 2003, the Company charged $34.5 million to loss expense, comprised of $9.2 million related to the CDO portfolio discussed above, $22.4 million for origination of new business and $2.9 million for the accretion of the discount on prior years' reserves. The general reserve increased by $21.8 million in 2003, consisting of the loss expense, a transfer to the general reserve of $1.4 million representing recoveries received on prior-year transactions and a transfer of $14.1 million from the general reserve to case reserves. In addition, the Company reclassified $2.2 million of case reserves, relating to a restructured transaction, to securitized loans on the balance sheet. Giving effect to these transfers, the general reserve totaled $111.5 million at December 31, 2003.
In 2003 and 2002, FSA exercised certain rights available under its financial guaranty policies and indentures relating to certain loan-backed notes issued by trusts. Those rights allowed FSA to accelerate the insured notes and pay claims under its insurance policy on an accelerated basis. Refinancing vehicles reimbursed FSA in whole for its claims payments in exchange for assignments of certain of FSA's rights against the trusts. The refinancing vehicles obtained funds from the proceeds of FSA-insured GICs issued in the ordinary course of business by FSA Capital Markets Services LLC and FSA Capital Management Services LLC (collectively, the GIC Subsidiaries). Since the notes represent 100% of the debt capitalization of the trusts and since FSA maintains all of the risk of further asset decline and maintains control over key decisions regarding the trusts (such as removal of servicer, sale of assets and liquidation of the entity), the trusts and refinancing vehicles were consolidated with FSA for accounting purposes. Although the securitized loans are included on FSA's balance sheet, the securitized loans continue to support FSA-insured transactions exclusively, subject to considerable first-loss and quota share reinsurance.
Other operating expenses for 2003 increased 14.9% from that of the previous year. The increase relates primarily to increased personnel, occupancy and consulting costs. The corresponding 43% increase in other operating expenses for 2002 is primarily related to higher personnel costs (see Note 10 to the Consolidated Financial Statements).
Total equity in earnings of unconsolidated affiliates was $5.5 million, $29.3 million and $11.7 million for 2003, 2002 and 2001, respectively. The decrease from 2002 to 2003 relates primarily to the equity in earnings from Fairbanks Capital Holding Corp., the parent company of Fairbanks Capital Corp. (collectively with its parent, "Fairbanks"). Fairbanks is owned 56.8% by The PMI Group Inc. and 29.8% by the Company, with the remainder owned by certain founders of Fairbanks. Fairbanks is a servicer of single-family residential mortgage loans originated by unaffiliated third parties. Most of the mortgage loans serviced by Fairbanks are considered "sub-prime," reflecting the lower than "prime" credit quality of the borrower/homeowner. At December 31, 2003, the Company's interest in Fairbanks had a book value of $46.4 million, of which $7.6 million represented goodwill. The Company's equity in earnings from Fairbanks for 2003, 2002 and 2001 was a loss of $13.5 million, income of $13.8 million and income of $4.5 million, respectively.
Fairbanks is also subject to private litigation, including a number of putative class action suits, alleging violations of federal and/or state laws. The publicity surrounding sub-prime lending and servicing practices may result in the filing of other putative class action suits against Fairbanks.
including the types and amounts of fees collected, without admitting any violations. Due to these developments, future income from Fairbanks' operations is expected to be reduced. While the impairment analysis performed by the Company did not result in a write-down of the investment, the Company continues to monitor the value of its investment in Fairbanks.
In the third quarter of 2002, the Company changed its method of taxing its equity in earnings from Fairbanks, an unconsolidated affiliate of the Company. Prior to 2002, the Company taxed 100% of its equity earnings from Fairbanks at the statutory rate of 35%. Following a change in Fairbanks' investors, the Company determined that it would be appropriate to apply the 80% dividend-received deduction allowed by the Internal Revenue Service when calculating the tax on its equity in earnings from Fairbanks, based on management's expectation that it would realize its gain on such investment through dividend distributions rather than through sale of its investment. In 2002, the Company recorded a cumulative-to-date benefit of $4.0 million.
In 2003 and 2002, the effective tax rates of 24% and 16%, respectively, differ from the statutory rate of 35% due primarily to tax-exempt interest income and income from Financial Security Assurance International Ltd. (FSA International) and, for 2002, the change in taxing the Company's equity in earnings from Fairbanks. Although FSA International is subject to U.S. income taxes as a controlled foreign corporation, it nonetheless benefits from a lower overall effective tax rate than the Company's domestic insurance company subsidiaries.
Net income for 2003 was $290.6 million, a 60% increase over that of 2002. In addition to net income, management views operating earnings (a non-GAAP measure) as an important measure of operating results. The Company defines operating earnings as net income before the effects of fair-value adjustments for FSA-insured CDS that have investment-grade underlying credit quality and are
Shareholders' equity (book value) grew 16.1% during 2003 and 14.2% during 2002. Management believes that the intrinsic value of the Company comprises not only book value and franchise value but also the estimated present value of future income from business it has already originated. Such future income is substantial because premiums are earned over the life of each insured transaction. It includes revenues from premiums that have been collected but have not yet been earned (deferred premium revenue), the estimated net present value (PV) of future premiums that will be collected in installments and, for GIC transactions, the estimated present value of future net interest margin. For this reason, management considers non-GAAP adjusted book value (ABV), which captures these forms of deferred income, to be a reasonable proxy for the intrinsic value of the Company, exclusive of franchise value. The Company uses ABV to calculate a portion of compensation paid to its employees, as described in Note 10 to the Consolidated Financial Statements. The following table is a reconciliation of book value to adjusted book value.
(1)Includes the effect of after-tax unrealized gains in the investment portfolio, which were $147.4 million at December 31, 2003 and $134.7 million at December 31, 2002.
In addition to its insurance company assets and other investments (the investment portfolio), the Company also maintains investments from proceeds of FSA-insured GICs (the GIC Portfolio) and the portfolio of securities owned by FSA Global and Canadian Global (the VIE Portfolio).
Management's primary objective in managing the Company's investment portfolio is to generate an optimal level of after-tax investment income while preserving capital and maintaining adequate liquidity. The Company bases its investment strategies on many factors, including the Company's tax position, anticipated changes in interest rates, regulatory and rating agency criteria and other market factors. One internal investment manager and two external investment managers execute fixed-income investments on behalf of the Company. Management, with the approval of the board of directors, establishes the guidelines for investment decisions.
FSA Asset Management LLC (FSAM) manages the investments in the GIC Portfolio and the VIE Portfolio. The primary objectives in managing the GIC Portfolio are to generate stable net interest margin, to maintain liquidity and to optimize risk-adjusted returns. FSAM arranges for the acquisition of the VIE Portfolio investments, which are generally held until maturity.
FSA-insured GICs subject the Company to risk associated with unexpected timing of withdrawal of principal allowed by the terms of the GICs. The majority of municipal GICs insured by FSA relate to debt service reserve funds and construction funds in support of municipal bond transactions. Debt service reserve fund GICs may be drawn unexpectedly when the underlying bond issuance suffers a debt service shortfall. Construction funds may experience withdrawal deviation when the underlying municipal project does not proceed as expected. In addition, most FSA-insured GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below AA- by S&P or Aa3 by Moody's, unless the GIC provider posts collateral or otherwise enhances its credit.
Management of the Company periodically evaluates the assumptions and judgments underlying its estimate for losses and loss adjustment expenses and establishes a liability that management believes is adequate to cover the present value of the ultimate net cost of claims. Management has applied this approach consistently from period to period. Since the reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates.
The Company's consolidated invested assets at December 31, 2003, net of unsettled security transactions, were $9,464.7 million, compared with the December 31, 2002 balance of $5,027.2 million. These balances include the change in the market value of the investment portfolio, which had an unrealized gain position of $225.5 million at December 31, 2003, compared with an unrealized gain position of $201.0 million at December 31, 2002. In addition to the increase in unrealized gains, the increase in invested assets was largely attributable to the growth of the Company's financial products segment and the consolidation of VIEs, as discussed above under "Results of Operations-Variable Interest Entities." Although included in total invested assets, the Company's management believes that the assets held by the VIEs, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. At December 31, 2003, the Company had, at the holding company level, an investment portfolio of $22.8 million available to fund the liquidity needs of its activities outside of its insurance operations. Because the majority of the Company's operations are conducted through FSA, the long-term ability of the Company to service its debt will largely depend on its receipt of dividends from, or payment on surplus notes by, FSA.
FSA's ability to pay dividends depends on FSA's financial condition, results of operations, cash requirements, determination that FSA's ratings will not be adversely affected and other related factors, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York, FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (i) 10% of policyholders' surplus as of its last statement filed with the Superintendent of Insurance of the State of New York (the New York Superintendent) or (ii) adjusted net investment income during this period. FSA paid no dividends in 2003 and 2002. Based on FSA's statutory statements for the year ended December 31, 2003, and considering dividends that can be paid by its subsidiary, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the following 12 months is approximately $112.6 million. In 2003 and 2002, FSA International paid preferred dividends of $3.3 million and $8.7 million, respectively, to XL Capital Ltd, its minority interest owner.
On July 31, 2003, the Company issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million will be amortized over the life of the Notes. In September 2003, the Company called for redemption, on November 1, 2003, its 6.950% Senior Quarterly Income Debt Securities (6.950% Senior QUIDS) due November 1, 2098 and delivered to the trustee sufficient collateral to legally defease the 6.950% Senior QUIDS. The unamortized debt issuance costs of $3.2 million for the 6.950% Senior QUIDS were charged to interest expense for 2003. Subsequently, the trustee used the defeasance collateral to redeem all of the 6.950% Senior QUIDS. The Company had two other debt issues outstanding at December 31, 2003: $230.0 million of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007, and $100.0 million of 67/8% Quarterly Income Bond Securities due December 15, 2101, which are callable without premium or penalty on or after December 19, 2006.
FSA's primary uses of funds are to pay operating expenses and to pay dividends to, or pay interest or principal on surplus notes held by, its parent. FSA's funds are also required to satisfy claims under insurance policies in the event of default by an issuer of an insured obligation and the unavailability or exhaustion of other payment sources in the transaction, such as the cash flow or collateral underlying the obligations. FSA seeks to structure asset-backed transactions to address liquidity risks by matching insured payments with available cash flow or other payment sources. The insurance policies issued by FSA provide, in general, that payments of principal, interest and other amounts insured by FSA may not be accelerated by the holder of the obligation but are paid by FSA in accordance with the obligation's original payment schedule or, at FSA's option, on an accelerated basis. These policy provisions prohibiting acceleration of certain claims are mandatory under Article 69 of the New York Insurance Law and serve to reduce FSA's liquidity requirements.
FSA has a credit arrangement aggregating $150.0 million, which is provided by commercial banks and intended for general application to transactions insured by its subsidiaries. At December 31, 2003, there were no borrowings under this arrangement, which expires on April 23, 2004, if not extended.
In June 2003, $200.0 million of money market committed preferred trust securities (the CPS Securities) were issued by trusts created for the primary purpose of issuing the CPS Securities, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the Preferred Stock) of FSA. If a put
option were to be exercised by FSA, the applicable trust would use the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, and transfer such proceeds to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $3.6 million for 2003 and was recorded in equity. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts under FIN 46 because it does not retain the majority of the residual benefits or expected losses.
S&P, Moody's and Fitch Ratings periodically assess the credits insured by FSA, and the reinsurers and other providers of capital support to FSA, to confirm that FSA continues to satisfy the rating agencies' capital adequacy criteria necessary to maintain FSA's Triple-A ratings. Capital adequacy assessments by the rating agencies are generally based on FSA's qualified statutory capital, which is the aggregate of policyholders' surplus and contingency reserves determined in accordance with statutory accounting principles.
FSA-insured GICs subject the Company to risk associated with early withdrawal of principal allowed by the terms of the GICs. The majority of municipal GICs insured by FSA relate to debt
II Condensed Financial Statements of Financial Security Assurance Holdings Ltd. as of December 31, 2003 and 2002 and for the Years Ended December 31, 2003, 2002 and 2001
In the third quarter of 2003, the Company consolidated two variable interest entities (VIEs), FSA Global Funding Limited (FSA Global) and Canadian Global Funding Corporation (Canadian Global), as a result of Financial Accounting Standards Board (FASB) Interpretation No. 46, "Consolidation of Variable Interest Entities, an interpretation of ARB No. 51" (FIN 46). The Company also consolidated another VIE, Premier International Funding Co. (Premier), in the third quarter as a result of obtaining control rights (see Note 25). The Company's management believes that the assets held by FSA Global, Canadian Global and Premier, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership.
On July 5, 2000, the Company completed a merger in which the Company became a direct subsidiary of Dexia Holdings, Inc., which, in turn, is owned 90% by Dexia Crédit Local and 10% by Dexia S.A. (Dexia), a Belgian corporation whose shares are traded on the Euronext Brussels and Euronext Paris markets, as well as on the Luxembourg stock exchange. Dexia Crédit Local is a wholly owned subsidiary of Dexia. At the merger date, each outstanding share of the Company's common stock was converted into the right to receive $76.00 in cash. At December 31, 2003, Dexia Holdings, Inc. owned approximately 99% of the Company's outstanding shares; the only other holders of the Company's common stock were an affiliate of White Mountains Insurance Group, Ltd. and certain current and former directors of the Company who owned shares of the Company's common stock or economic interests therein under the Director Share Purchase Program (see Note 10).
The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP), which, for the insurance company subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 5). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities in the Company's consolidated balance sheets at December 31, 2003 and 2002 and the reported amounts of revenues and expenses in the consolidated statements of operations and comprehensive income during the years ended December 31, 2003, 2002 and 2001. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses, fair value of financial instruments and the deferral and amortization of policy acquisition costs. Actual results may differ from those estimates. Significant accounting policies under GAAP are as follows:
purchase of three months or less and are included in short-term investments. Realized gains or losses on sale of investments are determined on the basis of specific identification. Investment income is recorded as earned. Other-than-temporary impairments are reflected in earnings as a realized loss.
The Company has also insured a number of CDS agreements that it intends, in each case, to hold for the full term of the agreement. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred. Changes in fair value are recorded in net realized and unrealized gains (losses) on derivative instruments and in other assets or other liabilities. The Company uses quoted market prices, when available, to determine fair value. If quoted prices are not available, management uses internally developed estimates of fair value. Due to a lack of a quoted market for the CDS obligations written by the Company, estimates generated from the Company's valuation process may differ materially from values that may be realized in market transactions.
Gross and ceded premiums received in upfront payouts are earned in proportion to the amount of risk outstanding over the expected period of coverage. The amount of risk outstanding is equal to the sum of the par amount of debt insured over the expected period of coverage. Deferred premium
revenue and prepaid reinsurance premiums represent the portion of premium that is applicable to coverage of risk to be provided in the future on policies in force. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred premium revenue and prepaid reinsurance premium, less any amount credited to a refunding issue insured by the Company, are recognized. For premiums received on an installment basis, the Company earns the premium over each installment period, typically less than one year, throughout the period of coverage. When the Company, through its ongoing credit review process, identifies transactions where certain triggers have been breached, the Company ceases to earn premiums on such transactions. The amount of any case reserves established for these transactions will be net of the unearned premiums for such transactions.
The Company establishes a case reserve for unpaid losses and loss adjustment expenses for the present value of the estimated loss, net of subrogation recoveries, when, in management's opinion, the likelihood of a future loss on a particular insured obligation is probable and determinable at the balance sheet date. The estimated loss on a transaction is discounted using the then current risk-free rates, which ranged from 4.94% to 6.1%. For insured collateralized debt obligations (CDOs), a case reserve is recorded to the extent that the overcollateralization ratio (non-defaulted collateral at par value divided by the debt insured) has fallen below 100% and there is a projected loss when calculating the present value of cash flows.
Deferred acquisition costs comprise expenses that vary with, and are primarily related to, the production of business, including commissions paid on reinsurance assumed, compensation and related costs of underwriting and marketing personnel, certain rating agency fees, premium taxes and certain other underwriting expenses, reduced by ceding commission income on premiums ceded to reinsurers. The Company does not defer acquisition costs relating to GICs issued by the GIC Subsidiaries, except for GIC commissions paid to third parties. Deferred acquisition costs are amortized over the period in which the related premiums are earned. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred acquisition cost is recognized. Recoverability of deferred acquisition costs is determined by considering deferred premium revenue and estimated installment premiums and the present value of anticipated losses and loss adjustment expenses.
Assets and liabilities denominated in foreign currencies are translated at the spot rate. Revenues and expenses denominated in foreign currencies are translated at average rates prevailing during the year. Unrealized gains and losses, net of deferred taxes, resulting from translating investments denominated in foreign currencies are recorded in shareholders' equity. Gains and losses from transactions in foreign currencies are recorded in income.
(1)Ratings are based on the higher of Moody's Investors Service, Inc. (Moody's) or Standard & Poor's Ratings Services (S&P) ratings available at December 31, 2003. Of the bonds included in the investment portfolio, 11.4% were AAA by virtue of insurance provided by FSA. Without giving effect to the FSA guaranty, the weighted-average rating of the FSA-insured investments was in the Double-A range, and all of these investments were investment grade.
Proceeds from sales of bonds for the investment portfolio during 2003, 2002 and 2001 were $948.3 million, $772.0 million and $537.1 million, respectively. Gross gains of $12.6 million, $30.3 million and $9.1 million and gross losses of $7.3 million, $1.3 million and $1.8 million were realized on sales in 2003, 2002 and 2001, respectively.
In 2002, the Company purchased foreign currency call options. These calls were marked to market through earnings and, for the years ended December 31, 2003 and 2002, resulted in net unrealized gains of $0.3 million and $0.2 million, respectively.
The amortized cost and fair value of the GIC Portfolio, at December 31, 2003, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
•Certain assets designated as "non-admitted assets" are charged directly to statutory surplus but are reflected as assets under GAAP;
•Non-insurance company subsidiaries do not prepare accounts applying statutory accounting standards.
Under the insurance laws of the State of New York, FSA may pay a dividend to the Company without the prior approval of the Superintendent of Insurance of the State of New York (the New York Superintendent) only from earned surplus subject to the maintenance of a minimum capital requirement. In addition, the dividend, together with all dividends declared or distributed by FSA during the preceding 12 months, may not exceed the lesser of 10% of its policyholders' surplus shown
FSA has a standby line of credit commitment in the amount of $325.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $325.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $865.6 million at December 31, 2003. The obligation to repay loans made under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a term expiring on April 30, 2010 and contains an annual renewal provision subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2003.
In June 2003, $200.0 million of money market committed preferred trust securities (the CPS Securities) were issued by trusts created for the primary purpose of issuing the CPS Securities, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the Preferred Stock) of FSA. If a put option were to be exercised by FSA, the applicable trust would use the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, and transfer such proceeds to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $3.6 million for 2003 and was recorded in equity. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts under FIN 46 because it does not retain the majority of the residual benefits or expected losses.
On July 31, 2003, the Company issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million will be amortized over the life of the Notes. In September 2003, the Company called for redemption, on November 1, 2003, $100.0 million of its 6.950% Senior Quarterly Income Debt Securities (6.950% Senior QUIDS) due November 1, 2098 and delivered to the trustee sufficient collateral to legally defease the 6.950% Senior QUIDS. Unamortized debt issuance costs of $3.2 million for the 6.950% Senior QUIDS were charged to interest expense. Subsequently, the trustee used the defeasance collateral to redeem all of the 6.950% Senior QUIDS.
On November 26, 2002, the Company issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt. The Company used a portion of the proceeds of this issuance to redeem in whole the Company's $130.0 million principal amount of 7.375% Senior Quarterly Income Debt Securities (Senior QUIDS) due September 30, 2097. Unamortized debt issuance costs of the retired debt of $4.1 million were charged to interest expense.
The Subsidiaries have an employee retirement savings plan for the benefit of eligible employees. The plan permits employees to contribute a percentage of their salaries up to limits prescribed by Internal Revenue Code Section 401(k). The Subsidiaries' contributions are discretionary, and none have been made.
Performance shares are awarded under the Company's 1993 Equity Participation Plan. The 1993 Equity Participation Plan authorizes the discretionary grant of performance shares by the Human Resources Committee to key employees of the Company and its Subsidiaries. The amount earned for each performance share depends on the attainment by the Company of certain growth rates of adjusted book value (or, in the case of performance shares issued after January 1, 2001, growth rates of adjusted book value and book value) per outstanding share over a three-year period. At the election of the participant at the time of award, growth rates may be determined including or excluding realized and unrealized gains and losses on the Company's investment portfolio. No payout occurs if the compound annual growth rate of the Company's adjusted book value (or in the case of performance shares issued after January 1, 2001, growth rates of adjusted book value and book value) per outstanding share is less than 7%, and a 200% payout occurs if the compound annual growth rate is 19% or greater. Payout percentages are interpolated for compound annual growth rates between 7% and 19%.
In the fourth quarter of 2000, the Company purchased 304,757 shares of its common stock from Dexia Holdings, Inc. for $24.0 million. This purchase was intended to fund obligations relating to the Company's Director Share Purchase Program (DSPP), which enables its participants to make deemed investments in the Company's common stock under the DCP and SERP. Under the DSPP, the deemed investments in the Company's stock are irrevocable, settlement of the deemed investments must be in stock and, after receipt, the participants must generally hold the stock for at least six months. In 2003, 2002 and 2001, $0, $0.3 million and $0.3 million, respectively, of restricted treasury stock was distributed to a director as a DSPP payout.
The Company and its Subsidiaries lease office space and equipment under non-cancelable operating leases, which expire at various dates through 2007. Future minimum rental payments are as follows (in thousands):
The Subsidiaries obtain reinsurance to increase their policy-writing capacity on both an aggregate-risk and a single-risk basis; to meet rating agency, internal and state insurance regulatory limits; to diversify risk; to reduce the need for additional capital; and to strengthen financial ratios. The Subsidiaries reinsure portions of their risks with affiliated (see Note 14) and unaffiliated reinsurers under quota share, first-loss and excess-of-loss treaties and on a facultative basis.
In the event that any or all of the reinsuring companies are unable to meet their obligations to the Subsidiaries, or contest such obligations, the Subsidiaries would be liable for such defaulted amounts. Certain of the reinsuring companies have provided collateral to the Subsidiaries to secure their reinsurance obligations.
In its asset-backed business, the Company considers geographic concentration as a factor in underwriting insurance covering securitizations of pools of such assets as residential mortgages or consumer receivables. However, after the initial issuance of an insurance policy relating to such securitizations, the geographic concentration of the underlying assets may not remain fixed over the life of the policy. In addition, in writing insurance for other types of asset-backed obligations, such as securities primarily backed by government or corporate debt, geographic concentration is not deemed
The Company seeks to maintain a diversified portfolio of insured municipal obligations designed to spread its risk across a number of geographic areas. The following table sets forth those states in which municipalities located therein issued an aggregate of 2% or more of the Company's net par amount outstanding (in millions) of insured municipal securities as of December 31, 2003:
The Subsidiaries had premiums earned of $20.5 million, $17.3 million and $7.2 million for the years ended December 31, 2003, 2002 and 2001, respectively, relating to business with affiliates of Dexia. Deferred premium revenue relating to those transactions was $6.9 million and $7.7 million at December 31, 2003 and 2002, respectively. Gross par outstanding relating to those transactions was $16,824.9 million and $16,166.0 million at December 31, 2003 and 2002, respectively. The Company also paid Dexia a fee of $0.7 million and $3.3 million in 2003 and 2002, respectively, relating to business in which both Dexia and the Company are involved. For the years ended December 31, 2003, 2002 and 2001, the Company recorded net revenues of $52.9 million, net expenses of $3.7 million and net revenues of $0.5 million, respectively, relating to swaps where Dexia was the counterparty. At December 31, 2003 and 2002, the Company recorded other assets of $233.3 million and other liabilities of $3.1 million, respectively, primarily relating to swaps where Dexia was the counterparty. In addition, the Company had $154.3 million in VIE debt at December 31, 2003, relating to debt issued to Dexia. During 2003, the Company recorded $3.3 million in VIE net interest expense relating to such debt.
Short-term investments, including the GIC short-term investment portfolio and VIE short-term investments-The carrying amount is fair value, which approximates cost due to the short maturity of these instruments.
Installment premiums-Consistent with industry practice, there is no carrying amount for installment premiums since the Company will receive premiums on an installment basis over the term of the insurance contract. Similar to the treatment of deferred premium revenue, the fair value of installment premiums is the estimated present value of the future contractual premium revenues that would be received under a reinsurance agreement with a third party to transfer the Company's financial guaranty risk, net of that portion of the premium retained by the Company to compensate it for originating and servicing the insurance contract.
Fair-value adjustments on derivatives-The carrying amount represents fair value. The Company uses quoted market prices, when available, to determine fair value. If quoted market prices are not available, management uses internally developed estimates.
During 2001, the Company increased its general reserve by $12.5 million, of which $8.2 million was for origination of new business and $4.3 million was for the accretion of the discount on prior years' reserves. Also during 2001, the Company transferred to the general reserve $0.1 million representing recoveries received on prior-year transactions and transferred $8.7 million from the general reserve to case reserves. Giving effect to these transfers, the general reserve totaled $69.1 million at December 31, 2001.
In the second quarter of 2002, as part of the Company's ongoing credit review process, management identified certain transactions not performing as expected in its portfolio of insured CDOs. As a result, management undertook a quantitative analysis of all CDO transactions in its insured portfolio that breached senior overcollateralization triggers, which were included in such transactions as one measure of adverse performance. A present value "deterministic" approach was utilized to estimate the loss inherent in this portfolio. The deterministic model takes the average cumulative default rate produced by a Monte Carlo simulation and applies those defaults to a cash flow model using (i) a timing sequence dependent on the portfolio's rating and maturity composition, (ii) an estimate of collateral recovery values for severity and (iii) the LIBOR forward curve as a predictor of interest rates. Management assumed that current default rates on CDO collateral would improve in a manner consistent with an economic recovery following a period of significant credit deterioration similar to that experienced in 1991/1992 and, as a result, management utilized the Moody's idealized default curve, adjusted by a factor consistent with the relationship between the 1992 cohort experience and the Moody's 30-year average default rate. The per-period default rate was calculated based on the Moody's weighted-average rating factor for each piece of surviving collateral. Recovery rates were judgmentally established by the Company. In considering the recovery rates to be utilized, management adjusted Moody's average recovery rates (observed since 1982) downward to reflect more recent adverse observations. At June 30, 2002, this analysis produced a present value of expected losses of $51.5 million, net of reinsurance recoveries and net of unearned premiums and future ceding commissions. Management addressed this net present value of expected loss ($51.5 million) through (i) an increase in the Company's general reserve ($31.0 million) and (ii) amounts already existing in its general reserve ($20.5 million), including general reserve amounts reallocated to case reserves ($11.3 million). The $31.0 million increase in the Company's general reserve resulted in a corresponding increase to losses and loss adjustment expenses in the income statement of $31.0 million. An additional adjustment of $10.1 million was made in the fourth quarter of 2002 as a result of further deterioration of the CDO portfolio. Management established a methodology of recording case reserves on CDO transactions based on the extent to which the overcollateralization ratio (non-defaulted collateral at par value divided by the debt insured) has fallen below 100%, since management believes that claims on such transactions are probable and that the amount of the undercollateralization is a reasonable estimate of such claims. Such transactions may benefit from excess cash flow attributable in part to higher interest rates on the underlying collateral than on the insured securities. In addition, such transactions generally require insured payments of principal only at the ultimate maturity of such transactions. As a result, the Company does not expect to be required to pay claims on these transactions for several years, but may elect to do so at an earlier date at its discretion. Application of this methodology resulted in recording $68.8 million in gross case reserves and $29.8 million in reinsurance recoverable on unpaid losses, resulting in a $39.0 million increase in net case reserves in 2002. Management, beginning in the second quarter of 2002, has refined the loss factor it applies to its net par underwritten when calculating the general reserve in order to reflect its recent adverse experience. As a result, the general reserve accrual for the year ended December 31, 2002 was $65.6 million, rather than approximately $14.9 million that would have been accrued using the prior assumptions.
During 2002, the Company increased its general reserve by $65.6 million, of which $41.1 million related to the CDO portfolio discussed above, $21.1 million was for origination of new business and $3.4 million was for accretion of the discount on prior years' reserves. Also during 2002, the Company
Certain prior-quarter balances have been reclassified to conform to the year-end presentation.
The Company made equity investments in Fairbanks of $0, $13.4 million and $15.0 million in 2003, 2002 and 2001, respectively. At December 31, 2003, the Company had a 29.8% interest in Fairbanks. The Company's investment in Fairbanks is accounted for using the equity method of accounting.
Amounts recorded by the Company in connection with Fairbanks at December 31, 2003, 2002 and 2001 were as follows (in thousands):
At December 31, 2003 and 2002, the Company's retained earnings included $3.5 million and $17.0 million, respectively, of accumulated undistributed earnings of Fairbanks.
Fairbanks is a servicer of single-family residential mortgage loans originated by unaffiliated third parties. Most of the mortgage loans serviced by Fairbanks are considered "sub-prime," reflecting the lower than "prime" credit quality of the borrower/homeowner. Fairbanks is owned 56.8% by The PMI Group Inc. and 29.8% by the Company, with the remainder owned by certain founders of Fairbanks.
On November 12, 2003, the FTC announced a settlement with Fairbanks, resolving the FTC's and HUD's civil allegations against Fairbanks. The settlement requires Fairbanks to pay $40.0 million to the FTC to compensate consumers who suffered harm, enjoins Fairbanks from future law violations and imposes new restrictions on Fairbanks' business practices. The settlement is contingent on approval by a federal district court in Massachusetts and is expected to be coordinated with a related settlement in a class action lawsuit. The Company guaranteed 34.4% of Fairbanks' obligations under a $30.7 million letter of credit that may be drawn upon by the FTC as security for a portion of the $40.0 million payment required under the terms of the FTC's settlement agreement with Fairbanks. Any payment by the Company under this agreement would be recorded as an additional equity investment in Fairbanks. The settlement amount and other costs, aggregating $55.0 million, have been reflected in Fairbanks', and hence the Company's, results for 2003.
Payments due under GICs, excluding hedge accounting adjustments and prepaid interest of $14.7 million, in each of the next five years ending December 31 and thereafter, based on expected withdrawal dates, are as follows (in thousands):
Derivative instruments, which are primarily designated as fair-value hedges, are entered into to manage the interest-rate and foreign currency exposure of the Company's GICs, GIC bond portfolio, VIE debt and VIE bond portfolio and are recorded at fair value. These derivatives generally include interest-rate futures and interest-rate and currency swap agreements, which are primarily utilized to convert the fixed-rate obligations into U.S. floating-rate obligations. The gains and losses relating to these fair-value hedges are included in GIC net interest income, GIC net interest expense, VIE net interest income and VIE net interest expense, as appropriate, along with the offsetting change in fair value of the hedged item attributable to the risk being hedged, on the consolidated statements of operations and comprehensive income. For the years ended December 31, 2003, 2002 and 2001, the Company recorded a net gain of $0.6 million, a net loss of $0.2 million and a net gain of $0.2 million, respectively, relating to the ineffectiveness of these hedges. For the years ended December 31, 2003, 2002 and 2001, the Company recorded a net gain of $5.0 million, $4.3 million and $0, respectively, relating to failed hedges. The inception-to-date net unrealized loss on these derivatives was recorded in accrued expenses and other liabilities and was $15.8 million and $12.1 million at December 31, 2003 and 2002, respectively.
The Company operates in two business segments: financial guaranty and financial products. The financial guaranty segment is primarily in the business of providing financial guaranty insurance on asset-backed and municipal obligations. The financial products segment includes the GIC operations of the Company, which issues GICs to municipalities and other market participants. The GICs provide for the return of principal and the payment of interest at a pre-specified rate. The following tables summarize the financial information (in thousands) by segment at, and for the years ended, December 31, 2003 and 2002:
The inter-segment assets consist of intercompany notes that are in the financial products investment portfolio and GICs issued by the GIC Subsidiaries that are in the financial guaranty investment portfolio. The inter-segment revenue relates to interest income on the intercompany assets.
In January 2003, the FASB issued FIN 46, which addresses consolidation of VIEs that have one or both of the following characteristics: (i) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity; and (ii) the equity investors lack the direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights, the obligation to absorb the expected losses of the entity if they occur or the right to receive the expected residual returns of the entity if they occur. In December 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003), "Consolidation of Variable Interest Entities, an interpretation of ARB 51" (FIN 46R). FIN 46R replaced FIN 46 and is effective for public companies for periods after December 15, 2003.
The Company applied FIN 46 and consolidated for financial reporting purposes, effective July 1, 2003, FSA Global and Canadian Global. In addition, as a result of the Company obtaining control rights of another VIE, Premier, on July 1, 2003, the Company consolidated Premier beginning July 1, 2003. FIN 46R requires that, upon consolidation, the Company initially measure the VIE's assets, liabilities and minority interest at their carrying amounts under existing GAAP as if the entity had been consolidated from the time the Company was considered its primary beneficiary (or parent). The increase in total assets and total liabilities related to the consolidation of these entities was $2.0 billion. Any differences upon consolidation were reflected as a cumulative effect of a change in accounting principle. The cumulative effect of a change in accounting principle for Canadian Global resulted in additional income of $4.8 million, net of income tax. There were no cumulative income statement effects from consolidating FSA Global and Premier. FSA Global is managed as a "matched funding
vehicle," in which the proceeds from the issuance of FSA-guaranteed notes are invested in obligations having cash flows substantially matched to those of, and maturing prior to, such notes. In certain cases, investments of FSA Global consist of GICs issued by the GIC Subsidiaries. Similarly, Canadian Global and Premier have GICs issued by the GIC Subsidiaries in their investment portfolios. In each such case, the Company's GIC liability and asset are eliminated in consolidation. At December 31, 2003, $559.9 million was eliminated as a result of such consolidation. In the cases of FSA Global and Canadian Global, permitted activities are limited by charter and do not involve active management; the legal documents that establish the VIEs do not permit the sale or other disposal of the financial assets they hold, except in automatic response to the terms of such financial assets; and the VIEs are structured as bankruptcy-remote entities. The Company's management believes that the assets held by the VIEs, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. All intercompany insured amounts between FSA and FSA Global and Canadian Global previously included in the Company's outstanding exposure are excluded from the Notes to the Condensed Consolidated Financial Statements for December 31, 2003.
All bonds in the VIE Portfolio are insured by FSA. The credit quality of the VIE Portfolio, without the benefit of FSA's insurance, at December 31, 2003 was as follows:
(1)Ratings are based on the higher of Moody's or S&P ratings available at December 31, 2003. The amortized cost and fair value of bonds in the VIE Portfolio were as follows (in thousands):
The amortized cost and fair value of bonds in the VIE Portfolio at December 31, 2003, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual
maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
At December 31, 2003, the interest rates on VIE Debt were between 1.12% and 10.0% per annum.
In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-3: Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. SOP 03-3 supersedes Practice Bulletin 6 for transactions entered into after the initial application of SOP 03-3. For loans acquired in fiscal years prior to the effective date of SOP 03-3 and within the scope of Practice Bulletin 6 (such as securitized loans, see Note 22), SOP 03-3 amends the application of Practice Bulletin 6 with regard to accounting for decreases in cash flows expected to be collected.
SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004. For loans acquired in fiscal years beginning on or before December 15, 2004 and that fall within the scope of Practice Bulletin 6 as it applies to decreases in cash flows expected to be collected, SOP 03-3 should
be applied prospectively for fiscal years beginning after December 15, 2004. Management believes that the implementation of SOP 03-3 will not have a material effect on the Company's financial position, results of operations or cash flows.