In accordance with accounting principles generally accepted in the United States of America (“GAAP”), our guarantees qualify as either insurance contracts or derivative contracts for accounting purposes. For insurance contracts, premiums and losses with respect thereto are recognized in accordance with GAAP as discussed in “-Critical Accounting Policies and Estimates-Reserves for Losses and Loss Adjustment Expenses”, whereas derivative contracts are reported at fair value in accordance with GAAP with no separate recognition given to premiums or management’s best estimate of losses under such derivative contracts. Accounting for our CDS contracts in accordance with GAAP is discussed in “-Critical Accounting Policies and Estimates-Valuation of CDS Contracts” and Note 6 to the Consolidated Financial Statements. Throughout the discussion which follows, references are made to anticipated claims on our CDS contracts, which represent management’s best estimate of the ultimate amount of losses and loss adjustment expenses on such contracts. Anticipated claims represent the equivalent of reserves for unpaid losses and loss adjustment expense recognized on insurance contracts under GAAP.
commutation of certain retrocession agreements we had in place with non-affiliates,
distribution from Syncora Guarantee Re of $30.8 million to Syncora Holdings, and
We derive our revenues principally from: (i) premiums from our in-force business, (ii) net investment income and net realized gains and losses from our investment portfolio supporting such business and (iii) the change in fair value of our credit derivatives. Net premiums received or receivable on financial guarantees executed in derivative form are included in “Realized gains and losses and other settlements” in our consolidated statements of operations. As a result of adverse developments in the credit markets generally and the mortgage market specifically which have resulted in material adverse effects on our business, results of operations, and financial condition, we suspended writing substantially all new business since January of 2008. See “-Recent
Premiums are accounted for as written when due; therefore, when we entered into policies that provided for upfront premium, all of the premium on the policy was accounted for as written generally when the policy commenced. The portion of the upfront premium that has been written but has not yet been earned is carried on our balance sheet as deferred premium revenue. When we entered into policies that provided for installment premium, only that installment of the premium that is then due (generally the current monthly, quarterly or semiannual installment) is accounted for as written. Future premium installments during the remainder of the life of the installment-based policy are not reflected on our financial statements. See “-Critical Accounting Policies and Estimates-Premium Revenue Recognition”. Therefore, in general, the amount of total premiums written by a financial guarantee insurance company that are reported in any period will be affected by the mix of policies that it wrote in that period on an “upfront” and, in that period and prior periods, on an “installment” basis. In addition, a financial guarantee insurance company with a growing in-force book of business should generally recognize an increasing amount of net earned premium from policies written in prior reporting periods, whether premiums are received on an upfront or installment basis. Future installments of premium on business written in a period are reported by financial guarantors as a component of adjusted gross premiums, a non-GAAP financial measure. See “-Other Measures Used by Management to Evaluate Operating Performance” for additional information. The amount of installment premiums actually realized by us in the future (and that would be otherwise reflected in revenue) could be reduced due to factors such as early termination of insurance contracts or accelerated prepayments of underlying obligations.
Set forth in the table below is a reconciliation of shareholders’ equity reported by us at December 31, 2008 to Adjusted Shareholders’ Equity at such date. Also, the following table presents the beneficial effect on our net credit derivative liability at December 31, 2008 of our risk of non-performance (“Non-Performance Risk”). Non-Performance Risk reflects the market perception of the risk that we will not be financially able to honor our obligations as they become due. For example, when the market price of buying credit protection on us increases reflecting our deteriorating financial position, the Non-Performance Risk component of the fair value of our CDS contracts reduces our derivative liabilities and increases shareholders’ equity, whereas when the market price of buying credit protection on us decreases reflecting our improving financial position, the Non-Performance Risk component of the fair value of our CDS contracts increases our derivative liabilities and decreases shareholders’ equity. The beneficial effect on our net credit derivative liability from our Non-Performance Risk was estimated based on quoted market prices of buying credit protection on Syncora Guarantee. We believe that it is important to understand the effect of Non-Performance Risk on the fair value of our obligations under our CDS contracts when evaluating our financial position in accordance with GAAP. As can be seen from the table below,
We are exposed to residential mortgages directly, through our insurance guarantees of RMBS and indirectly, through our guarantees of ABS CDOs, which were primarily issued in the form of CDS contracts.
The following table presents the net notional exposure of our ABS CDO portfolio by referenced asset type as of December 31, 2008:
information regarding the estimates and assumptions used for these items and should be read in conjunction with the notes to our Consolidated Financial Statements.
The following tables summarize our gross reserves (before the effect of reinsurance ceded) for losses and loss adjustment expenses by type of reserve as of December 31, 2008 and 2007. For a detailed discussion of our reserves for unpaid losses and loss adjustment expenses, at December 31, 2008 and 2007 see Note 16 to the Consolidated Financial Statements.
The following table sets forth certain information in regard to our closely monitored credits as of December 31, 2008 and 2007 (see also Note 16 to our Consolidated Financial Statements):
Typical market CDS contracts are standardized, liquid instruments that reference tradeable securities such as corporate bonds that also have observable prices. These market standard CDS contracts also involve collateral posting, and upon a default of the referenced bond obligation, can be settled in cash. In contrast, our CDS contracts do not contain the typical CDS market standard features as described above but have been customized to replicate our financial guarantee insurance. Our CDS contracts provide protection on specified obligations, such as those described above and,
credit price indices, published by non-affiliated financial institutions, for the type(s), or similar types, of assets referenced in our CDS contracts (both in terms of type of assets and their credit rating),
prices of guarantees issued in our retail market or commutations of contracts we have executed in proximity to the measurement date.
The following table summarizes the unrealized losses on debt securities in our investment portfolio by type of security and the length of time such securities have been in a continuous unrealized loss position as of December 31, 2008 and 2007:
Reinsurance premiums assumed in 2008 were $(29.4) million, a decrease of $85.6 million, or 152.3%, as compared to $56.2 million recorded in 2007. The decrease is attributable to an increase in ceding commission payable on assumed business resulting from the downgrade of our IFS ratings in 2008. Under certain of our reinsurance contracts, in the event of a downgrade of our IFS ratings, ceding commissions are retroactively increased by a stipulated percentage. For accounting purposes, these additional costs, which totaled $48.9 million, were treated as a reduction of deferred premium revenue. The remaining decrease reflects our cessation of new business production and the commutation of reinsurance agreements with FSA and other third-party primary companies. See “-Overview of Our Business-Description of the Transactions Comprising the 2008 MTA and Certain Summary Financial Information.”
Syncora Guarantee’s liquidity resources include investments in debt securities, short-term investments, cash and cash equivalents and accrued investment income. These liquidity resources are subject to market conditions, regulation and rating agency requirements and we cannot guarantee that it will have sufficient liquidity resources in the future or that it will not have to seek alternative sources of liquidity, which may be more expensive than its current liquidity resource options. Based on our estimates, we believe, however, that Syncora Guarantee’s sources of liquidity are adequate to meet its anticipated needs for at least the next twelve months. There can be no assurance that actual results will not differ materially from our estimates. However, substantially all of Syncora Guarantee’s CDS contracts have mark-to-market termination payments following the occurrence of events that are outside Syncora Guarantee’s control, such as Syncora Guarantee being placed into receivership, or rehabilitation by the NYID or the NYID taking control of Syncora Guarantee or, in limited cases, Syncora Guarantee’s insolvency. There can be no assurance that counterparties to Syncora Guarantee’s CDS contracts, including the Counterparties, will not assert that events have occurred which require Syncora Guarantee to make mark-to-market termination payments. If such events were to occur, the aggregate termination payments that we may be required to pay would significantly exceed our ability to make such payments and, accordingly, such events would have a material adverse effect on our financial position and results of operations. If Syncora Guarantee were required to pay termination values under its CDS contracts, Syncora Guarantee would not have sufficient liquidity to fund its obligations as they become due. See “Risk Factors-Risks Related to Our Company-If Syncora Guarantee should become subject to a regulatory proceeding or becomes insolvent, the holders of certain of the CDS contracts Syncora Guarantee has insured may asset the right to terminate the contracts and require Syncora Guarantee to pay them the termination values, which under current market conditions would be in excess of Syncora Guarantee’s resources.” and “-Overview of Our Business-Continuing Risks and Uncertainties Affecting Us, Assessment of Our Ability to Continue as a Going Concern, and Description of Our On-Going Strategic Plan”.
uncertainty in portfolio modeling which makes it difficult to estimate potential paid claims and loss reserves;
Readers are cautioned not to place undue reliance on forward-looking statements which speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements are made. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included herein or elsewhere. We undertake no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise.
Consolidated Statements of Cash Flows for the years ended December 31, 2008, 2007
Concurrent with the execution of the Master Transaction Agreement, Syncora Holdings, Syncora Guarantee and Syncora Guarantee Re entered into an agreement (the “Merrill Agreement”) with Merrill Lynch, Merrill Lynch International (“MLI”) and eight trusts affiliated with Syncora Holdings (the “CDS Trusts”), the obligations of which were guaranteed by policies issued by Syncora Guarantee. The Merrill Agreement provided for the termination of eight CDS contracts (the “Swaps”) and the related financial guarantee insurance policies issued by Syncora Guarantee with insured gross par outstanding as of June 30, 2008 of approximately $3.7 billion, in exchange for a payment by Syncora Guarantee to Merrill Lynch of an aggregate amount of $500 million. As part of the closing of the transactions comprising the Merrill Agreement, the parties provided mutual releases of claims with respect to the Swaps and the related policies. In addition, Syncora Guarantee and MLI have agreed to dismiss previously disclosed litigation related to seven of the Swaps. As a result of the termination of the Swaps, the Company recorded a realized loss of $94.0 million during the year ended December 31, 2008.
Concurrent with the execution of the Master Transaction Agreement, the Company also entered into an agreement (the “FSA Master Agreement”) with FSA. The FSA Master Agreement provided for the commutation of all reinsurance ceded by FSA and its subsidiaries to Syncora Guarantee Re, including that ceded under the amended and restated master facultative reinsurance agreement, dated as of November 3, 1998 (the “Old Master Facultative Agreement”) that was the subject of a guarantee issued by XLI (see Note 10). Commutation of the Old Master Facultative Reinsurance Agreement and all cessions thereunder was a condition to the obligations of XL Capital under the Master Transaction Agreement. Pursuant to the FSA Master Agreement, FSA and Syncora Guarantee Re entered into the commutation and release agreement (the “Commutation Agreement”), under which all existing cessions to Syncora Guarantee Re by FSA were commuted in return for a payment by Syncora Guarantee Re of approximately $165.4 million, representing statutory reserves less ceding commission plus a commutation premium. In turn, FSA and one of its subsidiaries entered into a new master facultative reinsurance agreement (the “New Master Facultative Agreement”) and related reinsurance memorandum (the “Reinsurance Memorandum”)
commutation of certain retrocession agreements the Company had in place with non-affiliates,
Key variables used in the Company’s valuation of substantially all of its CDS contracts at December 31, 2008 include the balance of unpaid notional, expected term, fair values of the underlying reference obligations, reference obligation credit ratings, assumptions about current financial guarantee CDS fee levels relative to reference obligation spreads, the Company’s Non-Performance Risk, as defined and described below, and other factors. Fair values of the underlying reference obligations are obtained from broker quotes when available, or are derived from other market indications such as new issuance and secondary spreads and quoted values for similar transactions and indices, such as ABX or CDX. The Company’s valuation of such CDS contracts does not generally provide for any adjustment to broker quotes. While such broker quotes are non-binding, the brokers from whom the Company obtains such quotes actively monitor and participate in the markets where such collateral is traded. Accordingly, the Company believes that such brokers rely on observable market information to the greatest extent possible when determining such quotes; however, such brokers may also rely on their internal models and unobservable inputs in making such determinations.
With respect to items (viii) and (ix) above, in any price discovery involving a commutation of a CDS contract with its counterparty to the transaction, the Company considered its performance risk as implied by the market price of buying credit protection on the Company, when assessing the estimated fair value of its obligations to the counterparty under the contract.
In May 2008, the FASB issued SFAS 163, Accounting for Financial Guarantee Insurance Contracts-an interpretation of FASB Statement No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”). SFAS 163 clarifies how SFAS 60 applies to financial guarantee insurance contracts. SFAS 163, among other things, changes current industry practices with respect to the recognition of premium revenue and claim liabilities. Under SFAS 163, a claim liability on a financial guarantee insurance contract is recognized when the insurance enterprise expects that a claim loss will exceed the deferred premium revenue (liability) for that contract based on expected cash flows. The discount rate used to measure the claim liability is based on the risk-free market rate and must be updated each quarter. Premium revenue recognition, under SFAS 163 is based on applying a fixed percentage of the premium to the amount of outstanding exposure at each reporting date (referred to as the level-yield approach). In addition, in regard to financial guarantee insurance contracts where premiums are received in installments SFAS 163 requires that an insurance enterprise recognize an asset for the premium receivable and a liability for the unearned premium
SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”
The other-than-temporary impairment charge recorded during the year ended December 31, 2008, was due to fact that the Company was not able to assert that it had the intent and ability to hold securities in an unrealized loss position until they mature or recover in value. The Company’s inability to make such assertion is due to its expectation that it will need to sell a significant amount of its invested assets to fund the transactions contemplated by the Letter of Intent if they are consummated. See Note 3.
In connection with the 2008 MTA, Syncora Holdings purchased all the outstanding Syncora Guarantee Re Series A Preferred Shares in exchange for $2.9 million and contributed them to Syncora Guarantee. In connection with the merger of Syncora Guarantee Re with and into Syncora Guarantee, such shares were cancelled. See Note 4.
There were no losses ceded by Syncora Guarantee Re under this agreement prior to 2007. At December 31, 2007, the Company had a recoverable from XLI under this agreement of $259.4 million, which is reflected in “reinsurance balances recoverable on unpaid losses” in the accompanying consolidated balance sheet for the year then ended. The ceded losses of $259.4 million represent the present value (discounted at 5.1%) of the full limit loss of $500 million under this agreement. The Company incurred expense under the excess of loss reinsurance agreement of $8.2 million and $0.5 million for the years ended December 31, 2007 and 2006, respectively. The expense recorded in 2007 reflects all future ceded premium that the Company would have been required to pay under the reinsurance agreement over the remaining average life of the loss payments and recoveries noted above, in order for the agreement to remain in-force and the Company recover the aforementioned ceded losses.
As of December 31, 2008 and 2007, the Company’s in-force portfolio of guaranteed risks was diversified by type of obligation as shown in the following table:
Company’s provision for unallocated reserves during the year ended December 31, 2008 was attributable to a significant increase in refunded bonds and other accelerations during such periods. At December 31, 2008 and 2007, the Company’s unallocated reserves were $71.6 million and $90.7 million, respectively.
The activities of the Company’s surveillance department are integral to the identification of specific credits that have experienced deterioration in credit quality and the assessment of whether losses on such credits are probable, as well as any estimation of the amount of loss expected to be incurred with respect to such credits. Closely monitored credits are divided into four categories: (i) Special Monitoring List-low investment grade credits where a material covenant or trigger may be breached and closer monitoring is warranted; (ii) Yellow Flag List-credits that the Company determines to be non- investment grade but a loss is unlikely, including credits where claims may have been paid or may be paid but reimbursement is likely; (iii) Red Flag List-credits where a loss is possible but not probable or reasonably estimable, including credits where claims may have been paid or may be paid but full recovery is in doubt; and (iv) Loss List-credits where a loss is probable and reasonably estimable. In general, credits not in the Flag List are considered fundamentally sound, normal risk. These credits are tracked according to a frequency of review schedule. All ABS and CDO credits are reviewed monthly at a minimum. Higher rated municipal credits are reviewed on an exception basis only frequency. Random audit checks are completed annually.
The weighted average expected tax provision or benefit has been calculated using the pre-tax accounting income or loss in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. The difference between the expected and actual tax benefit or expense for each of the years ending December 31, is primarily attributable to the taxable income or loss in the United States. Prior to the Closing Date, Syncora Guarantee has a facultative quota share reinsurance treaty with Syncora Guarantee Re. Under the terms of this treaty, Syncora Guarantee Re reinsured up to 75% of the guaranty business written by Syncora Guarantee Inc. The pre-tax income earned by Syncora Guarantee Re, which was a Bermuda company, was not subject to U.S. income tax. The components of the net deferred income tax position of the Company as of December 31, 2008 and 2007 are as follows:
On January 29, 2009, Syncora Guarantee filed suit in the Supreme Court of the State of New York, New York County, against Countrywide Home Loans, Inc., Countrywide Securities Corp., and Countrywide Financial Corp. (collectively referred to as “Countrywide”), alleging that Countrywide made misrepresentations in connection with several securitizations of home equity mortgage loans originated and serviced by Countrywide, and for which Syncora Guarantee acted as credit enhancer, and seeking damages and other relief for fraud and breach of contract.
estimates presented herein are not necessarily indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.