Effective August 4, 2006, XLA indemnified us for any dimunition in value below their carrying value at June 30, 2006 of certain investments which were acquired in connection with the satisfaction of a claim under a financial guarantee insurance policy issued by XLCA. In addition, pursuant to the aforementioned indemnity, XLA agreed to indemnify us for any costs arising out of any litigation or future claim in connection with the aforementioned insurance policy. See Note 13 (b) to our Consolidated Financial Statements elsewhere herein for further information.
Our premiums are a function of the amount of par or notional amount of debt obligations that we guarantee, market prices and the type of debt obligation guaranteed. We receive premiums either on an upfront basis when the policy is issued or the contract is executed or on an installment basis over the life of the applicable transaction.
We did not record any other-than-temporary declines in the fair value of debt securities or short-term investments for the years ended December 31, 2006, 2005 or 2004.
Reinsurance premiums assumed in 2006 were $55.3 million, an increase of $3.1 million or 5.9%, as compared to $52.2 million recorded in 2005. The increase resulted primarily from premiums assumed in connection with the transfer of business from XLI (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations -Formation Transactions”. The amount of reinsurance ceded to us from year to year by affiliates of FSA and other third-party primary companies depends upon the type and amount of insurance that they write, their capital needs and other factors.
Operating expenses were $67.6 million in 2005, an increase of $9.2 million or 15.8% as compared to $58.4 million in 2004. The increase in operating expenses in 2005, as compared to 2004, was primarily attributable to higher operating expenses in the financial guarantee insurance segment of $11.3 million, partially offset by lower operating expenses in the financial guarantee reinsurance segment of $2.1 million. The increase in operating expenses in the financial guarantee insurance segment was primarily due to higher information technology and other miscellaneous expenses related to the continued build-out of the infrastructure for our financial guarantee insurance business. The decrease in operating expenses in the financial guarantee reinsurance segment was primarily due to non-recurring costs incurred in 2004 in connection with the establishment of XLFA’s soft capital facility. See “-Liquidity and Capital Resources” for additional information regarding XLFA’s soft capital facility.
Net cash provided by (used in) financing activities was $363.7 million, $(7.5) million, and $(13.2) million for the years ended December 31, 2006, 2005 and 2004, respectively. We received proceeds, net of underwriting fees and issuance costs paid, of $342.3 million from our initial public offering in August of 2006. We received additional cash capital contributions from XL Capital Ltd of $28.5 million coincident with certain transactions described under “-Formation Transactions.” Cash outflows from financing activities relate to dividends paid to holders of the redeemable preferred shares of our subsidiary and, in the current year, holders of our common stock.
Interest and fees payable under the letter of credit and liquidity facility shall be determined based upon certain spreads over defined benchmarks, principally LIBOR. The commitments under the letter of credit and liquidity facility will expire on, and amounts borrowed under the letter of credit and liquidity facility may be borrowed, repaid and reborrowed from time to time until, the earlier of (i) the date that is five years after the closing date of the letter of credit and liquidity facility and (ii) the date of termination in whole of the commitments upon an optional termination or reduction of the commitments by the Account Parties or upon an event of default.
In April 2006, the FASB issued FSP FIN 46(R)-6, “Determining the Variability to be Considered in Applying FIN 46(R),” which states that the variability to be considered when applying FIN 46(R) should be based on an analysis of the design of an entity, which entails analyzing the nature of the risks in the entity and determining the purpose for which the entity was created and determining the variability the entity is designed to create and pass along to its interest holders. Typically, assets and operations of the entity create the variability (and thus are not variable interests), while liabilities and equity interests absorb that variability (and thus, are variable interests). The role of a contract or arrangement in the design of the entity, regardless of its legal form or accounting classification, shall dictate whether that interest should be treated as creating or absorbing variability for the entity. The Company adopted the guidance in this FSP as of July 1, 2006 and it did not have any material effect on the Company’s financial statements.
in whole but not in part, at any time after the tenth anniversary of the date of their initial issue. Dividends under the Series A Preferred Shares are cumulative.
of the preference shares was eliminated, the stated value of the preferred shares held by FSAH and its subsidiaries was increased to $54.0 million, and the fixed dividend rate was increased from 5% to 8.25%.
Effective January 1, 2004, XLCA commuted all the reinsurance ceded under the XL RE Treaty through December 31, 2003. As a result of the commutation, XL RE AM returned $6.0 million of premiums to XLCA, XLCA returned ceding commissions of $1.8 million to XL RE AM, and XL RE AM paid XLCA $4.2 million.
The Company provides financial guarantee insurance policies insuring timely payment of investment agreements issued by XL Asset Funding Company I LLC (“XLAF”), an affiliate of the Company. As of December 31, 2006 and 2005, the aggregate face amount of such investment agreements insured by the Company was $3.9 billion ($554.8 million net of reinsurance) and $3.7 billion ($366.7 million net of reinsurance), respectively. In addition, the Company insures XLAF’s obligations under certain derivative contracts issued and purchased by XLAF. As of December 31, 2006 and 2005, the total notional value of such contracts insured was $179.1 million and $167.8 million, respectively. For the years ended December 31, 2006, 2005, and 2004, the Company recorded earned premiums of $3.8 million, $3.0 million and $2.0 million, respectively, relating to the aforementioned contracts.
Set forth below is a discussion of certain case basis reserves established by the Company. The Company has been indemnified with respect to loss development relating to the insurance transactions described under “(a)” and “(b)” below by affiliates of XL Capital in connection with SCA’s IPO. As a result of such indemnifications, all adverse loss development on such insurance transactions subsequent to the effective date of the IPO, which is in excess of the Company’s carried reserves for such transactions at the date of the IPO, will be absorbed by the aforementioned affiliates of XL Capital. Such protection does not relieve the Company of its obligations under the aforementioned insurance transactions. Accordingly, the Company is still liable under the insurance transactions in the event that the affiliates of XL Capital do not meet their obligations under the indemnifications. For further information with respect to the indemnifications see Note 7.
During 2006, the reinsurance of the aforementioned two residential mortgage transactions was cancelled in settlement of a dispute with the reinsurer. As a result of the cancellation, all ceded premium (which was on an installment basis and consequently fully earned) aggregating $0.4 million, was returned to the Company and the Company’s net reserve increased by approximately $1.7 million. Also, during 2006, one of the insured debt obligations was retired early as a result of the exercise of a clean-up call by the entity which transferred the underlying mortgages to the special purpose issuer. As a result of the aforementioned retirement, the Company reduced the related case reserve by approximately $1.9 million. The Company’s earnings for 2006 were increased by approximately $0.6 million as a result of the aforementioned returned premium, cancellation, and early retirement. At December 31, 2006, the carrying amount of the case reserve with respect to the remaining outstanding insured transaction was $3.3 million on a gross and net basis. There continues to be no payment default with respect to this transaction and management continues to monitor the exposure and will revise its loss estimate if necessary, as new information becomes available.
The components of the net deferred Federal income tax position of the Company as of December 31, 2006 and 2005 are as follows:
SCA is a Bermuda corporation and, except as described below, neither it nor its non-United States subsidiaries have paid United States corporate income taxes on the basis that they are not engaged in a trade or business or otherwise subject to taxation in the U.S. However, because definitive identification of activities which constitute being engaged in a trade or business in the United States is not provided by the Internal Revenue Code of 1986, regulations or court decisions, there could be no assurance that the Internal Revenue Service will not contend that the Company or its non-United States subsidiaries are engaged in a trade or business or otherwise subject to taxation in the U.S. If the Company or its non-United States subsidiaries were considered to be engaged in a trade or business in the United States (and, if the Company or such subsidiaries were to qualify for the benefits under the income tax treaty between the United States and Bermuda and other countries in which the Company operates, such business were attributable to a “permanent establishment” in the U.S.), the Company or such subsidiaries could be subject to United States tax at regular tax rates on its taxable income that is effectively connected with its United States trade or business plus an additional 30% “branch profits” tax on such income remaining after the regular tax, in which case there could be a significant adverse effect on the Company’s results of operations and financial condition.
In addition, in connection with the IPO, XLCA has agreed with certain of the rating agencies that, until the second anniversary of the effective date of the IPO it will not declare or grant dividends on its common stock without the prior consent of those rating agencies, other than to fund certain parent holding company operating expenses and debt service requirements and to fund dividends on our preferred stock and “nominal” dividends on our common stock.
XLFA is subject to Bermuda regulatory constraints that will affect its ability to pay dividends on its common shares and to make other payments to us. Under Bermuda’s Insurance Act 1978, as amended, and related regulations, which we refer to as the “Insurance Act,” XLFA is required to maintain a minimum solvency margin and minimum liquidity ratio and is prohibited from declaring or paying dividends if such payment would result in its non-compliance with these requirements. In addition, under the Companies Act 1981 of Bermuda, as amended, which we refer to as the “Companies Act,” XLFA may not declare or pay a dividend, or make a distribution out of its contributed surplus, if there are reasonable grounds for believing that (1) it is, or would after the payment be, unable to pay its liabilities as they become due; or (2) the realizable value of its assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts (as such terms are defined in the Companies Act). Furthermore, in order to reduce its total statutory capital by 15% or more, XLFA would require the prior approval of the BMA.
Credit default swaps insured by the Company meet the definition of a derivative under SFAS No. 133. The Company has recorded these products at fair value, modeled on prevailing market conditions and certain other factors relating to the structure and credit quality of the transaction. The Company considers credit default swaps to be, in substance, financial guarantee contracts as the Company intends to hold them to maturity. See Note 2 for information regarding the Company’s accounting policy for credit default swaps.
Restricted stock awards issued under the 1991 Performance Incentive Program vest as set forth in the applicable award agreements. These shares contained certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability. Restricted stock issued to employees of the Company under the plan totaled 0 shares, 113,850 shares, and 66,675 shares in 2006, 2005, and 2004, respectively.