The Company undertakes no obligation to publicly correct or update any forward-looking statement if it later becomes aware that such results are not likely to be achieved.
The Company establishes two types of loss and loss adjustment expense (LAE) reserves for non-derivative financial guarantees: an unallocated loss reserve and case basis reserves. The unallocated loss reserve is established with respect to the Company’s entire insured portfolio. The Company’s unallocated loss reserve represents the Company’s estimate of losses that have or are probable to occur as a result of credit deterioration in the Company’s insured portfolio but which have not yet been specifically identified and applied to specific insured obligations.
The Company’s insurance operations are principally comprised of the activities of MBIA Corp. MBIA Corp. issues financial guarantees for municipal bonds, asset-backed and mortgage-backed securities, investor-owned utility bonds, bonds backed by publicly or privately funded public purpose projects, bonds issued by sovereign and sub-sovereign entities, obligations collateralized by diverse pools of corporate loans and credit default swaps and pools of corporate and asset-backed bonds, both in the new issue and secondary markets.
In 2004, GPW decreased 12% compared with 2003, reflecting declines in both U.S and non-U.S. business. NPW decreased 11% compared with 2003, resulting from the decline in GPW, slightly offset by lower cession rates on U.S. business. The growth in net premiums earned in 2004 compared with 2003 reflects the increase in new business written in past years, increased refundings and a decline in the use of reinsurance.
In 2004, global structured finance GPW increased 3% to $451 million from $436 million in 2003, resulting from an increase in non-U.S. business written. Overall, the global structured finance sector was adversely impacted by tight spreads and greater investor demand for uninsured transactions. NPW for 2004 increased 13% due to the increase in GPW and lower cession rates on both U.S. and non-U.S. business written. The 2004 cession rate on total global structured finance business written was 17%, which declined from a 24% cession rate in 2003. In 2004, global structured finance net premiums earned of $355 million increased 5% over 2003. This increase was driven by higher levels of new non-U.S. business written over the last two years and a declining cession rate.
NET GAINS AND LOSSES Net realized losses in the insurance operations were $8 million in 2005, compared with net realized gains of $109 million and $48 million in 2004 and 2003, respectively. In 2005, net realized losses were primarily due to $19 million of impairment losses on receivables the Company recorded through salvage and subrogation rights it obtained as a result of claim payments it previously made on insured credits. Partially offsetting the impairment losses were net gains from sales of investment securities. The net realized gains in 2004 were largely due to a $77 million realized gain resulting from the sale of a common stock investment MBIA Corp. purchased in 2002 and $41 million resulting from the termination of certain transactions that were accounted for as deposits. The increase in 2004 was partially offset by an $11 million realized loss resulting from an other-than-temporary impairment of a fixed-maturity security.
As a result of discussions in January and February 2005 between the SEC staff and several financial guarantee industry participants, including MBIA, the Financial Accounting Standards Board (FASB) staff is considering whether additional guidance with respect to accounting for financial guarantee insurance should be provided. In June 2005, the FASB decided to add to its agenda a project to consider the accounting by insurers for financial guarantee insurance. As part of this project, the FASB is considering several aspects of the insurance accounting model for financial guarantee insurers, including claims liability recognition, premium recognition and the related amortization of deferred policy acquisition costs. When the FASB or the SEC reaches a conclusion on this issue, the Company and its financial guarantor peers may be required to change some aspects of its loss reserving policies and the potential changes could extend to premium and expense recognition. The Company cannot currently assess how the FASB and SEC staff’s ultimate resolution of this issue will impact its loss reserving policy or the effect it might have on recognizing premium revenue and policy acquisition costs. Until the issue is resolved, the Company intends to continue to apply its existing policy with respect to the establishment of both case basis and unallocated loss reserves and the recognition of premium revenue and policy acquisition costs. A further description of the Company’s loss reserving policy is included in “Note 3: Significant Accounting Policies” in the Notes to Consolidated Financial Statements.
POLICY ACQUISITION COSTS AND OPERATING EXPENSES Expenses that vary with and are primarily related to the production of the Company’s insurance business (policy acquisition costs) are deferred and recognized over the period in which the related premiums are earned. If an insured bond issue is refunded and the related premium is earned early, the associated acquisition costs previously deferred are also recognized early.
Operating expenses increased 17% to $143 million in 2005 from $122 million in 2004. This increase was largely due to loss prevention costs, costs associated with the Company’s CPCT securities, consulting services and a decrease in the rate at which compensation costs are deferred as policy acquisition costs. In 2004, operating expenses increased 3% to $122 million from $119 million in 2003 largely due to higher compensation costs related to the expansion of the Company’s global operations, premiums related to the renewal of directors and officers’ liability insurance and loss prevention costs.
Net gains on derivative instruments and foreign exchange from the investment management services operations in 2005 were $43 million compared with net losses of $10 million and $9 million in 2004 and 2003, respectively. The net gains in 2005 were primarily generated from an increase in U.S. dollar interest rates resulting in higher market values on pay fixed/receive floating U.S. dollar interest rate swaps associated with the asset/liability products and conduit programs. Such swaps economically hedge against interest rate movements but do not qualify for hedge accounting treatment under SFAS 133. Similarly, the net losses on derivative instruments and foreign exchange in 2004 and 2003 were largely due to movements in interest rates on interest rate swaps associated with the asset/liability products and conduit programs.
Moody’s identified non-core activities as including investment management and related services and sponsored medium-term note programs. While Moody’s acknowledged that well managed non-core activities can provide certain benefits, it asserted that such activities introduce distinct risks that may contribute to stress at financial guaranty insurance companies. Moody’s also noted that significant growth in non-core activities could negatively impact the credit ratings assigned to affected financial guarantors if such growth occurred prior to publishing its findings. Moody’s expects to publish a report highlighting its findings upon completion of its review. While MBIA has had discussions with Moody’s with respect to its review, the Company cannot predict with certainty the outcome of the review or the effect the outcome will have on MBIA. However, MBIA does not anticipate that the outcome of the review will have a material impact on the Company’s ability to grow its investment management services operations.
On November 8, 2005, MBIA announced its decision to correct and restate its previously issued financial statements for 1998 and subsequent years in connection with potential settlements of investigations by the Securities and Exchange Commission (SEC) and the New York Attorney General’s Office (NYAG) regarding agreements entered into by its subsidiary, MBIA Insurance Corporation, in 1998. On November 12, 2005, MBIA filed with the SEC Amendment No. 1 on Form 10-K/A to its Form 10-K for the year ended December 31, 2004 to reflect the restatement of its financial statements as of and for the years ended December 31, 2004, 2003, 2002, 2001, 2000, 1999 and 1998.
On March 8, 2005, the Company announced its decision to restate its financial statements for 1998 and subsequent years to correct the accounting for the agreements with Converium and reflected this correction in the consolidated financial statements of its original Annual Report on Form 10-K for the year ended December 31, 2004. At that time, the Company believed that the accounting for the Excess of Loss Agreements and Quota Share Agreements with Munich Re and ARF was appropriate under Statement of Financial Accounting Standards (SFAS) 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts.”
Other investments include the Company’s interest in equity-oriented and equity method investments. The Company records its share of the unrealized gains and losses on equity-oriented investments, net of applicable deferred income taxes, in accumulated other comprehensive income in shareholders’ equity. The carrying amounts of equity method investments are initially recorded at cost and adjusted to recognize the Company’s share of the profits or losses, net of any intercompany gains and losses, of the investees subsequent to the purchase date. Such profits and losses are recorded within net investment income in the accompanying Consolidated Statements of Income. Dividends are applied as a reduction of the carrying amount of equity method investments.
Premiums ceded to reinsurers reduce the amount of earned premium the Company will recognize from its insurance policies. For both upfront and installment policies, ceded premium expense is recognized in earnings in proportion to and at the same time the related premium revenue is recognized. Ceding commission income is recognized in earnings at the time the related premium is recognized.
In January 2003, the FASB issued FIN 46, which was revised in December 2003 as FIN 46(R), as an interpretation of Accounting Research Bulletin No. (ARB) 51, “Consolidated Financial Statements.” FIN 46(R) addresses consolidation of VIEs by business enterprises. An entity is considered a VIE subject to consolidation if the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support or if the equity investors lack one of three characteristics of a controlling financial interest. First, the equity investors lack the ability to make decisions about the entity’s activities through voting rights or similar rights. Second, they do not bear the obligation to absorb the expected losses of the entity if they occur. Lastly, they do not claim the right to receive expected returns of the entity if they occur, which is the compensation for the risk of absorbing the expected losses. MBIA determined that FIN 46(R) applies to entities that it sponsors and, in certain cases, unaffiliated entities that it guarantees. See Note 6 for a further discussion on the impact of adoption of FIN 46(R) on the Company’s financial statements.
The Company’s investment objective is to optimize long-term, after-tax returns while emphasizing the preservation of capital through maintenance of high quality investments with adequate liquidity. The Company’s investment policies limit the amount of credit exposure to any one issuer. The fixed-maturity portfolio is comprised of high quality (average rating Aa) taxable and tax-exempt investments of diversified maturities.
The insurance operations constitute a reportable segment and provide an unconditional and irrevocable guarantee of the payment of principal and interest on insured obligations when due. MBIA issues financial guarantees for municipal bonds, asset-backed and mortgage-backed securities, investor-owned utility bonds, bonds backed by publicly or privately funded public-purpose projects, bonds issued by sovereign and sub-sovereign entities, obligations collateralized by diverse pools of corporate loans and credit default swaps and pools of corporate and asset-backed bonds, both in the new issue and secondary markets. This segment includes all activities related to global credit enhancement services provided principally by MBIA Corp. and its subsidiaries.
At December 31, 2005 and 2004, there were no assets associated with the Company’s discontinued operations. Identifiable assets at December 31, 2003 were $25.0 million. The identifiable assets in 2003 primarily consisted of cash, goodwill, property and equipment and other miscellaneous assets.
During 2005, 474,148 shares were purchased by the Company for settling awards under the Company’s long-term incentive plans.
The Company has $19.8 million of outstanding letters of credit for MBIA-MISC that are intended to support the net asset value of certain investment pools managed by MBIA-MISC. These letters of credit can be drawn upon in the event that the liquidation of such assets is required and the proceeds are less than the cost. In addition, the Company has issued commitments to three pooled investment programs managed or administered by MBIA-MISC and its subsidiary. These commitments cover losses in such programs should the net asset values per share decline below specified per share values. At December 31, 2005, the maximum amount of future payments that the Company would be required to make under these commitments was $2.7 billion. These commitments shall be in effect so long as MBIA-MISC and its subsidiary remain as manager or administrator and each program remains in compliance with its respective investment objectives and policies.
Effective January 1, 2002 the Company adopted the fair value recognition provisions of SFAS 123 and the modified prospective method of adoption under SFAS 148. Under the modified prospective method of adoption selected by the Company under the provisions of SFAS 148, employee stock option compensation expense for the years ended December 31, 2005, 2004 and 2003 totaled $18.6 million, $16.7 million and $26.4 million, respectively.