(4)The loss and loss adjustment expense ratio is calculated by dividing loss and loss adjustment expenses by net earned premiums.
A sensitivity analysis is not appropriate for our other segment reserves and our mortgage guaranty IBNR, since the amounts are fully reserved or reinsured and could not impact our net income, unless the reinsurance recoverable becomes uncollectible.
us. In establishing IBNR, we use traditional actuarial methods to estimate the reporting lag of such claims based on historical experience, claim reviews and information reported by ceding companies. We record IBNR for mortgage guaranty reinsurance on two specific quota-share contracts that are in run-off within our mortgage guaranty segment. We also record IBNR for title reinsurance, auto residual value reinsurance and trade credit reinsurance within our other segment. The other segment represents lines of business we have exited or sold prior to the IPO.
Valuation models include the use of management estimates and current market information. Management is also required to make assumptions on how the fair value of derivative instruments are affected by current market conditions. Management considers factors such as current prices charged for similar agreements, performance of underlying assets, and our ability to obtain reinsurance for our insured obligations. Due to the inherent uncertainties of the assumptions used in the valuation models to determine the fair value of these derivative products, actual experience may differ from the estimates reflected in our consolidated financial statements, and the differences may be material.
The fair value adjustment recognized in our statement of operations for the year ended December 31, 2004 was a $52.5 million gain compared with a $98.4 million gain for the year ended December 31, 2003 and a $54.2 million loss for the year ended December 31, 2002. The change in fair value is related to many factors but primarily due to changes in credit spreads. For example, the 2004 gain of $52.5 primarily relates to an approximate 15-20% tightening in investment grade corporate spreads over that period, the 2003 gain of $98.4 million primarily relates to an approximate 60-65% tightening, and the 2002 loss of $54.2 million primarily relates to an approximate 20-25% widening.
Derivative financial instruments are recorded at fair value as required by FAS 133. However, as explained under "-Critical Accounting Estimates," we record part of the change in fair value in the loss and LAE reserves as well as in unearned premium reserves. The fair value adjustment for the year ended December 31, 2004 was a $52.5 million gain as compared with a $98.4 million gain for the year ended December 31, 2003 and a $54.2 million loss for the same period in 2002. The change in fair value is related to many factors but primarily due to tightening credit spreads. For example, the 2004 gain of $52.5 primarily relates to an approximate 15-20% tightening in investment grade corporate spreads over that period, the 2003 gain of $98.4 million primarily corresponds to an approximate 60-65% tightening, and the 2002 loss of $54.2 million corresponds to an approximate 20-25% widening of such spreads.
For the years ended December 31, 2004, 2003 and 2002, operating expenses were $67.8 million, $41.0 million and $31.0 million, respectively. The increase for 2004 was primarily due to $11.3 million of accelerated employee stock awards vesting, which occurred as part of the IPO in addition to various expenses incurred as a result of the establishment of a holding company. The increase in 2003 from 2002 is principally due to changes in staffing levels and other resources as we focused on growing the financial guaranty direct segment.
For the years ended December 31, 2004, 2003 and 2002, income tax expense was $50.5 million, $31.7 million and $10.6 million, respectively. The increase reflects increased underwriting profitability
The financial guaranty direct segment consists of our primary financial guaranty insurance business and our credit derivative business. Financial guaranty insurance provides an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due. Financial guaranty insurance may be issued to the holders of the insured obligations at the time of issuance of those obligations, or may be issued in the secondary market to holders of public bonds and structured securities. As an alternative to traditional financial guaranty insurance, credit protection on a particular security or issuer can also be provided through a credit derivative, such as a credit default swap. Under a credit default swap, the seller of protection makes a specified payment to the buyer of protection upon the occurrence of one or more specified credit events with respect to a reference obligation or a particular reference entity. Credit derivatives typically provide protection to a buyer rather than credit enhancement of an issue as in traditional financial guaranty insurance.
Gross and net written premiums in this segment generally have been received on an installment basis, reflecting our focus on the structured finance and credit derivatives markets. In 2004, 2003 and 2002, installment premiums represented 93%, 98% and 96% of gross written premiums in this segment, or $75.1 million, $69.6 million and $45.3 million, respectively. The contribution of upfront premiums to gross written premiums were $5.7 million, $1.5 million and $2.1 million in 2004, 2003 and 2002, respectively.
For the years ended December 31, 2004, 2003 and 2002, acquisition costs were $4.5 million, $2.2 million and $2.4 million, respectively. The increases in acquisition costs in 2004 compared with 2003 are primarily due to increases in transaction rating agency fees related to the growth in gross written premiums as well as the increase in the proportion of such premiums subject to premium taxes.
The table below summarized the financial results of our mortgage guaranty segment for the periods presented:
•AGC Affiliate Reinsurance Transaction: AGC entered into an excess of loss reinsurance contract with a subsidiary of ACE, effective January 1, 2001. Under the terms of this reinsurance contract, AGC paid $27.5 million in 2001 and $25.0 million in 2002 for ten years of reinsurance coverage. This coverage provided a $150.0 million aggregate limit. The cost and benefit from this contract are included in the other segment. We terminated this agreement effective June 30, 2003 and received a cash payment of $53.8 million, consisting of ceded unearned premium of $39.8 million, reinsurance recoverables on paid losses of $12.5 million and profit commissions receivable of $1.5 million. There was no earnings impact from the termination of this contract.
We anticipate that a major source of our liquidity, for the next twelve months and for the longer term, will be amounts paid by our operating subsidiaries as dividends. Certain of our operating subsidiaries are subject to restrictions on their ability to pay dividends. See "Business-Regulation." The amount available at AGC to pay dividends in 2005 with notice to, but without the prior approval of, the Maryland Insurance Commissioner is approximately $23.7 million (unaudited). Dividends paid by a U.S. company to a Bermuda holding company presently are subject to withholding tax at a rate of 30%. The amount available at AGRI to pay dividends in 2005 in compliance with Bermuda law is $555.1 million (unaudited). AGC has committed to S&P and Moody's that it will not pay more than $10.0 million per year in dividends.
In 2003, the net cash flows provided by operating activities decreased by $77.7 million despite the increase of $142.0 million in net income in 2003 compared with 2002. The increase in net income was primarily due to the change in the market value of derivative financial instruments as the unrealized gains (losses) on derivative financial instruments increased to $98.4 million in 2003 from $(54.2) million in 2002. This change had no cash flow impact. Operating cash flow was negatively impacted by the decrease in cash received on written premiums of approximately $70.0 million in 2003 compared with 2002 primarily driven by the decreased premium writings of equity layer credit protection in 2003, which is reflected in the change in unearned premium reserves in the statement of cash flows.
(3)We have estimated the timing of these payments based on our historical experience and our expectation of future payment patterns. However, the timing of these payments may vary significantly from the amounts shown above, especially for our portfolio reserves.
As of December 31, 2004 and 2003, the Company did not have any significant off-balance-sheet arrangements that were not accounted for or disclosed in the consolidated financial statements.
The $250.0 million credit facility is a 364-day facility available for general corporate purposes, and any amounts outstanding under the facility at its expiration will be due and payable one year following the facility's expiry. As of December 31, 2004, no amounts were outstanding under this facility nor have there been any borrowings under the life of this facility. Under the $250.0 million credit facility, AGC can borrow up to $250.0 million, Assured Guaranty Ltd. has a borrowing limit not to exceed $50.0 million, and Assured Guaranty (UK) Ltd. has a borrowing limit not to exceed $12.5 million. The $250.0 million credit facility's financial covenants require that Assured Guaranty: (a) maintain a minimum net worth of 75% of its pro forma net worth (determined as of the first required reporting date under the facility), (b) maintain an interest coverage ratio of at least 2.5:1, and (c) maintain a maximum debt-to-capital ratio of 30%. Assured Guaranty is in compliance with all of these financial covenants. In addition, the $250.0 million credit facility requires that AGC: (a) maintain qualified statutory capital of at least 80% of its statutory capital as of the fiscal quarter prior to the closing date of the facility, (b) maintain a ratio of aggregate net par outstanding to qualified statutory capital of not more than 150:1, and (c) maintain a maximum debt-to-capital ratio of 35%. AGC is in compliance with all of these financial covenants. While the obligations of the borrowers under the $250.0 million credit facility are several, a default by one borrower will give rise to a right of the lenders to terminate the facility and accelerate all amounts then outstanding.
Assured Guaranty Ltd. is a Bermuda-based holding company which provides, through its operating subsidiaries, credit enhancement products to the public finance, structured finance and mortgage markets. Credit enhancement products are financial guarantees or other types of support, including credit derivatives, that improve the credit of underlying debt obligations. Assured Guaranty Ltd. applies its credit expertise, risk management skills and capital markets experience to develop insurance, reinsurance and derivative products that meet the credit enhancement needs of its customers. Under a reinsurance agreement, the reinsurer, in consideration of a premium paid to it, agrees to indemnify another insurer, called the ceding company, for part or all of the liability of the ceding company under one or more insurance policies that the ceding company has issued. A derivative is a financial instrument whose characteristics and value depend upon the characteristics and value of an underlying security. Assured Guaranty Ltd. markets its products directly to and through financial institutions, serving the U.S. and international markets. Assured Guaranty Ltd.'s financial results include four principal business segments: financial guaranty direct, financial guaranty reinsurance, mortgage guaranty and other. These segments are further discussed in Note 22.
expected future loss payments and loss adjustment expenses ("LAE"), net of estimated recoveries, but before considering ceded reinsurance. This reserving method is different from case reserves established by traditional property and casualty insurance companies, which establish case reserves upon notification of a claim and establish incurred but not reported ("IBNR") reserves for the difference between actuarially estimated ultimate losses and recorded case reserves. Financial guaranty insurance and assumed reinsurance case reserves and related salvage and subrogation, if any, are discounted at 6%, which is the approximate taxable equivalent yield on our investment portfolio in all periods presented.
The following table outlines the Company's net income, basic and diluted earnings per share for the year ended December 31, 2004, had the compensation expense been determined in accordance with the fair value method recommended in FAS 123.
Certain products (principally credit protection oriented) issued by the Company have been deemed to meet the definition of a derivative under FAS 133. These products consist primarily of credit derivatives. In addition, the Company issued a few index-based derivative financial instruments prior to 2004. The Company uses derivative instruments primarily to offer credit protection to others. Effective January 1, 2001, the Company records these transactions at fair value. Where available, the Company uses quoted market prices to fair value these insured credit derivatives. If quoted prices are not available, particularly for senior layer collateralized debt obligations ("CDO") and equity layer credit protection, the fair value is estimated using valuation models for each type of credit protection. These models may be developed by third parties, such as rating agency models, or may be developed internally, depending on the circumstances. These models and the related assumptions are continually reevaluated by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely market information. The fair value of derivative financial instruments reflects the estimated cost to the Company to purchase protection on its outstanding exposures and is not an estimate of expected losses incurred. Due to the inherent uncertainties of the assumptions used in the valuation models to determine the fair value of these derivative products,
Approximately 26% and 25% of the Company's total investment portfolio as of December 31, 2004 and 2003, respectively, was composed of mortgage-backed securities ("MBS"), including collateralized mortgage obligations and commercial mortgage-backed securities. As of December 31, 2004 and 2003, the weighted average credit quality of the Company's entire investment portfolio was AA+.
No material investments of the Company were non-income producing for the years ended December 31, 2004, 2003 and 2002.
In 2002, the favorable prior year development of $7.5 million relates primarily to $3.3 million of higher than previously estimated salvage on a non-municipal transaction and $1.7 million of favorable development in the trade credit reinsurance line of business.
Prior to the IPO in April 2004, Assured Guaranty US Holdings Inc. ("AGUS"), Assured Guaranty Corp. ("AGC"), Assured Value Insurance Company ("AVIC"), AG Financial Products Inc. ("AGFP") and AFP Transferor Inc. ("AFP") had historically filed their U.S. income tax returns in the consolidated U.S. tax return of its former shareholder. For periods after April 2004, AGUS and its subsidiaries, AGC, AVIC, AGFP and AFP will file a consolidated federal income tax return. Assured Guaranty Overseas US Holdings Inc. ("AGOUS") and its subsidiaries, AGRO, Assured Guaranty Mortgage Insurance Company ("AGMIC"), ACE Capital Title Reinsurance (for the period ending April 15, 2004) and Assured Guaranty Inc., have historically filed a consolidated federal income tax return. AGRO, a Bermuda domiciled company, has elected under Section 953(d) of the Internal Revenue Code to be taxed as a U.S. domestic corporation. Each company, as a member of its respective consolidated tax return group, has paid its proportionate share of the consolidated federal tax burden for its group as if each company filed on a separate return basis with current period credit for net losses.
(1)The 2004 amount is 100% guaranteed by ACE INA Overseas Ins. Co. 13. Insurance Regulations
As of December 31, 2003, the Company had entered into the following credit facilities, which were available for general corporate purposes:
On November 8, 2004 the Company, AGRI and AGRO entered into a standby letter of credit agreement (the "LOC Agreement") with KeyBank National Association ("KeyBank"). Under the LOC Agreement, KeyBank will issue up to $50.0 million in letters of credit on the Company's behalf. The obligations of the Company, AGRI and AGRO under the LOC Agreement are joint and several. The letters of credit will be used to satisfy AGRI's or AGRO's obligations under certain reinsurance agreements and for general corporate purposes. The LOC Agreement expires April 28, 2005, but its term may be extended with the consent of KeyBank under certain circumstances. The LOC Agreement contains covenants that limit debt, liens, guaranties, loans and investments, dividends, liquidations, mergers, consolidations, acquisitions, sales of assets or subsidiaries and affiliate transactions. Most of these restrictions are subject to certain minimum thresholds and exceptions. The LOC Agreement also contains financial covenants that require the Company: (i) to maintain the ratio of consolidated debt to total capitalization at not greater than 0.30 to 1.0; (ii) to maintain consolidated net worth of at least seventy-five percent (75%) of its consolidated net worth as of June 30, 2004; and (iii) to maintain the consolidated interest coverage ratio for any test period ending on the last day of a fiscal quarter at not less than 2.50 to 1.0. In addition, the LOC Agreement provides that the obligations of KeyBank to issue letters of credit may be terminated, and the Company's obligations under the agreement may be accelerated, upon an event of default. As of December 31, 2004, no amounts were payable under any letter of credit issued under this facility.
In connection with the IPO, awards of options and restricted common shares were made to the Company's officers and employees. Each of the options will vest in equal annual installments over a three-year period and will expire on the tenth anniversary of the date of grant. The exercise price of the options is $18.00, the public offering price of the IPO. Restricted common shares will vest in equal annual installments over a four-year period. Options to purchase an aggregate of 1,873,300 common shares and an aggregate of 966,400 restricted common shares were issued in connection with the IPO. As of December 31, 2004, 4,705,208 common shares were available for grant under the Incentive Plan.