| | March 31,
2003 | | March 31,
2002 | |
| |
| |
| |
| Cash used in operating activities | | | | | | | |
| Net loss | | $ | (2,400 | ) | $ | (2,520 | ) |
| |
| |
| |
Adjustments to reconcile net loss to net cash used in
operating activities | | | | | | | |
| Net realized losses (gains) on sale of investments | | | 62 | | | (135 | ) |
Net realized and unrealized losses (gains) on credit derivatives
excluding cash received and paid | | | 64 | | | (101 | ) |
| Amortization of premium on bonds | | | 201 | | | 43 | |
| (Decrease) increase in unpaid losses and loss adjustment expenses, net | | | (318 | ) | | 172 | |
| Increase in deferred premium revenue | | | 1,282 | | | 1,261 | |
| Deferred ceding commission, net | | | 814 | | | 203 | |
| Decrease in reinsurance premiums payable | | | (868 | ) | | (8,371 | ) |
| Increase in premiums receivable | | | (1,378 | ) | | (382 | ) |
| Decrease (increase) in accrued investment income | | | 171 | | | (53 | ) |
| Deferred Federal income tax liability | | | (1,610 | ) | | (1,237 | ) |
| (Decrease) increase in accounts payable and accrued expenses | | | (1,758 | ) | | 613 | |
| Increase (decrease) in intercompany payable to affiliates | | | 685 | | | (7,431 | ) |
| Other | | | 2 | | | 495 | |
| |
| |
| |
| Total adjustments | | | (2,651 | ) | | (14,923 | ) |
| |
| |
| |
| Net cash used in operating activities | | | (5,051 | ) | | (17,443 | ) |
| |
| |
| |
| Cash flows from investing activities | | | | | | | |
| Proceeds from sale of fixed maturities and short term investments | | | 20,143 | | | 5,386 | |
| Proceeds from maturity of fixed maturities and short term investments | | | 20,154 | | | 75,449 | |
| Purchase of fixed maturities and short term investments | | | (38,886 | ) | | (69,593 | ) |
| Payable for securities purchased | | | — | | | (12,974 | ) |
| |
| |
| |
| Net cash provided by (used in) investing activities | | | 1,411 | | | (1,732 | ) |
| |
| |
| |
| Decrease in cash and cash equivalents | | | (3,640 | ) | | (19,175 | ) |
| Cash and cash equivalents – beginning of year | | | 44,714 | | | 39,204 | |
| |
| |
| |
| Cash and cash equivalents – end of period | | $ | 41,074 | | $ | 20,029 | |
| |
| |
| |
| Taxes paid | | $ | — | | $ | 143 | |
| |
| |
| |
See notes to condensed consolidated financial statements.
XL CAPITAL ASSURANCE INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
(UNAUDITED)
1. ORGANIZATION AND OWNERSHIP
XL Capital Assurance Inc. and subsidiary (the “Company”) is a wholly owned subsidiary of XL Reinsurance America Inc. (“XL RE AM”), formerly known as NAC Reinsurance Corporation, which is an indirect wholly owned subsidiary of X.L. America, Inc. (“XLA”). XLA is an indirect wholly owned subsidiary of XL Insurance (Bermuda) Ltd (“XL Insurance”). XL Insurance is an indirect wholly owned subsidiary of XL Capital Ltd (“XL Capital”), a holding company incorporated in the Cayman Islands. XLA is XL Capital’s U.S. holding company.
The Company is an insurance company domiciled in the State of New York. The Company is engaged in the business of providing credit enhancement by writing financial guaranty insurance policies on asset-backed structured finance, essential infrastructure project finance, future flow, public finance transactions, and credit default swap obligations. The Company issued its first insurance contract in December 2000.
The Company was formed on September 13, 1999 and became licensed as a financial guaranty insurer in New York upon its merger with an affiliate, X.L. Risk Solutions, Inc. on September 30, 1999.
On February 22, 2001 XL RE AM acquired all the outstanding shares of The London Assurance of America, Inc. (“LAA”). LAA was incorporated in New York on July 25, 1991. Prior to its purchase by XL RE AM, LAA was a New York-domiciled property and casualty insurance company that was licensed in 44 states and the District of Columbia. The business previously underwritten through LAA, together with all the liabilities of LAA, was reinsured effective July 1, 2000 to an affiliate of LAA under a reinsurance, assignment and assumption agreement. XL RE AM caused the Company to merge with and into LAA on the day of the acquisition (with LAA as the surviving entity) and for LAA to simultaneously change its name to XL Capital Assurance Inc. and Subsidiary.
On May 15, 2002, the Company capitalized XL Capital Assurance (U.K.) Limited, (“XLCA-UK”), an insurance company organized under the laws of England. XLCA-UK is a direct wholly owned subsidiary of the Company.
2. BASIS OF PRESENTATION AND CONSOLIDATION
The accompanying condensed financial statements include the accounts of the Company and its subsidiary and are unaudited. The results include the consolidation of XLCA-UK, accounted for as a subsidiary with effect from April 24, 2002. In the opinion of management, all adjustments, which include normal recurring adjustments considered necessary to present fairly the financial position, results of operations and cash flows at March 31, 2003 and for all periods presented, have been made and all significant intercompany accounts and transactions have been eliminated.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These statements should be read in conjunction with the Company’s December 31, 2002 financial statements and notes thereto. The accompanying condensed balance sheet as of December 31, 2002 was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. The results of operations for the periods ended March 31, 2003 and 2002 are not necessarily indicative of the operating results for the full year.
XL CAPITAL ASSURANCE INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
(UNAUDITED)
3. CREDIT DEFAULT SWAPS
Credit default swaps are recorded at fair value which is determined using a model developed by the Company and is dependent upon a number of factors including changes in interest rates, credit spreads, changes in credit quality, expected recovery rates and other market factors. The change resulting from movements in these factors is unrealized as the credit default swaps are not traded to realize this value and is included in net realized and unrealized gains and losses on credit derivatives. Other elements of the change in fair value are based upon pricing established at the inception of the contract. Credit default swaps are considered by the Company to be, in substance, financial guaranty contracts as the Company has the intent to hold them to maturity.
The credit default swap portfolio is structured pools of corporate obligations that were awarded investment grade ratings at the deals’ inception. Approximately 78% of the portfolio is rated “AAA” with the remaining 22% allocated to other investment grade ratings. The weighted average term of the contracts in force was approximately 5.18 years. Credit default swaps represent approximately 15% of the Company’s credit enhancement par exposure. The portfolios are currently performing as expected.
The net fair value adjustment for the periods ended March 31, 2003 and 2002 was an unrealized loss of $64,323 and an unrealized gain of $101,106, respectively. At March 31, 2003 and December 31, 2002, the Company had a net credit default swap liability of $756,451 (gross liability of $7,564,514 less amount ceded of $6,808,063) and $692,128 (gross liability of $6,921,280 less amount ceded of $6,229,152), respectively.
4. RECENT ACCOUNTING PRONOUNCEMENTS
In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS No. 148”). SFAS No. 148 amends FASB Statement No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the prior disclosure guidance and requires prominent disclosures about the method of accounting for stock-based employee compensation and the effect of the method used on the reported results. The Company's ultimate parent, XL Capital Ltd. recorded option expense for options granted on behalf of its subsidiaries subsequent to January 1, 2003, in accordance with SFAS No. 123, as amended by SFAS No. 148. The effect of the adoption of SFAS No. 148 on the company for the first quarter of 2003 was not significant.
In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities”. FIN 46 establishes a consolidation policy for those entities where a voting interest consolidation policy is considered appropriate. The key determining factors of whether FIN 46 is applied is the amount, nature, and characteristics of the entity’s equity investment at risk. Additionally, FIN 46 requires that the Company disclose the nature, purpose, size and activities of the variable interest entities and the maximum exposure to loss. The consolidation requirements of this standard apply to all variable interest entities created after January 31, 2003.
In underwriting financial guaranty insurance, the Company believes the risk of loss to be remote based upon the Company’s requirement that guaranteed obligations be investment grade prior to the provision of credit enhancement. Typically, in the case of asset backed securities and other structured obligations, such investment grade ratings are based upon subordination, cash reserves, and other structural protections. Consequently, the Company has determined that it does not have a significant variable interest in such variable interest entities. Accordingly, these variable interest entities have not been consolidated and the disclosure requirements of FIN 46 do not apply.
XL CAPITAL ASSURANCE INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
(UNAUDITED)
5. VARIABLE INTEREST ENTITIES
The Company participates in transactions which utilize variable interest entities in the ordinary course of the Company’s business. The Company provides financial guaranty insurance of structured transactions backed by pools of assets of specified types, municipal obligations supported by the issuers’ ability to charge fees for specified services or projects, and corporate risk obligations including essential infrastructure projects and obligations backed by receivables from future sales of commodities and other specified services. The obligations related to these transactions are often securitized through off-balance sheet variable interest entities. In synthetic transactions, the Company guarantees payment obligations of counterparties, including variable interest entities, through credit default swaps referencing asset portfolios. The Company only provides financial guaranty insurance of the senior interests that would otherwise be rated investment grade of these variable interest entities for fixed premiums at market rates, but does not hold any equity positions or subordinated debt in these off-balance sheet arrangements. Accordingly, the Company does not consider its participation to be a significant variable interest in the entity and therefore these variable interest entities are not consolidated.
6. TAX SHARING AGREEMENT
The Company’s Federal income tax return is consolidated with XLA and its subsidiaries. XLA maintains a tax sharing agreement with its subsidiaries, whereby the consolidated tax liability is allocated among affiliates in the ratio that each affiliate’s separate return liability bears to the sum of the separate return liabilities of all affiliates that are members of the consolidated group. In addition, a complementary method is used which results in reimbursement by profitable affiliates to loss affiliates for tax benefits generated by loss affiliates. At March 31, 2003 and December 31, 2002 the Company had a deferred Federal income tax asset of $6,705,000 and $5,003,000, respectively. Management has concluded that the Federal tax assets are more likely than not to be realized. Therefore, no valuation allowance has been provided.
7. FACULTATIVE QUOTA SHARE REINSURANCE TREATY
On October 6, 1999, the Company entered into a Facultative Quota Share Reinsurance Treaty (“Treaty”) with XL Financial Assurance Ltd. (“XLFA”), a Bermuda financial guaranty insurer, which is 86.8% owned by XL Insurance. The remaining 13.2% is owned by Financial Security Assurance Holdings Ltd., an unrelated company. The Treaty was amended and restated on June 22, 2001. Under the terms of this agreement, XLFA agrees to reinsure up to 90% of the Company’s acceptable risks. The Company is allowed a 30% ceding commission on premiums written ceded under the terms of this agreement.
XL Insurance entered into a reinsurance agreement dated October 6, 1999 with the Company, that unconditionally and irrevocably guarantees the full and complete performance of all obligations of XLFA to the Company under the above described facultative quota share reinsurance treaty. In connection with the amendment and restatement of the Treaty, XL Insurance entered into another reinsurance agreement guarantee on June 22, 2001.
The Company entered into a Facultative Master Certificate (the “XL Re Treaty”) with XL RE AM, a New York insurance corporation with Administrative Offices in Stamford, Connecticut and the direct parent of the Company. The XL Re Treaty is effective as of November 1, 2002. Under the terms of the XL Re Treaty, XL RE AM agrees automatically to reinsure risk assumed by the Company under financial guaranty insurance policies up to the amount necessary for the Company to comply with single risk limitations set forth in Section 6904(d) of the New York Insurance Laws. The reinsurance provided by XL RE AM may be on an excess of loss or quota share basis. The Company is allowed a 30% ceding commission on premiums written ceded under the terms of this agreement.
