Assured Guaranty Municipal 10K 2002 Annual report | SEC Filing

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Exhibit 99.1

FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES

Consolidated Financial Statements and Report of Independent Accountants

December 31, 2002

FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS
AND REPORT OF INDEPENDENT ACCOUNTANTS
YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000

REPORT OF INDEPENDENT ACCOUNTANTS		1
CONSOLIDATED FINANCIAL STATEMENTS:
Consolidated Balance Sheets		2
Consolidated Statements of Operations and Comprehensive Income		3
Consolidated Statements of Changes in Shareholder's Equity		4
Consolidated Statements of Cash Flows		5
Notes to Consolidated Financial Statements		6

The New York State Insurance Department recognizes only statutory accounting practices for determining and reporting the financial condition and results of operations of an insurance company, for determining its solvency under the New York Insurance Law, and for determining whether its financial condition warrants the payment of a dividend to its stockholders. No consideration is given by the New York State Insurance Department to financial statements prepared in accordance with accounting principles generally accepted in the United States of America in making such determinations.

REPORT OF INDEPENDENT ACCOUNTANTS

To the Shareholder and Board of Directors
of Financial Security Assurance Inc.:

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and comprehensive income, changes in shareholder's equity, and cash flows present fairly, in all material respects, the financial position of Financial Security Assurance Inc. and Subsidiaries (the Company) at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP

PricewaterhouseCoopers LLP
New York, New York
February 6, 2003

FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data)

		December 31, 2002		December 31, 2001
ASSETS
Bonds at market value (amortized cost of $2,597,599 and $2,211,247)		$	2,811,747	$	2,303,431
Equity investments at market value (cost of $10,000)					10,070
Short-term investments			364,565		213,212

	Total investments		3,176,312		2,526,713
Cash			27,560		5,882
Deferred acquisition costs			253,777		240,492
Prepaid reinsurance premiums			557,659		420,798
Reinsurance recoverable on unpaid losses			75,950		28,880
Securitized loans at cost			431,718
Investment in unconsolidated affiliate			52,206		49,726
Other assets			206,458		165,788

	TOTAL ASSETS	$	4,781,640	$	3,438,279

LIABILITIES AND MINORITY INTEREST AND SHAREHOLDER'S EQUITY
Deferred premium revenue		$	1,450,211	$	1,090,332
Losses and loss adjustment expenses			223,618		114,428
Deferred federal income taxes			153,333		133,877
Ceded reinsurance balances payable			79,870		34,961
Notes payable to affiliate			431,360
Payable for securities purchased			2,481		28,214
Long-term debt			212,850		144,000
Minority interest			52,841		46,157
Accrued expenses and other liabilities			203,751		147,638

	TOTAL LIABILITIES AND MINORITY INTEREST		2,810,315		1,739,607

COMMITMENTS AND CONTINGENCIES
Common stock (400 shares authorized, issued and outstanding; par value of $37,500 per share)			15,000		15,000
Additional paid-in capital			813,002		794,797
Accumulated other comprehensive income [net of deferred income tax provision of $70,889 and $29,334]			143,260		62,920
Accumulated earnings			1,000,063		825,955

	TOTAL SHAREHOLDER'S EQUITY		1,971,325		1,698,672

	TOTAL LIABILITIES AND MINORITY INTEREST AND SHAREHOLDER'S EQUITY	$	4,781,640	$	3,438,279

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(Dollars in thousands)

			Years Ended December 31,
			2002			2001			2000
REVENUES:
	Net premiums written		$	535,956		$	319,638		$	218,138

	Premiums earned		$	318,089		$	230,999		$	192,149
	Net investment income			137,606			127,412			119,112
	Net realized gains (losses)			28,399			6,282			(31,468	)
	Net realized and unrealized gains (losses) on derivatives			(87,396	)		6,742
	Other income			6,018			1,097			1,445

		TOTAL REVENUES		402,716			372,532			281,238

EXPENSES:
	Losses and loss adjustment expenses			65,613			12,497			9,403
	Interest expense			12,174			5,762			6,000
	Policy acquisition costs			54,093			41,375			37,602
	Merger Related Expenses									33,912
	Other operating expenses			46,373			38,436			33,143

		TOTAL EXPENSES		178,253			98,070			120,060

Minority interest and equity in earnings of unconsolidated affiliates				2,461			(573	)		(2,205	)

INCOME BEFORE INCOME TAXES				226,924			273,889			158,973

Provision for income taxes:
	Current			68,033			45,361			23,913
	Deferred			(23,888	)		15,949			11,725

	Total provision			44,145			61,310			35,638

		NET INCOME		182,779			212,579			123,335

OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX:
	Unrealized gains (losses) on securities:
		Holding gains (losses) arising during period [net of deferred income tax provision (benefit) of $49,196, $(7,133) and $47,664]		101,098			(2,291	)		92,126
		Less: reclassification adjustment for gains (losses) included in net income [net of deferred income tax provision (benefit) of $7,641, $1,940 and $(10,375)]		20,758			4,342			(21,093	)

		Other comprehensive income (loss)		80,340			(6,633	)		113,219

	COMPREHENSIVE INCOME		$	263,119		$	205,946		$	236,554

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER'S EQUITY
(Dollars in thousands)

	Common Stock		Additional Paid-In Capital			Unrealized Gain (Loss) on Investments			Accumulated Earnings			Total
BALANCE, December 31, 1999	$	15,000	$	832,556		$	(43,666	)	$	491,056		$	1,294,946
Net income										123,335			123,335
Net change in accumulated comprehensive income (net of deferred income tax provision of $58,040)							113,219						113,219
Stock repurchase				(55,000	)								(55,000	)
Deferred equity payout by Parent				8,485									8,485
Capital contribution from Parent				3,881									3,881

BALANCE, December 31, 2000		15,000		789,922			69,553			614,391			1,488,866
Net income										212,579			212,579
Net change in accumulated comprehensive income (net of deferred income tax benefit of $5,193)							(6,633	)					(6,633	)
Dividends paid										(1,589	)		(1,589	)
Capital contribution from Parent				4,875									4,875
Other										574			574

BALANCE, December 31, 2001		15,000		794,797			62,920			825,955			1,698,672
Net income										182,779			182,779
Net change in accumulated comprehensive Income (net of deferred income tax benefit of $41,555)							80,340						80,340
Capital contribution from Parent				18,205									18,205
Dividends paid										(8,671	)		(8,671	)

BALANCE, December 31, 2002	$	15,000	$	813,002		$	143,260		$	1,000,063		$	1,971,325

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)

			Years Ended December 31,
			2002			2001			2000
Cash flows from operating activities:
	Premiums received, net		$	575,889		$	287,533		$	225,253
	Policy acquisition and other operating expenses paid, net			(101,215	)		(79,098	)		(73,358	)
	Termination fee on derivative			(38,000	)
	Recoverable advances recovered (paid)			5,010			(1,175	)		1,495
	Losses and loss adjustment expenses recovered (paid)			(2,403	)		(18,687	)		4,571
	Net investment income received			127,144			119,744			106,039
	Federal income taxes paid			(76,099	)		(35,117	)		(27,441	)
	Interest paid			(12,920	)		(4,500	)		(6,000	)
	Other			(1,682	)		5,385			(208	)

		Net cash provided by operating activities		475,724			274,085			230,351

Cash flows from investing activities:
	Proceeds from sales of bonds			747,470			483,892			1,440,090
	Proceeds from sales of equity investments
	Purchases of bonds and securitized loans			(1,543,216	)		(679,606	)		(1,742,929	)
	Purchases of equity investments
	Purchases of property and equipment			(5,591	)		(4,218	)		(3,727	)
	Net decrease (increase) in short-term investments			(150,328	)		(99,407	)		148,445
	Other investments			6,080			1,672			(14,330	)

		Net cash used for investing activities		(945,585	)		(297,667	)		(172,451	)

Cash flows from financing activities:
	Surplus notes issued			96,850			50,000
	Surplus notes repaid			(28,000	)		(26,000	)
	Issuance of notes payable			437,295
	Repayment of notes payable			(5,935	)
	Capital contribution(a)
	Dividends paid			(8,671	)		(1,589	)
	Stock repurchase									(55,000	)

		Net cash provided (used) by financing activities		491,539			22,411			(55,000	)

Net increase (decrease) in cash				21,678			(1,171	)		2,900
Cash at beginning of year				5,882			7,053			4,153

Cash at end of year			$	27,560		$	5,882		$	7,053

(a): In 2002, 2001 and 2000, the Company received a tax benefit of $18,205, $4,875 and $3,881, respectively, by utilizing its Parent's losses. These amounts were recorded as a capital contribution.
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(Dollars in thousands)

		Years Ended December 31,
		2002			2001			2000
Reconciliation of net income to net cash flows from operating activities:
Net income		$	182,779		$	212,579		$	123,335
	Increase in accrued investment income		(3,464	)		(894	)		(6,436	)
	Increase in deferred premium revenue and related foreign exchange adjustment		223,018			86,825			23,668
	Decrease (increase) in deferred acquisition costs		(13,285	)		(39,356	)		(3,088	)
	Increase in current federal income taxes payable		97			15,910			1,541
	Increase (decrease) in unpaid losses and loss adjustment expenses		62,120			(6,171	)		13,903
	Increase (decrease) in amounts withheld for others					(1,271	)		18
	Provision for deferred income taxes		(23,888	)		15,949			11,725
	Net realized losses (gains) on investments		(28,399	)		(6,282	)		31,468
	Depreciation and accretion of bond discount		(4,334	)		(4,504	)		(5,005	)
	Minority interest and equity in earnings of unconsolidated affiliates		(2,461	)		573			2,205
	Change in other assets and liabilities		83,541			727			37,017

Cash provided by operating activities		$	475,724		$	274,085		$	230,351

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000

1. ORGANIZATION AND OWNERSHIP

Financial Security Assurance Inc. (FSA or the Company), a wholly owned subsidiary of Financial Security Assurance Holdings Ltd. (the Parent), is an insurance company domiciled in the State of New York. The Company is engaged in providing financial guaranty insurance on asset-backed and municipal obligations. The Company's underwriting policy is to insure asset-backed and municipal obligations that it determines would be of investment-grade quality without the benefit of the Company's insurance. The asset-backed obligations insured by the Company are generally issued in structured transactions and are backed by pools of assets, such as residential mortgage loans, consumer or trade receivables, securities or other assets having an ascertainable cash flow or market value. The Company also insures synthetic asset-backed obligations that generally take the form of credit default swap (CDS) obligations or credit-linked notes that reference pools of securities or loans, with a defined deductible to cover credit risks associated with the referenced securities or loans. In addition, the Company insures guaranteed investment contracts (GICs) issued by FSA Capital Markets Services LLC and FSA Capital Management Services LLC (collectively, CMS), wholly owned subsidiaries of the Parent. The municipal obligations insured by the Company consist primarily of general obligation bonds that are supported by the issuers' taxing power and special revenue bonds and other special obligations of states and local governments that are supported by the issuers' ability to impose and collect fees and charges for public services or specific projects. Financial guaranty insurance written by the Company guarantees scheduled payments on an issuer's obligation. In the case of a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other amounts due in accordance with the obligation's original payment schedule or, at its option, to pay such amounts on an accelerated basis.

The Company expects to continue to emphasize a diversified insured portfolio characterized by insurance of both asset-backed and municipal obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. The Company's insured portfolio consists primarily of asset-backed and municipal obligations originated in the United States of America, but the Company has also written and continues to pursue business in Europe and the Asia Pacific region.

On July 5, 2000, the Parent completed a merger in which the Parent became a direct subsidiary of Dexia Holdings Inc., which, in turn, is owned 90% by Dexia Crédit Local and 10% by Dexia S.A. (Dexia), a Belgium corporation whose shares are traded on the Euronext Brussels and Euronext Paris markets as well as on the Luxembourg Stock Exchange. The net effect of the merger, reflected in the December 31, 2000 financial statements, decreased net income by $28.9 million. In addition, in connection with the merger, the Company repurchased $55,000,000 of its stock from its Parent in July 2000.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP), which differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 5). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities in the Company's consolidated balance sheets at December 31, 2002

and 2001 and the reported amounts of revenues and expenses in the consolidated statements of operations and comprehensive income during the years ended December 31, 2002, 2001 and 2000. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses and the deferral and amortization of deferred policy acquisition costs. Actual results may differ from those estimates. Significant accounting policies under GAAP are as follows:

Basis of Presentation

The consolidated financial statements include the accounts of the Company and its direct and indirect subsidiaries, FSA Insurance Company, Financial Security Assurance International Ltd. (FSA International), and Financial Security Assurance (U.K.) Limited (collectively, the Subsidiaries). All intercompany accounts and transactions have been eliminated. Certain prior-year balances have been reclassified to conform to the 2002 presentation.

Investments

Investments in debt securities designated as available for sale are carried at market value. Equity investments are carried at market value. Any resulting unrealized gain or loss is reflected as a separate component of shareholder's equity, net of applicable deferred income taxes. All of the Company's debt and equity securities are classified as available for sale.

Bond discounts and premiums are amortized on the effective yield method over the remaining terms of the securities acquired. For mortgage-backed securities, and any other holdings for which prepayment risk may be significant, assumptions regarding prepayments are evaluated periodically and revised as necessary. Any adjustments required due to the resulting change in effective yields are recognized in current income. Short-term investments, which are those investments with a maturity of less than one year at time of purchase, are carried at market value, which approximates cost. Cash equivalents are amounts deposited in money market funds and investments with a maturity at time of purchase of three months or less and are included in short-term investments. Realized gains or losses on sale of investments are determined on the basis of specific identification. Investment income is recorded as earned.

Investments in unconsolidated affiliates are reported in other assets and are based on the equity method of accounting (see Note 16).

Derivatives

The Company has also insured a number of credit default swap agreements that it intends, in each case, to hold for the full term of the agreement. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred. Changes in fair value are recorded in net realized and unrealized gains (losses) on derivative instruments and in other assets or other liabilities. The Company uses quoted market prices, when available, to determine fair value. If quoted prices are not available, management uses internally developed estimates. Due to a lack of a quoted market for the CDS obligations written by the Company, estimates generated from the Company's valuation process may differ materially from values that may be realized in market transactions.

Premium Revenue Recognition

Gross and ceded premiums are earned in proportion to the amount of risk outstanding over the expected period of coverage. The amount of risk outstanding is equal to the sum of the par amount of

debt insured. Deferred premium revenue and prepaid reinsurance premiums represent the portion of premium that is applicable to coverage of risk to be provided in the future on policies in force. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred premium revenue and prepaid reinsurance premium, less any amount credited to a refunding issue insured by the Company, are recognized.

Losses and Loss Adjustment Expenses

The Company establishes a case basis reserve for unpaid losses and loss adjustment expenses for the net present value of the estimated loss when, in management's opinion, the likelihood of a future loss on a particular insured obligation is probable and determinable at the balance sheet date. The estimated loss on a transaction is discounted using the then current risk-free rates ranging from 4.77% to 6.1%. For collateralized debt obligations (CDOs), a case basis reserve is recorded to the extent that the over-collateralization ratio (non-defaulted collateral at par value divided by the debt insured) has fallen below 100%.

The Company also maintains a non-specific general reserve, which is available to be applied against future additions or accretions to existing case basis reserves or to new case basis reserves to be established in the future. The general reserve is calculated by applying a loss factor to the total net par amount outstanding of the Company's insured obligations over the term of such insured obligations and discounting the result at the then current risk-free rates. The loss factor used for this purpose has been determined based upon an independent rating agency study of bond defaults and the Company's portfolio characteristics and history.

Management of the Company periodically evaluates its estimates for losses and loss adjustment expenses and establishes reserves that management believes are adequate to cover the net present value of the ultimate net cost of claims. The reserves are necessarily based on estimates, and there can be no assurance that the ultimate liability will not differ from such estimates. The Company will, on an ongoing basis, monitor these reserves and may periodically adjust such reserves based on the Company's actual loss experience, its future mix of business, and future economic conditions.

Deferred Acquisition Costs

Deferred acquisition costs comprise those expenses that vary with, and are primarily related to, the production of business, including commissions paid on reinsurance assumed, compensation and related costs of underwriting and marketing personnel, certain rating agency fees, premium taxes and certain other underwriting expenses, reduced by ceding commission income on premiums ceded to reinsurers. The Company does not defer acquisition costs relating to GICs issued by CMS, except for brokerage fees. Deferred acquisition costs and the cost of acquired business are amortized over the period in which the related premiums are earned. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred acquisition cost is recognized. Recoverability of deferred acquisition costs is determined by considering anticipated losses and loss adjustment expenses.

Federal Income Taxes

The provision for income taxes consists of an amount for taxes currently payable and a provision for the deferred tax consequences of temporary differences between tax basis of assets and liabilities and that reported in the financial statements.

Non-interest bearing tax and loss bonds are purchased for the tax benefit resulting from deducting contingency reserves as provided under Internal Revenue Code Section 832(e). The Company records the purchase of tax and loss bonds as pre-payments of federal income taxes and includes them in other assets.

Segment Reporting

As a monoline financial guaranty insurer, the Company has no reportable operating segments.

3. INVESTMENTS

Bonds at amortized cost of $8,474,000 and $8,493,000 at December 31, 2002 and 2001, respectively, were on deposit with state regulatory authorities as required by insurance regulations.

Consolidated net investment income consisted of the following (in thousands):

	Years Ended December 31,
	2002			2001			2000
Bonds	$	136,352		$	125,531		$	114,021
Equity investments		294			504			505
Short-term investments		3,337			3,652			6,218
Investment expenses		(2,377	)		(2,275	)		(1,632	)

Net investment income	$	137,606		$	127,412		$	119,112

The credit quality of bonds at December 31, 2002 was as follows:

Rating	Percent of Bonds
AAA	75.6	%
AA	19.8
A	4.5
Other	0.1

Of the AAA rated bonds included in the investment portfolio, 8.7% were AAA by virtue of insurance provided by the Company.

The amortized cost and estimated market value of bonds were as follows (in thousands):

December 31, 2002		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Market Value
U.S. Treasury securities and obligations of U.S. government corporations and agencies		$	60,101	$	7,178	$	(26	)	$	67,253
Obligations of states and political Subdivisions			2,034,691		186,352		(174	)		2,220,869
Mortgage-backed securities			250,092		8,203		(141	)		258,154
Corporate securities			177,934		10,547		(35	)		188,446
Asset-backed securities			74,781		2,244					77,025

	Total	$	2,597,599	$	214,524	$	(376	)	$	2,811,747

December 31, 2001		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Market Value
U.S. Treasury securities and obligations of U.S. government corporations and agencies		$	66,947	$	2,247	$	(257	)	$	68,937
Obligations of states and political Subdivisions			1,692,288		78,706		(5,276	)		1,765,718
Foreign securities			5,780		806					6,586
Mortgage-backed securities			227,954		8,578		(549	)		235,983
Corporate securities			173,776		6,759		(710	)		179,825
Asset-backed securities			44,502		1,984		(104	)		46,382

	Total	$	2,211,247	$	99,080	$	(6,896	)	$	2,303,431

The change in net unrealized gains (losses) consisted of (in thousands):

		Years Ended December 31,
		2002			2001			2000
Bonds		$	121,964		$	(12,156	)	$	171,187
Equity investments			(70	)		330			72

	Change in net unrealized gains (losses)	$	121,894		$	(11,826	)	$	171,259

The amortized cost and estimated market value of bonds at December 31, 2002, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.

		Amortized		Estimated Market Value
Due in one year or less		$	999	$	1,028
Due after one year through five years			141,441		148,059
Due after five years through ten years			261,060		288,388
Due after ten years			1,869,226		2,039,093
Mortgage-backed securities (stated maturities of 1 to 30 years)			250,092		258,154
Asset-backed securities (stated maturities of 1 to 14 years)			74,781		77,025

	Total	$	2,597,599	$	2,811,747

Proceeds from sales of bonds during 2002, 2001 and 2000 were $733,926,000, $483,127,000 and $1,404,050,000, respectively. Gross gains of $29,302,000, $8,007,000 and $9,741,000 and gross losses of $1,098, $1,725,000 and $41,145,000 were realized on sales in 2002, 2001 and 2000, respectively.

Equity investments had gross unrealized gains of $75,000 and gross unrealized losses of $5,000 as of December 31, 2001.

4. DEFERRED ACQUISITION COSTS

Acquisition costs deferred for amortization against future income and the related amortization charged to expenses are as follows (in thousands):

			Years Ended December 31,
			2002			2001			2000
Balance, beginning of period			$	240,492		$	201,136		$	198,048

Costs deferred during the period:
	Ceding commission income			(68,464	)		(41,935	)		(42,496	)
	Premium taxes			13,401			9,653			5,934
	Compensation and other acquisition costs			122,441			113,013			77,252

		Total		67,378			80,731			40,690

Costs amortized during the period				(54,093	)		(41,375	)		(37,602	)

Balance, end of period			$	253,777		$	240,492		$	201,136

5. STATUTORY ACCOUNTING PRACTICES

GAAP for the Company differs in certain significant respects from accounting practices prescribed or permitted by insurance regulatory authorities. The principal differences result from the following statutory accounting practices:

•

Upfront premiums on municipal business are recognized as earned when related principal and interest have expired rather than over the expected coverage period;

•

Acquisition costs are charged to operations as incurred rather than as related premiums are earned;

•

A contingency reserve (rather than a general reserve) is computed based on the following statutory requirements:

1): For all policies written prior to July 1, 1989, an amount equal to 50% of cumulative earned premiums less permitted reductions plus
2): For all policies written on or after July 1, 1989, an amount equal to the greater of 50% of premiums written for each category of insured obligation or a designated percentage of principal guaranteed for that category. These amounts are provided each quarter as either 1/60th or 1/80th of the total required for each category, less permitted reductions;

•: Certain assets designated as "non-admitted assets" are charged directly to statutory surplus but are reflected as assets under GAAP;
•: Bonds are carried at amortized cost; and
•: Surplus notes are recognized as surplus rather than as a liability.

A reconciliation of net income for the calendar years 2002, 2001 and 2000 and shareholder's equity at December 31, 2002 and 2001, reported by the Company on a GAAP basis, to the amounts reported by the Subsidiaries on a statutory basis, is as follows (in thousands):

Net Income:	2002			2001			2000
GAAP BASIS	$	182,779		$	212,579		$	123,335
Premium revenue recognition		(19,624	)		(23,113	)		(13,824	)
Losses and loss adjustment expenses incurred		20,585			3,867			10,233
Deferred acquisition costs		(13,285	)		(39,356	)		(3,088	)
Deferred income tax provision		(23,888	)		15,949			11,725
Current income tax benefit		(8,162	)		(6,239	)		837
Change in fair value of derivatives		48,788
Accrual of deferred compensation, net								(20,328	)
Other		7,895			9,383			4,869

STATUTORY BASIS	$	195,088		$	173,070		$	113,759

	December 31,
Shareholder's Equity:	December 31,
Shareholder's Equity:	2002			2001
GAAP BASIS	$	1,971,325		$	1,698,672
Premium revenue recognition		(162,788	)		(141,365	)
Loss and loss adjustment expense reserves		89,656			69,071
Deferred acquisition costs		(253,777	)		(240,492	)
Contingency reserve		(691,955	)		(784,591	)
Unrealized gain on investments, net of deferred tax		(214,148	)		(92,254	)
Deferred income taxes		168,452			134,655
Accrual of deferred compensation
Surplus notes		214,865			146,762
Other		62,532			18,521

STATUTORY BASIS SURPLUS	$	1,184,162		$	808,979

SURPLUS PLUS CONTINGENCY RESERVE	$	1,876,117		$	1,593,570

The U.S. domiciled Subsidiaries file statutory-basis financial statements with state insurance departments in all states in which the Subsidiaries are licensed. On January 1, 2001, significant changes to the statutory basis of accounting became effective. The cumulative effect of these changes, known as Codification guidance, was recorded as a direct adjustment to statutory surplus. The effect of adoption on January 1, 2001 was a $50,293,000 decrease to statutory surplus, which related primarily to the accrual of deferred compensation obligations.

6. FEDERAL INCOME TAXES

Prior to the merger with Dexia, the Parent, the Company and its Subsidiaries, except FSA International, filed a consolidated federal income tax return. The calculation of each company's tax benefit or expense was controlled by a tax-sharing agreement that based the allocation of such benefit or expense upon a separate return calculation. Dexia Holdings, the Parent and the Company and its Subsidiaries, except FSA International, will file a consolidated federal income tax return for periods subsequent to the merger, under a new tax sharing agreement. The new tax sharing agreement provides that each member's tax benefit or expense is calculated on a separate return basis and that any credits or losses available to the Parent or Dexia Holdings be allocated to the members based on the member's taxable income. At December 31, 2002 and 2001, the Company and its Subsidiaries received benefits from utilizing the Parent's credits and losses of $18,205,000 and $4,875,000, respectively. These

amounts have been recorded as capital contributions and reductions in amounts payable to the Parent in the financial statements.

Federal income taxes have not been provided on substantially all of the undistributed earnings of FSA International, since it is the Company's practice and intent to reinvest such earnings in the operations of these subsidiaries. The cumulative amount of such untaxed earnings was $57,063,000, $41,899,000 and $18,629,000 at December 31,2002, 2001 and 2000, respectively.

The cumulative balance sheet effects of deferred federal tax consequences are as follows (in thousands):

		December 31,
		2002			2001
Deferred acquisition costs		$	80,815		$	78,008
Deferred premium revenue adjustments			17,663			17,420
Unrealized capital gains			71,734			30,179
Contingency reserves			78,433			70,350
Undistributed earnings			2,195			1,340
Mark-to-market adjustments						2,092
Other, net			574

	Total deferred federal income tax liabilities		251,414			199,389

Loss and loss adjustment expense reserves			(27,526	)		(21,384	)
Deferred compensation			(54,990	)		(43,466	)
Mark-to-market adjustments			(15,565	)
Other, net						(662	)

	Total deferred federal income tax assets		(98,081	)		(65,512	)

Total deferred federal income taxes		$	153,333		$	133,877

No valuation allowance was necessary at December 31, 2002 or 2001.

A reconciliation of the effective tax rate with the federal statutory rate follows:

	Years Ended December 31,
	2002		2001		2000
Tax at statutory rate	35.0	%	35.0	%	35.0	%
Tax-exempt interest	(13.2	)	(9.6	)	(14.3	)
Income of foreign subsidiary	(2.3	)	(3.0	)	(2.6	)
Merger-related expenses					4.2
Other	0.0		0.0		0.1

Provision for income taxes	19.5	%	22.4	%	22.4	%

7. DIVIDENDS AND CAPITAL REQUIREMENTS

Under New York Insurance Law, the Company may pay a dividend without the prior approval of the Superintendent of Insurance of the State of New York (the New York Superintendent) only from earned surplus subject to the maintenance of a minimum capital requirement. In addition, the dividend, together with all dividends declared or distributed by it during the preceding twelve months, may not exceed the lesser of 10% of its policyholders' surplus shown on its last filed statement, or adjusted net investment income, as defined, for such twelve-month period. As of December 31, 2002, the Company had $113,983,000 available for the payment of dividends over the next twelve months. However, as a customary condition for approving the application of Dexia for a change in control of the Company, the prior approval of the New York Superintendent is required for any payment of dividends by the Company for a period of two years following such change in control, which began July 5, 2000. In 2002 and 2001, FSA International paid a preferred dividend of $8,671,000 and $1,589,000, respectively, to its minority interest owner.

8. CREDIT ARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES

The Company has a credit arrangement aggregating $125,000,000 at December 31, 2002, which is provided by commercial banks and intended for general application to transactions insured by the Company and the Subsidiaries. At December 31, 2002, there were no borrowings under this arrangement, which expires on April 26, 2003, if not extended. In addition, there are credit arrangements assigned to specific insured transactions. In August 1994, the Company entered into a facility agreement with Canadian Global Funding Corporation and Hambros Bank Limited. Under the agreement, which expires in August 2004, the Company can arrange financing for transactions subject to certain conditions. The amount of this facility was $186,911,000, of which $125,161,000 was unutilized at December 31, 2002.

The Company has a standby line of credit commitment in the amount of $240,000,000 with a group of international banks to provide loans to the Company after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $240,000,000 or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $704,553,000 at December 31, 2002. The obligation to repay loans made under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a term expiring on April 30, 2009 and contains an annual renewal provision subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2002.

The Company had borrowed $120,000,000 from its Parent in the form of Surplus Notes. These notes carry a simple interest rate of 5.0% per annum. Principal of and interest on the Surplus Notes may be paid at any time at the option of the Company, subject to prior approval of the New York Superintendent and compliance with the conditions to such payments as contained in the New York Insurance Laws. These notes have no stated maturity. The Company paid interest of $7,309,000, $4,500,000 and $6,000,000 in 2002, 2001 and 2000, respectively. In 2002 and 2001, with the approval of the New York Superintendent, the Company repaid $28,000,000 and $26,000,000, respectively, of principal on such notes and subsequently issued an additional $96,850,000 and $50,000,000 in 2002 and 2001, respectively, of notes to its Parent. As of December 31, 2002, the amount of surplus notes outstanding was $212,850,000.

9. EMPLOYEE BENEFIT PLANS

The Company and its Parent maintain both qualified and non-qualified, non-contributory defined contribution pension plans for the benefit of all eligible employees. The Company and its Parent's contributions are based upon a fixed percentage of employee compensation. Pension expense, which is funded as accrued, amounted to $4,761,000, $3,328,000 and $3,354,000, respectively, for the years ended December 31, 2002, 2001 and 2000, respectively.

The Company has an employee retirement savings plan for the benefit of all eligible employees. The plan permits employees to contribute a percentage of their salaries up to limits prescribed by IRS Code, Section 401(k). The Company's contributions are discretionary, and none have been made.

Performance shares are awarded under the Parent's 1993 Equity Participation Plan. The Plan authorizes the discretionary grant of performance shares by the Human Resources Committee to key employees of the Company. The amount earned for each performance share depends upon the attainment by the Parent of certain growth rates of adjusted book value (or in the case of performance shares issued on or after January 1, 2001, growth in adjusted book value and book value) per outstanding share over a three-year period. No payout occurs if the compound annual growth rate of the Parent's adjusted book value per outstanding share was less than 7% and 200% payout occurs if the

compound annual growth rate was 19% or greater. Payout percentages are interpolated for compound annual growth rates between 7% and 19%.

Performance shares granted under the 1993 Equity Participation Plan were as follows:

	Outstanding at Beginning of Year	Granted During the Year	Earned During the Year	Forfeited During the Year	Outstanding at End of Year	Price per Share at Grant Date
2000	1,223,025	437,300	540,710	24,781	1,094,834	52.1250
2001	1,094,834	310,200	261,034	12,250	1,131,750	79.0400
2002	1,131,750	376,775	380,279	13,901	1,114,345	85.6300

The Company applies APB Opinion 25 and related Interpretations in accounting for the Parent's performance shares. The Company estimates the final cost of these performance shares and accrues for this expense over the performance period. The accrued expense for the performance shares was $55,844,000, $46,371,000 and $34,248,000, for the years ended December 31, 2002, 2001 and 2000, respectively. The accrued expense for 2000 includes $12,076,000 of merger related costs. Prior to the merger, the performance shares were adjusted to payout from 0 to two common shares of the Parent. The Company recognized a benefit for the difference between the market value of the Parent's common stock and the cost of the stock when it was purchased by an independent trustee (which amount was reimbursed by the Company to its Parent) for shares distributed under the performance share plan. This benefit was recorded by the Company as a capital contribution which totaled $8,485,000 in 2000. Had the compensation cost for the Parent's performance shares been determined based upon the provisions of SFAS No. 123, there would have been no effect on the Company's reported net income.

The Company does not currently provide post-retirement benefits, other than under its defined contribution plans, to its employees, nor does it provide post-employment benefits to former employees other than under its severance plans or employment agreements with members of senior management.

10. COMMITMENTS AND CONTINGENCIES

The Company leases office space and equipment under non-cancelable operating leases, which expire at various dates through 2007.

Future minimum rental payments are as follows (in thousands):


2003	$	5,531
2004		5,397
2005		4,349
2006		1,460
2007		841

Total	$	17,578

Rent expense for the years ended December 31, 2002, 2001 and 2000 was $5,716,000, $5,852,000 and $4,745,000 respectively.

During the ordinary course of business, the Company and its Subsidiaries have become parties to certain litigation. Management believes that these matters will be resolved with no material impact on the Company's financial position, results of operations or cash flows.

11. REINSURANCE

The Subsidiaries obtain reinsurance to increase its policy writing capacity, both on an aggregate risk and a single risk basis, to meet state insurance regulatory, rating agency and internal limits, diversify risk, reduce the need for additional capital and strengthen financial ratios. The Subsidiaries reinsure portions of their risks with affiliated (see Note 13) and unaffiliated reinsurers under quota share, first-loss and excess-of-loss treaties and on a facultative basis.

In the event that any or all of the reinsuring companies were unable to meet their obligations to the Company, or contested such obligations, the Company would be liable for such defaulted amounts. Certain of the reinsuring companies have provided collateral to the Subsidiaries to secure their reinsurance obligations. The Company has also assumed reinsurance of municipal obligations from unaffiliated insurers.

Amounts reinsured were as follows (in thousands):

	Year Ended December 31,
	2002			2001			2000
Written premiums ceded	$	270,954		$	165,932		$	154,187
Written premiums assumed		2,443			3,130			9,702
Earned premiums ceded		134,093			99,251			85,175
Earned premiums assumed		4,079			3,653			3,312
Losses and loss adjustment expense payments ceded		(2,513	)		(4,199	)		1,616
Losses and loss adjustment expense payments assumed								26

	December 31,
	2002		2001
Principal outstanding ceded	$	92,141,112	$	75,407,703
Principal outstanding assumed		2,000,422		2,171,588
Deferred premium revenue ceded		557,659		420,798
Deferred premium revenue assumed		13,331		14,967
Losses and loss adjustment expense reserves ceded		75,950		28,880
Losses and loss adjustment expense reserves assumed		728		703

12. OUTSTANDING EXPOSURE AND COLLATERAL

The Company's policies insure the scheduled payments of principal and interest on asset-backed and municipal obligations. The principal amount insured (in millions) as of December 31, 2002 and 2001 (net of amounts ceded to other insurers) and the terms to maturity are as follows:

		December 31, 2002				December 31, 2001
Terms to Maturity		December 31, 2002				December 31, 2001
Terms to Maturity		Asset-Backed(1)		Municipal		Asset-Backed(1)		Municipal
0 to 5 Years		$	64,158	$	8,781	$	39,913	$	4,483
5 to 10 Years			33,908		18,221		32,373		12,508
10 to 15 Years			4,781		31,936		11,763		22,738
15 to 20 Years			1,667		33,809		1,260		29,101
20 Years and Above			24,009		44,430		26,204		36,768

	Total	$	128,523	$	137,177	$	111,513	$	105,598

(1): Includes $2,430 million and $479 million, in 2002 and 2001, respectively, relating to FSA-insured GICs issued by CMS that are excluded from the Parent's consolidated exposures. The consolidated financial statements of the Parent reflect the FSA-insured GICs as GIC liabilities instead of as insurance exposure because CMS is consolidated with the Parent.

The principal amount ceded as of December 31, 2002 and 2001 and the terms to maturity are as follows (in millions):

		December 31, 2002				December 31, 2001
Terms to Maturity		December 31, 2002				December 31, 2001
Terms to Maturity		Asset-Backed		Municipal		Asset-Backed		Municipal
0 to 5 Years		$	10,130	$	2,130	$	8,386	$	1,979
5 to 10 Years			6,851		4,628		5,907		3,606
10 to 15 Years			3,699		10,105		2,251		8,841
15 to 20 Years			1,428		16,433		1,140		12,514
20 Years and Above			5,906		30,830		5,282		25,501

	Total	$	28,014	$	64,126	$	22,966	$	52,441

The Company limits its exposure to losses from writing financial guarantees by underwriting investment-grade obligations, diversifying its portfolio and maintaining rigorous collateral requirements on asset-backed obligations, as well as through reinsurance. The gross principal amounts of insured obligations in the asset-backed insured portfolio are backed by the following types of collateral (in millions):

		Net of Amounts Ceded(1) December 31,				Ceded December 31,
Types of Collateral		Net of Amounts Ceded(1) December 31,				Ceded December 31,
Types of Collateral		2002		2001		2002		2001
Residential mortgages		$	23,379	$	26,084	$	5,954	$	4,554
Consumer receivables			19,454		19,856		5,480		4,981
Pooled corporate obligations			78,113		61,412		13,007		11,839
Investor-owned utility obligations			619		598		348		314
Other asset-backed obligations			6,958		3,563		3,225		1,278

	Total asset-backed obligations	$	128,523	$	111,513	$	28,014	$	22,966

(1): Includes $2,430 million and $479 million, in 2002 and 2001, respectively, relating to FSA-insured GICs issued by CMS that are excluded from the Parent's consolidated exposures. The consolidated financial statements of the Parent reflect the FSA-insured GICs as GIC liabilities instead of as insurance exposure because CMS is consolidated with the Parent.

The gross principal amount of insured obligations in the municipal insured portfolio includes the following types of issues (in millions):

		Net of Amounts Ceded December 31,				Ceded December 31,
Types of Issues		Net of Amounts Ceded December 31,				Ceded December 31,
Types of Issues		2002		2001		2002		2001
General obligation bonds		$	54,563	$	42,692	$	18,388	$	15,512
Housing revenue bonds			5,833		4,717		1,687		1,557
Municipal utility revenue bonds			23,442		16,497		13,468		10,955
Health care revenue bonds			5,970		5,642		6,683		6,004
Tax-supported bonds (non-general obligation)			27,556		21,982		12,391		10,143
Transportation revenue bonds			7,640		5,391		5,748		4,760
Other municipal bonds			12,173		8,677		5,761		3,510

	Total municipal obligations	$	137,177	$	105,598	$	64,126	$	52,441

In its asset-backed business, the Company considers geographic concentration as a factor in underwriting insurance covering securitizations of pools of such assets as residential mortgages or consumer receivables. However, after the initial issuance of an insurance policy relating to such securitizations, the geographic concentration of the underlying assets may not remain fixed over the life of the policy. In addition, in writing insurance for other types of asset-backed obligations, such as securities primarily backed by government or corporate debt, geographic concentration is not deemed by the Company to be significant, given other more relevant measures of diversification, such as issuer or industry diversification.

The Company seeks to maintain a diversified portfolio of insured municipal obligations designed to spread its risk across a number of geographic areas. The following table sets forth those states in which municipalities located therein issued an aggregate of 2% or more of the Company's net par amount outstanding of insured municipal securities as of December 31, 2002:

State		Number of Issues	Net Par Amount Outstanding		Percent of Total Municipal Net Par Amount Outstanding		Ceded Par Amount Outstanding
			(in millions)				(in millions)
California		837	$	19,379	14.1	%	$	7,299
New York		550		13,256	9.7			8,620
Texas		615		10,052	7.3			4,716
Pennsylvania		580		8,496	6.2			2,799
Florida		230		7,602	5.5			3,161
Illinois		580		6,697	4.9			2,988
New Jersey		445		6,322	4.6			3,545
Washington		239		5,020	3.7			2,506
Massachusetts		172		4,088	3.0			2,197
Michigan		340		3,864	2.8			1,345
Wisconsin		393		3,529	2.6			739
All other U.S. jurisdictions		2,622		45,399	33.1			20,481
International		40		3,473	2.5			3,730

	Total	7,643	$	137,177	100.0	%	$	64,126

13. RELATED PARTY TRANSACTIONS

Allocable expenses are shared by the Company and its Parent on a basis determined principally by estimates of respective usage as stated in an expense sharing agreement. The agreement is subject to the provisions of the New York Insurance Law. Amounts included in other assets at December 31, 2002 and 2001 are $8,162,000 and $2,572,000, respectively, for unsettled expense allocations due from the Parent.

The Company ceded premiums of $30,701,000 to Tokio Marine and Fire Insurance Co., Ltd. (Tokio Marine), a partial owner of the Parent prior to the merger, for the year ended December 31, 2000. The Company ceded losses and loss adjustment expenses of $2,935,000 to Tokio Marine for the year ended December 31, 2000. The Company ceded premiums of $23,393,000, $12,795,000 and $22,581,000 to XL Capital Ltd. (XL) and its subsidiaries, for the years ended December 31, 2002, 2001 and 2000, respectively. The amounts included in prepaid reinsurance premiums at December 31, 2002 and 2001 for reinsurance ceded to XL and its subsidiaries were $31,976,000 and $27,509,000, respectively.

The Company ceded premiums of $(1,401,000) on a quota share basis to Commercial Reinsurance Company (Comm Re), an affiliate of MediaOne Capital Corporation (MediaOne), a partial owner of the Parent prior to the merger, for the year ended December 31, 2000. The Company assumed premiums of $8,568,000 from Comm Re for the year ended December 31, 2000, in connection with the acquisition of Comm Re. The sellers have either posted a letter of credit or assumed Comm Re's exposure themselves to cover any losses on its exposure at the time of the acquisition, all of which is being accounted for as reinsurance by the Company. The Company ceded losses and loss adjustment expense recoveries of $501,000 to this affiliate for the year ended December 31, 2000.

The Company had premiums written of $59,103,000, $54,295,000 and $4,412,000 in 2002, 2001 and 2000, respectively, relating to the guaranty of debt issued by and of debt obligations purchased by FSA Global Funding Limited (Global), a 29% owned investment of the Company's Parent. The amounts included in deferred premium revenue relating to Global transactions are $35,452,000 and $40,090,000 at December 31, 2002 and 2001, respectively.

The Company had premiums earned of $17,272,000 and $7,159,000 for the years ended December 31, 2002 and 2001, respectively, relating to business with affiliates of Dexia. Deferred premium revenue was $7,675,000 and $4,336,000 and gross par outstanding relating to those transactions $16,165,980,000 and $10,906,755,000, at December 31, 2002 and 2001, respectively.

The Company had premiums earned of $3,209,000 relating to the guaranty of GICs issued by CMS.

14. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

The following estimated fair values have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret the data to develop the estimates of fair value. Accordingly, the 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.

Bonds and equity investments—The carrying amount represents fair value. The fair value is based upon quoted market price.

Short-term investments—The carrying amount is fair value, which approximates cost due to the short maturity of these instruments.

Cash, receivable for investments sold and payable for investments purchased—The carrying amount approximates fair value because of the short maturity of these instruments.

Securitized loans—The carrying amount is cost. The fair value of the loans is the present value of the expected cash flows as of the reporting date.

Deferred premium revenue, net of prepaid reinsurance premiums—The carrying amount of deferred premium revenue, net of prepaid reinsurance premiums, represents the Company's future premium revenue, net of reinsurance, on policies where the premium was received at the inception of the insurance contract. The fair value of deferred premium revenue, net of prepaid reinsurance premiums, is an estimate of the premiums that would be paid under a reinsurance agreement with a third party to transfer the Company's financial guaranty risk, net of that portion of the premiums retained by the Company to compensate it for originating and servicing the insurance contract.

Installment premiums—Consistent with industry practice, there is no carrying amount for installment premiums since the Company will receive premiums on an installment basis over the term of the insurance contract. Similar to deferred premium revenue, the fair value of installment premiums is the estimated present value of the future contractual premium revenues that would be paid under a reinsurance agreement with a third party to transfer the Company's financial guaranty risk, net of that portion of the premium retained by the Company to compensate it for originating and servicing the insurance contract.

Long-term debt—The Company could not determine the fair value of the notes because the related party debt does not contain normal commercial terms such as a maturity date.

Notes payable to affiliate—The fair value of a is the present value of the expected cash flows as of the reporting date.

Losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses—The carrying amount is fair value, which is the net present value of the expected cash flows for specifically identified claims and potential losses in the Company's insured portfolio.

		December 31, 2002				December 31, 2001
		Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
				(in thousands)
Assets:
	Bonds	$	2,811,747	$	2,811,747	$	2,303,431	$	2,303,431
	Equity investments						10,070		10,070
	Short-term investments		364,565		364,565		213,212		213,212
	Cash		27,560		27,560		5,882		5,882
	Securitized loans		431,718		437,231
	Receivable for securities sold		93		93		3,636		3,636
Liabilities:
	Deferred premium revenue, net of prepaid reinsurance premiums		892,552		738,738		669,534		567,629
	Losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses		147,668		147,668		85,548		85,548
	Notes payable to affiliate		431,360		440,589
	Long-term debt		212,850		N/A		144,000		N/A
	Payable for investments purchased		2,481		2,481		28,214		28,214
Off-balance-sheet instruments:
	Installment premiums				412,758				389,479

15. LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES

Activity in the liability for losses and loss adjustment expenses, which consists of the case basis and general reserves, is summarized as follows (in thousands):

		Year Ended December 31,
		2002			2001			2000
Balance at January 1		$	114,428		$	116,336		$	87,309
Less reinsurance recoverable			28,880			24,617			9,492

Net balance at January 1			85,548			91,719			77,817
Incurred losses and loss adjustment expenses:
	Current year		21,133			8,203			6,672
	Prior years		44,480			4,294			2,731
Recovered (paid) losses and loss adjustment expenses, net:
	Prior years		(3,493	)		(18,668	)		4,499

Net balance December 31			147,668			85,548			91,719
Plus reinsurance recoverable			75,950			28,880			24,617

	Balance at December 31	$	223,618		$	114,428		$	116,336

During 2000, the Company increased its general reserve by $9,403,000, of which $6,672,000 was for originations of new business and $2,731,000 was for the accretion of the discount on prior years' reserves. Also during 2000, the Company transferred to the general reserve $2,053,000 representing recoveries received on prior-year transactions and transferred $1,223,000 from the general reserve to case basis reserves. Giving effect to these transfers, the general reserve totaled $65,204,000 at December 31, 2000.

During 2001, the Company increased its general reserve by $12,497,000, of which $8,203,000 was for originations of new business and $4,294,000 was for the accretion of the discount on prior years' reserves. Also during 2001, the Company transferred to the general reserve $89,000 representing recoveries received on prior-year transactions and transferred $8,719,000 from the general reserve to case basis reserves. Giving effect to these transfers, the general reserve totaled $69,071,000 at December 31, 2001.

In the second quarter of 2002, as part of the Company's ongoing credit review process, management identified certain transactions not performing as expected in its portfolio of insured collateralized debt obligations (CDOs). As a result, management analyzed all CDO transactions in its insured portfolio that breached overcollateralization triggers, which were included in such transactions as one measure of adverse performance. A present value "deterministic" approach was utilized to estimate the loss inherent in this portfolio. The deterministic model applies a run of the collateral portfolio for each transaction considering each CDO transaction's unique attributes (such as reinsurance, individual collateral ratings and status, derivatives purchased, premiums due to the guarantor, etc.) utilizing a Moody's default pattern for frequency of defaults, an estimate of collateral recovery values for severity, and a risk-free rate of interest. Management assumed that current default rates on CDO collateral would improve in a manner consistent with an economic recovery following a period of significant credit deterioration similar to that experienced in 1991/1992 and, as a result, management selected Moody's 1992 idealized default curve as a predictor of future defaults on the CDO collateral. The per period default rate was calculated based on the Moody's weighted average rating factor for each piece of surviving collateral. Recovery rates were judgmentally established by the Company. In considering the recovery rates to be utilized, management adjusted Moody's average

recovery rates (observed since 1982) downward to reflect more recent and more adverse observations. At June 30, 2002, this analysis produced a present value of expected losses of $51.5 million, net of reinsurance recoveries and net of unearned premiums and future ceding commissions. As described in more detail below, management addressed this net present value of expected loss ($51.5 million) through (i) an increase in the Company's general reserve ($31.0 million) and (b) amounts already existing in its general reserve ($20.5 million), including general reserve amounts reallocated to case basis reserves ($11.3 million). The $31.0 million increase in the Company's general reserve resulted in a corresponding increase to losses and loss adjustment expense in the income statement of $31.0 million. An additional adjustment of $10.1 million was made in the fourth quarter of 2002 as a result of further deterioration of the CDO portfolio. Management has established a methodology of recording case basis reserves on CDO transactions to the extent that the overcollateralization ratio (non-defaulted collateral at par value divided by the debt insured) has fallen below 100%, since management believes that claims on such transactions are probable and that the amount of the undercollateralization is a reasonable estimate of such claims. Such transactions may benefit from excess cash flow attributable in part to higher interest rates on the underlying collateral than on the insured securities. In addition, such transactions generally require insured payments of principal only at the ultimate maturity of such transactions. As a result, the Company does not expect to be required to pay claims in respect of these transactions until 2010, but may elect to do so at an earlier date at its discretion. Application of this methodology resulted in recording $68.8 million in gross case basis reserves and $29.8 million in reinsurance recoverable on unpaid losses, resulting in a $39.0 million increase in net case basis reserves. Management, beginning in the second quarter of 2002, has refined the loss factor it applies to its net par underwritten when calculating the general reserve in order to reflect its recent adverse experience. As a result, the general reserve accrual for the year ended December 31, 2002 was $65.6 million, rather than the approximate $14.9 million that would have been accrued using the prior assumptions.

During 2002, the Company increased its general reserve by $65.6 million, of which $41.1 million related to the CDO portfolio discussed above, $21.1 million was for originations of new business and $3.4 million was for the accretion of the discount on prior years' reserves. Also during 2002, the Company transferred to the general reserve $0.8 million representing recoveries received on prior-year transactions and transferred $45.8 million from the general reserve to case basis reserves. Giving effect to these transfers, the general reserve totaled $89.7 million at December 31, 2002.

The cumulative amount of discount taken was approximately $44,690,000, $29,578,000 and $28,748,000 at December 31, 2002, 2001 and 2000, respectively.

16. INVESTMENTS IN UNCONSOLIDATED AFFILIATE

In November 1998, the Parent invested $19,900,000 to purchase a 19.9% interest in XL Financial Assurance Ltd (XLFA), a financial guaranty insurance subsidiary of XL. In February 1999, the Parent sold $4,900,000 of its interest back to XLFA, giving the Parent a 15.0% interest in XLFA, which it contributed to the Company in December 1999. In December 2000, the Company invested an additional $24,000,000 to maintain its 15.0% interest. The Company's investment in XLFA is accounted for using the equity method of accounting because the Company has significant influence over XLFA's operations. Amounts recorded by the Company in connection with XLFA as of December 31, 2002, 2001 and 2000 are as follows (in thousands):

	2002		2001		2000
Investment in XLFA	$	52,206	$	49,726	$	43,721
Equity in earnings from XLFA		9,145		8,356		3,090
Dividends received from XLFA		6,665		1,492		859

At December 31, 2002 and 2001, the Company's retained earnings included $13,206,000 and $9,287,000, respectively, of accumulated undistributed earnings of XLFA.

17. MINORITY INTEREST IN SUBSIDIARY

In November 1998, FSA International, a Bermuda-based financial guaranty subsidiary of the Company, sold to XL $20,000,000 of preferred shares representing a minority interest in FSA International. In December 1999, FSA International sold to XL an additional $10,000,000 of preferred shares to maintain its minority ownership percentage. The preferred shares are Cumulative Participating Voting Preferred Shares, which in total have a minimum fixed dividend of $1,500,000 per annum. For the years ended December 31, 2002, 2001 and 2000, the Company recognized minority interest of $6,684,000, $8,929,000 and $5,295,000, respectively.

18. SECURITIZED LOANS AND NOTES PAYABLE TO AFFILIATE

In 2002, the Company exercised certain rights available under its financial guaranty policy and the indenture relating to loan-backed notes issued by FMAC Loan Receivables Trust 1998-D and 2000-A (the Trusts). Those rights allowed the Company to accelerate the insured notes and pay claims under its insurance policy on an accelerated basis. Refinancing vehicles reimbursed the Company in whole for its claims payment in exchange for an assignment of certain of the Company's rights against the Trusts. The refinancing vehicles secured the funds to purchase the notes by issuing notes with interest rates ranging from 2.406% to 5.718%. These notes were purchased by FSA Asset Management LLC, a wholly owned subsidiary of the Parent. The Company maintains significant reinsurance, first loss and quota share, under this transaction.

Since the notes represented 100% of the debt capitalization of the Trusts and since the Company maintains all of the risk of further asset decline and maintains control over key decisions regarding the Trusts (such as removal of servicer, sale of assets and liquidation of the entity), the Company consolidated the Trusts.

Although the securitized loans are included in the Company's balance sheet, the securitized loans continue to support FSA-insured transactions exclusively, subject to considerable first loss and quota share reinsurance. In accordance with AICPA Practice Bulletin 6, "Amortization of Discounts on Certain Acquired Loan", the Company has recorded the securitized loans at cost, has determined net cash flows from the pool of securitized loans and is recording income based upon the constant yield method. The cash flows on the securitized loans will be monitored and the constant yield modified to reflect any change in cash flow estimates.

As a result of this transaction, the Company recorded $431,718,000 of securitized loans and $431,360,000 of notes payable. The Company recorded $5,294,000 of other income on the securitized loans and $4,861,000 of interest expense on the notes payable for the year ended December 31, 2002.

Principal payments due under these notes for each of the next five years ending December 31 and thereafter, are as follows (in millions):

Expected Withdrawal Date		Principal Amount
	2003	$	17.6
	2004		47.0
	2005		37.1
	2006		35.0
	2007		33.0
Thereafter			261.7

Total		$	431.4

19. STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 133

In August 2002, the single name credit default swap program was terminated in exchange for paying termination costs of $43 million, $38.0 million of which was related to the Company's exposure. The charge was included in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income.

The Company has also insured a number of credit default swap agreements that it intends, in each case, to hold for the full term of the agreement. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred. The Company recorded $35,033,000, $15,385,000 and $1,760,000 in net earned premium under these agreements for the years ended December 31, 2002, 2001 and 2000, respectively. The change in fair value, which were losses of $50.2 million and a gain of $6.7 million for the years ended December 31, 2002 and 2001, respectively, were recorded in net realized and unrealized gains (losses) on derivative instruments in the consolidated statement of operations and comprehensive income and in other assets or liabilities. The gains and losses recognized by recording these contracts at fair value will be determined each quarter based upon market pricing of Super Triple-A (defined as having first-loss protection of 1.3 times the level required for Triple-A rating) swap guarantees. The Company does not believe the fair value adjustments are an indication of potential claims under the Company's guarantees.

20. VARIABLE INTEREST ENTITY

An affiliate of the Company owns 29% of the equity of Global, a Cayman Islands domiciled issuer of FSA-insured notes and other obligations sold in international markets (generally referred to as medium term notes or "MTNs"). Global issues securities at the request of interested purchasers in a process known as "reverse inquiry," which generally results in lower interest rates and borrowing costs than would apply to direct borrowings. Global also issues securities in traditional private placements to institutional investors and to participants in lease financings in which the Company and its affiliates may play a number of financing roles. Global is managed as a "matched funding vehicle," in which the proceeds from the sale of Global notes are invested in obligations chosen to provide cash flows substantially matched to those of the Global notes (taking into account, in some cases, dedicated third party liquidity). The matched funding structure minimizes the market risks borne by Global and the Company. Global raises funds in U.S. dollars at LIBOR-based floating borrowing rates and invests its funds in obligations insured by the Company, maturing prior to the maturity of the related Global notes and paying a higher interest rate than the interest rate on the related Global notes. Total assets for Global at December 31, 2002 and 2001 were $9,182,028,000 (unaudited) and $3,561,344,000, respectively. Total liabilities at December 31, 2002 and 2001 were $9,188,967,000 (unaudited) and $3,565,255,000, respectively. The foregoing assets and liabilities include assets and matched liabilities that are "economically defeased" in lease financings in which the Company and its affiliates may play a number of financing roles. These economically defeased liabilities, and associated assets, are held in separate special purpose entities, Global and Premier International Funding Co. At December 31, 2002 and 2001, Global's economically defeased obligations were $6,708,688,000 and $1,982,961,000, respectively. For the years ended December 31, 2002 and 2001, total revenues for Global were $285,897,000 (unaudited) and $151,135,000, respectively. For the years ended December 31, 2002 and 2001, total expenses for Global were $284,945,000 (unaudited) and $150,530,000, respectively. Global's net income for 2002, 2001 and 2000 was $952,000 (unaudited), $605,000 and $383,000, respectively. Global's net income is determined net of premiums paid by Global to the Company. For the years ended December 31, 2002 and 2001, Global paid premiums to FSA of $7,707,000 and $7,502,000,

respectively. All amounts insured by the Company relating to Global are included in the Company's outstanding exposure, included in the Notes to the Consolidated Financial Statements for December 31, 2002. As of December 31, 2002, there were no case basis reserves for any transactions related to Global.

21. RECENTLY ISSUED ACCOUNTING STANDARDS

In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46 "Consolidation of Variable Interest Entities" (FIN No. 46), which is an interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements". FIN No. 46 addresses consolidation of VIEs which have one or both of the following characteristics: (1) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity; and (2) the equity investors lack the direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights, the obligation to absorb the expected losses of the entity if they occur or the right to receive the expected residual returns of the entity if they occur. The provisions of FIN No. 46 will be effective immediately for VIEs created after January 31, 2003 and to VIEs in which an enterprise obtains an interest after that date. For VIEs in which an enterprise holds a variable interest that it acquired prior to February 1, 2003, the interpretation is effective in the first fiscal year or interim period beginning after June 15, 2003. Management believes that the implementation of FIN No. 46, on July 1, 2003, will cause the Company to consolidate for financial reporting purposes, for the first time, Global (see Note 20) and Canadian Global (see Note 8). FIN No. 46 requires that, upon consolidation, the Company shall initially measure the VIEs' assets, liabilities and minority interest at their carrying amounts under existing Accounting Principles Generally Accepted in the United States as if the entity had been consolidated from the time the Company was considered its primary beneficiary (or parent). Any differences upon consolidation on July 1, 2003 will be reflected as a cumulative effect of a change in accounting principle. The carrying amounts of assets, liabilities and minority interest may change significantly from December 31, 2002 to July 1, 2003 as a result of transactions entered into during that period. The Company will continue to analyze the effects of FIN No. 46, considering the timing of its release and the complexity of practical application to the Company's transactions.

In November 2002, the FASB issued FASB Interpretation No. 45 (FIN No. 45), Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an Interpretation of FASB Statements No. 5, 57 and 107 and Rescission of FASB Interpretation No. 34. FIN No. 45 relates to the accounting for and disclosure of guarantees. FIN No. 45 excludes financial guarantee insurance contracts, including those accounted for as insurance contracts and those accounted for as derivatives, from its initial recognition and measurement requirements. However, those contracts accounted for as derivatives are subject to its disclosure requirements. The disclosure requirements in FIN No. 45 are consistent with those already provided by the Company.

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FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES Consolidated Financial Statements and Report of Independent Accountants December 31, 2002

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Assured Guaranty Municipal 10-K2002 FY Annual report

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