UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2006
Commission File Number 1-12644
Financial Security Assurance Holdings Ltd.
(Exact name of registrant as specified in its charter)
New York | | 13-3261323 |
(State or other jurisdiction of
incorporation or organization) | | (I.R.S. Employer
Identification No.) |
31 West 52nd Street, New York, New York 10019
(Address of principal executive offices, including zip code)
(212) 826-0100
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class | | Name of each exchange on which registered |
67¤8% Quarterly Interest Bond Securities Due 2101 | | New York Stock Exchange, Inc. |
6.25% Notes Due November 1, 2102 | | New York Stock Exchange, Inc. |
5.60% Notes Due July 15, 2103 | | New York Stock Exchange, Inc. |
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o Accelerated filer o Non-accelerated filer x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
The aggregate market value of common equity, excluding treasury shares, held by non-affiliates of the registrant at June 30, 2006 was $1,102,411. For purposes of the foregoing, directors are deemed to be affiliates of the registrant and the dollar amount shown is based on the price at which shares of the Company’s common stock were valued under the Company’s director share purchase program on June 30, 2006.
At March 26, 2007, there were outstanding 33,276,017 shares of common stock, par value $0.01 per share, of the registrant (excludes 241,978 shares of treasury stock).
Documents Incorporated By Reference
None.
PART I
Item 1. Business.
Financial Security Assurance Holdings Ltd., through its insurance company subsidiaries, is primarily engaged in the business of providing financial guaranty insurance on public finance and asset-backed obligations in domestic and international markets. The financial strength of the Company’s insurance company subsidiaries is rated “Triple-A” by the major securities rating agencies and obligations insured by them are generally awarded “Triple-A” ratings by reason of such insurance. The Company’s principal insurance company subsidiary is Financial Security Assurance Inc. (“FSA”), a wholly owned New York insurance company. FSA was the first insurance company organized to insure non-municipal obligations and has been a major insurer of asset-backed and other non-municipal obligations since its inception in 1985. FSA expanded the focus of its business in 1990 to include financial guaranty insurance of municipal obligations and has since become a major insurer of municipal and other public finance obligations. In addition, the Company offers FSA-insured guaranteed investment contracts and other investment agreements (“GICs”) through other consolidated entities. References to the “Company” are to Financial Security Assurance Holdings Ltd. together with its subsidiaries.
Financial guaranty insurance written by FSA typically guarantees scheduled payments on financial obligations. Upon a payment default on an insured obligation, FSA is generally required to pay the principal, interest or other amounts due in accordance with the obligation’s original payment schedule or may, at its option, pay such amounts on an accelerated basis. FSA’s underwriting policy is to insure obligations that would otherwise be investment grade without the benefit of FSA’s insurance.
For the year ended December 31, 2006, the Company had gross premiums written of $816.0 million, of which approximately 72.6% related to insurance of public finance obligations and approximately 27.4% related to insurance of asset-backed and other non-public finance obligations. As of December 31, 2006, the Company had net par outstanding of $359.6 billion, of which approximately 69.9% represented insurance of public finance obligations and approximately 30.1% represented insurance of asset-backed and other non-public finance obligations.
The Company provides FSA-insured GICs to municipalities and other market participants. As of December 31, 2006, the Company had $15.8 billion principal amount of outstanding GICs.
Organization
FSA wholly owns FSA Insurance Company (“FSAIC”), which in turn wholly owns Financial Security Assurance (U.K.) Limited (“FSA-UK”) and FSA Mexico Holdings Inc. (“FSA Mexico Holdings”). FSA and FSAIC together own Financial Security Assurance International Ltd. (“FSA International”). FSAIC is an Oklahoma insurance company that primarily provides reinsurance to FSA. FSA-UK is a United Kingdom insurance company that primarily provides financial guaranty insurance for transactions in the United Kingdom and other European markets. FSA International is a Bermuda insurance company that provides reinsurance to FSA and financial guaranty insurance for transactions outside United States and European markets. FSA Mexico Holdings is the New York holding company that, together with FSAIC, owns FSA’s Mexican subsidiary, FSA Seguros México, S.A. de C.V. (“FSA Mexico”). FSA Mexico has an application pending to be licensed to transact financial guaranty insurance in Mexico.
The Company conducts its GIC business through its affiliates FSA Capital Management Services LLC (“FSACM”), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the “GIC Affiliates”). The Company consolidates the results of the GIC Affiliates. FSACM has conducted substantially all of the Company’s GIC business since April 2003, following its receipt of an exemption from the requirements of the Investment Company Act of 1940. The GIC Affiliates lend the proceeds from their sales of GICs to FSA Asset Management LLC (“FSAM”), which invests the funds, generally in obligations that qualify for FSA insurance. FSAM wholly owns FSA Portfolio Asset Limited (“FSA-PAL”), a U.K. company that invests in non-U.S. securities.
The Company consolidates the results of certain variable interest entities (“VIEs”), including FSA Global Funding Limited (“FSA Global”) and Premier International Funding Co. (“Premier”). FSA Global is a special purpose funding vehicle partially owned by the Company. FSA Global issues FSA-insured medium term notes and generally invests the proceeds from the sale of its notes in FSA-insured GICs or other FSA-insured obligations with a view to realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. Premier is principally engaged in debt defeasance for lease transactions.
The Company divides its operations into two business segments: financial guaranty and financial products (“FP”). Prior to the period ended December 31, 2006, the VIEs were included in the financial guaranty segment. However, beginning December 31, 2006, the VIEs are included in the Company’s FP Segment, reflecting the Company’s management of the VIEs’ operations. The Company has reclassified the corresponding information for earlier periods to conform to the current year presentation. Together, the GIC Affiliates, FSAM, FSA-PAL and the VIEs make up the “FP Segment.”
The Company refinances certain underperforming transactions by employing special purpose vehicles to raise funds to refinance such transactions. These refinancing vehicles are also consolidated.
The Company’s management believes that the assets held by FSA Global, Premier and the refinancing vehicles, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Variable Interest Entities.”
FSA Portfolio Management Inc. (“FSA Portfolio Management”), a wholly owned subsidiary of the Company, is engaged in the business of managing a portion of the investment portfolios of the Company and certain of its subsidiaries. FSA Portfolio Management also owns various strategic and other investments funded from time to time by the FSA group of companies.
Transaction Services Corporation (“TSC”), a wholly owned subsidiary of the Company, is engaged in the business of managing troubled transactions, including, but not limited to, those referred to as refinanced transactions, within the insured portfolios of FSA and its subsidiaries.
The Company is a subsidiary of Dexia Holdings, Inc. (“Dexia Holdings”), which, in turn, is owned 90% by Dexia Crédit Local S.A. (“Dexia Crédit Local”) and 10% by Dexia S.A. (“Dexia”). Dexia is a Belgian corporation whose shares are traded on the Euronext Brussels and Euronext Paris markets as well as on the Luxembourg Stock Exchange. Dexia is primarily engaged in the business of public finance, banking and investment management in France, Belgium, Luxembourg and other European countries, as well as in the United States. Dexia Crédit Local is a wholly owned subsidiary of Dexia.
The Company’s Executive Management Committee manages the Company’s business. The Chief Executive Officer, President, General Counsel, Chief Risk Management Officer and Chief Financial Officer are members of the Executive Management Committee. The heads of Municipal Finance, Corporate Finance, the European Group, the Asia Group and Financial Products serve as part-time members of this committee and, collectively, comprise the “Management Committee.” Bruno Deletré, a director of the Company and a member of the Executive Board of Dexia Crédit Local, is an ex officio member of the Management Committee.
History
When the Company commenced operations in 1985, it was owned by a number of large insurance companies and other institutional investors. In 1989, the Company was acquired by U S WEST Capital Corporation, which subsequently changed its name to MediaOne Capital Corporation (“MediaOne”). MediaOne was a subsidiary of MediaOne Group, Inc., with operations and investments in domestic cable and broadband communications and international broadband and wireless communication. In 1990, the Company established a strategic relationship with The Tokio Marine and Nichido Fire Insurance Co., Ltd.
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(“Tokio Marine”), which acquired a minority interest in the Company. Tokio Marine is a major Japanese property and casualty insurance company.
In 1994, the Company completed an initial public offering of common shares, at which time White Mountains Insurance Group, Ltd. (“White Mountains”) (formerly known as Fund American Enterprises Holdings, Inc.) made an investment in the Company, and the chairman of White Mountains became non-executive chairman of the Company. White Mountains is an insurance holding company.
In 1998, the Company and XL Capital Ltd (“XL”), a major Bermuda-based insurance holding company, entered into a joint venture, establishing two Bermuda-domiciled financial guaranty insurance companies—FSA International and XL Financial Assurance Ltd (“XLFA”). In connection with the joint venture, XL acquired a minority interest in the Company and FSA International, and the Company acquired a minority interest in XLFA.
On July 5, 2000, the Company completed a merger in which the Company became a direct subsidiary of Dexia Holdings. At the merger date, each outstanding share of the Company’s common stock was converted into the right to receive $76.00 in cash. As of December 31, 2006, 99.7% of the Company’s common stock was held by Dexia Holdings. The other holders are certain current and former directors of the Company who own shares of the Company’s common stock or economic interests therein as described under “Item 11. Executive Compensation—Compensation of Directors—Director Share Purchase Program” and “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters—Directors and Executive Officers.” Dexia repurchased the last shares of the Company held by a White Mountains affiliate in May 2006.
In October 2005, FSA purchased the interest in FSA International owned by XL for a cash purchase price of $39.1 million in anticipation of the repatriation of earnings and profits of FSA International. Giving effect to such purchase, FSA International became an indirect, wholly owned subsidiary of the Company.
Although the Company’s common stock is no longer listed on the New York Stock Exchange (“NYSE”) as a consequence of the merger, the Company continues to file periodic reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), because the Company has debt securities listed on the NYSE.
The principal executive offices of the Company and FSA are located at 31 West 52nd Street, New York, New York, 10019. Subsidiaries of the Company maintain offices domestically in San Francisco and Dallas and abroad in London, Madrid, Mexico City, Paris, Singapore, Sydney, Tokyo and Bermuda.
Business Objectives
Financial Guaranty Business
The Company’s objective for its financial guaranty business is to remain a leading insurer of public finance and asset-backed obligations while generating premium volume at attractive returns and minimizing the occurrence and severity of credit losses in its insured portfolio. The Company believes that the demand for financial guaranty insurance will remain strong over the long term as a result of the anticipated continuation of the following trends:
· substantial volume of new domestic municipal bonds that are insured, due, in part, to the continued use of municipal bonds to finance repairs and improvements to the nation’s infrastructure and continued demand for credit enhancement by individuals who purchase municipal bonds;
· expansion of private finance for funding of infrastructure projects throughout the world;
· growth of asset securitization; and
· growing use of financial guaranty insurance in non-U.S. markets.
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The Company believes that short-term trends for financial guaranty insurance remain uncertain due, among other things, to:
· narrow interest rate spreads between Triple-A-rated obligations and lower rated obligations;
· potential decline in public finance issues, including refundings, should interest rates rise; and
· increased competition among financial guarantors and other alternative providers of credit enhancement.
The Company expects to continue to originate a diversified insured portfolio characterized by insurance of both public finance and asset-backed obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. In addition to its domestic business, the Company pursues international opportunities in Western European and Asia Pacific markets and, selectively, in Eastern European and Latin American markets.
Financial Products Business
The Company’s objective for its FP business is to generate net interest margin through borrowing funds at attractive rates in the municipal GIC and other markets and investing the proceeds in obligations satisfying the Company’s underwriting criteria while minimizing the Company’s exposure to interest rate changes. The Company anticipates continued demand over the long term for its GIC business and other financial products programs that employ financial guaranty insurance provided by FSA. A review by Moody’s Investors Service, Inc. (“Moody’s”) of the non-core business activities of financial guaranty insurers, completed in December 2006, proposed benchmark limits on the growth of insurers’ financial products businesses. The Company does not expect that such limits will affect its FP business in 2007.
Business of the Company
The Company is engaged in the financial guaranty business through FSA and its other insurance company subsidiaries and in the FP business through its GIC Affiliates, FSAM, FSA-PAL and the VIEs.
Financial Guaranty Business
FSA’s insurance is employed in both the new-issue and secondary markets. In the case of new issues, the insured obligations are sold with FSA insurance at the time the obligations are issued. For both public finance and asset-backed obligations, FSA participates in negotiated offerings, where the investment banker and often the insurer have been selected by the sponsor or issuer. In addition, FSA participates in competitive offerings, where underwriting syndicates bid for securities and submit bids that may include insurance.
FSA has several programs that provide insurance for obligations trading in the secondary markets, including its Custody Receipt Program, which provides insurance primarily for domestic municipal obligations trading in the secondary market, and its Triple-A Guaranteed Secondary Securities (“TAGSS”®) Program, which provides insurance primarily for asset-backed and public infrastructure obligations trading in the secondary market. Investors and dealers generally obtain secondary-market insurance to upgrade or stabilize the credit ratings of securities they already hold or plan to acquire or to increase the market liquidity of such securities. FSA’s underwriting guidelines require the same underwriting standards on secondary-market issues as on new issues, although FSA’s control rights in the event of default are generally more limited.
In many insured transactions, the issuer of insured securities is party to an interest rate, basis or currency swap that matches the issuer’s funding sources to the interest rate or currency of the insured securities or otherwise hedges the issuer’s exposure. In such transactions, FSA typically insures the issuer’s obligations under both the insured securities and the derivative contract.
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FSA insures payment obligations of counterparties and issuers under GICs, GIC equivalents, credit-linked notes and obligations under interest rate, currency and credit default swaps (“CDS”), including guarantees issued in connection with the Company’s FP business. FSA also issues surety bonds under its Sure-Bid program, which provides an alternative to traditional types of good faith deposits for competitive municipal bond transactions.
FSA insures obligations already carrying insurance from other monoline guarantors, with FSA generally obligated to pay claims on a “second-to-pay” basis, following a default by both the underlying obligor and the first-to-pay financial guarantor. In recent years, FSA has also reinsured a modest amount of business from other financial guaranty insurers.
The following table indicates the Company’s percentages of par amount (net of reinsurance) outstanding as of December 31, 2006 and 2005 with respect to each type of public finance and asset-backed program:
Net Par Amount and Percentage Outstanding by Program Type
| | As of December 31, 2006 | |
| | Public Finance Programs | | Asset-Backed Programs(1) | |
| | Net Par
Amount
Outstanding(1) | | Percent of
Total Net Par
Amount
Outstanding | | Net Par
Amount
Outstanding | | Percent of
Total Net Par
Amount
Outstanding | |
| | (dollars in millions) | |
New Issue | | | $ | 239,705 | | | | 95.4 | % | | | $ | 101,727 | | | | 94.0 | % | |
Secondary Market | | | 9,187 | | | | 3.6 | | | | 5,267 | | | | 4.9 | | |
Assumed | | | 2,401 | | | | 1.0 | | | | 1,273 | | | | 1.1 | | |
Total | | | $ | 251,293 | | | | 100.0 | % | | | $ | 108,267 | | | | 100.0 | % | |
| | As of December 31, 2006 | |
| | Public Finance Programs | | Asset-Backed Programs(1) | |
| | Net Par
Amount
Outstanding(1) | | Percent of
Total Net Par
Amount
Outstanding | | Net Par
Amount
Outstanding | | Percent of
Total Net Par
Amount
Outstanding | |
| | (dollars in millions) | |
New Issue | | | $ | 217,405 | | | | 95.7 | % | | | $ | 102,464 | | | | 92.8 | % | |
Secondary Market | | | 8,112 | | | | 3.6 | | | | 6,985 | | | | 6.3 | | |
Assumed | | | 1,543 | | | | 0.7 | | | | 974 | | | | 0.9 | | |
Total | | | $ | 227,060 | | | | 100.0 | % | | | $ | 110,423 | | | | 100.0 | % | |
(1) Excludes intercompany insurance of $16,558 million in 2006 and $13,463 million in 2005 relating to FSA-insured GICs issued by the GIC Affiliates.
Premiums
In setting insurance premium rates, FSA takes into account the risk it assumes and its projected return. Critical factors in assessing risk include the credit quality of the risk, type of issue, sources of repayment, transaction structure and term to maturity. The premium rate is also a function of market factors, capital charges assessed by securities rating agencies and the competitive environment. Market factors include the value added by the use of insurance, such as the interest rate savings obtained by the issuer of an insured obligation. Standard & Poor’s Ratings Services (“S&P”) assigns a “capital charge” for most obligations insured by FSA. The capital charge for a transaction is an important factor in determining the “return on equity” from a specified transaction premium rate under the Company’s proprietary model. Competition arises from other insurers and alternative executions that do not involve insurance. For insurance on GIC and medium term note transactions, transactions involving “repackaging” of outstanding
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securities and other transactions, FSA’s premium may be arbitrage-based, based upon the difference between the effective borrowing cost at a Triple-A rate and the interest rate on the underlying securities.
Public Finance Obligations
FSA insures a range of public finance obligations, including:
· general obligation bonds supported by the issuers’ taxing power;
· tax-supported bonds supported by leases, a specific or discrete source of taxation or “moral obligation” (that is, not a legally binding commitment);
· revenue bonds and other obligations of state and local governments supported by the issuers’ ability to impose and collect fees and charges for public services or specific projects, such as utility, health care and transportation revenue bonds, as well as housing bonds secured by portfolios of single-family mortgages or secured by mortgages for government-supported multifamily residences; and
· international public finance obligations, including obligations of sovereign and sub-sovereign issuers and project finance transactions.
Public finance obligations include municipal bonds, notes and other indebtedness issued by public and quasi-public entities, including states and their political subdivisions (such as counties, cities or towns), utility districts, universities and hospitals, and public housing and transportation authorities. Public finance obligations also include bonds, notes and other indebtedness issued by special purpose entities established to finance investments in infrastructure projects. An issuer’s obligation to pay is supported by the issuer’s taxing power in the case of general obligation bonds, and by the issuer’s or obligor’s ability to impose and collect fees and charges for public services or specific projects in the case of most revenue bonds and public-private infrastructure financings. Some public finance obligations, including most project finance obligations, include non-governmental credit risks (to swap counterparties, insurance companies, construction companies or other non-governmental credits) and operating risks (such as traffic volume or student enrollment).
According to industry sources, the total and insured volume since 2002 of long-term U.S. municipal new issues sold were as follows:
U.S. Municipal Obligations(1)
Year | | | | New Total Volume | | New Insured Volume | | New Insured Volume as
Percent of New Total Volume | |
| | (dollars in billions) | |
2002 | | | $ | 358.6 | | | | $ | 178.9 | | | | 49.9 | % | |
2003 | | | 383.6 | | | | 190.5 | | | | 49.7 | | |
2004 | | | 359.7 | | | | 194.9 | | | | 54.2 | | |
2005 | | | 408.3 | | | | 233.0 | | | | 57.1 | | |
2006 | | | 387.7 | | | | 190.6 | | | | 49.2 | | |
(1) Source: The Bond Buyer, February 7, 2007. Volume is expressed in terms of principal issued and insured on a sale-date basis. Subject to revision as additional information becomes available.
The U.S. municipal bond market is a mature market in which the volume of new issues has exceeded $358 billion in each of the five years from 2002 through 2006. Volume generally has been higher throughout this five-year period than in earlier periods, primarily due to low interest rates. Following a record year in 2005, market volume declined 5% in 2006. Bond insurers generally insure about 50% of the U.S. municipal bond market, although insurance penetration rose as high as 57% in 2005.
Outside the United States, guarantors have increased their presence in public infrastructure finance from 2002 levels. International public finance transactions include many public-private partnership
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financings, such as those authorized under the U.K. Private Finance Initiative, and other highly structured transactions. Because such transactions tend to have long development times and large par amounts, the timing of transactions may cause volatility in insured volume from year to year.
Since 2002, the annual totals of non-U.S. public finance par insured of financial guaranty insurance directly originated by monoline guarantors, according to industry sources, were as follows:
Non-U.S. Public Finance Obligations Insured by Monoline
Insurance Companies(1)
Year | | | | Amount | |
| | (in billions) | |
2002 | | | $ | 8.1 | | |
2003 | | | 13.9 | | |
2004 | | | 11.7 | | |
2005 | | | 14.9 | | |
2006 | | | N/A | (2) | |
(1) Source: Association of Financial Guaranty Insurers (“AFGI”) news release dated May 16, 2006. Data is subject to revision as additional information becomes available.
(2) Not available from the same source. Of the four largest monoline guarantors, three disclose the public finance component of their international business in their statistical operating supplements. According to such statistical operating supplements, those three companies insured directly or assumed, in the aggregate, a principal amount of $23.3 billion of non-U.S. public finance obligations in 2006.
Asset-Backed Obligations
Asset-backed obligations insured by FSA are generally issued in structured transactions 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. Asset-backed obligations insured by FSA also include payment obligations of counterparties and issuers under synthetic obligations such as CDS and credit-linked notes referencing asset-backed securities or pools of securities or other obligations.
Asset-backed obligations are typically issued in connection with structured financings or securitizations where the securities being issued are secured by or payable with funds from a specific pool of assets. The assets are typically held by a special purpose entity that also acts as the issuer of the insured obligations. Most asset-backed obligations are secured by or represent interests in diverse pools of assets, such as residential mortgage loans, auto loans, credit card receivables, other consumer receivables, corporate loans or bonds, government debt and small business loans. Asset-backed obligations may also be secured by less diverse payment sources, such as multifamily real estate.
Asset-backed obligations include funded and synthetic transactions. Funded asset-backed obligations are typically payable from cash flow generated by a pool of assets and take the form of either “pass-through” obligations, which represent interests in the related assets, or “pay-through” obligations, which generally are debt obligations collateralized by the related assets. Both types of funded asset-backed obligations generally have the benefit of one or more forms of credit enhancement, such as overcollateralization or excess cash flow, to cover credit risks associated with the related assets. Synthetic asset-backed obligations generally take the form of CDS obligations or credit-linked notes that reference either an asset-backed security or pool of securities or loans, with a defined deductible to cover credit risks associated with the referenced securities or loans.
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Asset securitization often represents an efficient way for commercial banks to comply with capital requirements and for corporations to access the capital markets at more attractive rates. Banks have responded to increased capital requirements by selling certain of their assets, such as credit card receivables and automobile loans, in securitized structures to the financial markets. Some corporations have found securitization of their assets to be a less costly funding alternative to traditional forms of borrowing or otherwise important in diversifying funding sources. Many finance companies fund consumer finance and home equity lending through securitization.
Since the late 1990s, a significant market has developed for funded and synthetic collateralized debt obligations (“CDOs”), which are securitizations of bonds, loans or other securities. CDOs are used by financial institutions to manage their risk profiles, optimize capital utilization and improve returns on equity. CDOs are also used by dealers or portfolio managers to provide leveraged investments in bond and loan portfolios tailored to conform to differing risk appetites of investors.
According to industry sources, the new par volumes since 2002 for each type of funded asset-backed security presented, including securities distributed under Rule 144A under the Securities Act of 1933 (as amended, the “Securities Act”), were as follows:
Year | | | | New Issues of Funded
U.S. Asset-Backed
Securities(1)(2) | | U.S. Public Issues of
Private-Label
Mortgage-Backed
Securities(1) | | Non-U.S. Asset-
Backed Securities(1)(3) | | Worldwide Funded
Collateralized Debt
Obligations(1) | |
| | (in billions) | |
2002 | | | $ | 413.2 | | | | $ | 214.0 | | | | $ | 117.3 | | | | $ | 87.7 | | |
2003 | | | 505.6 | | | | 297.1 | | | | 198.8 | | | | 82.6 | | |
2004 | | | 691.6 | | | | 329.1 | | | | 205.5 | | | | 127.6 | | |
2005 | | | 875.2 | | | | 540.5 | | | | 278.9 | | | | 241.3 | | |
2006 | | | 907.7 | | | | 566.3 | | | | 419.1 | | | | 445.3 | | |
(1) Source: Asset-Backed Alert, January 9, 2004, January 7, 2005, January 13, 2006 and January 12, 2007. Subject to revision as additional information becomes available.
(2) Includes public and privately placed corporate and consumer receivable-backed issues (including home equity loan issues) but excludes private-label mortgage-backed securities, CDOs, commercial paper and those private placements for which information is not available.
(3) Includes asset-backed and mortgage-backed securities but excludes CDOs.
The data in the above table excludes synthetic transactions and therefore does not reflect the growth in the use of CDS during the years covered. According to the International Swaps and Derivatives Association, Inc. (“ISDA”), the notional principal amount of CDS outstanding in world markets was as follows at the dates indicated:
| | Outstanding
Credit Default Swaps(1) | |
| | (in billions) | |
December 31, 2002 | | | $ | 2,191.6 | | |
December 31, 2003 | | | 3,779.4 | | |
December 31, 2004 | | | 8,422.3 | | |
December 31, 2005 | | | 17,096.1 | | |
June 30, 2006 | | | 26,005.7 | | |
(1) Source: ISDA web page, February 22, 2007.
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According to industry information, the annual totals of funded and synthetic asset-backed par insured of financial guaranty insurance directly originated by monoline guarantors during each year since 2002 were as follows:
Asset-Backed Obligations Insured by Monoline Insurance Companies(1)
Year Ended December 31, | | | | United States | | Non-U.S. | |
| | (in billions) | |
2002 | | | $ | 165.5 | | | | $ | 63.2 | | |
2003 | | | 120.4 | | | | 45.0 | | |
2004 | | | 200.0 | | | | 46.8 | | |
2005 | | | 216.3 | | | | 61.5 | | |
2006 | | | N/A | (2) | | | N/A | (2) | |
(1) Source: AFGI news release dated May 16, 2006. Includes all funded and synthetic primary-market and secondary-market U.S. insured transactions, excluding public finance obligations. Subject to revision as additional information becomes available.
(2) Not available from the same source. According to the statistical operating supplements published by the four largest monoline guarantors, those four companies insured directly or assumed, in the aggregate, approximately $177.7 billion of U.S. asset-backed par volume. Three of these companies disclose the non-U.S. component of their asset-backed business, which in aggregate was $43.5 billion in 2006.
Financial Products Business
The Company’s FP business provides GICs to municipalities and other market participants. FSA insures all GICs issued by the GIC Affiliates. The majority of municipal GICs insured by FSA relate to debt service reserve funds or construction funds that support municipal bond transactions.
Each GIC entitles its holder to receive the return of the holder’s initial principal plus interest at a specified rate, and to withdraw principal from the GIC as permitted. Generally, a municipal bond trustee or issuer will acquire a municipal GIC in order to invest funds on deposit in a debt service reserve fund or construction fund until it needs to use such funds to service debt or fund the payment of project expenses in accordance with the underlying bond documents. Non-municipal GICs include GICs acquired by issuers of credit-linked notes and GICs acquired by FSA Global.
The Company is exposed to risk associated with unexpected withdrawals on its FSA-insured GICs. Debt service reserve fund GICs may be drawn unexpectedly upon a payment default by the municipal issuer. Construction fund GICs may be drawn more quickly or more slowly than anticipated to pay project expenses. Structured finance GICs for credit-linked notes may be drawn unexpectedly upon certain credit events under the CDS related to such notes. In addition, most FSA-insured GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below AA- by S&P or Aa3 by Moody’s, unless the GIC provider posts collateral or otherwise enhances its credit. Some FSA-insured GICs also allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below A3 by Moody’s or A- by S&P, with no right of the GIC provider to avoid such withdrawal by posting collateral or otherwise enhancing its credit. The Company manages this risk through the maintenance of liquid collateral and liquidity agreements.
The GIC Affiliates issue GICs and, on the same terms, lend the funds raised to FSAM. The payment obligations relating to the GICs generally are (or are converted by FSAM into) U.S. dollar LIBOR-based floating rate obligations. FSAM typically invests the funds in U.S. dollar LIBOR-based floating rate
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investments. To the extent that such investments do not meet such criteria, FSAM utilizes swaps, futures and other hedge transactions to convert them into U.S. dollar LIBOR-based floating rate investments.
FSA-PAL, which was formed in 2006, invests in non-U.S. securities. FSAM’s and FSA-PAL’s investments are generally obligations that would qualify for FSA insurance from a credit perspective. The GIC Affiliates, FSAM and FSA-PAL generate their gross profits or losses from the difference between the rates at which the GIC Affiliates borrow the funds and the rates yielded by FSAM’s and FSA-PAL’s investments. All related risk management functions are performed by FSAM.
The following table indicates the Company’s carrying amount of debt outstanding as of December 31, 2006 and 2005 with respect to municipal and non-municipal GICs:
| | As of December 31 | |
| | 2006 | | 2005 | |
| | (in thousands) | |
Municipal | | $ | 6,725,578 | | $ | 7,311,530 | |
Non-municipal(1) | | 8,950,656 | | 5,318,152 | |
Total | | $ | 15,676,234 | | $ | 12,629,682 | |
(1) Excludes GICs acquired by FSA Global.
Consolidated Variable Interest Entities
FSA Global is a Cayman Islands-domiciled issuer of FSA-insured notes and other obligations sold in international markets that are generally referred to as “medium term notes.” The Company owns 49% of the voting ordinary shares and 100% of the nonvoting preference shares of FSA Global.
FSA 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. FSA Global also issues securities in traditional private placements to institutional investors and to participants in lease financings in which Company affiliates may play a number of financing roles. As of December 31, 2006, the VIEs, including FSA Global, had $2.7 billion principal amount of outstanding notes, after elimination of intercompany transactions.
FSA Global is managed as a “match funded vehicle,” in which the proceeds from the sale of FSA Global notes are invested in obligations chosen to provide cash flows substantially matched to those of the notes (taking into account, in some cases, dedicated third party liquidity). This match funded structure is designed to minimize the market risks borne by FSA Global and FSA.
FSA Global generally raises funds that are denominated in U.S. dollars or converted into U.S. dollars at LIBOR-based floating borrowing rates. In recent years, the funds FSA Global raises have generally been invested in FSA-insured GICs, but it may invest, and has in the past invested, in other FSA-insured obligations. FSA Global invests with a view to realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. While the majority of FSA Global’s investments are either denominated in U.S. dollars or converted into U.S. dollars at LIBOR-based floating rates, it also holds investments in other currencies.
FSA Global’s investments:
· mature prior to the maturity of the related FSA Global notes, and
· pay a higher interest rate than the interest rate on the related FSA Global notes.
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Insurance in Force
Set forth below is a summary of the Company’s par outstanding by type as of December 31, 2006:
| | Par Outstanding | |
| | Direct | | Assumed | | Total Gross | | Ceded | | Net | |
| | (in millions) | |
Public finance | | $ | 347,685 | | | $ | 2,461 | | | | $ | 350,146 | | | $ | 98,853 | | $ | 251,293 | |
Asset-backed(1) | | 129,947 | | | 1,297 | | | | 131,244 | | | 22,977 | | 108,267 | |
Total | | $ | 477,632 | | | $ | 3,758 | | | | $ | 481,390 | | | $ | 121,830 | | $ | 359,560 | |
(1) Excludes direct par outstanding on intercompany insurance of $16,558 million relating to FSA-insured GICs issued by the GIC Affiliates.
As of December 31, 2006, the weighted average life of the direct par insured on these policies was approximately five years for asset-backed and 15 years for public finance obligations.
Public Finance Obligations
FSA’s insured portfolio of public finance obligations is divided into nine major categories, which include funded and synthetic obligations:
Domestic General Obligation Bonds
General obligation or full faith and credit bonds are issued by states, their political subdivisions and other municipal issuers, and are supported by the general obligation of the issuer to pay from available funds and by a pledge of the issuer to levy taxes in an amount sufficient to provide for the full payment of the bonds.
Domestic Tax-Supported (Non-General Obligation) Bonds
Tax-supported (non-general obligation) bonds include a variety of bonds that, though not full faith and credit general obligations, are generally supported by leases, a specific or discrete source of taxation or moral obligation. Lease revenue bonds or certificates of participation (“COPs”) are usually general fund obligations that finance real property or equipment that, in the case of leases subject to annual appropriation or abatement, FSA deems to serve an essential public purpose (e.g., schools, public safety facilities, courts and correctional facilities). Tax-backed revenue bonds are secured by a lien on pledged tax revenues, including retail sales, excise and gasoline taxes, or from tax increments (or tax allocations) generated by growth in property values within a district. FSA also insures bonds secured by special assessments levied against property owners, which benefit from covenants by the issuer to levy, collect and enforce collections and to foreclose on delinquent properties.
Domestic Municipal Utility Revenue Bonds
Municipal utility revenue bonds include obligations of all forms of municipal utilities, including electric, gas, water and sewer and solid waste. Insurable utilities may be organized as municipal enterprise systems, authorities or joint-action agencies.
Domestic Health Care Revenue Bonds
Health care revenue bonds include bonds of state and local municipal authorities issued on a conduit basis on behalf of not-for-profit health care providers and health care provider systems, including health maintenance organizations, payable from amounts derived under loan agreements and notes of such health care providers with such authorities.
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Domestic Housing Revenue Bonds
Housing revenue bonds include both multifamily and single family housing bonds, with multi-tiered security structures based on the underlying mortgages, reserve funds, and various other features such as Federal Housing Administration or private mortgage insurance, bank letters of credit, first-loss guarantees and, in some cases, the general obligation of the issuing housing agency or a state’s moral obligation to make up deficiencies.
Domestic Transportation Revenue Bonds
Transportation revenue bonds include a wide variety of revenue-supported bonds, such as bonds for airports, ports, tunnels, municipal parking facilities, toll roads and toll bridges.
Domestic Education Bonds
Education bonds include obligations of colleges and universities, primarily public or state-supported, and independent primary and secondary schools.
Other Domestic Public Finance Obligations
Other domestic public finance obligations insured by FSA include previously insured bonds, bonds secured by revenues and guarantees from the federal government, financings supported by specific state or local government entity revenues, and stadium financings.
International Public Finance Obligations
International public finance obligations have non-U.S. obligors and include obligations of sovereign and sub-sovereign issuers, project finance transactions involving projects leased to or supported by payments from governmental or quasi-governmental entities, toll road transactions supported by toll revenues, obligations arising under leases of equipment or facilities by municipal obligors, utility financings, securitizations of government-supported receivables or sovereign or municipal debt, corporate debt guaranteed by government-owned financial institutions and other obligations having international aspects but otherwise within the public finance categories described above.
Asset-Backed and Other Non-Public Finance Obligations
FSA’s insured portfolio of asset-backed and other non-public finance obligations is divided into five major categories, which are broadly based on the type of assets backing the insured obligations and include funded and synthetic obligations:
Domestic Residential Mortgage Loans
Obligations primarily backed by residential mortgage loans generally take the form of conventional pass-through certificates or pay-through debt securities, but also include other structured products. Residential mortgage loans backing these insured obligations include closed- and open-end first and second mortgage loans or home equity loans on one-to-four family residential properties, including condominiums and cooperative apartments and non-owner occupied residential housing. More than half of the domestic residential mortgage loan obligations currently insured by FSA are in the “sub-prime” sector, characterized by lower quality borrowers and higher levels of structural credit protection through subordination and/or excess spread. FSA also insures “net interest margin” (“NIM”) securities backed by the senior portion of residual cash flows from securitizations of domestic residential mortgage loans. FSA has generally declined participation in securitizations of so-called “high-cost mortgage loans,”
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characterized by very high interest rates or “points and fees” and subject to restrictive federal and state regulations.
Domestic Consumer Receivables
Obligations primarily backed by consumer receivables include conventional pass-through and pay-through securities as well as more highly structured transactions. Consumer receivables backing these insured obligations include automobile loans, manufactured housing loans and credit card receivables. Consumer receivable transactions insured by FSA have tended to be concentrated in the subprime auto loan and credit card receivable sectors.
Domestic Pooled Corporate Obligations
Obligations primarily backed by pooled corporate obligations include funded and synthetic obligations collateralized by corporate debt securities or corporate loans and obligations backed by cash flow or market value of non-consumer indebtedness, and include CDOs, such as “collateralized bond obligations,” “collateralized loan obligations” and comparable risks under CDS obligations. Corporate obligations include corporate bonds, bank loan participations, trade receivables, franchise loans and equity securities. Some CDS obligations expose FSA to elements of market value risk arising from obligations to pay the difference between par and market value upon the occurrence of a payment default or other defined “credit events” specified in the CDS. FSA generally addresses these risks by requiring large deductibles as a condition to payment under pooled corporate CDS insured by FSA.
Other Domestic Non-Public Finance Obligations
Other domestic non-public finance obligations include bonds or other securities backed by government securities, letters of credit, guarantees by other monoline insurers or repurchase agreements collateralized by government securities, securities backed by a combination of assets that include elements of more than one of the categories set forth above and unsecured corporate obligations satisfying FSA’s underwriting criteria. Other domestic non-public finance obligations insured by FSA also include first mortgage bond obligations of for-profit electric or water utilities providing retail, industrial and commercial service, sale-leaseback obligation bonds supported by such utilities and other obligations backed by investor-owned utilities. These bonds are generally either secured by a mortgage on property owned by or leased to an investor-owned utility or have the benefit of a “negative pledge” ensuring that no other material creditors have priority claims to the utility assets. Other domestic non-public finance obligations include securitization of life insurance risks (including so-called “triple-X transactions”) and airplane leases, including transactions benefiting from third-party financial guaranty insurance.
International Asset-Backed Obligations
International asset-backed obligations include (1) funded and synthetic CDOs, (2) securitizations of perpetual floating rate notes of non-domestic banks, diversified payment rights, future flows, health care receivables and residential housing construction loans, (3) obligations of non-domestic investor-owned utilities and (4) other obligations having international aspects but otherwise within the asset-backed categories described above.
Insured Portfolio
A summary of FSA’s insured portfolio as of December 31, 2006 is shown below. Exposure amounts are expressed net of reinsurance but do not distinguish between quota share, first-loss or excess-of-loss reinsurance.
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Summary of Insured Portfolio
As of December 31, 2006(1)
| | Number of
Risks | | Net Par
Amount
Outstanding | | Net
Par and
Interest | | Percent
of Net
Par and
Interest | |
| | (dollars in millions) | |
Public finance obligations | | | | | | | | | | | | | | | |
General obligation | | | 6,912 | | | | $ | 103,112 | | | $ | 153,500 | | | 29 | % | |
Tax-supported | | | 1,128 | | | | 46,479 | | | 72,160 | | | 14 | | |
Municipal utility revenue | | | 1,115 | | | | 40,495 | | | 65,709 | | | 12 | | |
Health care revenue | | | 242 | | | | 13,155 | | | 24,140 | | | 5 | | |
Housing revenue | | | 183 | | | | 7,576 | | | 13,390 | | | 3 | | |
Transportation revenue | | | 119 | | | | 16,164 | | | 28,618 | | | 5 | | |
Education | | | 109 | | | | 4,378 | | | 6,989 | | | 1 | | |
Other domestic public finance | | | 85 | | | | 1,628 | | | 2,480 | | | — | | |
International | | | 143 | | | | 18,306 | | | 47,659 | | | 9 | | |
Total public finance obligations | | | 10,036 | | | | 251,293 | | | 414,645 | | | 78 | | |
Asset-backed obligations | | | | | | | | | | | | | | | |
Residential mortgages | | | 202 | | | | $ | 15,666 | | | $ | 17,441 | | | 3 | | |
Consumer receivables | | | 42 | | | | 10,599 | | | 11,214 | | | 2 | | |
Pooled corporate | | | 260 | | | | 45,914 | | | 48,745 | | | 9 | | |
Other domestic asset-backed | | | 113 | | | | 6,793 | | | 8,382 | | | 2 | | |
International | | | 103 | | | | 29,295 | | | 30,994 | | | 6 | | |
Total asset-backed obligations | | | 720 | | | | 108,267 | | | 116,776 | | | 22 | | |
Total | | | 10,756 | | | | $ | 359,560 | | | $ | 531,421 | | | 100 | % | |
(1) Excludes intercompany insurance of $16,558 million in net par outstanding and $20,850 million in net par and interest outstanding relating to FSA-insured GICs issued by the GIC Affiliates.
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Obligation Type
The table below sets forth the relative percentages of net par amount insured by obligation type during each of the last five years:
Annual New Business Insured by Obligation Type
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | | 2003 | | 2002 | |
Public finance obligations | | | | | | | | | | | | | | | | | | | | | |
General obligation | | | 27 | % | | | 30 | % | | | 20 | % | | | 28 | % | | | 19 | % | |
Tax-supported | | | 9 | | | | 12 | | | | 7 | | | | 15 | | | | 9 | | |
Municipal utility revenue | | | 8 | | | | 8 | | | | 5 | | | | 12 | | | | 9 | | |
Health care revenue | | | 3 | | | | 3 | | | | 3 | | | | 2 | | | | 1 | | |
Housing revenue | | | 1 | | | | 1 | | | | 2 | | | | 3 | | | | 2 | | |
Transportation revenue | | | 2 | | | | 4 | | | | 2 | | | | 5 | | | | 4 | | |
Education | | | 1 | | | | 1 | | | | 1 | | | | 2 | | | | 1 | | |
International | | | 7 | | | | 5 | | | | 2 | | | | 2 | | | | 2 | | |
Total public finance obligations | | | 58 | | | | 64 | | | | 42 | | | | 69 | | | | 47 | | |
Asset-backed and other non-public finance obligations | | | | | | | | | | | | | | | | | | | | | |
Residential mortgages | | | 10 | | | | 9 | | | | 29 | | | | 7 | | | | 9 | | |
Consumer receivables | | | 10 | | | | 5 | | | | 3 | | | | 6 | | | | 10 | | |
Pooled corporate | | | 11 | | | | 13 | | | | 14 | | | | 5 | | | | 14 | | |
Other domestic asset-backed(1) | | | 1 | | | | 1 | | | | 4 | | | | 2 | | | | 1 | | |
International | | | 10 | | | | 8 | | | | 8 | | | | 11 | | | | 19 | | |
Total asset-backed obligations | | | 42 | | | | 36 | | | | 58 | | | | 31 | | | | 53 | | |
Total | | | 100 | % | | | 100 | % | | | 100 | % | | | 100 | % | | | 100 | % | |
(1) Excludes intercompany transactions relating to FSA-insured GICs issued by the GIC Affiliates.
Terms to Maturity
The table below sets forth the contractual terms to maturity of the Company’s policies as of December 31, 2006 and 2005:
Contractual Terms to Maturity of Net Par Outstanding of Insured Obligations(1)
| | As of December 31, 2006 | | As of December 31, 2005 | |
Term to Maturity | | | | Public Finance | | Asset-
Backed(2) | | Public Finance | | Asset-
Backed(2) | |
| | (in millions) | |
0 to 5 years | | | $ | 48,273 | | | $ | 41,582 | | | $ | 44,272 | | | $ | 41,955 | |
5 to 10 years | | | 53,242 | | | 31,097 | | | 49,935 | | | 31,395 | |
10 to 15 years | | | 47,865 | | | 12,301 | | | 44,392 | | | 12,180 | |
15 to 20 years | | | 41,489 | | | 1,860 | | | 36,737 | | | 744 | |
20 years and above | | | 60,424 | | | 21,427 | | | 51,724 | | | 24,149 | |
Total | | | $ | 251,293 | | | $ | 108,267 | | | $ | 227,060 | | | $ | 110,423 | |
| | | | | | | | | | | | | | | | | | | |
(1) 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. The expected maturities for asset-backed obligations are expected to be considerably shorter than the contractual maturities for such obligations.
(2) Excludes intercompany insurance of $16,558 million in 2006 and $13,463 million in 2005 relating to FSA-insured GICs issued by the GIC Affiliates.
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Issue Size
The table below sets forth the net par outstanding as of December 31, 2006, broken out by original net par amount:
Net Par Amount Outstanding
| | As of December 31, 2006 | |
Original Net Par Amount | | | | Public Finance | | Asset-Backed(1) | |
| | (dollars in millions) | |
Less than $10 million | | | $ | 35,308 | | | | $ | 145 | | |
$10 to $50 million | | | 69,890 | | | | 4,003 | | |
$50 million to $100 million | | | 39,353 | | | | 7,687 | | |
$100 million or greater | | | 106,742 | | | | 96,432 | | |
Total | | | $ | 251,293 | | | | $ | 108,267 | | |
| | | | | | | | | | | | | |
(1) Excludes intercompany insurance of $16,558 million relating to FSA-insured GICs issued by the GIC Affiliates.
Geographic Concentration
The Company seeks to maintain a diversified portfolio of insured public finance obligations designed to spread its risk across a number of geographic areas. The table below sets forth those jurisdictions in which municipalities issued an aggregate of 2% or more of the total net par amount outstanding of FSA-insured public finance securities:
Public Finance Insured Portfolio by Jurisdiction
| | As of December 31, 2006 | |
Jurisdiction | | | | Number
of Risks | | Net Par
Amount
Outstanding | | Percent of Total
Net
Par Amount
Outstanding | |
| | (dollars in millions) | |
California | | | 1,022 | | | | $ | 31,724 | | | | 12.7 | % | |
New York | | | 703 | | | | 19,800 | | | | 7.9 | | |
Texas | | | 760 | | | | 17,123 | | | | 6.8 | | |
Pennsylvania | | | 782 | | | | 16,429 | | | | 6.5 | | |
Florida | | | 270 | | | | 13,061 | | | | 5.2 | | |
Illinois | | | 682 | | | | 12,641 | | | | 5.0 | | |
New Jersey | | | 609 | | | | 10,817 | | | | 4.3 | | |
Michigan | | | 542 | | | | 10,173 | | | | 4.0 | | |
Washington | | | 332 | | | | 9,067 | | | | 3.6 | | |
Massachusetts | | | 210 | | | | 6,304 | | | | 2.5 | | |
Ohio | | | 376 | | | | 6,160 | | | | 2.5 | | |
Indiana | | | 271 | | | | 5,451 | | | | 2.2 | | |
Georgia | | | 114 | | | | 5,050 | | | | 2.0 | | |
Wisconsin | | | 453 | | | | 4,982 | | | | 2.0 | | |
All other U.S. jurisdictions | | | 2,767 | | | | 64,205 | | | | 25.5 | | |
International | | | 143 | | | | 18,306 | | | | 7.3 | | |
Total | | | 10,036 | | | | $ | 251,293 | | | | 100.0 | % | |
| | | | | | | | | | | | | | | | |
In its asset-backed business, the Company considers geographic concentration as a factor in underwriting insurance for securitizations of pools of assets, such as residential mortgage loans or
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consumer receivables. However, the geographic concentration of the underlying assets may change 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 may not be a significant credit factor given other more relevant measures of diversification, such as issuer or industry diversification.
The Company’s revenues from external customers attributed to the United States and all foreign countries during each of the last three fiscal years is shown below:
Total Revenues From External Customers
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in thousands) | |
United States | | $ | 1,633,820 | | $ | 933,079 | | $ | 1,095,914 | |
International | | 57,048 | | 48,156 | | 52,355 | |
Total revenues | | $ | 1,690,868 | | $ | 981,235 | | $ | 1,148,269 | |
For a discussion of risks related to the Company’s foreign operations, see “Item 1A. Risk Factors—The Company’s international operations expose it to less predictable credit and legal risks.”
See Note 20 to the Consolidated Financial Statements in Item 8 for revenues from external customers, pre-tax earnings and total assets by segment.
Issuer Concentration
The Company has adopted underwriting and exposure management policies designed to limit the net par insured or net retained credit gap for any one risk. Credit gap is a concept employed by S&P to estimate the at-risk amount (worst-case risk) on an insured exposure. FSA has also established procedures to ensure compliance with regulatory single-risk limits applicable to bonds it has insured. In many cases, the Company uses reinsurance to limit net exposure to any one risk. As of December 31, 2006, the ten largest net insured public finance risks represented $11.1 billion, or 3.1%, of the total net par amount outstanding and the ten largest net insured asset-backed transactions represented $23.4 billion, or 6.2%, of the total net par amount outstanding. For purposes of the foregoing, different issues of asset-backed securities by the same originator have not been aggregated. However, the Company’s underwriting policies establish single-risk guidelines applicable to asset-backed securities of the same originator. In addition, individual corporate names may appear in more than one FSA-insured CDO transaction, but such exposures are not aggregated for purposes of identifying the largest insured risks. Instead, FSA addresses these risks through structural elements of the transactions and by limiting its exposure to the CDO sector in the aggregate. In addition to the single-risk limits established by its underwriting guidelines, the Company is subject to regulatory limits and rating agency guidelines on exposures to single risks.
Credit Underwriting Guidelines, Standards and Procedures
Financial Guaranty Business
Financial guaranty insurance written by FSA generally relies on an assessment of the adequacy of various payment sources to meet debt service or other obligations in a specific transaction without regard to premiums paid or income from investment of premiums. FSA’s underwriting policy is to insure public finance and asset-backed obligations that it determines are investment grade without the benefit of FSA’s insurance. To this end, each policy FSA writes or reinsures is designed to satisfy the general underwriting guidelines and specific standards for particular types of obligations approved by its Board of Directors. In addition, the Company’s Board of Directors has established an Underwriting Committee that reviews
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completed transactions, generally on a quarterly basis, to ensure conformity with underwriting guidelines and standards.
FSA’s underwriting guidelines for public finance obligations require that a transaction be rated investment grade by Moody’s or S&P or, in the alternative, that the credit quality of the obligor is considered by FSA to be the equivalent of investment grade. Where the obligor is a governmental entity with taxing power or providing an essential public service paid by taxes, assessments or other charges, supplemental protections may be required if such taxes, assessments or other charges are not projected to provide sufficient debt service coverage. Where appropriate, the obligor may be required to provide a rate covenant and a pledge of additional security (e.g., mortgages on real property, liens on equipment or revenue pledges) to secure the insured obligation.
FSA’s underwriting guidelines for asset-backed obligations are premised on the concept of multiple layers of protection, and vary by obligation type in order to reflect different structures and types of credit support. FSA seeks to insure asset-backed obligations that generally provide for one or more forms of overcollateralization (such as excess collateral value, excess cash flow or “spread,” reserves or, in the case of CDS, a deductible) or third-party protection (such as bank letters of credit, guarantees, net worth maintenance agreements, indemnity agreements, CDS or reinsurance agreements). Asset-backed obligations insured by FSA often benefit from self-adjusting mechanisms, such as cash traps or accelerated amortization that take effect upon a failure to satisfy performance-based triggers.
Overcollateralization or third-party protection does not need to protect FSA against all risk of loss, but is generally intended to assume the primary risk of financial loss. Overcollateralization and third-party protection may not be required in transactions in which FSA is insuring the obligations of certain highly rated issuers that typically are regulated, have implied or explicit government support, or are short term.
FSA’s underwriting policy allows for FSA to insure securities issued to refinance other securities insured by FSA as to which the issuer is or may be in default. Overcollateralization and third-party protection may not be required in such transactions.
In addition, FSA may insure so-called “future flow,” “diversified payment right,” “triple-X,” “airplane enhanced equipment trust certificate” and “whole business” securitizations in which FSA may be exposed to a level of corporate risk greater than found in traditional asset-backed securities. FSA has also insured “extreme mortality” transactions, which, like “triple-X” securitizations insured by FSA, expose FSA to investment-grade levels of mortality risk.
FSA’s general policy has been to insure 100% of the principal, interest and other amounts due in respect of funded asset-backed obligations rather than providing partial or first-loss coverage sufficient to confer a Triple-A rating on the senior obligations. In the CDS sector, FSA often insures risks, and in the funded sector FSA sometimes insures securities, on a “compressed” or “mezzanine” basis in which the obligations insured by FSA are subordinate, in whole or in part, to more senior uninsured obligations and where the risk insured by FSA is typically Triple-A without the benefit of FSA’s insurance.
The rating agencies participate to varying degrees in the underwriting process. Most asset-backed and international obligations insured by FSA are reviewed prior to issuance by both S&P and Moody’s to evaluate the risk proposed to be insured. In the case of domestic municipal obligations, prior rating agency review is a function of the type of insured obligation and the risk elements involved. The independent review of FSA’s underwriting practices performed by the rating agencies further strengthens the underwriting process.
The Company’s Risk Management Committee reviews the Company’s insured portfolio on a periodic basis. The Risk Management Committee includes FSA’s Chief Risk Management Officer and the four Chief Underwriting Officers (Domestic, International, International Structured Finance and Municipal
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Underwriting), as well as the Chief Executive Officer, President, General Counsel and Chief Financial Officer.
The underwriting process that implements the Company’s underwriting guidelines and standards is supported by FSA’s professional staff of analysts, underwriting officers, credit officers and attorneys. Moreover, the approval of senior management and/or designated senior underwriting officers is required for all transactions.
Each underwriting group in the Financial Guaranty Group is responsible for confirming that each transaction proposed by the Financial Guaranty Group conforms to the underwriting guidelines and standards. This evaluation is reviewed by the chief underwriting officer for the particular sector. This review may take place while the transaction is in its formative stages, thus facilitating the introduction of further enhancements at a stage when the transaction is more receptive to change.
Final transaction approval is obtained from FSA’s Management Review Committee (the “MRC”) for asset-backed transactions and international transactions and from FSA’s Municipal Underwriting Committee (the “MUNC”) for domestic municipal transactions. Approval is usually based upon both a written and an oral presentation by the underwriting group to the respective committee. Following approval, the Chair of the applicable underwriting committee may approve minor transaction modifications. Major changes require the concurrence of the applicable underwriting committee.
The MRC is composed of FSA’s Chief Executive Officer, President, Chief Risk Management Officer, Chief Domestic Underwriting Officer, Chief International Underwriting Officer, Chief International Structured Finance Officer, General Counsel and Associate General Counsel for Asset-Backed Transactions. The Chief Executive Officer, President, General Counsel and Chief Risk Management Officer are not required to participate in MRC meetings for transactions meeting certain criteria. The MRC may delegate approval authority for certain highly rated asset-backed transactions that fall below established monetary thresholds.
The MUNC is composed of FSA’s Chief Executive Officer, President, Chief Municipal Underwriting Officer, a Municipal Underwriting Officer, Managing Director of Public Finance and Associate General Counsel for Municipal Transactions. The MUNC approval process generally requires approval by at least:
· the Chief Executive Officer or President,
· the Chief Municipal Underwriting Officer or Municipal Underwriting Officer, and
· an Associate General Counsel for Municipal Transactions.
Subject to applicable limits, public finance transactions satisfying credit and return requirements may be approved by a committee (the “Demi-MUNC”) composed of at least two voting members, one of whom must be the Chief Municipal Underwriting Officer, Municipal Underwriting Officer or Managing Director for Municipal Operations, and any one of certain managing directors and directors designated by the MUNC.
Financial Products Business
The Company’s GIC Affiliates issue GICs and FSAM and its UK subsidiary FSA-PAL make investments in accordance with the FP underwriting guidelines. These underwriting guidelines require that each GIC and investment meet the funding strategy of the FP business. The funding strategy, in turn, reflects the Company’s short-term liquidity needs to meet withdrawals and purchase assets, the Company’s collateral posting obligations under collateralized GICs, the availability of attractive investments, the risk that actual GIC withdrawals may vary from expected withdrawals and other factors.
FP’s underwriting guidelines also govern FSAM’s investment of funds raised from the issuance of GICs. In general, investments are obligations that would qualify for FSA insurance from a credit
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perspective, and must therefore be investment-grade quality. The Company manages its GIC investment portfolio to maintain sufficient liquidity to address expected and unexpected GIC withdrawals and to maintain sufficient eligible collateral to support collateralized GICs.
Final transaction approval for a GIC depends on the type and size of the GIC along with other criteria. FP’s underwriting guidelines require that the head of the FP group approve all GICs and specify whether approval from FSA’s Chief Executive Officer, President, Chief Risk Management Officer and/or other officers is also required.
Final transaction approval for an investment by FSAM or FSA-PAL depends on the investment sector, credit rating, amount and other factors. The FP underwriting guidelines require that the head of the FP group approve all investments and specify whether approvals from FSA’s Chief Executive Officer, President, Chief Risk Management Officer and/or other officers is also required.
Corporate Research
FSA’s Corporate Research Department is composed of a professional staff under the direction of the Chief Risk Management Officer. The Corporate Research Department is responsible for evaluating the credit quality of entities participating in or providing recourse on obligations insured by FSA. It also provides analysis of industry segments. Members of the Corporate Research Department generally report their findings directly to the appropriate underwriting committee in the context of transaction review and approval, and to the Risk Management Committee as part of periodic portfolio reviews.
Transaction Oversight and Transaction Services
FSA’s Transaction Oversight Groups and its workout subsidiary TSC are independent of the analysts and credit officers involved in the underwriting process. The Municipal and Asset-Backed Transaction Oversight Groups are responsible for monitoring the performance of outstanding transactions. The Transaction Oversight Groups and TSC are responsible for taking remedial actions for underperforming transactions as appropriate. The managers of the transaction oversight and transaction services functions report to the Chief Risk Management Officer. The Underwriting Committee of the Board of Directors receives quarterly reports describing the changes in the overall insured portfolio during the quarter and developments with respect to poorly performing transactions. The Transaction Oversight Groups review insured transactions to confirm compliance with transaction covenants, monitor credit and other developments affecting transaction participants and collateral, and together with TSC and the Risk Management Committee determine the steps, if any, required to protect the interests of FSA and the holders of FSA-insured obligations.
Reviews of transactions typically include an examination of reports provided by, and (as circumstances warrant) discussions or site visits with, issuers, obligors, originators, servicers, collateral managers, trustees and other transaction participants. Review of reports may include financial audits, servicer audits, evaluations by third-party appraisers, engineers, consultants or reports by other experts retained by the obligor or FSA. The Transaction Oversight Groups review transactions to determine the level of ongoing attention required. These judgments relate to current credit quality and other factors, including compliance with reporting or other requirements, legal or regulatory actions involving transaction participants and liquidity or other concerns that may not have a direct bearing on credit quality. Transactions with the highest risk profile are generally subject to more intensive review and, if appropriate, remedial action. The Transaction Oversight Groups and TSC work together with the Legal Department and Corporate Research in monitoring these transactions, negotiating restructurings and pursuing appropriate legal remedies.
The Company’s Transaction Oversight Groups maintain and update internal credit ratings. They also categorize each credit to facilitate appropriate allocation of resources to loss mitigation efforts and to
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efficiently communicate the relative credit condition of each risk exposure, as well as the overall health of the insured portfolio. Such categorization is determined in part by the risk of loss and in part by the level of routine involvement required and monitoring cycle deemed appropriate. Each credit in the insured portfolio is designated one of five surveillance rating categories.
Categories I and II represent fundamentally sound transactions requiring routine monitoring, with Category II indicating that routine monitoring is more frequent, due, for example, to the sector or a need to monitor triggers.
Category III represents transactions with some deterioration in asset performance, financial health of the issuer, or other factors, but for which losses are deemed unlikely. Active monitoring and intervention is employed for Category III transactions.
Category IV reflects transactions demonstrating sufficient deterioration to indicate that material credit losses are possible even though not yet probable. Category IV is the equivalent of “watch list” by banking industry standards.
Category V reflects transactions where losses are probable. This category includes (1) risks where claim payments have been made and where additional payments, net of recoveries, are expected, and (2) risks where claim payments are probable but none have yet been made. Category IV and Category V transactions are subject to intense monitoring and intervention.
The table below presents the gross and net par outstanding and the gross and net reserves for risks classified as described above, as of December 31, 2006 and 2005.
Par Outstanding
| | As of December 31, | |
| | 2006 | | 2005 | |
| | Gross | | Net | | Gross | | Net | |
| | (in millions) | |
Categories I and II | | $ | 471,588 | | $ | 353,819 | | $ | 450,967 | | $ | 331,821 | |
Category III | | 8,851 | | 4,906 | | 6,244 | | 4,900 | |
Category IV | | 468 | | 435 | | 266 | | 242 | |
Category V no claim payments | | 399 | | 360 | | 506 | | 463 | |
Category V with claim payments | | 84 | | 40 | | 107 | | 57 | |
Total | | $ | 481,390 | | $ | 359,560 | | $ | 458,090 | | $ | 337,483 | |
Case Reserves
| | As of December 31, | |
| | 2006 | | 2005 | |
| | Gross | | Net | | Gross | | Net | |
| | (in millions) | |
Category V no claim payments | | $ | 48.4 | | $ | 39.3 | | $ | 49.3 | | $ | 40.6 | |
Category V with claim payments | | 41.9 | | 13.7 | | 40.7 | | 13.1 | |
Total | | $ | 90.3 | | $ | 53.0 | | $ | 90.0 | | $ | 53.7 | |
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Legal
The Company’s Legal Department is composed of a professional staff of attorneys and legal assistants under the direction of the General Counsel. The Company’s Legal Department is divided into five sectors: asset-backed transactions, municipal transactions, financial products, regulatory/reinsurance/corporate and compliance. The Legal Department plays a major role in establishing and implementing legal requirements and procedures applicable to obligations insured by the Company. Members of the Legal Department serve on the MRC and MUNC, which provide final underwriting approval for transactions. An attorney in the Legal Department works together with his or her counterpart in the relevant financial guaranty group in determining the legal and credit elements of each obligation proposed for insurance and in overseeing the execution of approved transactions. Asset-backed obligations insured by the Company are ordinarily executed with the assistance of outside counsel working closely with the Legal Department. Public finance obligations insured by the Company are ordinarily executed without employment of outside counsel. The financial products attorneys in the Legal Department work together with their counterparts in the FP group in developing and overseeing the execution of approved financial products transactions. The Legal Department works closely with the Transaction Oversight Groups and TSC in addressing legal issues, rights and remedies, as well as proposed amendments, waivers and consents, in connection with obligations insured by the Company. The Legal Department is also responsible for domestic and international regulatory compliance, reinsurance, secondary market transactions, litigation and other matters. The Chief Compliance Officer is a member of the Legal Department and provides quarterly compliance and regulatory activity reports to the Company’s Executive Management Committee and the Audit Committee of the Board of Directors of the Company.
Finance and Accounting
The Company’s Finance and Accounting Department is composed of a professional staff of accountants and financial analysts under the direction of the Chief Financial Officer. The Company’s Finance and Accounting Department is divided into two principal sections: Accounting and Treasury. Accounting plays the primary role in establishing and complying with accounting policies and procedures consistent with each of the various accounting standards under which the Company and its subsidiaries prepare its financial statements, including accounting principles generally accepted in the United States of America (“GAAP”), International Financial Reporting Standards (“IFRS”) for Dexia and various statutory methods prescribed for its domestic insurance operations and non-U.S. subsidiaries and branches. Treasury plays the primary role in developing and monitoring the operating and capital plans. This department is also responsible for optimizing the Company’s capital structure, ensuring the capital and liquidity resources are maintained at Triple-A levels and periodically evaluating returns on deployed capital. The Finance and Accounting Department works closely with all areas of the Company to ensure that all transactions are well understood, processed in an appropriate and controlled manner, and accounted for properly. This department is also responsible for ensuring that the Company maintains adequate internal control systems and periodically meets to review and discuss financial filings prior to their submission with the SEC. The Controller is the head of the Accounting Department and regularly attends meetings of the Audit Committee of the Board of Directors. The Treasurer is the leader of the Treasury Department and regularly attends meetings of the Investment Committee of the Board of Directors.
Competition and Industry Concentration
FSA faces competition from both other providers of and alternatives to third-party credit enhancement. Most securities are sold without third-party credit enhancement. Accordingly, each transaction FSA proposes to insure must generally compete against an alternative execution that does not employ third-party credit enhancement. Many financings may be funded by banks through loans or in the capital markets through the sale of securities. Both types of fundings may be executed with or without
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insurance. FSA faces competition from other Triple-A-rated monoline financial guaranty insurers, primarily Ambac Assurance Corp. (“Ambac”), CIFG Guaranty, Financial Guaranty Insurance Company (“FGIC”), MBIA Insurance Corp. (“MBIA”) and XL Capital Assurance Inc. Competition is largely based on premium rates, capacity, underwriting requirements and trading levels.
New entrants to the market provide increasing competition to more established market participants such as FSA as they attempt to grow their market share. Assured Guaranty Corp. and Radian Asset Assurance Inc., two market participants previously engaged primarily in reinsurance, either directly or through affiliates, now focus on the primary financial guaranty insurance market. From time to time other parties consider establishing new financial guaranty insurers that may compete with the Company. Entry requirements include:
· assembling the group of experts required to operate a financial guaranty insurance business,
· establishing claims-paying ability ratings with the credit rating agencies,
· complying with substantial capital requirements,
· developing name recognition and market acceptance with issuers, investment bankers and investors, and
· organizing a monoline insurance company and obtaining insurance licenses to do business in the applicable jurisdictions.
Traditional credit enhancers such as bank letter of credit providers and mortgage pool insurers provide competition to FSA as providers of credit enhancement for asset-backed obligations. Actions by securities rating agencies in recent years have significantly reduced the number of Triple-A-rated financial institutions that can offer a product directly competitive with FSA’s Triple-A guaranty, and risk-based capital guidelines applicable to banks have generally increased costs associated with letters of credit that compete directly with financial guaranty insurance. Nonetheless, bank sponsored commercial paper conduits, bank letter of credit providers and other forms of credit enhancement, such as cash collateral accounts provided by banks, continue to provide significant competition to FSA. In addition, CDS, credit-linked notes and other synthetic products provide coverage directly competitive with financial guaranty insurance, and expand the universe of participants in the financial risk market. In recent years, derivative product companies and other structured investment vehicles compete with the Company on a limited basis in the CDS market. Bank affiliates may participate in the U.S. insurance business, including the financial guaranty insurance business.
Government sponsored entities, including Fannie Mae and Freddie Mac, compete with the monoline financial guaranty insurers, on a limited basis, in the mortgage-backed and multifamily sectors. Expansion of the business franchises by government sponsored entities, as well as potential new entrants into the financial guaranty sector such as Federal Home Loan Banks and state pension funds, present competitive challenges to private sector participants such as FSA.
Insurance law generally restricts multiline insurance companies, such as large property/casualty insurers and life insurers, from engaging in the financial guaranty insurance business other than through separately capitalized monoline affiliates.
Set forth below are FSA’s aggregate gross insurance in force, net insurance in force, qualified statutory capital and capital ratio (represented by the ratio of its net insurance in force to qualified statutory capital) and the average industry capital ratio at the dates indicated. FSA’s net insurance in force is the outstanding principal, interest and other amounts payable over the remaining life of all obligations insured by FSA, net of ceded reinsurance and refunded bonds secured by U.S. government securities held in escrow or other qualifying collateral. Qualified statutory capital, determined in accordance with statutory accounting practices, is the aggregate of policyholders’ surplus and contingency reserves
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calculated in accordance with statutory accounting practices. Net insurance data does not distinguish between quota share reinsurance and first-loss reinsurance. In light of FSA’s use of first-loss reinsurance in the project finance and, to a lesser extent, asset-backed sectors, the data below tends to overstate FSA’s risk leverage in comparison with its industry counterparts. Conversely, FSA also insures mezzanine risks and obtains excess-of-loss credit protection in CDS transactions, which reduces FSA’s reported risk leverage. The statutory capital ratio does not reflect the underlying credit quality of the insurance in force, which diminishes the comparative value of the disclosure. Specifically, the credit quality of FSA’s insured portfolio as measured by S&P and Moody’s is generally higher than most of FSA’s industry peers, although FSA’s ratio of net debt service to statutory capital is also generally higher than most of FSA’s industry peers.
| | As of December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (dollars in millions) | |
Financial guaranty primary insurers, excluding FSA(1) | | | | | | | |
Capital ratio | | 144:1 | | 141:1 | | 147:1 | |
FSA(2) | | | | | | | |
Gross insurance in force | | $ | 765,632 | | $ | 686,134 | | $ | 633,037 | |
Net insurance in force | | 552,695 | | 497,624 | | 454,359 | |
Qualified statutory capital | | 2,554 | | 2,418 | | 2,281 | |
Capital ratio | | 216:1 | | 206:1 | | 199:1 | |
| | | | | | | | | | |
(1) Financial guaranty primary insurers for which data is included in this table are Ambac, FGIC and MBIA. Information relating to the financial guaranty primary insurers is derived from data from statutory accounting financial information publicly available from each insurer as of December 31, 2006, 2005 and 2004.
(2) Includes gross and net insurance in force relating to FSA-insured GICs issued by the GIC Affiliates of $20,850 million for 2006, $16,878 million for 2005, and $8,753 million for 2004.
In December 2004, FSA obtained CDS protection on an excess-of-loss basis (exceeding very large deductibles) on a number of FSA-insured synthetic CDO transactions shadow rated “Super Triple-A” at inception. As of December 31, 2006, the CDS provided approximately $4.6 billion of credit protection. Given the high credit quality of the risk transferred to the CDS provider, the main effect of this CDS was to improve FSA’s statutory capital ratios and increase FSA’s margin under regulatory risk limits on aggregate insured exposures. This CDS protection was terminated by FSA in January 2007.
Reinsurance
Reinsurance is the commitment by one insurance company, the “reinsurer,” to reimburse another insurance company, the “ceding company,” for a specified portion of the insurance risks underwritten by the ceding company in consideration for a portion of the premiums received. The ceding company typically but not always receives a ceding commission to cover the cost of business generation. Because the insured party contracts for coverage solely with the ceding company, the failure of the reinsurer to perform does not relieve the ceding company of its obligation to the insured party under the terms of the insurance contract.
As of December 31, 2006, FSA reinsured approximately 24.5% of its principal amount outstanding. FSA obtains reinsurance to increase its policy writing capacity, both on an aggregate-risk and a single-risk basis, to:
· meet internal, rating agency and regulatory limits,
· diversify risks,
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· reduce the need for additional capital, and
· strengthen financial ratios.
FSA’s reinsurance may be on a quota share, first-loss, or excess-of-loss basis. Quota share reinsurance generally provides protection against a fixed specified percentage of all losses incurred by FSA. First-loss reinsurance generally provides protection against a fixed specified percentage of losses incurred up to a specified limit. Excess-of-loss reinsurance generally provides protection against a fixed percentage of losses incurred to the extent that losses incurred exceed a specified limit. Reinsurance arrangements typically require FSA to retain a minimum portion of the risks reinsured.
FSA arranges reinsurance on both a facultative (transaction-by-transaction) and treaty basis. By annual treaty, FSA employs “automatic facultative” reinsurance that permits FSA to apply reinsurance to transactions it selects subject to certain limitations. The remainder of FSA’s treaty reinsurance provides coverage for a portion, subject in certain cases to adjustment at FSA’s election, of the exposure from all qualifying policies issued during the term of the treaty. The reinsurer’s participation in a treaty is either cancelable annually upon 90 days’ prior notice by either FSA or the reinsurer or has a one-year term. Treaties generally provide coverage for the full term of the policies reinsured during the annual treaty period, except that, upon a financial deterioration of the reinsurer or the occurrence of certain other events, FSA generally has the right to reassume all or a portion of the business reinsured. Reinsurance agreements may be subject to other termination conditions as required by applicable state law. FSA monitors the financial condition of its reinsurers.
Primary insurers, such as FSA, are required to fulfill their obligations to policyholders if reinsurers fail to meet their obligations. The financial condition of reinsurers is important to FSA, and FSA endeavors to place its reinsurance with financially strong reinsurers. FSA’s treaty reinsurers as of December 31, 2006 were Assured Guaranty Re International Ltd. (formerly ACE Capital Re International Ltd.); BluePoint Re, Limited; Mitsui Sumitomo Insurance Company, Limited; Radian Asset Reinsurance Inc. (successor to Radian Reinsurance Inc., formerly Enhance Reinsurance Company); RAM Reinsurance Co. Ltd.; Swiss Reinsurance Company; Tokio Marine and XLFA. FSA also has reciprocal surplus share reinsurance treaties with Ambac and FGIC, which provide quota share reinsurance on transactions exceeding specified par amounts insured.
Securities rating agencies allow FSA “credit” for reinsurance based on the reinsurer’s ratings. Generally, 95-100% credit is allowed for Triple-A reinsurance and 65-90% credit is allowed for Double-A reinsurance. In addition, a number of FSA’s reinsurers are required to pledge collateral to secure their reinsurance obligations to FSA. In some cases, the pledged collateral augments the rating agency credit for the reinsurance provided to FSA. Given the financial strength of its reinsurers, FSA requires collateral from reinsurers primarily to (a) receive statutory credit for the reinsurance, (b) provide liquidity to FSA in the event of claims on the reinsured exposures, and (c) enhance rating agency credit for the reinsurance.
In recent years, a number of FSA’s reinsurers have been downgraded from Triple-A to Double-A or lower by one or more rating agency. While ceding commissions or premium allocation adjustments may compensate in part for such downgrades, the effect of such downgrades, in general, is to decrease the financial benefits of using reinsurance under rating agency capital adequacy models.
In 2004, the insurance laws of the State of New York (the “New York Insurance Law”) were amended to allow financial guaranty insurers such as FSA to treat qualifying CDS from highly rated financial institutions as collateral for purposes of satisfying risk limits and certain reserve requirements. These amendments allow financial guaranty insurers to employ CDS as collateral for statutory accounting purposes, with the collateral having effects similar to reinsurance in reducing single and aggregate risks for statutory purposes. In December 2004, FSA obtained CDS protection on an excess-of-loss basis (exceeding very large deductibles) on a number of FSA-insured synthetic CDO transactions shadow rated “Super
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Triple-A” at inception. As of December 31, 2006, the CDS provided approximately $4.6 billion of credit protection. Given the high credit quality of the risk transferred to the CDS provider, the main effects of this CDS were to improve FSA’s statutory capital ratios and increase FSA’s margin under regulatory risk limits on aggregate insured exposures. This CDS was terminated by FSA in January 2007.
FSA, FSAIC and FSA International are party to a quota share reinsurance pooling agreement pursuant to which, after reinsurance cessions to other reinsurers, the FSA companies share in the net retained risk insured by each of these companies or reinsured by FSA from FSAUK. Under the pooling agreement, FSA, FSAIC and FSA International share the net retained risk in proportion to their policyholders’ surplus and contingency reserves, or “statutory capital,” at the end of the prior calendar quarter.
FSA-UK and FSA are party to a quota share and stop loss reinsurance agreement pursuant to which:
· FSA-UK reinsures with FSA its retention under its policies after third-party reinsurance based on an agreed-upon percentage that is substantially in proportion to the statutory capital of FSA-UK to the total statutory capital of FSA and its subsidiary insurers (including FSA-UK); and
· subject to certain limits, FSA is required to make payments to FSA-UK when FSA-UK’s annual net incurred losses and expenses exceeds FSA-UK’s annual net earned premiums plus draws on FSA-UK’s equalization reserves to pay incurred losses.
Under this agreement, FSA-UK ceded to FSA approximately 97.4% of its retention after third-party reinsurance of its policies issued in 2006.
Rating Agencies
The value of FSA’s insurance product is generally a function of the “rating” applied to the obligations it insures. The financial strength of FSA and its insurance company subsidiaries is rated “Aaa” by Moody’s and “AAA” by S&P, Fitch Ratings (“Fitch”) and Rating and Investment Information, Inc. Such ratings reflect only the views of the respective rating agencies, are not recommendations to buy, sell or hold securities and are subject to revision or withdrawal at any time by such rating agencies.
These rating agencies periodically review FSA’s business and financial condition, focusing on the insurer’s underwriting policies and procedures and the quality of the obligations insured, and publish their ratings and supporting analyses. Each rating agency performs periodic assessments of the credits insured by FSA, as well as the reinsurers and other providers of capital support to FSA, to confirm that FSA continues to satisfy such rating agency’s capital adequacy criteria necessary to maintain FSA’s Triple-A rating. FSA’s ability to compete with other Triple-A-rated financial guarantors, and its results of operations and financial condition, would be materially adversely affected by any reduction in its ratings.
Moody’s, S&P and Fitch apply their own capital adequacy models in assessing the financial strength of FSA. Financial factors considered by the rating agencies in assessing capital adequacy include:
· capital charges or other assessments of credit risks for FSA’s insured portfolio, including the degree of risk embedded in FSA-insured GICs;
· the quality of FSA’s assets and other investments;
· the credit quality of FSA’s reinsurers and the type of reinsurance and the collateral, if any, provided thereby;
· credit lines and other capital support arrangements (“soft capital”);
· premium revenues expected to be generated from outstanding policies;
· anticipated future new business originations and anticipated future losses; and
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· holding company financial strength and leverage.
Given the importance of its ratings to its on-going business, FSA’s underwriting process generally includes an analysis of the impact on rating agency capital adequacy determinations in addition to other measures of creditworthiness. Reference is made to the published reports of Moody’s, S&P and Fitch regarding the Company, capital adequacy models, the bond insurance business in general and FSA’s standing relative to its industry peers on the basis of capital adequacy and profitability.
Insurance Regulatory Matters
General
FSA is licensed to engage in insurance business in all 50 states, the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands. FSA is subject to the New York Insurance Law and is also subject to the insurance laws of the other states in which it is licensed to transact insurance business. FSAIC is an Oklahoma-domiciled insurance company also licensed in New York and subject to the New York Insurance Law. FSA and its domestic insurance company subsidiary are required to file quarterly and annual statutory financial statements in each jurisdiction in which they are licensed, and are subject to statutory restrictions concerning the types and quality of investments and the filing and use of policy forms and premium rates. FSA’s accounts and operations are subject to periodic examination by the Superintendent of Insurance of the State of New York (the “New York Superintendent”) and other state insurance regulatory authorities. The last completed examination was conducted in 2004 for the three-year period ended December 31, 2002.
FSA International is a Bermuda-domiciled insurance company subject to applicable requirements of Bermuda law. FSA International maintains its principal executive offices in Hamilton, Bermuda. FSA International does not intend to transact business or establish a permanent place of business in the United States or Europe.
FSA-UK is a United Kingdom domiciled insurance company subject to applicable requirements of English law. FSA-UK maintains its principal executive offices in London, England. Pursuant to European Union Directives, FSA-UK is generally authorized to write business out of its London office in other member countries of the European Union, subject to the satisfaction of perfunctory registration requirements.
FSA has a Tokyo branch authorized to transact insurance business in Japan and subject to regulation by Japanese authorities and a Singapore branch authorized to transact insurance business in Singapore and subject to regulation by Singapore authorities. FSA Mexico is currently seeking a license to transact financial guaranty insurance in Mexico.
Domestic Insurance Holding Company Laws
The Company and its domestic insurance company subsidiaries (FSA and FSAIC) are subject to regulation under insurance holding company statutes of their jurisdiction of domicile (New York and Oklahoma, respectively), as well as other jurisdictions where these insurers are licensed to do insurance business. The requirements of holding company statutes vary from jurisdiction to jurisdiction but generally require insurance holding companies and their insurance company subsidiaries to register and file certain reports describing, among other information, their capital structure, ownership and financial condition. The holding company statutes also require prior approval of changes in control, certain dividends and other intercorporate transfers of assets and transactions between insurance companies and their affiliates. The holding company statutes generally require that all transactions with affiliates be fair and reasonable and that those exceeding specified limits require prior notice to or approval by insurance regulators.
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Under the insurance holding company laws in effect in New York and Oklahoma, any acquisition of control of the Company, and thereby indirect control of FSA and FSAIC, requires the prior approval of the New York Superintendent and the Oklahoma Insurance Commissioner. “Control” is defined as the direct or indirect power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract or otherwise. Any purchaser of 10% or more of the outstanding voting securities of a corporation is presumed to have acquired control of that corporation and its subsidiaries, although the insurance regulator may find that “control” in fact does or does not exist when a person owns or controls either a lesser or greater amount of voting securities.
New York Financial Guaranty Insurance Law
Article 69 of the New York Insurance Law (“Article 69”), a comprehensive financial guaranty insurance statute, governs all financial guaranty insurers licensed to do business in New York, including FSA. This statute limits the business of financial guaranty insurers to financial guaranty insurance and related lines (such as surety).
Article 69 requires that financial guaranty insurers maintain a special statutory accounting reserve called the “contingency reserve” to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. Article 69 requires a financial guaranty insurer to provide a contingency reserve:
· with respect to policies written prior to July 1, 1989 in an amount equal to 50% of earned premiums; and
· with respect to policies written on and after July 1, 1989, quarterly on a pro rata basis over a period of 20 years for municipal bonds and 15 years for all other obligations, in an amount equal to the greater of 50% of premiums written for the relevant category of insurance or a percentage of the principal guaranteed, varying from 0.55% to 2.50%, depending on the type of obligation guaranteed, until the contingency reserve amount for the category equals the applicable percentage of net unpaid principal.
This reserve must be maintained for the periods specified above, except that reductions by the insurer may be permitted under specified circumstances in the event that actual loss experience exceeds certain thresholds or if the reserve accumulated is deemed excessive in relation to the insurer’s outstanding insured obligations. FSA has in the past sought and obtained releases of excessive contingency reserves from the New York Insurance Department. Financial guaranty insurers are also required to maintain reserves for losses and loss adjustment expenses on a case-by-case basis and reserves against unearned premiums.
For purposes of Article 69, “municipal bonds” includes qualifying project finance transactions, sovereign issuances and securitizations of government-supported receivables.
Article 69 establishes single risk limits for financial guaranty insurers applicable to all obligations issued by a single entity and backed by a single revenue source. For example, under the limit applicable to qualifying asset-backed securities, the lesser of:
· the insured average annual debt service for a single risk, net of qualifying reinsurance and collateral, or
· the insured unpaid principal (reduced by the extent to which the unpaid principal of the supporting assets exceeds the insured unpaid principal) divided by nine, net of qualifying reinsurance and collateral,
may not exceed 10% of the sum of the insurer’s policyholders’ surplus and contingency reserves, subject to certain conditions.
Under the limit applicable to municipal obligations, the insured average annual debt service for a single risk, net of qualifying reinsurance and collateral, may not exceed 10% of the sum of the insurer’s
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policyholders’ surplus and contingency reserves. In addition, insured principal of municipal obligations attributable to any single risk, net of qualifying reinsurance and collateral, is limited to 75% of the insurer’s policyholders’ surplus and contingency reserves. Single-risk limits are also specified for other categories of insured obligations, and generally are more restrictive than those listed for asset-backed or municipal obligations. Obligations not qualifying for an enhanced single-risk limit are generally subject to the “corporate” limit (applicable to insurance of unsecured corporate obligations) equal to 10% of the sum of the insurer’s policyholders’ surplus and contingency reserves. For example, “triple-X” and “future flow” securitizations, as well as unsecured investor-owned utility obligations, are generally subject to these “corporate” single-risk limits.
Article 69 also establishes aggregate risk limits on the basis of aggregate net liability insured as compared with statutory capital. “Aggregate net liability” is defined as outstanding principal and interest of guaranteed obligations insured, net of qualifying reinsurance and collateral. Under these limits, policyholders’ surplus and contingency reserves must not be less than a percentage of aggregate net liability equal to the sum of various percentages of aggregate net liability for various categories of specified obligations. The percentage varies from 0.33% for certain municipal obligations to 4% for certain non-investment-grade obligations.
Dividend Restrictions
FSA’s ability to pay dividends is dependent on FSA’s financial condition, results of operations, cash requirements, rating agency confirmation of non-impairment of FSA’s ratings and other related factors, and is also subject to restrictions contained in the New York Insurance Law. Under New York Insurance Law, FSA may pay dividends out of statutory earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of:
· 10% of policyholders’ surplus as of its last statement filed with the New York Superintendent; or
· adjusted net investment income during this period.
Based on FSA’s statutory statements for 2006, the maximum amount available for payment of dividends by FSA without regulatory approval over the 12 months following December 31, 2006 was approximately $156.6 million.
Financial Guaranty Insurance Regulation in Other Jurisdictions
FSA is subject to laws and regulations of jurisdictions other than the State of New York concerning the transaction of financial guaranty insurance. The laws and regulations of these other jurisdictions are generally not more stringent in any material respect than the New York Insurance Law.
The Bermuda Ministry of Finance regulates FSA International. The United Kingdom Financial Services Authority regulates FSA-UK. Pursuant to European Union Directives, FSA-UK has been authorized to provide financial guaranty insurance for transactions in numerous European countries from its home office in the United Kingdom. FSA has received a determination from the Australian Insurance and Superannuation Commissioner that the financial guarantees issued by FSA with respect to Australian transactions do not constitute insurance for which a license is required. The Monetary Authority of Singapore regulates activities of FSA’s Singapore branch and the Japan Financial Services Authority regulates the activities of FSA’s Tokyo branch. Upon receipt of a license to transact financial guaranty insurance in Mexico, FSA Mexico will become subject to regulation by the Ministry of Finance and the Mexican National Commission of Insurance and Finance.
U.S. Bank Holding Company Act
Dexia indirectly owns 99.7% of the Company’s common stock. Because Dexia has a non-U.S. bank subsidiary with a branch in the U.S., Dexia and all of its subsidiaries, including the Company and its subsidiaries, are subject to the U.S. Bank Holding Company Act (the “BHC Act”). In general, the BHC
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Act restricts the activities of banking organizations and their affiliates to the ownership and operation of banks and to other activities that are “closely related to banking” as determined by the Board of Governors of the Federal Reserve System. Insurance activities such as those conducted by certain of the Company’s subsidiaries are generally not permissible under this restriction. Under the BHC Act, however, an organization that qualifies as a “financial holding company” is permitted to engage in a broader range of permissible “financial activities.” “Financial activities” include insurance underwriting and agency activities as well as merchant banking. For Dexia to qualify as a “financial holding company,” it and its non-U.S. bank subsidiary with a branch in the U.S. must be both:
· “well capitalized,” which requires a Tier I capital to risk-based assets ratio of at least 6% and a total capital to risk-based assets ratio of at least 10%, as calculated under home country standards (Tier I, or core, capital includes equity capital less certain intangibles), and
· “well managed,” which requires a composite U.S. banking office examination rating by the relevant U.S. bank regulator of at least “satisfactory.”
Dexia holds its investment in, and operates, the Company and its subsidiaries under the “financial activities” authorization permitted to “financial holding companies.” If Dexia does not continue to meet the requirements for qualifying as a “financial holding company,” it may lose its ability to hold its investment in, or operate, the Company and its subsidiaries.
Investments
In addition to the investment portfolios maintained by the Company’s insurance company subsidiaries and directly by FSA Holdings (collectively, the “General Investment Portfolio”), the Company maintains investments from proceeds of FSA-insured GICs (the “FP Investment Portfolio”), the portfolio of securities owned by the VIEs (the “VIE Investment Portfolio”) and assets acquired from refinancing transactions. The FP Investment Portfolio and the VIE Investment Portfolio together constitute the “FP Segment Investment Portfolio.”
As of December 31, 2006, the Company also had investments in strategic partners, including:
· XLFA; and
· TheDebtCenter, L.L.C., which operates TheMuniCenter, L.L.C., an online exchange for municipal bonds.
On October 4, 2005, the Company sold its investment in SPS Holding Corp. (“SPS”) (formerly Fairbanks Capital Holding Corp.), a residential mortgage loan servicer, to an unaffiliated third party. For its interest in SPS, the Company was paid $42.9 million in cash. The Company has subsequently received an additional net amount of $11.2 million, and expects to receive additional amounts from time to time through March 31, 2008, out of income earned by SPS through December 31, 2007 from certain of its mortgage servicing activities. Under the sale documents, the Company’s subsidiary that owned the SPS investment made representations and warranties to, and undertook specified indemnification obligations for the benefit of, the purchaser.
Investments Insured by the Company
Both the General Investment Portfolio and the FP Investment Portfolio include fixed-income investments insured by FSA (“FSA-Insured Investments”). At December 31, 2006, the General Investment Portfolio included $303.3 million of FSA-Insured Investments, representing approximately 6.3% of the portfolio, and the FP Investment Portfolio included $732.1 million of FSA-Insured Investments, measured at fair value, representing approximately 4.4% of the portfolio.
The Company, like its industry peers, records these investments as available-for-sale securities and carries them at fair value, which includes the effect of the embedded FSA guaranty. The Company’s accounting treatment of the FSA-Insured Investments is based on Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” which requires
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that investment securities be carried at fair value, applying quoted prices where available. Quoted prices reflect the value of the embedded FSA insurance policy and related Triple-A rating.
General Investment Portfolio
Management’s primary objective in managing the General Investment Portfolio is to generate an optimal level of after-tax investment income while preserving capital and maintaining adequate liquidity, subject to rating agency capital adequacy criteria that reduce credit for investments based on their ratings to the extent rated less than Triple-A. The General Investment Portfolio is managed by unaffiliated professional investment managers and the Company’s affiliate FSA Portfolio Management, which manages the majority of the Company’s municipal portfolio. The investment management function is overseen by the Investment Committee of the Company’s Board of Directors.
To accomplish its objectives, the Company has established guidelines for eligible fixed-income investments by FSA, requiring that at least 95% of such investments be rated at least Single-A at acquisition and the overall portfolio be rated Double-A on average. Fixed-income investments falling below the minimum quality level are disposed of at such time as management deems appropriate. For liquidity purposes, the Company’s policy is to invest primarily in readily marketable investments with no legal or contractual restrictions on resale. Eligible fixed-income investments include U.S. Treasury and agency obligations, corporate bonds, tax-exempt bonds, asset-backed securities and mortgage-backed securities. In applying its investment guidelines, the Company uses the published rating for FSA-Insured Investments, rather than the rating that such securities would have without giving effect to the FSA guaranty, referred to as the “shadow rating.” The Company’s current investment strategy is to invest in quality, readily marketable instruments of intermediate average duration so as to generate stable investment earnings with minimal market value or credit risk.
The weighted average maturity of the fixed-income securities in the General Investment Portfolio as of December 31, 2006 was approximately 12 years.
The Company’s investment in XLFA preferred stock is included in the General Investment Portfolio.
The following tables set forth certain information concerning the fixed-income securities in the Company’s General Investment Portfolio based on amortized cost:
General Investment Portfolio Fixed-income Securities by Rating
As of December 31, 2006(1)
Rating | | | | Percent of
Investment
Portfolio | |
AAA(2) | | | 85.8 | % | |
AA | | | 11.2 | | |
A | | | 2.9 | | |
NR | | | 0.1 | | |
Total | | | 100.0 | % | |
(1) Excludes equity securities held in the General Investment Portfolio. As of December 31, 2006, equity securities accounted for 1.2% of the General Investment Portfolio’s amortized cost and are not rated. Ratings are based on the lower of Moody’s or S&P ratings available as of December 31, 2006. 6.2% of the bonds included in the General Investment Portfolio were rated Triple-A by virtue of insurance provided by FSA. Over 95% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments was in the Double-A range.
(2) Includes U.S. Treasury obligations, which comprised 4.0% of the portfolio as of December 31, 2006.
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Summary of Investments
| | As of December 31, | |
| | 2006 | | 2005 | |
Investment Category | | | | Amortized
Cost | | Weighted
Average
Yield(1) | | Amortized
Cost | | Weighted
Average
Yield(1) | |
| | (dollars in thousands) | |
Long term investments: | | | | | | | | | | | | | |
Taxable bonds | | $ | 882,326 | | | 4.92 | % | | $ | 788,298 | | | 4.61 | % | |
Tax-exempt bonds | | 3,663,821 | | | 4.91 | | | 3,431,046 | | | 4.77 | | |
Total long-term investments | | 4,546,147 | | | 4.91 | | | 4,219,344 | | | 4.74 | | |
Short-term investments | | 96,055 | | | 4.55 | | | 159,133 | | | 3.06 | | |
Total fixed-income investments | | 4,642,202 | | | 4.91 | | | 4,378,477 | | | 4.68 | | |
Equity investments | | 54,291 | | | | | | 54,370 | | | | | |
Total investments | | $ | 4,696,493 | | | | | | $ | 4,432,847 | | | | | |
| | | | | | | | | | | | | | | | | |
(1) Yields are stated on a pre-tax basis.
General Investment Portfolio by Security Type
| | As of December 31, | |
| | 2006 | | 2005 | |
Investment Category | | | | Amortized
Cost | | Weighted
Average
Yield(1) | | Amortized
Cost | | Weighted
Average
Yield(1) | |
| | (dollars in thousands) | |
U.S. government and agency securities | | $ | 165,530 | | | 4.72 | % | | $ | 195,495 | | | 4.49 | % | |
Mortgage-backed securities | | 262,651 | | | 5.37 | | | 250,001 | | | 5.24 | | |
Municipal bonds | | 3,663,821 | | | 4.91 | | | 3,431,046 | | | 4.77 | | |
Asset-backed securities | | 22,858 | | | 4.60 | | | 40,216 | | | 3.84 | | |
Corporate securities | | 218,222 | | | 4.96 | | | 186,369 | | | 4.66 | | |
Foreign securities | | 213,065 | | | 4.54 | | | 116,217 | | | 3.62 | | |
Total long-term investments | | 4,546,147 | | | 4.91 | | | 4,219,344 | | | 4.74 | | |
Short-term investments | | 96,055 | | | 4.55 | | | 159,133 | | | 3.06 | | |
Total fixed-income investments | | 4,642,202 | | | 4.91 | | | 4,378,477 | | | 4.68 | | |
Equity investments | | 54,291 | | | | | | 54,370 | | | | | |
Total investments | | $ | 4,696,493 | | | | | | $ | 4,432,847 | | | | | |
| | | | | | | | | | | | | | | | | |
(1) Yields are stated on a pre-tax basis.
The amortized cost and fair value of bonds in the General Investment Portfolio as of December 31, 2006 and 2005, by contractual maturity, are shown below. 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.
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Distribution of Fixed-Income Investments by Contractual Maturity
| | As of December 31, | |
| | 2006 | | 2005 | |
Investment Category | | | | Amortized
Cost | | Fair
Value | | Amortized
Cost | | Fair
Value | |
| | (in thousands) | |
Due in one year or less | | $ | 212,414 | | $ | 212,768 | | $ | 251,443 | | $ | 251,505 | |
Due after one year through five years | | 1,167,172 | | 1,223,913 | | 1,188,212 | | 1,248,314 | |
Due after five years through ten years | | 865,890 | | 894,927 | | 670,694 | | 701,085 | |
Due after ten years | | 2,111,217 | | 2,204,144 | | 1,977,911 | | 2,054,046 | |
Mortgage-backed securities | | 262,651 | | 259,468 | | 250,001 | | 246,246 | |
Asset-backed securities | | 22,858 | | 22,870 | | 40,216 | | 39,974 | |
Total fixed-income investments | | $ | 4,642,202 | | $ | 4,818,090 | | $ | 4,378,477 | | $ | 4,541,170 | |
| | | | | | | | | | | | | | | |
Mortgage-Backed Securities
Cost and Market Value by Investment Category
| | As of December 31, 2006 | |
| | Par Value | | Amortized
Cost | | Fair Value | |
| | (in thousands) | |
Pass-through securities—U.S. Government agency | | $ | 238,442 | | $ | 238,848 | | $ | 235,970 | |
CMOs—U.S. Government agency | | 8,683 | | 8,820 | | 8,715 | |
CMOs—non-agency | | 14,820 | | 14,983 | | 14,783 | |
Total mortgage-backed securities | | $ | 261,945 | | $ | 262,651 | | $ | 259,468 | |
The Company’s investments in mortgage-backed securities primarily consisted of pass-through certificates and collateralized mortgage obligations (“CMOs”), which are backed by mortgage loans guaranteed or insured by agencies of, or sponsored by, the federal government. These securities are highly liquid with readily determinable market prices. The Company also held, as of December 31, 2006, Triple-A-rated CMOs which are not guaranteed by government agencies. Secondary-market quotations are available for these securities, although they are not as liquid as government agency-backed securities.
The CMOs held as of December 31, 2006 have stated maturities ranging from two to 29 years and expected average lives ranging from one to 16 years based on anticipated prepayments of principal.
Mortgage-backed securities differ from traditional fixed-income bonds because they are subject to prepayments at par value without penalty when the underlying mortgage loans are prepaid at the borrower’s option. Prepayment rates on mortgage-backed securities are influenced primarily by the general level of prevailing mortgage interest rates, with prepayments increasing when prevailing loan interest rates are lower than the rates on the underlying mortgage loans, and by the terms of the loans. When prepayments occur, the proceeds must be reinvested at then-current market rates, which may be below the yield on the prepaid securities.
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FP Investment Portfolio
The following tables set forth certain information concerning the FP Investment Portfolio based on amortized cost:
FP Investment Portfolio by Rating
As of December 31, 2006(1)(2)
Rating | | | | Percent of Investment
Portfolio | |
AAA | | | 91.9 | % | |
AA | | | 7.0 | | |
A | | | 1.1 | | |
Total | | | 100.0 | % | |
(1) Ratings are based on the lower of Moody’s or S&P ratings available as of December 31, 2006.
(2) 4.4% of the FP Investment Portfolio was rated Triple-A by virtue of insurance provided by FSA. Over 97% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments was in the Triple-B range.
Summary of FP Investment Portfolio
| | December 31, | |
| | 2006 | | 2005 | |
| | Amortized
Cost | | Weighted
Average
Yield(1) | | Amortized
Cost | | Weighted
Average
Yield(1) | |
| | (dollars in thousands) | |
FP Investment Portfolio: | | | | | | | | | | | | | |
Taxable bonds | | $ | 15,681,969 | | | 5.57 | % | | $ | 11,754,330 | | | 3.54 | % | |
Short-term investments | | 640,226 | | | 5.26 | | | 1,015,509 | | | 3.31 | | |
Total investments | | $ | 16,322,195 | | | 5.53 | | | $ | 12,769,839 | | | 3.53 | | |
(1) Yields are stated on a pre-tax basis. The weighted average yield presented is net of the effects of derivative instruments used to economically convert interest rates from fixed to floating rate.
FP Investment Portfolio by Security Type
| | As of December 31, | |
| | 2006 | | 2005 | |
Investment Category | | | | Amortized
Cost | | Weighted
Average
Yield(1) | | Amortized
Cost | | Weighted
Average
Yield(1) | |
| | (dollars in thousands) | |
Mortgage-backed securities | | $ | 7,639,645 | | | 5.58 | % | | $ | 2,821,562 | | | 3.31 | % | |
Municipal bonds | | 1,195,326 | | | 4.75 | | | 809,856 | | | 3.93 | | |
U.S. government and agency securities | | 217,754 | | | 5.64 | | | 175,703 | | | 3.31 | | |
Asset-backed and other securities | | 6,629,244 | | | 5.72 | | | 7,947,209 | | | 3.56 | | |
Total fixed maturities | | 15,681,969 | | | 5.57 | | | 11,754,330 | | | 3.54 | | |
Short-term investments | | 640,226 | | | 5.26 | | | 1,015,509 | | | 3.31 | | |
Total investments | | $ | 16,322,195 | | | 5.53 | | | $ | 12,769,839 | | | 3.53 | | |
| | | | | | | | | | | | | | | | | |
(1) Yields are stated on a pre-tax basis. The weighted average yield presented is net of the effects of derivative instruments used to economically convert interest rates from fixed to floating rates.
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The amortized cost and fair value of bonds in the FP Investment Portfolio as of December 31, 2006, by contractual maturity, are shown below. 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.
Distribution of FP Investments by Contractual Maturity
| | As of December 31, 2006 | |
Investment Category | | | | Amortized
Cost | | Fair
Value | |
| | (in thousands) | |
Due in one year or less | | $ | 640,226 | | $ | 640,226 | |
Due after five years through ten years | | 28,429 | | 28,386 | |
Due after ten years | | 1,384,651 | | 1,416,372 | |
Mortgage-backed securities (stated maturities of 4 to 39 years) | | 7,639,645 | | 7,657,942 | |
Asset-backed and other securities (stated maturities of 1 to 49 years) | | 6,629,244 | | 6,646,448 | |
Total investments | | $ | 16,322,195 | | $ | 16,389,374 | |
| | | | | | | | | |
VIE Investment Portfolio
The Company’s management believes that the assets held by the VIEs, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership.
All bonds in the VIE Investment Portfolio are insured by FSA. The credit quality of the VIE Investment Portfolio, without the benefit of FSA’s insurance, as of December 31, 2006 was as follows:
VIE Investment Portfolio by Rating(1)
Rating | | | | Percent of Bonds | |
AAA | | | 1.5 | % | |
A | | | 80.8 | | |
NR | | | 17.7 | | |
Total | | | 100.0 | % | |
(1) Ratings are based on the lower of Moody’s or S&P ratings available as of December 31, 2006.
The amortized cost and estimated fair value of bonds in the VIE Investment Portfolio were as follows:
| | As of December 31, 2006 | |
| | Amortized Cost | | Fair Value | |
| | (in thousands) | |
Obligations of U.S. states and political subdivisions | | | $ | 15,750 | | | $ | 15,750 | |
Foreign | | | 9,086 | | | 9,643 | |
Asset-backed securities(1) | | | 1,102,862 | | | 1,102,862 | |
Short term investments | | | 19,478 | | | 19,478 | |
Total | | | $ | 1,147,176 | | | $ | 1,147,733 | |
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| | As of December 31, 2005 | |
| | Amortized Cost | | Fair Value | |
| | (in thousands) | |
Obligations of U.S. states and political subdivisions | | | $ | 15,879 | | | $ | 15,879 | |
Corporate securities | | | 20,013 | | | 19,327 | |
Foreign | | | 8,995 | | | 9,841 | |
Asset-backed securities(1) | | | 1,110,945 | | | 1,110,945 | |
Short term investments | | | 2,674 | | | 2,674 | |
Total | | | $ | 1,158,506 | | | $ | 1,158,666 | |
(1) Asset-backed securities consist of floating rate assets, which are valued using readily available quoted market prices or at amortized cost if there is no readily available valuation, as is primarily the case. Management believes that amortized cost closely approximates fair value for these securities.
The amortized cost and fair value of bonds in the VIE Investment Portfolio as of December 31, 2006, by contractual maturity, are shown below. 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.
| | As of December 31, 2006 | |
| | Amortized Cost | | Fair Value | |
| | (in thousands) | |
Due in one year or less | | | $ | 19,478 | | | $ | 19,478 | |
Due after one year through five years | | | 9,086 | | | 9,643 | |
Due after ten years | | | 15,750 | | | 15,750 | |
Asset-backed securities (stated maturities of 2 to 14 years) | | | 1,102,862 | | | 1,102,862 | |
Total | | | $ | 1,147,176 | | | $ | 1,147,733 | |
Employees
As of December 31, 2006, the Company had 375 employees. None of its employees are covered by collective bargaining agreements. The Company considers its employee relations to be satisfactory.
Available Information
The Company makes available, free of charge through its website, http://www.fsa.com, its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) and 15(d) of the Exchange Act as soon as reasonably practicable after the Company electronically files such materials with, or furnishes them to, the Securities and Exchange Commission.
Forward-Looking Statements
The Company relies on the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. This safe harbor requires that the Company specify important factors that could cause actual results to differ materially from those contained in forward-looking statements made by or on behalf of the Company. Accordingly, forward-looking statements by the Company and its affiliates are qualified by reference to the following cautionary statements.
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In its filings with the Securities and Exchange Commission (the “SEC”), reports to shareholders, press releases and other written and oral communications, the Company from time to time makes forward-looking statements. Such forward-looking statements include, but are not limited to:
· projections of revenues, income (or loss), earnings (or loss) per share, dividends, market share or other financial forecasts;
· statements of plans, objectives or goals of the Company or its management, including those related to growth in adjusted book value or return on equity; and
· expected losses on, and adequacy of loss reserves for, insured transactions.
Words such as “believes,” “anticipates,” “expects,” “intends” and “plans” and similar expressions are intended to identify forward looking statements but are not the exclusive means of identifying such statements.
The Company cautions that a number of important factors could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in forward-looking statements made by the Company. These factors include:
· the risks discussed in Item 1A of this report;
· changes in capital requirements or other criteria of securities rating agencies applicable to FSA;
· competitive forces, including the conduct of other financial guaranty insurers;
· changes in domestic or foreign laws or regulations applicable to the Company, its competitors or its clients;
· changes in accounting principles or practices that may result in a decline in securitization transactions or affect the Company’s reported financial results;
· an economic downturn or other economic conditions (such as a rising interest rate environment) adversely affecting transactions insured by FSA or its General Investment Portfolio;
· inadequacy of reserves established by the Company for losses and loss adjustment expenses;
· disruptions in cash flow on FSA-insured structured transactions attributable to legal challenges to such structures;
· downgrade or default of one or more of FSA’s reinsurers;
· market conditions, including the credit quality and market pricing of securities issued;
· capacity limitations that may impair investor appetite for FSA-insured obligations;
· market spreads and pricing on insured CDS exposures, which may result in gain or loss due to mark-to-market accounting requirements;
· prepayment speeds on FSA-insured asset-backed securities and other factors that may influence the amount of installment premiums paid to FSA; and
· other factors, most of which are beyond the Company’s control.
The Company cautions that the foregoing list of important factors is not exhaustive. In any event, such forward-looking statements made by the Company speak only as of the date on which they are made, and the Company does not undertake any obligation to update or revise such statements as a result of new information, future events or otherwise.
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Item 1A. Risk Factors.
The information contained in this report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. See “Item 1. Business—Forward-Looking Statements” for important factors that could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in forward-looking statements made by the Company. The Company’s actual future results may differ materially depending on a variety of factors including, but not limited to, the risks and uncertainties expressed below.
Loss of FSA’s “Triple-A” ratings would impair its ability to originate new business.
FSA’s ability to originate new insurance business is based upon the perceived financial strength of FSA’s insurance, which in turn is based in large part upon the financial strength ratings assigned to FSA by the major securities rating agencies. The rating agencies base their ratings upon a number of objective and subjective factors. Credit deterioration in FSA’s insured portfolio or changes to rating agency capital adequacy requirements could impair FSA’s ratings. For a discussion of other factors that might impair FSA’s ratings, see “Item 1. Business—Rating Agencies.” Most of the risk factors mentioned below would be expected to be considered by the rating agencies in assessing FSA’s financial strength.
The Company’s loss reserves may prove inadequate.
The Company’s insurance policies guarantee financial performance of obligations over specified periods of time, in some cases over 30 years, and are generally non-cancelable. The Company projects expected deterioration and ultimate loss amounts based on historical experience in order to estimate probable loss. If an individual policy risk has a probable and reasonably estimable loss as of the balance sheet date, the Company establishes a case reserve. For the remaining policy risks in the portfolio, the Company establishes a non-specific reserve to account for inherent credit losses. The establishment of these reserves is a systematic process that considers quantitative and statistical information together with qualitative factors, resulting in management’s best estimate of inherent losses associated with providing credit protection at a given date. However, the process is inherently uncertain, and the Company cannot assure that its reserves will prove adequate. If losses in its insured portfolio materially exceed the Company’s loss reserves, it could have a material adverse effect on the financial ratings, results of operations and financial condition of the Company. For additional discussion of the Company’s reserve methodologies, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Losses and Loss Adjustment Expenses.”
The Company is exposed to large risks.
FSA seeks to manage exposure to large single risks and concentrations of risks that may be correlated through credit and legal underwriting, reinsurance and other risk mitigation measures. In addition, the securities rating agencies and insurance regulations establish limits applicable to FSA on the size of risks and concentrations of risks that it may insure. Given FSA’s capital base and the quality of risks that it insures, FSA may insure and has insured individual public finance and asset-backed risks well in excess of $1 billion. Should FSA’s risk assessments prove inaccurate and should the limits applicable to FSA prove inadequate, FSA could be exposed to larger than anticipated losses. While FSA has to date experienced catastrophic events (such as the terrorist attacks of September 11, 2001 and the 2005 hurricane season) without material loss, unexpected catastrophic events may have a material adverse effect upon FSA’s insured portfolio and/or its investment portfolios.
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FSA is expanding into new business lines having a higher potential loss severity.
In recent years, an increasing percentage of FSA’s business has included insurance of risks with potential higher loss severity than its traditional municipal and asset-backed business. FSA expects to continue to expand its participation in these more volatile business lines, including project finance transactions, future flow securitizations and whole business securitizations.
Increased competition could reduce the Company’s new business originations.
The Company’s insurance company subsidiaries face competition from uninsured executions in the capital markets, other Triple-A-rated monoline financial guaranty insurers, banks and other credit providers, including government-sponsored entities in the mortgage-backed and multifamily sectors. During recent years, competitive forces have put considerable downward pressure on premium levels that FSA has been able to obtain, and has led FSA to decline to participate in many transactions. Competitive pressures may lead a bond insurer to sacrifice adequate pricing or adequate credit protection in order to maintain market share. See “Item 1. Business—Competition and Industry Concentration.”
Narrow credit spreads could continue to reduce demand and premiums for financial guaranty insurance.
Demand for financial guaranty insurance generally reflects prevailing credit spreads. When interest rates are lower or when the market is otherwise relatively non-risk adverse, the spread between insured and uninsured obligations typically narrows and, as a result, financial guaranty insurance typically provides lower cost savings to issuers than it would during periods of relatively wider spreads. These lower cost savings generally lead to a corresponding decrease in demand or premiums obtainable for financial guaranty insurance.
Widening credit spreads would reduce the market value of the Company’s FP Investment Portfolio.
As of December 31, 2006, more than 90% of the $16.3 billion in the Company’s FP Investment Portfolio was invested in bonds, primarily asset-backed and mortgage-backed bonds. The Company’s objective for its FP business is to generate net interest margin through borrowing funds at attractive rates in the municipal GIC and other markets and investing the proceeds in obligations satisfying the Company’s underwriting criteria while minimizing the Company’s exposure to interest rate changes. Nonetheless, any increase in prevailing credit spreads would reduce the market value of securities in the Company’s FP Investment Portfolio, which would in turn reduce the Company’s capital as measured under GAAP.
Increase in prevailing interest rates would result in a decline in the market value of the Company’s General Investment Portfolio.
As of December 31, 2006, the Company’s General Investment Portfolio was approximately $4.8 billion dollars, almost entirely invested in bonds, primarily municipal bonds. The Company’s investment strategy is to invest in highly rated marketable instruments of intermediate average duration so as to generate stable investment earnings with minimal market value or credit risk. Nonetheless, any increase in prevailing interest rates would reduce the market value of securities in the Company’s General Investment Portfolio, which would in turn reduce the Company’s capital as measured under GAAP.
Marking to market the Company’s insured CDS portfolio may subject the Company’s reported earnings to extreme volatility.
The Company is required to mark to market certain derivatives, including FSA-insured CDS considered derivatives, under GAAP. As a result of such treatment, and given the large principal balance of FSA’s insured CDS portfolio, small changes in the market pricing for insurance of CDS will generally result in recognition by the Company of material gains or losses, with material market price increases
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generally resulting in large reported losses under GAAP. In addition, any previously reported mark-to-market gains in respect of FSA’s insured portfolio would be expected to be reversed through the recognition of losses over the remaining terms of the insured risks. At December 31, 2006, the inception-to-date net gain on the Company’s insured CDS portfolio was $89.2 million. While management believes that reported mark to market gains or losses on insured CDS generally do not represent true economic gains or losses, certain constituents, including capital market participants, may rely upon reported GAAP results. As a result, the Company’s access to capital markets might be impaired if its reporting earnings were considered unusually volatile. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Operating Earnings and Adjusted Book Value.”
Change in industry and other accounting practices could impair the Company’s reported financial results and impede its ability to do business.
The Financial Accounting Standards Board (the “FASB”) is evaluating various accounting standards applicable to financial guaranty insurers under GAAP, including accounting for claims liability recognition and premium recognition. The Company and its industry peers will be required to implement any changes to GAAP reporting requirements adopted by the FASB. Any such changes may have an adverse effect on the Company’s reported financial results, including future revenues and non-GAAP adjusted book value. In addition, changes in the interpretation of current accounting guidance or the issuance of other new accounting standards may affect reported profitability or affect reported earnings during the terms of outstanding risks (so-called “earnings volatility”) and, as such, may influence the types and/or volume of business that management may choose to pursue.
The Company has received subpoenas related to an investigation of the municipal GIC industry by the Department of Justice and the SEC.
On November 15, 2006, the Company received a subpoena from the Antitrust Division of the U.S. Department of Justice (the “DOJ”) issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs. On November 16, 2006, FSA received a subpoena from the SEC related to an ongoing industry-wide civil investigation of brokers of municipal GICs. The Company issues municipal GICs through the FP Segment, but does not serve as a GIC broker. The subpoenas request that the Company furnish to the DOJ and SEC records and other information with respect to the Company’s municipal GIC business. The Company is cooperating with the investigations by the DOJ and the SEC. The Company is at risk that information provided pursuant to the subpoenas or otherwise provided to the government in the course of its investigation will lead to indictments of the Company and/or its employees, with the potential for convictions or settlements providing for the payment of fines, restrictions on future business activities and, in the case of individual employees, imprisonment. Such an adverse outcome would damage the reputation of the Company and might impair the ability of the Company to conduct its financial products business and its financial guaranty business.
Change in applicable law could impede the Company’s ability to do business.
The Company’s businesses are subject to direct and indirect regulation under, among other things, state insurance laws, federal securities law, the U.S. Bank Holding Company Act, tax law and legal precedents affecting public finance and asset-backed obligations, as well as applicable law in the other countries in which the Company operates. Future legislative, regulatory or judicial changes in the U.S. or abroad could adversely affect the Company’s business by, among other things, placing limits on the Company’s ability to carry out its non-insurance business, lowering applicable single or aggregate risk limits, increasing the level of supervision or regulation to which its operations may be subject, or creating restrictions that make the Company’s products less attractive to potential buyers. For additional
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information regarding the regulations to which the Company is subject, see “Item 1. Business—Insurance Regulatory Matters” and “—U.S. Bank Holding Company Act.”
Change in management personnel or share ownership may have an adverse effect on the Company’s business.
The Company’s senior management plays an active role in its underwriting and business decisions. In addition, FSA and Dexia have worked together on numerous new business opportunities, and such close cooperation may diminish were Dexia no longer an owner of the Company. Accordingly, a change in management or share ownership may have an adverse effect upon the Company’s business.
Losses may result from the ineffectiveness of hedges or unanticipated timing of withdrawals of funds in the Company’s FP Segment.
The Company hedges interest rate risks in its FP Segment by investing in floating rate instruments and issuing floating rate liabilities, or by employing derivative products to obtain the same economic result. Judgments are made in this process regarding the expected timing of withdrawals of funds under GICs and other financial products. The Company may be exposed to unexpected losses if its hedging strategy proves ineffective or its judgments prove inaccurate.
The Company’s ability to make debt service payments on its outstanding debt is subject to its insurance company operations.
Because it is a holding company, the registrant does not conduct operations or generate material income. Instead, the Company’s financial condition and results of operations, and thus its long-term ability to service its debt, will largely depend on its receipt of dividends from, or payment on surplus notes or share repurchases by, FSA. FSA’s ability to declare and pay dividends to the Company depends, among other factors, upon FSA’s financial condition, results of operations, cash requirements, and compliance with rating agency requirements for maintaining its Triple-A ratings, and is also subject to restrictions contained in the applicable insurance laws and regulations. Based on FSA’s statutory statements for 2006, the maximum amount available for payment of dividends by FSA without regulatory approval over the 12 months following December 31, 2006 is approximately $156.6 million. Payments on surplus notes or share repurchases by FSA require regulatory approval.
Downgrade or default of one or more of the Company’s reinsurers could reduce the Company’s capital adequacy and return on equity.
As of December 31, 2006, the Company had reinsured approximately 24.5% of its principal amount of insurance outstanding. In evaluating the credits insured by the Company, securities rating agencies allow “credit” for reinsurance, based on the reinsurers’ ratings. In recent years, a number of the Company’s reinsurers were downgraded by one or more rating agencies, resulting in decreases in the credit allowed for reinsurance and in the financial benefits of using reinsurance under existing rating agency capital adequacy models. By itself, a downgrade of all reinsurers to Double-A would not impair the Company’s Triple-A ratings. However, it would reduce the “margin of safety” by which the Company would survive a theoretical catastrophic depression, and a more significant downgrade of the reinsurers could impair the Company’s Triple-A ratings. The Company could be required to raise additional capital to replace the lost reinsurance credit in order to meet capital adequacy requirements. The rating agencies’ reduction in credit for reinsurance could also ultimately reduce the Company’s return on equity to the extent that ceding commissions paid to the Company by the reinsurers were not increased to compensate for such reduction. For further information regarding the Company’s use of reinsurance, see “Item 1. Business—Reinsurance.”
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The Company’s international operations expose it to less predictable credit and legal risks.
The Company pursues opportunities in international markets and currently operates in various countries in Europe, the Asia Pacific region and Latin America. The underwriting of obligations of an issuer in a foreign country involves the same process as that for a domestic issuer, but additional risks must be addressed, such as the evaluation of foreign currency exchange rates, foreign business and legal issues, and the economic and political environment of the foreign country or countries in which an issuer does business. Changes in such factors could impede the Company’s ability to insure, or increase the risk of loss from insuring, obligations in the countries in which it currently does business and limit its ability to pursue business opportunities in other countries.
Item 1B. Unresolved Staff Comments.
Item 1B is not applicable to the Company, because the Company is not an accelerated filer or large accelerated filer, as defined in Rule 12b-2 of the Exchange Act, or a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Item 2. Properties.
The principal executive offices of the Company and FSA are located at 31 West 52nd Street, New York, New York, 10019, and consist of approximately 110,000 square feet of office space.
FSA or its subsidiaries also maintain leased office space in San Francisco, Dallas, Hamilton (Bermuda), London (England), Madrid (Spain), Mexico City (Mexico), Paris (France), Singapore, Sydney (Australia) and Tokyo (Japan). The Company and its subsidiaries do not own any material real property.
The Company’s telephone number at its principal executive offices is (212) 826-0100.
Item 3. Legal Proceedings.
In the ordinary course of business, the Company and certain subsidiaries are parties to litigation. The Company is not subject to any material pending legal proceedings.
On November 15, 2006, the Company received a subpoena from the Antitrust Division of the U.S. Department of Justice issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs. On November 16, 2006, FSA received a subpoena from the SEC related to an ongoing industry-wide civil investigation of brokers of municipal GICs. The Company issues municipal GICs through the FP Segment, but does not serve as a GIC broker. The subpoenas request that the Company furnish to the DOJ and SEC records and other information with respect to the Company’s municipal GIC business. The Company is cooperating with the investigations by the DOJ and the SEC. See “Item 1A. Risk Factors—The Company has received subpoenas related to an investigation of the municipal GIC industry by the Department of Justice and the SEC.”
Item 4. Submission of Matters to a Vote of Security Holders.
No matter was submitted to a vote of security holders during the three month period ended December 31, 2006.
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PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
On July 5, 2000, the Company completed a merger in which the Company became an indirect wholly owned subsidiary of Dexia, a Belgian corporation whose shares are traded in the Euronext Brussels and Euronext Paris markets as well as on the Luxembourg Stock Exchange. See “Item 1. Business—Organization.” As a consequence of the merger, there is no longer an established public trading market for the Company’s common stock, and bid quotations are not reported or otherwise available.
As of March 15, 2007, the only holders of the Company’s common stock were Dexia Holdings and four current and former directors of the Company who own shares of the Company’s common stock or economic interests therein as described in “Item 11. Executive Compensation—Compensation of Directors—Director Share Purchase Program.”
After a period of suspension of dividends, the Company began payment of regular quarterly dividends in May 2004, paying $22.9 million in aggregate for 2004 and $71.1 million in aggregate for 2005. In 2006, the Company paid regular quarterly dividends of $130.0 million in aggregate, an extraordinary dividend of $300 million in November 2006 and an extraordinary dividend of $100 million in December 2006. In February 2007, the Board of Directors declared a regular quarterly dividend on the Company’s common stock of $0.91 per share, totaling $30.5 million in aggregate, to be paid on or before March 31, 2007. Information concerning restrictions on the payment of dividends is set forth in “Item 1. Business—Insurance Regulatory Matters—Dividend Restrictions.”
Information about securities authorized for issuance under the Company’s equity compensation plans is set forth in “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters—Securities Available Under Equity Compensation Plans.”
The Company does not have equity securities registered pursuant to Section 12 of the Exchange Act.
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Item 6. Selected Financial Data.
The following Selected Consolidated Financial Data should be read in conjunction with the Consolidated Financial Statements and accompanying notes included elsewhere herein.
| | As of and for the Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | | 2003 | | 2002 | |
| | (in millions) | |
SUMMARY OF OPERATIONS(a) | | | | | | | | | | | |
Gross premiums written | | $ | 816.0 | | $ | 833.8 | | $ | 832.0 | | $ | 895.8 | | $ | 803.7 | |
Net premiums written | | 527.2 | | 577.7 | | 587.8 | | 614.3 | | 532.7 | |
Net premiums earned | | 388.7 | | 404.1 | | 395.0 | | 356.4 | | 314.9 | |
Net investment income | | 218.9 | | 200.8 | | 172.1 | | 154.0 | | 139.1 | |
Net income | | 424.2 | | 326.1 | | 378.6 | | 298.1 | | 197.0 | |
BALANCE SHEET DATA(a) | | | | | | | | | | | |
Total investment portfolio(b) | | 22,747.4 | | 19,065.4 | | 14,577.7 | | 10,000.2 | | 5,037.4 | |
Total assets(b) | | 25,773.6 | | 22,001.6 | | 17,081.0 | | 12,407.6 | | 7,045.8 | |
Deferred premium revenue | | 2,653.3 | | 2,375.1 | | 2,095.4 | | 1,845.0 | | 1,448.2 | |
Losses and loss adjustment expense | | 228.1 | | 205.7 | | 179.9 | | 233.4 | | 223.6 | |
Notes payable | | 730.0 | | 430.0 | | 430.0 | | 430.0 | | 430.0 | |
GIC and VIE debt(b) | | 18,349.7 | | 14,947.1 | | 10,444.1 | | 6,639.4 | | 2,409.9 | |
Common shareholders’ equity | | 2,722.3 | | 2,822.9 | | 2,611.3 | | 2,219.2 | | 1,919.4 | |
ADDITIONAL DATA | | | | | | | | | | | |
Qualified statutory capital(c) | | 2,554.1 | | 2,417.5 | | 2,280.9 | | 2,104.3 | | 1,876.1 | |
Total claims-paying resources(d) | | 6,055.8 | | 5,675.8 | | 5,230.6 | | 4,657.7 | | 3,819.1 | |
Net par outstanding | | 359,559.8 | | 337,483.0 | | 317,742.6 | | 289,200.2 | | 263,010.5 | |
Net insurance in force (principal and interest) | | 531,421.0 | | 480,184.5 | | 444,511.5 | | 403,019.4 | | 364,908.5 | |
Total dividends | | 530.0 | | 71.1 | | 22.9 | | — | | 11.7 | |
| | | | | | | | | | | | | | | | |
(a) Prepared in accordance with accounting principles generally accepted in the United States of America.
(b) VIE balances are included beginning July 1, 2003 due to the adoption of Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.”
(c) Amounts are statutory data for FSA and therefore differ from comparable GAAP amounts.
(d) Total claims-paying resources is a term used by Moody’s to evaluate adequacy of claims-paying resources and credit ratings. Moody’s uses its judgment in making adjustments to some of the measures. The Company provides the adjusted balances. This term represents the sum of statutory capital, statutory unearned premium reserve, present value of future net installment premiums, statutory loss reserve, credit available under standby line of credit facility and money market committed preferred trust securities.
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
Management’s principal business objective is to grow the intrinsic value of the Company over the long term. To this end, it seeks to accumulate an insured portfolio of conservatively underwritten public finance and asset-backed obligations and attractively priced guaranteed investment contracts (“GICs”), in order to produce a reliable, predictable earnings stream. Strategically, the Company seeks to maintain balanced capabilities across domestic and international public finance and asset-backed markets in order to allow the flexibility to pursue the most attractive opportunities available at any point in the business cycle. References to the “Company” are to Financial Security Assurance Holdings Ltd. together with its subsidiaries.
To reflect accurately how management evaluates the Company’s operations and progress toward long-term goals, this discussion employs both measures promulgated in accordance with accounting principles generally accepted in the United States of America (GAAP measures) and measures not so promulgated (non-GAAP measures). Although the measures identified as non-GAAP in this discussion should not be considered substitutes for GAAP measures, management considers them key performance indicators and employs them in determining compensation. Non-GAAP measures therefore provide investors with important information about the way management analyzes its business and rewards performance.
Comparing 2006 GAAP results with those of 2005, the Company’s net income increased 30.1% to $424.2 million. Gross premiums written decreased 2.1% to $816.0 million. Shareholders’ equity decreased 3.6% to $2.7 billion.
Results of Operations
Premiums
Net Earned and Written Premiums
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
Premiums written, net of reinsurance | | $ | 527.2 | | $ | 577.7 | | $ | 587.8 | |
Premiums earned, net of reinsurance | | 388.7 | | 404.1 | | 395.0 | |
Net premiums earned excluding refundings and prepayments | | 339.9 | | 349.8 | | 350.6 | |
| | | | | | | | | | |
Net premiums earned decreased 3.8% in 2006 and increased 2.3% in 2005. Excluding the effects of refundings and prepayments, net premiums earned decreased 2.8% in 2006 and 0.2% in 2005. Refundings and prepayments result from interest rate movements and other factors outside the Company’s control, and no assurance can be given that refundings and prepayments will continue at the recent level. The decline in net premiums earned reflects a decrease in asset-backed premiums, offset in part by an increase in public finance earned premiums.
New Business Production
For each accounting period, the Company estimates the present value of originations (“PV originations”). This non-GAAP measure consists of the total present value of premiums originated (“PV premiums originated”) by Financial Security Assurance Inc. and its subsidiaries (“FSA”) and the present value of future net interest margin (“PV NIM”) originated by the Company’s financial products (“FP”) business (the “FP Segment”). The Company generated PV originations of $910.2 million in 2006, $1,014.0 million in 2005 and $927.2 million in 2004. Management believes that by disclosing the components of PV originations in addition to premiums written, the Company provides investors with a more comprehensive description of its new business activity in a given period.
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Present Value of Premiums Originated
The GAAP measure “gross premiums written” captures premiums collected or accrued for in a given period, whether collected for business originated in the period, or in installments for business originated in prior periods. It is not a precise measure of current-period originations because a significant portion of the Company’s premiums are collected in installments. Therefore, to measure current-period premium production, management calculates the gross present value of premium installments originated in the accounting period and combines it with premiums received upfront in the accounting period, which produces the non-GAAP measure PV premiums originated.
The Company’s insurance policies and insured credit derivative contracts are generally non-cancelable and remain outstanding for years from date of inception, in some cases 30 years or longer. Accordingly, current-period premium production, as distinct from earned premium, represents premiums to be earned in the future.
Viewed at a policy level, installment premiums are generally calculated as a fixed premium rate multiplied by the insured debt outstanding as of dates established by the terms of the policy. Because the actual installment premiums received could vary from the amount estimated at the time of origination based on variances in the actual outstanding debt balances and foreign exchange rate fluctuation, the realization of PV premiums originated could be greater or less than the amount reported.
Installment premiums are not recorded in the financial statements until due, which is a function of the terms of each insurance policy. Future installment premiums are not captured in premiums earned or premiums written, the most comparable GAAP measures. Management therefore uses PV premiums originated to evaluate current business production.
PV premiums originated reflects estimated future installment premiums discounted to their present value, as well as upfront premiums, for business originated during the reporting period. To calculate PV premiums originated, management discounts an estimate of all future installment premium receipts. The Company calculates the discount rate for PV premiums originated as the average pre-tax yield on its insurance investment portfolio for the previous three years. This rate serves as a proxy for the return that could be achieved if the premiums had been received upfront. The estimated installment premium receipts are determined based on each installment policy’s projected par balances outstanding multiplied by its premium rate. The Company’s Transaction Oversight Groups estimate the relevant schedule of future par balances outstanding for each insurance policy with installment premiums. At the time of origination, projected debt schedules are generally based on good faith estimates developed and used by the parties negotiating the transaction.
Year-to-year comparisons of PV premiums originated are affected by the application of a different discount rate each year. The discount rate employed by the Company for this purpose was 5.07% for 2006 originations, 5.30% for 2005 originations and 5.62% for 2004 originations. Management intends to revise the discount rate in future years according to the same methodology, in order to reflect specific return results realized by the Company.
Reconciliation of Gross Premiums Written to Non-GAAP PV Premiums Originated
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
Gross premiums written | | $ | 816.0 | | $ | 833.8 | | $ | 832.0 | |
Gross installment premiums received | | (241.9 | ) | (280.5 | ) | (332.4 | ) |
Gross upfront premiums originated | | 574.1 | | 553.3 | | 499.6 | |
Gross PV estimated installment premiums originated | | 215.6 | | 368.1 | | 353.9 | |
Gross PV premiums originated | | $ | 789.7 | | $ | 921.4 | | $ | 853.5 | |
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Financial Guaranty Insurance Originations
Unless otherwise noted, percentage changes in this discussion and analysis compare the period named with the comparable period of the prior year.
The tables below show the PV premiums originated and gross par amount insured by FSA in its major business sectors for transactions closed in the period.
Public Finance New Originations
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
United States: | | | | | | | |
Gross par insured (in billions) | | $ | 46.5 | | $ | 64.8 | | $ | 49.0 | |
Gross PV premiums originated (in millions) | | 309.6 | | 484.5 | | 433.5 | |
International: | | | | | | | |
Gross par insured (in billions) | | $ | 9.4 | | $ | 7.5 | | $ | 2.7 | |
Gross PV premiums originated (in millions) | | 317.7 | | 185.3 | | 127.5 | |
After strong new-issue volume in the fourth quarter, total issuance in the U.S. municipal bond market reached $387.7 billion for the year on a sale-date basis. This reflected a decline of approximately 5% from $408.3 billion in 2005, which was up 13% from $359.7 billion in 2004. Reduced refunding volume during 2006 was largely offset by growth in new-money issuance. Insurance penetration was approximately 49%, compared with 57% in 2005 and 54% in 2004. In all three years, low interest rates and continuing needs for infrastructure investment drove municipal borrowing levels. Of the insured par amount of municipal bonds sold each year, FSA guaranteed approximately 24% in 2006, 26% in 2005 and 24% in 2004.
Including both primary and secondary obligations with closing dates in 2006, FSA’s U.S. public finance par insured declined 28.3%, and PV premiums originated declined 36.1%, as FSA increased its strategic focus on core municipal sectors where high-quality transactions provided greater relative value.
In 2005, FSA’s U.S. public finance par origination increased 32.3% and the related PV premium originated increased 11.8%. The mix of business shifted toward a greater volume of general obligations, including school bonds, and other tax-backed transactions that tend to have lower absolute premiums than revenue bonds because of their lower risk.
In international public finance, originations grew 26.7% in par insured in 2006, while PV premiums grew at a higher rate, 71.4%, because of longer average lives. Originations were strongest in the United Kingdom and Australia, but FSA also guaranteed public finance transactions in Western and Central Europe, Asia and the Americas. In 2005, international public finance originations grew 173.0% in par insured and 45.3% in PV premiums. FSA insured infrastructure transactions in the United Kingdom, Australia, Canada, Western Europe and Asia. Expanding use of public-private partnership financings has helped drive growth in this sector.
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Asset-Backed New Originations
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
United States: | | | | | | | |
Gross par insured (in billions) | | $ | 28.6 | | $ | 24.5 | | $ | 48.6 | |
Gross PV premiums originated (in millions) | | 113.4 | | 195.4 | | 234.2 | |
International: | | | | | | | |
Gross par insured (in billions) | | $ | 9.3 | | $ | 6.6 | | $ | 7.5 | |
Gross PV premiums originated (in millions) | | 49.0 | | 56.2 | | 58.3 | |
The Company’s U.S. asset-backed gross par insured increased 17.0% in 2006 and decreased 49.7% in 2005. The Company’s associated U.S. PV premiums originated decreased 42.0% in 2006 and 16.6% in 2005. Throughout 2006, the asset-backed market was characterized by tight credit spreads, excess market liquidity and aggressive uninsured structures, which had a negative impact on pricing. Additionally, 2006 originations had shorter average lives. In 2005, PV premiums originated declined less than par originated due to a shift toward longer duration transactions in the mix of business. Declines in PV premiums from high-premium net interest margin mortgage-backed transactions, which are generally designed to securitize excess cash flow generated by an issuer’s residential mortgage loan securitization, and other residential mortgage transactions represented most of the decrease in PV premiums originated.
Outside the United States, FSA increased international asset-backed par originations by 39.8% in 2006, while PV premiums originated declined 12.7%. This compares with decreases in 2005 of 11.2% in the par amount originated and 3.7% in PV premium production. As in the United States, credit spreads were narrow in international asset-backed markets in both 2006 and 2005. In both years, 90% or more of the net par volume of originations was of Triple-A or Super Triple-A quality. “Super Triple-A” indicates underlying loss protection greater than the Triple-A standard.
Financial Products Originations
The FP Segment, in which the Company conducts business through affiliates (the “GIC Affiliates”) and variable interest entities (“VIEs”) produces net interest margin (“FP NIM”) rather than insurance premiums. Like installment premiums, the PV NIM originated is expected to be earned and collected in future periods.
GICs are issued at or converted into LIBOR-based floating rate obligations, with proceeds invested in or converted into LIBOR-based floating rate investments intended to result in profits from a higher investment rate than borrowing rate. The difference between the current-year investment revenue and borrowing cost is the FP NIM.
The non-GAAP measure PV NIM represents the difference between the present value of estimated interest to be received on the investments and the present value of estimated interest to be paid on liabilities issued in the form of GICs, net of the expected results of derivatives used to hedge interest rate risk. The Company’s future positive interest rate spread can be reasonably estimated and generally relates to contracts or security instruments that extend for multiple years.
Net interest income and net interest expense are reflected in the statements of operations and comprehensive income but are limited to current-year earnings. As GIC contracts extend beyond the current period, management considers the non-GAAP measure PV NIM to be a useful indicator of future FP NIM to be earned and includes it in the non-GAAP measure adjusted book value (“ABV”) as an element of intrinsic value that is not found in GAAP book value.
The majority of municipal GICs issued by the GIC Affiliates relate to debt service reserve funds and construction funds in support of municipal bond transactions. These funds may be drawn unexpectedly,
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with the result that the actual timing and amount of repayments may differ from the original estimates, which in turn would affect the realization of the estimate of PV NIM originated in a given accounting period.
PV outstanding is the sum of cumulative years’ reported PV premiums originated and PV NIM originated, less what has been earned or adjusted due to changes in estimates as described above. Installment payment contracts, whether in the form of premiums or NIM, are generally non-cancelable by the Company and represent a claim to future cash flows. Therefore, management includes these amounts in its estimate of ABV.
Financial Products PV NIM Originated
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
Gross present value of future net interest margin originated | | $ | 120.5 | | $ | 92.6 | | $ | 73.7 | |
| | | | | | | | | | |
PV NIM originations increased 30.1% in 2006 and 25.6% in 2005, reflecting the general growth trend of the FP Segment.
Operating Earnings and Adjusted Book Value
In addition to evaluating the Company’s GAAP financial information, management evaluates the Company’s business under certain non-GAAP performance measures that management refers to as operating earnings and ABV. Management uses these two metrics to measure the Company’s performance and to calculate long-term incentive compensation and the annual bonus pool. Management refers to this information in its presentations with rating agencies and the Board of Directors. While these metrics are not substitutes for reported results under GAAP, management regards operating earnings and ABV as meaningful indicators of operational performance that supplement the information available from GAAP measures. While GAAP provides a uniform comprehensive basis of accounting, management believes that operating earnings are an important additional measure for providing a more complete understanding of the Company’s results of operations.
The Company defines operating earnings as net income before the effects of fair-value adjustments for two items:
1. Economic interest rate hedges, defined as interest rate derivatives that are intended to hedge fixed rate assets and liabilities but do not meet the criteria for hedge accounting treatment under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), adjusted so that the impact of any residual hedge ineffectiveness remains in operating earnings; and
2. FSA-insured credit default swaps (“CDS”) that have investment-grade underlying credit quality and must be marked to fair value under SFAS 133.
Periodic unrealized gains and losses related to economic interest rate hedges arise primarily in the FP Segment, caused primarily by the one-sided mark-to-market derivative valuations prescribed by SFAS 133 for derivatives that do not qualify for “hedge-accounting treatment” under GAAP. Under the Company’s definition of operating earnings, the economic effect of these hedges is recognized, which, for interest rate swaps, generally results in any cash paid or received being recognized ratably as an expense or revenue over the hedged item’s life. Futures contracts used to hedge interest rate risk include both the embedded current net interest paid or received, as well as the value of the future net interest cash flow. Therefore, to reflect the equivalent of any cash paid or received being recognized ratably as an expense or revenue over the hedged item’s life, the current interest accretion amount embedded in the mark-to-market value of open futures positions is added back to operating earnings.
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CDS contracts are generally non-cancelable prior to maturity, and management views insured CDS risks as comparable to other insured risks. In a typical CDS transaction, the Company, in exchange for an upfront or periodic premium, indemnifies the insured party for economic losses (in excess of some agreed-upon deductible) related to debt obligations of specified obligors, structured such that the risk insured is investment grade without the benefit of the credit protection provided by the Company. In the event a CDS were to migrate below investment grade, the fair-value impact would be fully reflected in operating earnings.
Operating earnings are subject to certain general and specific limitations that investors should carefully consider. For example, as stated above, unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting. The Company’s operating earnings are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. Unlike GAAP, the Company’s operating earnings presentation does not represent a comprehensive basis of accounting. Investors, therefore, should not compare the Company’s performance with that of other financial guaranty companies based upon operating earnings. Operating earnings results are meant only to supplement GAAP results by providing additional information regarding the operational and performance indicators management, the Company’s Board of Directors and rating agencies follow most closely to assess performance.
Other limitations arise from the specific adjustments that management makes to GAAP results to derive operating earnings results. For example, in reversing the unrealized gains and losses that result from application of SFAS 133 to derivatives that do not qualify for hedge accounting, management focuses on the long-term economic effectiveness of those instruments relative to the underlying hedged item and isolates the effects of interest rate volatility and changing credit spreads on the fair value of such instruments during the period. Under GAAP, the effects of these factors on the fair value of the derivative instruments (but not the underlying hedged item) tend to show more volatility in the short term. While the Company believes that its presentation presents the economic substance of its FP Segment, the presentation understates GAAP earnings volatility.
Operating earnings also do not reflect earnings variability related to CDS fair-value adjustments. A significant percentage of the Company’s CDS exposures subject to fair-value adjustments are considered Triple-A or Super Triple-A, and the Company does not intend to trade these highly rated, highly structured contracts. Accordingly, management believes it is probable that the financial impact of the fair-value adjustments for the insured CDS will sum to zero over the finite terms of the exposures, which are typically five to ten years at inception. For this reason, management believes that the market volatility of credit-spread pricing, the primary driver of the Company’s change in fair-value results, should not influence a measure of the Company’s operating performance and therefore excludes CDS fair-value adjustments from operating earnings.
Operating earnings increased 8.7% in 2006 and 3.1% in 2005.
The following table reconciles net income to non-GAAP operating earnings:
Reconciliation of Net Income to Non-GAAP Operating Earnings
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
Net income | | $ | 424.2 | | $ | 326.1 | | $ | 378.6 | |
Less fair-value adjustments for economic interest rate hedges, net of taxes(1) | | 40.5 | | (15.0 | ) | 17.1 | |
Less fair-value adjustments for insured CDS, net of taxes | | 20.7 | | 7.2 | | 37.7 | |
Operating earnings | | $ | 363.0 | | $ | 333.9 | | $ | 323.8 | |
(1) Hedge ineffectiveness remains in operating earnings. Also, see following table for a more detailed presentation of fair-value adjustments for economic interest rate hedges.
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Fair-Value Adjustments for Economic Interest Rate Hedges
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
Fair-value adjustment for economic interest rate hedges | | $ | 10.3 | | $ | (19.0 | ) | $ | 106.5 | |
VIE minority interest | | 52.0 | | (4.1 | ) | (80.2 | ) |
Tax effect | | (21.8 | ) | 8.1 | | (9.2 | ) |
Total fair-value adjustments for economic interest rate hedges | | $ | 40.5 | | $ | (15.0 | ) | $ | 17.1 | |
Adjusted Book Value
To calculate ABV, the following adjustments, on an after-tax basis, are made to shareholders’ equity (GAAP “book value”):
1. addition of unearned premium revenues, net of amounts ceded to reinsurers;
2. addition of the present value of future installment premiums, net of amounts ceded to reinsurers;
3. addition of the present value of future net interest margin;
4. subtraction of the deferred costs of acquiring policies;
5. elimination of fair-value adjustments for investment grade insured CDS;
6. elimination of the fair-value adjustments for economic interest rate hedges;
7. elimination of unrealized gains or losses on investments; and
8. International Financial Reporting Standards (“IFRS”) adjustments.
Management considers ABV an operating measure of the Company’s intrinsic value. Book value reflects an estimate of loss for all insured risks made at the time of contract origination. ABV adds back certain GAAP liabilities and deducts certain GAAP assets (adjustments 1, 4, 5, 6 and 7 in the calculation above) and also captures the estimated value of future contractual cash flows related to transactions in force as of the balance sheet date (adjustments 2 and 3 in the calculation above) because installment payment contracts, whether in the form of premiums or NIM, are generally non-cancelable and represent a claim to future cash flows. Beginning in 2006, ABV also reflects certain IFRS adjustments in order to better align the interests of employees with the interests of Dexia S.A. (“Dexia”), the Company’s principal shareholder, whose accounts are maintained under IFRS. An investor attempting to evaluate the Company using GAAP measures alone would not have the benefit of this information. In addition, investors may consider the growth of ABV to be a performance measure indicating the degree to which management has succeeded in building a reliable source of future earnings. Certain of the Company’s compensation formulas are based, in part, on the ABV growth rate or ABV growth rate before IFRS adjustments.
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The limitations of the ABV metric are that it reflects the accelerated realization of certain assets and liabilities through equity and relies on an estimate of the amount and timing of the receipt of installment premiums and future net interest margin. Actual installment premium receipts could vary from the amount estimated due to differences between actual and estimated insured debt balances outstanding. Actual net interest margin results could vary from the amount estimated based on sales of investments prior to maturity and variances in the actual timing and amount of repayment associated with flexible-draw GICs that the Company issues. ABV excludes the fair-value adjustments for investment-grade insured CDS and the effective portion of fair-value adjustments for derivatives that hedge interest rate risk but do not qualify for hedge accounting under SFAS 133.
Adjustments 1, 2 and 3 above represent the sum of cumulative years’ reported PV premiums originated and PV NIM originated, less what has been earned or adjusted due to changes in estimates as described above. Adjustments 1 and 2 in the calculation of ABV together represent unearned premiums that have been collected and the Company’s best estimate of the present value of its future premium revenues (comprising current- and prior-period originations that have not yet been earned). Debt schedules related to installment transactions change from time to time. Critical assumptions underlying adjustment 2 are discussed above under “New Business Production—Financial Guaranty Insurance Originations.”
As discussed above under “New Business Production—Financial Products Originations,” the Company calculates PV NIM originated (adjustment 3) because net interest income and net interest expense reflected in the statements of operations and comprehensive income are limited to current-year earnings. The Company’s future positive interest rate spread from outstanding GIC business can be estimated and generally relates to contracts or security instruments that extend for multiple years. Management therefore includes it in ABV as another element of intrinsic value not found in GAAP book value.
Adjustment 4 reflects the realization in equity of deferred costs associated with the origination of premiums.
Through adjustments 5 and 6, the effect of certain items that are excluded from operating earnings is also excluded from ABV. As explained in the preceding discussion of operating earnings, management expects the financial impact of the CDS fair-value adjustments, reflected in adjustment 5, to sum to zero over the finite terms of the related exposures. Derivatives reflected in adjustment 6 reduce, on an economic basis, the interest rate risk of fixed rate assets and liabilities held in the FP Segment, which includes the FSA Global portfolios, although they do not meet SFAS 133 hedge-accounting requirements. The Company uses such derivatives to hedge against interest rate volatility, rather than to speculate on the direction of interest rates. The intent of management is to hold the derivatives until expected maturity along with the related hedged fixed rate assets or liabilities. In addition, through adjustment 7, ABV excludes the effect of fair-value adjustments made to investments and reflected in other comprehensive income. As the objective is to optimize long-term stable earnings, management generally seeks to minimize turnover and therefore any unrealized investment gain or loss is subtracted from book value to exclude it from the ABV metric. In the event that an investment is liquidated prior to its maturity, any related gain or loss is reflected in both earnings and ABV without further adjustment. Adjustment 8 reflects IFRS accounting treatment of items for which GAAP and IFRS treatments differ. These accounting differences relate primarily to foreign exchange, contingencies and fair-value adjustments.
Shareholders’ equity was $2.7 billion and non-GAAP ABV was $3.9 billion at December 31, 2006. During 2006, ABV (IFRS basis) grew 14.0%.
The following table reconciles book value to non-GAAP ABV:
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Reconciliation of Book Value to Non-GAAP Adjusted Book Value
| | As of December 31, | |
| | 2006 | | 2005 | |
| | (in millions) | |
Shareholders’ equity (U.S. GAAP) | | $ | 2,722.3 | | $ | 2,822.9 | |
After-tax adjustments: | | | | | |
Plus net unearned premium revenues | | 1,071.4 | | 981.4 | |
Plus present value future net installment premiums and PV NIM | | 627.2 | | 556.0 | |
Less net deferred acquisition costs | | 221.4 | | 217.8 | |
Less fair-value adjustments for insured CDS | | 58.0 | | 37.4 | |
Less fair value of economic interest rate hedges | | 72.6 | | 42.7 | |
Less unrealized gains on investments | | 154.9 | | 131.0 | |
Adjusted book value before IFRS adjustments | | 3,914.0 | | 3,931.4 | |
IFRS adjustments | | 4.8 | | (22.1 | ) |
Adjusted book value (IFRS basis) | | $ | 3,918.8 | | $ | 3,909.3 | |
Net Investment Income and Realized Gains
Net investment income from the General Investment Portfolio increased 9.0% in 2006, 16.7% in 2005 and 11.7% in 2004, primarily due to higher invested balances arising from new business writings and dividend income from the Company’s equity investment in XL Financial Assurance Ltd (“XLFA”). The dividend rate on the XLFA investment was reduced in 2006 from an effective rate of 19% in 2005 to a fixed rate of 8.25% in 2006.
Income from Investments
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
Net investment income | | $ | 218.9 | | $ | 200.8 | | $ | 172.1 | |
Net realized gains (losses) | | (8.3 | ) | 6.4 | | (0.5 | ) |
Effective tax rate on investment income, excluding effects of realized gains and losses | | 12.2 | % | 13.2 | % | 9.2 | % |
| | | | | | | | | | |
Realized gains and losses are generally a by-product of the normal investment management process and may vary substantially from period to period.
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Losses and Loss Adjustment Expenses
Activity in the liability for losses and loss adjustment expenses, which consists of case and non-specific reserves, is summarized as follows:
| | Case Reserve Activity for the
Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
Gross balance at January 1 | | $ | 90.0 | | $ | 80.6 | | $ | 121.9 | |
Less reinsurance recoverable | | 36.3 | | 35.4 | | 59.2 | |
Net balance at January 1 | | 53.7 | | 45.2 | | 62.7 | |
Transfer from non-specific reserve | | 1.2 | | 10.5 | | 30.7 | |
Restructured transactions | | — | | — | | (13.9 | ) |
Paid (net of recoveries) related to: | | | | | | | |
Current year | | — | | — | | — | |
Prior year | | (1.9 | ) | (2.0 | ) | (34.3 | ) |
Total paid | | (1.9 | ) | (2.0 | ) | (34.3 | ) |
Net balance at December 31 | | 53.0 | | 53.7 | | 45.2 | |
Plus reinsurance recoverable | | 37.3 | | 36.3 | | 35.4 | |
Gross balance at December 31 | | $ | 90.3 | | $ | 90.0 | | $ | 80.6 | |
| | Non-Specific Reserve
Activity for the
Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
Balance at January 1 | | $ | 115.7 | | $ | 99.3 | | $ | 111.5 | |
Provision for losses | | | | | | | |
Current year | | 17.8 | | 20.4 | | 20.4 | |
Prior year | | 5.5 | | 5.0 | | 0.2 | |
Transfers to case reserves | | (1.2 | ) | (10.5 | ) | (30.7 | ) |
Restructured transactions | | — | | 1.5 | | (2.1 | ) |
Balance at December 31 | | 137.8 | | 115.7 | | 99.3 | |
Total case and non-specific reserves | | $ | 228.1 | | $ | 205.7 | | $ | 179.9 | |
The gross and net par amounts outstanding on transactions with case reserves were $483.4 million and $399.6 million, respectively, at December 31, 2006. Net case reserves consisted primarily of five collateralized debt obligation (“CDO”) risks and two municipal risks, which collectively accounted for approximately 94.9% of the total net case reserve. The remaining eight exposures were in various sectors.
Case and non-specific reserves for losses and loss adjustment expenses are discounted when established using the risk-free rate appropriate for the term of the insured obligation at the time the reserve is established.
During 2006, the Company charged $23.3 million to loss expense, consisting of $17.8 million for originations of new business and $5.5 million related to accretion on the reserve for in-force business. Net case reserves decreased $0.7 million, due primarily to loss payments and some improvement in the CDO transactions, offset in part by the establishment of a new case reserve for a municipal health care transaction.
During 2005, the Company charged $25.4 million to loss expense, consisting of $20.4 million for originations of new business and $5.0 million related to accretion on the reserve for in-force business. The non-specific reserve increased $16.4 million in 2005, primarily due to loss expense of $25.4 million, partially
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offset by transfers from the non-specific reserve to case reserves of $10.5 million. Case reserves increased $8.5 million due primarily to deterioration of specific CDO risks.
Since case and non-specific reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates. The Company will continue, on an ongoing basis, to monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company’s revised estimate of loss, actual loss experience, its mix of business and economic conditions.
The table below presents the significant assumptions inherent in the calculations of the case and non-specific reserves:
| | As of December 31, | |
| | 2006 | | 2005 | |
Case reserve discount rate | | 3.13%–5.90% | | 3.13%–5.90% | |
Non-specific reserve discount rate | | 1.20%–7.95% | | 1.20%–7.95% | |
Current experience factor | | 1.6 | | 1.8 | |
At December 31, 2006, the reinsurance recoverable on unpaid losses from reinsurers and ceded par outstanding, by Standard & Poor’s Ratings Services (“S&P”) rating levels, were as follows:
Reinsurer’s S&P Rating | | | | Reinsurance
Recoverable | | Ceded Par
Outstanding | |
| | (in millions) | |
AAA | | | $ | 2.0 | | | $ | 22,967.2 | |
AA | | | 33.7 | | | 92,701.9 | |
A | | | 1.6 | | | 6,161.2 | |
Total | | | $ | 37.3 | | | $ | 121,830.3 | |
The primary estimates affecting the statistical calculation are probability of default and severity of loss given default. The Company applies its experience factor to the statistical calculation to reflect actual loss experience in terms of both frequency and severity. Historically, defaults on guaranteed obligations have been infrequent, but the size of resulting claims have varied widely due to both the differing sizes of the obligations guaranteed and the significant variability of the severity experienced. Severity represents the magnitude of loss, which is calculated as claims paid minus total recoveries, expressed as a percentage of par guaranteed. Recoveries include salvage value of assets and amounts due from reinsurers. Actual claim frequency and severity experience may evolve over time, affected by many factors, including changes in the insured portfolio’s distribution across sectors and underlying ratings, as well as changes in the economy and the political environment. The Company’s loss reserving methodology is designed to reflect these factors. Changes in the sectors and underlying credit quality of the transactions are captured in the formula directly, while changes in the economy and political environment are captured in the experience factor.
Given the broad diversification of FSA’s insured portfolio, management believes that a significant shift in overall portfolio quality is unlikely to occur except in a catastrophic economic environment. It is therefore necessary to look at particular sectors when examining the sensitivity of the insured portfolio to changes in underlying loss assumptions. Management believes that different analyses are required for the two broad sectors of the insured portfolio, public finance credits and asset-backed obligations.
Management believes that a material adverse change to the loss estimate in its public finance risk sectors, excluding the health care category, would not occur under any reasonably possible scenario. While the Company has not experienced a loss in the health care sector, the potential severity of health care losses is comparatively high. Hospital facilities are single-purpose assets and a failing health care issuer is likely to be liquidated or acquired. If there is collateral associated with a health care credit, it is generally in the form of a hospital facility, the value of which is primarily driven by the community’s need for that facility. The more hospitals competing in a community, the more fragile the value of the hospital collateral
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is likely to be in a stress scenario. FSA addresses the severity risk in this sector through internal policies that limit exposure to any single credit.
In an S&P scenario analysis, S&P assumed 75% loss severity for health care credits, which means that a loss would equal 75% of par insured. If losses of this severity occurred in the lowest rated hospital exposures in FSA’s insured portfolio, the estimated loss would be as much as $50.0 million on a pre-tax basis, net of reinsurance. This calculation includes the amount the Company recorded as a case reserve in 2006 for one health care risk.
A material adverse change from management’s current estimate of loss for public finance transactions with case reserves is considered unlikely because the largest such case reserve is set near the full policy amount. The additional estimated loss, assuming 75% loss severity, for the health care case reserve is included in the estimated loss above.
Asset-backed obligations insured by FSA are secured by pools of assets. While the assets in a given transaction are generally of one type (such as automobile loans, residential mortgage loans, corporate loans, etc.), they are diversified within that asset type. Due to characteristically low default frequency, losses on insured asset-backed transactions have been manageable, in management’s view, despite variability.
Management believes severity is not the primary determinant of possible loss in a portfolio of insured asset-backed obligations. Since introducing a non-specific reserve in 1993, actual aggregate losses have been reasonably consistent with management’s expectation in the majority of asset-backed categories, including insured obligations collateralized by automobile loan or residential mortgage debt of non-prime borrowers. The one exception involved senior bonds issued in 1998 and 1999 in connection with structured CDOs. In such a structure, the bonds insured by FSA are in second-loss positions, meaning that there are uninsured, subordinate bondholders or equity investors who must lose all of their investment outstanding at the time of default or earlier trigger event before the FSA-insured bonds become subject to loss. These transactions were structured to FSA’s requirement that the first-loss position provide FSA an investment-grade level of protection. The underlying assets supporting the insured obligations were pools of corporate bonds individually rated below investment grade. In this structure, multiple credits must fail before claims are triggered. In 2002, credit quality deteriorated across a broad spectrum of the corporate market, which led to projected claims on these transactions and charges to FSA’s statements of operations and comprehensive income, as well as an increase in the Company’s loss experience rate. Yet, even under this unprecedented stress scenario, the severity of the largest single loss was relatively modest.
Accordingly, management considers default frequency the relevant factor driving adverse loss experience in the asset-backed sector and believes that a reasonably possible adverse change in default frequencies would not result in a material adverse adjustment to the non-specific loss reserve.
Current asset-backed case reserves could vary from the current estimate of loss. In particular, the deterministic model used to establish case reserves for CDO transactions utilizes average cumulative default rates produced by a Monte Carlo simulation and applies those defaults to a cash flow model. While CDO exposures are affected by multiple variables, including default rates, collateral recovery rates, changes in interest rate movements and the prepayment speeds of the collateral, management believes default frequency is the key determinant of loss. Holding all other variables constant and assuming only that the CDO’s underlying corporate debt instruments were to default at a higher rate than the Monte Carlo average default rate, actual losses would exceed the current estimate. Applying a higher frequency of default, observed at the 90% confidence level, would result in additional present-value loss of $17.3 million.
FSA management believes that the liability it carries for losses and loss expenses is adequate to cover the net cost of claims. However, the loss liability is based on assumptions regarding the insured portfolio’s
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probability of default and its severity of loss and there can be no assurance that the liability for losses will not exceed such estimates.
The sensitivities described above are hypothetical and should be used with caution. The effect of variation in a particular assumption is calculated without changing any other assumption; in reality, changes in one factor may result in, or be accompanied by, changes in another, which might magnify or counteract the sensitivities.
Management is aware that there are differences regarding the method of defining and measuring both case reserves and non-specific reserves among participants in the financial guaranty industry. Other financial guarantors may establish case reserves only after a default and use different techniques to estimate probable loss. Other financial guarantors may establish the equivalent of non-specific reserves, but refer to these reserves by various terms such as, but not limited to, “unallocated losses,” “active credit reserves” and “portfolio reserves,” or may use different statistical techniques from those the Company uses to determine loss at a given point in time. Management and the industry expect accounting literature specific to the financial guaranty industry to evolve; however, management cannot predict or estimate the scope of the guidance or potential impact on the Company’s financial statements at this time. See Note 2 to the Consolidated Financial Statements in Item 8.
Impact of 2005 Hurricanes
The Company monitors its exposure to credits affected by the 2005 hurricanes in Louisiana and Mississippi. The Company believes that its estimate of its total loss liability is adequate given its current risk information and has not established a case reserve related to its 2005 hurricane-affected exposure.
As of December 31, 2006, FSA had not received notice of payment default on any hurricane-related exposures. The Company’s 11 credits that have suffered the most significant economic and property loss from the 2005 hurricanes had an aggregate net par exposure of $181.7 million at December 31, 2006. FSA-insured bonds are protected by various sources of support that would be invoked before FSA would incur losses. These sources include access to pledged taxes or revenues, reserve funds, property and casualty insurance and state and federal monies. The issuers of these insured bonds have generally continued to improve financially and management does not expect that FSA will sustain permanent losses.
In addition, to provide relief to local governments facing difficulties meeting debt service obligations during this recovery period, the State of Louisiana issued an aggregate of $400 million of Gulf Tax Credit and matching State General Obligation Bonds on July 19, 2006. The bond proceeds funded a State Debt Service Assistance Fund to provide loans to help qualifying local governments meet debt service obligations for the next several years. All of the qualifying entities are located in the New Orleans metropolitan area.
Among the exposures affected by the hurricane are $38.1 million of FSA-insured Orleans Levee District (the “District”) bonds. The District has explored the possibility of seeking bankruptcy protection, but has not received the authority from the State that is required to do so. In any event, FSA does not believe that payment of the FSA-insured bonds would be impaired by a bankruptcy filing. In addition, the District is a loan recipient under the State Debt Service Assistance Fund, with FSA-insured bonds receiving assistance through May 1, 2009.
Asset-backed transactions insured by FSA, backed by pools of geographically diverse assets, show no unusual concentrations in the affected areas.
The loss estimation process involves the exercise of considerable judgment and therefore FSA’s ultimate hurricane-related losses may be materially different from the current estimate and may affect future operating results.
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Other Operating Expenses
Other operating expenses increased 33.1% in 2006, compared with a decrease of 5.5% in 2005. Excluding compensation expenses related to the Company’s deferred compensation and supplemental executive retirement plans, other operating expenses were $110.2 million in 2006, $91.4 million in 2005 and $80.8 million in 2004. The increases in 2006 and 2005 relate primarily to a reduction in deferral rates and increases in personnel costs and premises and equipment expense as a result of the move to the Company’s new headquarters. The Company purchases assets selected by participants in the deferred compensation and supplemental executive retirement plans to economically defease the Company’s liability under these plans. Deferred compensation and supplemental executive retirement plan expenses are recorded in other operating expenses, and the related income on the assets is recorded in other income. Such expenses and income therefore have no effect on net income.
Financial Products Spread Portfolio Net Interest Margin
FP spread portfolio NIM, a non-GAAP measure, is defined as the FP Segment net interest margin excluding variable interest entities net interest margin (“VIE NIM”) and fair-value adjustments for economic interest rate hedges. Management uses FP spread portfolio NIM as a key performance measure of the Company’s growing FP business. FP spread portfolio NIM was $68.8 million in 2006, $40.5 million in 2005 and $23.5 million in 2004. The increases in FP spread portfolio NIM were related primarily to growth in the GIC portfolio. FP spread portfolio NIM is comparable to FP operating NIM, which the Company reported for periods prior to December 31, 2006. Beginning in the fourth quarter of 2006, FP Segment reporting includes the results of VIEs, which formerly were reported in the financial guaranty segment.
NIM shown in accordance with classifications required under GAAP on the consolidated statements of operations and comprehensive income (“Total NIM”) is calculated as net interest income from the FP Segment, plus FP net realized gains (losses), less net interest expense from the FP Segment. Total NIM was $93.3 million for 2006, negative $11.2 million for 2005 and negative $70.7 million for 2004, and primarily represents fixed rate liabilities (which are swapped to a floating rate obligation) funding floating rate assets.
The table below reconciles Total NIM with FP Segment NIM and FP spread portfolio NIM:
Reconciliation of Total NIM to Non-GAAP FP Spread Portfolio NIM
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
Total NIM | | $ | 93.3 | | $ | (11.2 | ) | $ | (70.7 | ) |
Realized gains (losses) from and ineffectiveness of economic interest rate hedges | | (40.7 | ) | 27.6 | | 75.6 | |
Intersegment income related to refinanced transactions | | 20.0 | | 28.2 | | 24.8 | |
Intercompany adjustments | | — | | — | | (1.4 | ) |
FP Segment NIM | | 72.6 | | 44.6 | | 28.3 | |
Less: VIE NIM(1) | | 3.8 | | 4.1 | | 4.8 | |
FP spread portfolio NIM | | $ | 68.8 | | $ | 40.5 | | $ | 23.5 | |
(1) VIE NIM represents the impact of consolidation of the VIEs on the Total NIM.
Net realized interest income and expense associated with economic interest rate hedges are recorded in realized and unrealized gains and losses on derivative instruments and are added back to calculate FP spread portfolio NIM. Derivatives that qualify for hedge accounting are classified in the consolidated statements of operations and comprehensive income with the underlying item being hedged. Gains and losses on derivatives that do not qualify for hedge accounting are shown under the caption net realized and
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unrealized gains (losses) on derivative instruments. Ineffectiveness related to derivatives that do not qualify for hedge accounting is added back to calculate FP spread portfolio NIM.
Intersegment income relates primarily to intercompany notes held in the FP Investment Portfolio. In connection with the Company’s refinancing transactions, FSA obtains funds from the FP operations to fund claim payments, as discussed further in Note 5 to the Consolidated Financial Statements in Item 8, creating an interest-bearing intercompany note. This intercompany note is included in the assets of the FP Segment, with the related net interest income added to FP Segment NIM, but is eliminated from the consolidated Total NIM.
VIE and FP net interest income are combined on the consolidated statements of operations and comprehensive income, as are VIE and FP net interest expense. VIE NIM pertains to the net interest margin derived from transactions executed by FSA Global and Premier International Funding Co. (“Premier”). The VIE NIM relates to a passively managed portfolio, while the growing GIC portfolio is actively managed. Accordingly, the VIE NIM is shown separately from the FP spread portfolio NIM.
Net Realized and Unrealized Gains (Losses) on Derivative Instruments
The components of net realized and unrealized gains (losses) on derivative instruments are shown in the table below:
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
FP Segment derivatives | | $ | 130.0 | | $ | (181.2 | ) | $ | 272.4 | |
FSA-Insured CDS | | 31.8 | | 11.1 | | 56.4 | |
Other | | 1.2 | | (2.4 | ) | 0.5 | |
Net realized and unrealized gains (losses) on derivative instruments | | $ | 163.0 | | $ | (172.5 | ) | $ | 329.3 | |
Credit Default Swaps
FSA’s financial guaranty business includes insurance of CDS. The net par outstanding was $74.7 billion relating to these transactions at December 31, 2006 and $66.6 billion at December 31, 2005. Many of these transactions require periodic accounting adjustments to reflect an estimate of fair value (or the replacement cost of the Company’s financial guaranty contract) under SFAS 133. These transactions have generally been underwritten with Triple-A or higher levels of credit protection provided by significant deductibles that must be exhausted prior to claims under FSA’s guaranty. Adjustments required by SFAS 133 resulted in pre-tax income of $31.8 million for 2006, $11.1 million for 2005 and $56.4 million for 2004. The benefits during 2006, 2005 and 2004 resulted primarily from tightening credit spreads in the CDS market. None of these adjustments indicate any material improvement or deterioration in the underlying credit quality of FSA’s insured CDS portfolio. The gain or loss created by estimated fair-value adjustments will rise or fall each quarter based on estimated market pricing of highly rated swap guarantees and is not expected to be an indication of potential claims under FSA’s guaranty or an indication of potential gains to be received from the derivative transactions.
Fair value is defined as the price at which an asset or a liability could be bought or sold in a current transaction between willing parties. Fair value is determined based on quoted market prices, if available. If quoted market prices are not available, as is primarily the case with CDS on pools of assets, then the determination of fair value is based on internally developed estimates. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, performance of underlying assets, changes in internal shadow ratings, the level at which the deductible has been set and FSA’s ability to obtain reinsurance for its insured obligations. Due to changes in these factors, the unrealized gain or loss from derivative instruments may vary substantially from period to period. Absent any claims under FSA’s guaranty, any “losses” recorded in marking a guaranty to fair
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value will be reversed by an equivalent “gain” at or prior to the expiration of the guaranty, and any “gain” recorded will be reversed by an equal “loss” over the remaining life of the transaction. The average remaining life of these contracts is 3.1 years. The inception-to-date pre-tax gain on the CDS portfolio was $89.2 million at December 31, 2006 and $57.4 million at December 31, 2005. Given the very high credit quality of FSA’s insured CDS portfolio and the Company’s intent to hold to maturity, management believes that “losses” or “gains” attributable to marking these exposures to fair value do not reflect on the profitability of the Company in a meaningful way.
FP and VIE Derivatives
The Company utilizes interest rate derivatives to hedge against fluctuations in interest rates, and foreign currency derivatives to hedge against fluctuations in exchange rates. All gains and losses from changes in the fair-value of derivatives that do not qualify for hedge accounting under SFAS 133 are recognized immediately in the consolidated statements of operations and comprehensive income under the caption net unrealized and realized gains (losses) on derivatives. Hedge accounting is applied to derivatives designated as hedging instruments in a fair-value hedge, provided certain criteria are met. Hedge accounting is applied to certain interest rate swaps used to hedge the GIC liabilities.
Income from Assets Acquired in Refinancing Transactions
Income from assets acquired in refinancing transactions, excluding realized gains or losses, was $24.7 million in 2006, $35.2 million in 2005 and $31.6 million in 2004. The increase in 2005 reflects the impact of a full year of income from transactions that were refinanced at various times during 2004, while 2006 reflects lower invested balances due to paydowns and dispositions of assets within this portfolio.
Equity in Earnings of Unconsolidated Affiliates
Total equity in earnings of unconsolidated affiliates was a pre-tax gain of $1.2 million in 2005 and a pre-tax loss of $3.3 million in 2004. There was none in 2006.
As of December 31, 2004, the Company owned 34.1% of SPS Holding Corp. (“SPS”), formerly Fairbanks Capital Holding Corp., and the Company’s interest in SPS had a book value of $49.6 million. In the third quarter of 2004, the Company determined that its $7.6 million of goodwill associated with its investment in SPS was impaired as a result of challenges encountered by SPS in acquiring new business. The Company’s equity in earnings from SPS was a pre-tax gain of $1.2 million in 2005 and a pre-tax loss of $7.1 million in 2004.
In October 2005, the Company sold its investment in SPS to an unaffiliated third party. For its interest in SPS, the Company was paid $42.9 million in cash at closing and expects to receive additional amounts, from time to time through March 31, 2008, out of income earned by SPS through December 31, 2007 from certain of its mortgage servicing activities. Under the sale documents, the Company’s subsidiary that owned the SPS investment made customary representations and warranties to, and undertook specified indemnification obligations for the benefit of, the purchaser. Based on an estimate of the assets retained and liabilities assumed, the Company recorded a $0.4 million loss on the sale of SPS. Under the terms of the agreement, the Company will receive cash payments through the first quarter of 2008 from a residual interest in mortgage servicing assets. The Company recorded an asset of $12.6 million representing this contingent payment asset. The Company and other prior shareholders indemnified the buyer for certain liabilities relating to SPS’s operations, including litigation and regulatory actions. The maximum indemnification obligation for SPS’s operations will not exceed approximately $34.0 million. The Company’s portion of this obligation is 37.4%, or $12.7 million. As of December 31, 2005, the Company recorded a $5.1 million liability related to this indemnification, representing the expected liability. As of December 31, 2006, the liability had a balance of $3.3 million. The Company has received a net amount of
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$11.2 million related to this asset and liability. The Company will continue to evaluate the appropriate carrying value of the liabilities assumed.
FSA’s investment in preferred shares of XLFA, a financial guaranty insurance subsidiary of XL, is redeemable by XLFA at a price equal to the fair market value of the preferred shares, subject to a cap defined as the internal rate of return of 19% per annum from the date of the investment through the date of redemption, plus accrued dividends as if 100% of current-year earnings were distributed. Based on this formula, the Company carries this investment at the lesser of the current calculated redemption value or the redemption value as of the next January first, which would exclude its share of accrued current-year earnings to the extent the cap had been otherwise met. Consistent with this policy, in the third quarter of 2004, the Company charged a pre-tax amount of $11.7 million to equity in earnings of unconsolidated affiliates and reduced its carrying value in this investment to $56.4 million.
For the first three quarters of 2004 and all prior years, equity in earnings of unconsolidated affiliates included the results of XLFA. In accordance with EITF 02-14, “Whether an Investor Should Apply the Equity Method of Accounting for Investments Other Than Common Stock,” the Company no longer accounts for its investment in XLFA under the equity method of accounting. Effective October 1, 2004, the Company’s investment in XLFA has been included in equity securities as an available-for-sale security. The fair value of the investment at December 31, 2006 was $54.0 million and at December 31, 2005 was $54.3 million. In March 2006, the XLFA Board of Directors approved a by-law amendment changing the coupon on XLFA’s preferred shares from the participating dividend described above to an 8.25% per annum fixed dividend effective January 1, 2006. The Company recognized dividend income from XLFA of $4.5 million during 2006.
FSA has an investment in TheMuniCenter with a fair value of $3.2 million at December 31, 2006 and $6.0 million at December 31, 2005. The Company wrote down the value of TheMuniCenter in the third quarter of 2006 by $3.0 million. The MuniCenter is an electronic municipal bond trading platform though which FSA provides secondary-market bond insurance.
Taxes
The Company’s effective tax rates were 28.8% in 2006, 27.3% in 2005 and 19.0% in 2004. The 2006 rate differs from the statutory rate of 35% due primarily to tax-exempt interest and minority interest. In 2005, the rate differed from the statutory rate of 35% due primarily to tax-exempt interest, minority interest, the Company’s reorganization of Financial Security Assurance International Ltd. (“FSA International”) and its intention to repatriate FSA International’s future earnings. The 2004 rate differed from the statutory rate of 35% primarily due to tax-exempt interest, income from FSA International, minority interest, the White Mountains indemnity payment (see below) and the expected repatriation of earnings of FSA International in 2005.
The American Jobs Creation Act of 2004 (the “Act”), enacted on October 22, 2004, added Section 965 to the Internal Revenue Code. Section 965 provides for the repatriation of dividends from a controlled foreign corporation to its U.S. shareholder at an effective tax rate of 5.25%, provided that proceeds from the repatriation are utilized for qualified domestic investment activities. The U.S. Treasury Department issued Notice 2005-10, which provided guidance on acceptable investment activities. The Company believes it qualifies for the beneficial treatment under Section 965 and accordingly accrued a tax liability and expense of $5.3 million at December 31, 2004. This amount approximated the tax effect on FSA International’s tax dividend distribution made in the fourth quarter of 2005.
In December 2005, the Company repatriated earnings from FSA International to avail itself of the reduced effective tax rate of 5.25% (compared with the normal effective tax rate of 35%) applicable to certain earnings and profits of offshore subsidiaries repatriated during 2005 and invested in the United States pursuant to a qualifying reinvestment plan in accordance with the Act. In connection with such repatriation, the Company recapitalized FSA International in October of 2005 to become a wholly owned
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subsidiary and declared that it no longer intends to leave future earnings of that subsidiary permanently offshore, with the effect that 2005 and future income from FSA International have become subject to an increased effective U.S. tax rate. The impact on earnings reflects (a) a tax liability of $15.1 million in respect of earnings of FSA International that have previously been recognized for GAAP but not yet for tax and (b) $14.2 million related to 2005 earnings.
Following a change in SPS’s investors in 2002, the Company determined that it would be appropriate to apply the 80% dividend-received deduction allowed by the Internal Revenue Service when calculating the tax on its equity earnings from SPS, based on management’s expectation that it would realize its gain on such investment through dividend distributions rather than through sale of its investment. Accordingly, for 2004, equity in earnings from SPS was taxed at an effective rate of 7.0%. In the first quarter of 2005, the Company, due to the pending sale of its investment in SPS, eliminated the assumption that accumulated earnings of SPS would be distributed in the form of dividends eligible for a dividend-received deduction. The net effect of this was to reserve for additional taxes of approximately $1.6 million.
In connection with Dexia’s acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains Insurance Group. While the Company had no legal liability in connection with the indemnity payment, the payment is treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, the Company has agreed to share 50% of the deferred tax benefit with White Mountains Insurance Group under certain circumstances, but did not satisfy the standards for recording a liability for accounting purposes as of December 31, 2006.
Critical Accounting Policies
The Company’s critical accounting policies and estimates are described in Note 2 to the Consolidated Financial Statements in Item 8. Note 2 to the Consolidated Financial Statements includes a discussion of the financial guaranty accounting project that the FASB staff has undertaken to provide accounting guidance to the financial guaranty industry.
Liquidity and Capital Resources
Liquidity
The Company’s consolidated invested assets at December 31, 2006, net of unsettled security transactions, were $21,261.4 million, compared with the December 31, 2005 balance of $17,392.3 million. These balances include the change in the market value of the Company’s various portfolios, which had an unrealized gain position of $333.1 million at December 31, 2006, compared with an unrealized gain position of $236.2 million at December 31, 2005. These balances exclude assets in the VIE Investment Portfolio and assets acquired under refinancing transactions that the Company’s management believes are beyond the reach of the Company and its creditors.
The Company includes variable rate demand notes (“VRDN”) and auction rate securities (“ARS”), which totaled $746.5 million at December 31, 2006 and $867.2 million at December 31, 2005, in its long-term bond portfolios. VRDNs are long-term bonds that bear floating interest rates and provide investors with the option to tender or put the bonds at par, generally on a daily, weekly or monthly basis. ARS are long-term securities with interest rate reset features and are traded in the marketplace through a bidding process. For management purposes, VRDN and ARS are managed as cash equivalents.
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Cash flow from operations was $611.2 million in 2006, $654.3 million in 2005 and $550.8 million in 2004. The decrease in cash flow from operations in 2006 is attributable primarily to the decrease in premiums and the activity in the trading portfolio, partially offset by an increase in net interest received from the FP Segment and a reduction in taxes paid. In 2005, the increase in cash flow from operations was primarily attributable to net interest received from the FP Segment, due to growth in the FP book of business, and to premiums, partially offset by increases in operating expenses and taxes paid. The increase in premium receipts was due primarily to increased refunding activity. The increase in taxes paid was due primarily to the repatriation of FSA International earnings.
At December 31, 2006, Financial Security Assurance Holdings Ltd. (as a separate holding company, “FSA Holdings”) had cash and investments of $42.7 million available to fund the liquidity needs of its non-insurance operations. Because the majority of the Company’s operations are conducted through FSA, the long-term ability of FSA Holdings to service its debt will largely depend on its receipt of dividends from, or payment on surplus notes by, FSA.
In its financial guaranty business, premiums and investment income are the Company’s primary sources of funds to pay its operating expenses, insured losses and taxes. In its FP Segment, the Company relies on net interest income to fund its net interest expense and operating expenses. Management believes that the Company’s operations provide sufficient liquidity to pay its obligations. If additional liquidity is needed or cash flow from operations significantly decreases, the Company can liquidate or utilize its investment portfolio as a source of funds in addition to its alternative liquidity arrangements, as discussed further below. The Company’s cash flows from operations are heavily dependent on market conditions, the competitive environment and the mix of business originated. In addition, payments made in settlement of the Company’s obligations in its insured portfolio may, and often do, vary significantly from year to year depending primarily on the frequency and severity of payment defaults and its decisions regarding whether to exercise its right to accelerate troubled insured transactions in order to mitigate future losses. In each of the three years reported, the Company has not drawn on any alternative sources of liquidity to meet its obligations, except that the Company has refinanced certain transactions using funds raised through its GIC Affiliates.
The following is a summary of the Company’s contractual obligations at December 31, 2006:
Contractual Obligations
| | Less than
1 Year | | 1–3 Years | | 3–5 Years | | Greater than
5 years | | Total | |
| | (in millions) | |
Loss reserves(1) | | $ | 5.0 | | $ | 17.1 | | $ | 44.8 | | | $ | 239.1 | | | $ | 306.0 | |
GIC and VIE debt obligations(2) | | 4,701.9 | | 4,941.5 | | 4,569.8 | | | 12,495.7 | | | 26,708.9 | |
Corporate debt obligations(3) | | 48.1 | | 92.1 | | 92.1 | | | 3,623.8 | | | 3,856.1 | |
Operating lease obligations | | 9.2 | | 16.4 | | 16.3 | | | 111.7 | | | 153.6 | |
Total | | $ | 4,764.2 | | $ | 5,067.1 | | $ | 4,723.0 | | | $ | 16,470.3 | | | $ | 31,024.6 | |
(1) Amounts represent the undiscounted estimated claim payments.
(2) Amounts include future implied interest accretion on zero-coupon obligations and future interest payments. Foreign amounts are calculated using spot rates as of December 31, 2006. Future interest payments are assumed to be at the rates in effect as of December 31, 2006 for floating rate debt.
(3) Amounts include principal and interest payments for the minimum contractual period.
Downgrades of FSA’s Triple-A financial strength ratings would adversely affect FSA’s ability to compete for business. Credit ratings are an important component of a financial institutions’ ability to compete in the financial guaranty, derivative, investment agreement and structured transaction markets. If FSA were downgraded, FSA might be required to post incremental collateral to its investment agreement
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and derivative counterparties, introducing liquidity risk. In addition, most investment agreements provide certain remedies for the investment agreement purchaser in the event of a downgrade of FSA’s credit rating, typically below Aa3 by Moody’s or AA- by S&P. Such remedies include termination of the investment agreement contract. In most cases FSA is permitted to post collateral or otherwise enhance its credit prior to an actual termination of the investment agreement.
At December 31, 2006, FSA Holdings held $108.9 million of FSA surplus notes. Payments of principal or interest on such notes may be made only with the approval of the Superintendent of Insurance of the State of New York (the “New York Superintendent”). FSA Holdings employs surplus note purchases in lieu of capital contributions in order to allow it to withdraw funds from FSA through surplus note payments without reducing earned surplus, thereby preserving the dividend capacity of FSA.
FSA Holdings paid dividends of $530.0 million in 2006, $71.1 million in 2005 and $22.9 million in 2004.
On November 22, 2006, FSA Holdings issued $300.0 million principal amount of Junior Subordinated Debentures with a scheduled maturity date of December 15, 2036 and a final repayment date of December 15, 2066. The final repayment date of December 15, 2066 may be automatically extended up to four times in five-year increments provided certain conditions are met. The debentures are redeemable, in whole or in part, at any time prior to December 15, 2036 at their principal amount plus accrued and unpaid interest to the date of redemption. Interest on the debentures will accrue from November 22, 2006 to December 15, 2036 at the annual rate of 6.40%. If any amount of the debentures remains outstanding after December 15, 2036, then the principal amount of the outstanding debentures will bear interest at a floating interest rate equal to one-month LIBOR plus 2.215% until repaid. FSA Holdings may elect at one or more times to defer payment of interest on the debentures for one or more consecutive interest periods that do not exceed ten years. In connection with the completion of this offering, FSA Holdings entered into a replacement capital covenant for the benefit of persons that buy, hold or sell a specified series of FSA Holdings long-term indebtedness ranking senior to the debentures. Under the covenant, the debentures will not be repaid, redeemed, repurchased or defeased by FSA Holdings or any of its subsidiaries on or before the date that is 20 years prior to the final repayment date, except to the extent that FSA Holdings has received proceeds from the sale of replacement capital securities. The proceeds from this offering were used to pay a dividend to the shareholders of FSA Holdings.
On July 31, 2003, FSA Holdings issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the Notes.
On November 26, 2002, FSA Holdings issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt. FSA Holdings used a portion of the proceeds of this issuance to redeem in whole FSA Holdings’ $130.0 million principal amount of 7.375% Senior QUIDS due September 30, 2097.
On December 19, 2001, FSA Holdings issued $100.0 million of 67¤8% Quarterly Income Bond Securities due December 15, 2101, which are callable without premium or penalty on or after December 19, 2006. Debt issuance costs of $3.3 million are being amortized over the life of the debt.
FSA’s ability to pay dividends depends, among other things, upon FSA’s financial condition, results of operations, cash requirements and compliance with rating agency requirements for maintaining its Triple-A ratings, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York (the “New York Insurance Law”), FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (a) 10% of policyholders’ surplus as of its last statement filed with the New York Superintendent or (b) adjusted net investment income during this period. Based on FSA’s statutory statements for 2006, and
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considering dividends that can be paid by its subsidiary, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the 12 months following December 31, 2006 is approximately $156.6 million. FSA paid dividends of $140.0 million in 2006, $87.0 million in 2005 and $30.0 million in 2004.
FSA may repurchase shares of its common stock from its shareholders subject to the New York Superintendent’s approval. The New York Superintendent has approved the repurchase by FSA of up to $500.0 million of its shares from FSA Holdings through December 31, 2008. In 2006, FSA repurchased $100 million of shares of its common stock from FSA Holdings and retired such shares.
FSA International paid preferred dividends of $6.9 million in 2005 and $7.0 million in 2004 to XL Capital Ltd, its minority interest owner. In October 2005, FSA purchased all the preferred shares of FSA International owned by XL Insurance (Bermuda) Ltd. for a cash purchase price of $39.1 million, in anticipation of the repatriation of earnings and profits of FSA International. Giving effect to such purchase, FSA International became an indirect wholly owned subsidiary of the Company.
Additional Capital Resources
FSA’s primary uses of funds are to pay operating expenses and to pay dividends to, or pay interest or principal on surplus notes held by, its parent FSA Holdings. FSA’s funds are also required to satisfy claims under insurance policies in the event of default by an issuer of an insured obligation and the unavailability or exhaustion of other payment sources in the transaction, such as the cash flow or collateral underlying the obligations. FSA seeks to structure asset-backed transactions to address liquidity risks by matching insured payments with available cash flow or other payment sources. Insurance policies issued by FSA guaranteeing payments under bonds and other securities provide, in general, that payments of principal, interest and other amounts insured by FSA may not be accelerated by the holder of the obligation but are paid by FSA in accordance with the obligation’s original payment schedule or, at FSA’s option, on an accelerated basis. Insurance policies issued by FSA guaranteeing payments under CDS may provide for acceleration of amounts due upon the occurrence of certain credit events subject to single-risk limits specified in the New York Insurance Law. These policy provisions prohibiting or limiting acceleration of certain claims are mandatory under Article 69 of the New York Insurance Law and serve to reduce FSA’s liquidity requirements.
Management believes that the Company’s expected operating liquidity needs, on both a short- and long-term basis, can be funded from its operating cash flow. In addition, the Company has a number of sources of liquidity available to pay claims on a short- and long-term basis: cash flow from premiums written, FSA’s investment portfolio and earnings thereon, reinsurance arrangements with third-party reinsurers, new borrowings through its GIC Affiliates, liquidity lines of credit with banks, and capital market transactions.
FSA has a credit arrangement aggregating $150.0 million, provided by commercial banks and intended for general application to transactions insured by FSA. If FSA is downgraded below Aa3 and AA-, the lenders may terminate the commitment, and the commitment commission becomes due and payable. If FSA is downgraded below Baa3 and BBB-, any outstanding loans become due and payable. At December 31, 2006, there were no borrowings under this arrangement, which expires on April 21, 2011, if not extended.
FSA has a standby line of credit in the amount of $350.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $350.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $1,328.3 million at December 31, 2006. The obligation to repay loans 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 ten-year term expiring on April 30, 2015 and contains an annual renewal provision, commencing April 30, 2008, subject to approval by the banks. A ratings downgrade of FSA would result in an increase in the commitment fee. No amounts have been utilized under this commitment as of December 31, 2006.
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In June 2003, $200.0 million of money market committed preferred trust securities (the “CPS Securities”) were issued by trusts created for the primary purpose of issuing the CPS Securities, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the “Preferred Stock”) of FSA. If FSA were to exercise a put option, the applicable trust would transfer the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $1.0 million for 2006 and $1.3 million for 2005 and was recorded as other operating expense in the Company’s Consolidated Financial Statements. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts under Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (revised December 2003) (“FIN 46-R”) because it does not retain the majority of the residual benefits or expected losses.
FSA-insured GICs subject the Company to risk associated with unexpected withdrawals of principal allowed by the terms of the GICs. The majority of municipal GICs insured by FSA relate to debt service reserve funds and construction funds in support of municipal bond transactions. Debt service reserve fund GICs may be drawn unexpectedly upon a payment default by the municipal issuer. Construction fund GICs may be drawn unexpectedly when construction of the underlying municipal project does not proceed as expected. In addition, most FSA-insured GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below Aa3 by Moody’s Investors Service, Inc. (“Moody’s”) or AA- by S&P, unless the GIC provider posts collateral or otherwise enhances its credit. Some FSA-insured GICs also allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below A3 by Moody’s or A- by S&P, with no right of the GIC provider to avoid such withdrawal by posting collateral or otherwise enhancing its credit. The Company manages this risk through the maintenance of liquid collateral and bank liquidity facilities.
FSA Asset Management LLC (“FSAM”) has a $100.0 million line of credit with UBS Loan Finance LLC, which expires December 7, 2007, unless extended. This line of credit provides an additional source of liquidity should there be unexpected draws on GICs issued by the GIC Affiliates. There were no borrowings under this arrangement at December 31, 2006. Borrowings under this agreement are conditioned on FSA having a Triple-A rating by either Moody’s or S&P, and on neither Moody’s nor S&P having issued a rating to FSA below Aa1 or AA+, respectively.
Certain FSA Global debt issuances contain provisions that could extend the stated maturities of those notes. To ensure FSA Global will have sufficient cash flow to repay its funding requirements, it entered into four liquidity facilities with Dexia for amounts totaling $419.4 million.
Capital Adequacy
S&P, Moody’s and Fitch Ratings periodically assess the credits insured by FSA, and the reinsurers and other providers of capital support to FSA, to confirm that FSA continues to satisfy the rating agencies’ capital adequacy criteria necessary to maintain FSA’s Triple-A ratings. Capital adequacy assessments by the rating agencies are generally based on FSA’s qualified statutory capital, which is the aggregate of policyholders’ surplus and contingency reserves determined in accordance with statutory accounting principles.
In the case of S&P, assessments of the credits insured by FSA are reflected in defined “capital charges,” which are reduced by reinsurance and collateral to the extent “credit” is allowed for such reinsurance and collateral. Credit provided for reinsurance under the S&P capital adequacy model is generally a function of the S&P rating of the reinsurer, as well as any collateral provided by the reinsurer. Capital charges on outstanding insured transactions and reinsurer ratings are subject to change by S&P at
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any time. In recent years, a number of Triple-A rated reinsurers employed by FSA have been downgraded by S&P. Downgrade of these reinsurers by S&P to the Double-A category resulted in a decline in the credit allowed for reinsurance by S&P from 100% to 70% or 65% under present criteria. While a downgrade by S&P of all reinsurers to the Double-A category would not impair FSA’s Triple-A ratings, it would reduce the “margin of safety” by which FSA would survive a theoretical catastrophic depression modeled by S&P. A reduction by S&P in credit for reinsurance used by FSA would also be expected ultimately to reduce the Company’s return on equity to the extent that ceding commissions paid to FSA by such reinsurers were not increased to compensate for such reduction. FSA employs considerable reinsurance in its business to manage its single-risk exposures on insured credits. Any material increase in capital charges by S&P on FSA’s insured portfolio would likewise be expected to have an adverse effect on FSA’s margin of safety under the S&P capital adequacy model and, ultimately, the Company’s return on equity. The Company may seek to raise additional capital to replenish capital eliminated by any of the rating agencies in their assessment of FSA’s capital adequacy.
Capital adequacy is one of the financial strength measures under Moody’s financial guarantor model. The model includes a penalty for risk concentration and recognizes a benefit for diversification. The published results reflect four metrics of financial strength relating to the insured portfolio’s credit quality, correlation risk, concentration of risk and capital adequacy. Moody’s assesses capital adequacy by comparing FSA’s claims-paying resources to a Moody’s-derived probability of potential credit losses. Moody’s loss distribution reflects FSA’s current distribution of risk by sector, the credit quality of insured exposures, correlations that exist between transactions, the credit quality of FSA’s reinsurers and the term to maturity of FSA’s insured portfolio. The published results compare levels of theoretical loss in the tail of this distribution to various measures of FSA’s claims-paying resources.
Capital Expenditures
The Company incurred approximately $3.4 million in capital expenditures in 2006 for leasehold improvements, furniture and fixtures, which were funded from cash flows from operations.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments caused by interest rate, foreign exchange rate or equity price movements. The Company has exposure to market risk in (a) the General Investment Portfolio, (b) the portfolio of insured CDS, (c) the portfolio of assets acquired in refinancing transactions, and (d) the FP Segment Investment Portfolio. Substantially all of the income statement volatility related to changes in foreign exchange rates is mitigated through the use of cross-currency swaps.
General Investment Portfolio
Over 98.8% of the Company’s General Investment Portfolio was invested in fixed-income securities at December 31, 2006. Changes in interest rates affect the value of the Company’s fixed-income portfolio. As interest rates rise, the fair value of fixed-income securities decreases.
Management’s primary objective in managing the Company’s General Investment Portfolio is to generate an optimal level of after-tax investment income while preserving capital, maintaining adequate liquidity and meeting rating agency capital adequacy criteria that apply discount factors to investments based on their ratings. The Company bases its investment strategies on many factors, including the Company’s tax position, anticipated changes in interest rates, regulatory and rating agency criteria and other market factors. One internal investment manager and two external investment managers buy primarily fixed-income investments on behalf of the Company. Management, with the approval of the Board of Directors, establishes guidelines for investment decisions.
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Sensitivity of the Company’s General Investment Portfolio to interest rate movements can be estimated by projecting a hypothetical increase in interest rates of 1.0%. Based on market values and interest rates at year-end 2006 and 2005, this hypothetical increase in interest rates of 1.0% across the entire yield curve would result in an estimated after-tax decrease of $124.7 million and $130.2 million, respectively, in the fair value of the Company’s fixed-income portfolio, which would be recorded in other comprehensive income.
The Company’s General Investment Portfolio holdings are primarily U.S. dollar-denominated fixed-income securities, including municipal bonds, U.S. government and agency bonds and mortgage-backed, asset-backed, corporate and foreign securities. In calculating the sensitivity to interest rates for the taxable securities, U.S. Treasury rates are changed instantaneously by 1.0%. Tax-exempt securities are subjected to a parallel shift in the municipal Triple-A obligation curve that would be equivalent to a 1.0% taxable interest rate change based on the average taxable/tax-exempt ratios for the prior 12 months. The tax-exempt simulation utilizes duration, which takes into account the applicable call date if the bond is priced at a premium or the maturity date if the bond is priced at a discount.
Credit Default Swaps
Financial instruments that may be affected by changes in credit spreads include structured FSA-guaranteed CDS contracts. Such contracts are considered derivative instruments subject to fair-value accounting under SFAS 133. Because the Company generally provides credit protection under such contracts, widening credit spreads will have an adverse mark-to-fair-value effect on the Company’s consolidated statements of operations and comprehensive income while tightening credit spreads will have a positive effect. These contracts require the Company to make payments upon the occurrence of certain defined credit events relating to underlying obligations (generally fixed-income obligations), which may be individual obligations or a pool of obligations, subject to a deductible. These deductibles mitigate the risk of loss. If credit spreads of the underlying obligations change, the fair value of the related structured CDS changes. Changes in credit spreads are generally caused by changes in the market’s perception of the credit quality of the underlying referenced obligations and by supply and demand factors.
The portfolio of CDS contracts consists primarily of synthetic structured credit derivatives guaranteed by the Company and is organized into various categories, which are defined by the underlying assets, credit rating, maturity dates and other terms. Changes in fair value of CDS contracts are generally due to changes in credit spreads. Because the portfolio of FSA-insured CDS is not traded, the Company has developed a series of asset credit-spread algorithms to estimate fair value. These algorithms derive fair value from several publicly available indices, depending on the types of assets referenced by the CDS.
Management does not analyze the market sensitivity of its insured CDS portfolio for purposes other than to quantify the potential exposure to quarterly fair-value gain or loss. Management believes that each of the transactions for which it has provided CDS protection contains significant protections against loss and that quarterly changes in credit spreads generally do not imply any fundamental change in future loss potential. Any quantitative fair-value risk information generated by the application of statistical techniques is limited by the methods, assumptions and parameters established in creating the model. The history of relevant asset credit-spread information is relatively short, and the insight gained by using such information to forecast potential future fair-value changes may therefore be limited.
The effect of any change in credit spreads is recognized in current income. Generally, a sensitivity analysis is presented in terms of the effect of a predetermined basis-point change in pricing or credit spreads. However, due to the wide range of pricing of the CDS portfolio, management believes that this type of sensitivity analysis is not the most relevant measure. For example, a hypothetical one-basis-point change in fair value would have a significantly greater impact on a CDS contract priced at five basis points than a CDS contract valued at 20 basis points.
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The Company has evaluated the sensitivity of the CDS contracts by calculating the effect of percentage changes in pricing. The following table summarizes the estimated pre-tax effect of hypothetical changes in the fair value of the Company’s portfolio of CDS contracts, which are defined as derivatives for accounting purposes. In 2006, the effect of changes in premiums was lower due to lower prices, notably in the investment-grade and high-yield sectors. In accordance with SFAS 133, any changes in pricing would be recorded in the statements of operations.
Effect of Hypothetical Increase in CDS Premiums
| | Estimated pre tax loss | |
| | 2006 | | 2005 | |
| | (in millions) | |
+25% | | | $ | 42.8 | | | | $ | 56.4 | | |
+50% | | | 85.5 | | | | 112.7 | | |
+75% | | | 128.3 | | | | 169.1 | | |
Assets Acquired in Refinancing Transactions
As of December 31, 2006 and 2005, a hypothetical increase in interest rates of 1.0% would result in an estimated after-tax decrease of $8.3 million and $11.3 million, respectively, in the fair value of certain assets acquired under refinancing transactions, offset by an after-tax gain of $9.9 million and $11.9 million, respectively, on derivatives used to economically hedge the portfolio of assets acquired under refinancing transactions.
Financial Products Segment
FSAM manages the FP Investment Portfolio, which supports the GIC liabilities. The primary objectives in managing this portfolio are to generate a stable net interest margin, to maintain liquidity and to optimize risk-adjusted returns.
The assets and liabilities supporting the GIC business are hedged using interest rate swaps or futures. Certain categories of assets and liabilities are economically hedged, without the use of derivatives. A hypothetical increase in interest rates of 1% would have the following after-tax effect:
| | 2006 | | 2005 | |
| | (in millions) | |
Change in fair value of assets(1) | | $ | (129.2 | ) | $ | (95.0 | ) |
Change in fair value of derivatives hedging assets(2) | | 107.0 | | 80.3 | |
Change in fair value of liabilities(3) | | 245.9 | | 223.5 | |
Change in fair value of derivatives hedging liabilities(2) | | (225.2 | ) | (208.1 | ) |
Net changes in fair value | | $ | (1.5 | ) | $ | 0.7 | |
(1) Recorded in other comprehensive income.
(2) Recorded in current income.
(3) Changes in the fair value of the liability portfolio are not recorded in the financial statements unless they are designated as hedges for accounting purposes in accordance with SFAS 133.
There were no assets in a designated hedging relationship as of December 31, 2006 and 2005. Approximately $3.3 billion in liabilities are marked to market in income because designated SFAS 133 hedges have been applied. A 1% increase in interest rates would result in higher reported net income of $80.9 million in 2006 and lower reported net income of $127.8 million in 2005, which represents the change in fair value on all derivatives used to economically hedge the assets and liabilities and the change in fair
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value on liabilities in SFAS 133-qualifying hedging relationships. The decrease in the effect on net income from 2005 to 2006 is primarily due to the impact of hedge accounting in accordance with SFAS 133 in 2006 for certain hedging relationships in the liability portfolio, which allows the changes in fair value of hedged risks to be included in net income. Since the Company does not expect to trade the investments or derivatives prior to maturity absent an unusually large demand for funds, it does not expect to recognize any material adverse impact to cash flows under the above scenario.
The FP Investment Portfolio consists primarily of U.S. dollar-denominated asset-backed securities, U.S. agency and government securities and mortgage-backed securities. FSAM generally converts all fixed rate assets and liabilities to floating U.S. dollar interest rates using hedging instruments. As interest rates change, and assuming an economically effective fair-value hedging arrangement, the change in value of the fixed-income securities will be substantially offset by a similar but opposite change in value of the related hedging instruments. To the extent the Company does not qualify for hedge accounting, such economic offsets cannot be presented in the financial statements, resulting in greater reported volatility arising from changes in interest rates.
Assets supporting VIE liabilities (the VIE Investment Portfolio) are generally held until maturity. The VIE fixed rate liabilities are economically hedged against changes in interest rates largely through the use of swap contracts, which convert fixed interest rates to floating U.S. dollar interest rates.
FSA Global is managed as a “match funded vehicle,” in which the proceeds from the sale of FSA Global notes are invested in obligations chosen to provide cash flows substantially matched to those of the notes (taking into account, in some cases, dedicated third-party liquidity). This match funded structure is designed to minimize the market risks borne by FSA Global and FSA.
FSA Global generally raises funds that are denominated in U.S. dollars or converted into U.S. dollars at LIBOR-based floating borrowing rates. In recent years, the funds FSA Global raises have generally been invested in FSA-insured GICs, but it may invest, and has in the past invested, in other FSA-insured obligations. FSA Global invests with a view to realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. While the majority of FSA Global’s investments are either denominated in U.S. dollars or converted into U.S. dollars at LIBOR-based floating rates, it also holds investments in other currencies.
FSA Global’s investments:
· mature prior to the maturity of the related FSA Global notes, and
· pay a higher interest rate than the interest rate on the related FSA Global notes.
The VIE fixed rate investments and liabilities are economically hedged against changes in interest rates largely through the use of interest rate swap contracts, which convert fixed interest rates to floating rates. A hypothetical increase in interest rates of 1% would result in an approximate after-tax loss of $74.2 million on the derivatives used to economically hedge the VIE asset and liability portfolios and would be recorded in current income.
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Item 8. Financial Statements and Supplementary Data.
Financial Security Assurance Holdings Ltd. and Subsidiaries
Index to Consolidated Financial Statements and Schedule
| | Page | |
Report of Independent Registered Public Accounting Firm | | | 72 | | |
Consolidated Balance Sheets as of December 31, 2006 and 2005 | | | 73 | | |
Consolidated Statements of Operations and Comprehensive Income for the Years Ended December 31, 2006, 2005 and 2004 | | | 74 | | |
Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2006, 2005 and 2004 | | | 75 | | |
Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2005 and 2004 | | | 76 | | |
Notes to Consolidated Financial Statements | | | 78 | | |
Schedule: | | | | | |
I Condensed Financial Statements of Financial Security Assurance Holdings Ltd. as of December 31, 2006 and 2005 and for the Years Ended December 31, 2006, 2005 and 2004 | | | 164 | | |
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Report of Independent Registered Public Accounting Firm
To Board of Directors and Shareholders
of Financial Security Assurance Holdings Ltd.:
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Financial Security Assurance Holdings Ltd. and Subsidiaries (the “Company”) at December 31, 2006 and December 31, 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards 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 | | |
New York, New York | | |
March 29, 2007 | | |
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FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
| | As of December 31, | |
| | 2006 | | 2005 | |
ASSETS | | | | | |
General Investment Portfolio: | | | | | |
Bonds at fair value (amortized cost of $4,546,147 and $4,219,344) | | $ | 4,721,512 | | $ | 4,382,037 | |
Equity securities at fair value (cost of $54,291 and $54,370) | | 54,325 | | 54,370 | |
Short-term investments (cost of $96,055 and $159,133) | | 96,578 | | 159,133 | |
Financial Products Segment Investment Portfolio: | | | | | |
Bonds at fair value (amortized cost of $16,692,183 and $12,910,162) | | 16,757,979 | | 12,983,816 | |
Short-term investments | | 659,704 | | 1,018,183 | |
Trading portfolio at fair value | | 119,424 | | — | |
Assets acquired in refinancing transactions: | | | | | |
Bonds at fair value (amortized cost of $40,133 and $65,865) | | 41,051 | | 68,421 | |
Securitized loans | | 241,785 | | 296,965 | |
Other | | 55,036 | | 102,487 | |
Total investment portfolio | | 22,747,394 | | 19,065,412 | |
Cash | | 32,471 | | 43,629 | |
Deferred acquisition costs | | 340,673 | | 335,129 | |
Prepaid reinsurance premiums | | 1,004,987 | | 865,192 | |
Reinsurance recoverable on unpaid losses | | 37,342 | | 36,339 | |
Other assets (See Notes 16 and 21) | | 1,610,759 | | 1,655,941 | |
TOTAL ASSETS | | $ | 25,773,626 | | $ | 22,001,642 | |
LIABILITIES, MINORITY INTEREST AND SHAREHOLDERS’ EQUITY | | | | | |
Deferred premium revenue | | $ | 2,653,321 | | $ | 2,375,059 | |
Losses and loss adjustment expenses | | 228,122 | | 205,718 | |
Guaranteed investment contracts and variable interest entities’ debt | | 18,349,665 | | 14,947,118 | |
Deferred federal income taxes | | 298,542 | | 231,265 | |
Notes payable | | 730,000 | | 430,000 | |
Accrued expenses, other liabilities and minority interest (See Note 16) | | 791,664 | | 989,580 | |
TOTAL LIABILITIES AND MINORITY INTEREST | | 23,051,314 | | 19,178,740 | |
COMMITMENTS AND CONTINGENCIES (See Note 17) | | | | | |
Common stock (200,000,000 shares authorized; 33,517,995 issued; par value of $.01 per share) | | 335 | | 335 | |
Additional paid-in capital—common | | 906,687 | | 905,190 | |
Accumulated other comprehensive income (net of deferred income taxes of $86,119 and $84,123) | | 160,038 | | 156,229 | |
Accumulated earnings | | 1,655,252 | | 1,761,148 | |
Deferred equity compensation | | 19,225 | | 20,177 | |
Less treasury stock at cost (241,978 and 254,736 shares held) | | (19,225 | ) | (20,177 | ) |
TOTAL SHAREHOLDERS’ EQUITY | | 2,722,312 | | 2,822,902 | |
TOTAL LIABILITIES, MINORITY INTEREST AND SHAREHOLDERS’ EQUITY | | $ | 25,773,626 | | $ | 22,001,642 | |
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
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FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(in thousands)
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
REVENUES: | | | | | | | |
Net premiums written | | $ | 527,177 | | $ | 577,694 | | $ | 587,769 | |
Net premiums earned | | $ | 388,709 | | $ | 404,059 | | $ | 395,015 | |
Net investment income | | 218,850 | | 200,827 | | 172,051 | |
Net realized gains (losses) | | (8,328 | ) | 6,392 | | (473 | ) |
Net interest income from financial products segment | | 861,772 | | 487,916 | | 194,675 | |
Net realized gains (losses) from financial products segment | | 108 | | (7,473 | ) | 2,217 | |
Net realized and unrealized gains (losses) on derivative
instruments | | 163,046 | | (172,475 | ) | 329,259 | |
Income from assets acquired in refinancing transactions | | 24,661 | | 35,190 | | 31,634 | |
Net realized gains from assets acquired in refinancing transactions | | 12,729 | | 5,601 | | — | |
Other income | | 29,321 | | 21,198 | | 23,891 | |
TOTAL REVENUES | | 1,690,868 | | 981,235 | | 1,148,269 | |
EXPENSES: | | | | | | | |
Losses and loss adjustment expenses | | 23,303 | | 25,365 | | 20,599 | |
Interest expense | | 29,096 | | 26,990 | | 26,993 | |
Policy acquisition costs | | 63,012 | | 68,340 | | 62,201 | |
Foreign exchange (gains) losses from financial products segment | | 159,424 | | (189,785 | ) | 91,309 | |
Net interest expense from financial products segment | | 768,583 | | 491,640 | | 267,599 | |
Other operating expenses | | 124,622 | | 93,614 | | 99,054 | |
TOTAL EXPENSES | | 1,168,040 | | 516,164 | | 567,755 | |
INCOME BEFORE INCOME TAXES, MINORITY INTEREST AND EQUITY IN LOSSES OF UNCONSOLIDATED AFFILIATES | | 522,828 | | 465,071 | | 580,514 | |
Provision (benefit) for income taxes: | | | | | | | |
Current | | 85,454 | | 127,479 | | 53,472 | |
Deferred | | 65,226 | | (606 | ) | 57,084 | |
Total provision | | 150,680 | | 126,873 | | 110,556 | |
NET INCOME BEFORE MINORITY INTEREST AND EQUITY IN LOSSES OF UNCONSOLIDATED AFFILIATES | | 372,148 | | 338,198 | | 469,958 | |
Less: Minority interest | | (52,006 | ) | 11,224 | | 87,408 | |
Plus: Equity in losses of unconsolidated affiliates, net of income tax provisions of $2,026 and $604 | | —— | | (866 | ) | (3,943 | ) |
NET INCOME | | 424,154 | | 326,108 | | 378,607 | |
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX: | | | | | | | |
Unrealized gains (losses) arising during the period, net of deferred income tax provision (benefit) of $5,438, $(13,427) and $18,698 | | 10,202 | | (32,012 | ) | 36,164 | |
Less: Reclassification adjustment for gains included in net income, net of deferred income tax provision of $3,442, $6,205 and $237 | | 6,393 | | 11,523 | | 1,017 | |
Other comprehensive income (loss) | | 3,809 | | (43,535 | ) | 35,147 | |
COMPREHENSIVE INCOME | | $ | 427,963 | | $ | 282,573 | | $ | 413,754 | |
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
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FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(in thousands)
| | Common
Stock | | Additional
Paid-In
Capital-
Common | | Unrealized
Gain
on
Investments | | Accumulated
Earnings | | Deferred
Equity
Compensation | | Treasury
Stock | | Total | |
BALANCE, December 31, 2003 | | | $ | 335 | | | | $ | 903,829 | | | | $ | 164,617 | | | | $ | 1,150,368 | | | | $ | 23,445 | | | $ | (23,445 | ) | $ | 2,219,149 | |
Net income for the year | | | | | | | | | | | | | | | 378,607 | | | | | | | | | 378,607 | |
Net change in accumulated other comprehensive income, net of deferred income tax expense of $18,461 | | | | | | | | | | | 35,147 | | | | | | | | | | | | | 35,147 | |
Capital contribution | | | | | | | 1,251 | | | | | | | | | | | | | | | | | 1,251 | |
Dividends paid on common stock | | | | | | | | | | | | | | | (22,876 | ) | | | | | | | | (22,876 | ) |
Deferred equity payout | | | | | | | | | | | | | | | | | | | 83 | | | (83 | ) | — | |
BALANCE, December 31, 2004 | | | 335 | | | | 905,080 | | | | 199,764 | | | | 1,506,099 | | | | 23,528 | | | $ | (23,528 | ) | 2,611,278 | |
Net income for the year | | | | | | | | | | | | | | | 326,108 | | | | | | | | | 326,108 | |
Net change in accumulated other comprehensive income, net of deferred income tax (benefit) of ($19,632) | | | | | | | | | | | (43,535 | ) | | | | | | | | | | | | (43,535 | ) |
Capital contribution | | | | | | | 110 | | | | | | | | | | | | | | | | | 110 | |
Dividends paid on common stock | | | | | | | | | | | | | | | (71,059 | ) | | | | | | | | (71,059 | ) |
Deferred equity payout | | | | | | | | | | | | | | | | | | | (3,351 | ) | | 3,351 | | — | |
BALANCE, December 31, 2005 | | | 335 | | | | 905,190 | | | | 156,229 | | | | 1,761,148 | | | | 20,177 | | | (20,177 | ) | 2,822,902 | |
Net income for the year | | | | | | | | | | | | | | | 424,154 | | | | | | | | | 424,154 | |
Net change in accumulated other comprehensive income, net of deferred income tax expense of $1,996 | | | | | | | | | | | 3,809 | | | | | | | | | | | | | 3,809 | |
Capital contribution | | | | | | | 1,497 | | | | | | | | | | | | | | | | | 1,497 | |
Dividends paid on common stock | | | | | | | | | | | | | | | (530,050 | ) | | | | | | | | (530,050 | ) |
Deferred equity payout | | | | | | | | | | | | | | | | | | | (952 | ) | | 952 | | — | |
BALANCE, December 31, 2006 | | | $ | 335 | | | | $ | 906,687 | | | | $ | 160,038 | | | | $ | 1,655,252 | | | | $ | 19,225 | | | $ | (19,225 | ) | $ | 2,722,312 | |
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
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FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
| | Years Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
Cash flows from operating activities: | | | | | | | |
Premiums received, net | | $ | 523,416 | | $ | 594,390 | | $ | 571,696 | |
Policy acquisition and other operating expenses paid, net | | (176,425 | ) | (167,947 | ) | (141,875 | ) |
Salvage and subrogation | | 1,745 | | (362 | ) | 7,327 | |
Losses and loss adjustment expenses paid, net | | (405 | ) | (1,124 | ) | (42,936 | ) |
Net investment income received | | 215,656 | | 204,460 | | 171,915 | |
Federal income taxes paid | | (92,394 | ) | (122,754 | ) | (62,723 | ) |
Interest paid on notes payable | | (26,878 | ) | (26,957 | ) | (27,789 | ) |
Interest paid in financial products segment | | (511,226 | ) | (274,649 | ) | (74,608 | ) |
Interest received in financial products segment | | 784,480 | | 432,821 | | 139,181 | |
Net derivative payments in financial products segment | | (48,457 | ) | (21,016 | ) | (18,848 | ) |
Income received from refinanced assets | | 41,525 | | 37,359 | | 28,485 | |
Purchases of trading portfolio securities | | (117,483 | ) | — | | — | |
Other | | 17,597 | | 103 | | 1,023 | |
Net cash provided by (used for) operating activities | | 611,151 | | 654,324 | | 550,848 | |
Cash flows from investing activities: | | | | | | | |
Proceeds from sales of bonds in general investment portfolio | | 1,637,339 | | 1,757,590 | | 1,187,349 | |
Proceeds from maturities of bonds | | 163,257 | | 130,900 | | 267,800 | |
Purchases of bonds | | (2,161,561 | ) | (2,217,506 | ) | (1,918,477 | ) |
Net change in short-term investments | | 64,296 | | (47,672 | ) | (32,106 | ) |
Proceeds from sales of bonds in financial products segment | | 4,512,453 | | 5,635,291 | | 2,511,815 | |
Proceeds from maturities of bonds in financial products segment | | 4,509,784 | | 1,605,170 | | 132,245 | |
Purchases of bonds in financial products segment | | (12,830,545 | ) | (11,107,956 | ) | (6,197,067 | ) |
Securities purchased under agreements to resell | | 200,000 | | (350,000 | ) | 175,000 | |
Net change in financial products segment short-term investments | | 358,481 | | (748,863 | ) | (29,385 | ) |
Purchases of property, plant and equipment | | (3,441 | ) | (32,973 | ) | (5,427 | ) |
Assets acquired in refinancing transactions | | — | | — | | (378,672 | ) |
Paydowns of assets acquired in refinancing transactions | | 88,477 | | 92,514 | | 102,534 | |
Proceeds from sales of assets acquired in refinancing transactions | | 13,642 | | 182,701 | | 60,953 | |
Other investments | | 24,100 | | 46,877 | | 247 | |
Net cash provided by (used for) investing activities | | (3,423,718 | ) | (5,053,927 | ) | (4,123,191 | ) |
Cash flows from financing activities: | | | | | | | |
Issuance of notes payable | | 295,788 | | — | | — | |
Distribution to minority shareholder | | — | | (55,443 | ) | (6,980 | ) |
Dividends paid | | (530,050 | ) | (71,059 | ) | (22,876 | ) |
Securities sold under repurchase agreements | | — | | (5,656 | ) | (58,309 | ) |
Proceeds from issuance of financial products segment debt | | 6,751,556 | | 8,289,950 | | 6,586,020 | |
Repayment of financial products segment debt | | (3,715,670 | ) | (3,734,635 | ) | (2,931,057 | ) |
Capital issuance costs | | (964 | ) | (1,343 | ) | (1,260 | ) |
Capital contribution | | — | | 110 | | — | |
Repayment of preferred stock | | — | | — | | (6,300 | ) |
Net cash provided by (used for) financing activities | | 2,800,660 | | 4,421,924 | | 3,559,238 | |
Effect of changes in foreign exchange rates on cash balances | | 749 | | (1,330 | ) | 1,966 | |
Net (decrease) increase in cash | | (11,158 | ) | 20,991 | | (11,139 | ) |
Cash at beginning of year | | 43,629 | | 22,638 | | 33,777 | |
Cash at end of year | | $ | 32,471 | | $ | 43,629 | | $ | 22,638 | |
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
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FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(in thousands)
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
Reconciliation of net income to net cash flows from operating activities: | | | | | | | |
Net income | | $ | 424,154 | | $ | 326,108 | | $ | 378,607 | |
Increase in accrued investment income | | (25,516 | ) | (14,126 | ) | (15,976 | ) |
Increase in deferred premium revenue, net of prepaid reinsurance premiums | | 138,467 | | 173,635 | | 169,670 | |
Increase in deferred acquisition costs | | (5,544 | ) | (27,114 | ) | (34,369 | ) |
Increase (decrease) in current federal income taxes payable | | (11,935 | ) | 5,921 | | 7,430 | |
Increase (decrease) in unpaid losses and loss adjustment expenses, net of reinsurance recoverable | | 21,401 | | 24,856 | | (29,651 | ) |
Provision (benefit) for deferred income taxes | | 65,226 | | 1,330 | | 57,689 | |
Net realized losses (gains) on investments | | (5,734 | ) | (5,427 | ) | (1,744 | ) |
Depreciation and accretion of discount | | 102,818 | | 96,907 | | 29,639 | |
Minority interest and equity in earnings of unconsolidated affiliates | | (52,006 | ) | 14,116 | | 90,746 | |
Change in other assets and liabilities | | (40,180 | ) | 58,118 | | (101,193 | ) |
Cash provided by operating activities | | $ | 611,151 | | $ | 654,324 | | $ | 550,848 | |
The Company received no tax benefits in 2006 or 2005 and received tax benefits of $1.2 million in 2004 from its parent company, which was recorded as a capital contribution. See Note 12 for disclosure of non-cash transactions relating to restricted treasury stock transactions.
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
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FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
1. ORGANIZATION AND OWNERSHIP
Financial Security Assurance Holdings Ltd. (“FSA Holdings,” or together with its consolidated entities, the “Company”) is a holding company incorporated in the State of New York. The Company is principally engaged, through its insurance company subsidiaries, in providing financial guaranty insurance on public finance and asset-backed obligations. Its primary insurance company subsidiary is Financial Security Assurance Inc. (“FSA”). The Company’s underwriting policy is to insure public finance and asset-backed obligations that it determines would be investment-grade quality without the benefit of the Company’s insurance. Public finance obligations insured by the Company consist primarily of general obligation bonds that are supported by the issuers’ taxing powers and special revenue bonds and other special obligations of states and local governments that are supported by the issuers’ abilities to impose and collect fees and charges for public services or specific projects. Public finance obligations include obligations backed by the cash flow from leases or other revenues from projects serving substantial public purposes, including government office buildings, toll roads, health care facilities and utilities. 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 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.
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 public finance and asset-backed obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. The Company’s insured portfolio consists primarily of public finance and asset-backed obligations originated in the United States of America, but the Company has also written and continues to pursue business in Europe, the Asia Pacific region and elsewhere in the Americas.
The Company issues guaranteed investment contracts (“GICs”) through its consolidated affiliates FSA Capital Management Services LLC (“FSACM”), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the “GIC Affiliates”). FSACM has conducted substantially all of the Company’s GIC business since April 2003, following the receipt of an exemption from the requirements of the Investment Company Act of 1940. The GIC Affiliates lend the proceeds from their sales of GICs to FSA Asset Management LLC (“FSAM”), which invests the funds, generally in obligations that qualify for FSA insurance. FSAM wholly owns FSA Portfolio Asset Limited (“FSA-PAL”), a U.K. Company that invests in non-U.S. securities.
The Company consolidates the results of certain variable interest entities (“VIEs”), including FSA Global Funding Limited (“FSA Global”) and Premier International Funding Co. (“Premier”). The Company consolidates FSA Global in accordance with Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51”
78
(revised December 2003) (“FIN 46-R”). The Company also consolidates Premier as a result of obtaining control rights.
FSA Global is a special purpose funding vehicle partially owned by a subsidiary of FSA Holdings. FSA Global issues FSA-insured medium term notes and invests the proceeds from the sale of its notes in FSA-insured obligations with a view to realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. Premier is principally engaged in debt defeasance for public finance lease transactions. The GIC Affiliates, FSAM, FSA-PAL, FSA Global and Premier are collectively referred to as the “FP Segment.”
The Company refinanced certain defaulted transactions by employing refinancing vehicles to raise funds. These refinancing vehicles are also consolidated. The Company’s management believes that the assets held by FSA Global, Premier and the refinancing vehicles, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership.
On July 5, 2000, the Company completed a merger in which FSA Holdings became a direct subsidiary of Dexia Holdings, Inc. (“Dexia Holdings”), which, in turn, is owned 90% by Dexia Crédit Local S.A. (“Dexia Crédit Local”) and 10% by Dexia S.A. (“Dexia”), a Belgian corporation whose shares are traded on the Euronext Brussels and Euronext Paris markets, as well as on the Luxembourg Stock Exchange. Dexia Crédit Local is a wholly owned subsidiary of Dexia. At December 31, 2006, Dexia Holdings owned over 99% of FSA Holdings outstanding shares; the only other holders of FSA Holdings common stock were certain current and former directors of FSA Holdings who owned shares of FSA Holdings common stock or economic interests therein under the Director Share Purchase Program (see Note 12). During 2006, Dexia purchased all the shares previously owned by an affiliate of White Mountains Insurance Group, Ltd. (“White Mountains”).
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), which, for the insurance company subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 23). 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 in the Company’s consolidated balance sheets at December 31, 2006 and 2005, the reported amounts of revenues and expenses in the statements of operations and comprehensive income during the years ended December 31, 2006, 2005 and 2004 and disclosure of contingent assets and liabilities. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses, fair value of financial instruments and the deferral and amortization of 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 FSA Holdings and its direct and indirect subsidiaries, principally including FSA, FSA Insurance Company, Financial Security Assurance International Ltd. (“FSA International”), Financial Security Assurance (U.K.) Limited, the GIC Affiliates, FSAM, FSA Portfolio Management Inc., Transaction Services Corporation, FSA Services (Australia) Pty Limited, FSA Mexico Holdings Inc. and FSA Services (Japan) Inc. (collectively, the “Subsidiaries”). The Consolidated Financial Statements also include the accounts of certain VIEs and refinancing vehicles. All intercompany accounts and transactions have been eliminated.
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Investments
Investments in debt and equity securities designated as available for sale are carried at fair value. The unrealized gain or loss on investments that are not hedged or are economically hedged but do not qualify for hedge accounting is reflected as a separate component of shareholders’ equity, net of applicable deferred income taxes. The unrealized gain or loss attributable to the hedged risk on investments that qualify as fair-value hedges is recorded in income currently. Investments in debt and equity securities designated as trading are carried at fair value. The unrealized gain or loss on trading investments are recognized in income currently. The cost of securities sold is based on specific identification of each security.
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 fair value. Changes in fair value of short-term investments are due to changes in foreign exchange rates. Amounts deposited in money market funds and investments with a maturity at time of purchase of three months or less are included in short-term investments.
Variable rate demand notes (“VRDNs”) are included in bonds in the General Investment Portfolio. Auction rate securities (“ARS”) are included in bonds in the FP Segment Investment Portfolio. The FP Segment Investment Portfolio consists of investments supporting GIC liabilities (“FP Investment Portfolio”) and investments supporting VIE liabilities (“VIE Investment Portfolio”). The FP Investment Portfolio includes securities classified as trading securities.
VRDNs are long-term bonds that bear floating interest rates and provide investors with the option to tender or put the bonds at par, generally on a daily, weekly or monthly basis. ARS are long-term securities with interest rate reset features and are traded in the marketplace through a bidding process. The cash flows related to these securities are presented on a gross basis in the consolidated statements of cash flows.
Mortgage loans are carried at the lower of cost or market on an aggregate basis. Realized gains or losses on sale of investments are determined on the basis of specific identification. Investment income is recorded as earned. Other-than-temporary impairments are reflected in earnings as a realized loss.
Investments in unconsolidated affiliates are based on the equity method of accounting (see Note 3). The Company records its share of unrealized gains or losses of unconsolidated affiliates, net of applicable deferred taxes, in other comprehensive income.
Included in assets acquired in refinancing transactions are asset-backed senior notes that represent the Company’s purchase of less than 50% of a refinanced transaction. These assets are designated as available for sale. Certain other asset-backed securities are carried at cost, with any reduction in carrying value recognized as an adjustment to yield in accordance with American Institute of Certified Public Accountants Statement of Position 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.”
Derivatives
The Company enters into derivative contracts to manage interest rate and foreign currency risks associated with the Company’s GIC and VIE debt and FP Segment Investment Portfolio. The derivatives are recorded at fair value and generally include interest rate futures and interest rate and currency swap agreements, which are primarily utilized to convert the Company’s fixed rate GIC and VIE debt and FP Segment Investment Portfolio into U.S.-dollar floating rate assets and liabilities. The gains and losses relating to derivatives not designated as fair-value hedges are included in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income.
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The gains and losses related to derivatives designated as fair-value hedges are included in either net interest income or net interest expense from the FP Segment, as appropriate, along with the offsetting change in the fair value of the risk being hedged.
The Company has also insured a number of CDS 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 record earned premiums over the installment period, 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 either other assets or other liabilities, as appropriate. The Company uses quoted market prices, when available, to determine fair value. If quoted prices are not available, as is generally the case, management uses internally developed estimates of fair value. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, performance of underlying assets, changes in internal shadow ratings, the level at which the deductible has been set and the Company’s ability to obtain reinsurance for its insured obligations. 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.
Securities Purchased under Agreements to Resell and Securities Sold under Agreements to Repurchase
Securities purchased under agreements to resell and securities sold under agreements to repurchase are accounted for as collateralized transactions and are recorded at contract value plus accrued interest. It is the Company’s policy to take possession of securities borrowed under agreements to resell.
Premium Revenue Recognition
Gross and ceded premiums received in upfront payouts are earned in proportion to the expiration of the related risk. For upfront premium transactions, premium earnings are greater in the earlier periods when there is a higher amount of exposure outstanding. The amount of risk outstanding is equal to the sum of the par amount of debt insured over the expected period of coverage. Deferred premium revenue and prepaid reinsurance premiums represent the portion of gross and ceded premium, respectively, 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.
For premiums received on an installment basis, the Company earns the premium over the installment period, typically less than one year, throughout the period of coverage. Typically, installment premiums are applicable to insured transactions that involve CDS or special purpose vehicles (“SPVs”) structured to finance pools of assets such as auto loans or mortgage loans. Premiums on such transactions are typically paid in installments, as the nature of the assets financed can have uncertain debt service schedules due to prepayments. When the Company, through its ongoing credit review process, identifies transactions where premiums are paid on an installment basis and certain default triggers have been breached, the Company ceases to earn premiums on such transactions. Premium revenue recognition is subject to change as a result of the FASB project described in “—Losses and Loss Adjustment Expenses.”
Losses and Loss Adjustment Expenses
Background
Financial guaranty insurance generally provides an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due. Upon
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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 financial guaranty industry has emerged over the past 35 years. Management believes that existing insurance accounting under Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”), does not specifically address financial guaranty insurance. Accordingly, the accounting for loss and loss adjustment expenses within the financial guaranty insurance industry has developed based on analogy to the most directly comparable elements of existing literature, including sections of SFAS 60, Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS 5”) and Emerging Issues Task Force Issue 85-20, “Recognition of fees for guaranteeing a loan” (“EITF 85-20”).
Company-Specific Policy
The Company establishes loss liabilities based on its estimate of specific and non-specific losses. The Company also establishes liabilities for loss adjustment expenses (“LAE”), consisting of the estimated cost of settling claims, including legal and other fees and expenses associated with administering the claims process.
The Company calculates a loss and LAE liability based upon identified risks inherent in its insured portfolio. If an individual policy risk has a reasonably estimable and probable loss as of the balance sheet date, a case reserve is established. For the remaining policy risks in the portfolio, a non-specific reserve is established to account for the inherent credit losses that can be statistically estimated.
Case reserves for financial guaranty insurance companies differ from those of traditional property and casualty insurance companies. The primary difference is that traditional property and casualty case reserves include only claims that have been incurred and reported to the insurance company. In a traditional property and casualty company, claims are incurred when defined events occur such as an auto accident, home fire or storm. Unlike traditional property and casualty claims, financial guaranty losses arise from the extension of credit protection and occur as the result of the credit deterioration of the issuer or underlying assets of the insured obligations over the lives of those insured obligations. Such deterioration and ultimate loss amounts can be projected based on historical experience in order to estimate probable loss, if any. Accordingly, specific loss events that require case reserves include (1) policies under which claim payments have been made and additional claim payments are expected and (2) policies under which claim payments are probable and reasonably estimable, but have not yet been made.
The Company establishes a case reserve for the present value of the estimated loss, net of subrogation recoveries, when, in management’s opinion, the likelihood of a future loss on a particular insured obligation is probable and reasonably estimable at the balance sheet date. When an insured obligation has met the criteria for establishing a case reserve and that transaction pays a premium in installments, those premiums, if expected to be received prospectively, are considered a form of recovery and are no longer earned as premium revenue. A case reserve is determined using cash flow or similar models that represent the Company’s estimate of the net present value of the anticipated shortfall between (1) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (2) anticipated cash flow from and proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries. The estimated loss, net of recovery, on a transaction is discounted using the risk-free rate appropriate for the term of the insured obligation at the time the reserve is established and is not subsequently adjusted.
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The Company records a non-specific reserve to reflect the credit risks inherent in its portfolio. The non-specific and case reserves together represent the Company’s estimate of total reserves. Generally, when an insured credit deteriorates to a point where claims are expected, a case reserve is established. The establishment of a non-specific reserve for credits that have not yet defaulted is a common practice in the financial guaranty industry, although there are differences in the specific methodologies applied by other financial guarantors in establishing and measuring these reserves.
The Company establishes a non-specific reserve on its portfolio of credits because management believes that a portfolio of insured obligations will deteriorate over its life and that the existence of inherent loss can be proven statistically by data such as that published by rating agencies. The establishment of the reserve is a systematic process that considers this quantitative, statistical information obtained primarily from Moody’s Investors Service, Inc. (“Moody’s”) and Standard & Poor’s Ratings Services (“S&P”), together with qualitative factors such as overall credit quality trends resulting from economic and political conditions, recent loss experience in particular segments of the portfolio and changes in underwriting policies and procedures. The factors used to establish reserves are evaluated periodically by comparing the statistically computed loss amount with the incurred losses as represented by case reserve activity to develop an experience factor that is updated and applied to current-year originations. The process results in management’s best estimate of inherent losses associated with providing credit protection at each balance sheet date.
The non-specific reserve established considers all levels of protection (e.g., reinsurance and overcollateralization). Net par outstanding for policies originated in the current period is multiplied by loss frequency and severity factors, with the resulting amounts discounted at the risk-free rates using the treasury yield curve (the “statistical calculation”). The discount rate does not change and is used to accrete the loss for the life of each policy. The loss factors used for the calculation are the product of default frequency rates obtained from Moody’s and severity factors obtained from S&P. Moody’s is chosen for default frequency rates due to its credibility, large population, statistical format and reliability of future update. The Moody’s default information is applied to all credit sectors or asset classes as described below. In its publication of default rates for bonds issued from 1970-2005, Moody’s tracks bonds over a 20-year horizon by credit rating at time of issuance. For the purpose of establishing appropriate severity factors, the Company’s methodology segregates the portfolio into asset classes, including health care transactions, all other public finance transactions, pooled corporate transactions, commercial real estate, and all other asset-backed transactions. The severity factors are derived from capital charge assessments provided by S&P. S&P capital charges project loss levels by asset class and are incorporated into their capital adequacy stress scenario analysis.
The product of the current-year statistical calculation multiplied by the current-year experience factor represents the present value of loss amounts calculated for current-year originations. The experience factor is based on the Company’s inception-to-date historical losses (starting from 1993, when the Company established the non-specific reserve methodology). The experience factor is calculated by dividing cumulative inception-to-date actual losses incurred by the Company by the cumulative inception-to-date losses determined by the statistical calculation. The experience factor that applies to the whole portfolio is reviewed and, where appropriate, updated periodically, but no less than annually.
The present value of loss amounts calculated for the current-year originations is established at inception of each policy, and there is no subsequent change unless significant adverse or favorable loss experience is observed. In the event that the experience factor is either increased or decreased based on adverse or favorable loss experience, an analysis is performed of the non-specific reserve balance with particular emphasis on the asset class, if any, driving the experience factor adjustment. The objective of such analysis is to quantify the appropriate adjustment to the overall non-specific reserve balance for the change in experience. The adjustment that increases or decreases the non-specific reserve is charged or credited to loss expense.
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The present value of loss amounts calculated for the current-year originations plus an amount representing the accretion of discount pertaining to prior-year originations are charged to loss expense and increase the non-specific loss reserve after adjustments that may be made to reflect observed favorable or adverse experience. The entire non-specific reserve is available to absorb probable losses inherent in the portfolio. As there are no specific losses provided in the non-specific reserve, there is no identifiable reinsurance recoverable. At the time that a case reserve is identified, the gross loss liability is recognized along with the reinsurance recoverable, if any. The amount of reinsurance recoverable depends on the policy ceded and the reinsurance agreements covering such policy. Management cannot predict the specific policies that will emerge as case-basis losses from the portfolio and is not entitled to recovery from the reinsurer in advance of producing a case reserve.
Since the non-specific reserve contains the inherent losses of the portfolio, when a case reserve adjustment is deemed appropriate, whether the result of adverse or positive credit developments, accretion or the addition of a new case reserve, a full transfer is made between the non-specific reserve and the case reserve balances with no effect to income. The adequacy of the non-specific reserve balance is reviewed periodically and at least annually. Such analyses are performed to quantify appropriate adjustments that may be either charges or benefits on the consolidated statements of operations and comprehensive income, as occurred in 2004.
The table below presents the significant assumptions inherent in the calculations of the case and non-specific reserves.
| | As of December 31, | |
| | 2006 | | 2005 | |
Case reserve discount rate | | 3.13%–5.90% | | 3.13%–5.90% | |
Non-specific reserve discount rate | | 1.20%–7.95% | | 1.20%–7.95% | |
Current experience factor | | 1.6 | | 1.8 | |
Reserving Methodology Industry Practice
Management is aware that there are differences regarding the method of defining and measuring both case reserves and non-specific reserves among participants in the financial guaranty industry. Other financial guarantors may establish case reserves only after a default and use different techniques to estimate probable loss. Other financial guarantors may establish the equivalent of non-specific reserves, but refer to these reserves by various terms such as, but not limited to, “unallocated losses,” “active credit reserves” and “portfolio reserves,” or may use different statistical techniques from those the Company uses to determine loss at a given point in time.
Management believes that existing accounting literature does not address the unique attributes of financial guaranty insurance. As an insurance enterprise, the Company initially refers to the accounting and financial reporting guidance in SFAS 60. In establishing loss liabilities, the Company relies principally on SFAS 60, which prescribes differing treatment depending on whether a contract is a short-duration contract or a long-duration contract. Financial guaranty insurance does not fall clearly within the definition of either short-duration or long-duration contracts. Therefore, the Company does not believe that SFAS 60 alone provides sufficient guidance for financial guaranty claim liability recognition.
As a result, the Company also analogizes to SFAS 5, which requires the establishment of liabilities when a loss is both probable and reasonably estimable. The Company also relies by analogy on EITF 85-20, which provides general guidance on the recognition of losses related to guaranteeing a loan. In the absence of a comprehensive accounting model provided by SFAS 60, industry participants, including the Company, have looked to such other guidance referred to above to develop their accounting policies for the establishment and measurement of loss liabilities. The Company believes that its financial guaranty loss reserve policy is appropriate under the applicable accounting literature, and that it best reflects the fact that a portfolio of credit-based insurance, comprising irrevocable contracts that cannot be unilaterally
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changed by the insurer and that match the maturity terms of the underlying insured obligations, contains probable and reasonably estimable losses.
The Financial Accounting Standards Board (“FASB”) staff is considering additional guidance regarding financial guaranty insurance. When and if the FASB reaches a conclusion on this issue, the Company and the rest of the financial guaranty industry may be required to change some aspects of their loss reserving policies, and the potential changes could extend to premium recognition. The Company cannot predict how the FASB will resolve this issue and the resulting impact on its financial statements.
Until additional guidance is issued, the Company intends to continue applying its existing policy regarding the establishment of both case and non-specific loss reserves.
Deferred Costs
Financial Guaranty
Deferred acquisition costs comprise expenses 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 received on premiums ceded to reinsurers. Deferred acquisition costs 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. A premium deficiency would be recognized if the present value of anticipated losses and loss adjustment expenses exceeded the sum of deferred premium revenue and estimated installment premiums.
Financial Products
The Company does not defer origination costs relating to GICs issued by the GIC Affiliates, except for GIC commissions paid to third parties, which are included in other assets. The amortization of these commissions is recorded in net interest expense from the FP Segment.
GIC and VIE Debt
GIC and VIE debt is recorded at amortized cost. The Company may enter into transactions in order to reduce the Company’s exposure to fluctuations in interest rates and foreign exchange rates. For GIC and VIE debt in a qualifying accounting hedge, the change in the fair value of debt adjusts the carrying amount of the debt and is recognized in income currently. VIE debt may include hybrid debt instruments that contain embedded derivatives. Under certain conditions, GAAP requires that embedded derivatives be separated from the debt instrument and accounted for at fair value, with all changes in fair value reflected through earnings.
Foreign Currency Translation
Monetary assets and liabilities denominated in foreign currencies are translated at the spot rate at the balance sheet date. Non-monetary assets and liabilities are translated at historical rates. Revenues and expenses denominated in foreign currencies are translated at average rates prevailing during the year. Unrealized gains and losses on available-for-sale securities, net of deferred taxes, resulting from translating investments denominated in foreign currencies are recorded in shareholders’ equity. Gains and losses from transactions in foreign currencies are recorded in other income.
Federal Income Taxes
The provision for income taxes consists of an amount for taxes currently payable and an amount for deferred taxes arising from temporary differences between the tax bases of assets and liabilities and the
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reported amounts in the financial statements that will result in deductible or taxable amounts in future years when the reported amounts of assets and liabilities are recovered or settled.
Non-interest-bearing tax and loss bonds are purchased to prepay the tax benefit that results from deducting contingency reserves as provided under Internal Revenue Code Section 832(e). The Company records the purchase of tax and loss bonds in other assets.
Special Purpose Entities
Asset-backed and, to a lesser extent, public finance transactions insured by FSA may employ special purpose entities for a variety of purposes. A typical asset-backed transaction, for example, employs a special purpose entity as the purchaser of the securitized assets and as the issuer of the insured obligations. FSA’s participation is typically requested by the sponsor of the special purpose entity or the underwriter, either via a bid process or on a sole-source basis. Special purpose entities are typically owned by transaction sponsors or charitable trusts, although FSA may have an ownership interest in some cases. FSA maintains certain contractual rights and exercises varying degrees of influence over special purpose entity issuers of FSA-insured obligations. FSA also bears some of the “risks and rewards” associated with the performance of those special purpose entities’ assets. Specifically, as issuer of the financial guaranty insurance policy insuring a given special purpose entity’s obligations, FSA bears the risk of asset performance (typically, but not always, after a significant depletion of overcollateralization, excess spread, a deductible or other credit protection). FSA’s underwriting policy is to insure only obligations that are otherwise investment grade. In addition, the special purpose entity typically pays a periodic premium to FSA in consideration of the issuance by FSA of its insurance policy, with the special purpose entity’s assets typically serving as the source of such premium, thereby providing some of the “rewards” of the special purpose entity’s assets to FSA. Special purpose entities are also employed by FSA in connection with “repackaging” of outstanding securities into new securities insured by FSA and with refinancing underperforming, non-investment-grade transactions insured by FSA.
The degree of influence exercised by FSA over these special purpose entities varies from transaction to transaction, as does the degree to which “risks and rewards” associated with asset performance are assumed by FSA.
FIN 46-R addresses consolidation of VIEs that have one or both of the following characteristics: (a) 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 (b) the equity investors lack the direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights and do not have 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. In analyzing special purpose entities described above, the Company considers reinsurance to be an implicit variable interest. Where the Company determines it is required to consolidate the special purpose entity, the outstanding exposure is excluded from Note 10.
Recently Issued Accounting Standards
In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), an interpretation of Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS 109 and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is applicable for fiscal years beginning after December 15, 2006, with early application encouraged if financial statements, including interim financial statements, have not been issued in the
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period of adoption. The Company does not expect FIN 48 to have a material impact on its financial statements.
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”), which amends Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” SFAS 155 permits hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation to be irrevocably accounted for at fair value, with changes in fair value recognized in the statements of operations and comprehensive income. The fair-value election may be applied on an instrument-by-instrument basis. SFAS 155 also eliminates a restriction that prevents qualifying special purpose entities from holding derivative financial instruments that pertain to beneficial interests that are not derivative financial instruments. SFAS 155 is effective for all financial instruments acquired or issued after December 31, 2006. The Company does not expect SFAS 155 to have a material impact on its financial statements.
On September 15, 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), which addresses how companies should measure fair value when required to use fair value measures for recognition or disclosure purposes under GAAP. SFAS 157 adopted an “exit price” approach to determining fair value and established a three-level fair value hierarchy to prioritize the inputs used in valuation techniques. Level 1 is the highest priority and is defined as observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 is defined as inputs other than quoted prices included in Level 1 that are observable for the asset or liability through corroboration with observable market data. Level 3 is the lowest priority and is defined as a valuation based on unobservable inputs such as a company’s own data. Prioritization of inputs, as well as other considerations, determine the level of disclosure required. SFAS 157 is applicable to financial statements issued for fiscal years beginning after November 15, 2007 and for interim periods within those fiscal years. The Company is in the process of evaluating the impact of SFAS 157 on its financial statements.
In February 2007, The FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits reporting entities to choose to measure at fair value many financial instruments and certain other items that are not currently required to be measured at fair value. The fair value option may be applied instrument by instrument, is irrevocable and is applied only to entire instruments and not to portions of instruments. SFAS 159 is effective for fiscal years beginning after November 15, 2007. Early adoption is permitted, under certain circumstances, provided the provisions of SFAS 157 are also applied. The Company is currently evaluating the implication of SFAS 159 for its financial statements.
Revisions
The statement of cash flows for the period ended December 31, 2006 appropriately segregates the effect of changes in foreign exchange rates on cash balances into a separate line item. The effect of foreign exchange rates on cash balances has historically been included in cash flows from operations. As part of the review of these foreign cash accounts, it was determined that certain of these accounts are appropriately classified as cash rather than as short-term investments at December 31, 2006. The statements of cash flows for the periods ended December 31, 2005 and 2004 have been revised to conform to the 2006 presentation. Changes in classification of these accounts to cash from short-term investments are also reflected in the balance sheet. The amounts revised for 2005 and 2004 from short-term investments to cash were $23.5 million and $8.3 million, respectively.
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3. GENERAL INVESTMENT PORTFOLIO
Bonds and short-term deposits at an amortized cost of $10.5 million and $9.9 million at December 31, 2006 and 2005, respectively, were on deposit with state regulatory authorities as required by insurance regulations.
Consolidated net investment income attributable to the General Investment Portfolio consisted of the following:
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in thousands) | |
Bonds and short-term investments | | $ | 217,253 | | $ | 194,736 | | $ | 174,551 | |
Equity investments | | 4,523 | | 8,931 | | — | |
Investment expenses | | (2,926 | ) | (2,840 | ) | (2,500 | ) |
Net investment income | | $ | 218,850 | | $ | 200,827 | | $ | 172,051 | |
The credit quality of bonds in the General Investment Portfolio, based on amortized cost, at December 31, 2006 was as follows:
Rating(1) | | | | Percent of Bonds | |
AAA | | | 85.8 | % | |
AA | | | 11.2 | | |
A | | | 2.9 | | |
NR | | | 0.1 | | |
Total | | | 100.0 | % | |
(1) Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2006.
The General Investment Portfolio includes bonds insured by FSA (“FSA-Insured Investments”). Of the bonds included in the General Investment Portfolio, 6.2% were Triple-A by virtue of insurance provided by FSA. Over 95% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments, which is the rating without giving effect to the FSA insurance, was in the Double-A range.
The amortized cost and fair value of the bonds in the General Investment Portfolio were as follows:
| | As of December 31, 2006 | |
| | Amortized
Cost | | Gross
Unrealized
Gains | | Gross
Unrealized
Losses | | Fair Value | |
| | (in thousands) | |
U.S. Treasury securities and obligations of U.S. government corporations and agencies | | $ | 165,530 | | | $ | 2,392 | | | | $ | (1,898 | ) | | $ | 166,024 | |
Obligations of states and political subdivisions | | 3,663,821 | | | 171,564 | | | | (1,182 | ) | | 3,834,203 | |
Mortgage-backed securities | | 262,651 | | | 1,000 | | | | (4,183 | ) | | 259,468 | |
Corporate securities | | 218,222 | | | 1,534 | | | | (2,207 | ) | | 217,549 | |
Foreign securities | | 213,065 | | | 8,508 | | | | (175 | ) | | 221,398 | |
Asset-backed securities | | 22,858 | | | 145 | | | | (133 | ) | | 22,870 | |
Subtotal | | 4,546,147 | | | 185,143 | | | | (9,778 | ) | | 4,721,512 | |
Short-term investments | | 96,055 | | | 600 | | | | (77 | ) | | 96,578 | |
Total | | $ | 4,642,202 | | | $ | 185,743 | | | | $ | (9,855 | ) | | $ | 4,818,090 | |
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| | As of December 31, 2005 | |
| | Amortized
Cost | | Gross
Unrealized
Gains | | Gross
Unrealized
Losses | | Fair Value | |
| | (in thousands) | |
U.S. Treasury securities and obligations of U.S. government corporations and agencies | | $ | 195,495 | | | $ | 3,881 | | | | $ | (755 | ) | | $ | 198,621 | |
Obligations of states and political subdivisions | | 3,431,046 | | | 173,279 | | | | (5,457 | ) | | 3,598,868 | |
Mortgage-backed securities | | 250,001 | | | 809 | | | | (4,564 | ) | | 246,246 | |
Corporate securities | | 186,369 | | | 1,797 | | | | (2,124 | ) | | 186,042 | |
Foreign securities | | 116,217 | | | 842 | | | | (4,773 | ) | | 112,286 | |
Asset-backed securities | | 40,216 | | | 10 | | | | (252 | ) | | 39,974 | |
Subtotal | | 4,219,344 | | | 180,618 | | | | (17,925 | ) | | 4,382,037 | |
Short-term investments | | 159,133 | | | — | | | | — | | | 159,133 | |
Total | | $ | 4,378,477 | | | $ | 180,618 | | | | $ | (17,925 | ) | | $ | 4,541,170 | |
Foreign securities consist primarily of government-issued and corporate securities that are denominated in either British pound sterling or the euro.
The following table shows the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position:
| | As of December 31, 2006 | |
| | Less than 12 Months | | 12 Months or More | | Total | |
| | Fair Value | | Unrealized
Losses | | Fair Value | | Unrealized
Losses | | Fair Value | | Unrealized
Losses | |
| | (in thousands) | |
U.S. Treasury securities and obligations of U.S. government corporations and agencies | | $ | 76,125 | | | $ | (566 | ) | | $ | 44,776 | | | $ | (1,332 | ) | | $ | 120,901 | | | $ | (1,898 | ) | |
Obligations of states and political subdivisions | | 99,977 | | | (205 | ) | | 69,847 | | | (977 | ) | | 169,824 | | | (1,182 | ) | |
Mortgage-backed securities | | 53,656 | | | (423 | ) | | 137,608 | | | (3,760 | ) | | 191,264 | | | (4,183 | ) | |
Corporate securities | | 52,097 | | | (229 | ) | | 94,357 | | | (1,978 | ) | | 146,454 | | | (2,207 | ) | |
Foreign securities | | 23,212 | | | (103 | ) | | 2,683 | | | (72 | ) | | 25,895 | | | (175 | ) | |
Asset-backed securities | | 3,009 | | | (6 | ) | | 11,102 | | | (127 | ) | | 14,111 | | | (133 | ) | |
Total | | $ | 308,076 | | | $ | (1,532 | ) | | $ | 360,373 | | | $ | (8,246 | ) | | $ | 668,449 | | | $ | (9,778 | ) | |
| | As of December 31, 2005 | |
| | Less than 12 Months | | 12 Months or More | | Total | |
| | Fair Value | | Unrealized
Losses | | Fair Value | | Unrealized
Losses | | Fair Value | | Unrealized
Losses | |
| | (in thousands) | |
U.S. Treasury securities and obligations of U.S. government corporations and agencies | | $ | 65,922 | | | $ | (436 | ) | | $ | 14,635 | | | $ | (319 | ) | | $ | 80,557 | | | $ | (755 | ) | |
Obligations of states and political subdivisions | | 375,766 | | | (3,609 | ) | | 108,031 | | | (1,848 | ) | | 483,797 | | | (5,457 | ) | |
Mortgage-backed securities | | 141,687 | | | (2,272 | ) | | 48,060 | | | (2,292 | ) | | 189,747 | | | (4,564 | ) | |
Corporate securities | | 103,144 | | | (1,492 | ) | | 23,650 | | | (632 | ) | | 126,794 | | | (2,124 | ) | |
Foreign securities | | 91,981 | | | (4,727 | ) | | 409 | | | (46 | ) | | 92,390 | | | (4,773 | ) | |
Asset-backed securities | | 18,540 | | | (124 | ) | | 14,813 | | | (128 | ) | | 33,353 | | | (252 | ) | |
Total | | $ | 797,040 | | | $ | (12,660 | ) | | $ | 209,598 | | | $ | (5,265 | ) | | $ | 1,006,638 | | | $ | (17,925 | ) | |
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At December 31, 2006, there were 451 investments in fixed-income securities for which amortized cost exceeded fair value; the aggregate amount of the excess over fair value was $9.8 million, or 1.5%. At December 31, 2005, there were 616 such investments, for which the aggregate amount of the excess over fair value was $17.9 million, or 1.8%. Management has determined that the unrealized losses in fixed income securities at December 31, 2006 are primarily attributable to the current interest rate environment and has concluded that these unrealized losses are temporary in nature based upon (a) no principal and interest payment defaults on these securities; (b) analysis of the creditworthiness of the issuer; and (c) FSA’s ability and current intent to hold these securities until a recovery in fair value or maturity. There were no individual securities with material unrealized losses as of December 31, 2006 and 2005. As of December 31, 2006 and 2005, 100% of the securities that were in a gross unrealized loss position were rated investment grade.
The amortized cost and fair value of bonds in the General Investment Portfolio at December 31, 2006, by contractual maturity, are shown below. 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
Cost | | Fair Value | |
| | (in thousands) | |
Due in one year or less | | $ | 212,414 | | $ | 212,768 | |
Due after one year through five years | | 1,167,172 | | 1,223,913 | |
Due after five years through ten years | | 865,890 | | 894,927 | |
Due after ten years | | 2,111,217 | | 2,204,144 | |
Mortgage-backed securities (stated maturities of 2 to 30 years) | | 262,651 | | 259,468 | |
Asset-backed securities (stated maturities of 1 to 28 years) | | 22,858 | | 22,870 | |
Total | | $ | 4,642,202 | | $ | 4,818,090 | |
Proceeds from sales of bonds for the General Investment Portfolio during 2006, 2005 and 2004 were $1,637.3 million, $1,757.6 million and $1,187.3 million, respectively. Proceeds from maturities of bonds for the General Investment Portfolio during 2006, 2005 and 2004 were $163.3 million, $130.9 million and $267.8 million, respectively. Gross gains of $0.9 million, $10.9 million and $5.2 million and gross losses of $5.8 million, $6.1 million and $5.7 million were realized on sales in 2006, 2005 and 2004, respectively.
Equity Investments
SPS Holding Corp.
At December 31, 2004, the Company had a 34.1% interest in SPS Holding Corp. (“SPS”) (formerly Fairbanks Capital Holding Corp.). The Company’s investment in SPS was accounted for using the equity method of accounting.
In the third quarter of 2004, the Company determined that its $7.6 million of goodwill associated with its investment in SPS was impaired, and it charged that amount to income, as a result of challenges encountered by SPS in acquiring new business, despite servicer ratings of “Average.”
In October 2005, the Company sold its investment in SPS to an unaffiliated third party. For its interest in SPS, the Company was paid $42.9 million in cash at closing and expects to receive additional amounts, from time to time through March 31, 2008, out of income earned by SPS through December 31, 2007 from certain of its mortgage servicing activities. Under the sale documents, the Company’s subsidiary that owned the SPS investment made customary representations and warranties to, and undertook specified indemnification obligations for the benefit of, the purchaser. Based on an estimate of the assets retained and liabilities assumed, the Company recorded a $0.4 million loss on the sale of SPS. Under the terms of the agreement, the Company will receive cash payments through the first quarter of 2008 from a residual
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interest in mortgage servicing assets. The Company recorded an asset of $12.6 million representing this contingent payment asset. The Company and other prior shareholders indemnified the buyer for certain liabilities relating to SPS’s operations, including litigation and regulatory actions. The maximum indemnification obligation for SPS’s operations will not exceed approximately $34.0 million. The Company’s portion of this obligation is 37.4% or $12.7 million. As of December 31, 2005, the Company recorded a $5.1 million liability related to this indemnification, representing the expected liability. As of December 31, 2006, the liability had a balance of $3.3 million. The Company has received a net amount of $11.2 million related to this asset and liability. The Company will continue to evaluate the appropriate carrying value of the liabilities assumed. Amounts recorded by the Company in connection with SPS at December 31, 2005 and 2004 were as follows:
| | 2005 | | 2004 | |
| | (in thousands) | |
Investment in SPS | | — | | $ | 49,645 | |
Equity in earnings (losses) from SPS (pre-tax) | | 1,160 | | (7,100 | ) |
| | | | | | |
XL Financial Assurance Ltd.
FSA’s investment in preferred shares of XL Financial Assurance Ltd (“XLFA”), a financial guaranty insurance company and indirect subsidiary of XL, is redeemable by XLFA at a price equal to the fair market value of the preferred shares, subject to a cap defined as the internal rate of return of 19% per annum from the date of the investment through the date of redemption, plus accrued dividends as if 100% of current-year earnings were distributed. Based on this formula, in 2004, the Company adopted a policy of carrying this investment at the lesser of the current calculated redemption value or the redemption value as of the next January first, which would exclude its share of accrued current-year earnings to the extent the cap had been otherwise met. Consistent with this policy, in the third quarter of 2004, the Company charged $11.7 million to equity in earnings of unconsolidated affiliates and reduced its carrying value in this investment to $56.4 million.
Until the fourth quarter of 2004 this investment was accounted for using the equity method of accounting because the Company had significant influence over XLFA’s operations. In the second quarter of 2004, the Emerging Issues Task Force (“EITF”) reached a consensus that under EITF Issue 02-14, “Whether an Investor Should Apply the Equity of Method of Accounting to Investments Other Than Common Stock” (EITF 02-14), an investor should only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. The EITF 02-14 consensus is applicable to reporting periods beginning after September 15, 2004. In accordance with this consensus, the Company no longer accrues undistributed earnings related to its investment in XLFA.
In March 2006, the XLFA Board of Directors approved a by-law amendment changing the coupon on XLFA’s preferred shares from a participating dividend based on an internal rate of return up to 19% to a fixed rate dividend of 8.25% per annum, effective January 1, 2006. Amounts recorded by the Company in connection with XLFA as of and for the years ending December 31, 2006, 2005 and 2004 are as follows :
| | 2006 | | 2005 | | 2004 | |
| | (in thousands) | |
Equity securities | | $ | 54,016 | | $ | 54,300 | | $ | 54,300 | |
Equity in earnings from XLFA (pre-tax) | | — | | — | | 3,761 | |
Dividends earned from XLFA | | 4,518 | | 8,926 | | 14,103 | |
| | | | | | | | | | |
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4. FP SEGMENT INVESTMENT PORTFOLIO
FP Investment Portfolio
Net investment income for the FP Investment Portfolio consisted of the following:
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in thousands) | |
Bonds available for sale | | $ | 725,736 | | $ | 391,125 | | $ | 137,548 | |
Trading portfolio | | 3,850 | | —— | | —— | |
Short-term investments | | 49,822 | | 29,639 | | 3,499 | |
Net investment income | | $ | 779,408 | | $ | 420,764 | | $ | 141,047 | |
The credit quality of bonds held in the FP Investment Portfolio based on amortized cost at December 31, 2006 was as follows:
Rating(1) | | | | Percent of Bonds | |
AAA | | | 91.9 | % | |
AA | | | 7.0 | | |
A | | | 1.1 | | |
Total | | | 100.0 | % | |
(1) Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2006.
Of the bonds included in the FP Investment Portfolio, 4.4% were Triple-A by virtue of insurance provided by FSA. Over 97% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments was in the Triple-B range.
The amortized cost and fair value of bonds held in the FP Investment Portfolio were as follows:
| | As of December 31, 2006 | |
| | Amortized
Cost | | Gross
Unrealized
Gains | | Gross
Unrealized
Losses | | Fair Value | |
| | (in thousands) | |
Obligations of U.S. states and political subdivisions | | $ | 1,413,080 | | | $ | 37,776 | | | | $ | (6,098 | ) | | $ | 1,444,758 | |
Mortgage-backed securities | | 7,639,645 | | | 19,419 | | | | (1,122 | ) | | 7,657,942 | |
Asset-backed and other securities | | 6,629,244 | | | 21,761 | | | | (4,557 | ) | | 6,646,448 | |
Subtotal | | 15,681,969 | | | 78,956 | | | | (11,777 | ) | | 15,749,148 | |
Short-term investments | | 640,226 | | | — | | | | — | | | 640,226 | |
Total | | $ | 16,322,195 | | | $ | 78,956 | | | | $ | (11,777 | ) | | $ | 16,389,374 | |
| | As of December 31, 2005 | |
| | Amortized
Cost | | Gross
Unrealized
Gains | | Gross
Unrealized
Losses | | Fair Value | |
| | (in thousands) | |
Obligations of U.S. states and political subdivisions | | $ | 985,559 | | | $ | 55,595 | | | | $ | (684 | ) | | $ | 1,040,470 | |
Mortgage-backed securities | | 2,821,562 | | | 8,994 | | | | (1,071 | ) | | 2,829,485 | |
Asset-backed and other securities | | 7,947,209 | | | 13,387 | | | | (2,727 | ) | | 7,957,869 | |
Subtotal | | 11,754,330 | | | 77,976 | | | | (4,482 | ) | | 11,827,824 | |
Short-term investments | | 1,015,509 | | | — | | | | — | | | 1,015,509 | |
Total | | $ | 12,769,839 | | | $ | 77,976 | | | | $ | (4,482 | ) | | $ | 12,843,333 | |
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The following table shows the gross unrealized losses and fair value for the FP Investment Portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2006:
| | As of December 31, 2006 | |
| | Less than 12 Months | | 12 Months or More | | Total | |
| | Fair Value | | Unrealized
Losses | | Fair Value | | Unrealized
Losses | | Fair Value | | Unrealized
Losses | |
| | (in thousands) | |
Obligations of U.S. states and political subdivisions | | $ | 209,267 | | | $ | (3,914 | ) | | $ | 73,097 | | | $ | (2,184 | ) | | $ | 282,364 | | | $ | (6,098 | ) | |
Mortgage-backed securities | | 732,267 | | | (1,009 | ) | | 47,498 | | | (113 | ) | | 779,765 | | | (1,122 | ) | |
Asset-backed securities | | 511,899 | | | (1,979 | ) | | 193,856 | | | (2,578 | ) | | 705,755 | | | (4,557 | ) | |
Total | | $ | 1,453,433 | | | $ | (6,902 | ) | | $ | 314,451 | | | $ | (4,875 | ) | | $ | 1,767,884 | | | $ | (11,777 | ) | |
| | As of December 31, 2005 | |
| | Less than 12 Months | | 12 Months or More | | Total | |
| | Fair Value | | Unrealized
Losses | | Fair Value | | Unrealized
Losses | | Fair Value | | Unrealized
Losses | |
| | (in thousands) | |
Obligations of U.S. states and political subdivisions | | $ | 39,163 | | | $ | (207 | ) | | $ | 35,523 | | | $ | (477 | ) | | $ | 74,686 | | | $ | (684 | ) | |
Mortgage-backed securities | | 779,147 | | | (1,068 | ) | | 5,993 | | | (3 | ) | | 785,140 | | | (1,071 | ) | |
Asset-backed securities | | 912,314 | | | (2,375 | ) | | 158,116 | | | (352 | ) | | 1,070,430 | | | (2,727 | ) | |
Total | | $ | 1,730,624 | | | $ | (3,650 | ) | | $ | 199,632 | | | $ | (832 | ) | | $ | 1,930,256 | | | $ | (4,482 | ) | |
At December 31, 2006, there were 111 investments in fixed-income securities for which amortized cost exceeded fair value; the aggregate amount of the excess over fair value was $11.8 million, or 0.7%. At December 31, 2005, there were 97 such investments, for which the aggregate amount of the excess over fair value was $4.5 million, or 0.2%. Management has determined that the unrealized losses in fixed income securities at December 31, 2006 are attributable primarily to the current interest rate environment and has concluded that these unrealized losses are temporary in nature based upon (a) no principal and interest payment defaults on these securities; (b) analysis of the creditworthiness of the issuer; and (c) FSA’s ability and current intent to hold these securities until a recovery in fair value or maturity. There were no individual securities with material unrealized losses as of December 31, 2006 and 2005. As of December 31, 2006 and 2005, 100% of the securities that were in a gross unrealized loss position were rated investment grade.
The amortized cost and fair value of the FP Investment Portfolio, at December 31, 2006, by contractual maturity, are shown below. 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
Cost | | Fair Value | |
| | (in thousands) | |
Due in one year or less | | $ | 640,226 | | $ | 640,226 | |
Due after one year through five years | | — | | — | |
Due after five years through ten years | | 28,429 | | 28,386 | |
Due after ten years | | 1,384,651 | | 1,416,372 | |
Mortgage-backed securities (stated maturities of 4 to 39 years) | | 7,639,645 | | 7,657,942 | |
Asset-backed and other securities (stated maturities of 1 to 49 years) | | 6,629,244 | | 6,646,448 | |
Total | | $ | 16,322,195 | | $ | 16,389,374 | |
Proceeds from sales of bonds held in the FP Investment Portfolio during 2006, 2005 and 2004 were $4,512.5 million, $5,635.3 million and $2,511.8 million, respectively. Proceeds from maturities of bonds for
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the FP Investment Portfolio during 2006, 2005 and 2004 were $4,485.1 million, $1,422.0 million and $65.7 million, respectively. Gross gains of $0.1 million were realized on sales in 2006. Gross gains of $0.4 million and gross losses of $7.9 million were realized on sales in 2005. Gross gains of $2.2 million were realized on sales in 2004.
VIE Investment Portfolio
On April 28, 2006, the Company increased its ownership of the ordinary shares of FSA Global from 29% to 49% through an acquisition of shares from an unaffiliated third party. Immediately thereafter, FSA Global’s charter documents were amended to create a new class of non-voting preference shares, all of which were issued to the Company. Holders of such preference shares have exclusive rights to any future dividends and, upon any winding up of FSA Global, all net assets available for distribution to shareholders (after a distribution of $250,000 to the ordinary shares). As a result of the issuance of such preference shares, (a) a substantive sale and purchase of an interest took place between the ordinary shareholders of FSA Global and the Company, resulting in an assessment and recording of the fair value of the assets and liabilities sold and purchased at the time of such transaction, and (b) the Company’s minority interest liability associated with FSA Global was eliminated. In the second quarter of 2006, the Company realized a pre-tax gain of $1.8 million as a result of this transaction.
All the investments supporting VIE liabilities are insured by FSA. The credit quality of the VIE Investment Portfolio, without the benefit of FSA’s insurance, at December 31, 2006 was as follows:
Rating(1) | | | | Percent of Bonds | |
AAA | | | 1.5 | % | |
A | | | 80.8 | | |
NR | | | 17.7 | | |
Total | | | 100.0 | % | |
(1) Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2006.
The amortized cost and fair value of bonds in the VIE Investment Portfolio were as follows:
| | As of December 31, 2006 | |
| | Amortized Cost | | Fair Value | |
| | (in thousands) | |
Obligations of states and political subdivisions | | | $ | 15,750 | | | $ | 15,750 | |
Foreign securities | | | 9,086 | | | 9,643 | |
Asset-backed securities(1) | | | 1,102,862 | | | 1,102,862 | |
Short-term investments | | | 19,478 | | | 19,478 | |
Total | | | $ | 1,147,176 | | | $ | 1,147,733 | |
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| | As of December 31, 2005 | |
| | Amortized Cost | | Fair Value | |
| | (in thousands) | |
Obligations of states and political subdivisions | | | $ | 15,879 | | | $ | 15,879 | |
Corporate securities | | | 20,013 | | | 19,327 | |
Foreign securities | | | 8,995 | | | 9,841 | |
Asset-backed securities(1) | | | 1,110,945 | | | 1,110,945 | |
Short-term investments | | | 2,674 | | | 2,674 | |
Total | | | $ | 1,158,506 | | | $ | 1,158,666 | |
(1) Asset-backed securities consist of floating rate assets, which are valued using readily available quoted market prices or at amortized cost if there is no readily available valuation. Management believes that amortized cost closely approximates fair value for these securities.
The Company periodically monitors its investment portfolio for individual investments in an unrealized loss position in order to assess whether that investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2006 and 2005, there were no securities in an unrealized loss position. The Company determined that no investments were considered other-than-temporarily impaired.
The amortized cost and fair value of bonds in the VIE Investment Portfolio at December 31, 2006, by contractual maturity, are shown below. 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 Cost | | Fair Value | |
| | (in thousands) | |
Due in one year or less | | | $ | 19,478 | | | $ | 19,478 | |
Due after one year through five years | | | 9,086 | | | 9,643 | |
Due after five years through ten years | | | — | | | — | |
Due after ten years | | | 15,750 | | | 15,750 | |
Asset-backed securities (stated maturities of 2 to 14 years) | | | 1,102,862 | | | 1,102,862 | |
Total | | | $ | 1,147,176 | | | $ | 1,147,733 | |
The Company pledges and receives collateral related to certain business lines or transactions. The following is a description of those arrangements by transaction type.
Securities Pledged to Note Holders
In the normal course of business, the Company may hold securities purchased under agreements to resell. A portion of these securities may be pledged to the Company’s investment agreement counterparties (including counterparties with agreements structured as investment repurchase agreements). However, such securities generally may not be rehypothecated by the investment agreement counterparty. The Company also pledges investments held in the FP Investment Portfolio to investment agreement counterparties. At December 31, 2006, $4.7 billion of the assets held in its FP Investment Portfolio and related accrued interest were pledged as collateral to investment agreement counterparties. In addition, substantially all the assets of FSA Global are pledged to secure the repayment, on a pro rata basis, of FSA Global’s notes and its other obligations.
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Securities Pledged to Derivative Counterparties
Securities purchased under agreements to resell are eligible to be pledged to certain interest rate swap counterparties. In general, under the terms of each of these counterparty-specific derivative agreements, the Company and its counterparty may be required to pledge collateral or transfer assets as a result of changes in the fair value of those derivative agreements. The timing and amount are generally dependent on which entity is exposed as well as the credit rating of the party in the payable position. The Company and the counterparty typically have identical rights and obligations to pledge and rehypothecate collateral according to the terms included within each of the counterparty-specific derivative agreements. At December 31, 2006, $7.3 million of the assets held in the FP Investment Portfolio and related accrued interest were pledged as collateral to margin accounts. FSA Global, under the terms of its derivative agreements, is not required to pledge collateral. Its counterparties, however, may be required to pledge collateral or transfer assets to FSA Global. FSA Global is not permitted to rehypothecate any such collateral or assets.
5. ASSETS ACQUIRED IN REFINANCING TRANSACTIONS
The Company generally has rights under its financial guaranty insurance policies and indentures that allow it to accelerate the insured notes and pay claims under its insurance policies upon the occurrence of predefined events of default. To mitigate future losses, the Company may elect to purchase the outstanding insured obligation or its underlying collateral. Generally, refinancing vehicles reimburse FSA in whole for its claims payments in exchange for assignments of certain of FSA’s rights against the trusts. The refinancing vehicles obtain their funds from the proceeds of FSA-insured GICs issued in the ordinary course of business by the GIC Affiliates. The refinancing vehicles are consolidated into the Company’s financial statements. The Company maintains its reinsurance on these transactions.
The following table presents the balance sheet components of the assets acquired in refinancing transactions:
| | As of December 31, | |
| | 2006 | | 2005 | |
| | (in thousands) | |
Securitized loans | | $ | 241,785 | | $ | 296,965 | |
Bonds | | 41,051 | | 68,421 | |
Equity securities | | 4,434 | | 3,488 | |
Mortgage loans | | 34,407 | | 56,165 | |
Short-term investments | | 12,662 | | 37,512 | |
Other assets | | 3,533 | | 5,322 | |
Total | | $ | 337,872 | | $ | 467,873 | |
The accretable yield on the securitized loans at December 31, 2006, 2005 and 2004 was $157.3 million, $149.7 million and $151.3 million, respectively. The cash flows on the securitized loans, net of reinsurance, are monitored and the effective yield modified to reflect any change in the cash flow estimate on a prospective basis. Since the notes represent 100% of the debt capitalization of the trusts and since FSA maintains all the risk of further asset decline (except as provided by reinsurance) and maintains control over key decisions regarding the trusts (such as removal of the servicer, sale of the assets and liquidation of the entity), the trusts were consolidated with the Company for accounting purposes. The Company also consolidated the refinancing vehicles.
Bonds, equity securities and mortgage loans represent liquidations of previously insured obligations and subsequent purchases of the underlying collateral. Bonds and equity securities are available for sale and carried at fair value.
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The credit quality of bonds within the refinanced asset portfolio at December 31, 2006 was as follows:
Rating(1) | | | | Percent of Bonds | |
BBB | | | 13.1 | % | |
CCC | | | 84.2 | | |
NR | | | 2.7 | | |
Total | | | 100.0 | % | |
(1) Ratings are based on internal shadow ratings available at December 31, 2006.
The amortized cost and fair value of fixed-income assets within the refinanced asset portfolio were as follows:
| | As of December 31, 2006 | |
| | Amortized
Cost | | Gross
Unrealized
Gains | | Gross
Unrealized
Losses | | Fair Value | |
| | (in thousands) | |
Corporate securities | | | $ | 1,074 | | | | $ | 29 | | | | $ | — | | | | $ | 1,103 | | |
Asset-backed securities | | | 39,059 | | | | 889 | | | | — | | | | 39,948 | | |
Short-term investments | | | 12,662 | | | | — | | | | — | | | | 12,662 | | |
Total | | | $ | 52,795 | | | | $ | 918 | | | | $ | — | | | | $ | 53,713 | | |
| | As of December 31, 2005 | |
| | Amortized
Cost | | Gross
Unrealized
Gains | | Gross
Unrealized
Losses | | Fair Value | |
| | (in thousands) | |
Corporate securities | | $ | 5,946 | | | $ | 3,199 | | | | $ | — | | | $ | 9,145 | |
Asset-backed securities | | 59,920 | | | — | | | | (644 | ) | | 59,276 | |
Short-term investments | | 37,512 | | | — | | | | — | | | 37,512 | |
Total | | $ | 103,378 | | | $ | 3,199 | | | | $ | (644 | ) | | $ | 105,933 | |
The amortized cost and fair value of equities held within the refinanced asset portfolio were as follows:
| | As of December 31, 2006 | |
| | Amortized
Cost | | Gross
Unrealized
Gains | | Gross
Unrealized
Losses | | Fair Value | |
| | (in thousands) | |
Equity securities | | | $ | 1,003 | | | | $ | 3,431 | | | | — | | | | $ | 4,434 | | |
| | | | | | | | | | | | | | | | | | | | |
| | As of December 31, 2005 | |
| | Amortized
Cost | | Gross
Unrealized
Gains | | Gross
Unrealized
Losses | | Fair Value | |
| | (in thousands) | |
Equity securities | | | $ | 2,206 | | | | $ | 1,282 | | | | — | | | | $ | 3,488 | | |
| | | | | | | | | | | | | | | | | | | | |
The amortized cost and fair value of fixed-income assets within the refinanced asset portfolio at December 31, 2006, are shown below by contractual maturity. 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 Cost | | Fair Value | |
| | (in thousands) | |
Due in one year or less | | | $ | 12,669 | | | | $ | 12,689 | | |
Due after one year through five years | | | 40,126 | | | | 41,024 | | |
Total | | | $ | 52,795 | | | | $ | 53,713 | | |
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At December 31, 2006 and 2005, there were no securities in an unrealized loss position for a continuous 12-month period or longer. In 2006, the Company determined that there were three securities considered other-than-temporarily impaired, and a $2.5 million impairment charge was recorded in the consolidated statements of operations and comprehensive income. In 2005, the Company determined that there were six securities considered other-than-temporarily impaired, and a $4.5 million impairment charge was recorded in the consolidated statements of operations and comprehensive income.
6. DEFERRED ACQUISITION COSTS
Acquisition costs deferred for amortization against future income and the related amortization charged to expenses are as follows:
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in thousands) | |
Balance, beginning of period | | $ | 335,129 | | $ | 308,015 | | $ | 273,646 | |
Costs deferred during the period: | | | | | | | |
Ceded and assumed commissions | | (79,713 | ) | (63,174 | ) | (65,838 | ) |
Premium taxes | | 14,032 | | 20,894 | | 16,551 | |
Compensation and other acquisition costs | | 134,237 | | 137,734 | | 145,857 | |
Total | | 68,556 | | 95,454 | | 96,570 | |
Costs amortized during the period | | (63,012 | ) | (68,340 | ) | (62,201 | ) |
Balance, end of period | | $ | 340,673 | | $ | 335,129 | | $ | 308,015 | |
7. LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the liability for losses and loss adjustment expenses, which consists of the case and non-specific reserves, is summarized as follows:
| | Case Reserve Activity for the
Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
Gross balance at January 1 | | $ | 90.0 | | $ | 80.6 | | $ | 121.9 | |
Less reinsurance recoverable | | 36.3 | | 35.4 | | 59.2 | |
Net balance at January 1 | | 53.7 | | 45.2 | | 62.7 | |
Transfer from non-specific reserve | | 1.2 | | 10.5 | | 30.7 | |
Restructured transactions | | — | | — | | (13.9 | ) |
Paid (net of recoveries) related to: | | | | | | | |
Current year | | — | | — | | — | |
Prior year | | (1.9 | ) | (2.0 | ) | (34.3 | ) |
Total paid | | (1.9 | ) | (2.0 | ) | (34.3 | ) |
Net balance at December 31 | | 53.0 | | 53.7 | | 45.2 | |
Plus reinsurance recoverable | | 37.3 | | 36.3 | | 35.4 | |
Gross balance at December 31 | | $ | 90.3 | | $ | 90.0 | | $ | 80.6 | |
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| | Non-Specific Reserve Activity
for the Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
Balance at January 1 | | $ | 115.7 | | $ | 99.3 | | $ | 111.5 | |
Provision for losses | | | | | | | |
Current year | | 17.8 | | 20.4 | | 20.4 | |
Prior year | | 5.5 | | 5.0 | | 0.2 | |
Transfers to case reserves | | (1.2 | ) | (10.5 | ) | (30.7 | ) |
Restructured transactions | | — | | 1.5 | | (2.1 | ) |
Balance at December 31 | | 137.8 | | 115.7 | | 99.3 | |
Total case and non-specific reserves | | $ | 228.1 | | $ | 205.7 | | $ | 179.9 | |
The gross and net par amounts outstanding on transactions with case reserves were $483.4 million and $399.6 million, respectively, at December 31, 2006. The net case reserve consisted primarily of five CDO risks and two municipal risks, which collectively accounted for approximately 94.9% of the total net case reserve. The remaining eight risks were in various sectors.
During 2006, the Company charged $23.3 million to loss expense, consisting of $17.8 million for originations of new business and $5.5 million related to accretion on the reserve for in-force business. Net case reserves decreased $0.7 million due primarily to loss payments and some improvement in the CDO transactions, offset in part by the establishment of a new case reserve for a municipal health care transaction.
During 2005, the Company charged $25.4 million to loss expense, consisting of $20.4 million for originations of new business and $5.0 million related to accretion on the reserve for in-force business. The non-specific reserve increased $16.4 million in 2005, due primarily to loss expense of $25.4 million, partially offset by transfers from the non-specific reserve to case reserves of $10.5 million. Net reserves increased $8.5 million due primarily to deterioration of specific CDO risks.
During 2004, the Company charged $20.6 million to loss expense, consisting of $20.4 million for originations of new business, $4.6 million for accretion related to prior years and $3.2 million related to reassumptions of previously ceded business, offset by reserve releases related primarily to a large refinancing transaction in 2004.
In September 2004, FSA exercised its rights to have the collateral of a defaulted collateralized bond obligation liquidated at a public sale, in which the Company offered the highest bid. The Company acquired the collateral to gain control of the portfolio in order to mitigate future losses. The previously established case reserve was drawn down to reflect the excess of the purchase amount over the fair value of the collateral. The remaining $9.5 million balance in the case reserve related to this transaction was returned to the non-specific reserve. After reevaluating its requirements for the CDO portion of the non-specific reserve, the Company then reduced the non-specific reserve by $9.5 million, which was partially offset by normal reserve additions. The net amount transferred from case reserves to the non-specific reserve was $1.4 million, which also included a transfer from the non-specific reserve to a case reserve for a municipal utility transaction. The CDO portfolio continues to perform within the expectations reflected in previously recorded provisions for CDOs.
Since case and non-specific reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates. The Company will continue, on an ongoing basis, to monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company’s actual loss experience, its future mix of business and future economic conditions.
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Impact of 2005 Hurricanes
The Company monitors its exposure to credits affected by the 2005 hurricanes in Louisiana and Mississippi. The Company believes that its estimate of its total loss liability is adequate given its current risk information and has not established a case reserve related to its 2005 hurricane-affected exposure.
As of December 31, 2006, FSA had not received notice of payment default on any hurricane-related exposures. The Company’s 11 credits that have suffered the most significant economic and property loss from the 2005 hurricanes had an aggregate net par exposure of $181.7 million at December 31, 2006.
FSA-insured bonds are protected by various sources of support that would be invoked before FSA would incur losses. These sources include access to pledged taxes or revenues, reserve funds, property and casualty insurance and state and federal monies. The issuers of these insured bonds have generally continued to improve financially and management does not expect that FSA will sustain permanent losses.
In addition, to provide relief to local governments facing difficulties meeting debt service obligations during this recovery period, the State of Louisiana issued an aggregate of $400 million of Gulf Tax Credit and matching State General Obligation Bonds on July 19, 2006. The bond proceeds funded a State Debt Service Assistance Fund to provide loans to help qualifying local governments meet debt service obligations for the next several years. All of the qualifying entities are located in the New Orleans metropolitan area.
Among the exposures affected by the hurricane are $38.1 million of FSA-insured Orleans Levee District (the “District”) bonds. The District has explored the possibility of seeking bankruptcy protection, but has not received the authority from the State that is required to do so. In any event, FSA does not believe that payment of the FSA-insured bonds would be impaired by a bankruptcy filing. In addition, the District is a loan recipient under the State Debt Service Assistance Fund, with FSA-insured bonds receiving assistance through May 1, 2009.
Asset-backed transactions insured by FSA, backed by pools of geographically diverse assets, show no unusual concentrations in the affected areas.
The loss estimation process involves the exercise of considerable judgment and therefore FSA’s ultimate 2005 hurricane-related losses may be materially different from the current estimate and may affect future operating results.
8. GIC AND VIE DEBT
The obligations under GICs issued by the GIC Affiliates may be called at various times prior to maturity based on certain agreed-upon events. As of December 31, 2006, interest rates were between 1.6% and 6.1% per annum on outstanding GICs and between 1.98% and 6.20% per annum on VIE debt. Payments due under GICs are based on expected withdrawal dates and exclude negative hedge accounting adjustments and prepaid interest of $77.6 million, and include accretion of $899.5 million. VIE debt excludes fair-value adjustments of $146.3 million and includes $1,042.1 million of future interest accretion on zero-coupon obligations. The following table presents the combined principal amounts due under GICs and VIE debt for 2007 and each of the next four years ending December 31, and thereafter:
| | Principal
Amount | |
| | (in millions) | |
2007 | | | $ | 3,791.2 | | |
2008 | | | 1,287.5 | | |
2009 | | | 2,237.2 | | |
2010 | | | 2,448.4 | | |
2011 | | | 1,156.1 | | |
Thereafter | | | 9,302.2 | | |
Total | | | $ | 20,222.6 | | |
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9. LONG-TERM DEBT
On November 22, 2006, FSA Holdings issued $300.0 million principal amount of Junior Subordinated Debentures with a scheduled maturity date of December 15, 2036 and a final repayment date of December 15, 2066. The final repayment date of December 15, 2066 may be automatically extended up to four times in five-year increments provided certain conditions are met. The debentures are redeemable, in whole or in part, at any time prior to December 15, 2036 at their principal amount plus accrued and unpaid interest to the date of redemption. Interest on the debentures will accrue from November 22, 2006 to December 15, 2036 at the annual rate of 6.40%. If any amount of the debentures remains outstanding after December 15, 2036, then the principal amount of the outstanding debentures will bear interest at a floating interest rate equal to one-month LIBOR plus 2.215% until repaid. FSA Holdings may elect at one or more times to defer payment of interest on the debentures for one or more consecutive interest periods that do not exceed ten years. In connection with the completion of this offering, FSA Holdings entered into a replacement capital covenant for the benefit of persons that buy, hold or sell a specified series of FSA Holdings long-term indebtedness ranking senior to the debentures. Under the covenant, the debentures will not be repaid, redeemed, repurchased or defeased by FSA Holdings or any of its subsidiaries on or before the date that is 20 years prior to the final repayment date, except to the extent that FSA Holdings has received proceeds from the sale of replacement capital securities. The proceeds from this offering were used to pay a dividend to the shareholders of FSA Holdings.
On July 31, 2003, the Company issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the notes.
On November 26, 2002, the Company issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt.
On December 19, 2001, the Company issued $100.0 million of 67¤8% Quarterly Income Bond Securities due December 15, 2101, which are callable without premium or penalty on or after December 19, 2006. Debt issuance costs of $3.3 million are being amortized over the life of the debt.
10. OUTSTANDING EXPOSURE AND COLLATERAL
The Company’s policies insure the scheduled payments of principal and interest on public finance and asset-backed (including FSA-insured CDS) obligations. The gross amount of financial guarantees in force (principal and interest) was $743.9 billion at December 31, 2006 and $668.2 billion at December 31, 2005. The net amount of financial guarantees in force was $531.4 billion at December 31, 2006 and $480.2 billion at December 31, 2005.
The net par outstanding as of December 31, 2006 and 2005 and the contractual terms to maturity are as follows:
| | As of December 31, 2006 | | As of December 31, 2005 | |
Terms to Maturity(1) | | | | Public
Finance | | Asset-Backed(2) | | Public
Finance | | Asset-Backed(2) | |
| | (in millions) | |
0 to 5 years | | $ | 48,273 | | | $ | 41,582 | | | $ | 44,272 | | | $ | 41,955 | | |
5 to 10 years | | 53,242 | | | 31,097 | | | 49,935 | | | 31,395 | | |
10 to 15 years | | 47,865 | | | 12,301 | | | 44,392 | | | 12,180 | | |
15 to 20 years | | 41,489 | | | 1,860 | | | 36,737 | | | 744 | | |
20 years and above | | 60,424 | | | 21,427 | | | 51,724 | | | 24,149 | | |
Total | | $ | 251,293 | | | $ | 108,267 | | | $ | 227,060 | | | $ | 110,423 | | |
| | | | | | | | | | | | | | | | | | | |
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The par amount ceded as of December 31, 2006 and 2005 and the terms to maturity are as follows:
| | As of December 31, 2006 | | As of December 31, 2005 | | |
Terms to Maturity(1) | | | | Public
Finance | | Asset-Backed(2) | | Public
Finance | | Asset-Backed(2) | | |
| | (in millions) | | |
0 to 5 years | | $ | 14,375 | | | $ | 9,091 | | | | $ | 12,950 | | | | $ | 16,180 | | |
5 to 10 years | | 16,635 | | | 6,485 | | | | 16,332 | | | | 7,011 | | |
10 to 15 years | | 17,163 | | | 1,847 | | | | 16,954 | | | | 1,477 | | |
15 to 20 years | | 17,200 | | | 1,905 | | | | 15,180 | | | | 1,474 | | |
20 years and above | | 33,480 | | | 3,649 | | | | 29,048 | | | | 4,001 | | |
Total | | $ | 98,853 | | | $ | 22,977 | | | | $ | 90,464 | | | | $ | 30,143 | | |
| | | | | | | | | | | | | | | | | | | | | | |
(1) 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.
(2) Excludes intercompany insurance of $16,558 million in 2006 and $13,463 million in 2005 relating to FSA-insured GICs issued by the GIC Affiliates.
The net par outstanding of insured obligations in the public finance insured portfolio includes the following amounts by type of issue:
| | Net Par Outstanding
as of December 31, | | Ceded
as of December 31, | |
Types of Issues | | | | 2006 | | 2005 | | 2006 | | 2005 | |
| | (in millions) | |
General obligation | | $ | 103,112 | | $ | 93,284 | | $ | 28,143 | | $ | 26,020 | |
Tax-supported | | 46,479 | | 43,855 | | 18,733 | | 18,276 | |
Municipal utility revenue | | 40,495 | | 37,245 | | 13,367 | | 14,091 | |
Health care revenue | | 13,155 | | 11,789 | | 10,144 | | 8,889 | |
Housing revenue | | 7,576 | | 7,585 | | 2,039 | | 2,153 | |
Transportation revenue | | 16,164 | | 15,299 | | 10,337 | | 9,766 | |
Education | | 4,378 | | 4,065 | | 1,027 | | 1,184 | |
Other domestic public finance | | 1,628 | | 1,690 | | 509 | | 531 | |
International | | 18,306 | | 12,248 | | 14,554 | | 9,554 | |
Total public finance obligations | | $ | 251,293 | | $ | 227,060 | | $ | 98,853 | | $ | 90,464 | |
| | | | | | | | | | | | | | | |
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 net par outstanding of insured obligations in the asset-backed insured portfolio includes the following amounts by type of collateral:
| | Net Par Outstanding(1)
as of December 31, | | Ceded
as of December 31, | |
Types of Collateral | | | | 2006 | | 2005 | | 2006 | | 2005 | |
| | (in millions) | |
Residential mortgages | | $ | 15,666 | | $ | 18,401 | | $ | 2,555 | | $ | 3,056 | |
Consumer receivables | | 10,599 | | 8,366 | | 664 | | 1,569 | |
Pooled corporate obligations | | 45,914 | | 47,253 | | 8,729 | | 11,141 | |
Other domestic asset-backed obligations | | 6,793 | | 7,328 | | 2,952 | | 2,890 | |
International obligations | | 29,295 | | 29,075 | | 8,077 | | 11,487 | |
Total asset-backed obligations | | $ | 108,267 | | $ | 110,423 | | $ | 22,977 | | $ | 30,143 | |
| | | | | | | | | | | | | | | |
(1) Excludes intercompany insurance of $16,558 million in 2006 and $13,463 million in 2005 relating to FSA-insured GICs issued by the GIC Affiliates.
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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 public finance 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 public finance securities as of December 31, 2006:
State | | | | Number of
Risks | | Net Par Amount
Outstanding | | Percent of Total
Net Par Amount
Outstanding | | Ceded Par
Amount
Outstanding | |
| | (in millions) | |
California | | | 1,022 | | | | $ | 31,724 | | | | 12.7 | % | | | $ | 10,753 | | |
New York | | | 703 | | | | 19,800 | | | | 7.9 | | | | 9,172 | | |
Texas | | | 760 | | | | 17,123 | | | | 6.8 | | | | 5,578 | | |
Pennsylvania | | | 782 | | | | 16,429 | | | | 6.5 | | | | 4,197 | | |
Florida | | | 270 | | | | 13,061 | | | | 5.2 | | | | 4,764 | | |
Illinois | | | 682 | | | | 12,641 | | | | 5.0 | | | | 6,140 | | |
New Jersey | | | 609 | | | | 10,817 | | | | 4.3 | | | | 5,710 | | |
Michigan | | | 542 | | | | 10,173 | | | | 4.0 | | | | 2,266 | | |
Washington | | | 332 | | | | 9,067 | | | | 3.6 | | | | 3,715 | | |
Massachusetts | | | 210 | | | | 6,304 | | | | 2.5 | | | | 3,513 | | |
Ohio | | | 376 | | | | 6,160 | | | | 2.5 | | | | 2,034 | | |
Indiana | | | 271 | | | | 5,451 | | | | 2.2 | | | | 1,277 | | |
Georgia | | | 114 | | | | 5,050 | | | | 2.0 | | | | 1,426 | | |
Wisconsin | | | 453 | | | | 4,982 | | | | 2.0 | | | | 1,326 | | |
All other U.S. jurisdictions | | | 2,767 | | | | 64,205 | | | | 25.5 | | | | 22,428 | | |
International | | | 143 | | | | 18,306 | | | | 7.3 | | | | 14,554 | | |
Total | | | 10,036 | | | | $ | 251,293 | | | | 100.0 | % | | | $ | 98,853 | | |
11. FEDERAL INCOME TAXES
Dexia Holdings, the Company and its Subsidiaries, except FSA International, file a consolidated U.S. federal income tax return. Prior to 2006, a tax-sharing agreement among the Subsidiaries provided that each member’s tax benefit or expense is calculated on a separate-return basis and that any credits or losses available to the Company are allocated among the members based on each member’s taxable income. Effective January 1, 2006, the tax sharing agreement was amended so that Dexia Holdings’ credits are no longer available to the members. For the 2006 and 2005 tax years, the Company and its Subsidiaries did not receive any such benefits from utilizing Dexia Holdings’ credits.
Except as described below, federal income taxes were not provided on all of the undistributed earnings of FSA International, since it was the Company’s practice and intent to reinvest such earnings in the operations of this subsidiary. The cumulative amount of such untaxed earnings was $22.6 million at December 31, 2004.
The American Jobs Creation Act of 2004 (the “Act”), enacted on October 22, 2004, added Section 965 to the Internal Revenue Code. Section 965 provides for the repatriation of dividends from a controlled foreign corporation to its U.S. shareholder at an effective tax rate of 5.25%, provided that
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proceeds from the repatriation are utilized for qualified domestic investment activities. The U.S. Treasury Department issued Notice 2005-10, which provided guidance on acceptable investment activities. The Company believes it qualifies for the beneficial treatment under Section 965 and accordingly accrued a tax liability and expense of $5.3 million at December 31, 2004. This amount approximated the tax effect on FSA International’s tax dividend distribution made in the fourth quarter of 2005.
In December 2005, the Company repatriated earnings from FSA International to avail itself of the reduced effective tax rate of 5.25% (compared with the normal effective tax rate of 35%). In connection with such repatriation, the Company recapitalized FSA International in October of 2005 to become a wholly owned subsidiary and declared that it no longer intends to leave future earnings of that subsidiary permanently offshore. As a result, FSA International is subject to an increased effective U.S. tax rate on its 2005 and future income. The impact on earnings reflected (a) a tax liability of $15.1 million in respect of undistributed earnings of FSA International that had previously been recognized for GAAP but not yet for tax purposes and (b) $14.2 million related to 2005 earnings.
Following a change in ownership of SPS in 2002, the Company determined that it would be appropriate to apply the 80% dividend-received deduction allowed by the Internal Revenue Service when accounting for the tax on its equity in earnings from SPS, based on management’s expectation that it would realize its gain on such investment through dividend distributions rather than through sale of its investment. For 2004 and 2003, equity in earnings from SPS was taxed at an effective rate of 7%. In the first quarter of 2005, due to the pending sale of its investment in SPS, the Company eliminated the assumption that accumulated earnings of SPS would be distributed in the form of dividends eligible for a dividend-received deduction. The net effect of this was to provide additional taxes on SPS’s accumulated earnings of approximately $1.6 million.
In connection with Dexia’s acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains. While the Company had no legal liability in connection with the indemnity payment, the payment was treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, the Company has agreed to share 50% of the deferred tax benefit with White Mountains under certain circumstances, but did not satisfy the standards for recording a liability for accounting purposes as of December 31, 2006.
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The cumulative balance sheet effects of deferred federal tax consequences are as follows:
| | As of December 31, | |
| | 2006 | | 2005 | |
| | (in thousands) | |
Deferred acquisition costs | | $ | 106,596 | | $ | 104,335 | |
Deferred premium revenue adjustments | | 57,992 | | 36,302 | |
Unrealized capital gains | | 86,119 | | 84,058 | |
Contingency reserves | | 135,992 | | 114,166 | |
Undistributed earnings | | 18,297 | | 16,613 | |
Derivative fair-value adjustments | | 154,911 | | 15,152 | |
Minority interest | | —— | | 63,142 | |
Other | | 5,032 | | 8,212 | |
Total deferred federal income tax liabilities | | 564,939 | | 441,980 | |
Loss and loss adjustment expense reserves | | (49,079 | ) | (41,533 | ) |
Deferred compensation | | (91,442 | ) | (90,866 | ) |
White Mountains indemnity payment | | (16,450 | ) | (16,450 | ) |
Foreign currency transaction loss | | (102,927 | ) | (56,129 | ) |
Other | | (6,499 | ) | (5,737 | ) |
Total deferred federal income tax assets | | (266,397 | ) | (210,715 | ) |
Net deferred federal income tax liability | | $ | 298,542 | | $ | 231,265 | |
Management believes it is more likely than not that the tax benefit of the deferred tax assets will be realized. Accordingly, no valuation allowance was necessary at December 31, 2006 or 2005.
A reconciliation of the effective tax rate with the federal statutory rate follows:
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
Tax at statutory rate | | 35.0 | % | 35.0 | % | 35.0 | % |
Tax-exempt investments | | (10.4 | ) | (9.8 | ) | (7.1 | ) |
Income of foreign subsidiary | | —— | | 2.7 | | (1.2 | ) |
White Mountains indemnity payment | | —— | | — | | (2.8 | ) |
Minority interest and equity in unconsolidated subsidiaries | | 3.5 | | (0.8 | ) | (4.9 | ) |
Other | | 0.7 | | 0.2 | | — | |
Provision for income taxes | | 28.8 | % | 27.3 | % | 19.0 | % |
12. EMPLOYEE BENEFIT PLANS
The Company maintains both qualified and non-qualified, non-contributory defined contribution pension plans for the benefit of eligible employees. Contributions are based on a fixed percentage of employee compensation. Pension expense, which is funded annually, amounted to $7.5 million, $7.0 million and $5.8 million for the years ended December 31, 2006, 2005 and 2004, respectively.
The Company has an employee retirement savings plan for the benefit of eligible employees. The plan permits employees to contribute a percentage of their salaries up to limits prescribed by Internal Revenue Code Section 401(k). Contributions by the Company are discretionary, and none have been made.
Through 2004, performance shares were awarded under the 1993 Equity Participation Plan (the “1993 Equity Plan”). The 1993 Equity Plan authorized the discretionary grant of performance shares by the Human Resources Committee to key employees. The amount earned for each performance share depends on the attainment of certain growth rates of adjusted book value and book value per outstanding share over a three-year period.
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Performance shares issued prior to January 1, 2005 permitted the participant to elect, at the time of award, growth rates including or excluding realized and unrealized gains and losses on the General Investment Portfolio. Performance shares issued after January 1, 2005 do not offer the option to include the impact of unrealized gains and losses on the General Investment Portfolio. No payout occurs if the compound annual growth rate of adjusted book value and book value per outstanding share over specified three-year performance cycles is less than 7%, and a 200% payout occurs if the compound annual growth rate is 19% or greater. Payout percentages are interpolated for compound annual growth rates between 7% and 19%.
In 2004, the Company adopted the 2004 Equity Participation Plan (the “2004 Equity Plan”), which continues the incentive compensation program formerly provided under the Company’s 1993 Equity Participation Plan. The 2004 Equity Plan provides for performance share units comprised 90% of performance shares (which provide for payment based upon the Company’s performance over two specified three-year performance cycles) and 10% of shares of Dexia restricted stock. Performance shares have generally been awarded on the basis of two sequential three-year performance cycles, with one-third of each award allocated to the first cycle, which commences on the date of grant, and two-thirds of each award allocated to the second cycle, which commences one year after the date of grant. The total number of performance shares authorized under this plan was 3.3 million. At December 31, 2006, 2.7 million performance shares remained available for distribution.
The Dexia restricted stock component is a fixed plan, where the Company purchases Dexia shares and establishes a prepaid expense for the amount paid, which is amortized over 2.5-year and 3.5-year vesting periods. In 2006 and 2005, FSA purchased shares to economically defease its liability for $4.6 million and $4.4 million, respectively. These amounts are being amortized to expense over the employees’ vesting periods. For the years ended December 31, 2006 and 2005, the after-tax amounts amortized into income were $1.9 million and $0.9 million, respectively.
Performance shares granted under the 1993 Equity Plan and 2004 Equity Plan are as follows:
| | Outstanding
at
Beginning of
Year | | Granted
During
the Year | | Paid out
During
the Year | | Forfeited
During the
Year | | Outstanding
at
End of Year | | Price per
Share
at Grant
Date | | Paid During
the Year | |
| | | | | | | | | | | | | | (in thousands) | |
2004 | | | 1,280,632 | | | 355,459 | | 398,292 | | | 20,038 | | | | 1,217,761 | | | $ | 109.71 | | | $ | 64,278 | | |
2005 | | | 1,217,761 | | | 316,638 | | 313,987 | | | 24,434 | | | | 1,195,978 | | | 131.30 | | | 61,584 | | |
2006 | | | 1,195,978 | | | 370,441 | | 340,429 | | | 15,696 | | | | 1,210,294 | | | 139.22 | | | 60,993 | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
At December 31, 2006, 364,510 outstanding performance shares were fully vested, with a value of $61.9 million. These amounts were paid in the first quarter of 2007. At December 31, 2006, the total compensation cost related to non-vested performance shares not yet recognized was $73.9 million. This amount is expected to be recognized as an expense over a weighted-average period of 1.14 years.
The estimated final cost of these performance shares is accrued over the performance period. The after-tax expense for the performance shares was $39.2 million, $36.3 million and $47.6 million for the years ended December 31, 2006, 2005 and 2004, respectively.
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Awards of Dexia restricted stock remain restricted for an additional six months after the end of the last year of each vesting period. Shares of Dexia restricted stock purchased under the 2004 Equity Plan are as follows:
| | Outstanding
at
Beginning of
Year | | Purchased
During
the Year | | Vested
During
the Year | | Forfeited
During the
Year | | Outstanding
at
End of Year | | Price per
Share at
Purchase
Date | |
2005 | | | — | | | | 194,202 | | | | 8,756 | | | | 5,150 | | | | 180,296 | | | | $ | 22.69 | | |
2006 | | | 180,296 | | | | 190,572 | | | | 22,146 | | | | 4,574 | | | | 344,148 | | | | 24.17 | | |
In the fourth quarter of 2000, the Company purchased 304,757 shares of its common stock from Dexia Holdings for $24.0 million. Additional purchases are intended to fund obligations relating to the Company’s Director Share Purchase Program (“DSPP”), which enables its participants to make deemed investments in the Company’s common stock under the Deferred Compensation Plan and Supplemental Executive Retirement Plan. Under the DSPP, the deemed investments in the Company’s stock are irrevocable, settlement of the deemed investments must be in stock and, after receipt, the participants must generally hold the stock for at least six months. Restricted treasury stock is distributed to a director as a DSPP payout at the end of applicable restriction periods.
The Company purchased and distributed shares of its common stock under the DSPP in the following amounts:
| | Outstanding
at
Beginning of
Year | | Purchased
During
the Year | | Payouts
During
the Year | | Outstanding
at
End of Year | | Purchase
Amount | | Cost of
Shares
Distributed | | Fair Value
of Shares
Distributed | |
| | (dollars in thousands) | |
2004 | | | 297,658 | | | | 1,890 | | | | 2,272 | | | | 297,276 | | | | $ | 262.0 | | | | $ | 178.9 | | | | $ | 331.6 | | |
2005 | | | 297,276 | | | | — | | | | 42,540 | | | | 254,736 | | | | — | | | | 3,350.5 | | | | 6,862.5 | | |
2006 | | | 254,736 | | | | 532 | | | | 13,290 | | | | 241,978 | | | | 94.8 | | | | 1,046.7 | | | | 2,438.2 | | |
Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” did not have any impact on the consolidated statements of operations and comprehensive income.
13. DERIVATIVE INSTRUMENTS
Credit Default Swaps
FSA has insured a number of CDS with the expectation that these transactions will not be subject to a market value termination for which the Company would be liable. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes and therefore are recorded at fair value. The Company recorded $87.2 million, $89.2 million and $69.1 million of net earned premium under these agreements for the years ended 2006, 2005 and 2004, respectively.
Changes in the fair value of CDS, which were gains of $31.8 million, $11.1 million and $56.4 million for the years ended December 31, 2006, 2005, and 2004, respectively, were recorded in net realized and unrealized gains on derivative instruments in the consolidated statements of operations and comprehensive income. The Company’s net par outstanding of $74.7 billion and $66.6 billion relating to these CDS transactions at December 31, 2006 and December 31, 2005, respectively, are included in the asset-backed insured balances in Note 10. The Company does not believe that the fair-value adjustments are an indication of potential claims under FSA’s guarantees or an indication of potential gains to be realized from the derivative transactions. The average remaining life of these contracts at December 31,
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2006 was 3.1 years. The inception-to-date gain on the balance sheet was $89.2 million at December 31, 2006 and $57.4 million at December 31, 2005, and was recorded in other assets.
Interest Rate and Foreign Exchange Rate Derivatives
The Company enters into derivative contracts to manage interest rate and foreign currency exposure in its GICs, FP Investment Portfolio, VIE debt and VIE Investment Portfolio. The inception-to-date net unrealized loss on derivatives used to hedge GIC liabilities and the FP Investment Portfolio of $23.0 million and $56.9 million at December 31, 2006 and December 31, 2005, respectively, is recorded in other assets or accrued expenses, other liabilities and minority interest, as applicable. The inception-to-date net unrealized gain on the outstanding derivatives used to economically hedge the VIE debt and VIE Investment Portfolio of $516.8 million and $433.7 million at December 31, 2006 and December 31, 2005, respectively, is recorded in other assets.
In order for a derivative to qualify for hedge accounting, it must be highly effective at reducing the risk associated with the exposure being hedged. An effective hedge is defined as one whose periodic fair value change is 80% to 125% correlated with the fair value of the hedged item. The difference between a perfect hedge (i.e., one that is 100% correlated) and the actual correlation within the 80% to 125% range is the ineffective portion of the hedge. A failed hedge is one whose correlation falls outside of the 80% to 125% range. The table below presents the net gain related to the ineffective portion of the Company’s fair-value hedges and net gain related to failed hedges at December 31, 2006 (in millions).
Ineffective portion of fair-value hedges(1) | | $ | 9.3 | |
Failed hedges | | 3.5 | |
(1) Includes the changes in value of hedging instruments related to the passage of time, which have been excluded from the assessment of hedge effectiveness.
Other Derivatives
The Company enters into various other derivative contracts that do not qualify for hedge accounting treatment. These derivatives include swaptions, caps and other derivatives, which are used principally as protection against large interest rate movements. Gains and losses on these derivatives are reflected in net realized and unrealized gains (losses) on derivative instruments in the statements of operations and comprehensive income.
14. MINORITY INTEREST IN SUBSIDIARY
In 1998, the Company and XL entered into a joint venture, establishing two Bermuda-domiciled financial guaranty insurance companies: FSA International and XLFA. At December 31, 2004, XL owned a minority interest in FSA International, and the Company owned a minority interest in XLFA. In October 2005, FSA purchased all the preferred shares of FSA International owned by XL Insurance (Bermuda), Ltd. for a cash purchase price of $39.1 million in anticipation of the repatriation of earnings and profits of FSA International. Giving effect to such purchase, FSA International became an indirect, wholly owned subsidiary of the Company. The preferred shares were Cumulative Participating Voting Preferred Shares that, in total, had a minimum fixed dividend of $1.5 million per annum. In 2005 and 2004, FSA International paid preferred dividends of $16.3 million and $7.0 million, respectively, to XL. For the years ended December 31, 2005 and 2004, the Company recognized minority interest of $6.9 million and $7.0 million, respectively.
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15. REINSURANCE
The Company obtains reinsurance to increase its policy-writing capacity on both an aggregate-risk and a single-risk basis; to meet rating agency, internal and state insurance regulatory limits; to diversify risk; to reduce the need for additional capital; and to strengthen financial ratios. The Company reinsures portions of its risks with affiliated (see Note 21) 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 are unable to meet their obligations, or contest such obligations, the Company would be unable to recover such defaulted amounts. A number of FSA’s reinsurers are required to pledge collateral to secure their reinsurance obligations to FSA. Given the financial strengths of its reinsurers, FSA requires collateral from reinsurers primarily to receive statutory credit for the reinsurance, to provide liquidity to FSA in the event of claims on the reinsured exposures, and to enhance rating agency credit for the reinsurance.
Amounts of ceded and assumed business were as follows:
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in thousands) | |
Written premiums ceded | | $ | 288,780 | | $ | 256,087 | | $ | 244,211 | |
Written premiums assumed | | 12,066 | | 9,474 | | 11,567 | |
Earned premiums ceded | | 154,997 | | 150,087 | | 161,733 | |
Earned premiums assumed | | 4,627 | | 3,521 | | 6,608 | |
Losses and loss adjustment expense payments ceded | | 3,486 | | 1,465 | | 52,372 | |
Losses and loss adjustment expense payments assumed | | 8 | | 8 | | 16 | |
| | | | | | | | | | |
| | As of December 31, | |
| | 2006 | | 2005 | |
| | (in thousands) | |
Principal outstanding ceded | | $ | 121,830,282 | | $ | 120,607,468 | |
Principal outstanding assumed | | 3,757,565 | | 2,597,375 | |
Deferred premium revenue assumed | | 31,216 | | 23,777 | |
Losses and loss adjustment expense reserves assumed | | 610 | | 643 | |
| | | | | | | |
16. OTHER ASSETS AND LIABILITIES
The detailed balances that comprise other assets and accrued expenses, other liabilities and minority interest at December 31, 2006 and 2005 are as follows:
| | 2006 | | 2005 | |
| | (in thousands) | |
Other assets: | | | | | |
Fair value of VIE swaps | | $ | 516,762 | | $ | 433,670 | |
Fair value adjustment on CDS | | 89,195 | | 57,372 | |
VIE other invested assets | | 157,810 | | 146,710 | |
Securities purchased under agreements to resell | | 150,000 | | 350,000 | |
Deferred compensation trust | | 114,181 | | 107,140 | |
Tax and loss bonds | | 127,150 | | 105,324 | |
Accrued interest on VIE swaps | | 136,975 | | 108,421 | |
Accrued interest income | | 92,951 | | 76,295 | |
Other assets | | 225,735 | | 271,009 | |
Total other assets | | $ | 1,610,759 | | $ | 1,655,941 | |
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| | 2006 | | 2005 | |
| | (in thousands) | |
Accrued expenses and other liabilities: | | | | | |
Payable for securities purchased | | $ | 33,046 | | $ | 91,529 | |
Deferred compensation trust | | 114,181 | | 107,140 | |
Equity participation plan | | 112,688 | | 116,887 | |
Accrued interest on FP GICs | | 124,856 | | 83,828 | |
Fair-value adjustments on derivatives | | 33,230 | | 61,924 | |
Other liabilities | | 373,413 | | 347,866 | |
Minority interest in VIEs | | 250 | | 180,406 | |
Total accrued expenses, other liabilities and minority interest | | $ | 791,664 | | $ | 989,580 | |
17. COMMITMENTS AND CONTINGENCIES
Effective June 2004, the Company entered into a 21-year sublease agreement with Deutsche Bank AG for office space at 31 West 52nd Street, New York, New York, to be used as the Company’s new headquarters. The Company moved to this new space in June 2005. The lease contains scheduled rent increases every five years after a 19-month rent-free period, as well as lease incentives for initial construction costs of up to $6.0 million, as defined in the sublease. The lease contains provisions for rent increases related to increases in the building’s operating expenses. The lease also contains a renewal option for an additional ten-year period and an option to rent additional office space at various points in the future, in each case at then-current market rents. In addition, the Company and its Subsidiaries lease additional office space under non-cancelable operating leases, which expire at various dates through 2013. Future minimum rental payments are as follows:
Year Ended December 31, | | | | (in thousands) | |
2007 | | | 9,163.6 | | |
2008 | | | 8,217.4 | | |
2009 | | | 8,204.7 | | |
2010 | | | 8,141.2 | | |
2011 | | | 8,125.3 | | |
Thereafter | | | 111,723.1 | | |
Total | | | $ | 153,575.3 | | |
| | | | | | | | |
Rent expense was $10.7 million in 2006, $10.1 million in 2005 and $7.8 million in 2004. Rent expense in 2005 includes a $1.2 million lease termination fee related to the Company’s former headquarters.
In the ordinary course of business, the Company and certain Subsidiaries are parties to litigation. The Company is not a party to any material pending litigation.
On November 15, 2006, the Company received a subpoena from the Antitrust Division of the U.S. Department of Justice (“DOJ”) issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs. On November 16, 2006, FSA received a subpoena from the Securities and Exchange Commission (“SEC”) related to an ongoing industry-wide civil investigation of brokers of municipal GICs. The Company issues municipal GICs through the FP Segment, but does not serve as a GIC broker. The subpoenas request that the Company furnish to the DOJ and SEC records and other information with respect to the Company’s municipal GIC business. The Company is cooperating with the investigations by the DOJ and SEC.
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18. DIVIDENDS AND CAPITAL REQUIREMENTS
Because the majority of the Company’s operations are conducted through FSA, the long-term ability of FSA Holdings to service its debt will largely depend on its receipt of dividends from, or payment on surplus notes by, FSA.
FSA’s ability to pay dividends depends on FSA’s financial condition, results of operations, cash requirements, rating agency capital adequacy and other related factors, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York, FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (a) 10% of policyholders’ surplus as of its last statement filed with the Superintendent of Insurance of the State of New York (the “New York Superintendent”) or (b) adjusted net investment income during this period. FSA paid $140.0 million of dividends in 2006, $87.0 million in 2005 and $30.0 million in 2004. Based upon FSA’s statutory statements for December 31, 2006, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the following 12 months would be approximately $156.6 million.
At December 31, 2006, FSA Holdings held $108.9 million of FSA surplus notes. Payments of principal or interest on such notes may be made only with the approval of the Superintendent of Insurance of the State of New York (the “New York Superintendent”). FSA Holdings employs surplus note purchases in lieu of capital contributions in order to allow it to withdraw funds from FSA through surplus note payments without reducing earned surplus, thereby preserving the dividend capacity of FSA.
FSA may repurchase shares of its common stock from shareholders subject to the New York Superintendent’s approval. The New York Superintendent has approved the repurchase by FSA of up to $500.0 million of its shares from FSA Holdings through December 31, 2008. In 2006, FSA repurchased $100.0 million of shares of its common stock from FSA Holdings and retired such shares.
FSA Holdings paid dividends of $530.0 million in 2006, $71.1 million in 2005 and $22.9 million in 2004.
19. CREDIT ARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES
FSA has a credit arrangement aggregating $150.0 million that is provided by commercial banks and intended for general application to insured transactions. If FSA is downgraded below Aa3 and AA-, the lenders may terminate the commitment and the commitment commission becomes due and payable. If FSA is downgraded below Baa3 and BBB-, any outstanding loans become due and payable. At December 31, 2006, there were no borrowings under this arrangement, which expires on April 21, 2011, if not extended.
FSA has a standby line of credit commitment in the amount of $350.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $350.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $1,328.3 million at December 31, 2006. 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, 2015 and contains an annual renewal provision, commencing April 30, 2008, subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2006.
FSAM has a $100.0 million line of credit with UBS Loan Finance LLC, which expires December 7, 2007, unless extended. This line of credit provides an additional source of liquidity should there be
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unexpected draws on GICs issued by the GIC Affiliates. There were no borrowings under this agreement at December 31, 2006. Borrowings under this agreement are conditioned on FSA having a Triple-A rating by either Moody’s or S&P, and on neither Moody’s nor S&P having issued a rating to FSA below Aa1 or AA+, respectively.
In June 2003, $200.0 million of money market committed preferred trust securities (the “CPS Securities”) were issued by trusts created for the primary purpose of issuing the CPS Securities, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the “Preferred Stock”) of FSA. If FSA were to exercise a put option, the applicable trust would transfer the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, to FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $1.0 million and $1.3 million for 2006 and 2005, respectively, and was recorded within other operating expenses. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts because it does not retain the majority of the residual benefits or expected losses.
Certain FSA Global debt issuances contain provisions that could extend the stated maturities of those notes. To ensure FSA Global will have sufficient cash flow to repay its funding requirements, it has entered into four liquidity facilities with Dexia aggregating $419.4 million.
20. SEGMENT REPORTING
The Company operates in two business segments: financial guaranty and financial products. The financial guaranty segment is primarily in the business of providing financial guaranty insurance on public finance and asset-backed obligations. The FP Segment includes the GIC operations of the Company, which issues GICs to municipalities and other market participants. GICs provide for the return of principal and the payment of interest at pre-specified rates. Reflecting the Company’s management of the VIEs’ operations, the results of the VIEs are included in the FP Segment beginning in 2006. Prior-year disclosures have been reclassified to conform to the 2006 presentation. The following tables summarize the financial information by segment as of and for the years ended December 31, 2006, 2005 and 2004:
| | For the Year Ended December 31, 2006 | |
| | Financial
Guaranty | | Financial
Products | | Intersegment
Eliminations | | Total | |
| | (in thousands) | |
Revenues: | | | | | | | | | | | |
External | | $ | 698,213 | | $ | 992,655 | | | $ | — | | | $ | 1,690,868 | |
Intersegment | | 3,584 | | 20,055 | | | (23,639 | ) | | — | |
Expenses: | | | | | | | | | | | |
External | | (217,019 | ) | (951,021 | ) | | — | | | (1,168,040 | ) |
Intersegment | | (20,055 | ) | (3,584 | ) | | 23,639 | | | — | |
Less: | | | | | | | | | | | |
SFAS 133 fair-value adjustments for CDS and economic interest rate hedges | | 31,823 | | 10,257 | | | — | | | 42,080 | |
Pre-tax segment operating earnings | | 432,900 | | 47,848 | | | — | | | 480,748 | |
Segment assets | | $ | 7,160,055 | | $ | 18,934,942 | | | $ | (321,371 | ) | | $ | 25,773,626 | |
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| | For the Year Ended December 31, 2005 | |
| | Financial
Guaranty | | Financial
Products | | Intersegment
Eliminations | | Total | |
| | (in thousands) | |
Revenues: | | | | | | | | | | | |
External | | $ | 682,503 | | $ | 298,732 | | | $ | — | | | $ | 981,235 | |
Intersegment | | 3,947 | | 28,162 | | | (32,109 | ) | | — | |
Expenses: | | | | | | | | | | | |
External | | (192,906 | ) | (323,258 | ) | | — | | | (516,164 | ) |
Intersegment | | (28,162 | ) | (3,947 | ) | | 32,109 | | | — | |
Plus: | | | | | | | | | | | |
Equity in earnings and minority interest in International | | (5,980 | ) | — | | | — | | | (5,980 | ) |
Less: | | | | | | | | | | | |
SFAS 133 fair-value adjustments for CDS and economic interest rate hedges | | 11,106 | | (18,962 | ) | | — | | | (7,856 | ) |
Pre-tax segment operating earnings | | 448,296 | | 18,651 | | | — | | | 466,947 | |
Segment assets | | $ | 6,881,422 | | $ | 15,585,118 | | | $ | (464,898 | ) | | $ | 22,001,642 | |
| | For the Year Ended December 31, 2004 | |
| | Financial
Guaranty | | Financial
Products | | Intersegment
Eliminations | | Total | |
| | (in thousands) | |
Revenues: | | | | | | | | | | | |
External | | $ | 679,194 | | $ | 469,075 | | | $ | — | | | $ | 1,148,269 | |
Intersegment | | 4,855 | | 24,800 | | | (29,655 | ) | | — | |
Expenses: | | | | | | | | | | | |
External | | (193,390 | ) | (374,365 | ) | | — | | | (567,755 | ) |
Intersegment | | (24,800 | ) | (4,855 | ) | | 29,655 | | | — | |
Plus: | | | | | | | | | | | |
Equity in earnings and minority interest in International | | (10,287 | ) | — | | | — | | | (10,287 | ) |
Less: | | | | | | | | | | | |
SFAS 133 fair-value adjustments for CDS and economic interest rate hedges | | 56,391 | | 106,500 | | | — | | | 162,891 | |
Pre-tax segment operating earnings | | 399,181 | | 8,155 | | | — | | | 407,336 | |
Segment assets | | $ | 6,658,094 | | $ | 11,178,330 | | | $ | (755,416 | ) | | $ | 17,081,008 | |
The following tables present reconciliations of segments’ pre-tax operating earnings to net income.
| | For the Year Ended December 31, 2006 | |
| | Financial
Guaranty | | Financial
Products | | Intersegment
Eliminations | | Total | |
| | (in thousands) | |
Pre-tax operating earnings | | $ | 432,900 | | | $ | 47,848 | | | | $ | — | | | $ | 480,748 | |
SFAS 133 fair-value gain (loss) for CDS and economic interest rate hedges | | 31,823 | | | 10,257 | | | | — | | | 42,080 | |
Taxes | | — | | | — | | | | — | | | (150,680 | ) |
Minority interest | | — | | | — | | | | — | | | 52,006 | |
Net income | | — | | | — | | | | — | | | $ | 424,154 | |
| | | | | | | | | | | | | | | | | |
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| | For the Year Ended December 31, 2005 | |
| | Financial
Guaranty | | Financial
Products | | Intersegment
Eliminations | | Total | |
| | (in thousands) | |
Pre-tax operating earnings | | $ | 448,296 | | $ | 18,651 | | | $ | — | | | $ | 466,947 | |
SFAS 133 fair-value gain (loss) for CDS and economic interest rate hedges | | 11,106 | | (18,962 | ) | | — | | | (7,856 | ) |
Taxes | | — | | — | | | — | | | (128,900 | ) |
Minority interest | | — | | — | | | — | | | (4,083 | ) |
Net income | | — | | — | | | — | | | $ | 326,108 | |
| | | | | | | | | | | | | | | |
| | For the Year Ended December 31, 2004 | |
| | Financial
Guaranty | | Financial
Products | | Intersegment
Eliminations | | Total | |
| | (in thousands) | |
Pre-tax operating earnings | | $ | 399,181 | | $ | 8,155 | | | $ | — | | | $ | 407,336 | |
SFAS 133 fair-value gain (loss) for CDS and economic interest rate hedges | | 56,391 | | 106,500 | | | — | | | 162,891 | |
Taxes | | — | | — | | | — | | | (111,160 | ) |
Minority interest | | — | | — | | | — | | | (80,460 | ) |
Net income | | — | | — | | | — | | | $ | 378,607 | |
| | | | | | | | | | | | | | | |
The intersegment assets consist of intercompany notes issued by FSA and held within the FP Investment Portfolio. The intersegment revenues and expenses relate to interest income and interest expense on intercompany notes and premiums paid by FSA Global on FSA-insured notes.
The amount of SFAS 133 fair-value adjustments for CDS is a reconciling item between pre-tax segment operating earnings and net income. In addition, management subtracts the impact of economic interest rate hedges when analyzing the segments. By removing the effect of the one-sided accounting caused by marking the derivatives to fair value, but not the hedged assets or liabilities, the measure will more closely reflect the underlying performance of segment operations.
21. RELATED PARTY TRANSACTIONS
The table below summarizes amounts included in the financial statements and outstanding exposures resulting from various types of transactions executed with related parties:
| | As of December 31, | |
| | 2006 | | 2005 | |
| | (in millions) | |
XL(1) | | | | | |
Prepaid reinsurance | | $ | 109.7 | | $ | 84.4 | |
Reinsurance recoverable for unpaid losses | | 3.2 | | 1.8 | |
Dexia(2) | | | | | |
Other assets(3) | | 353.4 | | 320.4 | |
Deferred premium revenue | | 18.2 | | 22.5 | |
Variable interest entities debt | | 181.8 | | 172.1 | |
Gross par outstanding | | 17,034.4 | | 22,846.6 | |
Other liabilities | | 2.1 | | 2.3 | |
| | | | | | | | |
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| | For the Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
| | (in millions) | |
XL(1) | | | | | | | |
Ceded premiums | | $ | 46.1 | | $ | 31.6 | | $ | 35.2 | |
Dividends paid | | — | | 16.3 | | 7.0 | |
Dexia(2) | | | | | | | |
Gross premiums earned | | 26.4 | | 29.5 | | 29.3 | |
Derivative (gains/losses) | | (7.3 | ) | (2.7 | ) | 104.0 | |
Variable interest entities net interest expense | | 9.8 | | 9.3 | | 8.8 | |
| | | | | | | | | | |
(1) The Company ceded business to XL Capital Ltd. (“XL”), a major Bermuda-based insurance holding company that owned an interest in FSA International prior to October 2005. The Company maintains an investment in XLFA, an indirect subsidiary of XL.
(2) Represents business with affiliates of Dexia.
(3) Represents primarily derivative fair-value adjustments and accrued interest.
FSA Global maintains liquidity facilities with Dexia (see Note 19).
22. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company determines fair value 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.
For bonds and equity securities in the General Investment Portfolio and the FP Segment Investment Portfolio, the carrying amount represents fair value. The fair value is generally based on quoted market price or, in the case of the Company’s investment in XLFA, redemption value.
For short-term investments, including the FP short-term investment portfolio and the VIE short-term investments, the carrying amount approximates fair market value due to the short maturity of the instruments.
For cash, receivable for investments sold, and payable for investments purchased, the carrying amount is cost, which approximates fair value because of the short maturity of these instruments.
For assets acquired under refinancing transactions, each asset’s fair value is either the present value of expected cash flows or a quoted market price as of the reporting date.
For deferred premium revenue, net of prepaid reinsurance premiums, the carrying amount represents the Company’s future premium revenue, net of reinsurance, on policies where the premium was received at inception. The fair value of deferred premium revenue, net of prepaid reinsurance premiums, is an estimate of the statutory premiums that would be paid under a reinsurance agreement with a third party to transfer the Company’s financial guaranty risk, net of the premiums retained by the Company to compensate it for originating and servicing the insurance contract.
For notes payable, the carrying amount represents the principal amount due at maturity. The fair value is based on the quoted market price or other third party sources.
For installment premiums, consistent with industry practice, there is no carrying amount. Similar to the treatment of deferred premium revenue, the fair value of installment premiums is the estimated present value of the future contractual premium revenues that would be received from reinsurers assuming
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the Company’s financial guaranty risk, net of the premium retained by the Company to compensate it for originating and servicing the insurance contract.
For GICs and VIE debt, the fair value is the present value of the expected cash flows as of the reporting date.
For losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses, the carrying amount is equal to the present value of the expected cash flows for specifically identified claims plus statistical losses representing the inherent losses in the Company’s insured portfolio. Management believes the carrying amount is a reasonable proxy for fair value.
For fair-value adjustments on derivatives, the carrying amount represents fair value. The Company uses quoted market prices when available, but if quoted market prices are not available, management uses internally developed estimates.
The table below shows the carrying amount and fair value of the Company’s financial instruments:
| | As of December 31, 2006 | | As of December 31, 2005 | |
| | Carrying
Amount | | Fair Value | | Carrying
Amount | | Fair Value | |
| | (in thousands) | |
Assets: | | | | | | | | | |
Bonds | | $ | 4,721,512 | | $ | 4,721,512 | | $ | 4,382,037 | | $ | 4,382,037 | |
Equity securities | | 54,325 | | 54,325 | | 54,370 | | 54,370 | |
Short-term investments | | 96,578 | | 96,578 | | 159,133 | | 159,133 | |
FP Segment bond portfolio | | 16,757,979 | | 16,757,979 | | 12,983,816 | | 12,983,816 | |
FP Segment short-term investment portfolio | | 659,704 | | 659,704 | | 1,018,183 | | 1,018,183 | |
Cash | | 32,471 | | 32,471 | | 43,629 | | 43,629 | |
Assets acquired in refinancing transactions | | 337,872 | | 333,389 | | 467,873 | | 460,770 | |
Fair-value adjustments for derivatives | | 616,179 | | 616,179 | | 494,490 | | 494,490 | |
Receivable for investments sold | | 161 | | 161 | | 1,382 | | 1,382 | |
Liabilities: | | | | | | | | | |
Deferred premium revenue, net of prepaid reinsurance premiums | | 1,648,334 | | 1,449,526 | | 1,509,867 | | 1,295,312 | |
Losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses | | 190,780 | | 190,780 | | 169,379 | | 169,379 | |
GIC and VIE debt | | 18,349,665 | | 19,155,018 | | 14,947,118 | | 15,185,891 | |
Notes payable | | 730,000 | | 726,117 | | 430,000 | | 423,904 | |
Fair-value adjustments for derivatives | | 40,215 | | 40,215 | | 61,924 | | 61,924 | |
Payable for investments purchased | | 33,046 | | 33,046 | | 91,529 | | 91,529 | |
Off-balance-sheet instruments: | | | | | | | | | |
Installment premiums | | — | | 450,215 | | — | | 438,109 | |
| | | | | | | | | | | | | |
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23. STATUTORY ACCOUNTING PRACTICES
GAAP differs in certain significant respects from statutory accounting practices, applicable to insurance companies, that are prescribed or permitted by insurance regulatory authorities. The principal differences result from the following statutory accounting practices:
· upfront premiums are earned when related principal and interest have expired rather than earned over the expected period of coverage;
· acquisition costs are charged to operations as incurred rather than over the period that related premiums are earned;
· a contingency reserve (rather than a non-specific 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;
· deferred tax assets are generally admitted to the extent reversals of existing temporary differences in the subsequent year can be recovered through carryback;
· insured CDS are accounted for as insurance contracts rather than as derivative contracts recorded at fair value;
· bonds are carried at amortized cost rather than fair value;
· VIEs and refinancing vehicles are not consolidated;
· surplus notes are recognized as surplus rather than as a liability unless approved for repayment; and
· non-insurance company subsidiaries do not prepare accounts applying statutory accounting standards.
Consolidated statutory net income was $339.6 million for 2006, $293.0 million for 2005 and $242.1 million for 2004. Statutory surplus plus contingency reserves totaled $2,554.1 million for 2006, $2,417.5 million for 2005 and $2,280.9 million for 2004.
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24. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
| | First | | Second | | Third | | Fourth | | Full Year | |
| | (in thousands) | |
2006 | | | | | | | | | | | |
Net premiums written | | 88,732 | | 150,996 | | 125,655 | | 161,794 | | 527,177 | |
Net premiums earned | | 94,495 | | 98,461 | | 91,755 | | 103,998 | | 388,709 | |
Net investment income | | 53,046 | | 53,254 | | 55,403 | | 57,147 | | 218,850 | |
Net interest income from financial products segment | | 176,289 | | 207,522 | | 226,713 | | 251,248 | | 861,772 | |
Net realized and unrealized gains (losses) on derivative instruments | | 58,105 | | 74,478 | | (30,200 | ) | 60,663 | | 163,046 | |
Losses and loss adjustment expenses | | 3,285 | | 7,899 | | 5,159 | | 6,960 | | 23,303 | |
Policy acquisition costs | | 16,210 | | 14,421 | | 14,103 | | 18,278 | | 63,012 | |
Net interest expense from financial products segment | | 155,660 | | 180,983 | | 203,811 | | 228,129 | | 768,583 | |
Other operating expenses | | 31,304 | | 19,967 | | 27,842 | | 45,509 | | 124,622 | |
Income before income taxes and minority interest | | 146,464 | | 131,525 | | 121,293 | | 123,546 | | 522,828 | |
Net income | | $ | 130,205 | | $ | 109,720 | | $ | 91,479 | | $ | 92,750 | | $ | 424,154 | |
2005 | | | | | | | | | | | |
Net premiums written | | 109,502 | | 143,916 | | 160,918 | | 163,358 | | 577,694 | |
Net premiums earned | | 94,881 | | 96,254 | | 116,832 | | 96,092 | | 404,059 | |
Net investment income | | 49,446 | | 50,404 | | 50,696 | | 50,281 | | 200,827 | |
Net interest income from financial products segment | | 85,351 | | 95,250 | | 143,768 | | 163,547 | | 487,916 | |
Net realized and unrealized gains (losses) on derivative instruments | | (70,812 | ) | 18,179 | | (42,431 | ) | (77,411 | ) | (172,475 | ) |
Losses and loss adjustment expenses | | 3,984 | | 6,238 | | 10,185 | | 4,958 | | 25,365 | |
Policy acquisition costs | | 15,408 | | 16,198 | | 20,247 | | 16,487 | | 68,340 | |
Net interest expense from financial products segment | | 100,642 | | 94,353 | | 144,135 | | 152,510 | | 491,640 | |
Other operating expenses | | 27,009 | | 23,868 | | 20,151 | | 22,586 | | 93,614 | |
Income before income taxes, minority interest and equity in losses of unconsolidated affiliates | | 82,231 | | 235,832 | | 97,136 | | 49,872 | | 465,071 | |
Net income | | $ | 63,156 | | $ | 129,307 | | $ | 73,811 | | $ | 59,834 | | $ | 326,108 | |
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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
There have been no changes in, or any disagreements with, accountants on accounting and financial disclosure within the two years ended December 31, 2006.
Item 9A. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, completed an evaluation of the effectiveness of design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of December 31, 2006. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that as of such date the Company’s disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the rules and forms of the Securities and Exchange Commission (the “SEC”), and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, in a manner that allows timely decisions regarding required disclosure.
Remediation of Material Weakness
As disclosed in the Company’s amended annual report on Form 10-K/A for the year ended December 31, 2004, filed December 19, 2005, management of the Company had determined that, based on its evaluation and because of the material weakness in internal control over financial reporting discussed below, as of such date the Company’s disclosure controls and procedures were ineffective. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Management of the Company has addressed the reported material weakness as discussed below, and has concluded that this material weakness in internal control over financial reporting has been remediated as of December 31, 2006.
Management concluded that the Company did not maintain effective controls to ensure that hedge accounting was correctly applied pursuant to generally accepted accounting principles as of December 31, 2005. Specifically, the Company’s accounting documentation for certain hedging relationships did not meet the requirements of Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and related interpretations and the Company incorrectly applied the short-cut method of hedge accounting to certain other hedge relationships. This control deficiency resulted in the restatement of the Company’s Consolidated Financial Statements for the years ended December 31, 2004, 2003 and 2002, the periods ended March 30, June 30, September 30 and December 31, 2003 and 2004 and opening retained earnings at January 1, 2002. In addition, this control deficiency could result in a misstatement of interest income and expense from financial products and variable interest entities, net realized and unrealized gains and losses on derivative instruments, income from assets acquired in refinancing transactions and related accounts and disclosures that would cause a material misstatement in the annual and interim financial statements. Accordingly, management determined that this control deficiency constituted a material weakness in internal control over financial reporting as of December 31, 2004.
To remediate the material weakness, the Company:
· revised the Company’s accounting documentation of policies and procedures and review to meet the standard of hedge documentation expected under SFAS 133;
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· applied such standard to certain liabilities effective January 1, 2006; and
· strengthened the Company’s internal knowledge base regarding hedge accounting through improved training designed to ensure that all relevant personnel understand and apply hedge accounting in compliance with SFAS 133.
Based upon the actions taken and the results of its testing and evaluation of the effectiveness of the controls, management has concluded that the material weakness described above has been remediated as of December 31, 2006.
Changes in Internal Control over Financial Reporting
Other than as described above, there has been no change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) or 15d-15(f) under the Exchange Act) during the year ended December 31, 2006 that has materially affected, or that is reasonably likely to materially affect, the Company’s internal control over financial reporting.
There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. The Company will continue to improve the design and effectiveness of its disclosure controls and procedures and internal control over financial reporting to the extent necessary in the future to provide management with timely access to such material information and to correct any deficiencies that may be discovered in the future.
Item 9B. Other Information.
None.
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PART III
Item 10. Directors and Executive Officers of the Registrant.
Directors
On May 18, 2006, the Company’s shareholders appointed twelve directors to serve until the later of the Company’s next annual meeting of shareholders or until their successors have been duly elected and qualified. Information about the directors as of December 31, 2006 is set forth below and in “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters—Directors and Executive Officers.”
Robert P. Cochran | | Chairman of the Board of Directors of the Company since |
Age 57 | | November 1997, and Chief Executive Officer and a Director of the Company since August 1990. Mr. Cochran served as President of the Company and FSA from August 1990 until November 1997. He has been Chief Executive Officer of FSA since August 1990, Chairman of FSA since July 1994, and a director of FSA since July 1988. Prior to joining the Company in 1985, Mr. Cochran was Managing Partner of the Washington, D.C. office of the Kutak Rock law firm. Mr. Cochran is a Director of White Mountains Insurance Group, Ltd. |
Bruno Deletré | | Director of the Company since September 2001. In January 2007, |
Age 45 | | Mr. Deletré became a member of the Management Board of Dexia. In January 2006, he became an Executive Vice President and member of the Executive Committee of Dexia. Mr. Deletré was a member of the Executive Board of Dexia Crédit Local from 2001 through January 2006 and Managing Director from December 2003. Prior to that time, he held various positions in the French Ministry of Finance—Treasury, and served as Advisor to the French Minister of Economy and Finance from 1995 to 1997. Mr. Deletré is a member of the Board of Directors of several banking subsidiaries of Dexia Crédit Local and of the Board of Directors of Dexia Asset Management. |
Robert N. Downey | | Director of the Company since August 1994. Mr. Downey has been a |
Age 71 | | Senior Director of Goldman Sachs & Co. since 1999, a Limited Partner from 1991 to 1999, and a General Partner from 1976 until 1991. At Goldman, Sachs & Co., Mr. Downey served as head of the Municipal Bond Department and Vice Chairman of the Fixed Income Division. Mr. Downey was a Director of the Securities Industry Association from 1987 through 1991 and served as its Chairman in 1990 and Vice Chairman in 1988 and 1989. He was also formerly Chairman of the Municipal Securities Division of the Public Securities Association and Vice Chairman of the Municipal Securities Rulemaking Board. |
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Jacques Guerber | | Director of the Company since September 2002. In January 2006, |
Age 57 | | Mr. Guerber became Vice Chairman of the Management Board of Dexia, a Member of the Management Boards of Dexia Crédit Local, Dexia Banque Belgique S.A., and Dexia Banque Internationale a Luxembourg. He has been a Member of the Supervisory Board of Financiere Centuria since January 2002, a Director of Credit du Nord since February 2000, and Chairman of the Supervisory Board of Dexia Municipal Agency since August 1999. Mr. Guerber was Chairman of the Executive Board of Dexia Crédit Local from 2000 through January 2006, and a member of the Executive Committee of Dexia from December 1999 to January 2006. Prior to then he was Senior Executive Vice President of Crédit Local de France (subsequently known as Dexia Crédit Local) from 1996 and a member of that company’s Management Board from 1988. Earlier, he held management positions in the Local Development Division of Caisse des Dépôts et Consignations. |
Rembert von Lowis | | Director of the Company since July 2000. Mr. von Lowis has been a |
Age 53 | | Member of the Management Board of Dexia since October 1996 and of the Management Board of Dexia Credit Local since January 2006. He became Senior Executive Vice President of Crédit Local de France in 1993. Mr. von Lowis joined Crédit Local de France as Chief Financial Officer and a Member of its Executive Board in 1988. Earlier, he held management positions in the Local Development Division in Caisse des Dépôts et Consignations and the Local Authorities Department of the French Ministry of Interior. |
Séan W. McCarthy | | Director of the Company since February 1999. Mr. McCarthy has been |
Age 47 | | President and Chief Operating Officer of the Company since January 2002, and prior to that time served as Executive Vice President of the Company since November 1997. He has been President of FSA since November 2000, and served as Chief Operating Officer of FSA from November 1997 until November 2000. Mr. McCarthy was named a Managing Director of FSA in March 1989, head of its Financial Guaranty Department in April 1993 and Executive Vice President of FSA in October 1999. He has been a director of FSA since September 1993. Prior to joining FSA in 1988, Mr. McCarthy was a Vice President of PaineWebber Incorporated. |
Axel Miller | | Director of the Company since February 2006. Mr. Miller obtained his law |
Age 42 | | degree, a Licence en droit, from the Université Libre de Bruxelles. After having worked for 14 years as a lawyer specialized in finance law, mergers & acquisitions and international commercial law, Mr. Miller joined the Dexia Group in 2001 as General Counsel. He became a member of the Management Board of Dexia Bank in January 2002 and Chairman of the Management Board of Dexia Bank and Head of Personal Financial Services at Group level in January 2003. On January 1, 2006, Mr. Miller became CEO and Chairman of the Management Board of Dexia. He is also a Director of several Dexia Group companies, Crédit du Nord and LVI Holding (Groupe Carmeuse). |
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James H. Ozanne | | Director of the Company since September 2004. Mr. Ozanne previously |
Age 63 | | served on the Board of Directors of the Company from January 1990 through May 2003, when he became Chief Executive Officer of SPS Holding Corp., a mortgage servicing holding company in which the Company owned a minority interest, a position he held until September 2004. He served as Vice Chairman of the Board of Directors of the Company from May 1998 until July 2000. Mr. Ozanne is Chairman of Greenrange Partners. He was Chairman of Source One Mortgage Services Corporation, which was a subsidiary of White Mountains (“Source One”), from March 1997 to May 1999, Vice Chairman of Source One from August 1996 until March 1997, and a director of Source One from August 1996 to May 1999. He was Chairman and Director of Nations Financial Holdings Corporation from January 1994 to January 1996. He was President and Chief Executive Officer of U S WEST Capital Corporation (“USWCC”) from September 1989 until December 1993. Prior to joining USWCC, Mr. Ozanne was Executive Vice President of General Electric Capital Corporation. Mr. Ozanne is currently a director of Distributed Energy Services Corp. He was Chairman of PECO Pallet, a privately owned grocery pallet rental company, from 2000 to 2006. |
Roger K. Taylor | | Director of the Company since February 1995. Mr. Taylor was a part-time |
Age 55 | | employee of the Company and Vice Chairman of FSA from January 2002 until his retirement in July 2004. Mr. Taylor served as Chief Operating Officer of the Company from May 1993 through December 2001 and President of the Company from November 1997 through December 2001. Mr. Taylor joined FSA in January 1990, and served FSA as its President from November 1997 until November 2000, a director since January 1992 and a Managing Director since January 1991. Prior to joining FSA, Mr. Taylor was Executive Vice President of Financial Guaranty Insurance Company. |
Xavier de Walque | | Director of the Company since May 2006. In 2006, Mr. de Walque became |
Age 42 | | a member of the Management Board of Dexia S.A. From 2004 to 2006, he was chief financial officer and a member of the management board of Dexia Bank Belgium.Mr. de Walque joined Dexia S.A. in 2001 as Head of Mergers and Acquisitions; from 2003 to 2004 he was Deputy Chief Financial Officer. Prior to then he was responsible for Corporate Finance at Compagnie Benelux Paribas (“Cobepa”) from 1991 to 2001, serving on the Management Board of Cobepa from 1997 and as head of Belgian Corporate Finance at BNP Paribas from 1999. Mr. de Walque was an advisor in the cabinet of the Deputy Prime Minister and the Budget Ministry of Belgium between 1988 and 1990. Xavier de Walque is chairman of the Board of Directors and member of the audit committee of Dexia Insurance Belgium. |
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George U. Wyper | | Director of the Company since September 2004. Mr. Wyper is the founder |
Age 51 | | and managing member of Wyper Capital Management, L.P., which he founded in 1998. He was Senior Managing Director and a member of the Operating Committee of Warburg Pincus Counsellors, Inc from 1994 to 1998. He served as Chief Investment Officer of White River Corporation from 1991 to 1994 and as President and Chief Executive Officer of Hanover Advisors from 1992 to 1994. Prior to 1991, he was Chief Investment Officer of Fund American Enterprises from 1988 to 1990 and Director of Fixed Income Investments for Fireman’s Fund Insurance Company from 1987 to 1988. Mr. Wyper serves on the boards of the Yale School of Management, the American Numismatic Society and the Museum of Rhode Island School of Design. |
On February 15, 2007, the Board of Directors elected Michèle Colin to the Board of Directors. Information about Ms. Colin is set forth below and in “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters—Directors and Executive Officers.”
Michèle Colin | | Director of the Company since February 2007. In January 2006, Ms. Colin |
Age 53 | | became the Head of Risk Management of Dexia Crédit Local. Ms. Colin was previously the Dexia Crédit Local Compliance Officer from September 2005 to September 2006. Ms. Colin joined Dexia Crédit Local in 1997 as Deputy Head of the Credit Risk Management Department, becoming the Deputy Head of Human Resources in 2001. Prior to joining Dexia, she served as a civil servant as Deputy Head of the Financing and Planning Department of the City of Paris. Ms. Colin is on the Board of Directors of Dexia Crédit Local. |
Executive Officers of the Company
In addition to Messrs. Cochran and McCarthy (who are described above under the caption “Directors”), the Company’s other executive officers are described below. The Company’s executive officers consist of the members of the Executive Management Committee.
Name | | | | Age | | Position |
Russell B. Brewer II | | | 51 | | | Managing Director of the Company and FSA; Chief Risk Management Officer and Director of FSA |
Joseph W. Simon | | | 48 | | | Managing Director and Chief Financial Officer of the Company and FSA; Director of FSA |
Bruce E. Stern | | | 54 | | | Managing Director, General Counsel and Secretary of the Company and FSA; Director of FSA |
The present principal occupation and five-year employment history of each of the above-named executive officers of the Company, as well as other directorships of corporations currently held by each such person, are set forth below.
Mr. Brewer has been a Managing Director of FSA since March 1989 and the Chief Risk Management Officer of FSA since September 2003. Mr. Brewer was the Chief Underwriting Officer of FSA from September 1990 until September 2003. He has been a Managing Director of the Company since May 1999 and a director of FSA since September 1993. From March 1989 to August 1990, Mr. Brewer was Managing Director, Asset Finance Group, of FSA. Prior to joining FSA in 1986, Mr. Brewer was an Associate Director of Moody’s Investors Service, Inc.
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Mr. Simon was elected a Managing Director and the Chief Financial Officer of the Company and FSA in September 2002, having served in such capacity since April 2002. Prior to joining the Company, Mr. Simon was Chief Financial Officer of Intralinks, a technology company serving the financial markets. From 1993 to 1999, he was a senior financial officer, last serving as the Chief Financial Officer, of Cantor Fitzgerald. From 1986 to 1993 he was a senior member of Morgan Stanley’s controller department. Mr. Simon, a certified public accountant, began his professional career at Price Waterhouse in 1983.
Mr. Stern has been a Managing Director, the Secretary and the General Counsel of the Company since April 1993. Since April 1993, he has been the Secretary of FSA, and since March 1989, he has been a Managing Director of FSA. He has been a director of FSA since August 1990. Prior to joining FSA as General Counsel in 1987, Mr. Stern was an attorney with Cravath, Swaine & Moore.
Audit Committee
The Company has a separately designated standing Audit Committee established in accordance with Section 3(a)(58)(A) of the Exchange Act. During January 2005, the Audit Committee consisted of Mr. Ozanne (Chairman), David Maxwell and Mr. Wyper. In February 2006, Mr. Taylor was elected to the Audit Committee and Mr. Maxwell ceased to be a member of the Committee. Mr. Maxwell left the Board of Directors in May 2006.
All members of the Audit Committee are independent within the meaning of Rule 10A-3(a)(b)(1) of the Exchange Act. Because the Company has only debt securities listed on the NYSE, it is not subject to the additional independence standards for directors imposed by the NYSE.
The Board of Directors of the Company has determined that Audit Committee members James H. Ozanne and George U. Wyper are audit committee financial experts as defined by item 407(d)(5) of Regulation S-K of the Exchange Act.
Code of Ethics
The Company has adopted a code of ethics for directors, officers (including the Company’s principal executive officer, principal financial officer, and principal accounting officer and controller) and employees, known as the Code of Conduct. The Company has posted its Code of Conduct on its Internet website, www.fsa.com. The Company intends to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding amendments to, or waivers from, provisions of its code of ethics that applies to its principal executive officer, principal financial officer and principal accounting officer and controller, or persons performing similar functions, and that relates to any element of the code of ethics definition enumerated in paragraph (b) of Item 406 of Regulation S-K of the Exchange Act, by posting such information on its website, www.fsa.com.
Nomination of Directors
Holders of the Company’s registered debt securities are not entitled to recommend nominees to the Company’s Board of Directors.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16 of the Exchange Act requires periodic reporting by beneficial owners of more than 10% of any equity security registered under Section 12 of the Exchange Act and directors and executive officers of issuers of such equity securities. Upon its merger with a subsidiary of Dexia in July 2000, the Company’s common stock ceased to be registered under Section 12 of the Exchange Act or listed on the NYSE. Consequently, the reporting obligations of Section 16 of the Exchange Act do not apply.
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Item 11. Executive Compensation.
Compensation Discussion and Analysis
The Company’s compensation program has been designed to attract, motivate and retain employees while, at the same time, aligning the interests of the Company’s employees with those of the Company’s shareholders. The Company’s compensation program was established in substantially its current form in 1994, in connection with the initial public offering by the Company. When the Company was acquired by Dexia in 2000, the acquisition documents expressly provided for continuation of the Company’s existing compensation programs through 2004, with specified changes to the compensation program to reflect the fact that the Company’s shares were no longer publicly traded. In 2004, the Human Resources Committee (the “HR Committee”) of the Board of Directors of the Company reviewed the Company’s compensation program with the advice of the HR Committee’s independent compensation consultants, Hewitt Associates, and on the basis of that advice determined to continue the Company’s compensation program with only minor changes, concluding that the existing program was successful in achieving its intended purposes.
Compensation Philosophy
The objectives underlying the Company’s compensation program include the following:
· The Company seeks to attract and retain quality employees at all levels of the organization. To this end, the HR Committee has maintained a general target of compensating the Company’s employees within the 75th percentile of overall compensation provided by the Company’s industry peers.
· The Company seeks to align the interests of employees with those of the Company’s parent and, specifically, to motivate employees to grow the value and earnings of the Company. To this end, the Company employs measures of value and earnings generation in determining annual and longer term compensation.
· The Company seeks to have its employees take a long term view of the Company’s business and the risks that the Company underwrites. To this end, higher ranking employees of the Company receive a high percentage of their overall compensation in the form of incentive compensation that pays out based upon the Company’s performance over three to four year periods.
Measures of Value Creation Underlying the Company’s Compensation Program
The Company measures its overall success on the basis of a number of factors, including growth in adjusted book value (“ABV”) per share and growth in book value per share (adjusted as described below). See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Operating Earnings and Adjusted Book Value” for a discussion of these measures. ABV and book value growth are measures of value creation. ABV growth emphasizes new business production, since it captures the present value of insurance premiums and financial products net interest margin originated during a specified period. Book value growth emphasizes operating earnings, can be considerably more volatile than ABV growth, and will, for example, be more influenced by negative events such as increases in loss reserves. In applying these measures for compensation purposes, certain aspects of GAAP are eliminated that, in the view of management and the Board of Directors, distort the Company’s economic results, most notably the impact of (i) marking to market investment grade FSA-insured credit default swaps under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and (ii) not applying hedge accounting treatment for economic hedges under SFAS 133. See “Item 5. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Operating Earnings and Adjusted Book
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Value.” The Growth in ABV and book value are applied on a per share basis. In order to incentivize management to return capital to the Company’s shareholders to the extent such capital is not being deployed, the calculation of the rate of growth per share is adjusted to offset the effects of dividends and capital contributions, which do not affect the number of shares outstanding.
Components of Compensation Provided by the Company
The Company’s compensation program includes the following basic elements (described in more detail below): (i) salary; (ii) cash bonus; (iii) equity compensation in the form of performance share units under the Corporation’s 2004 Equity Compensation Plan (the “2004 Equity Plan”); (iv) health and other predominately customary benefit plans; and (v) optional participation in Employee Share Plans sponsored by Dexia S.A. In addition, the Company has employment agreements with its two most senior executive officers. The Company’s compensation program is designed, in part, upon the “Wall Street” model. For the more highly compensated employees within the Company, equity compensation represents the largest component of compensation, followed by cash bonus and salary.
Salaries
Employee salaries are generally established on the basis of competitive market standards, and are thereafter generally changed to reflect cost of living adjustments and changes in responsibility.
Cash Bonuses
Cash bonuses are paid on an annual basis out of a bonus pool (the “Bonus Pool”) determined pursuant to a guideline formula intended to provide employees with a percentage of the growth in value in the Company during the preceding calendar year. In establishing this guideline, the HR Committee recognized that non-distributed Bonus Pool amounts from prior years may to a limited extent be accumulated and memorialized in future years for purposes of supplementing the guideline Bonus Pool for future years. The Committee also recognized that adjustments to the Bonus Pool guideline may be recommended by management, subject to approval of the HR Committee, to reflect changes in circumstances. Notwithstanding the Bonus Pool guideline, bonuses remain within the discretion of the HR Committee, except insofar as otherwise provided in the Company’s employment agreements. Specifically, aggregate bonuses in any year may be more or less than the guideline Bonus Pool for that year, and individual employee bonuses are not directly tied to the guideline Bonus Pool, except insofar as provided in the Company’s employment agreements.
The current Bonus Pool Guideline (approved by the HR Committee in November 2004) provides for an annual Bonus Pool equal to a predetermined percentage (the “Specified Percentage”) of the increase in ABV of the Company during the applicable year (as derived from the Company’s IFRS financial statements), excluding unrealized gains and losses on investments, net of tax, and excluding the mark-to-market, net of tax, of investment grade credit derivatives, but including a transaction return on equity (“Transaction ROE”) modifier described below. ABV growth is considered by management and the HR Committee as a proxy for value creation. For the 2004 Bonus Pool, the HR Committee set the Specified Percentage at 11.25%. The increase in ABV during the applicable year is equal to (a) the percentage growth in ABV per share during such year, with credit given for dividends paid, multiplied by (b) ABV as of the beginning of such year. The HR Committee retained the right to evaluate the Bonus Pool formula annually; however, the intent was to maintain the Bonus Pool formula as long as practicable to promote stability. Since 2004, the Specified Percentage has remained unchanged.
The Transaction ROE modifier adjusts downward the percentage growth in ABV per share if the Transaction ROE achieved in the aggregate for all transactions insured during the applicable year (the “Actual Average Transaction ROE”) is less than the “Target Transaction ROE,” with a maximum
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adjustment of 2%. The Actual Average Transaction ROE is a measure of the return on equity expected from transactions insured and GICs written by the Company during a specified period, based upon the Company’s internal proprietary capital model. The “Target Transaction ROE” equals the after-tax book yield on the Company’s investment portfolio (excluding the investment portfolios for financial products, variable interest entities and refinanced transactions) (determined as of the December 31 immediately preceding the compensation year) plus 9%, with a maximum Target Transaction ROE of 15%. In the event that the Actual Average Transaction ROE is less than the Target Transaction ROE for any year, then percentage growth in ABV per share for such year is reduced by an amount equal to ½ the excess of the Target Transaction ROE (expressed as a percentage) over the Actual Average Transaction ROE (expressed as a percentage), subject to a maximum reduction of 2%. The Transaction ROE modifier was intended to motivate management to use the Company’s capital prudently in building ABV per share. The HR Committee concluded that 9% over the Company’s insurance company investment portfolio yield represented a reasonable target for aggregate transaction returns under the Company’s internal capital model based upon the historical performance of the Company and its industry peers.
Amounts of the Bonus Pool in respect of any year, determined as provided above, that are not distributed to employees for that year are credited, but not accrued for accounting purposes, to a “Rainy Day Fund” that will be available in subsequent years to fund bonus payments to employees in excess of the Bonus Pool determined as provided above, provided that the Rainy Day Fund may not exceed an amount equal to $25 million, adjusted to reflect increases in the Consumer Price Index from and after January 1, 2005. The Rainy Day Fund concept was employed to allow management to “save” Bonus Pool allocations for future years when the formula dictates a reduced Bonus Pool although staff retention and other considerations might support larger bonuses than the formula would dictate. At December 31, 2006, the Rainy Day Fund balance was approximately $26.8 million. Neither the Rainy Day Fund nor the guideline Bonus Pool, however, provides any entitlement to employees, since the HR Committee retains full discretion to award or decline to award bonuses, subject, in the case of the Chief Executive Officer and the President, to provisions of their employment agreements with the Company. To date, the Rainy Day Fund has not been used to supplement the guideline Bonus Pool for any year.
In January 2006, the HR Committee decided that determinations under the Bonus Pool Guideline would be made in accordance with IFRS rather than GAAP, subject to the HR Committee’s obligation to make adjustments to reflect a change in, or a change in the interpretation or application by the Company of, such accounting principles to preserve the value of the Bonus Pool consistent with the intent that such value should reflect true economic financial performance of the Company, with any such adjustment determined by the HR Committee (or, if any director shall object to any such adjustment, by the Board of Directors of the Company). IFRS was chosen in order to better align the interests of employees with the interests of the Company’s principal shareholder (Dexia), whose accounts are maintained under IFRS.
Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX Section 404”) provides that if the Company must prepare an accounting restatement due to the Company’s material noncompliance, as a result of misconduct, with any financial reporting requirement under the securities laws, the principal executive and financial officers must reimburse the Company for any bonus or other incentive-based or equity-based compensation received from the Company during the 12-month period following the first public issuance or filing with the SEC of the financial document embodying the financial reporting requirement, and any profits realized from the sale of securities of the Company during that 12-month period. The Company does not have any other express policy regarding the adjustment or recovery of bonuses if the relevant Company performance measures upon which the guideline Bonus Pool is based are restated or otherwise adjusted following the bonus payment date in a manner that would reduce the size of the guideline Bonus Pool.
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Performance Share Units
The 2004 Equity Plan provides for awards of performance share units, which represent awards of both performance shares and shares of Dexia restricted stock. The Company has employed performance shares as its principal form of equity compensation since implementation by the Company of its 1993 Equity Participation Plan (the “1993 Equity Plan”) in connection with its 1994 initial public offering. In 2004, the Company adopted the 2004 Equity Plan to replace the 1993 Equity Plan and ceased making further awards under the 1993 Equity Plan. The 2004 Equity Plan adds Dexia restricted stock as a component of equity awards in order to further align the interests of the Company’s employees with its parent, and to give Company employees a greater sense of membership in the Dexia group. The 2004 Equity Plan also provides that book value measurements employed in valuing performance shares are determined in accordance with IFRS, whereas valuations under the 1993 Equity Plan are in accordance with GAAP. Again, IFRS was chosen in order to better align the interests of employees with the interests of the Company’s parent, whose accounts are maintained under IFRS. Performance share units awarded under the 2004 Equity Plan are comprised 90% of performance shares and 10% of Dexia restricted stock. Specifically, in order to determine the number of shares of Dexia restricted stock allocable to an award of performance shares units, the recipient receives the number of Dexia shares that can be purchased (at a purchase price per share historically equal to the average cost in dollars paid by the Company to acquire such shares) with the proceeds of 10% of the units, with each unit given the value of one outstanding share of the Company’s common stock valued as of the preceding year-end as described below with respect to performance shares. Historically, performance share units have been awarded to Company employees no more frequently than once per calendar year.
Performance Shares. Performance shares are designed to provide recipients with an interest in the growth in value of the Company’s shares during specified performance cycles. Performance shares have generally been awarded on the basis of two sequential three-year performance cycles, with 1/3 of each award allocated to the first cycle and 2/3 of each award allocated to the second cycle. For example, an award of 300 performance shares made in 2007 represents 100 performance shares allocated to the 2007/2008/2009 performance cycle and 200 performance shares allocated to the 2008/2009/2010 performance cycle. The length of the cycles are intended to provide employees with a “longer term” view of the Company’s financial performance and to provide the Company with retentive value insofar as employees generally forfeit performance share awards should they voluntarily terminate employment with the Company prior to the completion of the related performance cycle.
Each performance share represents a right to receive up to two shares of the Company’s common stock (or the cash value thereof), with the actual number of common shares receivable determined on the basis of the increase in ABV and book value per share over a specified performance cycle. The performance shares were designed to provide less compensation to participants than stock options if the Company performs poorly and more compensation to participants if the Company performs well. In particular, the performance shares were designed to have no value if the Company fails to generate growth in “value” per share in excess of 7%, which at the time of initial program implementation was a proxy for the risk-free yield on treasury securities. The actual dollar value received by a holder of performance shares, in general, varies in accordance with the annualized rate of ABV growth and book value growth per share (the “Internal Rate of Return” or “IRR”) of the Company’s common stock during an applicable “performance cycle” and the value of common stock at the time of payout of such performance shares.
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For purposes of the foregoing, ABV per share and book value per share are adjusted to exclude the after-tax change in accumulated “other comprehensive income” and any mark-to-market adjustments on investment grade CDS and economic interest rate hedges. Accumulated other comprehensive income includes, for example, unrealized gains and losses in the Company’s investment portfolio. Specifically,
· if the IRR is 7% or less per annum for any performance cycle, no shares of common stock will be earned for the performance cycle;
· if the IRR is 13% per annum for any performance cycle, a number of shares of common stock equal to the number of performance shares will be earned for the performance cycle; and
· if the IRR is 19% per annum or higher for any performance cycle, a number of shares of common stock equal to two times the number of performance shares will be earned for the performance cycle.
If the IRR is between 7% and 19%, the payout percentage is interpolated. The median IRR allowing for a 100% payout was set at 13%, which was considered reasonably acceptable Company performance.
So long as the Company’s common stock is not publicly traded, the Company expects to pay its performance shares in cash rather than stock, with shares under the 1993 Equity Plan and the 2004 Equity Plan valued at the greater of (1) the average of (a) 1.15 times ABV per share and (b) 14 times “operating earnings” per share (each such term as defined in the respective Equity Plans) and (2) 0.85 times ABV per share. The 1.15 times ABV and 14 times operating earnings multiples were based upon the multiples of ABV and operating earnings prevailing in the marketplace for the Company’s industry peers when Dexia acquired the Company in 2000, representing a discount to the multiples (1.4676 times ABV and 17 times operating earnings) paid by Dexia when it acquired the Company in 2000. The 0.85 ABV floor in share value was intended to reflect a minimum value for shares in the face of an adverse earnings environment. At December 31, 2006, the estimated present value of one performance share at a 100% payout was $145.61 per share under the 1993 Equity Plan and $149.57 per share under the 2004 Equity Plan. In the case of performance shares awarded under the 1993 Equity Plan, holders of performance shares were entitled at the time of grant to elect to have their performance shares valued at the time of payout either including or excluding unrealized gains and losses in the Company’s investment portfolio. In the case of performance shares awarded under the 2004 Equity Plan, performance shares exclude unrealized gains and losses in the Company’s investment portfolio. This modification was made because unrealized gains and losses in the Company’s investment portfolio are only influenced by a few Company employees.
Performance shares awarded under the 1993 Equity Plan entitle the holder to additional performance shares equal in number to the number of shares of the Company’s common stock having a value equal to any dividends paid on the Company’s common stock during the applicable performance cycle.
Except as otherwise provided in the employment agreements described below, performance shares (i) are generally forfeited in the event of a voluntary termination of employment prior to completion of the performance cycle; (ii) vest pro-rata in the event of termination without cause or retirement; and (iii) vest fully in the event of death, disability or, in the case of awards under the 1993 Equity Plan, absent a continuation of the Equity Plan by the Board of Directors of the Company, a change in control.
Since the inception of the 2004 Equity Plan, up to 3,300,000 shares of common stock have been available for distribution in respect of performance shares. Such shares may be newly issued shares, treasury shares or shares purchased in the open market. If performance shares awarded under the 2004 Equity Plan are forfeited, the shares allocated to such awards are again available for distribution in connection with future awards under the Plan.
Except as provided by SOX Section 404, the Company does not have any express policy regarding the adjustment or recovery of performance share payouts if the relevant Company performance measures
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upon which they are based are restated or otherwise adjusted following the payment date in a manner that would reduce the amount of a performance share payout.
Dexia Restricted Stock. Shares of Dexia restricted stock awarded under the 2004 Equity Plan represent ordinary shares of Dexia, including the right to receive dividends thereon. Dexia restricted stock associated with a performance share unit award is allocated (i) 1/3 to a 2.5-year vesting period and 3-year restricted period and (ii) 2/3 to a 3.5-year vesting period and 4-year restricted period. Except as otherwise provided in the employment agreements described below, unvested Dexia restricted stock (i) is generally forfeited in the event of a voluntary termination of employment prior to completion of the performance cycle; (ii) vests pro-rata in the event of termination without cause or eligibility for retirement (generally at age 55); and (iii) vests in the event of death or disability. The restricted period (during which Dexia restricted stock may not be traded) lapses six months after vesting. Short sales of Dexia stock by any Company employee are prohibited as a matter of corporate policy, absent prior approval of the Company’s Executive Management Committee.
Benefit Plans and Programs
Benefit plans and programs generally available at the Company for all full time U.S. resident employees are, for the most part, customary in nature, and include:
· medical, prescription drug and dental plans;
· a qualified defined contribution “money purchase pension plan” (the “Pension Plan”) with an annual contribution by the Company equal to 9% of prior year salary and bonus, subject to a salary/bonus cap provided under the Internal Revenue Code;
· a cash or deferred (“401(k)”) plan, that does not include Company contributions, allowing pre-tax employee contributions up to limits provided under the Internal Revenue Code;
· a flexible spending plan (the “Flex Plan”) allowing employees to pay certain medical, dependent care, mass transit and parking expenses with pre-tax dollars;
· a severance plan;
· life insurance coverage (the “Life Insurance Program”) in the amount of two times annual salary up to a limit of $500,000;
· a program (the “Travel Incentive Program”) under which employees share a portion of the savings from flying a lower class or less expensive flight pattern than allowed under the Company’s travel policy or for using non-refundable tickets;
· an optional retiree medical program under which Company retirees are entitled to participate in the Company’s medical plan following retirement provided that they pay the full cost plus a 5% administrative fee to the Company;
· $65 per month of “transit cheks” for commutation expenses (the “Transit Chek Program”);
· reimbursement of up to $400 per annum for health club expenses (the “Health Club Program”);
· a matching gift program for gifts to qualifying charities of up to $20,000 per annum in the aggregate (the “Matching Gift Program”); and
· customary vacation, leave of absence, bereavement and similar policies.
The Company also maintains “top hat” plans, which are unfunded and unsecured non-qualified plans restricted under the tax laws to a limited number of highly compensated employees, and consist of (i) supplemental executive retirement plans (each, a “SERP”) under which the Company makes an annual
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contribution equal to 9% of prior year salary and bonus in excess of the money purchase plan salary/bonus cap (but disregarding salary/bonus in excess of $1 million) payable upon termination of employment unless deferred by the employee, with such contributed amounts generally credited with returns on mutual funds or securities selected by the participants and “match funded” by the Company and (ii) deferred compensation plans (each, a “DCP”) under which participants are entitled to defer receipt (generally for a minimum deferral period of three years) of bonus and performance share compensation otherwise payable to them by the Company, with such deferred amounts generally credited with returns on mutual funds or securities selected by the participants and “match funded” by the Company. The Company maintains two SERPs and two DCPs due to tax law changes adopted in 2004 under Section 409A of the Internal Revenue Code with respect to “deferred compensation arrangements.” The Company adopted a new SERP and new DCP in 2004 conforming with the new tax law requirements to receive all new contributions, while the pre-existing SERP and DCP were “grandfathered” under the pre-existing tax law but were closed to further contributions. As described in more detail below, the Company maintains a separate severance plan for members of its Executive Management Committee and has employment agreements providing severance arrangements for its two most senior executive officers.
Different benefit plans and programs may apply to Company employees who are not United States residents.
Dexia Employee Share Plans
Company employees are entitled to participate in Employee Share Plans sponsored and funded by Dexia S.A. Under the Dexia Employee Share Plans, Company employees are generally entitled to invest up to 25% of their prior year compensation (comprised primarily of salary, bonus and performance share payout for such year) in Dexia shares subject to a 5-year minimum investment period (with specified rights to withdraw funds in the event of termination of employment or special circumstances). The investment alternatives include (i) a “classic option” under which U.S. resident employees may purchase Dexia shares at a 15% discount (up to a limit prescribed annually under Section 423 of the Internal Revenue Code, which was $21,250 for 2006); and (ii) leveraged options, under which employees may purchase Dexia shares at a 20% discount employing 90% leverage pursuant to which (a) the discount, dividends and a portion of any profits from the investment are allocated to the lender, and (b) the employee receives (i) a guaranteed return of the dollars invested and (ii) either (depending on which option the employee has elected) (A) a multiple (9.5 times for shares purchased in 2006) of the Dexia share appreciation over the initial non-discounted purchase price in euros over the five-year term (the “Standard Leveraged Option”); (B) a multiple (11 times for shares purchased in 2006) of the average monthly increase in Dexia share price over the initial non-discounted purchase price in euros over 52 months of the five-year term (the “Average Leveraged Option”); and (C) a multiple (5 times for shares purchased in 2006) of the sum of the annual gains in Dexia share price during each year of the 5-year term (the “Click Leveraged Option”).
Employment Agreements and Arrangements
Each of Messrs. Cochran and McCarthy entered into four-year employment agreements with the Company effective with the July 2000 acquisition of the Company by Dexia. Upon expiration of these initial agreements, each of Messrs Cochran and McCarthy entered into similar employment agreements with the Company effective July 5, 2004, which agreements were amended January 1, 2005 to address provisions of Section 409A of the Internal Revenue Code applicable to severance and other deferred compensation arrangements. Each of the employment agreements generally guarantees continuation of compensation and benefits through December 31, 2007, and provides for renewals and extensions of their initial term for two-year terms, subject to notice of termination from either party at least six months prior to the end of the expiring term. At any point after the initial term has expired, Mr. Cochran may elect to become Non-Executive Chairman of the Company for the remainder of the term and any extensions.
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Under the agreements, compensation consists of:
· base salary at the annual rate in effect immediately prior to the agreement, subject to increase at the Board’s discretion;
· annual bonus equal to a minimum percentage of a “bonus pool” determined pursuant to formulae from time to time determined by the HR Committee; and
· annual awards of performance shares under the 1993 Equity Plan and the 2004 Equity Plan (together, the “Equity Plans”), having an estimated economic value at least equal to the employee’s 2004 performance share award.
Their employment agreements provide that Messrs. Cochran and McCarthy are entitled to receive an annual cash bonus equal to at least 5.0% and 4.0%, respectively, of the Company’s annual bonus pool. The employment agreements provide that an additional 2.0% of the annual bonus pool will be allocated among those two executive officers as determined by the HR Committee.
For a discussion of the terms of the employment agreements relating to payments to Messrs. Cochran and McCarthy at, following or in connection with any termination of employment with the Company, retirement or change in control of the Company, see “—Potential Payments Upon Termination of Employment, Retirement or Change-in-Control.”
Tax and Accounting Considerations Bearing on the Company’s Compensation Program
The Company designed performance shares so that the cost to the Company is fully expensed, based upon the principal that fully expensed compensation properly reflects the financial performance of the Company, while noting that such treatment puts the Company at a disadvantage in comparing its financial results to those of its industry peers that employ stock options or other equity compensation that is not fully expensed. The Company designed Dexia restricted stock awarded under the 2004 Equity Plan to qualify as equity (as opposed to liability) awards under Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123-R”). The Company is not subject to Section 162(m) of the Internal Revenue Code, which limits the deductibility of non-performance based compensation paid to executives of corporations having common equity securities required to be registered under Section 12 of the Exchange Act. The Company’s various benefit programs described above are intended to comply with applicable tax requirements, including Section 409A of the Internal Revenue Code governing deferred compensation arrangements.
The Company’s 2006 Compensation Process
The HR Committee determines the compensation of the Chief Executive Officer and the Chief Operating Officer and reviews and approves management’s compensation recommendations for other employees of the Company. The Committee is comprised of Messrs. Downey (Chairman), Cochran, Deletré, Miller and Taylor. Mr. Cochran recuses himself from HR Committee deliberations concerning his own compensation.
In 2006, the HR Committee engaged Johnson Associates, Inc. (“Johnson Associates”), independent compensation consultants, to review market compensation levels. Johnson Associates prepared a report reviewed by the HR Committee in November 2006. The report was intended as background prior to consideration of 2006 bonuses, 2007 salaries and 2007 performance share unit awards under the 2004 Equity Plan. At its November 2006 meeting, the HR Committee also reviewed management’s estimate of (i) the 2006 Bonus Pool determined pursuant to the Bonus Pool guideline described above; (ii) the valuation of performance shares issued under the 1993 Equity Plan to be paid out in the first quarter of 2007 related to performance cycles ending December 31, 2006; (iii) 2007 salaries; and (iv) 2007 performance share unit awards under the 2004 Equity Plan.
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The Company’s Executive Management Committee (comprised of Messrs. Cochran, McCarthy, Stern, Brewer and Simon) serves as management’s compensation committee. During the fourth quarter of 2006, managers within the Company prepared compensation recommendations of 2006 bonuses, 2007 salaries and 2007 performance share unit awards for employees under their supervision, in what management characterizes as a “bottom-up” compensation process, with initial compensation recommendations originating from lower levels of management. The compensation recommendations provided by managers took into account an estimated 2006 guideline Bonus Pool, which at the time indicated an increase in the guideline Bonus Pool compared with the prior year, counterbalanced by increased dollar compensation requirements for the Company’s foreign employees attributable to the decline in the exchange rate for the U.S. dollar against the British pound sterling and the euro. The Executive Management Committee reviewed the managers’ recommendations and, in turn, prepared compensation recommendations of 2006 bonuses, 2007 salaries and 2007 performance share unit awards for all Company employees other than members of the Executive Management Committee. These recommendations, along with a review prepared by management of the Company’s performance in 2006, were reviewed by the HR Committee at its January 2007 meeting at which 2006 bonuses, 2007 salaries and 2007 performance share unit awards were approved for all Company employees other than members of the Executive Management Committee.
At its February 2007 meeting, the HR Committee was provided with (i) a 2006 financial guaranty industry profile prepared by management setting forth comparative financial performance data for the six largest financial guaranty insurers, (ii) the range of salary, bonus and performance share unit awards payable under the Company’s employment agreements with the Chief Executive Officer and Chief Operating Officer and (iii) the Chief Executive Officer’s recommendation of compensation for the other members of the Company’s Executive Management Committee (the General Counsel, the Chief Risk Management Officer and the Chief Financial Officer). On the basis of the foregoing information and the compensation consultant’s reports described below, the HR Committee approved 2006 bonuses, 2007 salaries and 2007 performance share unit awards for Executive Management Committee members.
The Compensation Consultant’s Reports
At its November 2006 meeting, the HR Committee reviewed a “2006 Broad Competitive Market Update” provided by Johnson Associates (the “November Report”). The objective of the November Report was to provide the HR Committee a high level update to be followed by more detailed market compensation analysis and recommendations for consideration by the HR Committee at its January 2007 and February 2007 meetings at which actual compensation decisions were made. The November Report noted:
· overall 2006 incentive funding (cash bonus and equity long-term awards) was expected to increase in the 10% range for financial guarantors and in the 15% to 20% range for investment banks;
· strong hiring trends in the financial guaranty sector were expected to accelerate, with increased retention and recruitment issues to be faced by the Company and its industry peers;
· the Company’s 2006 projected incentive compensation increases were below those of its industry peers;
· little change in 2006 equity awards was expected among industry peers, with the general move away from stock options towards restricted stock having stabilized; and
· compensation program design changes were not anticipated at the Company’s industry peers.
The November Report included comparative compensation data for the top five named executive officers for eight corporations in the comparative group, as well as comparative data by function for the chief executive officer, general counsel and chief financial officer. The comparative group was comprised of Ambac Financial Group Inc.; Assured Guaranty Ltd.; MBIA Inc.; MGIC Investment Corporation; PMI Group Inc.; Radian Group Inc.; Security Capital Assurance Ltd.; and XL Capital Ltd. The scope of the
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comparative group was limited because data was not publicly available with respect to certain industry participants. The Company competes for talent with other financial guaranty insurers, as well as with investment banks and commercial banks that generally provide higher compensation but less job security than financial guaranty insurers.
At its January 2007 meeting, the HR Committee reviewed a “2006 Competitive Market Analysis” prepared by Johnson Associates (the “January Report”). The objective of the January Report was to provide more detailed market compensation analysis and recommendations than provided in the November Report. The January Report noted:
· The Company’s proposed 3% increase in combined incentive spending was below the projected market increase of 10%.
· The Company’s proposed professional staff total compensation positioning was just above the 50th percentile of the estimated 2006 comparative group.
· The Company’s competitive positioning had declined somewhat over the past few years.
· The Company’s mix of equity versus cash compensation was slightly higher than the market’s.
At its January 2007 meeting, the HR Committee also reviewed the following materials prepared by Johnson Associates at the request of the HR Committee:
· an historical analysis of the actual value of stock option awards made to senior executives of industry peers based on stock prices compared to the actual value of performance share awards made to senior executives of the Company based on payout values; and
· a “Top 10 Market Analysis” comparing the compensation of the Company’s top ten most highly compensated employees to a broad market and to a narrower defined comparative group.
At its February 2007 meeting, the HR Committee reviewed the following materials prepared by Johnson Associates at the request of the HR Committee:
· a “2005 Competitor Proxy Analysis” setting forth compensation information for the industry peer group for the five most highly compensated executives and for the chief executive officer, general counsel and chief financial officer;
· a “Competitive Long Term Gains Analysis 2001-2005” comparing the value at grant of 2001-2005 restricted stock, stock options and long term incentive plan awards to the appreciated value actually realized or currently projected for the industry peer group for the chief executive officer and the number two most highly compensated executive officer;
· a “Long-Term Grants Analysis 2001-2005” illustrating long-term values as compared to realized and unrealized gains from 2001-2005 for the industry peer group for the chief executive officer and the number two most highly compensated executive officer; and
· a “Top 10 Market Analysis” comparing the compensation of the Company’s top ten most highly compensated employees to a broad market and to a narrower defined comparative group.
The materials provided by Johnson Associates supported the HR Committee’s conclusions that the compensation awarded to the named executive officers at the HR Committee’s February 2007 meeting was reasonable compared with those of industry peers and the broader comparative group, taking into account the 2006 financial performance of the Company and the tenure and experience of the Company’s officers. The comparative data reviewed by the Committee addressed the difficulty of comparing the value of performance shares awarded by the Company to stock options awarded by the Company’s industry peers, noting the disparities in valuing stock options for compensation and financial reporting purposes and the arbitrary compensatory elements of stock option programs during periods of volatile stock performance.
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HR Committee Report
The HR Committee has reviewed and discussed with management the Compensation Discussion and Analysis required by Item 402(b) of Regulation S-K. Based on such review and discussions, the HR Committee recommended to the Board of Directors of the Company that the Compensation Discussion and Analysis be included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.
| Robert N. Downey (Chairman) |
| Robert P. Cochran |
| Bruno Deletré |
| Axel Miller |
| Roger K. Taylor |
Summary Compensation Table
The table below sets forth a summary of all compensation paid to the chief executive officer, the principal financial officer and the three most highly compensated other executive officers of the Company, in each case for services rendered in all capacities to the Company for the year ended December 31, 2006.
2006 Summary Compensation Table(1)
Name and Principal Position | | | | Year | | Salary | | Bonus(2) | | Stock
Awards(3) | | Nonqualified
Deferred
Compensation
Earnings(4) | | All Other
Compensation(5) | | Total(7) | |
Robert P. Cochran | | 2006 | | $ | 500,000 | | $ | 3,300,000 | | $ | 6,721,121 | | | $ | 491,881 | | | | $ | 357,889 | (6) | | $ | 10,879,010 | |
Chairman of the Board and | | | | | | | | | | | | | | | | | | | |
Chief Executive Officer | | | | | | | | | | | | | | | | | | | |
Séan W. McCarthy | | 2006 | | 330,000 | | 3,000,000 | | 4,773,490 | | | 150,380 | | | | 116,162 | | | 8,219,652 | |
President and | | | | | | | | | | | | | | | | | | | |
Chief Operating Officer | | | | | | | | | | | | | | | | | | | |
Bruce E. Stern | | 2006 | | 260,000 | | 900,000 | | 1,738,733 | | | — | | | | 99,419 | | | 2,998,152 | |
Managing Director, General | | | | | | | | | | | | | | | | | | | |
Counsel and Secretary | | | | | | | | | | | | | | | | | | | |
Russell B. Brewer II | | 2006 | | 260,000 | | 900,000 | | 1,738,733 | | | — | | | | 99,419 | | | 2,998,152 | |
Managing Director and | | | | | | | | | | | | | | | | | | | |
Chief Underwriting Officer | | | | | | | | | | | | | | | | | | | |
Joseph W. Simon | | 2006 | | 260,000 | | 900,000 | | 1,255,879 | | | — | | | | 98,895 | | | 2,514,774 | |
Managing Director and | | | | | | | | | | | | | | | | | | | |
Chief Financial Officer | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
(1) Annual compensation for each year includes amounts deferred under the DCPs or paid into the Company’s 401(k) plan or Flex Plan.
(2) The bonus set forth for the specified year was paid to the named executive officer in February of the subsequent year.
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(3) The amount under this column reflects the expense reported by the Company in the specified year under SFAS 123-R with respect to performance shares and Dexia restricted stock awarded under the Equity Plans in 2006, 2005, 2004 and 2003, except that (a) estimates of forfeiture related to service-based vesting provisions have not been taken into account in calculating such dollar amounts and (b) for purposes of determining the amount of compensation reflected for pre-2006 awards, the “modified prospective transition method” under SFAS 123-R was employed. No awards of restricted stock of the Company or options were made to any of the executives named in the table during the period covered by the table. Amounts included under this column were attributable to performance shares and Dexia restricted stock as set forth below:
Name | | | | Performance
Share
Compensation | | Dexia Restricted
Stock
Compensation | |
Robert P. Cochran | | | $ | 6,427,750 | | | | $ | 293,371 | | |
Séan W. McCarthy | | | 4,557,777 | | | | 215,713 | | |
Bruce E. Stern | | | 1,661,075 | | | | 77,658 | | |
Russell B. Brewer II | | | 1,661,075 | | | | 77,658 | | |
Joseph W. Simon | | | 1,182,648 | | | | 73,231 | | |
(4) The amount under this column reflects the excess, if any, of (a) income on Company common stock acquired under the Director Share Purchase Program described below and credited by the Company to participants under the DCPs and SERPs over (b) a market rate of interest identified by the Internal Revenue Service as a proxy for the rate the Company would be paying to a lender if the Company had paid out the deferred compensation up front and did not have the use of funds, equal to 120% of the federal rate with compounding prescribed under Section 1274(d) of the Internal Revenue Code (5.88% for 2006) (the “Proxy Market Rate”). This column does not include earnings on publicly traded securities and mutual funds credited by the Company to participants under the DCPs and SERPs. The Company currently match funds substantially all phantom investments (other than money market fund investments) made by participants in the DCPs and SERPs. Investment alternatives under the DCPs include mutual funds, shares of individual companies and, in the case of director participants, shares under the Director Share Purchase Program described below. Since the Company match funds substantially all phantom investments under the DCPs and SERPs, the principal costs associated with these plans (in addition to the amounts actually contributed by the Company under the SERPs) come from (i) the delay in recognition by the Company of compensation expense for the deferred amounts and (ii) the recognition of gains on matched investments if and when realized by the Company prior to the time that the Company recognizes a deduction for compensation expense to the employee (at the time payments are made by the plans to the participants). Reference is made to “—Nonqualified Deferred Compensation,” below, for a list of the mutual funds and stock benchmarks under the DCPs and SERPs and their respective 2006 rates of return. The dollar amounts under this column do not include earnings under the SERPs, which qualify as “excess benefit plans” under Rule 16(b)-3(b)(2) of the Exchange Act, except insofar as SERP investments are in Company common stock under the Director Share Purchase Program. The dollar amounts under this column are not included in determining amounts under the “total” compensation column.
(5) All Other Compensation includes the contributions by the Company to the Pension Plan and SERPs set forth below:
Name | | | | Pension Plan | | SERPs | |
Robert P. Cochran | | | $ | 19,800 | | | $ | 70,200 | |
Séan W. McCarthy | | | 19,800 | | | 70,200 | |
Bruce E. Stern | �� | | 19,800 | | | 70,200 | |
Russell B. Brewer II | | | 19,800 | | | 70,200 | |
Joseph W. Simon | | | 19,800 | | | 70,200 | |
| | | | | | | | | | | |
Pension Plan and SERP amounts shown were accrued during 2006 and paid in February of 2007. The Pension Plan provides for a Company funded contribution equal to 9% of cash compensation (salary and bonus) up to the compensation limit specified by the Internal Revenue Service. The SERPs provide for an unfunded Company contribution equal to 9% of cash compensation over and above the Pension Plan compensation limit but limited to $1 million of compensation. The Pension Plan and SERPs provide for vesting of contributions over a six-year employment period, after which all subsequent contributions are 100% vested. Given the tenure with the Company of the named executive officers, all contributions to the Pension Plan and SERPs on behalf of the named executive officers are fully vested when made, except in the case of Mr. Simon, who was 60% vested in April 2006 and will be 100% vested in April 2008.
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All other compensation includes dividends on unvested shares of Dexia restricted stock paid (without adjustment for withholding taxes) by Dexia during 2006 in the amounts set forth below:
Name | | Dollar Value of
Dividends | |
Robert P. Cochran | | | $ | 26,930 | | |
Séan W. McCarthy | | | 26,162 | | |
Bruce E. Stern | | | 9,419 | | |
Russell B. Brewer II | | | 9,419 | | |
Joseph W. Simon | | | 8,895 | | |
All other compensation does not include the dollar value of the Company’s Travel Incentive Program, Transit Chek Program, Health Club Program or group life, health, hospitalization and medical reimbursement plans that do not discriminate in scope, terms or operation in favor of the named executive officers and that are available generally to all salaried employees. All other compensation also does not include payments contributed under the Company’s Matching Gift Program. Neither Mr. Cochran nor Mr. McCarthy receive additional compensation for their services as directors of the Company, although such service entitles them to participate in the Director Share Purchase Program described below.
(6) All other compensation for Mr. Cochran includes the excess of (a) realized and unrealized gains on common stock of the Company, purchased through the Director Share Purchase Program (and not owned under the DCPs or SERPs), over (b) the Proxy Market Rate of 5.88%, which was $240,959 for 2006. For a discussion of the Director Share Purchase Program, see “—Compensation of Directors—Director Share Purchase Program,” below.
(7) Total compensation does not include nonqualified deferred compensation earnings.
Performance shares generally vest upon completion of the related 3-year performance cycle. The dollar value of performance share awards reported in the Summary Compensation Table vest as follows, absent termination of employment, death, retirement or change in control without a plan continuation:
Name | | | | 2006 | | 2007 | | 2008 | |
Robert P. Cochran | | $ | 2,909,760 | | $ | 2,013,487 | | $ | 1,504,503 | |
Séan W. McCarthy | | 1,986,263 | | 1,465,261 | | 1,106,253 | |
Bruce E. Stern | | 751,619 | | 511,206 | | 398,250 | |
Russell B. Brewer II | | 751,619 | | 511,206 | | 398,250 | |
Joseph W. Simon | | 429,418 | | 384,479 | | 368,751 | |
| | | | | | | | | | | | |
Generally, one third of a Dexia restricted stock award vests after 2.5 years and two thirds vests after 3.5 years, with transfer restrictions lapsing six months after the vesting date. The 2004 Equity Plan provides that, when a participant becomes eligible for retirement at age 55, shares of Dexia restricted stock vest thereafter to the extent the shares would have vested had the employee actually retired. Mr. Cochran is the only named executive officer above the age of 55. The dollar value of Dexia restricted stock reported in the Summary Compensation Table for Messrs. Cochran, McCarthy, Stern, Brewer and Simon have vested or will vest as follows, absent termination of employment, death or retirement:
Name | | | | 2006 | | 2007 | | 2008 | | 2009 | |
Robert P. Cochran | | $ | 293,371 | | $ | — | | $ | — | | $ | — | |
Séan W. McCarthy | | — | | 36,923 | | 108,827 | | 69,963 | |
Bruce E. Stern | | — | | 13,292 | | 39,178 | | 25,188 | |
Russell B. Brewer II | | — | | 13,292 | | 39,178 | | 25,188 | |
Joseph W. Simon | | — | | 11,817 | | 36,226 | | 25,188 | |
| | | | | | | | | | | | | | | |
Discussion of 2006 Compensation for the Named Executive Officers
Set forth below is a discussion of the 2006 bonuses, 2007 salaries and 2007 performance share unit awards for the named executive officers. The 2006 compensation of the Chief Executive Officer and the President was determined with reference to their entitlements under their employment agreements with the Company. The compensation of the General Counsel, Chief Risk Management Officer and Chief
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Financial Officer was determined with a premise that these senior officers are partners in the enterprise and should share similarly in the overall enterprise profits or losses, consistent with the overall compensation changes for other employees of the Company. The Company’s “bottom-up” compensation process was conducted during the fourth quarter of 2006, and was premised upon an expectation that the 2006 guideline Bonus Pool would be substantially unchanged from the bonus pool distributed in 2005. Although better than expected fourth quarter 2006 financial performance resulted in a 2006 guideline Bonus Pool substantially larger than the bonus pool distributed in 2005, management elected to exercise restraint and forgo distribution of the increased bonus pool for 2006. Accordingly, the Chief Executive Officer also generally recommended 2006 bonuses unchanged as compared with those of the prior year for Executive Management Committee members. The HR Committee of the Board of Directors accepted management’s recommendation.
2007 Salaries
The named executive officers received salary increases for 2007 in the range of 0 to 4%, primarily representing cost of living adjustments.
Chief Executive Officer. The 2007 salary for the Company’s Chief Executive Officer was set at $500,000, unchanged from his 2006 salary. The Chief Executive Officer’s salary was left unchanged at his own request, given the flat over-all year-over-year compensation increases for employees of the Company as a whole. Under his employment agreement with the Company, Mr. Cochran is entitled to a base salary at the annual rate in effect immediately prior to the effective date of the agreement ($490,000), subject to increase at the Board’s discretion.
Chief Operating Officer. The 2007 salary for the Company’s Chief Operating Officer was set at $340,000 compared to a 2006 salary of $330,000. The salary increase primarily represents a cost of living adjustment. Under his employment agreement with the Company, Mr. McCarthy is entitled to a base salary at the annual rate in effect immediately prior to the effective date of the agreement ($300,000), subject to increase at the Board’s discretion.
General Counsel, Chief Risk Management Officer and Chief Financial Officer. The 2007 salaries for the Company’s General Counsel, Chief Risk Management Officer and Chief Financial Officer were set at $270,000 compared to 2006 salaries of $260,000. The salary increases primarily represent cost of living adjustments.
2006 Cash Bonuses
At its November 2006 meeting, the HR Committee left the Specified Percentage for the guideline Bonus Pool unchanged at 11.25%. The effect of the 2006 target Bonus Pool was to require substantial 2006 ABV growth with a satisfactory Actual Average Transaction ROE to maintain the Bonus Pool at the level paid in the prior year. As a result of 2006 performance, the 2006 Bonus Pool determined by the Bonus Pool guideline was $61.4 million, of which $57.3 million was distributed, compared to the 2005 bonus pool formula amount of $55.5 million, of which $55.2 million was distributed. The Chief Executive Officer recommended no increase in 2006 bonuses for members of the Executive Management Committee despite better than expected 2006 performance, in keeping with 2006 bonus levels in general for other Company employees, which were determined in advance of better than anticipated financial performance by the Company in the fourth quarter of 2006.
Chief Executive Officer. The 2006 bonus for the Company’s Chief Executive Officer was set at $3,300,000, unchanged from his 2005 bonus. Under his employment agreement with the Company, Mr. Cochran is entitled to receive an annual cash bonus equal to at least 5.0% of the Company’s annual bonus pool ($3,071,950) plus an additional 2.0% of the annual bonus pool ($1,228,790) is to be allocated between Mr. Cochran and Mr. McCarthy as determined by the HR Committee. Mr. Cochran declined any increase in his 2006 bonus in view of the flat over-all year-over-year bonus increases for other employees of
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the Company, notwithstanding his entitlement to a greater amount under his employment agreement with the Company.
Chief Operating Officer. The 2006 bonus for the Company’s Chief Operating Officer was set at $3,000,000, unchanged from his 2005 bonus. Under his employment agreement with the Company, Mr. McCarthy is entitled to receive an annual cash bonus equal to at least 4.0% of the Company’s annual bonus pool ($2,457,560) plus an additional 2.0% of the annual bonus pool ($1,228,790) is to be allocated between Mr. Cochran and Mr. McCarthy as determined by the HR Committee.
General Counsel, Chief Risk Management Officer and Chief Financial Officer. The 2006 bonus for the Company’s General Counsel, Chief Risk Management Officer and Chief Financial Officer was set at $900,000 each. The bonuses for the General Counsel and Chief Risk Management Officer were unchanged from their 2005 bonuses. The bonus for the Chief Financial Officer was increased from $800,000 in 2005, raising the Chief Financial Officer’s bonus to the level of the General Counsel and Chief Risk Management Officer in recognition of their equal stature as Executive Management Committee members.
2007 Performance Share Unit Awards
As in prior years, the named executive officers were awarded performance share units by the HR Committee in February 2007.
Chief Executive Officer. The 2007 performance share unit award for the Company’s Chief Executive Officer was 34,000 performance share units, unchanged from his 2006 award. Under his employment agreement with the Company, Mr. Cochran is entitled to receive annual performance share unit awards having an estimated economic value at least equal to his 2004 performance share award of 40,000 performance shares. For purposes of the foregoing, Mr. Cochran’s 2004 performance share award of 40,000 performance shares was deemed to have a dollar value of $4,388,400 based upon the December 31, 2003 estimated present value of one performance share at a 100% payout of $109.71, which equates to approximately 29,340 2007 performance share units based upon the December 31, 2006 estimated present value of one performance share at a 100% payout (and associated Dexia restricted stock at fair market value of $29.80 per share). The HR Committee determined to leave the Chief Executive Officer’s 2007 performance share unit award unchanged for the 2006 award in recognition of the overall performance of the Company for 2006, comparative compensation data for industry peers and counterbalancing in part the lack of any increase in his 2006 bonus from the previous year’s level, recognizing that the 2007 performance share unit award was higher than the entitlement under his employment agreement with the Company.
Chief Operating Officer. The 2007 performance share unit award for the Company’s Chief Operating Officer was 26,000 performance share units, compared to 25,000 performance share units awarded the previous year. Under his employment agreement with the Company, Mr. McCarthy is entitled to receive annual performance share unit awards having an estimated economic value at least equal to his 2004 performance share award of 29,000 performance shares. For purposes of the foregoing, Mr. McCarthy’s 2004 performance share award of 29,000 performance shares was deemed to have a dollar value of $3,181,590 based upon the December 31, 2003 estimated present value of one performance share at a 100% payout of $109.71, which equates to approximately 21,271 2007 performance share units based upon the December 31, 2006 estimated present value of one performance share at a 100% payout (and associated Dexia restricted stock at market value of $29.80 per share). The HR Committee determined to increase the Chief Operating Officer’s 2007 performance share unit award from the prior year award amount based upon the compensation recommendation of the Chief Executive Officer, and in recognition of the overall performance of the Company for 2006, comparative compensation data for industry peers and counterbalancing in part the lack of any increase in his 2006 bonus from the previous year’s level, recognizing that the 2007 performance share unit award was higher than the entitlement under his employment agreement with the Company.
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General Counsel, Chief Risk Management Officer and Chief Financial Officer. The 2007 performance share unit awards for the Company’s General Counsel, Chief Risk Management Officer and Chief Financial Officer were 9,000 performance share units each, unchanged from their 2006 awards. The HR Committee accepted the Chief Executive Officer’s recommendation to leave the 2007 performance share unit awards unchanged from the prior year’s awards in light of the Company’s overall 2006 financial performance modestly exceeding budget, comparative compensation data from industry peers and consistent with the partnership compensation methodology for the General Counsel, Chief Risk Management Officer and Chief Financial Officer.
Grants of Plan-Based Awards for 2006
The table set forth below provides information with respect to performance share unit awards (comprised of performance shares and Dexia restricted stock) under the 2004 Equity Plan to the named executive officers, in each case for the year ended December 31, 2006 (which awards were made in February 2007).
Grants of Plan-Based Awards for 2006
| | Grant | | Number of
Performance
Share | | Number of
Performance | | Estimated Future Payouts
of Performance Shares Under
Equity Incentive Plan Awards | | All Other
Stock
Awards-#
of Shares of
Stock or | | Full Grant
Date Fair | |
Name | | | | Date | | Units(1) | | Shares(2) | | Threshold (3) | | Target(4) | | Maximum(5) | | Units(6) | | Value(7) | |
Robert P. Cochran | | 2/14/07 | | | 34,000 | | | | 30,600 | | | | $ | 0 | | | $ | 4,576,842 | | | $ | 9,153,684 | | | | 17,065 | | | $ | 5,085,380 | |
Séan W. McCarthy | | 2/14/07 | | | 26,000 | | | | 23,400 | | | | 0 | | | 3,499,938 | | | 6,999,876 | | | | 13,050 | | | 3,888,820 | |
Bruce E. Stern | | 2/14/07 | | | 9,000 | | | | 8,100 | | | | 0 | | | 1,211,517 | | | 2,423,034 | | | | 4,517 | | | 1,346,130 | |
Russell B. Brewer II | | 2/14/07 | | | 9,000 | | | | 8,100 | | | | 0 | | | 1,211,517 | | | 2,423,034 | | | | 4,517 | | | 1,346,130 | |
Joseph W. Simon | | 2/14/07 | | | 9,000 | | | | 8,100 | | | | 0 | | | 1,211,517 | | | 2,423,034 | | | | 4,517 | | | 1,346,130 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
(1) These performance share units were awarded under the 2004 Equity Plan in February 2007 for the year ended December 31, 2006. The table excludes performance share units awarded in February 2006 for the year ended December 31, 2005, which are set forth in “Item 11. Executive Compensation—Summary Compensation Table” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.
(2) This column sets forth the number of performance shares included in the performance share units awarded to the named executive officer. One-third of each performance share award relates to the three-year performance cycle ending December 31, 2009 and two-thirds of each performance share award relates to the three-year performance cycle ending December 31, 2010.
(3) The threshold value is the minimum value of performance shares. There is no minimum value for performance shares. Specifically, performance shares have no value if the IRR is not more than 7% per annum for the three-year performance cycle.
(4) The target value for performance share units is based upon a 100% payout, which is obtained if the IRR is 13% per annum for each three-year performance cycle. For purposes of the foregoing, Company common shares are valued in accordance with the 2004 Equity Plan at December 31, 2006.
(5) The maximum value for performance share units is based upon a 200% payout, which is obtained if the IRR is 19% or more per annum for each three-year performance cycle. For purposes of the foregoing, Company common shares are valued in accordance with the 2004 Equity Plan at December 31, 2006.
(6) This column sets forth the number of shares of Dexia restricted stock included in the performance share units awarded to the named executive officers.
(7) This column sets forth the full grant date fair value of the performance share units awarded to the named executive officers, with each performance share valued at $149.57 and each share of Dexia restricted stock valued at $29.80. Performance share values were determined on the basis of ABV, including IFRS adjustments, and operating income as of December 31, 2006. Dexia restricted stock was valued on the basis of the actual purchase price, converted into dollars at Euro 1.00 = $1.3026, paid by the Company in February 2007 to acquire Dexia ordinary shares to fund the 2007 Dexia restricted stock awards.
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Outstanding Equity Awards
The following table sets forth a summary of the outstanding unvested equity awards to each of the named executive officers as of December 31, 2006 (excluding (a) awards vesting on such date and paid in February 2007 described below under “2004/2005/2006 Performance Share Payouts”; and (b) awards for the year ended December 31, 2006 made in February 2007 described above under “Grants of Plan Based Awards”).
Outstanding Equity Awards at 2006 Fiscal Year-End
Name | | | | Number of
Performance Shares
That Have Not
Vested | | Market Value of
Performance Shares
That Have Not
Vested(1) | | Equity Incentive
Plan Awards:
Number of Shares of
Dexia Restricted
Stock That Have Not
Vested | | Equity Incentive
Plan Awards:
Market Value of
Dexia Restricted
Stock That Have Not
Vested(2) | |
Robert P. Cochran | | | 91,442 | | | | $ | 13,557,444 | | | | 20,179 | | | | $ | 552,659 | | |
Séan W. McCarthy | | | 66,925 | | | | 9,923,377 | | | | 28,869 | | | | 790,662 | | |
Bruce E. Stern | | | 23,761 | | | | 3,523,977 | | | | 10,393 | | | | 284,643 | | |
Russell B. Brewer II | | | 23,761 | | | | 3,523,977 | | | | 10,393 | | | | 284,643 | | |
Joseph W. Simon | | | 20,592 | | | | 3,059,092 | | | | 9,815 | | | | 268,812 | | |
(1) Market value is based upon a 100% payout for performance shares using the December 31, 2006 share value under the 2004 Equity Plan.
(2) Market value is based upon the December 31, 2006 closing price of Dexia ordinary shares converted into dollars at Euro 1.00 = $1.3199, the December 31, 2006 exchange rate as reported on the Bloomberg data screen.
2004/2005/2006 Performance Share Payout
Performance Shares awarded under the 1993 Equity Plan with respect to the 2004/2005/2006 performance cycle (“2004/2005/2006 performance shares”) vested in accordance with their award agreements on December 31, 2006 and were paid in January 2007 in accordance with their terms. The 2004/2005/2006 performance shares held by the named executive officers were awarded in February 2003 and February 2004, and disclosed in the Company’s Annual Reports on Form 10-K for the years ended December 31, 2002 and December 31, 2003, respectively. The value of the 2004/2005/2006 performance shares was approved by the HR Committee at its January 2007 meeting, based upon calculations prepared by management and verified by the Company’s independent accountants. The table below sets forth the dollar value of 2004/2005/2006 performance shares paid to the named executive officers.
2004/2005/2006 Performance Share Payout
Name | | | | Dollar Value of Payout | |
Robert P. Cochran | | | $ | 7,433,855 | | |
Séan W. McCarthy | | | 5,062,712 | | |
Bruce E. Stern | | | 1,922,549 | | |
Russell B. Brewer II | | | 1,922,549 | | |
Joseph W. Simon | | | 1,089,444 | | |
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Dexia Restricted Stock Vested During 2006
The following table sets forth a summary of Dexia Restricted Stock awarded to each of the named executive officers that vested during the year ended December 31, 2006:
Dexia Restricted Stock Vested During 2006
Name | | | | Number of Shares
Acquired on Vesting | | Value Realized
on Vesting | |
Robert P. Cochran(1) | | | 12,713 | | | | $ | 327,915 | | |
Séan W. McCarthy | | | — | | | | — | | |
Bruce E. Stern | | | — | | | | — | | |
Russell B. Brewer II | | | — | | | | — | | |
Joseph W. Simon | | | — | | | | — | | |
(1) Because Mr. Cochran is above the minimum retirement age (55 years old), the 2004 Equity Plan provides that shares of Dexia Restricted Stock owned by Mr. Cochran vest pro-rata over the vesting period otherwise applicable to employees below the retirement age. The value realized on vesting is based upon the reported share price of Dexia ordinary shares as of the last day of each calendar quarter converted into U.S. dollars as reported on the books of the Company.
Nonqualified Deferred Compensation
The following table sets forth a summary of information with respect to the Company’s Deferred Compensation Plans (DCPs) and Supplemental Executive Retirement Plans (SERPs) as of and for the year ended December 31, 2006:
2006 Nonqualified Deferred Compensation
Name | | | | Executive
Contributions
in Last FY
(DCPs)(1) | | Registrant
Contributions
in Last FY
(SERPs)(2) | | Aggregate
Earnings
in Last FY(3) | | Aggregate
Withdrawals/
Distributions
in Last FY | | Aggregate
Balance
at Last FYE | |
Robert P. Cochran | | | $ | — | | | | $ | 71,100 | | | | $ | 2,296,678 | | | $ | — | | $ | 32,497,486 | |
Séan W. McCarthy | | | — | | | | 71,100 | | | | 442,999 | | | — | | 5,449,623 | |
Bruce E. Stern | | | — | | | | 71,100 | | | | 246,994 | | | (2,000,000 | ) | 4,990,542 | |
Russell B. Brewer II | | | — | | | | 71,100 | | | | 815,013 | | | — | | 11,627,006 | |
Joseph W. Simon | | | — | | | | 71,100 | | | | 17,495 | | | — | | 171,270 | |
| | | | | | | | | | | | | | | | | | | | | | | | |
(1) This column reflects compensation otherwise payable in 2006 (i.e., 2005 bonus and payouts of performance shares for cycles ending December 31, 2005) voluntarily deferred by the named executive officer under the DCPs.
(2) This column reflects contributions by the Company to the SERPs on behalf of the named executive officers accrued in 2005 and contributed in 2006. These amounts were included in the Summary Compensation Table. All amounts were 100% vested at December 31, 2006, except that Mr. Simon’s amount was 60% vested as of such date.
(3) The following portion of the amounts included in this column are included in the Summary Compensation Table under the caption “Nonqualified Deferred Compensation Earnings”: $491,881 for Mr. Cochran, $150,380 for Mr. McCarthy and $0 for Mr. Stern, Mr. Brewer and Mr. Simon.
The SERPs and DCPs are “top hat” plans, which are unfunded and unsecured non-qualified plans restricted under the tax laws to a limited number of highly compensated employees. Under the SERPs, the
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Company makes an annual contribution equal to 9% of prior year salary and bonus in excess of the money purchase plan salary/bonus cap (but disregarding salary/bonus in excess of $1 million), with such contributed amounts generally credited with returns on mutual funds or securities selected by the participants and “match funded” by the Company. The mutual funds and securities employed as investment benchmarks under the DCPs and SERPs in 2006 and their respective 2006 rates of return were as follows:
Name of Mutual Fund or Stock Benchmark | | | | 2006
% Rate of Return | |
Dodge & Cox Income Fund | | | 5.3 | | |
Dodge & Cox Stock Fund | | | 18.5 | | |
Fidelity Contrafund | | | 11.5 | | |
Fidelity Investment Grade Bond Fund | | | 4.8 | | |
Fidelity Money Market Portfolio | | | 4.8 | | |
Financial Security Assurance Holdings Ltd. common shares
(Director Share Purchase Program) | | | 9.1 | | |
Harbor Capital Appreciation Fund | | | 2.3 | | |
Julius Baer International Fund | | | 32.1 | | |
Longleaf Partners Fund | | | 21.6 | | |
Longleaf Partners Small Cap Fund | | | 22.3 | | |
Montpelier Re common shares | | | 0.1 | | |
Northern Select Equities Fund | | | 8.0 | | |
Olympus Re common shares | | | (7.3 | ) | |
PIMCO Stocks Plus | | | 14.7 | | |
White Mountains Insurance Group common shares | | | 5.3 | | |
Amounts contributed by the Company under the SERPs and the earnings thereon are payable upon termination of employment unless deferred by the employee. Employees are entitled to irrevocably defer receipt of SERP payments for one or more years beyond termination of employment. Under the DCPs, participants are entitled to irrevocably defer receipt (generally for a minimum deferral period equal to the earlier of three years or termination of employment) of bonus and performance share compensation otherwise payable to them by the Company, with such deferred amounts generally credited with returns on mutual funds or securities selected by the participants and “match funded” by the Company. While the SERPs and DCPs are unfunded plans, the plans contemplate that the Company will make available to plan participants “deemed” investment alternatives comprised of mutual funds or securities. Plan participants are generally entitled to select one or more such “deemed” investments for their plan balances (and to change such selections on a quarterly basis) and their plan balances are credited or debited with the performance of such selected investments. Plan participants are entitled to elect to receive SERP and DCP payouts in lump sums at the payout date or in installments (over a period of years elected in advance by the participant) commencing with the payout date. The SERPs and DCPs generally do not permit early withdrawals of funds absent extreme financial hardship, but allow for extensions of deferrals to the extent permitted by the Internal Revenue Code.
Potential Payments Upon Termination of Employment, Retirement or Change-in-Control
Set forth below is a description of amounts payable to the named executive officers upon termination of employment with the Company, retirement from the Company or change in control of the Company. Amounts set forth below do not include amounts payable under the Company’s Pension Plan, 401(k) plan, DCPs or SERPs described above.
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Payments Upon Termination of Employment
Chief Executive Officer and Chief Operating Officer
The employment agreements provide for continued participation by Messrs. Cochran and McCarthy in the Company’s benefit plans and severance benefits in lieu of the Company’s existing severance policy. Specifically, if the Company terminates Mr. Cochran or Mr. McCarthy without “cause” or either of such executive officers terminates his employment for “good reason,” the terminated employee will be entitled to:
· his pro-rata annual base salary and annual bonus through the date of termination;
· twice his annual base salary at the rate then in effect and twice his average annual bonus for the two immediately prior years;
· vesting of his outstanding performance shares;
· the minimum annual performance shares that he is entitled to receive through the end of the agreement’s term; and
· a gross-up payment to hold the employee harmless from any excise tax imposed by Section 4999 of the Internal Revenue Code of 1986, as amended (“Golden Parachute Tax”).
For purposes of each employment agreement, (a) “cause” means conviction of, or a plea of nolo contendere to, a criminal misdemeanor or felony materially injurious to the Company, willful and continued failure to perform duties after a specific demand to do so or willful misconduct in carrying out duties directly and materially harmful to the Company’s business or reputation; and (b) “good reason” means a diminution in the employee’s significant duties or responsibilities, breach by the Company of its obligations under the employment agreement, relocation of the executive more than 25 miles from New York City, a material adverse change in total compensation, or, in the case of Mr. McCarthy, not being named Mr. Cochran’s successor as Chief Executive Officer of the Company.
If his employment with the Company had been terminated without cause by the Company on December 31, 2006, then pursuant to his employment agreement Mr. Cochran would have been entitled to receive a minimum of $29,884,994, comprised of:
(a) $1,025,055, representing (i) $1,000,000, equal to two times the annual base salary at the 2006 rate, plus (ii) interest at the year-end three-month Treasury rate for the six month period prior to payment;
(b) $6,867,869, representing (i) $6,700,000, equal to two times the average annual bonus payable for the two years immediately prior to the termination, plus (ii) interest at the year-end three-month Treasury rate for the six month period prior to payment;
(c) $16,211,700, representing (i) the vesting of all previously granted outstanding performance shares valued at $145.61 per share under the 1993 Equity Plan and $149.57 per share under the 2004 Equity Plan, with the payouts for each completed year based on actual results and the payout for uncompleted years valued at 100%, plus (ii) interest at 8% per annum, compounded semi-annually, for the two year restricted period described below;
(d) $646,563, representing (i) the vesting of the 20,179 outstanding shares of Dexia restricted stock previously granted under the 2004 Equity Plan, valued as of December 31, 2006 at $27.39 per share, plus (ii) interest at 8% per annum, compounded semi-annually, for a two year restricted period; and
(e) $5,133,807, representing (i) the minimum annual award of 2007 performance shares entitled to be received through the contract term, equal to 29,340 performance shares with an estimated
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economic value at least equal to the employee’s 2004 performance share award of 40,000 performance shares (having an economic value of $4,388,400) and with the payouts for each cycle valued at 100%, plus (ii) interest at 8% per annum, compounded semi-annually, for a two year restricted period.
The foregoing termination payment excludes the minimum 2006 bonus ($3,071,950, equal to 5% of the guideline bonus pool) and 2004/2005/2006 performance share payout ($7,433,855) that Mr. Cochran would have been entitled to receive whether or not his employment had been terminated.
If his employment with the Company had been terminated without cause by the Company on December 31, 2006, then pursuant to his employment agreement Mr. McCarthy would have been entitled to receive a minimum of $23,340,231, comprised of:
(a) $676,536, representing (i) $660,000, equal to two times the annual base salary at the 2006 rate, plus (ii) interest at the year-end three-month Treasury rate for the six month period prior to payment;
(b) $6,150,330, representing (i) $6,000,000, equal to two times the average annual bonus payable for the two years immediately prior to the termination, plus (ii)interest at the year-end three-month Treasury rate for the six month period prior to payment;
(c) $11,866,392, representing (i) the vesting of all previously granted outstanding performance shares valued at $145.61 per share under the 1993 Equity Plan and $149.57 per share under the 2004 Equity Plan, with the payouts for each completed year based on actual results and the payout for uncompleted years valued at 100%, plus (ii) interest at 8% per annum, compounded semi-annually, for the two year restricted period described below;
(d) $924,963, representing (i) the vesting of the 28,869 outstanding shares of Dexia restricted stock previously granted under the 2004 Equity Plan, valued as of December 31, 2006 at $27.39 per share, plus (ii) interest at 8% per annum, compounded semi-annually, for a two year restricted period; and
(e) $3,722,010, representing (i) the minimum annual award of 2007 performance shares entitled to be received through the contract term, equal to 21,271 performance shares with an estimated economic value at least equal to the employee’s 2004 performance share award of 29,000 performance shares (having an economic value of $3,181,590) and with the payouts for each cycle valued at 100%, plus (ii) interest at 8% per annum, compounded semi-annually, for the two year restricted period.
The foregoing termination payment excludes the minimum 2006 bonus ($2,457,560, equal to 4% of the guideline bonus pool) and 2004/2005/2006 performance share payout ($5,062,712) that Mr. McCarthy would have been entitled to receive whether or not his employment had been terminated.
Both employment agreements provide that payments in respect of salary and bonus are, to the extent otherwise subject to penalty under Section 409A of the Internal Revenue Code, payable six months after termination of employment and are credited with interest at the three-month Treasury bill rate until so paid. Payments in respect of performance shares (a) are subject to forfeiture in the event of a breach by the employee of the covenant not to compete or covenant not to solicit Company clients or employees during a two year restricted period following termination of employment, and (b) are payable in a lump sum following expiration of the restricted period, together with interest accrued at 8% per annum, compounded semi-annually, during the restricted period.
Both employment agreements provide that, if the employee is terminated for cause or terminates his employment without “good reason” during the term, he will be entitled only to be paid his pro rata annual base salary through the date of termination and all unvested performance shares and Dexia restricted stock
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will be forfeited. If such termination occurs after the term of the agreement, he will also be entitled to his pro-rata annual bonus through the date of termination and his performance shares will vest pro rata in proportion to the percentage of the applicable performance cycle during which he was employed by the Company. Each employment agreement contains a non-compete provision extending through the greater of two years and the term of the agreement.
If Mr. Cochran becomes Non-Executive Chairman of the Company, he will be entitled to his then-current salary and an annual performance share unit award with an estimated economic value at least equal to 50% of normal prior awards, but will not be entitled to a mandatory annual cash bonus. If Mr. McCarthy becomes the Chief Executive Officer of the Company, he will be entitled to compensation equal to 90% or more of Mr. Cochran’s latest compensation, including salary, bonus and performance share units.
General Counsel, Chief Risk Management Officer and Chief Financial Officer
Pursuant to the Severance Policy for Senior Management, upon termination of employment (including constructive termination) by the Company other than for cause, each of Messrs. Stern, Brewer and Simon will become entitled to twelve months of pay, as well as a gross-up payment to hold the employee harmless from any excise Golden Parachute Tax. For purposes of the foregoing:
· “for cause” means termination for unethical practices, illegal conduct or gross insubordination, but specifically excludes termination as a result of substandard performance;
· “constructive termination” of employment occurs if an eligible employee’s compensation opportunity is significantly reduced out of line with Company results, or if there is a material reduction in responsibilities, such that the employee’s termination of employment is an involuntary termination under Section 409A of the Internal Revenue Code; and
· “months of pay” (a) shall be determined on the basis of the eligible employee’s monthly salary on his separation date and (b) shall include the eligible employee’s most recent bonus (or three year average, if higher), with one-twelfth (1/12th) of such bonus amount being allocated to each month of pay.
An eligible employee’s base salary and bonus shall include amounts deferred under the DCPs and the 401(k), and amounts allocated to the Flex Plan. In addition, severance benefits (applicable to all employees of the Company during their severance period) include:
· continuation of employee hospital, medical, dental, prescription drug and vision coverages for the severance period;
· continuation of life and disability insurance coverage at the employee’s expense for the severance period to the extent allowed by the insurer (such coverage is not currently allowed by the insurer);
· reimbursement of life insurance premiums to the extent that such life insurance is continued during the severance period; and
· payment for unused vacation days.
Payments of severance under the Severance Policy for Senior Management is subject to execution by the employee of a waiver and release agreement, and any unpaid severance amounts are subject to up to a 50% reduction when offset by any employment or consulting income of the employee during the severance period. If any of Mr. Stern, Mr. Brewer or Mr. Simon is terminated for cause or terminates his employment absent “constructive termination”, he will be entitled only to be paid his pro rata annual base salary through the date of termination and all unvested performance shares and Dexia restricted stock will be forfeited.
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If his employment with the Company had been terminated without cause by the Company on December 31, 2006, then pursuant to the Severance Policy for Senior Management, each of Mr. Stern and Mr. Brewer would have been entitled to receive $2,814,097, comprised of:
(a) one year salary at the 2006 rate of $260,000;
(b) one year bonus at the 2005 rate of $900,000;
(c) $1,580,344, the estimated value of outstanding performance shares and performance share units vested pro-rata under the 1993 Equity Plan and 2004 Equity Plan, representing (i) 9,540 performance shares valued at $1,441,997 based upon a 100% pay out and the December 31, 2006 per share value of $145.61 under the 1993 Equity Plan and $149.57 under the 2004 Equity Plan and (ii) $138,347 in respect of 5,051 shares of Dexia restricted stock valued at $27.39 per share;
(d) $25,420, representing the estimated cost of continuation of hospital, medical, dental, prescription drug and vision coverages for the severance period; and
(e) $48,333, representing payment for unused vacation days.
If his employment with the Company had been terminated without cause by the Company on December 31, 2006, then pursuant to the Severance Policy for Senior Management, Mr. Simon would have been entitled to receive $2,390,139, comprised of:
(a) one year salary at the 2006 rate of $260,000;
(b) one year bonus at the 2005 rate of $800,000;
(c) $1,284,386, the estimated value of outstanding performance shares and performance share units vested pro-rata under the 1993 Equity Plan and 2004 Equity Plan, representing (i) 7,628 performance shares valued at $1,156,283 based upon a 100% pay out and the December 31, 2006 per share value of $145.61 under the 1993 Equity Plan and $149.57 under the 2004 Equity Plan and (ii) $128,103 in respect of 4,677 shares of Dexia restricted stock valued at $27.39 per share;
(d) $23,670, representing the estimated cost of continuation of hospital, medical, dental, prescription drug and vision coverages for the severance period; and
(e) $22,083, representing payment for unused vacation days.
Payments Upon Retirement
Their employment agreements provide that Messrs. Cochran and McCarthy may elect to retire at the end of any employment agreement term after age 60, but that retirement is mandatory at age 65. Upon any such retirement, each of Mr. Cochran and Mr. McCarthy will be entitled to his pro-rata annual base salary and annual bonus through the date of retirement and the vesting of his outstanding performance shares over time as if he remained employed. Messrs. Cochran and McCarthy are not entitled to any other on-going retirement compensation except as provided by the Pension Plan and SERPs. Each of Mr. Cochran and Mr. McCarthy is below the minimum retirement age of 60 provided in their employment agreements. Each of Mr. Stern, Mr. Brewer and Mr. Simon is below the minimum retirement age of 55 otherwise applicable to employees of the Company. Accordingly, none of the named executive officers would be entitled to any payments by reason of retirement at December 31, 2006. In addition, under the Company’s Optional Retiree Medical Program applicable to all U. S. Company employees, Messrs. Cochran, McCarthy, Stern, Brewer and Simon are entitled to participate in the Company’s medical plan following retirement provided that they pay the full cost of coverage plus a 5% administrative fee to the Company. The Company retains the right to terminate the Optional Retiree Medical Program at any time.
Payments Upon Change in Control
The Equity Plans provide for accelerated vesting and payment of performance shares and accelerated vesting of Dexia restricted stock upon the occurrence of certain change in control transactions involving
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the Company. These provisions are generally applicable to all participants in the Equity Plans. Each of the named executive officers holds performance shares and Dexia restricted stock awarded under the Equity Plans.
The 1993 Equity Plan provides that the Company’s Board of Directors may elect to continue the plan and the 2004 Equity Plan provides that the plan shall automatically continue if a change in control occurs. Following a “plan continuation,” performance shares and Dexia restricted stock are not accelerated, but vest and are payable as if no change in control had occurred, except that performance shares and Dexia restricted stock vest in the case of any employee who is terminated without cause or leaves for “good reason” following the change in control. If a change in control of the Company occurred at December 31, 2006 and a plan continuation was not elected under the 1993 Equity Plan, then each participant in the 1993 Equity Plan would be entitled to pro-rata vesting of their outstanding performance shares under the 1993 Equity Plan, with an estimated value of $2,987,718 for Mr. Cochran, $2,166,095 for Mr. McCarthy, $746,930 for Mr. Stern, $746,930 for Mr. Brewer and $522,851 for Mr. Simon, in each case valued at the December 31, 2006 share value of $145.61 per share under the 1993 Equity Plan, with the payouts for each completed cycle based on actual results and the payout for uncompleted cycles valued at 100%.
Compensation of Directors
The table below sets forth a summary of all compensation paid to the directors of the Company, in each case for services rendered to the Company for the year ended December 31, 2006. Employees of the Company and Dexia received no additional compensation for their services as directors of the Company.
2006 Director Compensation Table
Name | | | | Fees Earned
Or Paid in Cash | | Nonqualified
Deferred Compensation
Earnings(1) | | All Other
Compensation(2) | | Total(3) | |
Robert N. Downey | | | $ | 79,000 | | | | $ | 52,528 | | | | $ | 116,364 | | | $ | 195,364 | |
James H. Ozanne | | | 102,000 | | | | 141,947 | | | | — | | | 102,000 | |
Roger K. Taylor | | | 88,000 | | | | 556,963 | (4) | | | — | | | 88,000 | |
George U. Wyper | | | 87,750 | | | | — | | | | 35,782 | | | 123,532 | |
David O. Maxwell(5) | | | 23,750 | | | | — | | | | 111,400 | | | 135,150 | |
| | | | | | | | | | | | | | | | | | | | | |
(1) The amount under this column reflects the excess, if any, of (a) income on Company common stock acquired under the Director Share Purchase Program described below and credited by the Company to participants under the DCPs over (b) the Proxy Market Rate of 5.88%. This column does not include earnings on publicly traded mutual funds credited by the Company to participants under the DCPs. The Company currently match funds substantially all phantom investments (other than money market fund investments) made by participants in the DCPs. Since the Company match funds substantially all phantom investments under the DCPs, the principal costs associated with these plans come from (i) the delay in recognition by the Company of compensation expense for the deferred amounts and (ii) the recognition of gains on matched investments if and when realized by the Company prior to the time that the Company recognizes a deduction for compensation expense to the employee (at the time payments are made by the plans to the participants). Reference is made to “—Nonqualified Deferred Compensation,” above, for a list of the mutual funds and stock benchmarks under the DCPs and their respective 2006 rates of return. The dollar amounts under this column are not included in determining amounts under the “total” compensation column.
(2) Amounts under this column reflect the excess of (a) realized and unrealized gains on common stock of the Company, purchased through the Director Share Purchase Program (excluding shares held under the DCPs), over (b) the Proxy Market Rate of 5.88%. For discussion of the Director Share Purchase Program, see “—Director Share Purchase Program,” below.
(3) Total compensation does not include nonqualified deferred compensation earnings.
(4) The amounts deferred by Mr. Taylor under the DCPs primarily relate to compensation earned while employed by the Company.
(5) Mr. Maxwell retired from the Board of Directors of the Company in May 2006.
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Each director of the Company who is not an officer of the Company or Dexia received a fee of $50,000 per annum for service as a director and an additional annual fee of $20,000 if Chairman of the Underwriting Committee or Audit Committee of the Board of Directors or $5,000 if Chairman of another Committee of the Board of Directors. Each director also received $2,000 for each Board meeting and regular Committee meeting attended and reimbursement for expenses for each such meeting attended. Each director is entitled to defer fees under the Company’s DCP and to participate in the Director Share Purchase Program.
Director Share Purchase Program
In the fourth quarter of 2000, the Company entered into an agreement with Dexia Holdings and Dexia Public Finance Bank, now Dexia Crédit Local, to establish the Director Share Purchase Program (the “Director Share Purchase Program”), pursuant to which Company directors could invest in shares of the Company’s common stock. Dexia and the Company established the Director Share Purchase Program to encourage directors to have a financial interest in the Company to better align their financial interests with those of the Company’s shareholders.
The Director Share Purchase Program entitles each director of the Company to purchase from Dexia (or an affiliate thereof) up to 126,958 restricted shares of the Company’s common stock (which represented a $10 million investment at the purchase price at inception of the program) at a price determined in accordance with the formula described below, provided that:
· restricted shares must be held for the lesser of four years or the participant’s tenure as a director of the Company;
· restricted shares may be put to Dexia Crédit Local at any time or from time to time following the required holding period for cash; and
· purchases of shares after inception of the program are at a price equal to the purchase price for shares put to Dexia Crédit Local described below.
Directors may purchase such shares either directly or through deemed investments under the DCPs or, in the case of Company employees, the SERPs. Each deemed investment election with respect to these shares is irrevocable.
The Director Share Purchase Program enables the Company to purchase from Dexia Holdings, at the same price, the same number of shares of common stock purchased by directors through phantom investments under the DCPs or SERPs. Upon expiration of any applicable deferral period, the Company is obligated to pay out the phantom investments in shares of common stock, which must be held by the participant as if acquired directly from Dexia Holdings for generally a minimum of six months.
The purchase price for each restricted share acquired by a director or put to Dexia Crédit Local is equal to the product of 1.4676 and adjusted book value per share (“ABV per share”), with ABV per share determined in accordance with the methodology employed for valuing performance share award payouts under the Equity Plans. The 1.4676 times ABV multiple was based upon the ABV multiple paid by Dexia when it acquired the Company in 2000. The purchase price per share, determined pursuant to such formula, was $178.16 as of December 31, 2006. ABV per share is measured at the close of the calendar quarter in which a director submits a repurchase notice, provided that ABV per share for a terminated director freezes at the end of the calendar quarter including the first anniversary of the later of the termination of directorship or, in the case of deferred shares, receipt of shares upon expiration of the deferral period.
Sales under the program are not registered under the Securities Act of 1933, as amended, in reliance upon an exemption from registration under Section 4(2) of that Act. For more information regarding the directors’ share ownership, see “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters—Directors and Executive Officers.”
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Compensation Committee Interlocks and Insider Participation
As of January 1, 2006, the HR Committee consisted of Messrs. Cochran, Deletré, Downey and Taylor as well as David O. Maxwell (chairman) and Pierre Richard, then-members of the Board of Directors who retired from the board in May 2006. In February 2006, Mr. Downey was named Chairman of the Committee, Mr. Miller was elected to the Committee, and Messrs. Maxwell and Richard ceased to be members of the committee in connection with their retirement from the Company’s Board of Directors.
Except for Messrs. Cochran and Taylor, none of such persons is currently or has ever been an officer or employee of the Company or any subsidiary of the Company. Mr. Miller is the Group Chief Executive Officer and Member of the Board of Directors and Chairman of the Management Board of Dexia. Mr. Deletré is a Member of the Management Board of Dexia. Mr. Richard is the Chairman of the Board of Directors of Dexia.
As described in “Director Share Purchase Program,” above, members of the HR Committee are entitled to participate in a share purchase program available to all directors of the Company, either directly or through deemed investments under the Company’s DCPs or SERPs.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
5% Shareholders
The following table sets forth certain information regarding beneficial ownership of the Company’s equity at March 15, 2007 as to each person known by the Company to beneficially own, within the meaning of the Exchange Act, 5% or more of the outstanding shares of the common stock, par value $.01 per share, of the Company.
Title of class | | | | Name and address of
beneficial owner | | Amount and nature of
beneficial ownership | | Percent of
class | |
Common stock, par value | | Dexia S.A.(1) | | 33,188,616 shares(1)(2) | | | 99.7 | %(2) | |
$.01 per share | | 7 à 11 quai André Citröen
BP-1002
75 901 Paris Cedex 15, France | | | | | | | |
| | Place Rogier 11
B - 1210 Brussels, Belgium | | | | | | | |
(1) Shares are held indirectly through a subsidiary of Dexia.
(2) For purposes of this table, Dexia is not deemed to be the beneficial owner of 241,978 shares acquired by the Company in connection with the Director Share Purchase Program described in “Item 11. Executive Compensation—Compensation of Directors—Director Share Purchase Program.” Ownership percentage is calculated based on 33,276,017 shares of common stock outstanding at March 15, 2007, which excludes such shares acquired by the Company.
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Directors and Executive Officers
Ownership of Company Common Stock
The following table sets forth certain information regarding beneficial and economic ownership of the Company’s common stock at March 15, 2007 for (a) each director of the Company, (b) each named executive officer named in the “Summary Compensation Table” in Item 11, and (c) all executive officers and directors of the Company as a group.
Beneficial ownership is less than 1% for each executive officer and director listed, individually and as a group.
Name of Beneficial Owner | | | | Amount and
Nature of Beneficial
Ownership(1) | | Economic
Ownership(1) | |
Robert P. Cochran | | | 41,744 | | | | 245,425 | | |
Michèle Colin(2) | | | — | | | | — | | |
Bruno Deletré(2) | | | — | | | | — | | |
Robert N. Downey | | | 20,159 | | | | 29,259 | | |
Jacques Guerber(2) | | | — | | | | — | | |
Rembert von Lowis(2) | | | — | | | | — | | |
Séan W. McCarthy | | | — | | | | 113,785 | | |
Axel Miller(2) | | | — | | | | — | | |
James H. Ozanne | | | — | | | | 25,123 | | |
Roger K. Taylor | | | — | | | | 96,489 | | |
Xavier de Walque(2) | | | — | | | | — | | |
George U. Wyper | | | 6,199 | | | | 6,199 | | |
Bruce E. Stern | | | — | | | | 30,967 | | |
Russell B. Brewer II | | | — | | | | 30,967 | | |
Joseph W. Simon | | | — | | | | 28,067 | | |
All executive officers and directors as a group (15 persons) | | | 68,102 | | | | 606,281 | | |
(1) Shares beneficially owned were acquired under the Company’s Director Share Purchase Program described under “Item 11. Executive Compensation—Compensation of Directors—Director Share Purchase Program.” To the extent shares economically owned exceed shares beneficially owned, such economic ownership is attributable to (a) deemed investments in the Company’s common stock under the Director Share Purchase Program, and (b) performance shares, with each performance share treated as one share of common stock, in the amounts shown below (excluding fractional shares):
Officer | | | | Performance Shares | |
Robert P. Cochran | | | 118,467 | | |
Séan W. McCarthy | | | 87,733 | | |
Bruce E. Stern | | | 30,967 | | |
Russell B. Brewer II | | | 30,967 | | |
Joseph W. Simon | | | 28,067 | | |
In December 2000, the Company acquired 304,757 shares of its common stock from Dexia Holdings to satisfy most of its obligations under the Director Share Purchase Program in an amount equal to the number of shares deemed invested by directors at the Program’s inception date under the DCP and SERP. The Company held 241,978 of those shares as of December 31, 2006.
(2) Ms. Colin and Messrs. Deletré, Guerber, von Lowis, Miller and de Walque are directors of the Company and officers of Dexia or its subsidiaries. Dexia indirectly owns 99.7% of the Company’s common stock.
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The Company is not aware of any arrangements that may result in a change in control of the Company.
Ownership of Dexia Common Stock
The following table sets forth beneficial ownership of common shares of the Company’s parent, Dexia, at March 15, 2007, for (a) each director of the Company, (b) each executive officer and (c) all executive officers and directors of the Company as a group. Beneficial ownership is less than 1% for each executive officer and director listed, individually and as a group.
Directors and Executive Officers(1) | | | | Amount and Nature of
Beneficial Ownership | |
Robert P. Cochran(2) | | | 632,458 | | |
Michèle Colin | | | 3,490 | | |
Bruno Deletré | | | 1,435 | | |
Robert N. Downey | | | — | | |
Jacques Guerber | | | 10,677 | | |
Rembert von Lowis | | | 26,053 | | |
Séan W. McCarthy(2) | | | 611,459 | | |
Axel Miller | | | 100 | | |
James H. Ozanne | | | — | | |
Roger K. Taylor | | | — | | |
Xavier de Walque | | | 49,484 | | |
George U. Wyper | | | — | | |
Bruce E. Stern(2) | | | 215,508 | | |
Russell B. Brewer II(2) | | | 210,538 | | |
Joseph W. Simon(2) | | | 58,112 | | |
All executive officers and directors as a group (15 persons) | | | 1,819,314 | | |
(1) Dexia has provided the Company with information regarding shares owned by Ms. Colin and Messrs. Deletré, Guerber, von Lowis, Miller and de Walque, and has advised the Company that:
(a) shares presented for those directors include only shares owned directly by such directors or shares for which those directors can cast a vote and exclude warrants, and
(b) as of December 31, 2006, the total number of outstanding Dexia shares was 1,163,184,325, so that together the Company’s executive officers and directors owned 0.16% of the Dexia shares and the maximum amount owned by any of the Company’s executive officers and directors represents 0.05% of the Dexia shares.
A majority of the shares set forth above were acquired under the Dexia Employee Share Plans, as described in “Item 11. Executive Compensation—Components of Compensation Provided by the Company—Dexia Employee Share Plans.” Under the Plans, the investment alternatives include a “classic option,” under which U.S. resident employees may purchase Dexia shares at a 15% discount (up to a limit prescribed annually under Section 423 of the Internal Revenue Code, which was $21,250 for 2006), and three leveraged options. The following table shows the number of leveraged shares beneficially held by each of the named executive officers as of March 15, 2006:
Officer | | | | Leveraged Shares | |
Robert P. Cochran | | | 591,860 | | |
Séan W. McCarthy | | | 569,540 | | |
Bruce E. Stern | | | 190,110 | | |
Russell B. Brewer II | | | 190,600 | | |
Joseph W. Simon | | | 43,780 | | |
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(2) Includes shares granted under the 2004 Equity Plan, as described in “Item 11. Executive Compensation—Compensation Discussion and Analysis—Components of Compensation Provided by the Company—Performance Share Units.” Generally, one-third of an award of Dexia restricted stock vests after 2.5 years and two-thirds vests after 3.5 years, with transfer restrictions lapsing on one-third of each award after three years and on two thirds of each award after four years.
Securities Available under Equity Compensation Plans
The following table sets forth information as of December 31, 2006 with respect to each compensation plan of the Company under which equity securities of the Company are authorized for issuance.
Equity Compensation Plan Information
Plan Category | | | | Number of securities
to be issued upon
exercise of outstanding
options, warrants and
rights(a) | | Weighted average
exercise price of
outstanding options,
warrants and rights(b) | | Number of securities
remaining available
for future issuance
under equity
compensation plans
(excluding securities
reflected in
column (a))(c) | |
Equity compensation plans approved by security holders(1) | | | 0 | | | | — | | | | 2,705,775 | (3) | |
Equity compensation plans not approved by security holders(2) | | | Not applicable | | | | — | | | | Not applicable | | |
Total | | | 0 | | | | — | | | | 2,705,775 | | |
(1) The Company currently maintains one such plan, the 2004 Equity Plan. A second plan, the Director Share Purchase Program, permits each director of the Company to purchase, directly from Dexia Holdings or through “phantom” investments in the Company’s DCP or SERP, up to 126,958 shares of common stock. However, such shares are already issued and outstanding. As of December 31, 2006, there were 1,086,458 shares available under the Director Share Purchase Program, based on the number of directors as of December 31, 2006 (11) and deducting shares that have already been purchased. See “Item 11. Executive Compensation—Compensation Discussion and Analysis—Components of Compensation Provided by the Company” and “—Compensation of Directors—Director Share Purchase Program” for further discussion of these plans.
(2) All of the Company’s equity compensation plans have been approved by the Company’s shareholders.
(3) Shares available for future issuance under the 2004 Equity Plan. Since its inception, up to 3,300,000 shares of common stock have been available for distribution under the 2004 Equity Plan in respect of performance shares. Such shares may be newly issued shares, treasury shares or shares purchased in the open market. If performance shares awarded under the 2004 Equity Plan are forfeited, the shares allocated to such awards are again available for distribution in connection with future awards under the Plan. So long as the Company’s common stock is not registered under the Exchange Act, the Company expects to pay its performance shares in cash rather than stock.
Item 13. Certain Relationships and Related Transactions.
Financial Guaranty Transactions
Since the Company’s merger with a subsidiary of Dexia in July 2000, various affiliates of Dexia, including certain wholly owned bank subsidiaries and/or their U.S. branches, have participated in transactions in which subsidiaries of the Company have provided financial guaranty insurance. For example, Dexia affiliates have provided liquidity facilities and letters of credit in FSA-insured transactions, and have been the beneficiaries of financial guaranty insurance policies issued by insurance company
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subsidiaries of the Company. In the opinion of management of the Company, the terms of these arrangements are no less favorable to the Company than the terms that could be obtained from unaffiliated parties. See Note 21 to the Consolidated Financial Statements in Item 8.
Director Share Purchase Program
As of December 31, 2006, each director was entitled to purchase up to 126,958 actual or phantom shares of the Company’s common stock, as described in “Item 11. Executive Compensation—Compensation of Directors—Director Share Purchase Program.”
Other Relationships
Under a cost-sharing agreement, the Company reimburses Dexia Crédit Local for the portion of director Bruno Deletré’s Dexia Crédit Local compensation that relates to his work as liaison with the Company on behalf of Dexia.
Additional information relating to certain relationships and related transactions is set forth in “Item 11. Executive Compensation—Compensation Committee Interlocks and Insider Participation.”
Review, Approval or Ratification of Transactions with Related Persons
The Company’s ability to enter into related party transactions is limited by law. Under the New York Insurance Holding Company Act, the Company is required to obtain the prior approval of the New York Superintendent of the following transactions with related parties in amounts greater than 5% of the Company’s admitted assets: sales, purchases, exchanges, loans or extensions of credits or investments. The Company must provide the New York Superintendent with 30 days’ prior notice of such transactions with related parties in amounts equal to 0.5%-5% of the Company’s admitted assets or involving reinsurance treaties or agreements or the rendering of services on a regular or systematic basis. For these purposes, an entity is presumed to be a “related party” if the direct or indirect voting control is 10% or greater. Absent a determination by the New York Superintendent of non-control, acquisition of a voting interest of 10% or more of Dexia would require prior approval of the New York Superintendent.
The Company provides an annual report to the New York Superintendant and the Board of Directors of the Company of all transactions with Dexia and its affiliates that are not members of the FSA group.
All directors and officers are subject to the “Corporate Policy for Directors and Officers on Conflicts of Interest,” pursuant to which no director or officer may have, directly or indirectly:
· a personal or financial interest in any transaction adverse to the Company; or
· without prompt disclosure to the Board of Directors or Executive Management Committee of the Company, a financial interest in any insurance agency, brokerage business or other business enterprise (a) with which the Company engages in the purchase, sale or exchange of property, or the rental of real or personal property, or (b) to which it renders or from which it secures services.
For these purposes, “interest” includes the interest of the spouse or dependents of a director or officer, and “financial interest” does not include ownership of less than 1/10 of one percent of the outstanding stock of any corporation listed on a national securities exchange or less than $10,000 of the outstanding stock of any corporation whose stock is regularly sold at least once a week on the over-the-counter market in the U.S. In addition, pursuant to the bylaws of the Company, the Board of Directors must ratify any loans or debt of the Company. The Company does not have any other written policies and procedures for the review, approval or ratification of related party transactions.
As noted above, affiliates of Dexia have participated in transactions in which subsidiaries of the Company have provided financial guaranty insurance, including by providing liquidity facilities and letters of credit in FSA-insured transactions, and have been beneficiaries of financial guaranty insurance policies
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issued by insurance company subsidiaries of the Company. Such transactions are the principal context in which affiliates of Dexia participate in transactions with the Company, and are subject to the same credit committee reviews as transactions in which no Dexia affiliates participate. In the opinion of management of the Company, the terms of these arrangements are no less favorable to the Company than the terms that could be obtained from unaffiliated parties.
Director Independence
Board members Robert N. Downey, James H. Ozanne, Roger K. Taylor and George U. Wyper are independent within the meaning of Rule 10A-3 of the Exchange Act and Messrs Downey, Taylor and Wyper satisfy the requirements for independence of the NYSE. Messrs. Ozanne (Chairman), Taylor and Wyper comprise the Audit Committee of the Board of Directors and Messrs. Downey and Taylor are members of the Human Resources Committee of the Board of Directors.
In determining whether or not a director is independent, the Company uses the standards set out in Rule 10A-3(a)(b)(1) of the Exchange Act. Because the Company has only debt securities listed on the NYSE, it is not subject to the additional independence standards imposed by the NYSE, and is not subject to the NYSE requirement that a majority of the members of a board of directors and all members of a human resources committee be independent.
Item 14. Principal Accounting Fees and Services.
Aggregate fees (in thousands) for professional services by PricewaterhouseCoopers LLP for 2006 and 2005 were:
| | 2006 | | 2005 | |
Audit | | $ | 1,498.3 | | $ | 2,033.9 | |
Audit related | | 416.6 | | 392.1 | |
Tax | | 15.0 | | 328.0 | |
Other non-audit | | 31.4 | | | |
Total | | $ | 1,961.3 | | $ | 2,754.0 | |
Audit fees for the years ended December 31, 2006 and 2005 were for professional services rendered for the audits of the Company’s Consolidated Financial Statements, audits of the Subsidiaries, and issuance of consents and comfort letters. Included in this amount is $0.1 million and $0.2 million in fees relating to consents that are reimbursed to the Company by the issuers of FSA-insured deals for the years ended December 31, 2006 and 2005, respectively.
Audit related fees for the years ended December 31, 2006 and 2005 were for assurance and related services related to the Company’s retirement plans, actuarial certifications and consultations concerning financial accounting and reporting standards.
Tax fees for the year ended December 31, 2006 were related to tax compliance. Tax fees for the year ended December 31, 2005 were for services related to tax compliance, including the preparation of tax returns for expatriates, assistance with tax audits and appeals, and tax services for employee benefit plans.
Other non-audit fees for the year ended December 31, 2006 were related primarily to work performed in conjunction with the licensing of the Company’s Tokyo branch.
Audit Committee Pre-Approval Policies and Procedures
The Audit Committee of the Company’s Board of Directors pre-approves all audit and non-audit related fees paid to the Company’s auditors.
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PART IV
Item 15. Exhibits, Financial Statement Schedules.
1. Consolidated Financial Statements
Item 8 sets forth the following financial statements of Financial Security Assurance Holdings Ltd. and Subsidiaries:
Report of Independent Registered Public Accounting Firm | | 72 | |
Consolidated Balance Sheets at December 31, 2006 and 2005 | | 73 | |
Consolidated Statements of Operations and Comprehensive Income for the Years Ended December 31, 2006, 2005 and 2004 | | 74 | |
Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2006, 2005 and 2004 | | 75 | |
Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2005 and 2004 | | 76 | |
Notes to Consolidated Financial Statements | | 78 | |
2. Financial Statement Schedules
The following financial statement schedule is filed as part of this Report.
Schedule | | Title |
I | | Parent Company Condensed Financial Information at December 31, 2006 and 2005 and for the Years Ended December 31, 2006, 2005 and 2004. |
| | The report of the Independent Registered Public Accounting Firm with respect to the above listed financial statement schedule is set forth under Item 8 of this Report. |
| | All other schedules are omitted because they are either inapplicable or the required information is presented in the Consolidated Financial Statements of the Company or the notes thereto. |
3. Exhibits
The following are annexed as exhibits to this Report:
Exhibit No. | | Exhibit |
2.1 | | Agreement and Plan of Merger dated as of March 14, 2000 by and among Dexia S.A., Dexia Crédit Local de France S.A., PAJY Inc. and the Company. (Previously filed as Exhibit 2.1 to Current Report on Form 8-K (Commission File No. 1-12644) dated March 14, 2000, and incorporated herein by reference.) |
3.1 | | Restated Certificate of Incorporation of the Company. (Previously filed as Exhibit 3.1 to the Company’s Registration Statement on Form S-3 (Reg. No. 333-74165) (the “Form S-3”), and incorporated herein by reference.) |
3.1A | | Certificate of Merger of PAJY Inc. into the Company under Section 904 of the Business Corporation Law of the State of New York (effective July 5, 2000). (Previously filed as Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q (Commission File No. 1-12644) for the quarterly period ended September 30, 2000 (the “September 30, 2000 10-Q”), and incorporated herein by reference.) |
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3.1B | | Certificate of Merger of White Mountains Holdings, Inc. and the Company into the Company under Section 904 of the Business Corporation Law (effective July 5, 2000). (Previously filed as Exhibit 3.2 to the September 30, 2000 10-Q, and incorporated herein by reference.) |
3.2 | | Amended and Restated By-laws of the Company, as amended and restated on July 5, 2000. (Previously filed as Exhibit 3.3 to the September 30, 2000 10-Q, and incorporated herein by reference.) |
4.1 | | Amended and Restated Trust Indenture dated as of February 24, 1999 (the “Amended and Restated Senior Indenture”) between the Company and the Senior Debt Trustee. (Previously filed as Exhibit 4.1 to the Company’s Registration Statement on Form S-3 (Reg. No. 33-74165), and incorporated herein by reference.) |
4.1A | | Form of 67¤8% Quarterly Interest Bond Securities due December 15, 2101. (Previously filed as Exhibit 2 to the Company’s Current Report on Form 8-K (Commission File No. 1-12644) dated December 12, 2001 (the “December 2001 Form 8-K”), and incorporated herein by reference.) |
4.1B | | Officers’ Certificate pursuant to Sections 2.01 and 2.03 of the Amended and Restated Senior Indenture. (Previously filed as Exhibit 3 to the December 2001 Form 8-K, and incorporated herein by reference.) |
4.1C | | Form of 6.25% Notes due 2102. (Previously filed as Exhibit 3 to the Company’s Current Report on Form 8-K (Commission File No. 1-12644) dated November 6, 2002 and filed November 25, 2002 (the “November 2002 Form 8-K”), and incorporated herein by reference.) |
4.1D | | Officers’ Certificate pursuant to Sections 2.01 and 2.03 of the Amended and Restated Senior Indenture. (Previously filed as Exhibit 4 to the November 2002 Form 8-K, and incorporated herein by reference.) |
4.1E | | Form of 5.60% Notes due 2103. (Previously filed as Exhibit 2 to the Company’s Current Report on Form 8-K (Commission File No. 1-12644) dated July 17, 2003 and filed July 30, 2003 (the “July 2003 Form 8-K”), and incorporated herein by reference.) |
4.1F | | Officers’ Certificate pursuant to Sections 2.01 and 2.03 of the Amended and Restated Senior Indenture. (Previously filed as Exhibit 3 to the July 2003 Form 8-K, and incorporated herein by reference.) |
4.2 | | Indenture, dated as of November 22, 2006, between Financial Security Assurance Holdings Ltd. and The Bank of New York, as Trustee. (Previously filed as Exhibit 4.1 to Current Report on Form 8-K (Commission File No. 1-12644) dated November 22, 2006 (the “November 2006 8-K”), and incorporated herein by reference.) |
4.2A | | Financial Security Assurance Holdings Ltd., Officer’s Certificate Pursuant to Sections 1.02 and 3.01 of the Indenture, dated as of November 22, 2006, between Financial Security Assurance Holdings Ltd. and The Bank of New York, as Trustee. (Previously filed as Exhibit 10.2 to the November 2006 8-K, and incorporated herein by reference.) |
4.2B | | Form of Junior Subordinated Debenture, Series 2006-1. (Previously filed as Exhibit 10.3 to the November 2006 8-K, and incorporated herein by reference.) |
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10.1 | | Amended and Restated Agreement, dated as of April 21, 2006, among Financial Security Assurance Inc., the additional borrowers party thereto, various banks and The Bank of New York, as agent. (Previously filed as Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q (Commission File No. 1-12644) for the quarterly period ended March 31, 2006, and incorporated herein by reference.) |
10.2 | | Third Amended and Restated Credit Agreement dated as of April 30, 2005, among Financial Security Assurance Inc., FSA Insurance Company, the Banks party thereto from time to time and Bayerische Landesbank, acting through its New York Branch, as Agent. (Previously filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q (Commission File No. 1-12644) for the quarterly period ended March 31, 2005 (the “March 31, 2005 10-Q”), and incorporated herein by reference.) |
10.3† | | 1989 Supplemental Executive Retirement Plan (amended and restated as of December 17, 2004). (Previously filed as Exhibit 10.4 to the Company’s Current Report on Form 8-K (Commission File No. 1-12644) dated December 17, 2004 and filed on December 17, 2004 (the “December 2004 Form 8-K”), and incorporated herein by reference.) |
10.4† | | 2004 Supplemental Executive Retirement Plan, dated as of December 17, 2004. (Previously filed as Exhibit 10.3 to the December 2004 Form 8-K, and incorporated herein by reference. |
10.4A† | | 2004 Supplemental Executive Retirement Plan, as amended on May 18, 2006. (Previously filed as Exhibit 10.1 to the Current Report on Form 8-K (Commission File No. 1-12644) dated May 18, 2006 (the “May 2006 8-K”), and incorporated herein by reference.) |
10.5† | | Amended and Restated 1993 Equity Participation Plan (amended and restated as of May 17, 2001). (Previously filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q (Commission File No. 1-12644) for the quarterly period ended June 30, 2001 (the “June 30, 2001 10-Q”), and incorporated herein by reference.) |
10.6† | | 2004 Equity Participation Plan (Previously filed as Exhibit 10.1 to the Company’s current report on Form 8-K (Commission File No. 1-12644) dated November 18, 2004 and filed on November 23, 2004 (the “November 2004 Form 8-K”) and incorporated herein by reference.) |
10.6A† | | 2004 Equity Participation Plan, as amended on September 15, 2005. (Previously filed as Exhibit 10.1 to Current Report on Form 8-K (Commission File No. 1-12644) dated September 16, 2005, and incorporated herein by reference.) |
10.6B† | | 2004 Equity Participation Plan, as amended on February 16, 2006. (Previously filed as Exhibit 10.1 to Current Report on Form 8-K (Commission File No. 1-12644) dated February 16, 2006 (the “February 16, 2006 8-K”), and incorporated herein by reference.) |
10.6C† | | Form of Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award of Dexia Restricted Stock. (Previously filed as Exhibit 10.4 to the March 31, 2005 10-Q, and incorporated herein by reference.) |
10.6D† | | Form of Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award of Dexia Restricted Stock, as amended on February 16, 2006. (Previously filed as Exhibit 10.2 to the February 16, 2006 8-K, and incorporated herein by reference.) |
10.6E†* | | Form of Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award of Dexia Restricted Stock, as amended on February 14, 2007. |
10.6F†* | | Amendment to Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award of Dexia Restricted Stock to Robert P. Cochran, dated as of February 14, 2007. |
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10.6G† | | Form of Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award of Performance Shares. (Previously filed as Exhibit 99.1 to the Current Report on Form 8-K (Commission File No. 1-12644) dated February 16, 2005, and incorporated herein by reference.) |
10.6H† | | Form of Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award of Performance Shares, as amended on February 16, 2006. (Previously filed as Exhibit 10.3 to the February 16, 2006 8-K, and incorporated herein by reference.) |
10.7† | | Financial Security Assurance Inc. Overseas Pension Plan. (Previously filed as Exhibit 10.3 to the February 16, 2006 8-K, and incorporated herein by reference.) |
10.8† | | 1995 Deferred Compensation Plan (amended and restated as of December 17, 2004). (Previously filed as Exhibit 10.2 to the December 2004 8-K, and incorporated herein by reference.) |
10.9† | | 2004 Deferred Compensation Plan, dated December 17, 2004. (Previously filed as Exhibit 10.1 to the December 2004 8-K, and incorporated herein by reference.) |
10.9A† | | 2004 Deferred Compensation Plan, as amended on May 18, 2006. (Previously filed as Exhibit 10.2 to the May 2006 8-K, and incorporated herein by reference.) |
10.10† | | Severance Policy for Senior Management (amended and restated as of November 13, 2003). (Previously filed as Exhibit 10.7 to the Company’s Annual Report on Form 10-K (Commission File No. 1-12644) for the fiscal year ended December 31, 2003, and incorporated herein by reference.) |
10.10A† | | Severance Policy for Senior Management, as amended on May 18, 2006. (Previously filed as Exhibit 10.3 to the May 2006 8-K, and incorporated herein by reference.) |
10.11† | | Share Purchase Program Agreement dated as of December 15, 2000, among Dexia Public Finance Bank, Dexia Holdings, Inc. and the Company. (Previously filed as Exhibit 10.9(B) to the Company’s Annual Report on Form 10-K (Commission File No. 1-12644) for the fiscal year ended December 31, 2000 (the “December 31, 2000 10-K”), and incorporated herein by reference.) |
10.12† | | Employment Agreement by and between the Company and Robert P. Cochran, as amended on May 18, 2006. (Previously filed as Exhibit 10.4 to the May 2006 8-K, and incorporated herein by reference.) |
10.13† | | Employment Agreement by and between the Company and Séan W. McCarthy, as amended on May 18, 2006. (Previously filed as Exhibit 10.5 to the May 2006 8-K, and incorporated herein by reference.) |
10.14†* | | Financial Security Assurance Holdings Ltd. Annual Bonus Pool Guideline. |
10.15 | | Put Option Agreement, dated as of June 23, 2003 by and between FSA and Sutton Capital Trust I. (Previously filed as Exhibit 99.5 to the Company’s Quarterly Report on Form 10-Q (Commission File No. 1-12644) for the quarterly period ended June 30, 2003 (the “June 30, 2003 10-Q”), and incorporated herein by reference.) |
10.16 | | Put Option Agreement, dated as of June 23, 2003 by and between FSA and Sutton Capital Trust II. (Previously filed as Exhibit 99.6 to the June 30, 2003 10-Q, and incorporated herein by reference.) |
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10.17 | | Put Option Agreement, dated as of June 23, 2003 by and between FSA and Sutton Capital Trust III. (Previously filed as Exhibit 99.7 to the June 30, 2003 10-Q, and incorporated herein by reference.) |
10.18 | | Put Option Agreement, dated as of June 23, 2003 by and between FSA and Sutton Capital Trust IV. (Previously filed as Exhibit 99.8 to the June 30, 2003 10-Q, and incorporated herein by reference.) |
10.19 | | Contribution Agreement, dated as of November 22, 2006, between Dexia S.A. and Financial Security Assurance Holdings Ltd. (Previously filed as Exhibit 10.4 to the November 2006 8-K, and incorporated herein by reference.) |
10.20 | | Replacement Capital Covenant, dated as of November 22, 2006, by Financial Security Assurance Holdings Ltd. (Previously filed as Exhibit 10.5 to the November 2006 8-K, and incorporated herein by reference.) |
10.21 | | Purchase Agreement, dated November 17, 2006, among Goldman, Sachs & Co., Lehman Brothers Inc., JPMorgan Securities Inc., UBS Securities LLC and Wachovia Capital Markets, LLC, as Initial Purchasers, and Financial Security Assurance Holdings Ltd. (Previously filed as Exhibit 10.1 to the November 2006 8-K, and incorporated herein by reference.) |
21* | | List of Subsidiaries. |
23* | | Consent of PricewaterhouseCoopers LLP. |
24.1 | | Powers of Attorney. (Previously filed as Exhibit 24 to the Company’s Annual Report on Form 10-K (Commission File No. 1-12644) for the fiscal year ended December 31, 2002, as Exhibit 24.2 to the Company’s Annual Report on Form 10-K (Commission File No. 1-12644) for the fiscal year ended December 31, 2004, and Exhibit 24.2 to the Company’s Annual Report on Form 10-K (Commission File No. 1-12644) for the fiscal year ended December 31, 2006 and incorporated herein by reference.) |
24.2* | | Power of Attorney. |
31.1* | | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
31.2* | | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
32.1** | | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
32.2** | | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
99.1* | | Financial Security Assurance Inc. and Subsidiaries 2006 Consolidated Financial Statements and Report of Independent Registered Public Accounting Firm. |
* Filed herewith.
** Furnished herewith.
† Management contract of compensatory plan or arrangement.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. |
| By: | /s/ ROBERT P. COCHRAN |
| | Name: Robert P. Cochran |
| | Title: Chairman and Chief Executive Officer |
| | Dated: April 2, 2007 |
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature | | Title | | Date |
/s/ ROBERT P. COCHRAN | | Chairman, Chief Executive Officer and | | April 2, 2007 |
Robert P. Cochran | | Director (Principal Executive Officer) | | |
/s/ SÉAN W. MCCARTHY | | President, Chief Operating Officer and | | April 2, 2007 |
Séan W. McCarthy | | Director | | |
/s/ JOSEPH W. SIMON | | Managing Director and Chief Financial | | April 2, 2007 |
Joseph W. Simon | | Officer (Principal Financial Officer) | | |
/s/ LAURA A. BIELING | | Managing Director and Controller | | April 2, 2007 |
Laura A. Bieling | | (Principal Accounting Officer) | | |
/s/ MICHÈLE COLIN | | Director | | April 2, 2007 |
Michèle Colin | | | | |
/s/ BRUNO DELETRÉ | | Director | | April 2, 2007 |
Bruno Deletré | | | | |
/s/ ROBERT N. DOWNEY | | Director | | April 2, 2007 |
Robert N. Downey | | | | |
/s/ JACQUES GUERBER | | Director | | April 2, 2007 |
Jacques Guerber | | | | |
/s/ AXEL MILLER | | Director | | April 2, 2007 |
Axel Miller | | | | |
/s/ JAMES H. OZANNE | | Director | | April 2, 2007 |
James H. Ozanne | | | | |
/s/ ROGER K. TAYLOR | | Director | | April 2, 2007 |
Roger K. Taylor | | | | |
/s/ REMBERT VON LOWIS | | Director | | April 2, 2007 |
Rembert von Lowis | | | | |
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/s/ XAVIER DE WALQUE | | Director | | April 2, 2007 |
Xavier de Walque | | | | |
/s/ GEORGE U. WYPER | | Director | | April 2, 2007 |
George U. Wyper | | | | |
* Robert P. Cochran, by signing his name hereto, does hereby sign this Annual Report on Form 10-K on behalf of himself and on behalf of each of the Directors and Officers of the Registrant named above after whose typed names asterisks appear pursuant to powers of attorney duly executed by such Directors and Officers and filed with the Securities and Exchange Commission as exhibits to this Report.
| | By: | /s/ ROBERT P. COCHRAN |
| | | Robert P. Cochran |
| | | Attorney in fact |
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Schedule I
Parent Company Condensed Financial Information
Condensed Balance Sheets
(in thousands)
| | December 31, | |
| | 2006 | | 2005 | |
Assets: | | | | | |
Bonds at market value (amortized cost of $39,839 and $10,923) | | $ | 39,956 | | $ | 11,158 | |
Short-term investments | | 1,900 | | 47,140 | |
Cash | | 844 | | 1,895 | |
Investment in subsidiaries | | 3,407,902 | | 3,158,563 | |
Deferred compensation | | 114,181 | | 107,140 | |
Deferred taxes | | 1,899 | | 34,011 | |
Other assets | | 49,370 | | 40,836 | |
Total Assets | | $ | 3,616,052 | | $ | 3,400,743 | |
Liabilities and Shareholders’ Equity: | | | | | |
Notes Payable | | $ | 730,000 | | $ | 430,000 | |
Other Liabilities | | 36,960 | | 30,293 | |
Deferred compensation | | 114,181 | | 107,140 | |
Taxes payable | | 12,599 | | 10,408 | |
Shareholders’ equity | | 2,722,312 | | 2,822,902 | |
Total Liabilities and Shareholders’ Equity | | $ | 3,616,052 | | $ | 3,400,743 | |
Condensed Statements of Income
(in thousands)
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
Investment Income | | $ | 3,018 | | $ | 1,266 | | $ | 679 | |
Net realized gains (losses) | | (108 | ) | (395 | ) | 497 | |
Other income (loss) | | 14,831 | | 2,152 | | 18,138 | |
Interest and amortization expense | | (29,096 | ) | (26,993 | ) | (26,993 | ) |
Other expenses | | (20,403 | ) | (6,539 | ) | (18,451 | ) |
Net unrealized gains (losses) on derivative instruments | | 761 | | (304 | ) | 1,589 | |
| | (30,997 | ) | (30,813 | ) | (24,541 | ) |
Equity in income of subsidiaries | | 473,652 | | 338,177 | | 374,839 | |
Income before taxes | | 442,655 | | 307,364 | | 350,298 | |
Income tax (provision) benefit | | (18,501 | ) | 18,744 | | 28,309 | |
Net Income | | $ | 424,154 | | $ | 326,108 | | $ | 378,607 | |
The Parent Company Condensed Financial Information should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in Item 8.
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Condensed Statements of Cash Flows
(in thousands)
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
Cash flows from operating activities: | | | | | | | |
Other operating expenses paid, net | | $ | (3,758 | ) | $ | (1,678 | ) | $ | (1,271 | ) |
Net investment income received | | 7,520 | | 6,869 | | 8,858 | |
Federal income taxes received | | 1,991 | | — | | — | |
Interest paid | | (26,878 | ) | (26,993 | ) | (26,850 | ) |
Dividend from subsidiary | | 140,000 | | 87,000 | | 30,000 | |
Other | | (1,057 | ) | (2,689 | ) | 1,489 | |
Net cash provided by (used for) operating activities | | 117,818 | | 62,509 | | 12,226 | |
Cash flows from investing activities: | | | | | | | |
Proceeds from sales of bonds | | 55,650 | | 41,837 | | 31,600 | |
Proceeds from maturities of bonds | | 2,410 | | — | | — | |
Purchases of bonds | | (87,098 | ) | (27,830 | ) | (36,103 | ) |
Capital contribution | | (1,500 | ) | (5,700 | ) | (29,500 | ) |
Return of capital from subsidiary | | — | | 48,000 | | — | |
Repurchase of stock by subsidiary | | 100,000 | | — | | — | |
Surplus notes redeemed | | — | | — | | 44,000 | |
Net change in short-term investments | | 45,931 | | (46,920 | ) | 465 | |
Net cash provided by (used for) investing activities | | 115,393 | | 9,387 | | 10,462 | |
Cash flows from financing activities: | | | | | | | |
Issuance of notes payable | | 295,788 | | — | | — | |
Dividends paid | | (530,050 | ) | (71,059 | ) | (22,876 | ) |
Net cash provided by (used for) financing activities | | (234,262 | ) | (71,059 | ) | (22,876 | ) |
Net (decrease) increase in cash | | (1,051 | ) | 837 | | (188 | ) |
Cash at beginning of year | | 1,895 | | 1,058 | | 1,246 | |
Cash at end of year | | $ | 844 | | $ | 1,895 | | $ | 1,058 | |
In 2006, 2005 and 2004, the Company’s subsidiaries received a tax benefit (expense) of $(1,200), $4,624 and $20,164, respectively, by utilizing the Company’s losses. These balances were recorded as capital contributions.
The Parent Company Condensed Financial Information should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in Item 8.
| | Year Ended December 31, | |
| | 2006 | | 2005 | | 2004 | |
Reconciliation of net income to net cash provided by operating activities: | | | | | | | |
Net income | | $ | 424,154 | | $ | 326,108 | | $ | 378,607 | |
Equity in undistributed net income of subsidiary | | (329,566 | ) | (245,735 | ) | (339,849 | ) |
Decrease (increase) in accrued investment income | | (269 | ) | 154 | | 1,373 | |
Increase (decrease) in accrued income taxes | | 2,191 | | (6,676 | ) | (10,821 | ) |
Provision (benefit) for deferred income taxes | | 20,775 | | (12,166 | ) | (10,932 | ) |
Net realized losses (gains) on investments | | 108 | | 395 | | (497 | ) |
Accretion of bond discount | | (509 | ) | (23 | ) | 96 | |
Change in other assets and liabilities | | 934 | | 452 | | (5,751 | ) |
Cash used for operating activities | | $ | 117,818 | | $ | 62,509 | | $ | 12,226 | |
The Parent Company Condensed Financial Information should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in Item 8.
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SCHEDULE II
Financial Security Assurance Holdings Ltd. (Parent Company)
Notes to Condensed Financial Statements
1. Condensed Financial Statements
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 condensed financial statements should be read in conjunction with the Company’s Consolidated Financial Statements and the notes thereto. Certain reclassifications have been made to conform to the current year presentation.
The Company previously reported ‘dividends from subsidiary’ as cash provided by investing activities and ‘surplus notes redeemed’ as cash provided by financing activities. In 2006, The Company appropriately reported ‘dividends from subsidiary’ as a cash flow from operating activities with conforming changes to 2005 and 2004 and ‘surplus notes redeemed’ as a cash flow from investing activities in 2004.
2. Significant Accounting Policies
The Parent Company carries its investments in subsidiaries under the equity method.
3. Long-Term Debt
On November 22, 2006, FSA Holdings issued $300.0 million principal amount of Junior Subordinated Debentures with a scheduled maturity date of December 15, 2036 and a final repayment date of December 5, 2066. The final repayment date of December 5, 2066 may be automatically extended up to four times in five-year increments provided certain conditions are met. The debentures are redeemable, in whole or in part, at any time prior to December 15, 2036 at their principal amount plus accrued and unpaid interest to the date of redemption. Interest on the debentures will accrue from November 22, 2006 to December 15, 2036 at the annual rate of 6.40%. If any amount of the debentures remains outstanding after December 15, 2036, then the principal amount of the outstanding debentures will bear interest at a floating interest rate equal to one-month LIBOR plus 2.215% until repaid. FSA Holdings may elect at one or more times to defer payment of interest on the debentures for one or more consecutive interest periods that do not exceed ten years. The proceeds from this offering were used to pay a dividend to the shareholders of FSA Holdings.
On July 31, 2003, FSA Holdings issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the Notes.
On November 26, 2002, FSA Holdings issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt. The Company used a portion of the proceeds of this issuance to redeem in whole the Company’s $130.0 million principal amount of 7.375% Senior QUIDS due September 30, 2097.
On December 19, 2001, FSA Holdings issued $100.0 million of 67¤8% Quarterly Income Bond Securities due December 15, 2101, which are callable without premium or penalty on or after December 19, 2006. Debt issuance costs of $3.3 million are being amortized over the life of the debt.
4. Taxes
In connection with the Dexia group’s acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains Insurance Group for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity
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payment of $47.0 million to the third party with funds provided for such purpose by White Mountains Insurance Group. While the Company had no legal liability in connection with the indemnity payment, the payment should be treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, the Company has agreed to share 50% of the deferred tax benefit with White Mountains Insurance Group under certain circumstances but did not satisfy the standards for recording a liability for accounting purposes as of December 31, 2006.
5. Notes receivable from subsidiary
At December 31, 2006, FSA Holdings held $108.9 million of FSA surplus notes. Payments of principal or interest on such notes may be made only with the approval of the Superintendent of Insurance of the State of New York. FSA Holdings employs surplus note purchases in lieu of capital contributions in order to allow it to withdraw funds from FSA through surplus note payments without reducing earned surplus, thereby preserving dividend capacity of FSA.
6. Legal proceedings
In the ordinary course of business, the Company and certain Subsidiaries are parties to litigation. The Company is not a party to any material pending litigation.
On November 15, 2006, the Company received a subpoena from the Antitrust Division of the U.S. Department of Justice (“DOJ”) issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs. On November 16, 2006, FSA received a subpoena from the Securities and Exchange Commission (“SEC”) related to an ongoing industry-wide civil investigation of brokers of municipal GICs. The Company issues municipal GICs through the FP Segment, but does not serve as a GIC broker. The subpoenas request that the Company furnish to the DOJ and SEC records and other information with respect to the Company’s municipal GIC business. The Company is cooperating with the investigations by the DOJ and SEC.
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