[Page 25 of 1997 Annual Report to Shareholders]
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholders and Board of Directors
of Financial Security Assurance Holdings Ltd.:
We have audited the accompanying consolidated balance sheets of Financial
Security Assurance Holdings Ltd. and Subsidiaries as of December 31, 1997 and
1996 and the related consolidated statements of income, changes in shareholders'
equity, and cash flows for each of the three years in the period ended December
31, 1997. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. 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. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Financial Security
Assurance Holdings Ltd. and Subsidiaries as of December 31, 1997 and 1996, and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 1997, in conformity with
generally accepted accounting principles.
/s/ Coopers & Lybrand L.L.P.
New York, New York
January 26, 1998
[Page 26 of 1997 Annual Report to Shareholders]
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data)
December 31, December 31,
ASSETS 1997 1996
------------ ------------
Bonds at market value (amortized cost of $1,230,479 and $1,058,417) $ 1,268,158 $ 1,072,439
Equity investments at market value (cost of $29,430 and $8,336) 30,539 8,336
Short-term investments 132,931 73,641
----------- -----------
Total investments 1,431,628 1,154,416
Cash 12,475 8,146
Deferred acquisition costs 171,098 146,233
Prepaid reinsurance premiums 173,123 151,224
Reinsurance recoverable on unpaid losses 30,618 29,875
Receivable for securities sold 20,623 --
Other assets 61,079 47,848
----------- -----------
TOTAL ASSETS $ 1,900,644 $ 1,537,742
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Deferred premium revenue $ 595,196 $ 511,196
Losses and loss adjustment expenses 75,417 72,079
Deferred federal income taxes 56,872 41,167
Ceded reinsurance balances payable 11,199 12,599
Payable for securities purchased 72,979 14,390
Notes payable 130,000 30,000
Accrued expenses and other liabilities 76,621 55,051
----------- -----------
TOTAL LIABILITIES 1,018,284 736,482
----------- -----------
COMMITMENTS AND CONTINGENCIES
Preferred stock (3,000,000 shares authorized; 2,000,000
issued and outstanding; par value of $.01 per share) 20 20
Common stock (50,000,000 shares authorized; 32,276,301
issued; par value of $.01 per share) 323 323
Additional paid-in capital - preferred 680 680
Additional paid-in capital - common 693,851 695,118
Unrealized gain on investments (net of deferred income tax
provision of $13,575 and $4,908) 25,212 9,114
Accumulated earnings 231,124 142,721
Deferred equity compensation 26,181 12,069
Less treasury stock at cost (3,521,847 and 2,303,407 shares held) (95,031) (58,785)
----------- -----------
TOTAL SHAREHOLDERS' EQUITY 882,360 801,260
----------- -----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 1,900,644 $ 1,537,742
=========== ===========
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
2
[Page 27 of 1997 Annual Report to Shareholders]
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except per share data)
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
REVENUES:
Net premiums written (net of premiums ceded of
$63,513, $55,965 and $33,166, of which
$38,105, $35,299 and $20,582 were ceded to
affiliates) $ 172,878 $ 121,000 $ 77,576
Increase in deferred premium revenue (63,367) (30,552) (8,229)
--------- --------- ---------
Premiums earned (net of premiums ceded of
$41,198, $38,723 and $38,013) 109,511 90,448 69,347
Net investment income 72,085 65,064 48,965
Net realized gains 11,522 3,189 5,120
Other income 9,303 297 3,841
--------- --------- ---------
TOTAL REVENUES 202,421 158,998 127,273
--------- --------- ---------
EXPENSES:
Losses and loss adjustment expenses:
Related to Merger -- -- 15,400
Other (net of reinsurance recoveries of
$3,605, ($2,249) and $9,101, of which
$3,199, ($3,084) and $7,111 were ceded
to affiliates) 9,156 6,874 6,258
Policy acquisition costs 27,962 23,829 16,888
Other operating expenses 26,804 18,524 13,685
--------- --------- ---------
TOTAL EXPENSES 63,922 49,227 52,231
--------- --------- ---------
INCOME BEFORE INCOME TAXES 138,499 109,771 75,042
--------- --------- ---------
Provision (benefit) for income taxes:
Current 30,960 27,227 23,187
Deferred 7,037 1,784 (3,183)
--------- --------- ---------
Total provision 37,997 29,011 20,004
--------- --------- ---------
NET INCOME $ 100,502 $ 80,760 $ 55,038
========= ========= =========
Basic earnings per common share $ 3.35 $ 2.64 $ 2.13
========= ========= =========
Diluted earnings per common share $ 3.25 $ 2.61 $ 2.13
========= ========= =========
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
3
[Page 28 of 1997 Annual Report to Shareholders]
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars in thousands, except per share data)
Additional Additional Unrealized
Paid-In Paid-In Gain Deferred
Preferred Common Capital - Capital - (Loss) on Accumulated Equity Treasury
Stock Stock Preferred Common Investment Earnings Compensation Stock Total
----- ----- --------- ------ ---------- -------- ------------ ----- -----
BALANCE, December 31, 1994 $ 20 $ 262 $ 680 $544,266 $(21,709) $ 25,647 $ -- $ (3,730) $545,436
Net income for the year 55,038 55,038
Net change in unrealized gain on
investments (net of deferred
income taxes of $22,421) 41,640 41,640
Issuance of common stock - 6,051,661
shares 61 151,987 152,048
Dividends paid on common
stock ($0.32 per share) (8,275) (8,275)
Deferred equity compensation 6,504 6,504
Purchase of 591,714 shares of
common stock (14,444) (14,444)
-------- -------- -------- -------- -------- -------- -------- -------- --------
BALANCE, December 31, 1995 20 323 680 696,253 19,931 72,410 6,504 (18,174) 777,947
Net income for the year 80,760 80,760
Net change in unrealized loss on
investments (net of deferred
income tax benefit of $5,823) (10,817) (10,817)
Dividends paid on common
stock ($0.35 per share) (10,536) (10,536)
Deferred equity compensation 5,565 5,565
Purchase of 1,529,131 shares of
common stock (40,611) (40,611)
Other common stock transactions (1,135) (1,135)
Adjustment to prior-year disposal of
subsidiary 87 87
-------- -------- -------- -------- -------- -------- -------- -------- --------
BALANCE, December 31, 1996 20 323 680 695,118 9,114 142,721 12,069 (58,785) 801,260
Net income for the year 100,502 100,502
Net change in unrealized gain on
investments (net of deferred
income taxes of $8,667) 16,098 16,098
Dividends paid on common stock
($0.405 per share) (12,099) (12,099)
Deferred equity compensation 17,781 17,781
Deferred equity payout 187 (3,287) 56 (3,044)
Purchase of 162,573 shares of
common stock (5,434) (5,434)
Issuance of 125,106 shares of
treasury stock for
options exercised 688 (382) 3,042 3,348
Forward share transactions:
Settlements with employees
and directors (2,142) (2,142)
Settlements with counterparties (33,910) (33,910)
-------- -------- -------- -------- -------- -------- -------- -------- --------
BALANCE, December 31, 1997 $ 20 $ 323 $ 680 $693,851 $ 25,212 $231,124 $ 26,181 $(95,031) $882,360
======== ======== ======== ======== ======== ======== ======== ======== ========
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
4
[Page 29 of 1997 Annual Report to Shareholders]
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
Cash flows from operating activities:
Premiums received, net $ 171,145 $ 124,540 $ 85,481
Policy acquisition and other operating expenses
paid, net (43,279) (32,266) (36,067)
Recoverable advances received (paid) (7,629) 10,213 (9,419)
Losses and loss adjustment expenses paid (6,463) (15,473) (4,954)
Net investment income received 65,662 63,533 41,939
Federal income taxes paid (19,797) (34,595) (15,890)
Interest paid (5,158) (2,115) (95)
Other (2,017) (4,253) 9,872
----------- ----------- -----------
Net cash provided by operating activities 152,464 109,584 70,867
----------- ----------- -----------
Cash flows from investing activities:
Proceeds from sales of bonds 1,078,226 1,117,473 624,802
Proceeds from maturities of bonds 32,468 2,965 606
Purchases of bonds (1,254,274) (1,150,024) (713,799)
Net gain on sale of subsidiaries 7,986 -- --
Purchases of property and equipment (3,097) (2,188) (999)
Payment for purchase of subsidiary, net of cash
acquired -- -- (11,447)
Net decrease (increase) in short-term
investments (55,551) (18,586) 56,689
----------- ----------- -----------
Net cash used for investing activities (194,242) (50,360) (44,148)
----------- ----------- -----------
Cash flows from financing activities:
Issuance of notes payable, net 125,905 -- --
Repayment of notes payable (30,000) -- --
Dividends paid (12,099) (10,536) (8,275)
Treasury stock, net (36,246) (41,660) (14,444)
Payment of management notes -- -- (5,624)
Other (1,453) -- --
----------- ----------- -----------
Net cash provided by (used for) financing
activities 46,107 (52,196) (28,343)
----------- ----------- -----------
Net increase (decrease) in cash 4,329 7,028 (1,624)
Cash at beginning of year 8,146 1,118 2,742
----------- ----------- -----------
Cash at end of year $ 12,475 $ 8,146 $ 1,118
=========== =========== ===========
Continued
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
5
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(Dollars in thousands)
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
Reconciliation of net income to net cash flows
from operating activities:
Net income $ 100,502 $ 80,760 $ 55,038
Decrease (increase) in accrued investment income (2,504) (578) 124
Increase in deferred premium revenue and related
foreign exchange adjustment 62,101 29,622 8,141
Increase in deferred acquisition costs (24,865) (13,282) (10,305)
Increase (decrease) in current federal income
taxes payable 7,891 (7,368) 7,297
Increase (decrease) in unpaid losses and loss
adjustment expenses 2,596 (8,023) 14,587
Increase in amounts withheld for others 133 52 30
Provision (benefit) for deferred income taxes 10,309 1,784 (3,183)
Net realized gains on investments (11,522) (3,189) (5,120)
Deferred equity compensation 14,299 5,565 5,735
Depreciation and accretion of bond discount (2,802) (1,735) (5,735)
Net gain on sale of subsidiaries (7,986) -- --
Change in other assets and liabilities 4,312 25,976 4,258
----------- ----------- -----------
Cash provided by operating activities $ 152,464 $ 109,584 $ 70,867
=========== =========== ===========
Additional common stock was issued in relation to the Merger in 1995.
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
6
[Pages 30 - 44 of 1997 Annual Report to Shareholders]
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
1. ORGANIZATION AND OWNERSHIP
Financial Security Assurance Holdings Ltd. (the Company) is a holding
company incorporated in the State of New York. The Company is principally
engaged (through its insurance subsidiaries) in providing financial guaranty
insurance on asset-backed and municipal obligations. The Company's underwriting
policy is to insure asset-backed and municipal obligations that it determines
would be of investment-grade quality without the benefit of the Company's
insurance. The asset-backed obligations insured by the Company are generally
issued in structured transactions and are backed by pools of assets such as
residential mortgage loans, consumer or trade receivables, securities or other
assets having an ascertainable cash flow or market value. The municipal
obligations insured by the Company consist primarily of general obligation bonds
that are supported by the issuers' taxing power and of special revenue bonds and
other special obligations of states and local governments that are supported by
the issuers' ability to impose and collect fees and charges for public services
or specific projects. Financial guaranty insurance written by the Company
guarantees payment when due of scheduled payments on an issuer's obligation. In
the case of a payment default on an insured obligation, the Company is generally
required to pay the principal, interest or other amounts due in accordance with
the obligation's original payment schedule or, at its option, to pay such
amounts on an accelerated basis.
The Company expects to continue to emphasize a diversified insured
portfolio characterized by insurance of both asset-backed and municipal
obligations, with a broad geographic distribution and a variety of revenue
sources and transaction structures. The Company's insured portfolio consists
primarily of asset-backed and municipal obligations originated in the United
States, but the Company has also written and continues to pursue business in
Europe and the Pacific Rim.
On December 20, 1995, a subsidiary of the Company merged (the Merger) with
Capital Guaranty Corporation (CGC). The Merger provided for each CGC share to be
exchanged for 0.6716 share of the Company's common stock and cash of $5.69. The
Company issued in the aggregate 6,051,661 common shares and paid aggregate cash
consideration of $51,300,000. At December 31, 1995, the Company was owned 50.3%
by U S WEST, Inc. (U S WEST), 7.8% by Fund American Enterprises Holdings, Inc.
(Fund American), 6.1% by The Tokio Marine and Fire Insurance Co., Ltd. (Tokio
Marine) and 35.8% by the public and employees. At December 31, 1996, the Company
was owned 40.4% by U S WEST, 11.5% by Fund American, 6.4% by Tokio Marine and
41.7% by the public and employees. At December 31, 1997, the Company was owned
42.1% by U S WEST, 12.0% by Fund American, 6.7% by Tokio Marine and 39.2% by the
public and employees. These percentages are calculated based upon outstanding
shares, which are reduced by treasury shares as presented in these financial
statements.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying financial statements have been prepared in accordance
with generally accepted accounting principles (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
6). The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities in the Company's consolidated
balance sheets at December 31, 1997 and 1996 and the reported amounts of
revenues and expenses in the consolidated statements of income during the years
ended December 31, 1997, 1996 and 1995. Such estimates and assumptions include,
but are not limited to, losses and loss adjustment expenses and the deferral and
amortization of deferred policy acquisition costs. Actual results may differ
from those estimates. Significant accounting policies under GAAP are as follows:
7
Basis of Presentation
The consolidated financial statements include the accounts of the Company
and its direct and indirect wholly owned subsidiaries, FSA Portfolio Management
Inc., CGC, Transaction Services Corporation, Financial Security Assurance Inc.
(FSA), FSA Insurance Company, Financial Security Assurance of Oklahoma, Inc. and
Financial Security Assurance (U.K.) Limited (collectively, the Subsidiaries).
All intercompany accounts and transactions have been eliminated. Certain
prior-year balances have been reclassified to conform to the 1997 presentation.
The Merger was accounted for on a purchase accounting basis. In view of the
short period between the date of the Merger, December 20, 1995, and the
year-end, the date of the Merger for accounting purposes is considered to be
December 31, 1995. As a result, the accounting for the Merger has no effect on
the Company's consolidated statement of income for the year ended December 31,
1995, except for the recording of $15,400,000 in losses and loss adjustment
expenses to increase FSA's general reserve to provide for the insured portfolio
assumed by FSA in the Merger (see Notes 17 and 19).
Investments
Investments in debt securities designated as available for sale are
carried at market value. Any resulting unrealized gain or loss is reflected as a
separate component of shareholders' equity, net of applicable deferred income
taxes. All of the Company's long-term investments are classified as available
for sale.
Bond discounts and premiums are amortized on the effective yield method
over the remaining terms of the securities acquired. For mortgage-backed
securities, and any other holdings for which prepayment risk may be significant,
assumptions regarding prepayments are evaluated periodically and revised as
necessary. Any adjustments required due to the resulting change in effective
yields are recognized in current income. Short-term investments, which are those
investments with a maturity of less than one year at time of purchase, are
carried at market value, which approximates cost. Realized gains or losses on
sale of investments are determined on the basis of specific identification.
Investment income is recorded as earned.
To manage adverse movements in interest rates, the Company uses exchange
traded futures and options. Primarily, these contracts are designated as hedges
of specific identified securities and any gains or losses on these hedges are
deferred and included as part of the Company's unrealized gains or losses in
stockholders' equity until the disposition of the hedged assets. The Company
will discontinue to account for these contracts as hedges if there ceases to be
a high correlation between the change in price of the hedged assets and the
hedge. Other derivative positions, also in exchange traded futures contracts,
that are not accounted for as hedges are marked-to-market on a daily basis, and
any gains or losses are included in capital gains or losses.
Premium Revenue Recognition
Gross and ceded premiums are earned in proportion to the amount of risk
outstanding over the expected period of coverage. Deferred premium revenue and
prepaid reinsurance premiums represent the portion of premium that is applicable
to coverage of risk to be provided in the future on policies in force. When an
insured issue is retired or defeased prior to the end of the expected period of
coverage, the remaining deferred premium revenue and prepaid reinsurance
premium, less any amount credited to a refunding issue insured by the Company,
are recognized.
Losses and Loss Adjustment Expenses
A case basis reserve for unpaid losses and loss adjustment expenses is
recorded at the present value of the estimated loss when, in management's
opinion, the likelihood of a future loss is probable and determinable at the
balance sheet date. The estimated loss on a transaction is discounted using
current risk-free rates.
The general reserve is calculated by applying a loss factor to the total
net par amount outstanding of the Company's insured obligations over the term of
such insured obligations and discounting the result at risk-free rates. The loss
factor used for this purpose has been determined based upon an independent
rating agency study of bond defaults and the Company's portfolio characteristics
and history. The general reserve is available to be applied against future
additions or accretions to existing case basis reserves or to new case basis
reserves to be established in the future.
Management of the Company periodically evaluates its estimates for losses
and loss adjustment expenses and establishes reserves that management believes
are adequate to cover the ultimate net cost of claims. The reserves are
necessarily based on estimates, and there can be no assurance that the ultimate
liability will not differ from such estimates. The Company will, on an
8
ongoing basis, monitor these reserves and may periodically adjust such reserves
based on the Company's actual loss experience, its future mix of business, and
future economic conditions.
Deferred Acquisition Costs
Deferred acquisition costs comprise those expenses that vary with and are
primarily related to the production of business, including commissions paid on
reinsurance assumed, compensation and related costs of underwriting and
marketing personnel, certain rating agency fees, premium taxes and certain other
underwriting expenses, reduced by ceding commission income on premiums ceded to
reinsurers. Deferred acquisition costs and the cost of acquired business are
amortized over the period in which the related premiums are earned.
Recoverability of deferred acquisition costs is determined by considering
anticipated losses and loss adjustment expenses.
Federal Income Taxes
The provision for income taxes consists of an amount for taxes currently
payable and a provision for tax consequences deferred to future periods
reflected at current income tax rates.
Earnings per Common Share
In 1997, the Company adopted Statement of Financial Accounting Standards
(SFAS) No. 128, Earnings Per Share (EPS), specifying the computation,
presentation and disclosure requirements for EPS (see Note 20). The new standard
defines "basic" and "diluted" earnings per share. Basic earnings per share are
based on average basic shares outstanding, which is calculated by adding shares
earned but not issued under the Company's equity bonus and performance share
plans to the average common shares outstanding. Diluted earnings per share are
based on average diluted shares outstanding, which is calculated by adding
shares contingently issuable under stock options, the performance share plan and
the Company's convertible preferred stock to the average basic shares
outstanding. All earnings per share have been restated to reflect the adoption
of SFAS No. 128.
3. INVESTMENTS
Bonds at amortized cost of $11,025,000 and $17,669,000 at December 31,
1997 and 1996, respectively, were on deposit with state regulatory authorities
as required by insurance regulations.
Consolidated net investment income consisted of the following (in
thousands):
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
Bonds $ 65,422 $ 61,740 $ 43,789
Equity investments 1,393 928 --
Short-term investments 7,206 3,966 6,070
Investment expenses (1,936) (1,570) (894)
-------- -------- --------
Net investment income $ 72,085 $ 65,064 $ 48,965
======== ======== ========
The credit quality of the investment portfolio at December 31, 1997 was as
follows:
Percent of
Rating Investment Portfolio
-------------------- ----------------------
AAA 69.1%
AA 16.0
A 11.5
BBB 1.1
Other 2.3
9
The amortized cost and estimated market value of bonds were as follows (in
thousands):
Gross Gross
Amortized Unrealized Unrealized Estimated
December 31, 1997 Cost Gains Losses Market Value
- ----------------- ---- ----- ------ ------------
U.S. Treasury securities and obligations
of U.S. government corporations
and agencies $ 122,817 $ 799 $ (454) $ 123,162
Obligations of states and political
subdivisions 777,042 40,187 (135) 817,094
Foreign securities 48,078 -- (6,126) 41,952
Mortgage-backed securities 195,567 2,213 (27) 197,753
Corporate securities 66,014 1,375 (501) 66,888
Asset-backed securities 20,961 349 (1) 21,309
---------- ---------- ---------- ----------
Total $1,230,479 $ 44,923 $ (7,244) $1,268,158
========== ========== ========== ==========
December 31, 1996
U.S. Treasury securities and obligations
of U.S. government corporations
and agencies $ 55,619 $ 1,103 $ (557) $ 56,165
Obligations of states and political
subdivisions 661,831 15,208 (2,870) 674,169
Foreign securities 15,019 197 (71) 15,145
Mortgage-backed securities 177,818 1,432 (906) 178,344
Corporate securities 76,760 381 (403) 76,738
Asset-backed securities 71,370 680 (172) 71,878
---------- ---------- ---------- ----------
Total $1,058,417 $ 19,001 $ (4,979) $1,072,439
========== ========== ========== ==========
The change in net unrealized gains (losses) consisted of (in thousands):
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
Bonds $ 23,657 $(16,640) $ 64,061
Equity investments 1,109 -- --
-------- -------- --------
Change in net unrealized gains (losses) $ 24,766 $(16,640) $ 64,061
======== ======== ========
10
The amortized cost and estimated market value of bonds at December 31,
1997 and 1996, by contractual maturity, are shown below (in thousands). Actual
maturities could differ from contractual maturities because borrowers have the
right to call or prepay certain obligations with or without call or prepayment
penalties.
December 31, 1997 December 31, 1996
----------------- -----------------
Estimated Estimated
Amortized Market Amortized Market
Cost Value Cost Value
---- ----- ---- -----
Due in one year or less $ 4,009 $ 4,007 $ 38,305 $ 38,626
Due after one year through five years 70,283 70,007 57,531 57,712
Due after five years through ten years 208,986 208,170 105,495 105,848
Due after ten years 730,673 766,912 607,898 620,031
Mortgage-backed securities (stated
maturities of 4 to 39 years) 195,567 197,753 177,818 178,344
Asset-backed securities (stated
maturities of 2 to 30 years) 20,961 21,309 71,370 71,878
---------- ---------- ---------- ----------
Total $1,230,479 $1,268,158 $1,058,417 $1,072,439
========== ========== ========== ==========
Proceeds from sales of bonds during 1997, 1996 and 1995 were
$1,131,317,000, $1,118,112,000 and $608,773,000, respectively. Gross gains of
$12,659,000, $15,335,000 and $12,434,000 and gross losses of $1,440,000,
$12,146,000 and $7,314,000 were realized on sales in 1997, 1996 and 1995,
respectively.
To hedge against changes in yields on certain one-year corporate
securities, the Company entered into a series of Eurodollar futures contracts,
which were marked-to-market on a daily basis. These contracts were accounted for
as hedges. At year-end 1996, the net unrealized loss on the contracts, included
in the Company's unrealized gains in the stockholders' equity section, was not
material. The aggregate notional amount of these contracts was $83,728,000 as of
December 31, 1996.
The Company held open positions in U.S. Treasury bond futures contracts
with an aggregate notional amount of $33,300,000 and $20,600,000 as of December
31, 1997 and 1996, respectively. Such positions are marked-to-market on a daily
basis, and for the years ended December 31, 1997 and 1996, the Company reported
net realized gains of $190,000 and $923,000, respectively, which are included in
gross realized capital gains, above.
4. DEFERRED ACQUISITION COSTS
Acquisition costs deferred for amortization against future income and the
related amortization charged to expenses are as follows (in thousands):
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
Balance, beginning of period $ 146,233 $ 132,951 $ 91,839
--------- --------- ---------
Costs deferred during the period:
Ceding commission income (18,956) (15,956) (9,836)
Assumed commission expense 31 38 55
Premium taxes 5,554 3,718 2,537
Compensation and other acquisition costs 66,198 49,311 34,437
--------- --------- ---------
Total 52,827 37,111 27,193
--------- --------- ---------
Costs amortized during the period (27,962) (23,829) (16,888)
--------- --------- ---------
Balance of acquired subsidiary -- -- 30,807
--------- --------- ---------
Balance, end of period $ 171,098 $ 146,233 $ 132,951
========= ========= =========
11
5. OTHER OPERATING EXPENSES
Total salary expense and related benefits included in other operating
expenses were $19,796,000, $14,596,000 and $12,046,000 for the years ended
December 31, 1997, 1996 and 1995, respectively.
6. STATUTORY ACCOUNTING PRACTICES
GAAP for the Subsidiaries differs in certain significant respects from
accounting practices prescribed or permitted by insurance regulatory
authorities. The principal differences result from the following statutory
accounting practices:
- Upfront premiums on municipal business are recognized as earned when
related principal and interest have expired rather than over the expected
coverage period;
- Acquisition costs are charged to operations as incurred rather than as
related premiums are earned;
- A contingency reserve (rather than a general loss reserve) is computed
based on the following statutory requirements:
(i) For all policies written prior to July 1, 1989, an amount equal
to 50% of cumulative earned premiums less permitted reductions, plus;
(ii) 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;
- Federal income taxes are provided only on taxable income for which
income taxes are currently payable;
- Accruals for deferred compensation are not recognized;
- Purchase accounting adjustments are not recognized;
- Bonds are carried at amortized cost;
- Surplus notes are recognized as surplus rather than a liability.
A reconciliation of net income for the calendar years 1997, 1996 and 1995
and shareholders' equity at December 31, 1997, 1996 and 1995, reported by the
Company on a GAAP basis, to the amounts reported by the Subsidiaries on a
statutory basis, is as follows (in thousands):
Net Income: 1997 1996 1995
---- ---- ----
GAAP BASIS $ 100,502 $ 80,760 $ 55,038
Non-insurance companies net loss (gain) (243) 95 (50)
Premium revenue recognition (23,130) (5,518) (4,805)
Losses and loss adjustment expenses incurred 4,653 (2,138) 10,871
Deferred acquisition costs (24,865) (12,482) (10,305)
Deferred income tax provision (benefit) 8,025 911 (3,055)
Amortization of bonds 56 566 1,195
Accrual of deferred compensation, net 26,681 12,737 5,663
Other (61) 1,404 (1,580)
--------- --------- ---------
STATUTORY BASIS $ 91,618 $ 76,335 $ 52,972
========= ========= =========
12
December 31,
------------------------------
Shareholders' Equity: 1997 1996 1995
---- ---- ----
GAAP BASIS $ 882,360 $ 801,260 $ 777,947
Non-insurance companies liabilities, net 15,500 14,072 12,039
Premium revenue recognition (74,863) (51,760) (46,248)
Loss and loss adjustment expense reserves 34,313 29,660 31,798
Deferred acquisition costs (171,098) (146,233) (132,951)
Contingency reserve (287,694) (227,139) (183,967)
Unrealized gain on investments, net of tax (43,027) (14,084) (30,298)
Deferred income taxes 59,867 41,682 43,205
Accrual of deferred compensation 41,451 18,390 5,653
Surplus notes 50,000 -- --
Other (12,841) (17,043) (16,492)
--------- --------- ---------
STATUTORY BASIS (SURPLUS) $ 493,968 $ 448,805 $ 460,686
========= ========= =========
SURPLUS PLUS CONTINGENCY RESERVE $ 781,661 $ 675,944 $ 644,653
========= ========= =========
7. FEDERAL INCOME TAXES
For periods prior to May 13, 1994, the date of the initial public offering
when the Company became less than 80% owned by U S WEST, the Company and its
Subsidiaries joined with U S WEST and its subsidiaries in filing a consolidated
federal income tax return. Under a U S WEST practice, an income tax benefit or
liability was allocated to the Company to the extent that benefits were usable
or additional liabilities were incurred by U S WEST due to the Company's
inclusion in the U S WEST tax returns. For each year since the Company's
acquisition by U S WEST, the Company's resulting income tax provision has been
the same as if the allocation of taxes were based on a separate return
calculation. For the Subsidiaries, under a separate tax sharing agreement with U
S WEST, the allocation of income taxes was based upon separate return
calculations, which provided that benefits or liabilities created by the
Subsidiaries were allocated to the Subsidiaries regardless of whether the
benefits were usable or additional liabilities were incurred in the U S WEST tax
returns. For periods subsequent to May 12, 1994, the Company and all members of
its group elected to file consolidated federal income tax returns. The
calculation of each member's tax benefit or liability was controlled by a tax
sharing agreement that based the allocation of such benefit or liability upon a
separate return calculation.
The cumulative balance sheet effects of deferred tax consequences are (in
thousands):
December 31,
------------
1997 1996
---- ----
Deferred acquisition costs $ 59,884 $ 51,182
Deferred premium revenue adjustments 8,424 3,520
Unrealized capital gains 15,618 7,952
Contingency reserves 38,037 30,893
Market discounts 2,016 1,950
--------- ---------
Total deferred tax liabilities 123,979 95,497
--------- ---------
Loss and loss adjustment expense reserves (12,009) (10,381)
Deferred compensation (21,503) (10,730)
Tax credits (1,807) (7,861)
Tax and loss bonds (30,520) (22,526)
Other, net (1,268) (2,832)
--------- ---------
Total deferred tax assets (67,107) (54,330)
--------- ---------
Total deferred income taxes $ 56,872 $ 41,167
========= =========
No valuation allowance was necessary at December 31, 1997 or 1996.
13
A reconciliation of the effective tax rate with the federal statutory rate
follows:
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
Tax at statutory rate 35.0% 35.0% 35.0%
Tax-exempt interest (7.9) (8.9) (8.5)
Other 0.3 0.3 0.2
---- ---- ----
Provision for income taxes 27.4% 26.4% 26.7%
==== ==== ====
8. SHAREHOLDERS' EQUITY
On September 2, 1994, the Company issued to Fund American 2,000,000 shares
of Series A, non-dividend paying, voting, convertible preferred stock having an
aggregate liquidation preference of $700,000. The preferred stock is
convertible, at the option of the holder upon payment of the conversion price
therefor, into an equal number of shares of common stock (subject to
anti-dilutive adjustment). The conversion price per share (subject to
anti-dilutive adjustment) is $29.65. The preferred stock will be redeemed (if
then outstanding) on May 13, 2004 at a redemption price of $0.35 per share. Fund
American is entitled to one vote per share of preferred stock, voting together
as a single class with the holders of common stock on all matters upon which
holders of common stock are entitled to vote. As the holder of the preferred
stock, Fund American is not entitled to receive dividends or other distributions
of any kind payable to shareholders of the Company, except that, in the event of
the liquidation, dissolution or winding up of the Company, it is entitled to
receive out of the assets of the Company available therefor, before any
distribution or payment is made to the holders of common stock or to any other
class of capital stock of the Company ranking junior to the Company's preferred
stock, liquidation payments in the amount of $0.35 per share. Fund American may
not transfer the preferred stock, except to one of its majority-owned
subsidiaries.
On December 20, 1995, CGC merged with a subsidiary of the Company. The
Merger provided for each CGC share to be exchanged for 0.6716 share of the
Company's common stock and cash of $5.69. The Company issued in the aggregate
6,051,661 common shares and paid aggregate cash consideration of $51,300,000.
In May 1996, the Company repurchased 1,000,000 shares of its common stock
from U S WEST for a purchase price of $26.50 per share. At the same time, the
Company also entered into forward agreements with National Westminster Bank Plc
and Canadian Imperial Bank of Commerce (the Counterparties) in respect of
1,750,000 shares (the Forward Shares) of the Company's common stock. Under the
forward agreements, the Company has the obligation either: (i) to purchase the
Forward Shares from the Counterparties for a price equal to $26.50 per share
plus carrying costs or (ii) to direct the Counterparties to sell the Forward
Shares, with the Company receiving any excess or making up any shortfall between
the sale proceeds and $26.50 per share plus carrying costs in cash or additional
shares, at its option. Simultaneous with the Company entering into the forward
agreements, the Company made the economic benefit and risk of 750,000 of these
shares available for subscription by certain of the Company's employees and
directors. When an individual participant exercises Forward Shares under the
subscription program, the Company settles with the participant but does not
necessarily close out the corresponding forward share position with the
Counterparties. The cost of these settlements during 1997 was $2,142,000 and was
charged to additional paid-in capital. By the fourth quarter of 1997, such
exercises by participants had increased the number of shares allocated to the
Company from 1,000,000 shares to 1,187,800 shares. During the fourth quarter of
1997, the Company purchased 1,187,800 Forward Shares for $33,910,000 by
exercising rights under the forward agreements. At December 31, 1997, as a
result of the Company's exercise, the repurchased shares are held as treasury
stock, and the remaining 562,200 Forward Shares were allocated to the
subscription program.
14
9. DIVIDENDS AND CAPITAL REQUIREMENTS
Under New York Insurance Law, FSA may pay a dividend to the Company
without the prior approval of the Superintendent of the New York State Insurance
Department only from earned surplus subject to the maintenance of a minimum
capital requirement. In addition, the dividend, together with all dividends
declared or distributed by FSA during the preceding twelve months, may not
exceed the lesser of 10% of its policyholders' surplus shown on FSA's last filed
statement, or adjusted net investment income, as defined, for such twelve-month
period. As of December 31, 1997, FSA had $49,846,000 available for the payment
of dividends over the next twelve months. In addition, the New York
Superintendent has approved the repurchase by FSA of up to $75,000,000 of its
shares from the Company through December 31, 1998, pursuant to which FSA has
repurchased $66,500,000 of its shares through December 31, 1997.
10. CREDIT ARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES
The Company has a credit arrangement aggregating $150,000,000 at December
31, 1997, which is provided by commercial banks and intended for general
application to transactions insured by the Subsidiaries. At December 31, 1997,
there were no borrowings under this arrangement, which expires on November 23,
1999. In addition, there are credit arrangements assigned to specific insured
transactions. In August 1994, FSA entered into a facility agreement with
Canadian Global Funding Corporation and Hambros Bank Limited. Under the
agreement, FSA can arrange financing for transactions subject to certain
conditions. The amount of this facility was $186,911,000, of which $100,911,000
was unutilized at December 31, 1997.
FSA has a standby line of credit commitment in the amount of $240,000,000
with a group of international Aaa/AAA-rated 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 $230,000,000 or 5.75% of
average annual debt service of the covered portfolio. 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 including certain installment premiums and other collateral.
This commitment has a term beginning on April 30, 1997 and expiring on April 30,
2004 and contains an annual renewal provision subject to approval by the banks.
No amounts have been utilized under this commitment as of December 31, 1997.
In connection with the Merger, the Company assumed $30,000,000 of CGC's
senior notes. Interest on these notes was paid semiannually at the rate of 7.05%
per annum. These notes were repaid in September 1997.
On September 18, 1997, the Company issued $130,000,000 of 7.375% Senior
Quarterly Income Debt Securities (Senior QUIDS) due September 30, 2097 and
callable without premium or penalty on or after September 18, 2002. Interest on
these notes is paid quarterly beginning on December 31, 1997. Debt issuance
costs of $4,300,000 are being amortized over the life of the debt. The Company
used the proceeds to repay the CGC senior notes described above, to augment
capital in the Subsidiaries, to repurchase Forward Shares (see Note 8) and for
general corporate purposes.
11. EMPLOYEE BENEFIT PLANS
The Subsidiaries maintain both a qualified and a non-qualified
non-contributory defined contribution pension plan for the benefit of all
eligible employees. The Subsidiaries' contributions are based upon a fixed
percentage of employee compensation. Pension expense, which is funded as
accrued, amounted to $2,535,000, $2,215,000 and $1,898,000 for the years ended
December 31, 1997, 1996 and 1995, respectively.
The Subsidiaries have an employee retirement savings plan for the benefit
of all eligible employees. The plan permits employees to contribute a percentage
of their salaries up to limits prescribed by the Internal Revenue Service (IRS
Code, Section 401(k)). The Subsidiaries' contributions are discretionary, and
none have been made.
15
During 1991, the Subsidiaries established the Profit Participation Plan as
a long-term incentive compensation plan for the benefit of certain of its
employees. Prior to the Company's initial public offering in 1994, the Company
adopted a Supplemental Restricted Stock Plan. Pursuant to this plan, awards of
outstanding units to existing employees under the Profit Participation Plan were
valued at $0.20 per dollar of award ($0.70 per dollar of award in the case of
1994 regular units granted thereunder) and, at the election of each outstanding
employee, were exchanged for restricted shares of common stock valued at the
initial public offering price of $20.00 per share. All employees of the Company,
including all senior executives, exchanged their outstanding interests in the
Profit Participation Plan for restricted shares of common stock at the public
offering price under the Supplemental Restricted Stock Plan. In exchange for an
accrued balance of $7,126,000 in such Profit Participation Plan, the Company
issued 356,345 shares of restricted stock. This transaction was treated as a
non-cash financing transaction for cash flow purposes. The stock was restricted
because ownership of the shares by employees required continued employment. The
shares vested ratably over a three-year period on July 1, 1994, 1995 and 1996.
Pursuant to the 1993 Equity Participation Plan, 1,810,780 shares of common
stock, subject to anti-dilutive adjustment, were reserved for awards of options,
restricted shares of common stock, and performance shares to employees for the
purpose of providing, through the grant of long-term incentives, a means to
attract and retain key personnel and to provide to participating officers and
other key employees long-term incentives for sustained high levels of
performance. Shares available under the 1993 Equity Participation Plan were
increased from 1,810,780 to 2,110,780 in May 1995. The 1993 Equity Participation
Plan also contains provisions that permit the Human Resources Committee to pay
all or a portion of an employee's bonuses in the form of shares of common stock
credited to the employees at a 15% discount from current market value and paid
to employees five years from the date of award. Up to an aggregate of 10,000,000
shares may be allocated to such equity bonuses. Common stock to pay performance
shares, stock options and equity bonus awards is acquired by the Company through
open-market purchases by a trust established for such purpose.
During 1994, under the Company's 1993 Equity Participation Plan, the
Company granted to officers and employees, in respect of future performance,
non-qualified options to purchase an aggregate of 1,099,000 shares of common
stock, of which 39,000 were forfeited and 1,060,000 were still outstanding at
December 31, 1994, substantially all of which have an exercise price of $20.00
per share. (As described below, 1,025,500 of these options were converted to
performance shares.) The foregoing options vest, subject to continuation of
employment and other terms of the option grants, at the rate of 20% per year,
for five one-year periods, with the first period ending on July 1, 1994. Such
options expire ten years after the effective dates of their grant. In the fourth
quarter of 1994, holders of outstanding stock options under the 1993 Equity
Participation Plan were offered the right to exchange such stock options for an
equal number of performance shares under such Plan. Also, as a result of the
Merger, the Company granted stock options to acquire an aggregate of 169,956
shares of common stock with strike prices ranging from $18.63 to $23.53 per
share to employees of CGC in exchange for outstanding stock options of CGC.
During 1997, employees acquired 125,106 shares subject to options at an average
strike price of $22.32 per share and with an average market price of $41.47 per
share. In addition, options to purchase 20,194 shares were forfeited during
1997. Giving effect to such exchange and subsequent awards, at December 31,
1997, there were outstanding 1,366,375 performance shares and options to
purchase 56,656 shares of common stock.
Performance shares granted under the 1993 Equity Participation Plan were
as follows:
Outstanding Granted Earned Forfeited Outstanding Market
at Beginning During During During at End Price at
of Year the Year the Year the Year of Year Grant Date
------- -------- -------- -------- ------- ----------
1995 1,025,500 83,650 -- -- 1,109,150 $19.250
1996 1,109,150 282,490 -- 17,300 1,374,340 25.250
1997 1,374,340 253,057 201,769 59,253 1,366,375 35.500
The Company applies APB Opinion 25 and related Interpretations in
accounting for its performance shares. The Company estimates the final cost of
these performance shares and accrues for this expense over the performance
period. The accrued expense for the performance shares was $29,500,000,
$13,741,000 and $5,744,000 for the years ended December 31, 1997, 1996 and 1995,
respectively. In tandem with this accrued expense, the Company estimates those
performance shares that it expects to settle in stock and records this amount in
stockholders' equity as deferred compensation. The remainder of the accrual,
which represents the amount of performance shares that the Company estimates it
will settle in cash, is recorded in accrued expenses and other liabilities. In
1996, the Company adopted disclosure provisions of SFAS No. 123. Had the
compensation cost for the Company's performance shares been determined based
upon the provisions of SFAS No. 123, there would have been no effect on the
Company's reported net income and earnings per share.
16
In November 1994, the Company appointed an independent trustee authorized
to purchase shares of the Company's common stock in open market transactions, at
times and prices determined by the trustee. These purchases are intended to fund
future obligations relating to equity bonuses, performance shares and stock
options under the 1993 Equity Participation Plan and are presented as treasury
stock in these financial statements. During 1997, 1996 and 1995, the total
number of shares purchased by the trust was 162,573, 529,131 and 591,714,
respectively, at a cost of $5,434,000, $14,111,000 and $14,444,000,
respectively. In 1996 and 1995, the Company also repurchased stock from its
employees in satisfaction of withholding taxes on shares distributed under its
restricted stock plan.
The Company does not currently provide post-retirement benefits, other
than under its defined contribution plans, to its employees, nor does it provide
post-employment benefits to former employees.
12. COMMITMENTS AND CONTINGENCIES
The Company and its Subsidiaries lease office space and equipment under
non-cancelable operating leases, which expire at various dates through 2005.
Future minimum rental payments are as follows (in thousands):
Year Ended December 31,
-----------------------
1998 $ 2,477
1999 2,440
2000 2,301
2001 2,014
2002 1,739
Thereafter 5,071
-------
Total $16,042
=======
Rent expense for the years ended December 31, 1997, 1996 and 1995 was
$4,067,000, $3,816,000 and $3,712,000, respectively.
During the ordinary course of business, the Subsidiaries have become
parties to certain litigation. Management believes that these matters will be
resolved with no material financial impact on the Company.
13. REINSURANCE
The Subsidiaries reinsure portions of their risks with affiliated (see
Note 15) and unaffiliated reinsurers under quota share treaties and on a
facultative basis. The Subsidiaries' principal ceded reinsurance program
consisted in 1997 of two quota share treaties and three automatic facultative
facilities. One treaty covered all of the Subsidiaries' approved regular lines
of business, except U.S. municipal obligation insurance. Under this treaty in
1997, the Subsidiaries ceded 9.75% of each covered policy, up to a maximum of
$19,500,000 insured principal per policy. At their sole option, the Subsidiaries
could have increased, and in certain instances did increase, the ceding
percentage to 19.5% up to $39,000,000 of each covered policy. A second treaty
covered the Subsidiaries' U.S. municipal obligation insurance business. Under
this treaty in 1997, the Subsidiaries ceded 9% of each covered policy that is
classified by the Subsidiaries as providing U.S. municipal bond insurance as
defined by Article 69 of the New York Insurance Law up to a limit of $24,000,000
per single risk, which is defined by revenue source. At their sole option, the
Subsidiaries could have increased, and in certain instances did increase, the
ceding percentage to 35% up to $93,333,000 per single risk. These cession
percentages under both treaties were reduced on smaller-sized transactions.
Under the three automatic facultative facilities in 1997, the Subsidiaries at
their option could allocate up to a specified amount for each reinsurer (ranging
from $4,000,000 to $50,000,000 depending on the reinsurer) for each transaction,
subject to limits and exclusions, in exchange for which the Subsidiaries agreed
to cede in the aggregate a specified percentage of gross par insured by the
Subsidiaries. Each of the treaties and automatic facultative facilities allowed
the Subsidiaries to withhold a ceding commission to defray their expenses. The
Subsidiaries also employed non-treaty, quota share facultative reinsurance on
various transactions in 1997 in keeping with prior practices. In 1997, the
Subsidiaries also implemented facultative first-loss reinsurance on selected
asset-backed transactions.
17
In the event (which management considers to be highly unlikely) that any
or all of the reinsuring companies were unable to meet their obligations to the
Subsidiaries, the Subsidiaries would be liable for such defaulted amounts. The
Subsidiaries have also assumed reinsurance of municipal obligations from
unaffiliated insurers.
Amounts reinsured were as follows (in thousands):
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
Written premiums ceded $ 63,513 $ 55,965 $ 33,166
Written premiums assumed 1,352 1,873 1,684
Earned premiums ceded 41,713 38,723 38,013
Earned premiums assumed 5,121 6,020 2,759
Loss and loss adjustment expense payments
ceded 2,862 29,408 3,060
Loss and loss adjustment expense payments
assumed 2 3 3
Incurred losses and loss adjustment expenses ceded 3,605 (2,249) 9,101
Incurred losses and loss adjustment expenses
assumed 161 38 81
December 31,
------------
1997 1996
---- ----
Principal outstanding ceded $24,547,361 $20,292,615
Principal outstanding assumed 1,670,468 1,995,752
Deferred premium revenue ceded 173,123 151,224
Deferred premium revenue assumed 14,128 18,929
Loss and loss adjustment expense reserves ceded 30,618 29,875
Loss and loss adjustment expense reserves assumed 865 705
14. OUTSTANDING EXPOSURE AND COLLATERAL
The Company's policies insure the scheduled payments of principal and
interest on asset-backed and municipal obligations. The principal amount insured
(in millions) as of December 31, 1997 and 1996 (net of amounts ceded to other
insurers of $10,129 and $9,601 of asset-backed and $14,418 and $10,691 of
municipal, respectively) and the terms to maturity are as follows:
December 31, 1997 December 31, 1996
----------------- -----------------
Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal
- ----------------- ------------ --------- ------------ ---------
0 to 5 Years $ 7,553 $ 2,230 $ 7,424 $ 1,571
5 to 10 Years 5,637 5,683 3,920 3,841
10 to 15 Years 2,858 8,257 1,461 6,272
15 to 20 Years 524 14,340 714 11,433
20 Years and Above 11,917 16,479 9,681 12,877
------- ------- ------- -------
Total $28,489 $46,989 $23,200 $35,994
======= ======= ======= =======
18
The principal amount ceded as of December 31, 1997 and 1996 and the terms
to maturity are as follows (in millions):
December 31, 1997 December 31, 1996
----------------- -----------------
Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal
- ----------------- ------------ --------- ------------ ---------
0 to 5 Years $ 3,828 $ 965 $ 3,695 $ 769
5 to 10 Years 2,118 1,693 2,413 1,192
10 to 15 Years 553 2,078 452 1,479
15 to 20 Years 257 3,005 302 2,345
20 Years and Above 3,373 6,677 2,739 4,906
------- ------- ------- -------
Total $10,129 $14,418 $ 9,601 $10,691
======= ======= ======= =======
The Company limits its exposure to losses from writing financial
guarantees by underwriting investment-grade obligations, by diversifying its
portfolio and by maintaining rigorous collateral requirements on asset-backed
obligations. The gross principal amounts of insured obligations in the
asset-backed insured portfolio are backed by the following types of collateral
(in millions):
Net of Amounts Ceded Ceded
December 31, December 31,
------------ ------------
Types of Collateral 1997 1996 1997 1996
- ------------------- ---- ---- ---- ----
Residential mortgages $12,928 $10,987 $ 3,665 $ 3,077
Consumer receivables 10,659 7,548 4,601 3,735
Government securities 787 1,477 120 449
Pooled corporate obligations 3,004 1,663 540 852
Commercial mortgage portfolio:
Commercial real estate 98 113 418 463
Corporate secured 55 66 481 619
Investor-owned utility obligations 643 791 229 266
Other asset-backed obligations 315 555 75 140
------- ------- ------- -------
Total asset-backed obligations $28,489 $23,200 $10,129 $ 9,601
======= ======= ======= =======
The asset-backed insured portfolio, which aggregated $38,618,244,000
principal before reinsurance at December 31, 1997, was collateralized by assets
with an estimated fair value of $44,382,716,000. At December 31, 1996, it
aggregated $32,792,722,000 principal before reinsurance and was collateralized
by assets with an estimated fair value of $38,323,180,000. Such estimates of
fair value are calculated at the inception of each insurance policy and are
changed only in proportion to changes in exposure. At December 31, 1997, the
estimated fair value of collateral and reserves over the principal insured
averaged from 100% for commercial real estate to 172% for corporate secured
obligations. At December 31, 1996, the estimated fair value of collateral and
reserves over the principal insured averaged from 100% for commercial real
estate to 168% for corporate secured obligations. Collateral for specific
transactions is generally not available to pay claims related to other
transactions. The amounts of losses ceded to reinsurers are determined net of
collateral.
The gross principal amount of insured obligations in the municipal insured
portfolio includes the following types of issues (in millions):
Net of Amounts Ceded Ceded
December 31, December 31,
------------ ------------
Types of Issues 1997 1996 1997 1996
- --------------- ---- ---- ---- ----
General obligation bonds $17,101 $12,523 $ 3,182 $ 2,423
Housing revenue bonds 1,770 1,794 955 1,033
Municipal utility revenue bonds 5,892 4,671 2,294 1,472
Health care revenue bonds 3,924 2,854 2,175 2,049
Tax-supported bonds (non-general obligation) 11,210 8,805 3,526 2,152
Transportation revenue bonds 1,972 1,479 1,041 436
Other municipal bonds 5,120 3,868 1,245 1,126
------- ------- ------- -------
Total municipal obligations $46,989 $35,994 $14,418 $10,691
======= ======= ======= =======
19
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
securitization, 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.
The Company seeks to maintain a diversified portfolio of insured municipal
obligations designed to spread its risk across a number of geographic areas. The
following table sets forth, by state, those states in which municipalities
located therein issued an aggregate of 2% or more of the Company's net par
amount outstanding of insured municipal securities as of December 31, 1997:
Net Par Percent of Total Ceded Par
Number Amount Municipal Net Par Amount
State of Issues Outstanding Amount Outstanding Outstanding
----- --------- ----------- ------------------ -----------
(in millions) (in millions)
California 403 $ 7,832 16.7% $ 1,929
New York 281 4,307 9.2 2,163
Pennsylvania 231 3,125 6.6 650
New Jersey 207 2,730 5.8 1,260
Florida 103 2,669 5.7 817
Texas 294 2,472 5.3 669
Illinois 274 1,851 3.9 254
Massachusetts 101 1,460 3.1 553
Michigan 147 1,417 3.0 409
Minnesota 129 1,152 2.5 111
Wisconsin 179 1,138 2.4 206
All Other States 1,190 15,575 33.1 4,528
Non-U.S 29 1,261 2.7 869
------- ------- ----- -------
Total 3,568 $46,989 100.0% $14,418
======= ======= ===== =======
15. RELATED PARTY TRANSACTIONS
The Subsidiaries ceded premiums of $21,216,000, $19,890,000 and
$13,061,000 to Tokio Marine for the years ended December 31, 1997, 1996 and
1995, respectively. The amounts included in prepaid reinsurance premiums at
December 31, 1997 and 1996 for reinsurance ceded to Tokio Marine were
$53,603,000 and $44,634,000, respectively. Reinsurance recoverable on unpaid
losses ceded to Tokio Marine was $613,000 and $477,000 at December 31, 1997 and
1996, respectively.
The Subsidiaries ceded premiums of $16,890,000, $15,409,000 and $7,522,000
on a quota share basis to affiliates of U S WEST for the years ended December
31, 1997, 1996 and 1995, respectively, of which $351,000, $372,000 and $629,000,
respectively, were ceded to Commercial Reinsurance Company (Commercial Re). The
amounts included in prepaid reinsurance premiums for reinsurance ceded to these
affiliates were $51,980,000 and $49,649,000 at December 31, 1997 and 1996,
respectively, of which $5,554,000 and $8,728,000, respectively, were ceded to
Commercial Re. The amounts of reinsurance recoverable on unpaid losses ceded to
these affiliates at December 31, 1997 and 1996 were $24,195,000 and $23,473,000,
respectively, of which $20,335,000 and $19,170,000, respectively, were ceded to
Commercial Re. The Commercial Re reinsurance agreement was subject to, and
received, the non-disapproval of the State of New York Insurance Department due
to its nature as an affiliate transaction. FSA has taken credit for the
reinsurance ceded to Commercial Re.
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16. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following estimated fair values have been determined by the Company
using available market information and appropriate valuation methodologies.
However, considerable judgment is necessary to interpret the data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amount the Company could realize in a current
market exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
Bonds -- The carrying amount of bonds represents fair value. The fair
value of bonds is based upon quoted market price.
Short-term investments -- The carrying amount is fair value, which
approximates cost due to the short maturity of these instruments.
Cash, receivable for investments sold and payable for investments
purchased -- The carrying amount approximates fair value because of the short
maturity of these instruments.
Deferred premium revenue, net of prepaid reinsurance premiums -- The
carrying amount of deferred premium revenue, net of prepaid reinsurance
premiums, represents the Company's future premium revenue, net of reinsurance,
on policies where the premium was received at the inception of the insurance
contract. The fair value of deferred premium revenue, net of prepaid reinsurance
premiums, is an estimate of the premiums that would be paid under a reinsurance
agreement with a third party to transfer the Company's financial guaranty risk,
net of that portion of the premiums retained by the Company to compensate it for
originating and servicing the insurance contracts.
Installment premiums -- Consistent with industry practice, there is no
carrying amount for installment premiums since the Company will receive premiums
on an installment basis over the term of the insurance contract. Similar to
deferred premium revenue, the fair value of installment premiums is the
estimated present value of the future contractual premium revenues that would be
paid under a reinsurance agreement with a third party to transfer the Company's
financial guaranty risk, net of that portion of the premium retained by the
Company to compensate it for originating and servicing the insurance contract.
Losses and loss adjustment expenses, net of reinsurance recoverable on
unpaid losses -- The carrying amount is fair value, which is the present value
of the expected cash flows for specifically identified claims and potential
losses in the Company's insured portfolio.
December 31, 1997 December 31, 1996
----------------- -----------------
(In thousands) Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
------ ---------- ------ ----------
Assets:
Bonds $1,268,158 $1,268,158 $1,072,439 $1,072,439
Short-term investments 132,931 132,931 73,641 73,641
Cash 12,475 12,475 8,146 8,146
Receivable for securities sold 20,623 20,623 -- --
Liabilities:
Deferred premium revenue, net of
prepaid reinsurance premiums 422,073 295,451 359,972 251,980
Losses and loss adjustment expenses,
net of reinsurance recoverable on
unpaid losses 44,799 44,799 42,204 42,204
Notes payable 130,000 131,612 30,000 30,000
Payable for investments purchased 72,979 72,979 14,390 14,390
Off-balance-sheet instruments:
Installment premiums -- 116,888 -- 102,988
21
17. LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
The Company's liability for losses and loss adjustment expenses consists
of the case basis and general reserves. Activity in the liability for losses and
loss adjustment expenses is summarized as follows (in thousands):
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
Balance at January 1 $ 72,079 $ 111,759 $ 91,130
Less reinsurance recoverable 29,875 61,532 55,491
--------- --------- ---------
Net balance at January 1 42,204 50,227 35,639
Incurred losses and loss adjustment expenses:
Current year 5,400 5,300 3,000
Prior years 3,756 1,574 3,258
Related to Merger -- -- 15,400
Paid losses and loss adjustment expenses:
Current year (2,850) -- --
Prior years (3,711) (14,897) (7,070)
--------- --------- ---------
Net balance December 31 44,799 42,204 50,227
Plus reinsurance recoverable 30,618 29,875 61,532
--------- --------- ---------
Balance at December 31 $ 75,417 $ 72,079 $ 111,759
========= ========= =========
During 1995, the Company increased its general reserve by $6,258,000, of
which $3,000,000 was for originations of new business and $3,258,000 was to
reestablish the general reserve for transfers from general reserves to case
basis reserves. During 1995, the Company transferred $10,788,000 from its
general reserve to case basis reserves associated predominantly with certain
residential mortgage and timeshare receivables transactions. Also in December
1995, FSA recognized a one-time increase of $15,400,000 to the general reserve
to provide for the insured portfolio it had assumed in the Merger with CGC in a
manner consistent with the Company's reserving methodology. Prior to the Merger,
CGC did not maintain a general reserve. Giving effect to all the 1995 events,
the general reserve totaled $31,798,000 at December 31, 1995.
During 1996, the Company increased its general reserve by $6,874,000, of
which $5,300,000 was for originations of new business and $1,574,000 was to
reestablish a portion of the general reserve that had previously been
transferred to case basis reserves. During 1996, the Company transferred
$9,012,000 from its general reserve to case basis reserves associated
predominantly with certain residential mortgage and timeshare receivables
transactions. Giving effect to these transfers, the general reserve totaled
$29,660,000 at December 31, 1996.
During 1997, the Company increased its general reserve by $9,156,000, of
which $5,400,000 was for originations of new business and $3,756,000 was to
reestablish a portion of the general reserve that had previously been
transferred to case basis reserves. During 1997, the Company transferred
$4,503,000 from its general reserve to case basis reserves associated
predominantly with certain residential mortgage transactions. Giving effect to
these transfers, the general reserve totaled $34,313,000 at December 31, 1997.
Reserves for losses and loss adjustment expenses are discounted at
risk-free rates. The amount of discount taken was approximately $19,779,000,
$17,944,000 and $15,276,000 at December 31, 1997, 1996 and 1995, respectively.
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18. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
(In thousands, except share data) First Second Third Fourth Full Year
----- ------ ----- ------ ---------
1997
Gross premiums written $41,111 $90,995 $42,470 $61,815 $236,391
Net premiums written 27,184 67,495 28,911 49,288 172,878
Net premiums earned 24,774 27,561 27,204 29,972 109,511
Net investment income 16,361 17,121 17,920 20,683 72,085
Losses and loss adjustment expenses 2,285 2,156 2,426 2,289 9,156
Income before taxes 27,266 35,058 37,896 38,279 138,499
Net income 20,250 25,233 27,225 27,794 100,502
Basic earnings per common share 0.67 0.84 0.91 0.93 3.35
Diluted earnings per common share 0.66 0.82 0.88 0.90 3.25
1996
Gross premiums written $52,580 $44,762 $38,994 $40,630 $176,966
Net premiums written 34,139 30,726 28,449 27,686 121,000
Net premiums earned 22,734 19,750 21,637 26,327 90,448
Net investment income 15,682 15,986 16,467 16,929 65,064
Losses and loss adjustment expenses 1,625 1,530 1,482 2,237 6,874
Income before taxes 26,234 25,211 22,948 35,378 109,771
Net income 19,544 18,748 17,210 25,258 80,760
Basic earnings per common share 0.62 0.61 0.57 0.84 2.64
Diluted earnings per common share 0.62 0.60 0.57 0.83 2.61
19. PRO FORMA RESULTS OF ACQUISITION (UNAUDITED)
The unaudited consolidated results of operations (in thousands, except per
share data) on a pro forma basis as though the Merger had been consummated on
January 1, 1995, excluding the effect of the one-time general reserve charge in
1995 of $15,400, were as follows:
December 31,
1995
----
Total revenues $157,150
Total expenses 44,239
Earnings per common share 2.53
The pro forma information is presented for informational purposes only and
is not necessarily indicative of the operating results that would have occurred
had the Merger been consummated as of January 1, 1995, nor is it necessarily
indicative of future operating results.
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20. EARNINGS PER SHARE
In 1997, the Company adopted SFAS No. 128 specifying the computation,
presentation and disclosure requirements for EPS. The new standard defines
"basic" and "diluted" earnings per share. Basic earnings per share are based on
average basic shares outstanding, which is calculated by adding shares earned
but not issued under the Company's equity bonus and performance share plans to
the average common shares outstanding. Diluted earnings per share are based on
average diluted shares outstanding, which is calculated by adding shares
contingently issuable under stock options, the performance share plan and the
Company's convertible preferred stock to the average basic shares outstanding.
The calculations of average basic and diluted common shares outstanding are as
follows (in thousands):
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
Average common shares outstanding 29,858 30,547 25,797
Shares earned but unissued under stock-based
compensation plans 170 80 59
------ ------ ------
Average basic common shares outstanding 30,028 30,627 25,856
Shares contingently issuable under:
Stock-based compensation plans 395 268 43
Convertible preferred stock 490 -- --
------ ------ ------
Average diluted common shares outstanding 30,913 30,895 25,899
21. RECENTLY ISSUED ACCOUNTING STANDARDS
In February 1997, the Securities and Exchange Commission (SEC) issued
Financial Reporting Release No. 48, Disclosure of Accounting Policies for
Derivative Financial Instruments and Derivative Commodity Instruments and
Disclosure of Quantitative and Qualitative Information about Market Risk
Inherent in Derivative Financial Instruments, Other Financial Instruments, and
Derivative Commodity Instruments (FRR No. 48).
FRR No. 48 amends rules and forms for registrants and requires
clarification and expansion of existing disclosures for derivative financial
instruments, other financial instruments and derivative commodity instruments,
as defined therein. The amendments require enhanced disclosure with respect to
these derivative instruments in the footnotes to the financial statements.
Additionally, the amendments expand existing disclosure requirements to include
quantitative and qualitative discussions with respect to market risk inherent in
market-risk-sensitive instruments such as equity and fixed-maturity securities,
as well as derivative instruments.
In June 1997, the Financial Accounting Standards Board issued SFAS No.
130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for
reporting and display of comprehensive income and its components (revenues,
expenses, gains and losses) in a full set of general-purpose financial
statements. Comprehensive income is defined as the change in stockholders'
equity during a period from transactions and other events and circumstances from
non-owner sources and includes net income and all changes in stockholders'
equity except those resulting from investments by owners and distributions to
owners.
SFAS No. 130 requires that an enterprise (i) classify items of other
comprehensive income by their nature in a financial statement and (ii) display
the accumulated balance of other comprehensive income separately from retained
earnings and additional paid-in capital in the equity section of a statement of
financial position.
SFAS No. 130 is effective for fiscal years beginning after December 15,
1997. Reclassification of financial statements for earlier periods provided for
comparative purposes is required.
Also in June 1997, the Financial Accounting Standards Board issued SFAS
No. 131, Disclosure about Segments of an Enterprise and Related Information.
SFAS No. 131 establishes standards for the way that public business enterprises
report information about operating segments in annual and interim financial
statements and requires presentation of a measure of profit or loss, certain
specific revenue and expense items and segment assets. It also establishes
standards for related disclosures about products and services, geographic areas
and major customers, superseding most of SFAS No. 14, Financial Reporting for
Segments of a Business Enterprise.
24
SFAS No. 131 requires that a public business enterprise report financial
and descriptive information about its reportable operating segments. Generally,
financial information is required to be reported on the basis that is used
internally for evaluating segment performance and deciding how to allocate
resources to segments. The enterprise must report information about revenues
derived, major customers, and countries in which it earns revenues and holds
assets, regardless of whether that information is used in making operating
decisions. However, SFAS No. 131 does not require an enterprise to report
information that is not prepared for internal use if reporting would be
impracticable.
SFAS No. 131 is effective for financial statements for periods beginning
after December 15, 1997. SFAS No. 131 need not be applied to interim financial
statements in the initial year of its application, but comparative information
for interim periods in the initial year of application is to be reported in
financial statements of the interim periods in the third year of application.
The Company is in the process of determining the effect of these standards
on its financial statements.
25