SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
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 (I.R.S. Employer
incorporation or organization) Identification No.)
350 Park Avenue, New York, New York 10022
(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
------------------- -----------------------------------------
Common Stock, par value $.01 per share New York Stock Exchange, Inc.
7.375% Senior Quarterly Income
Debt Securities Due 2097 New York Stock Exchange, Inc.
Securities registered pursuant to Section 12(g) of the Act:
None
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 [ ]
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. [ ]
The aggregate market value of voting stock, excluding treasury shares,
held by non-affiliates of the registrant at March 11, 1998 was $1,609,291,128
(based upon the closing price of the registrant's shares on the New York Stock
Exchange on March 11, 1998, which was $53.875). For purposes of the foregoing,
only U S WEST Capital Corporation and Fund American Enterprises Holdings, Inc.
were deemed to be affiliates of the registrant.
At March 11, 1998, there were outstanding 29,870,833 shares of Common
Stock, par value $0.01 per share, of the registrant (includes 1,107,765 shares
of Common Stock owned by a trust on behalf of the Company and excludes 2,405,468
shares of Common Stock actually held in treasury).
Documents Incorporated By Reference
Portions of the registrant's Annual Report to Shareholders for the year
ended December 31, 1997 are incorporated by reference into Part II hereof.
Portions of the registrant's definitive Proxy Statement dated March 23, 1998 in
connection with the Annual Meeting of Shareholders to be held on May 14, 1998
are incorporated by reference into Part III hereof.
<PAGE>
TABLE OF CONTENTS
Page
----
Item 1. Business........................................................... 2
Item 2. Properties......................................................... 23
Item 3. Legal Proceedings.................................................. 23
Item 4. Submission of Matters to a Vote of Security Holders................ 23
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters.............................................. 24
Item 6. Selected Financial Data............................................ 24
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations.............................. 24
Item 8. Financial Statements and Supplementary Data........................ 24
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.............................. 24
Item 10. Directors and Executive Officers of the Registrant................. 25
Item 11. Executive Compensation............................................. 25
Item 12. Security Ownership of Certain Beneficial Owners and Management..... 25
Item 13. Certain Relationships and Related Transactions..................... 25
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K... 26
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Item 1. Business.
General
Financial Security Assurance Holdings Ltd. (the "Company"), through its
wholly owned subsidiary, Financial Security Assurance Inc. ("FSA"), is primarily
engaged in the business of providing financial guaranty insurance on
asset-backed and municipal obligations. FSA was the first insurance company
organized to insure asset-backed obligations and has been a leading insurer of
asset-backed obligations (based on number of transactions insured) since its
inception in 1985. FSA expanded the focus of its business in 1990 to include
financial guaranty insurance of municipal obligations. For the year ended
December 31, 1997, FSA had gross premiums written of $236.4 million, of which
45% related to insurance of asset-backed obligations and 55% related to
insurance of municipal obligations. At December 31, 1997, FSA had net insurance
in force of $117.4 billion, of which 69% represented insurance of municipal
obligations and 31% represented insurance of asset-backed obligations. FSA is
licensed to engage in the financial guaranty insurance business in all 50
states, the District of Columbia and Puerto Rico.
At December 31, 1993, the Company was owned 92.5% by U S WEST Capital
Corporation ("U S WEST") and 7.5% by The Tokio Marine and Fire Insurance Co.,
Ltd. ("Tokio Marine"). The Company completed an initial public offering (the
"IPO") of common shares on May 13, 1994, at which time Fund American Enterprises
Holdings, Inc. (together with its wholly owned subsidiaries, "Fund American")
purchased 2,000,000 shares of the Company's common stock. In connection with the
IPO, the Company, U S WEST and Fund American entered into certain agreements
providing, among other things, Fund American certain rights to acquire
additional shares of the Company from the Company and U S WEST. Pursuant to
these agreements, 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 a liquidation preference of $700,000. In December 1995, the Company
acquired Capital Guaranty Corporation ("Capital Guaranty") in a merger
transaction in which Capital Guaranty became a direct wholly owned subsidiary of
the Company (the "Merger"). Capital Guaranty, through its wholly owned
subsidiary, Capital Guaranty Insurance Corporation ("CGIC"), provided financial
guaranty insurance on municipal bonds. In 1997, FSA sold CGIC and all the
policies of CGIC were assumed by FSA. At December 31, 1997, voting control of
the Company was held 33.2% by U S WEST, 23.9% by Fund American, 6.3% by Tokio
Marine and 36.6% by the public and employees. U S WEST has previously announced
its intention to dispose of its remaining interest in the Company as part of its
strategic plan to withdraw from businesses not directly involved in
telecommunications. Most of the Company's shares owned by U S WEST are either
subject to stock options held by Fund American or potentially deliverable in
satisfaction of DECS (Debt Exchangeable for Common Stock) securities issued in
May 1996 by U S WEST, Inc.
U S WEST is a subsidiary of U S WEST, Inc., which operates businesses
involved in communications, data solutions, marketing services and capital
assets, including the provision of telephone services in 14 states in the
western and midwestern United States. Fund American is a financial services
holding company whose operating subsidiaries include various insurance companies
and one of the largest mortgage loan servicers in the United States. Tokio
Marine is a major Japanese property and casualty insurance company.
FSA wholly owns FSA Insurance Company ("FSAIC"), which in turn wholly owns
Financial Security Assurance of Oklahoma, Inc. ("Oklahoma"). FSAIC and Oklahoma
provide reinsurance to FSA.
Financial Security Assurance (U.K.) Limited ("FSA-UK"), a wholly owned
subsidiary of Oklahoma, is authorized to transact an insurance business in the
United Kingdom, and provides financial guaranty insurance for transactions in
the United Kingdom and other European markets.
FSA Portfolio Management Inc. ("FSA Portfolio Management"), a wholly owned
subsidiary of the Company, is engaged in the business of managing the investment
portfolios of the Company and its subsidiaries and of certain third parties.
Transaction Services Corporation ("TSC"), a wholly owned subsidiary of the
Company, is engaged in the business of managing workout transactions within the
insured portfolios of the Company and its subsidiaries and of certain third
parties.
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Industry Overview
Financial guaranty insurance written by FSA typically guarantees scheduled
payments on an issuer's 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, at
its option, to pay such amounts on an accelerated basis. FSA's underwriting
policy is to insure asset-backed and municipal obligations that would otherwise
be investment grade without the benefit of FSA's insurance. The 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. The municipal obligations insured by FSA consist primarily of
general obligation bonds supported by the issuers' taxing power and special
revenue bonds and other special obligations of state and local governments
supported by the issuers' ability to impose and collect fees and charges for
public services or specific projects.
The Company's business objective is to remain a leading insurer of
asset-backed obligations and to become a more prominent insurer of municipal
obligations. The Company's acquisition of Capital Guaranty in December 1995
increased the Company's presence in the insured municipal bond sector. The
Company believes that the demand for its financial guaranty insurance will grow
over the long term in response to anticipated growth in insured asset-backed and
municipal obligations. The Company expects continued growth in the insurance of
asset-backed obligations, due in part to the continued expansion of asset
securitization outside of the residential mortgage sector. In the long term, the
Company also expects continued growth in the insurance of municipal obligations,
due in part to increased issuance of municipal bonds to finance repairs and
improvements to the nation's infrastructure and increased municipal bond
purchases by individuals who generally purchase insured obligations. In
addition, the percentage of new domestic municipal bond volume which is insured
has increased each year since 1986, to 49% for the year ending 1997 according to
published sources. Financial guaranty insurance has also begun to be applied to
obligations of municipal issuers located outside of the United States.
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.
In addition to its domestic business, the Company pursues international
opportunities and currently operates in the European and Pacific Rim markets.
The Company was the first financial guaranty insurance company to insure
asset-backed obligations in international markets. The Company is also party to
a Cooperation Agreement with Tokio Marine, which provides an arrangement to
develop financial guaranty insurance opportunities in Japan.
Business of FSA
Insurance Markets
FSA writes financial guaranty insurance on asset-backed obligations and
municipal obligations, a description of which follows.
Asset-Backed Obligations
Asset-backed obligations are typically issued in connection with
structured financings or securitizations, in which the securities being issued
are secured by or payable from a specific pool of assets having an ascertainable
cash flow or market value and held by a special purpose issuing entity. While
most asset-backed obligations are secured by or represent interests in diverse
pools of assets, such as residential mortgage loans and credit card and auto
loan receivables, monoline financial guarantors have also insured asset-backed
obligations secured by less diverse payment sources, such as utility mortgage
bonds and multifamily real estate.
In general, asset-backed obligations are 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 asset-backed
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obligations also generally have the benefit of overcollateralization, excess
cash flow or one or more forms of credit enhancement to cover credit risks
associated with the related assets.
The following table sets forth certain industry information relating to
selected asset-backed obligations for the periods indicated:
New Asset-Backed Obligations
Volume of Combined
Private-Label Volume of Other Volume Asset-Backed Volume
Residential Public of Insured by Monoline
Mortgage Asset-Backed Asset-Backed Insurance
Obligations(1) Obligations(2) Obligations(3) Companies(4)
-------------- --------------- -------------- -------------------
(dollars in billions)
1991..... $49.3 $ 50.6 $ 99.9 $ 9.8
1992..... 89.5 51.1 140.6 10.3
1993..... 98.5 61.0 159.5 21.4
1994..... 63.2 75.5 138.7 24.7
1995..... 37.0 108.0 145.0 44.7
1996..... 38.4 151.1 189.5 74.5
1997..... 63.5 176.0 239.5 N/A(5)
- ----------
(1) Information is from Inside Mortgage Securities, January 8, 1993, January
14, 1994, January 20, 1995, February 2, 1996, Inside MBS & ABS, February
14, 1997 and January 16, 1998 and includes all U.S. public and rated
private residential first mortgage-backed transactions, except obligations
issued or guaranteed by government related entities.
(2) Information is from Asset Sales Report, January 18, 1993, January 25,
1993, January 10, 1994, January 9, 1995, January 22, 1996, January 27,
1997 and January 5, 1998 and includes all U.S. public asset-backed
obligations (other than commercial paper transactions) backed by consumer
receivables (including home equity loans), pooled corporate obligations
and commercial mortgages.
(3) Combined volume excludes both (i) private placement non-residential
asset-backed obligations and (ii) asset-backed commercial paper.
(4) Information for 1991 through 1992 is based on data provided in the
Association of Financial Guaranty Insurors (AFGI), Report of Combined
Financial Results and New Business Written for the period ended December
31, 1992. Information for 1993 is based on data provided in the AFGI,
Annual Report 1993. Information for 1994, 1995 and 1996 is based upon AFGI
reporting for those years.
(5) Not available.
The issuance of asset-backed obligations of the type included in the table
experienced substantial growth in each year over the 1991 to 1997 period, with
the exception of 1994. The combined volume of such asset-backed obligations grew
from $99.9 billion in 1991 to $239.5 billion in 1997.
During 1991, credit card obligations were the largest single component of
public, non-residential asset-backed obligations. Automobile loans were the
largest component in 1992 and 1993. Credit card obligations were the largest
component in 1994, 1995 and 1996. Home equity loans were the largest component
in 1997.
The par value of new asset-backed obligations insured by monoline
financial guaranty insurance companies rose in every year from 1991 through
1996.
The growth in the issuance of asset-backed obligations since 1991 has been
due in part to increased capital requirements of commercial banks and insurance
companies and the contraction of credit extended to corporations. 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. Moreover, many corporations have found securitization
of their assets to be a less costly funding alternative to traditional forms of
borrowing.
Residential mortgage-backed issuance declined in 1994 because interest
rates rose, causing a reduction in mortgage loan refinancings and therefore in
the amount of new loan originations available for securitization. The decline
continued in 1995, as interest rates stabilized, and ended in 1996. In addition,
a substantial amount of
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residential first mortgage loans were securitized in the home equity loan sector
of the asset-backed market in 1996 and 1997.
The demand for asset securitizations continues to deepen and broaden as
issuers securitize new classes of assets through increasingly complex
structures. Properly structured credit enhancements are often attractive in
providing market acceptability, liquidity and security.
Municipal Obligations
Municipal obligations include bonds, notes and other evidences of
indebtedness issued by states and their political subdivisions (such as
counties, cities or towns), utility districts, public universities and
hospitals, public housing and transportation authorities and other public and
quasi-public entities. Municipal obligations are supported by the issuer's
taxing power in the case of general obligation bonds, or by the issuer's ability
to impose and collect fees and charges for public services or specific projects
in the case of most special revenue bonds.
Insurance of municipal obligations represents the largest portion of the
financial guaranty insurance business. Since the early 1980s, insured municipal
obligation volume has grown substantially in terms of insurance in force, the
number of municipalities issuing insured obligations and the types of municipal
obligations that are insured. The percentage of municipal obligations insured
has also increased substantially. From 1988 to 1993, municipal issuance
increased each year. The low market interest rates which prevailed during 1993
resulted in record levels of new issuances and refundings of municipal bonds. As
expected, these record levels of issuances and refundings were not sustained
when interest rates increased. Consequently, the volume of issuances and
refundings of municipal bonds, and opportunities to write insurance for such
bonds, fell significantly in 1994 and modestly in 1995. Both total issuance and
refundings increased in 1996 and 1997, primarily because of lower interest
rates.
The following table sets forth certain information regarding long-term
municipal obligations, issued during the periods indicated:
Insured Municipal Obligations(1)
New Insured
Volume
New New as Percent
Year Total Volume Insured Volume of New Total Volume
- ---- ------------ -------------- -------------------
(dollars in billions)
1988 ..................... $ 117.3 $ 27.1 23.1%
1989 ..................... 125.0 31.1 24.9
1990 ..................... 127.8 33.5 26.2
1991 ..................... 172.4 51.9 30.1
1992 ..................... 234.7 80.8 34.4
1993 ..................... 292.2 107.9 36.9
1994 ..................... 164.9 61.4 37.2
1995 ..................... 160.1 68.5 42.8
1996 ..................... 185.0 85.7 46.3
1997 ..................... 220.5 107.3 48.7
- ----------
(1) Information is based on data provided in The Bond Buyer, January 8, 1998.
Volume is expressed on the basis of principal value insured.
Types of Products
FSA's insurance is employed in both the new issue and secondary markets.
Insurance premium rates take into account the cost and the projected return to
and the risk assumed by FSA. Critical factors in assessing risk include the
credit quality of the issuer, type of issue, sources of repayment, transaction
structure and term to maturity. Each obligation is evaluated on the basis of,
and the final premium rate is a function of, such factors and subject to FSA's
underwriting guidelines.
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In the case of new issues, the insured obligations are sold with FSA
insurance at the time the obligations are issued. For both municipal 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.
In the secondary market, FSA's Triple-A Guaranteed Secondary Securities
(TAGSS(R)) Program provides insurance for uninsured asset-backed obligations
trading in the secondary market. TAGSS-insured securities include
mortgage-backed securities and utility first mortgage bonds. FSA's Custody
Receipt Program provides insurance for uninsured municipal obligations trading
in the secondary market. The insurance of obligations outstanding in the
secondary market generally affords a wider secondary market and therefore
greater marketability to a given issue of previously issued obligations. FSA's
underwriting guidelines require it to apply the same underwriting standards on
secondary market issues that it does on new security issues, although the
evaluation procedures are typically abbreviated.
FSA also writes portfolio insurance for securities held by investment
funds, such as unit investment trusts and mutual funds. Such insurance covers
securities either while they are held by the fund or to their maturity, whether
or not held by the fund.
The following table indicates the percentages of par amount (net of
reinsurance) outstanding at December 31, 1997 and 1996 with respect to each type
of asset-backed and municipal program:
Net Par Amount and Percentage Outstanding by Program Type
December 31, 1997
-----------------------------------------------------
Asset-Backed Programs Municipal Programs
-------------------------- -------------------------
Percent of Percent of
Total Net Total Net
Net Par Net Par
Par Amount Amount Par Amount Amount
Outstanding Outstanding Outstanding Outstanding
----------- ----------- ----------- -----------
(dollars in millions)
New Issue ................ $26,989 95.5% $39,976 87.6%
Secondary Market ......... 1,244 4.4 5,652 12.4
Portfolio Insurance ...... 26 0.1 -- 0.0
------- ----- ------- -----
Total ............... $28,259(1) 100.0% $45,628(2) 100.0%
======= ===== ======= =====
December 31, 1996
-----------------------------------------------------
Asset-Backed Programs Municipal Programs
-------------------------- -------------------------
Percent of Percent of
Total Net Total Net
Net Par Net Par
Par Amount Amount Par Amount Amount
Outstanding Outstanding Outstanding Outstanding
----------- ----------- ----------- -----------
(dollars in millions)
New Issue ................ $21,455 93.7% $29,390 85.5%
Secondary Market ......... 1,417 6.2 4,986 14.5
Portfolio Insurance ...... 26 0.1 13 0.0
------- ----- ------- -----
Total ............... $22,898(1) 100.0% $34,389(2) 100.0%
======= ===== ======= =====
- ----------
(1) Excludes $231 million and $302 million par amount outstanding assumed by
FSA under reinsurance agreements at December 31, 1997 and 1996,
respectively.
(2) Excludes $1,361 million and $1,605 million par amount outstanding assumed
by FSA under reinsurance agreements at December 31, 1997 and 1996,
respectively.
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Insurance in Force
FSA has insured a variety of asset-backed obligations, including
obligations backed by residential mortgages, consumer receivables, corporate
bonds, bank loans, government debt and commercial mortgages. FSA has insured a
broad array of municipal obligations. FSA has also insured investor-owned
utility first mortgage bonds.
FSA ceased writing insurance for commercial mortgage transactions in 1990.
In December 1993, the Company took certain steps (the "Restructuring") to reduce
its risk of loss from commercial mortgage transactions previously insured by FSA
and its subsidiaries. As part of the Restructuring, (i) the Company established
Commercial Reinsurance Company ("Commercial Re"), a special purpose reinsurance
company; (ii) the Company distributed all the outstanding shares of Commercial
Re to the existing shareholders of the Company in proportion to their ownership
interests in the Company at the time; and (iii) Commercial Re assumed
approximately 64.4% of the exposure of FSA and its subsidiaries, on a weighted
average basis, on commercial mortgage transactions previously insured by FSA and
its subsidiaries.
FSA has selectively expanded its insured portfolio in a manner intended to
achieve diversification. At December 31, 1997, FSA and its subsidiaries had in
force 583 issues insuring approximately $38.4 billion in gross direct par amount
outstanding of asset-backed obligations and 3,568 issues insuring approximately
$60.0 billion in gross direct par amount outstanding of municipal obligations.
In addition, at December 31, 1997, FSA had assumed pursuant to certain
reinsurance contracts approximately $0.2 billion and $1.4 billion in par amount
outstanding on asset-backed and municipal obligations, respectively, resulting
in a total gross par amount outstanding of approximately $100.0 billion. At such
date, the total net par amount outstanding, determined by reducing the gross par
amount outstanding to reflect reinsurance ceded of approximately $24.5 billion,
was approximately $75.5 billion. At December 31, 1997, the weighted average life
of the direct principal insured on these policies was approximately four and
thirteen years, respectively, for asset-backed and municipal obligations.
Asset-Backed Obligations
FSA's insured portfolio of asset-backed obligations is divided into seven
major categories:
Residential Mortgages. Obligations primarily backed by residential
mortgages generally take the form of conventional pass-through certificates or
pay-through debt securities, but also include commercial paper obligations and
other highly structured products. Residential mortgages backing these insured
obligations include closed-end first mortgages and closed- and open-end second
mortgages or home equity loans on one-to-four family residential properties,
including condominiums and cooperative apartments.
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 and leases, credit card receivables, mobile
home loans, timeshare loans and limited partnership investor notes.
Government Securities. Obligations primarily backed by government
securities include insured investment funds that invest in government securities
and insured bonds backed by letters of credit or repurchase agreements
collateralized by government securities. Government securities include full
faith and credit obligations of the United States and obligations of public and
quasi-public agencies of the United States, such as the Federal National
Mortgage Association ("FNMA") and the Federal Home Loan Mortgage Corporation
("Freddie Mac"), as well as obligations of non-U.S. sovereigns.
Pooled Corporate Obligations. Obligations primarily backed by pooled
corporate obligations include obligations collateralized by corporate debt
securities or corporate loans and obligations backed by cash flow or market
value of non-consumer indebtedness, and include "collateralized bond
obligations" and "collateralized loan obligations". Corporate obligations
include corporate bonds, bank loan participations, trade receivables and equity
securities.
Investor-Owned Utility Obligations. Obligations backed by investor-owned
utilities include, most commonly, first mortgage bond obligations of for-profit
electric or water utilities providing retail, industrial and
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commercial service, and also include sale-leaseback obligation bonds supported
by such entities. In each case, these bonds are secured by a mortgage on
property owned by or leased to an investor-owned utility.
Commercial Mortgage Portfolio. FSA ceased writing insurance in this sector
in 1990 and as part of the Restructuring obtained reinsurance from Commercial Re
relating to risk of loss in this sector. Obligations backed by commercial
mortgages are divided into commercial real estate and corporate secured
obligations. Commercial real estate obligations are primarily backed by
commercial real estate, including hotel properties, office buildings and
warehouses and consist of pay-through bonds, pass-through certificates and more
structured products, with credit protection provided by property cash flow,
property values, first loss letters of credit, cash reserves and other means.
Corporate secured obligations generally take the form of bond obligations
secured by mortgages on properties leased to one or more affiliated corporate
tenants, in which the obligations are secured primarily by the lease cash flow
and secondarily by the value of the mortgaged properties.
Other Asset-Backed Obligations. Other asset-backed obligations insured by
FSA include bonds or other securities backed by a combination of assets that
include elements of more than one of the categories set forth above.
Municipal Obligations
FSA's insured portfolio of municipal obligations is divided into seven
major categories:
General Obligation Bonds. General obligation 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 sufficient in an amount to provide for the full
payment of the bonds to the extent other available funds are insufficient.
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,
and, in some cases, the general obligation of the issuing housing agency or a
state's "moral obligation" (that is, not a legally binding commitment) to make
up deficiencies.
Municipal Utility Revenue Bonds. Municipal utility revenue bonds include
obligations of all forms of municipal utilities, including electric, water and
sewer utilities. Insurable utilities may be organized as municipal enterprise
systems, authorities or joint-action agencies.
Health Care Revenue Bonds. Health care revenue bonds include both
long-term maturities for capital construction or improvements of health care
facilities and medium-term maturities for equipment purchase.
Tax-Supported (Non-General Obligation) Bonds. Tax-supported (non-general
obligation) bonds include a variety of bonds that, though not general
obligations, are supported by the taxing ability of the issuer, such as
tax-backed revenue bonds and lease revenue bonds. Tax-backed revenue bonds may
be secured by a first lien on pledged tax revenues, such as those from special
taxes, including those on retail sales and gasoline, 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 district to levy, collect and
enforce collections and to foreclose on delinquent properties. Lease revenue
bonds or certificates of participation (COPs) may be secured by long-term
obligations or by lease obligations subject to annual appropriation. The
financed project is generally real property or equipment that, in the case of
annual appropriation leases, FSA deems to serve an essential public purpose
(e.g., schools, prisons, courts) or, in the case of long-term leases, is
insulated from the risk of abatement resulting from nontenantability.
Transportation Revenue Bonds. Transportation revenue bonds include a wide
variety of revenue-supported bonds, such as bonds for airports, ports, tunnels,
parking facilities, toll roads and toll bridges.
Other Municipal Bonds. Other municipal bonds insured by FSA include
college and university revenue bonds, moral obligation bonds, resource recovery
bonds and debt issued, guarantied or otherwise supported by the national or
local governments of Australia, Denmark, Finland, France, Italy, Spain and
Sweden.
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A summary of FSA's insured portfolio at December 31, 1997 is shown below:
Summary of Insured Portfolio at December 31, 1997
<TABLE>
<CAPTION>
Percent
Number of Net Par Net of Net
Issues In Amount Par and Par and
Force Outstanding Interest Interest
--------- ----------- -------- --------
(dollars in millions)
<S> <C> <C> <C> <C>
Asset-backed obligations
Residential mortgages ............. 305 $ 12,928 $ 17,312 14.7%
Consumer receivables .............. 167 10,660 11,633 9.9
Government securities ............. 25 787 1,285 1.1
Pooled corporate obligations ...... 24 3,004 3,641 3.1
Investor-owned utility obligations 44 643 1,573 1.3
Commercial mortgage portfolio ..... 10 153 189 0.2
Other asset-backed obligations .... 8 315 470 0.4
-------- -------- -------- -------
Total asset-backed obligations .. 583 28,490 36,103 30.7
-------- -------- -------- -------
Municipal obligations
General obligation bonds .......... 2,020 17,101 27,332 23.3
Housing revenue bonds ............. 230 1,770 3,776 3.2
Municipal utility revenue bonds ... 352 5,892 10,369 8.8
Health care revenue bonds ......... 113 3,924 7,165 6.1
Tax-supported (non-general
obligation) bonds ............... 480 11,210 20,142 17.2
Transportation revenue bonds ...... 45 1,972 3,767 3.2
Other municipal bonds ............. 328 5,120 8,775 7.5
-------- -------- -------- -------
Total municipal obligations ..... 3,568 46,989 81,326 69.3
-------- -------- -------- -------
Total ....................... 4,151 $ 75,479 $117,429 100.0%
======== ======== ======== =======
</TABLE>
Obligation Type
The table below sets forth the relative percentages of net par amount
written of obligations insured by FSA by obligation type during each of the last
five years:
Annual New Business Insured by Obligation Type
Year Ended December 31,
--------------------------------
Obligation Type 1997 1996 1995 1994 1993
--------------- ---- ---- ---- ---- ----
Asset-backed obligations
Residential mortgages .................... 19% 29% 26% 25% 14%
Consumer receivables ..................... 24 25 29 23 12
Government securities .................... 2 1 0 0 0
Pooled corporate obligations ............. 10 1 10 4 1
Commercial mortgage portfolio ............ 0 0 0 0 0
Investor-owned utility obligations ....... 0 0 0 2 3
Other asset-backed obligations ........... 0 2 1 2 3
--- --- --- --- ---
Total asset-backed obligations ......... 55 58 66 56 33
Municipal obligations
General obligations bonds ................ 18 20 11 12 14
Housing revenue bonds .................... 1 1 2 1 3
Municipal utility revenue bonds .......... 2 4 4 8 10
Health care revenue bonds ................ 4 2 3 4 7
Tax-supported (non-general
obligation) bonds ...................... 10 9 6 11 17
Transportation revenue bonds ............. 2 1 6 1 3
Other municipal bonds .................... 8 5 2 7 13
--- --- --- --- ---
Total municipal obligations ............ 45 42 34 44 67
--- --- --- --- ---
Total .............................. 100% 100% 100% 100% 100%
=== === === === ===
9
<PAGE>
Terms to Maturity
The table below sets forth the estimated terms to maturity of FSA's
policies at December 31, 1997 and 1996:
Estimated Terms to Maturity of Net Par of Insured Obligations(1)
December 31, 1997 December 31, 1996
--------------------- --------------------
(in millions)
Estimated Asset- Asset-
Term to Maturity Backed Municipal 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
======= ======= ======= =======
- ----------
(1) Based on estimates made by the issuers of the insured obligations as of the
original issuance dates of such obligations. 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.
Issue Size
The tables below set forth information with respect to the original net
par amount of insurance written per issue insured by FSA at December 31, 1997:
Asset-Backed
Original Net Par Amount Per Issue(1)
Percent of
Percent of Total
Total Net Par Net Par
Original Number Number Amount Amount
Net Par Amount of Policies of Issues Outstanding Outstanding
-------------- ----------- ---------- ----------- -----------
(dollars in millions)
Less than $10 million ..... 463 40.0% $ 690 2.4%
$10 to $25 million ........ 141 12.2 1,316 4.7
$25 to $50 million ........ 142 12.3 1,930 6.8
$50 million or greater .... 410 35.5 24,323 86.1
------- ----- ------- -----
Total .................. 1,156 100.0% $28,259 100.0%
======= ===== ======= =====
- ----------
(1) Does not include $231 million net par amount outstanding assumed by FSA
and its subsidiaries under reinsurance agreements.
10
<PAGE>
Municipal
Original Net Par Amount Per Issue(1)
Percent of
Percent of Total
Total Net Par Net Par
Original Number Number Amount Amount
Net Par Amount of Policies Of Issues Outstanding Outstanding
-------------- ----------- ---------- ----------- -----------
(dollars in millions)
Less than $10 million ..... 5,000 76.9% $13,115 28.7%
$10 to $25 million ........ 893 13.7 9,525 20.9
$25 to $50 million ........ 320 4.9 7,172 15.7
$50 million or greater .... 294 4.5 15,816 34.7
------- ----- ------- -----
Total .................. 6,507 100.0% $45,628 100.0%
======= ===== ======= =====
- ----------
(1) Does not include $1,361 million net par amount outstanding assumed by FSA
and its subsidiaries under reinsurance agreements.
Geographic Concentration
In its asset-backed business, FSA considers geographic concentration as a
factor in underwriting insurance covering securitizations of asset pools such as
residential mortgage loans or consumer receivables. However, after the initial
issuance of an insurance policy relating to such securitizations, 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 is not deemed by FSA to be a significant credit factor given other
more relevant measures of diversification such as issuer or industry
diversification.
FSA seeks to maintain a diversified portfolio of insured municipal
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 FSA's net par amount outstanding of insured municipal
securities:
Municipal
Insured Portfolio by Jurisdiction
at December 31, 1997
Percent of Total
Net Par Municipal Net
Number Amount Par Amount
Jurisdiction of Issues Outstanding Outstanding
------------ --------- ----------- -----------
(dollars in millions)
California....................... 403 $7,832 16.7%
New York......................... 281 4,307 9.2
Pennsylvania..................... 231 3,125 6.6
New Jersey....................... 207 2,730 5.8
Florida.......................... 103 2,669 5.7
Texas............................ 294 2,472 5.3
Illinois......................... 274 1,851 3.9
Massachusetts.................... 101 1,460 3.1
Michigan......................... 147 1,417 3.0
Minnesota........................ 129 1,152 2.5
Wisconsin........................ 179 1,138 2.4
All other states................. 1,190 15,575 33.1
Non-U.S.......................... 29 1,261 2.7
----- ------- -----
Total....................... 3,568 $46,989 100.0%
===== ======= =====
11
<PAGE>
Issuer Concentration
FSA has adopted underwriting and exposure management policies designed to
limit the net insurance in force for any one credit. In many cases, FSA uses
reinsurance to limit net exposure to any one credit. At December 31, 1997,
insurance of asset-backed obligations constituted 30.7% of FSA's net insurance
in force and insurance of municipal obligations constituted 69.3% of FSA's net
insurance in force. At such date, FSA's ten largest net insured asset-backed
transactions represented $5.0 billion, or 6.7%, of its total net par amount
outstanding, and FSA's ten largest net insured municipal credits represented
$3.4 billion, or 4.5%, of its total net par amount outstanding. For purposes of
the foregoing, different issues of asset-backed securities by the same sponsor
have not been aggregated. FSA has, however, adopted underwriting policies
establishing single risk guidelines applicable to asset-backed securities of the
same sponsor. FSA is also subject to certain regulatory limits and rating agency
guidelines on exposure to single credits.
The following tables set forth the net par amount outstanding of FSA's
insurance for the ten largest asset-backed transactions and municipal credits
insured by FSA at December 31, 1997:
Ten Largest Insured Asset-Backed Transactions at December 31, 1997
Net Par
Amount
Transaction Asset Type Outstanding
----------- ---------- -----------
(in millions)
IMC 1997-7 .............................. Residential Mortgages $ 656.2
Merit Securities Corp. Series 8 ......... Residential Mortgages 559.4
IMC Home Equity 1997- 6 ................. Residential Mortgages 539.2
Arcadia Auto Receivable Trust 1997 ...... Consumer Receivables 521.2
Archimedes Funding LLC .................. Pooled Corporate 476.5
WFS Financial 1997-C .................... Consumer Receivables 474.5
PAMCO CLO Series 1997-1 ................. Pooled Corporate 470.5
Arcadia Auto Receivable Trust 1997 D .... Consumer Receivables 464.6
CICB - Household Credit Cards ........... Consumer Receivables 441.6
SERAIL P.L.C ............................ Pooled Corporate 430.8
--------
Total .............................. $5,034.5
========
Ten Largest Insured Municipal Credits at December 31, 1997
Net Par
Amount
Credit Obligation Type Outstanding
------ --------------- -----------
(in millions)
Washington State Public Power Supply
System................................. Utility Revenue $ 399.6
New York State Dormitory Agency ......... Tax-Supported 389.7
New York City ........................... General Obligation 368.4
Puerto Rico Municipal Finance Agency .... Other Obligation 355.3
New York City Municipal Water Finance
Authority.............................. Utility Revenue 332.2
State of California ..................... General Obligation 323.0
Southern California Public Power
Authority.............................. Utility Revenue 317.0
State of New Jersey Pension Obligations . Tax Supported 313.8
Commonwealth of Puerto Rico ............. General Obligation 305.7
Puerto Rico Electric Power Authority .... Utility Revenue 283.7
--------
Total .............................. $3,388.4
========
12
<PAGE>
Credit Underwriting Guidelines, Standards and Procedures
Financial guaranty insurance, as written by FSA, relies on an assessment
of the adequacy of various payment sources to meet debt service payments 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
asset-backed and municipal obligations that it determines would be of
investment-grade quality without the benefit of the Company's insurance. To this
end, each policy written or reinsured by FSA must meet 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 which periodically reviews completed
transactions to ensure conformity with underwriting guidelines and standards.
FSA's underwriting guidelines for asset-backed obligations are built on
the concept of multiple layers of protection, and vary by obligation type in
order to reflect different structures and credit support. In this regard,
asset-backed obligations insured by FSA are generally issued in structured
transactions and backed by pools of assets such as consumer or trade
receivables, residential mortgage loans, securities or other assets having an
ascertainable cash flow or market value. In addition, 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," or reserves) or third-party protection (such as bank letters of
credit, guarantees, net worth maintenance agreements, indemnity agreements or
reinsurance agreements). This overcollateralization or third-party protection
need not indemnify FSA against all loss, but is generally intended to assume the
primary risk of financial loss. Overcollateralization or third-party protection
may not, however, 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, or in transactions in
which FSA is insuring bonds issued to refinance other bonds insured by FSA as to
which the issuer is or may be in default. FSA's general policy has been to
insure 100% of the principal, interest and other amounts due in respect of
asset-backed insured obligations rather than providing partial or first loss
coverage sufficient to convey a triple-A rating on the insured obligations.
FSA's underwriting guidelines for municipal obligations require that the
municipal obligor be rated investment grade by Moody's Investors Service, Inc.
("Moody's") or Standard & Poor's Ratings Services ("S&P") or, in the
alternative, such obligor is considered by FSA to be the equivalent of
investment grade. Where the municipal 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 municipal obligor is required to
provide a rate or charge covenant and a pledge of additional security (e.g.,
mortgages on real property, liens on equipment or revenue pledges) to secure the
obligation.
The rating agencies participate to varying degrees in the underwriting
process. Each asset-backed obligation insured by FSA is reviewed prior to
issuance by both S&P and Moody's to evaluate the risk proposed to be insured. In
the case of municipal obligations, prior rating agency review is a function of
the type of the insured obligation and the risk elements involved. In addition,
substantially all transactions insured by FSA are reviewed by at least one of
the major rating agencies after issuance to confirm continuing compliance with
rating agency standards. The independent review of FSA's underwriting practices
performed by the rating agencies further strengthens the underwriting process.
The underwriting process that implements these underwriting guidelines and
standards is supported by its professional staff of analysts, underwriting
officers, credit officers and attorneys. Moreover, the approval of senior
management is required for all transactions.
Each underwriting group in the Financial Guaranty Department has a senior
underwriting officer responsible for confirming that each transaction proposed
by the Financial Guaranty Department conforms to the underwriting guidelines and
standards. The evaluation by the senior underwriting officer 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 for asset-backed transactions and from FSA's Municipal Underwriting
Committee for municipal transactions. Approval is usually
13
<PAGE>
based upon both a written and an oral presentation by the underwriting group to
the respective committee. The Management Review Committee is comprised of FSA's
Chief Executive Officer, President, Chief Operating Officer, Chief Underwriting
Officer, Chief International Underwriting Officer and General Counsel. The
Municipal Underwriting Committee is comprised of FSA's Chief Executive Officer,
President, Chief Municipal Underwriting Officer, an Associate General Counsel
for Municipal Transactions and the Managing Director for Municipal Surveillance.
Following approval, minor transaction modifications may be approved by the
Chairs of the underwriting groups. Major changes require the concurrence of the
appropriate underwriting committee. Subject to applicable limits, secondary
market and partial maturity asset-backed transactions that meet certain credit
and return criteria may be approved by the Chief Underwriting Officer and the
head of the department involved, with a third signature from a member of the
Management Review Committee for larger transactions. Subject to applicable
limits, municipal transactions that meet certain credit and return criteria may
be approved by a committee composed of the Chief Municipal Underwriting Officer
or the Head of Municipal Surveillance, an Associate General Counsel for
Municipal Transactions and any one of certain designated managing directors of
the Municipal Department.
Corporate Underwriting and Research
FSA's Corporate Underwriting and Research Department is comprised of a
professional staff under the direction of the Chief Underwriting Officer. The
Corporate Underwriting and Research Department is responsible for evaluating the
credit of entities participating or providing recourse in obligations insured by
FSA. The Corporate Underwriting and Research Department also provides analysis
of relevant industry segments. Members of the Corporate Underwriting and
Research Department generally report their findings directly to the appropriate
underwriting committee in the context of transaction review and approval.
Transaction Oversight and Transaction Services
The Transaction Oversight and Transaction Services Departments are
independent of the analysts and credit officers involved in the underwriting
process. The Asset-Backed and Municipal Transaction Oversight Departments are
responsible for monitoring the performance of outstanding transactions. The
Transaction Services Department, together with the Transaction Oversight
Departments, is responsible for taking remedial actions as appropriate. The
managing directors responsible for the Transaction Oversight and Transaction
Services Departments report to an Oversight Committee comprised of the Chairman,
the President, the General Counsel, the Chief Underwriting Officer and the Chief
Financial Officer. The Transaction Oversight Departments review each insured
transaction to confirm compliance with transaction covenants, monitor credit and
other developments affecting transaction participants and collateral, and
determine the steps, if any, required to protect the interests of FSA and the
holders of FSA-insured obligations. Reviews for asset-backed transactions
typically include an examination of reports provided by, and (as circumstances
warrant) discussions with, issuers, servicers, trustees and other transaction
participants. Reviews of asset-backed transactions often include servicer
audits, site visits or evaluations by third-party appraisers, engineers or other
experts retained by FSA. The Transaction Oversight Departments review each
transaction to determine the level of ongoing attention it will require. 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 and Transaction Services Departments
work together with the Legal Department and the Corporate Underwriting and
Research Department in monitoring these transactions, negotiating restructurings
and pursuing appropriate legal remedies.
Legal
FSA's Legal Department is comprised of a professional staff of attorneys
and legal assistants under the direction of the General Counsel. The Legal
Department plays a major role in establishing and implementing legal
requirements and procedures applicable to obligations insured by FSA. Members of
the Legal Department serve on the Management Review Committee and the Municipal
Underwriting Committee, which provide final underwriting approval for
transactions. An attorney in the Legal Department works together with a
counterpart in the Financial Guaranty Department 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 FSA are
ordinarily executed with the assistance of outside counsel working closely with
the Legal Department. Municipal obligations insured by FSA are ordinarily
executed without employment of outside counsel. The Legal Department works
closely with the Transaction Oversight and Transaction Services Departments in
addressing legal issues, rights and
14
<PAGE>
remedies, as well as proposed amendments, waivers and consents, in connection
with obligations insured by FSA. The Legal Department is also responsible for
domestic and international regulatory compliance, reinsurance, secondary market
transactions, litigation and other matters.
Loss Reserves
FSA establishes a case basis reserve for 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. A case basis reserve for a
particular insured obligation represents FSA's estimate of the present value of
the anticipated shortfall, net of reinsurance, between (i) scheduled payments on
the insured obligations plus anticipated loss adjustment expenses and (ii)
anticipated cash flow from and proceeds to be received on sales of any
collateral supporting the obligation.
In addition to the case basis reserves, FSA maintains a general reserve in
order to account for unidentified risks inherent in its overall portfolio. FSA
does not consider traditional actuarial approaches used in the property/casualty
insurance industry to be applicable to the determination of its loss reserves
because of the absence of a sufficient number of losses in its financial
guaranty insurance activities and in the financial guaranty industry generally
to establish a meaningful statistical base. The general reserve amount was
calculated by applying a loss factor to the total net par amount of FSA's
insured obligations outstanding over the term of such insured obligations and
discounting the result at a risk-free rate. The loss factor used for this
purpose has been determined based upon an independent rating agency study of
bond defaults and FSA's portfolio characteristics and history. FSA will, on an
ongoing basis, monitor the general reserve and may periodically adjust such
reserve based on FSA's actual loss experience, its future mix of business and
future economic conditions. 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. To the extent that any such
future additions to case basis reserves are applied from the available general
reserve, there will be no impact on the Company's earnings for that period. To
the extent that additions to case basis reserves for any period exceed the
remaining available general reserve or are not applied from the general reserve,
the excess will be charged against the Company's earnings for that period. Any
addition to the general reserve which results from applying the loss factor to
new par written or from replenishing amounts applied against new case basis
reserves will result in a charge to earnings at that time. Amounts released from
the general reserve as a result of the runoff of existing net insurance in force
may be applied against additions to the general reserve required for new
business written.
FSA maintains reserves in an amount believed by its management to be
sufficient to pay its estimated ultimate liability for losses and loss
adjustment expenses with respect to obligations it has insured. At December 31,
1997 and 1996, FSA's net loss reserves totaled $44.8 million and $42.2 million,
respectively. During 1995, the Company increased its general reserve by $6.3
million, of which $3.0 million was for originations of new business and $3.3
million was to reestablish the general reserve following transfers from the
general reserve to case basis reserves. During 1995, the Company transferred
$10.8 million 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 $15.4
million to the general reserve to provide for the insured portfolio it had
assumed in the Merger in a manner consistent with the Company's reserving
methodology. Prior to the Merger, Capital Guaranty did not maintain a general
reserve. The general reserve was $31.8 million at December 31, 1995. During
1996, the Company increased its general reserve by $6.9 million, of which $5.3
million was for new business originations and $1.6 million was to reestablish
the general reserve for transfers from the general reserves to case basis
reserves. During 1996, the Company transferred $9.0 million from its general
reserve to case basis reserves associated predominantly with certain residential
mortgage transactions. The general reserve was $29.7 million at December 31,
1996. During 1997, the Company increased its general reserve by $9.2 million, of
which $5.4 million was for new business originations and $3.8 million was to
reestablish the general reserve for transfers from the general reserves to case
basis reserves. During 1997, the Company transferred $4.5 million from its
general reserve to case basis reserves associated predominantly with certain
residential mortgage transactions. The general reserve was $34.3 million at
December 31, 1997.
Reserves for losses and loss adjustment expenses are discounted at
risk-free rates. The amount of discount taken was approximately $19.8 million
and $17.9 million at December 31, 1997 and 1996, respectively.
Since reserves are necessarily based on estimates and because of the
absence of a sufficient number of losses in its financial guaranty insurance
activities and in the financial guaranty insurance industry generally to
15
<PAGE>
establish a meaningful statistical base, there can be no assurance that the case
basis reserves or the general reserve will be adequate to cover losses in FSA's
insured portfolio.
Competition and Industry Concentration
FSA faces competition from both other providers of third party credit
enhancement and alternatives to third party credit enhancement. The majority of
asset-backed and municipal obligations are sold without third party credit
enhancement. Accordingly, each transaction proposed to be insured by FSA must
generally compete against an alternative execution which does not employ third
party credit enhancement. FSA also faces competition from other monoline primary
financial guaranty insurers, primarily Ambac Assurance Corp. ("Ambac"),
Financial Guaranty Insurance Company ("FGIC") and MBIA Insurance Corp. ("MBIA").
There has recently been further consolidation in the financial guaranty
industry, with Capital Markets Assurance Corp. being acquired by MBIA and Connie
Lee Insurance Company being acquired by Ambac. As a result of this
consolidation, FSA is now the smallest of the major primary financial guaranty
insurers in terms of statutory capital. Traditional credit enhancers such as
bank letter of credit providers and mortgage pool insurers also provide
significant competition to FSA as providers of credit enhancement for
asset-backed obligations. While actions by securities rating agencies in recent
years have significantly reduced the number of triple-A rated banks 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, bank letter of credit providers and other credit enhancement, such as
cash collateral accounts, provided by banks, continue to provide significant
competition to FSA. In addition, government sponsored entities, including FNMA
and Freddie Mac, have begun to compete with the monoline financial guaranty
insurers in the mortgage-backed and multifamily sectors.
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
affiliates. Entry requirements include (i) assembling the group of experts
required to operate a financial guaranty insurance business, (ii) establishing
the triple-A claims-paying ability ratings with the credit rating agencies,
(iii) complying with substantial capital requirements, (iv) developing name
recognition and market acceptance with issuers, investment bankers and investors
and (v) organizing a monoline insurance company and obtaining insurance licenses
to do business in the applicable jurisdictions.
FSA's net insurance in force is the outstanding principal, interest and
other amounts to be paid over the remaining life of all obligations insured by
FSA, net of ceded reinsurance, refunded bonds secured by United States
government securities held in escrow or other qualified collateral. Qualified
statutory capital, determined in accordance with statutory accounting
principles, is the aggregate of policyholders' surplus and contingency reserves
calculated in accordance with statutory accounting principles. Set forth below
are FSA's aggregate gross insurance in force, net insurance in force, qualified
statutory capital and leverage ratio (represented by the ratio of its net
insurance in force to qualified statutory capital) and the average industry
leverage ratio at the dates indicated:
December 31,
------------------------------
1997 1996 1995
---- ---- ----
(dollars in millions)
Financial guaranty primary insurers,
excluding FSA(1)
Leverage ratio .............................. N/A(2) 151:1 146:1
FSA
Gross insurance in force .................... $158,020 $125,423 $ 99,034
Net insurance in force ...................... $117,429 $ 93,704 $ 75,360
Qualified statutory capital ................. $ 782 $ 676 $ 645
Leverage ratio .............................. 150:1 139:1 117:1
- ----------
(1) Financial guaranty primary insurers for which data is included in this
table are Ambac, Capital Guaranty Insurance Company (1995 only), Capital
Markets Assurance Corporation, Connie Lee Insurance Company, 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 at December 31, 1996 and 1995.
(2) Not available
16
<PAGE>
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 also
usually receives ceding commissions to cover costs 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.
Reinsurance Ceded
FSA obtains reinsurance to increase its policy writing capacity, both on
an aggregate risk and a single risk basis, meet state insurance regulatory,
rating agency and internal limits, diversify risks, reduce the need for
additional capital and strengthen financial ratios. At December 31, 1997, FSA
had reinsured approximately 25.0% of its direct principal amount outstanding.
Most of FSA's reinsurance is on a quota share basis, with a small portion being
provided on a first loss or excess of loss per risk basis. Reinsurance
arrangements typically require FSA to retain a specified amount of the risk.
FSA arranges reinsurance on both a facultative
(transaction-by-transaction) and treaty basis. Treaty reinsurance provides
coverage for a portion of the exposure from all qualifying policies issued
during the term of the treaty. In addition, FSA employs "automatic facultative"
reinsurance which permits FSA to apply reinsurance to transactions selected by
it subject to certain limitations. The reinsurer's participation in a treaty is
cancelable annually upon 90 days' prior notice by either FSA or the reinsurer
and is cancelable by FSA upon specified financial deterioration of the
reinsurer. As required by applicable state law, reinsurance agreements may be
subject to certain other termination conditions.
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 and the occurrence of certain other conditions,
FSA generally has the right to reassume all of the business reinsured.
In 1997, FSA's principal ceded reinsurance program consisted of two quota
share treaties. One treaty (the "asset-backed treaty") covered all of FSA's
approved regular lines of business, except municipal bond insurance. In 1997,
FSA ceded 9.75% of each covered policy under this treaty, up to a maximum of
$19.5 million insured principal per single risk. At its sole option, FSA was
entitled to increase the ceding percentage to 19.5% up to $39 million insured
principal per single risk which is defined by revenue source. A second treaty
(the "municipal treaty") covered FSA's municipal bond insurance business. In
1997, FSA ceded 9% of each covered policy under this treaty that is classified
by FSA as providing municipal bond insurance as defined by Article 69 of the
insurance laws of New York up to a limit of $24 million insured principal per
single risk. At its sole option, FSA was entitled to increase the ceding
percentage to 35% up to $93.3 million insured principal per single risk. These
cession percentages under both treaties were reduced on smaller-sized
transactions. Under the three automatic facultative facilities in 1997, FSA at
its option could allocate up to a specified amount for each reinsurer (ranging
from $4 million to $50 million depending on the reinsurer) for each transaction,
subject to limits and exclusions, in exchange for which FSA agreed to cede in
the aggregate a specified percentage of gross par insured by FSA. Each of the
two treaties and automatic facultative facilities allows FSA to withhold a
ceding commission to defray their expenses. In 1997, FSA also implemented
facultative first-loss reinsurance on selected asset-backed transactions.
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 therefore evaluated carefully by FSA, and FSA's
reinsurance is placed with high quality and financially strong reinsurers. FSA's
treaty reinsurers at December 31, 1997 were Capital Reinsurance Company,
Employers Reinsurance Company, Enhance Reinsurance Company and Tokio Marine. In
1997, four reinsurers participated in the asset-backed treaty and three
reinsurers participated in the municipal treaty.
FSA, FSAIC and Oklahoma have entered into a quota share reinsurance
pooling agreement pursuant to which, after reinsurance cessions to other
reinsurers, FSA, FSAIC and Oklahoma share in the net retained risk insured by
each of these three companies in proportion to their policyholders' surplus and
contingency reserve as of December 31 of the prior year (with the percentages
adjusted commencing April 1 of each year) through September 30, 1996 and each
calendar quarter thereafter. For the quarter commencing October 1, 1997, FSA
retained 65.89%,
17
<PAGE>
FSAIC retained 23.36% and Oklahoma retained 10.75% of each policy issued by
these companies after cessions to all other reinsurers. FSA-UK and FSA have
entered into a quota share and stop loss reinsurance agreement pursuant to which
(i) 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 policyholders' surplus and contingency reserve of FSA-UK to
the total policyholders' surplus and contingency reserves of FSA and its
subsidiary insurers (including FSA-UK) and (ii) subject to certain limits, FSA
is required to make payments to FSA-UK when FSA-UK's loss ratio and expense
exceeds 100%. Under this agreement, FSA-UK ceded to FSA 98.090% of its retention
after other reinsurance of its policies issued in 1997.
In connection with the Restructuring, FSA is party to a quota share
reinsurance agreement with Commercial Re pursuant to which Commercial Re assumed
approximately 64.4% of FSA's exposure, on a weighted average basis, on
transactions in FSA's commercial mortgage portfolio.
Rating Agencies
Moody's , S&P and Fitch IBCA, Inc. periodically review the business and
financial condition of FSA and other companies providing financial guaranty
insurance. These rating agency reviews focus on the insurer's underwriting
policies and procedures and the quality of the obligations insured. The rating
agencies frequently perform assessments of the credits insured by FSA, and the
reinsurers and other providers of capital support to FSA, to confirm that FSA
continues to meet the capital adequacy criteria considered necessary by the
particular rating agency to maintain FSA's triple-A claims-paying ability
rating. See "Credit Underwriting Guidelines, Standards and Procedures" above.
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.
Insurance Regulatory Matters
General
FSA is licensed to engage in insurance business in all 50 states, the
District of Columbia and Puerto Rico. FSA is subject to the insurance laws of
the State of New York ("New York Insurance Law"), and both FSA's domestic
operating insurance company subsidiaries, FSAIC and Oklahoma, are subject to the
insurance laws of the State of Oklahoma which is their state of incorporation.
Each is also subject to the insurance laws of the other states in which it is
licensed to transact an insurance business. Each of FSA and its domestic
insurance company subsidiaries 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 New York
Superintendent of Insurance (the "New York Superintendent") (the last such
examination having been conducted in 1995 for the period ended December 31,
1994) and other state insurance regulatory authorities.
Insurance Holding Company Laws
The Company and its domestic operating insurance company subsidiaries
(FSA, FSAIC and Oklahoma) are subject to regulation under insurance holding
company statutes of New York and Oklahoma, where these respective insurers are
domiciled, as well as other jurisdictions where these companies 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 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, of certain dividends and other intercorporate transfers of
assets and of 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.
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, FSAIC and Oklahoma, 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
18
<PAGE>
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 ("Article 69") of the New York Insurance Law, 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 (i) with respect to policies written prior to July 1, 1989
in an amount equal to 50% of earned premiums and (ii) 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 guarantied, varying from 0.55% to
2.50%, depending upon the type of obligation guarantied, 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. 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.
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 (i) the insured average annual debt
service for a single risk or (ii) 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 reserve, 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 policyholders' surplus and contingency reserve. 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 reserve. 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.
Article 69 also establishes aggregate risk limits on the basis of
aggregate net liability insured as compared to statutory capital. "Aggregate net
liability" is defined as outstanding principal and interest of guarantied
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 upon FSA's financial
condition, results of operations, cash requirements, rating agency approval 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 New
York State 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 (i) 10% of
policyholders' surplus as of its last statement filed with the New York
Superintendent of Insurance or (ii) adjusted net investment income during this
period. FSA has paid no dividends during 1997. Based upon FSA's statutory
statements for the quarter ended December 31, 1997, the maximum amount available
for payment of dividends by FSA without regulatory approval over the following
12 months is approximately $49.8 million. The New York Superintendent has
approved the
19
<PAGE>
repurchase by FSA of up to $75.0 million of its shares from its parent, pursuant
to which FSA has repurchased $66.5 million of its shares through December 31,
1997, including $39.5 million during 1997.
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 United Kingdom's Department of Trade and Industry (the "DTI")
regulates FSA-UK. Pursuant to European Union Directives, FSA-UK has since been
authorized to provide financial guaranty insurance for transactions in France
and Ireland from its home office in the United Kingdom. FSA has received a
determination from the Australian Insurance and Superannuation Commissioner that
the financial guaranties issued by it with respect to Australian transactions do
not constitute insurance for which a license is required.
Investment Portfolio
FSA manages its investments with the objectives of preserving its capital
and claims-paying ability, maintaining a high level of liquidity and, within
these constraints, obtaining a high long-term total return. FSA's investment
portfolio is managed in part by its affiliate, FSA Portfolio Management, and in
part by unaffiliated investment managers. The Company's investment strategy is
to emphasize total return rather than current income. To accomplish its
objectives, the Company has established guidelines for eligible investments by
FSA, requiring that each individual investment must be rated at least "single A"
at acquisition and the overall portfolio must be rated "double A" on average.
Investments falling below the minimum quality level are disposed of at such time
as management shall deem appropriate. For liquidity purposes, the Company's
policy is to invest FSA assets in investments which are readily marketable with
no legal or contractual restrictions on resale. Eligible investments include
U.S. Treasury and agency obligations, corporate bonds, tax-exempt bonds and
mortgage pass-through instruments. The Company has also invested in an equity
fund and a portfolio of convertible debt securities. In addition, the Company
has from time to time invested in sponsors of, or interests in, transactions
insured or proposed to be insured by FSA, none of which investments is material
to the Company.
The weighted average maturity of the Company's investment portfolio at
December 31, 1997 was approximately 12.6 years. 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 following tables set forth certain information concerning the
investment portfolio of the Company:
Investment Portfolio by Rating
at December 31, 1997(1)
Percent of
Investment
Rating Portfolio
-------------------- ----------
AAA(2).............. 69.1%
AA ................ 16.0
A ................ 11.5
BBB ................ 1.1
Other............... 2.3
-----
100.0%
=====
- ----------
(1) Ratings are for the fixed income portfolio (96.3% of the entire investment
portfolio as of December 31, 1997) and are based on the higher of Moody's
or S&P ratings available at December 31, 1997.
(2) Includes U.S. Treasury and agency obligations, which comprised 9.2% of the
total portfolio at December 31, 1997.
20
<PAGE>
Summary of Investments
<TABLE>
<CAPTION>
December 31,
-------------------------------------------------------------
1997 1996 1995
------------------- ------------------- -------------------
Weighted Weighted Weighted
Amortized Average Amortized Average Amortized Average
Investment Category Cost Yield(1) Cost Yield(1) Cost Yield(1)
------------------- --------- -------- --------- -------- --------- --------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Long-term investments:
Taxable bonds .............. $ 453,437 6.52% $ 396,586 6.76% $ 383,790 7.00%
Tax-exempt bonds ........... 777,042 5.58 661,831 5.70 643,624 5.62
---------- ---------- ----------
Total long-term investments 1,230,479 5.92 1,058,417 6.09 1,027,414 6.13
Short-term investments(2) ....... 110,308 6.22 56,733 5.43 14,567 5.97
---------- ---------- ----------
Total investments(3) ...... $1,340,787 5.95% $1,115,150 6.06% $1,041,981 6.13%
========== ========== ==========
</TABLE>
- ----------
(1) Yields are stated on a pre-tax basis.
(2) Includes taxable and tax-exempt investments and excludes cash equivalents
of $22.6 million, $16.9 million and $38.1 million, respectively.
(3) Excludes stocks at cost of $29.4 million, $8.3 million and $0,
respectively.
Investment Portfolio by Security Type
<TABLE>
<CAPTION>
December 31,
-------------------------------------------------------------
1997 1996 1995
------------------- ------------------- -------------------
Weighted Weighted Weighted
Amortized Average Amortized Average Amortized Average
Investment Category Cost Yield(1) Cost Yield(1) Cost Yield(1)
------------------- --------- -------- --------- -------- --------- --------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
U.S. government securities ...... $ 122,817 6.20% $ 55,619 6.63% $ 45,139 6.27%
Mortgage-backed securities ...... 195,567 6.62 177,818 6.88 265,213 7.15
Municipal bonds ................. 777,042 5.58 661,831 5.70 643,624 5.62
Asset-backed securities ......... 20,961 6.69 71,370 6.82 43,493 6.83
Corporate securities ............ 66,014 5.72 76,760 6.55 1,254 6.86
Foreign securities .............. 48,078 7.62 15,019 6.50 28,691 7.04
---------- ---------- ----------
Total fixed maturities ..... 1,230,479 5.92 1,058,417 6.09 1,027,414 6.13
Short-term investments(2) ....... 110,308 6.22 56,733 5.43 14,567 5.97
---------- ---------- ----------
Total investments(3) ....... $1,340,787 5.95% $1,115,150 6.06% $1,041,981 6.13%
========== ========== ==========
</TABLE>
- ----------
(1) Yields are stated on a pre-tax basis.
(2) Includes taxable and tax-exempt investments and excludes cash equivalents
of $22.6 million, $16.9 million and $38.1 million, respectively.
(3) Excludes stocks of $29.4 million, $8.3 million and $0, respectively.
21
<PAGE>
Distribution of Investments by Maturity
<TABLE>
<CAPTION>
December 31,
---------------------------------------------------------------------------
1997 1996 1995
----------------------- ----------------------- -----------------------
Estimated Estimated Estimated
Amortized Market Amortized Market Amortized Market
Investment Category Cost Value Cost Value Cost Value
---------- ---------- ---------- ---------- ---------- ----------
(in thousands)
<S> <C> <C> <C> <C> <C> <C>
Due in one year or less(1) . $ 114,317 $ 114,315 $ 95,038 $ 95,359 $ 17,343 $ 17,345
Due after one year through
five years ............... 70,283 70,007 57,531 57,712 26,036 26,375
Due after five years through
ten years ................ 208,986 208,170 105,495 105,848 157,161 162,573
Due after ten years ........ 730,673 766,912 607,898 620,031 532,735 551,239
Mortgage-backed securities . 195,567 197,753 177,818 178,344 265,213 271,087
Asset-backed securities .... 20,961 21,309 71,370 71,878 43,493 44,024
---------- ---------- ---------- ---------- ---------- ----------
Total investments(2) .. $1,340,787 $1,378,466 $1,115,150 $1,129,172 $1,041,981 $1,072,643
========== ========== ========== ========== ========== ==========
</TABLE>
- ----------
(1) Includes short-term investments in the amount of $110.3 million, $56.7
million and $14.6 million at December 31, 1997, 1996 and 1995,
respectively, but excludes cash equivalents of $22.6 million, $16.9
million, and $38.1 million, respectively.
(2) Excludes stocks of $29.4 million, $8.3 million and $0, respectively.
Mortgage-Backed Securities
Cost and Market Value by Investment Category
December 31, 1997
----------------------------------
Amortized Estimated
Investment Category Par Value Cost Market Value
------------------- --------- ---- ------------
(in thousands)
Pass-through securities--U.S. Government
agency ................................... $145,087 $145,915 $147,575
CMO's--U.S. Government agency .............. 17,934 17,961 18,116
CMO's--non-agency .......................... 31,625 31,691 32,062
-------- -------- --------
Total mortgage-backed securities ...... $194,646 $195,567 $197,753
======== ======== ========
The Company's investments in mortgage-backed securities consisted of
pass-through certificates and collateralized mortgage obligations ("CMO's")
which are secured by mortgage loans guarantied or insured by agencies of the
federal government. These securities are highly liquid with readily determinable
market prices. The Company also held triple-A rated CMO's which are not
guarantied by government agencies. Secondary market quotations are available for
these securities, although they are not as liquid as the government
agency-backed securities.
At December 31, 1997, the Company held sequential pay CMO tranches and
Planned Amortization Classes (PAC) of CMO's. The CMO's held at December 31, 1997
have stated maturities ranging from 16 to 30 years, and expected average lives
ranging from 0.5 to 17.9 years based on anticipated prepayments of principal.
None of the Company's holdings of CMO's is subject to extraordinary interest
rate sensitivity. At December 31, 1997, the Company did not own any
interest-only stripped mortgage securities or inverse floating rate CMO
tranches.
Mortgage-backed securities differ from traditional fixed income bonds
because they are subject to prepayments at par value without penalty at the
borrower's option. Prepayment rates on mortgage-backed securities are influenced
primarily by the general level of prevailing interest rates, with prepayments
increasing when prevailing interest rates are lower than the rates on the
underlying mortgages. When prepayments occur, the proceeds must be re-invested
at then current market rates, which are generally below the yield on the prepaid
securities. Prepayments on mortgage-backed securities purchased at a premium to
par will result in a loss to the Company to the extent of the unamortized
premium.
22
<PAGE>
Employees
At December 31, 1997, the Company and its subsidiaries had 217 employees.
None of its employees are covered by collective bargaining agreements. The
Company considers its employee relations to be satisfactory.
Forward-Looking Statements
The Company relies upon 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.
In its filings with 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, (i) projections of revenues, income (or loss), earnings (or loss)
per share, dividends, market share, or other financial forecasts, (ii)
statements of plans, objectives or goals of the Company or its management,
including those related to growth in adjusted book value per share or return on
equity and (iii) 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: (i) changes in capital requirements or other criteria of
securities rating agencies applicable to financial guaranty insurers in general
or to FSA specifically; (ii) competitive forces, including the conduct of other
financial guaranty insurers in general; (iii) changes in domestic or foreign
laws or regulations applicable to the Company, its competitors or its clients;
(iv) an economic downturn or other economic conditions (such as a rising
interest rate environment) adversely affecting transactions insured by FSA or
its investment portfolio; (v) inadequacy of loss reserves established by the
Company; (vi) temporary or permanent disruptions in cash flow on structured
transactions attributable to legal challenges to such structures; and (vii)
downgrade or default of one or more of FSA's reinsurers. 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.
Item 2. Properties.
The principal executive offices of the Company and FSA are located at 350
Park Avenue, New York, New York 10022. The principal executive offices, which
consist of approximately 53,000 square feet of office space, are under lease
agreements which expire in 2005. The Company's telephone number at its principal
executive offices is (212) 826-0100. FSA also maintains leased office space in
San Francisco, Dallas, London (England), Paris (France), Madrid (Spain),
Singapore and Sydney (Australia). The Company and its subsidiaries do not own
any real property.
Item 3. Legal Proceedings.
In the ordinary course of business, certain subsidiaries of the Company
have become party to certain litigation. The Company believes that these matters
will be resolved with no material financial impact on the Company.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of the Company's shareholders during
the fourth quarter of 1997.
23
<PAGE>
Part II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
Information relating to the principal market on which the Company's common
stock is tradable, the high and low sales prices per share for each quarterly
period for the past two years and the frequency and amount of any cash dividends
declared in the past two years is set forth on page 48 of the Company's 1997
Annual Report to Shareholders and such information is incorporated herein by
reference. Information concerning restrictions on the payment of dividends is
set forth in Item 1 above under the caption "Insurance Regulatory Matters --
Dividend Restrictions." At February 23, 1998, there were approximately 2,900
holders of the Company's Common Stock, which is listed on the New York Stock
Exchange.
Item 6. Selected Financial Data.
Selected financial data for the Company and its subsidiaries for each of
the last five years is set forth under the caption "Financial Highlights" on
page 16 of the Company's 1997 Annual Report to Shareholders. Such information is
incorporated herein by reference and should be read in conjunction with the
Consolidated Financial Statements and the Notes thereto contained on pages 26 to
44 of such Annual Report.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
Management's Discussion and Analysis of Financial Condition and Results of
Operations is set forth under the caption "Management's Discussion and Analysis
of Financial Condition and Results of Operations" on pages 18 through 24 of the
Company's 1997 Annual Report to Shareholders. Such information is incorporated
herein by reference and should be read in conjunction with the Consolidated
Financial Statements and the Notes thereto contained on pages 26 to 44 of such
Annual Report.
Item 8. Financial Statements and Supplementary Data.
The 1997 Consolidated Financial Statements, together with the Notes
thereto and the Report of Independent Accountants thereon, are set forth on
pages 25 through 44 of the Company's 1997 Annual Report to Shareholders. Such
information is incorporated herein by reference.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
None.
24
<PAGE>
Part III
Item 10. Directors and Executive Officers of the Registrant.
Information relating to the Company's directors and executive officers is
set forth under the captions "Election of Directors" on pages 1 through 5,
"Section 16(a) Beneficial Ownership Reporting Compliance" on page 16, and
"Executive Officers of the Company" on page 6 of the Company's 1998 Proxy
Statement. Such information is incorporated herein by reference.
Item 11. Executive Compensation.
Information relating to compensation of the Company's directors and
executive officers is set forth under the captions "Executive Compensation" on
pages 10 through 12, "Report of the Human Resources Committee of the Board of
Directors of Financial Security Assurance Holdings Ltd." on pages 13 through 16,
and "Stock Price Performance" on page 17 of the Company's 1998 Proxy Statement.
Such information is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
Information relating to security ownership of certain beneficial owners of
the Company's equity securities and by the Company's directors and executive
officers is set forth under the caption "Ownership of the Company" on pages 6
through 9 of the Company's 1998 Proxy Statement. Such information is
incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions.
Information relating to certain relationships and related transactions is
set forth under the captions "Compensation Committee Interlocks and Insider
Participation" on page 16 and "Certain Relationships and Related Transactions"
on pages 18 through 21 of the Company's 1998 Proxy Statement. Such information
is incorporated herein by reference.
25
<PAGE>
Part IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) Financial Statements and Financial Statement Schedules and Exhibits.
1. Financial Statements
The Registrant has incorporated by reference from the 1997 Annual
Report to Shareholders the following consolidated financial
statements of Financial Security Assurance Holdings Ltd. and
Subsidiaries:
1997 Annual Report to
Shareholders (Pages)
--------------------
Report of Independent Accountants 25
Consolidated Balance Sheets at
December 31, 1997 and 1996 26
Consolidated Statements of Income
for the Years Ended
December 31, 1997, 1996 and 1995 27
Consolidated Statements of Changes in
Shareholders' Equity for the Years Ended
December 31, 1997, 1996 and 1995 28
Consolidated Statements of Cash Flows
for the Years Ended
December 31, 1997, 1996 and 1995 29
Notes to Consolidated Financial Statements 30-44
2. Financial Statement Schedules
The following financial statement schedule is filed as part of this
Report.
Schedule Title
-------- -----
II Condensed Financial Statements of the Registrant for the
Years Ended December 31, 1997, 1996 and 1995.
The report of the Registrant's independent auditors with respect to
the above listed financial statement schedule is set forth on page
33 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.
26
<PAGE>
3. Exhibits
The following are annexed as exhibits to this Report:
Exhibit No. Exhibit
- ----------- -------
3.1 Restated Certificate of Incorporation of the Company.
(Previously filed as Exhibit 3.1 to the Company's Annual
Report on Form 10-K (Commission File No. 1-12644) for the
fiscal period ended December 31, 1994 (the "1994 Form 10-K"),
and incorporated herein by reference.)
3.1(A) Certificate of Amendment of the Amended and Restated
Certificate of Incorporation of the Company. (Previously filed
as Exhibit 3.1(A) to the Company's Registration Statement on
Form S-1 (Reg. No. 33-70230), as such Registration Statement
has been amended (the "Form S-1"), and incorporated herein by
reference.)
3.2 Amended and Restated By-laws of the Company, as amended and
restated on February 14, 1996. (Previously filed as Exhibit 5
to the Company's Quarterly Report on Form 10-Q (Commission
File No. 1-12644) for the quarterly period ended March 31,
1996 (the "March 31, 1996 10-Q"), and incorporated herein by
reference.)
4.1 Indenture dated as of September 15, 1997 (the "Senior QUIDS
Indenture") between the Company and First Union National Bank,
as Trustee. (Previously filed as Exhibit 2 to the Company's
Current Report on Form 8-K (Commission File No. 1-12644) dated
September 15, 1997 (the "Form 8-K"), and incorporated herein
by reference.)
4.1(A) Form of 7.375% Senior Quarterly Income Debt Securities due
2097. (Previously filed as Exhibit 3 to the Form 8-K, and
incorporated herein by reference.)
4.1(B) Officers' Certificate pursuant to Section 2.01 and 2.03 of the
Senior QUIDS Indenture. (Previously filed as Exhibit 5 to the
Company's Quarterly Report on Form 10-Q (Commission File No.
1-12644) for the quarterly period ended September 30, 1997,
and incorporated herein by reference.)
9 Voting Trust Agreement dated as of September 2, 1994 among
Fund American, U S WEST Capital Corporation ("USWCC") and
First Chicago Trust Company of New York, as voting trustee.
(Previously filed as Exhibit 9 to the 1994 Form 10-K, and
incorporated herein by reference.)
10.1 Credit Agreement dated as of November 23, 1994 among FSA,
Various Banks and Swiss Bank Corporation, New York Branch, as
agent. (Previously filed as Exhibit 10.2(B) to the 1994 Form
10-K, and incorporated herein by reference.)
10.2 Facility Agreement dated as of August 30, 1994, among FSA,
Canadian Global Funding Corporation and Hambros Bank Limited.
(Previously filed as Exhibit 2 to the Company's Quarterly
Report on Form 10-Q (Commission File No. 1-12644) for the
quarterly period ended September 30, 1994, and incorporated
herein by reference.)
10.3 Credit Agreement dated as of April 30, 1996, among FSA,
Financial Security Assurance of Maryland Inc., Financial
Security Assurance of Oklahoma, Inc., the Banks signatory
thereto and Bayerische Landesbank Girozentrale, New York
Branch, as Agent. (Previously filed as Exhibit 2 to the
Company's Quarterly Report on Form 10-Q (Commission File No.
1-12644) for the quarterly period ended June 30, 1996, and
incorporated herein by reference.)
27
<PAGE>
10.4+ Money Purchase Pension Plan and Trust Agreement dated as of
January 1, 1989 between FSA and Transamerica, with Adoption
Agreement No. 001 and Addendum. (Previously filed as Exhibit
10.7 to the Form S-1, and incorporated herein by reference.)
10.5+ Supplemental Executive Retirement Plan as amended and restated
as of January 1, 1995. (Previously filed as Exhibit 10.8(A) to
the 1994 Form 10-K, and incorporated herein by reference.)
10.6+* Amended and Restated 1993 Equity Participation Plan (as
amended and restated on February 26, 1998).
10.7+ Deferred Compensation Plan (Effective as of June 1, 1995).
(Previously filed as Exhibit No. 3 to the Company's Quarterly
Report on Form 10-Q (Commission File No. 1-12644) for the
quarterly period ended June 30, 1995 (the "June 30, 1995
10-Q"), and incorporated herein by reference.)
10.8+ Severance Policy for Senior Management (Effective as of
February 8, 1995). (Previously filed as Exhibit No. 3 to the
March 31, 1996 10-Q, and incorporated herein by reference.)
10.9 Cooperation Agreement dated as of December 27, 1990 among
Tokio Marine, the Company and FSA. (Previously filed as
Exhibit 10.17 to the Form S-1, and incorporated herein by
reference.)
10.10 Tokio Marine Stockholders Agreement dated December 27, 1990
among Tokio Marine, the Company and USWCC. (Previously filed
as Exhibit 10.18 to the Form S-1, and incorporated herein by
reference.)
10.10(A) Letter Agreement dated as of September 2, 1994 concerning the
Tokio Marine Stockholders Agreement between U S WEST, Inc.,
and the Company. (Previously filed as Exhibit 10.18(A) to the
1994 Form 10-K, and incorporated herein by reference.)
10.10(B) Amendment No. 1 dated December 23, 1993 to Tokio Marine
Stockholders Agreement. (Previously filed as Exhibit 10.19 to
the Form S-1, and incorporated herein by reference.)
10.11 Master Reinsurance Placement Memorandum dated December 27,
1991 between Tokio Marine and FSA. (Previously filed as
Exhibit 10.20 to the Form S-1, and incorporated herein by
reference.)
10.12 Amended and Restated Interests and Liabilities Contract
concerning the Quota Share Treaty effective as of January 1,
1991 among Tokio Marine and FSA and its identified
subsidiaries and affiliates, with Amendment No. 1 thereto.
(Previously filed as Exhibit 10.21(A) to the 1994 Form 10-K,
and incorporated herein by reference.)
10.13 Amended and Restated Interests and Liabilities Contract
concerning the Municipal Bond Insurance Quota Share Treaty
effective as of January 1, 1991 among Tokio Marine, FSA and
its identified subsidiaries and affiliates, with Amendment No.
1 thereto. (Previously filed as Exhibit 10.22(A) to the 1994
Form 10-K, and incorporated herein by reference.)
10.14 Investment Management Agreement dated as of December 1, 1995
between FSA Portfolio Management Inc. and Charter Indemnity
Company. (Previously
28
<PAGE>
filed as Exhibit 10.23 to the 1995 Form 10-K, and incorporated
herein by reference.)
10.15 Investment Management Agreement dated as of December 1, 1995
between FSA Portfolio Management Inc. and Northern County
Mutual Insurance Company. (Previously filed as Exhibit 10.24
to the 1995 Form 10-K, and incorporated herein by reference.)
10.16 Investment Management Agreement dated as of December 1, 1995
between FSA Portfolio Management Inc. and Valley Insurance
Company. (Previously filed as Exhibit 10.25 to the 1995 Form
10-K, and incorporated herein by reference.)
10.17+ Promissory Note between the Company and Sean W. McCarthy dated
December 20, 1993. (Previously filed as Exhibit 10.30(A) to
the Form S-1, and incorporated herein by reference.)
10.18 Quota Share Reinsurance Agreement dated December 22, 1993,
among Commercial Re, FSA and International. (Previously filed
as Exhibit 10.17 to the Form S-1, and incorporated herein by
reference.)
10.19 Share Purchase Agreement dated as of December 23, 1993 among
Commercial Re, U S WEST and the Company. (Previously filed as
Exhibit 10.32 to the Form S-1, and incorporated herein by
reference.)
10.20 Federal Income Tax Allocation Agreement dated as of December
23, 1993 among Commercial Re, U S WEST and the Company.
(Previously filed as Exhibit 10.33 to the Form S-1, and
incorporated herein by reference.)
10.21 Liquidity Facility dated as of December 23, 1993 among U S
WEST, Inc., Commercial Re and the Company. (Previously filed
as Exhibit 10.34 to the Form S-1, and incorporated herein by
reference.)
10.22 Investment Management Agreement dated as of December 23, 1993
among FSA Portfolio Management, Commercial Re and the Company.
(Previously filed as Exhibit 10.35 to the Form S-1, and
incorporated herein by reference.)
10.23 Agreement for Management and the Provision of Personnel,
Property and Services dated as of December 23, 1993 between
Commercial Re and the Company. (Previously filed as Exhibit
10.36 to the Form S-1, and incorporated herein by reference.)
10.24 Securities Purchase Agreement among U S WEST, Inc., USWCC,
Fund American and the Company (including Exhibit A thereto).
(Previously filed as Exhibit 10.38 to the Form S-1, and
incorporated herein by reference.)
10.24(A) Amendment dated as of May 6, 1994 to Securities Purchase
Agreement among U S WEST, Inc., USWCC, Fund American and the
Company. (Previously filed as Exhibit 10.38(A) to the 1994
Form 10-K, and incorporated herein by reference.)
10.25 Registration Rights Agreement dated as of May 13, 1994 among
the Company, USWCC and Fund American. (Previously filed as
Exhibit 10.39 to the 1994 Form 10-K, and incorporated herein
by reference.)
10.26 Fund American Shareholders Agreement dated as of September 2,
1994 among USWCC, Fund American and the Company. (Previously
filed as Exhibit 10.40 to the 1994 Form 10-K, and incorporated
herein by reference.)
29
<PAGE>
10.27 Five-Year Option dated as of September 2, 1994. (Previously
filed as Exhibit 10.41 to the 1994 Form 10-K, and incorporated
herein by reference.)
10.28 Ten-Year Option dated as of September 2, 1994. (Previously
filed as Exhibit 10.42 to the 1994 Form 10-K, and incorporated
herein by reference.)
13* Annual Report to Shareholders for the Year Ended December 31,
1997. Such report is furnished for the information of the
Securities and Exchange Commission only and, except for those
portions thereof which are expressly incorporated by reference
in the Annual Report on Form 10-K, is not to be deemed filed
as part of this Report.
21* List of Subsidiaries.
23* Consent of Coopers & Lybrand L.L.P.
24* 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 period ended December 31, 1996, and
incorporated herein by reference, other than the power of
attorney for Mr. Post, which is filed herewith).
27* Financial Data Schedules
99* Financial Security Assurance Inc. and Subsidiaries 1997
Consolidated Financial Statements and Report of Independent
Accountants.
- ----------
+ Management contract or compensatory plan or arrangement required to be
filed as an exhibit to this Form 10-K pursuant to Item 14(c).
* Filed herewith.
(b) Reports on Form 8-K
The Company did not file any Reports on Form 8-K during the fourth quarter
of 1997.
30
<PAGE>
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. (Registrant)
By: /s/ ROBERT P. COCHRAN
-----------------------------
Name: Robert P. Cochran
Title: Chairman and Chief Executive Officer
Dated: March 23, 1998
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*
- --------------------------
Robert P. Cochran Chairman, Chief March 23, 1998
Executive Officer
and Director (Principal
Executive Officer)
/s/ JOHN J. BYRNE*
- --------------------------
John J. Byrne Vice Chairman of the March 23, 1998
Board and Director
/s/ ROGER K. TAYLOR*
- --------------------------
Roger K. Taylor President, March 23, 1998
Chief Operating
Officer and Director
/s/ JOHN A. HARRISON*
- --------------------------
John A. Harrison Managing Director March 23, 1998
and Chief Financial
Officer (Principal
Financial Officer)
/s/ JEFFREY S. JOSEPH*
- --------------------------
Jeffrey S. Joseph Managing Director March 23, 1998
and Controller (Principal
Accounting Officer)
/s/ MICHAEL DJORDJEVICH*
- --------------------------
Michael Djordjevich Director March 23, 1998
/s/ ROBERT N. DOWNEY*
- --------------------------
Robert N. Downey Director March 23, 1998
/s/ ANTHONY M. FRANK*
- --------------------------
Anthony M. Frank Director March 23, 1998
/s/ TOSHIKI KANEDA*
- --------------------------
Toshiki Kaneda Director March 23, 1998
31
<PAGE>
/s/ K. THOMAS KEMP*
- --------------------------
K. Thomas Kemp Director March 23, 1998
/s/ DAVID O. MAXWELL*
- --------------------------
David O. Maxwell Director March 23, 1998
/s/ JAMES M. OSTERHOFF*
- --------------------------
James M. Osterhoff Director March 23, 1998
/s/ JAMES H. OZANNE*
- --------------------------
James H. Ozanne Director March 23, 1998
/s/ STAATS M. PELLETT, JR.*
- --------------------------
Staats M. Pellett, Jr. Director March 23, 1998
/s/ RICHARD A. POST*
- --------------------------
Richard A. Post Director March 23, 1998
/s/ HOWARD M. ZELIKOW*
- --------------------------
Howard M. Zelikow Director March 23, 1998
- ----------
* Robert P. Cochran, by signing his name hereto, does hereby sign this Annual
Report on Form 10-K 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
32
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholders and Board of Directors
of Financial Security Assurance Holdings Ltd.:
Our report on the consolidated financial statements of Financial Security
Assurance Holdings Ltd. and Subsidiaries has been incorporated by reference in
this Form 10-K from page 25 of the 1997 Annual Report to Shareholders of
Financial Security Assurance Holdings Ltd. and Subsidiaries. In connection with
our audits of such financial statements, we have also audited the related
financial statement schedule listed in the index on page 26 of this Form 10-K.
In our opinion, the financial statement schedule, referred to above, when
considered in relation to the basic financial statements taken as a whole,
presents fairly, in all material respects, the information required to be
included therein.
/s/ COOPERS & LYBRAND L.L.P.
----------------------------
COOPERS & LYBRAND L.L.P.
New York, New York
January 26, 1998
33
<PAGE>
Schedule II
Parent Company Condensed Financial Information
Condensed Balance Sheets
(Dollars in thousands)
December 31,
-------------------
1997 1996
---- ----
Assets:
Investments $ 65,044 $ 28,741
Investment in and advances to subsidiary,
at equity in net assets 947,860 785,332
Deferred taxes 2,995 515
Other assets 25,287 7,071
---------- ----------
$1,041,186 $ 821,659
========== ==========
Liabilities and Shareholders' Equity:
Notes payable $ 130,000 $ --
Other liabilities 28,826 20,399
Shareholders' equity 882,360 801,260
---------- ----------
$1,041,186 $ 821,659
========== ==========
Condensed Statements of Income
(Dollars in thousands)
Year Ended December 31,
------------------------------
1997 1996 1995
---- ---- ----
Dividends received from subsidiary $ -- $ 18,000 $ 19,000
Other revenue 6,470 3,469 1,089
--------- --------- ---------
Total revenue 6,470 21,469 20,089
Total expenses 6,087 3,672 1,333
--------- --------- ---------
383 17,797 18,756
Equity in undistributed net
income of subsidiary 100,259 62,855 35,988
--------- --------- ---------
Income before income taxes 100,642 80,652 54,744
Income tax benefit (provision) (140) 108 294
--------- --------- ---------
Net income $ 100,502 $ 80,760 $ 55,038
========= ========= =========
The Parent Company Condensed Financial Information should be read in
conjunction with the Consolidated Financial Statements and Notes to Consolidated
Financial Statements as incorporated by reference in Item 8 Financial Statements
and Supplementary Data.
34
<PAGE>
Schedule II
Parent Company Condensed Financial Information (Continued)
Condensed Statements of Cash Flows
(Dollars in thousands)
<TABLE>
<CAPTION>
Year Ended December 31,
------------------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities:
Other operating expenses recovered, net $ 6,767 $ 16,995 $ 10
Dividends from subsidiary 18,000 19,000
Net investment income received 2,455 3,610 1,779
Federal income taxes received (paid) 7,283 (1,298) 1,405
Interest paid (5,158) (2,093) (57)
Other (4,159) (5,583) 12,973
--------- --------- ---------
Net cash provided by operating activities 7,188 29,631 35,110
--------- --------- ---------
Cash flows from investing activities:
Proceeds from sales of bonds 2,813 21,544 21,257
Purchases of bonds (33,495) (10,895) (27,815)
Purchases of property and equipment (112) (107) (41)
Investment in affiliate (11,646)
Net increase in short-term securities (9,890) (14,911) (38,038)
Other (1,500)
--------- --------- ---------
Net cash used for investing activities (42,184) (4,369) (56,283)
--------- --------- ---------
Cash flows from financing activities:
Issuance of notes payable, net 125,905
Net return of capital (investment in) subsidiaries (40,500) 27,000 50,000
Dividends paid (12,099) (10,536) (8,275)
Treasury stock purchases (36,246) (41,660) (14,444)
Payment of management notes (5,624)
Other (1,453)
--------- --------- ---------
Net cash provided by (used for) financing activities 35,607 (25,196) 21,657
--------- --------- ---------
Net increase in cash 611 66 484
Cash at beginning of year 629 563 79
--------- --------- ---------
Cash at end of year $ 1,240 $ 629 $ 563
========= ========= =========
Reconciliation of net income to net cash provided by
operating activities:
Net income $ 100,502 $ 80,760 $ 55,038
Equity in undistributed net income of subsidiary (100,259) (62,855) (35,988)
Decrease (increase) in accrued investment income (693) 264 110
Increase (decrease) in accrued income taxes 8,410 (2,278) 1,240
Provision (benefit) for deferred income taxes (987) 873 (128)
Net realized gains on investments (5,499) (1,338) (88)
Deferred equity compensation 14,299 5,565 5,735
Depreciation and accretion of bond discount (1,066) (119) (171)
Change in other assets and liabilities (7,519) 8,759 9,362
--------- --------- ---------
Cash provided by operating activities $ 7,188 $ 29,631 $ 35,110
========= ========= =========
</TABLE>
The Parent Company Condensed Financial Information should be read in
conjunction with the Consolidated Financial Statements and Notes to Consolidated
Financial Statements as incorporated by reference in Item 8 Financial Statements
and Supplementary Data.
35
<PAGE>
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 generally accepted
accounting principles 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 incorporated by
reference in Item 8 Financial Statements and Supplementary Data.
2. Significant Accounting Policies
The Parent Company carries its investments in subsidiaries under the
equity method.
3. Preferred Stock
On September 2, 1994, the Parent 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 Parent Company, except that, in the event
of the liquidation, dissolution or winding up of the Parent Company, it is
entitled to receive out of the assets of the Parent 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 Parent Company
ranking junior to the Parent 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.
4. Notes Payable
On September 18, 1997, the Parent 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 Parent Company used the proceeds to repay the Capital
Guaranty senior notes described above, to augment capital in the
Subsidiaries, to repurchase Forward Shares and for general corporate
purposes.
36
Exhibit 10.6
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
---------------------------------------
1993 Equity Participation Plan
---------------------------------------
Amended and Restated as of February 26, 1998
<PAGE>
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
---------------------------------------
1993 Equity Participation Plan
---------------------------------------
SECTION CONTENTS PAGE
- --------------------------------------------------------------------------------
Section 1. General Purpose of Plan; Definitions...................... 1
Section 2. Administration............................................ 4
Section 3. Stock Subject to Plan..................................... 6
Section 4. Eligibility............................................... 6
Section 5. Stock Options............................................. 7
Section 6. Restricted Stock......................................... 10
Section 7. Equity Bonuses............................................ 12
Section 8. Performance Shares........................................ 17
Section 9. Transfer, Leave of Absence, etc........................... 26
Section 10. Amendments and Termination................................ 26
Section 11. General Provisions........................................ 27
Section 12. Effective Date of Plan.................................... 28
Section 13. Term of Plan.............................................. 29
<PAGE>
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
1993 Equity Participation Plan
(Amended and Restated as of February 26, 1998)
Section 1. General Purpose of Plan; Definitions.
The name of this plan is the Financial Security Assurance Holdings Ltd.
1993 Equity Participation Plan (the "Plan"). The purpose of the Plan is to
enable the Company to retain and attract executives and employees who will
contribute to the Company's success by their ability, ingenuity and industry,
and to enable such executives and employees to participate in the long-term
growth of the Company by obtaining a proprietary interest in the Company or the
cash equivalent thereof.
The Plan shall be unfunded. All obligations of the Company under the Plan
shall be paid from the general assets of the Company.
For purposes of the Plan, the following terms shall be defined as set
forth below:
a. "Act" means the Securities Exchange Act of 1934, as amended.
b. "Board" means the Board of Directors of Financial Security Assurance
Holdings Ltd.
c. "Bonus Account" means an account established under Section 7 to record
Equity Bonuses and related credits and debits.
d. "Cause" means a Participant's commission of a felony, or a
Participant's misconduct or dishonesty, any of which is directly and materially
harmful to the business or reputation of the Company.
e. "Change in Control" means (i) an event or series of events as a result
of which any "person" or "group" (as such terms are defined in Rule 13d-5 under
the Act) is or becomes the "beneficial owner" (as defined in Rules 13d-3 and
13d-5 under the Act) of shares of capital stock entitling the holder thereof to
cast more than 50% of the votes for the election of directors of the Company; or
(ii) the approval by the Company's shareholders of the Company's consolidation
with or merger into another corporation, or another corporation's merger into
the Company, or the conveyance, transfer or lease of all or substantially all of
its assets to any person, or the liquidation or dissolution of the Company;
provided that a Change in Control shall not arise from any event
1
<PAGE>
or series of events as a result of which U S WEST, Inc. or Fund American
Enterprises Holdings, Inc. is or becomes the beneficial owner of shares of
capital stock entitling it to cast more than 50% of the votes for the election
of directors of the Company.
f. "Code" means the Internal Revenue Code of 1986, as amended.
g. "Committee" means the Committee referred to in Section 2.
h. "Company" means Financial Security Assurance Holdings Ltd. (and, unless
required otherwise by the context, its Subsidiaries), a corporation organized
under the laws of the State of New York (or any successor corporation).
i. "Disability" means permanent and total disability as determined under
the Company's long-term disability program or as otherwise determined by the
Committee.
j. "Disinterested Person" shall have the meaning set forth in Rule
16b-3(c)(2)(i) as promulgated by the Securities and Exchange Commission under
the Act, or any successor definition adopted by the Commission.
k. "Division" means any of the operating units or divisions of the Company
designated as a Division by the Committee.
l. "Equity Bonus" means a bonus accrued for and paid in accordance with
Section 7.
m. "Fair Market Value" per share of Stock as of a particular date means
(i) the closing sales price per share on a national securities exchange for the
last preceding date on which there was a sale of Stock on such exchange, or (ii)
if Stock is then traded on an over-the-counter market, the average of the
closing bid and asked prices for Stock in such over-the-counter market for the
last preceding date on which there was a sale of Stock in such market, or (iii)
if Stock is not then listed on a national securities exchange or traded in an
over-the-counter market, such value as the Committee in its sole discretion may
determine; provided that, if Stock is then so listed but there has been no
trading for ten business days, the "Fair Market Value" shall be such value as
the Committee in its sole discretion may determine.
n. "Incentive Stock Option" means any Stock Option intended to be and
designated as an "Incentive Stock Option" within the meaning of Section 422 of
the Code.
2
<PAGE>
o. "Non-Qualified Stock Option" means any Stock Option that is not an
Incentive Stock Option.
p. "Participant" means any employee of the Company selected for
participation in the Plan by the Committee (either as an optionee with respect
to Stock Options or as a recipient with respect to Restricted Stock, Equity
Bonuses or Performance Shares).
q. "Performance Cycle" means a time period specified by the Committee at
the time a grant of Performance Shares is made, during which the performance of
the Company, a Subsidiary or a Division will be measured.
r. "Performance Objectives" means goals set by the Committee with respect,
but not limited to: (i) earnings per share of Stock, (ii) pre-tax profits, (iii)
net earnings or net worth, (iv) absolute and/or relative return on equity or
assets, (v) any combination of the foregoing, or (vi) any other standard or
standards deemed appropriate by the Committee at the time a grant of Performance
Shares is made. Performance Objectives may be in respect of the performance of
the Company and its Subsidiaries (which may be on a consolidated basis), a
Subsidiary or a Division.
s. "Performance Shares" means Performance Shares granted to a Participant
under Section 8 of the Plan.
t. "Realization Event" means an event described in the first sentence of
Section 7(f) (without regard to any additional deferrals under the other
provisions of Section 7(f)).
u. "Retirement" means retirement from active employment with the Company,
on or after the normal retirement date specified in the Company's pension plan
or as otherwise determined by the Committee, or, if determined by the Committee
in advance, early retirement (after satisfaction of any age and/or service
requirements imposed by the Committee).
v. "Restricted Stock" means an award of shares of Stock that are subject
to restrictions under Section 6.
w. "Stock" means the Common Stock, $.01 par value per share, of Financial
Security Assurance Holdings Ltd.
x. "Stock Option" means any option to purchase shares of Stock granted
pursuant to Section 5.
y. "Subsidiary" means any corporation (other than the Company) that is a
"subsidiary corporation" with respect to the Company under Section 424(f)
3
<PAGE>
of the Code. In the event the Company becomes a subsidiary of another company,
the provisions hereof applicable to Subsidiaries shall, unless otherwise
determined by the Committee, also be applicable to any Company that is a "parent
corporation" with respect to the Company under Section 424(e) of the Code.
Section 2. Administration.
The Plan shall be administered by a Committee of not less than two
Disinterested Persons, who shall be members of and appointed by the Board of
Directors of the Company and who shall serve at the pleasure of the Board,
unless otherwise determined by the Board.
The Committee shall have the power and authority to grant to Participants,
pursuant to the terms of the Plan: (a) Stock Options, (b) Restricted Stock, (c)
Equity Bonuses and (d) Performance Shares.
In particular, the Committee shall have the authority:
(i) to select the officers and other key employees of the Company to
whom Stock Options, Restricted Stock, Equity Bonuses and/or Performance
Shares may from time to time be granted hereunder;
(ii) to determine whether and to what extent Incentive Stock
Options, Non-Qualified Stock Options, Restricted Stock, Equity Bonuses or
Performance Shares, or a combination of any of the foregoing, are to be
granted hereunder;
(iii) to determine the number of shares to be covered by each such
award granted hereunder; provided that not more than one-half of the
shares available for distribution hereunder may be covered by options
granted to any single Participant over the life of the Plan;
(iv) to determine the terms and conditions, not inconsistent with
the terms of the Plan, of any award granted hereunder (including, but not
limited to, any vesting requirements or other restrictions or performance
criteria relating to any Stock Option, Restricted Stock award, Equity
Bonus or Performance Shares and/or the shares of Stock relating thereto);
(v) to establish or assist in the establishment of a program under
which the Company or a third party may make bona fide loans on arm's
length terms to any or all optionees hereunder to assist such optionees
with the satisfaction of any or all of the obligations that such optionees
may have hereunder (including, without limitation, a loan
4
<PAGE>
program under which the Company or third party would advance the aggregate
option price to the optionee and be repaid with Stock obtained upon the
exercise of a Stock Option, or the proceeds thereof);
(vi) to determine whether, and to what extent any one or more
specified Performance Objectives, relating to an award of Performance
Shares under the Plan, have been met by the Company over any one
Performance Cycle; and
(vii) to determine whether, to what extent and under what
circumstances stock and other amounts otherwise payable with respect to an
award under the Plan shall be deferred either automatically or at the
election of the Participant.
The Committee shall have the authority to adopt, alter and repeal such
administrative rules, guidelines and practices governing the Plan as it shall,
from time to time, deem advisable; to interpret provisions of the Plan and any
award issued under the Plan (and any agreements relating thereto); and to
otherwise supervise the administration of the Plan. Without limiting the
generality of the foregoing, the Committee may (subject to such considerations
as may arise under Section 16 of the Act, or under other corporate, securities
and tax laws) take any steps it deems appropriate, that are not materially
substantive and are not inconsistent with the purposes and intent of the Plan,
to take into account the provisions of Section 162(m) of the Code and the
Committee may take any steps it deems appropriate (including amending the terms
or imposing further conditions on any award issued under the Plan), that are not
inconsistent with the purposes and intent of the Plan, to take into account any
proposed or existing legislation or regulations (whether U.S. federal, state, or
local or foreign), or to obtain or maintain favorable taxation, exchange control
or securities regulatory treatment for the Company or a Participant.
All decisions made by the Committee pursuant to the provisions of the Plan
shall be final and binding, in the absence of bad faith or manifest error, on
all persons (including, without limitation, any interpretations of the Plan),
including the Company and Participants, and otherwise entitled to the maximum
deference permitted by law.
To the maximum extent permitted by law, the Committee and the members
thereof shall be indemnified by the Company for all action and inaction by each
of them in connection with the administration of the Plan or otherwise in
connection with the Plan.
5
<PAGE>
Section 3. Stock Subject to Plan.
The total number of shares of Stock reserved and available for
distribution under the Plan, other than under Section 7, shall be 2,110,780;
such shares may consist, in whole or in part, of authorized and unissued shares,
treasury shares, re-acquired shares, or shares purchased by a grantor trust as
provided for in Section 8. The total number of shares of Stock available with
respect to Equity Bonuses under Section 7 shall be as set forth under Section 7.
If any shares that have been optioned cease to be subject to option, if
any shares subject to any Restricted Stock award granted hereunder are forfeited
or such award otherwise terminates, or if any shares issuable pursuant to any
Performance Shares award granted hereunder cease to be issuable thereunder or
such award otherwise terminates, such shares shall again be available for
distribution in connection with future awards under the Plan.
The aggregate number of shares reserved for issuance under the Plan and
the number and option price of shares subject to outstanding options and the
number of shares issuable pursuant to outstanding Performance Shares and to the
Equity Bonus provisions hereof shall be appropriately adjusted by the Committee
in the event of any increase or decrease in the number of outstanding shares of
Stock resulting from payment of a Stock dividend on Stock, a subdivision or
combination of shares of Stock, a reclassification of Stock, a recapitalization
involving the Company or in the event of a merger or consolidation in which the
Company shall be the surviving corporation.
Section 4. Eligibility.
Officers and other employees of the Company (but not any person who serves
only as a director) who are responsible for or contribute to the management,
growth and/or profitability of the business of the Company are eligible to be
granted Stock Options, Restricted Stock awards, Performance Shares and/or Equity
Bonuses under the Plan. The optionees and other Participants under the Plan
shall be selected from time to time by the Committee, in its sole discretion,
from among those eligible, and the Committee shall determine, in its sole
discretion, the number of shares covered by each award.
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Section 5. Stock Options.
Any Stock Options granted under the Plan shall be in such form as the
Committee may from time to time approve. Such stock option shall be evidenced by
a written agreement between the Company and the optionee.
The Stock Options granted under the Plan may be of two types: (i)
Incentive Stock Options and (ii) Non-Qualified Stock Options.
The Committee shall have the authority to grant any optionee Incentive
Stock Options, Non-Qualified Stock Options, or both types of options. To the
extent that any option does not qualify as an Incentive Stock Option, it shall
constitute a separate Non-Qualified Stock Option.
Options granted under the Plan shall be subject to the following terms and
conditions and shall contain such additional terms and conditions, not
inconsistent with the terms of the Plan, as the Committee shall deem desirable:
(a) Option Price. The option price per share of Stock purchasable under a
Stock Option shall be determined by the Committee at the time of grant and may
be more or less than 100% of the Fair Market Value of the Stock on the date of
the grant of the Option. If an employee owns or is deemed to own (by reason of
the attribution rules applicable under Section 424(d) of the Code) more than 10%
of the combined voting power of all classes of stock of the Company, and an
Incentive Stock Option is granted to such employee, the option price shall be no
less than 110% of the Fair Market Value of the Stock on the date the option is
granted.
(b) Option Term. The term of each Stock Option shall be fixed by the
Committee, but no Incentive Stock Option shall be exercisable more than ten
years after the date the option is granted and no Non-Qualified Stock Option
shall be exercisable more than ten years and one day after the day the option is
granted. If an employee owns or is deemed to own (by reason of the attribution
rules of Section 424(d) of the Code) more than 10% of the combined voting power
of all classes of stock of the Company and an Incentive Stock Option is granted
to such employee, the term of such option shall be no more than five years from
the date of grant.
(c) Exercisability. Stock Options shall be exercisable at such time or
times as determined by the Committee (taking into account, without limitation,
Section 16 of the Act) at or after grant. If the Committee provides, in its
discretion, that any option is exercisable only in installments, the Committee
may waive such installment exercise provisions at any time. The aggregate Fair
Market Value, determined as of the date a Stock Option is granted, of the Stock
for which any optionee may be awarded Incentive Stock Options which
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are first exercisable by the optionee during any calendar year under the Plan
(or any other stock option plan required to be taken into account under Section
422(d) of the Code) shall not exceed $100,000; provided that any Stock Options
purporting to be Incentive Stock Options that are granted in excess of this
$100,000 limitation shall be treated as Non-Qualified Stock Options.
(d) Method of Exercise. Stock Options may be exercised in whole or in part
during the option period by giving written notice of exercise to the Company
specifying the number of shares to be purchased. Such notice shall be
accompanied by payment in full of the purchase price, either by certified, bank
or personal check as determined by the Committee (or, if the Committee has
established or assisted with the establishment of a Company or third-party loan
program in accordance with the Plan for which the optionee is eligible, with the
proceeds of a loan from the Company or third party), in its sole discretion, at
or after grant. Payment in full or in part may also be made in the form of Stock
(not subject to restrictions) already owned by the optionee based on the Fair
Market Value of the Stock on the date the option is exercised. No shares of
Stock shall be issued until full payment therefor has been made. An optionee
shall generally have the rights to dividends or other rights of a stockholder
with respect to shares subject to the option when the optionee has given written
notice of exercise, has paid in full for such shares, and, if requested, has
given the representation described in paragraph (a) of Section 11.
(e) Non-Transferability of Options. No Stock Option shall be transferable
by the optionee, or otherwise subject to voluntary or involuntary sale, pledge,
anticipation, alienation, encumbrance, assignment, garnishment or attachment,
other than by will or by the laws of descent and distribution, and all Stock
Options shall be exercisable, during the optionee's lifetime, only by the
optionee.
(f) Termination by Death. If an optionee's employment by the Company
terminates by reason of death, the Stock Option (whether or not then otherwise
exercisable) may thereafter be immediately exercised by the legal representative
of the estate or by the legatee of the optionee under the will of the optionee,
for a period of one year (or such shorter period as the Committee shall specify
at grant) from the date of such death or until the expiration of the stated term
of the option, whichever period is the shorter.
(g) Termination by Reason of Disability. If an optionee's employment by
the Company terminates by reason of Disability, any Stock Option (whether or not
then otherwise exercisable) held by such optionee may thereafter be exercised,
but may not be exercised after one year (or such shorter period as the Committee
shall specify at grant) from the date of such termination of employment or the
expiration of the stated term of the option, whichever period
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is the shorter; provided, however, that, if the optionee dies within such
period, any unexercised Stock Option held by such optionee shall thereafter be
exercisable for a period of twelve months from the date of such death or for the
stated term of the option, whichever period is the shorter. In the event of
termination of employment by reason of Disability, if an Incentive Stock Option
is exercised after the expiration of the exercise period that applies for
purposes of Section 422 of the Code, the option will then and thereafter be
treated as a Non-Qualified Stock Option.
(h) Termination by Reason of Retirement. If an optionee's employment by
the Company terminates by reason of Retirement, any Stock Option (whether or not
then otherwise exercisable) held by such optionee may thereafter be exercised,
but may not be exercised after three years (or such shorter period as Committee
shall specify at grant) from the date of such termination of employment or the
expiration of the stated term of the option, whichever period is the shorter;
provided, however, that, if the optionee dies within such three-year period, any
unexercised Stock Option held by such optionee shall thereafter be exercisable
for a period of twelve months from the date of such death or for the stated term
of the option, whichever period is the shorter. In the event of termination of
employment by reason of Retirement, if an Incentive Stock Option is exercised
after the expiration of the exercise period that applies for purposes of Section
422 of the Code, the option will then and thereafter be treated as a
Non-Qualified Stock Option.
(i) Termination by the Optionee or for Cause; Termination Without Cause.
Unless otherwise determined by the Committee, if an optionee's employment by the
Company is terminated by the optionee for any reason other than death,
Disability or Retirement, or by the Company for Cause, the Stock Option shall
thereupon be terminated, except that options that have become exercisable under
the terms of the applicable award agreement may be exercised for the lesser of
three months or the balance of the option's term. Unless otherwise determined by
the Committee, if an optionee's employment is terminated by the Company without
Cause (and not by reason of Disability or Retirement), any Stock Option (whether
or not then otherwise exercisable) held by such optionee may thereafter be
exercised, but may not be exercised after nine months from the date of such
termination of employment or the expiration of the stated term of the option,
whichever period is the shorter; provided, however, that, if the optionee dies
within such period, any unexercised Stock Option held by such optionee shall
thereafter be exercisable for a period of twelve months from the date of such
death or for the stated term of the option, whichever period is the shorter. In
the event of such a termination of employment without Cause, if an Incentive
Stock Option is exercised after the expiration of the exercise period that
applies for purposes of Section 422 of the Code, the option will then and
thereafter be treated as a Non-Qualified Stock Option.
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(j) Change in Control. In the event of a Change in Control of the Company
all outstanding unexercised Stock Options shall become immediately exercisable.
If the optionee shall so elect by notice to the Company within the later of 60
days or the first available window period (as provided in Rule 16b-3(e)(1) and
(3) under the Act) following such Change in Control, the optionee's outstanding
unexercised Stock Options shall be cancelled and the Company shall immediately
pay and the optionee shall immediately receive in cash an amount equal to the
product of (i) the difference between (a) the greater of the (then current) Fair
Market Value of Company Stock, the Fair Market Value within 30 days preceding
such Change in Control or the highest offered price in any tender offer for
shares of Company Stock and (b) the exercise price of the cancelled Stock
Options and (ii) the number of unexercised Stock Options then held by the
optionee.
(k) No Rights until Option Exercised. Neither any optionee hereunder nor
any person entitled to exercise the optionee's rights in the event of death
shall have any rights of a stockholder with respect to the shares subject to
each Option, except to the extent that a certificate for such shares shall have
been issued upon the exercise of each Option as provided for herein.
Section 6. Restricted Stock.
(a) Administration. Shares of Restricted Stock may be issued either alone
or in addition to other awards granted under the Plan. The Committee shall
determine the officers and key employees of the Company to whom, and the time or
times at which, grants of Restricted Stock will be made, the number of shares to
be awarded, the time or times within which such awards may be subject to
forfeiture, and all other conditions of the awards. The Committee may also
condition the grant of Restricted Stock upon the attainment of specified
performance goals. The provisions of Restricted Stock awards need not be the
same with respect to each recipient.
(b) Awards and Certificates. The prospective recipient of an award of
shares of Restricted Stock shall not have any rights with respect to such award,
unless and until such recipient has executed an agreement evidencing the award
and has delivered a fully executed copy thereof to the Company, and has
otherwise complied with the then applicable terms and conditions.
(i) Each recipient shall be issued a stock certificate in respect of
shares of Restricted Stock awarded under the Plan. Such certificate shall
be registered in the name of the recipient, and shall bear an appropriate
legend referring to the terms, conditions, and restrictions applicable to
such award, substantially in the following form:
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The transferability of this certificate and the shares of
stock represented hereby are subject to the terms and conditions
(including forfeiture) of the Financial Security Assurance Holdings
Ltd. 1993 Equity Participation Plan and an Agreement entered into
between the registered owner and Financial Security Assurance
Holdings Ltd. Copies of such Plan and Agreement are on file in the
offices of Financial Security Assurance Holdings Ltd., 350 Park
Avenue, New York, New York 10022.
(ii) The Committee shall require that the stock certificates
evidencing such shares shall be held in custody by the Company until the
restrictions thereon shall have lapsed, and that, as a condition of any
Restricted Stock award, the Participant shall have delivered a stock
power, endorsed in blank, relating to the stock covered by such award. If
and when such restrictions so lapse, the stock certificates shall be
delivered by the Company to the recipient or his or her designee.
(c) Restrictions and Conditions. The shares of Restricted Stock awarded
pursuant to the Plan shall be subject to the following restrictions and
conditions:
(i) Subject to the provisions of the Plan and the award agreements,
during a period set by the Committee commencing with the date of such
award and ending on a date established by the Committee (the "Restriction
Period"), the recipient shall not be permitted voluntarily or
involuntarily to sell, transfer, pledge, anticipate, alienate, encumber or
assign shares of Restricted Stock awarded under the Plan (or have such
shares attached or garnished). Within these limits, the Committee may
provide for the lapse of such restrictions in installments where deemed
appropriate.
(ii) Except as provided in paragraph (c)(i) of this Section 6, the
recipient shall have, in respect of the shares of Restricted Stock, all of
the rights of a stockholder of the Company, including the right to vote
the shares, and the right to receive any cash dividends. The Committee
may, in its sole discretion, defer the payment of any cash dividends
otherwise payable until such date or dates upon which the restrictions on
the related shares of Restricted Stock shall lapse. Certificates for
shares of Stock (not subject to restrictions) shall be delivered to the
grantee promptly after, and only after, the period of forfeiture shall
expire without forfeiture in respect of such shares of Restricted Stock.
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(iii) Subject to the provisions of the award agreement and
paragraphs (c)(iv) and (c)(v) of this Section 6, upon termination of
employment for any reason during the Restriction Period, all shares still
subject to restriction shall be forfeited by the recipient.
(iv) In the event a recipient's employment is terminated by the
Company (other than for Cause), the Committee may (in its sole
discretion), when it finds that a waiver would be in the best interests of
the Company, waive in whole or in part any or all remaining restrictions
with respect to such recipient's shares of Restricted Stock.
(v) In the event of Death, Disability, Retirement or a Change in
Control (as previously defined herein) during the Restriction Period,
restrictions will immediately lapse on all Restricted Stock granted under
this Section 6.
Section 7. Equity Bonuses.
(a) Stock Subject to Equity Bonuses. The number of shares of Stock that
may be allocated under this Section 7 shall be 10,000,000. If any Equity Bonus
(or related Stock) is forfeited, the shares allocated and/or otherwise to be
distributed under this Section 7 with respect thereto shall again be available
for distribution in connection with future awards under the Plan.
(b) Awards of Equity Bonuses. Subject to the other terms of the Plan,
Equity Bonuses may be granted to Participants in lieu of cash bonuses otherwise
payable thereto. The amount of any Equity Bonus for a year shall be determined
by the Committee (i) under a formula established by the Committee and applicable
to one or more groups of Participants or one or more individual Participants,
(ii) on a Participant-by-Participant basis or (iii) pursuant to any combination
of the foregoing methods. Without limitation by specification, this formula may
mandate that a designated percentage of the cash bonus otherwise payable be
granted as an Equity Bonus and that Participants be allowed to elect (in
accordance with procedures established by the Committee) that an amount up to
such additional percentage of such cash bonus, as designated by the Committee,
be payable in the form of an Equity Bonus. Unless expressly determined to the
contrary by the Committee, no such Equity Bonus with respect to a Participant
shall be greater than the excess of (i) the amount of the bonus payable to the
Participant for the year without regard to this Section 7, over (ii) the amount
(if any) of such bonus that is (A) deferred (or diverted to another use (e.g.,
without limitation, to the purchase of Company stock or the payment of medical
premiums or other expenses)) at the option of the Company, a Subsidiary or the
Participant in accordance with any otherwise existing deferral (or other)
program offered by the Company or a Subsidiary or
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(B) otherwise excluded for these programs by the Committee. The amount of any
bonus payable without regard to this Section 7 shall be reduced (but not to
below zero) by the amount of the applicable Equity Bonus. No Equity Bonus (or
credit or payment with respect thereto) shall be transferable by the
Participant, or otherwise subject to voluntary or involuntary sale, pledge,
anticipation, alienation, encumbrance, assignment, garnishment or attachment,
other than by will or by the laws of descent and distribution.
(c) Vesting and Conditions. Subject to the following provisions of this
Section 7(c), and to any fluctuations in value over time, each Participant shall
be 100% vested in the Participant's Equity Bonus (and any allocations of Stock
or other amounts related thereto). A Participant shall forfeit any Equity Bonus
(and Stock or other allocations attributable thereto) if, prior to the
Realization Event applicable to that Equity Bonus, the Participant is terminated
for Cause. In addition, unless determined otherwise by the Committee, the
following individuals shall not be entitled to an Equity Bonus for a year
(whether or not the Equity Bonus has already been awarded to the Participant or
any related allocations have been made):
(i) An individual who, prior to the last day of such year, has
notified the Company that the individual intends to terminate employment
with the Company effective in such year or the next succeeding year.
(ii) An individual who, prior to the last day of such year, has been
notified by the Company that the individual's employment with the Company
will be terminated effective in such year or the next succeeding year.
(iii) An individual whose employment with the Company terminates
prior to the end of such year.
The Committee may require that, prior to receiving any distribution of Stock
under this Section 7, each Participant shall be required to certify in a form
acceptable to the Committee that at no time on or after the implementation of
this Section 7 (or such earlier date as may be specified by the Committee), and
before the occurrence of the Realization Event with respect to which the
distribution is to be made, has the Participant, directly or indirectly, held
any equity or derivative security position with respect to Stock, such as a
short sale, a long put option or a short call option, that increases in value as
the value of Stock decreases. If the Participant does not make such
certification, the Participant shall receive a distribution with respect to the
applicable Equity Bonus equal to the number of shares of Stock otherwise to be
distributed as of the Realization Event reduced by 0.1765 multiplied by the
number of shares of Stock otherwise to be distributed as of the Realization
Event. The number of
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shares by which the distribution is reduced shall be forfeited as of such
Realization Event. If a Participant makes a false certification, the Participant
shall forfeit as of such Realization Event all of the shares allocated to his
accounts in respect of Equity Bonuses. All amounts forfeited hereunder shall be
treated as purchases for the Plan in accordance with rules to be established by
the Committee.
(d) Accounts. Each Participant's Bonus Account shall be credited with a
number of shares of Stock equal to the dollar amount of such Participant's
Equity Bonus award divided by the product of 0.85 multiplied by the Fair Market
Value of Stock on the date on which the shares are credited to such
Participant's Bonus Account. The establishment and maintenance of, and credits
to (including without limitation credits of Stock) and deductions from, the
Bonus Accounts (whether under the foregoing sentence or otherwise under this
Section 7) shall be mere bookkeeping entries, and shall not vest in the employee
or his beneficiary any right, title or interest in or to any specific assets of
the Company. All payments from the Bonus Accounts shall be made from the general
funds of the Company, and, except as provided below, no special or separate fund
shall be established or other segregation of assets made to assure such
payments.
(e) Deemed Dividends. For each dividend declared and paid on shares of
Stock, an amount equal to such dividend (referred to herein as "deemed
dividend") shall be credited with respect to each share of Stock allocated to
the Bonus Accounts. The Committee may provide that such amounts be deemed
reinvested in additional Stock (which would thereupon be credited to the Bonus
Accounts), and may provide that the credit resulting from such reinvestment be
equal to the dollar amount of the deemed dividend divided by the product of 0.85
multiplied by the Fair Market Value of Stock on the date on which the shares are
credited to such Participant's Bonus Account.
(f) Distributions. Except as otherwise determined by the Committee,
amounts attributable to Equity Bonuses shall be distributed upon the first to
occur of (i) the expiration of the period specified by the Board or Committee
beginning on the date as of which the Equity Bonus is awarded, (ii) the
occurrence of a Change in Control, (iii) the termination of this Section 7
pursuant to Section 10, (iv) the Participant's termination of employment with
the Company as a result of the Participant's Disability or (v) the Participant's
Death. Notwithstanding the foregoing, the Committee may permit Participants to
elect additional deferral and/or to receive earlier distributions. In the case
of additional deferral, the Committee may establish rules under which Stock
allocated to a Bonus Account may (i) continue to be allocated as such, and/or
(ii) may be converted to cash and credited from time to time with earnings in
accordance with procedures determined by the Committee. Distributions shall be
made in Stock and/or cash, as determined and in accordance with rules to
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be established by the Committee (which may be rules of general applicability or
rules applicable to specified Participants), except that fractional shares shall
be in cash.
(g) Funding. Prior to the award of any Equity Bonus, the Committee shall
establish a funding vehicle (a "Fund") to assist the Company with its
obligations under this Section 7. The Committee may provide that credits and
allocations otherwise provided for by this Section 7 shall be adjusted to take
into account the amount and timing of purchases and sales of, and dividends with
respect to, Stock under such Fund; the manner in which such Fund otherwise
operates; the amount of Stock in such Fund from time to time; and such other
factors as the Committee may deem relevant; provided that the limitation in
Section 7(a) may not be adjusted under this sentence. Any Fund shall be designed
not to cause the Plan to be considered to be funded for tax purposes or for
purposes of Title I of the Employee Retirement Income Security Act of 1974, as
amended.
(h) Allocations from a Fund. Without limiting the generality of Section
7(g), the Committee shall establish rules regarding Stock purchases by a Fund
and related allocations to Bonus Accounts that are consistent with the following
rules:
(i) The Fund may make purchases and/or receive contributions of
Stock, with such Stock to be allocated as indicated below. If, on November
30 of each calendar year (or such other date as may be specified by the
Committee), the number of unallocated shares held in the Fund is at least
equal to 90% (on such other percentage specified by the Committee) of the
amount of shares necessary to satisfy the total amount of Equity Bonuses
granted for such calendar year, each Participant's Bonus Account shall be
credited with a number of shares of Stock equal to the dollar amount of
such Participant's Equity Bonus divided by the product of 0.85 multiplied
by the average cost per share of Stock (as determined in accordance with
rules established by the Committee) purchased (or deemed purchased) by the
Fund, with such cost being determined as of November 30 (or such other
date) of the calendar year for which the Equity Bonus was granted to such
Participant. In the event that the number of shares held in the Fund is
less than 90% (or such other percentage) of the number of shares necessary
to satisfy the total amount of Equity Bonuses granted for a year, each
Participant's Stock Account shall be credited with a number of shares of
Stock equal to the dollar amount of such Participant's Equity Bonus
divided by the product of 0.85 multiplied by the average cost per share of
Stock on the date on which the shares are credited to such Participant's
Bonus Account.
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(ii) If, as of the date a Bonus Award is granted, the number of
unallocated shares held in the Fund is insufficient to satisfy such Equity
Bonus, the date on which Stock in respect of such Equity Bonus is credited
to a Participant's Bonus Account shall be deferred until such date as the
number of unallocated shares held in the Fund equals or exceeds the number
of shares with respect to such Equity Bonus.
(iii) If the date as of which Equity Bonuses are granted for a
calendar year is on or prior to the record date for the dividends payable
on Stock but the number of unallocated shares held in the Fund is
insufficient to satisfy such Equity Awards, (A) for purposes of Section
7(h)(iv) and (vi), the unallocated shares held in the Fund shall be
treated as held in each Participant's Account pro rata in proportion to
each Participant's Bonus for such calendar year and (B) Financial Security
Assurance Holdings Ltd. shall make a contribution to the Fund equal to the
difference between (I) the dividends that would have been paid on shares
in respect of Equity Bonuses for such calendar year had the Fund held
sufficient Equity shares to satisfy the Equity Bonuses for such calendar
year and (II) the dividends actually paid on the shares held in the Fund.
For purposes of Section 7(h)(iv) and (vi), the Company contribution
described in clause (B) of the foregoing sentence shall be treated as a
dividend paid on Stock held in a Participant's Bonus Account, pro rata in
proportion to each Participant's Equity Bonus for such calendar year.
(iv) As of the payment date for dividends paid (or deemed paid) on
Stock held (or deemed held) in a Participant's Bonus Account as of the
record date for such dividends, each such Participant's Bonus Account
shall be credited with the number of shares of Stock that are in fact
purchased or deemed to have been purchased with such dividends and the
additional 17.65% compensation contribution made in respect of such
dividends, as determined pursuant to Section 7(h)(vi).
(v) Each Participant's Bonus Account shall be reduced by the number
of shares of Stock distributed to the Participant in respect of an Equity
Bonus, whether such shares are distributed from the Fund or directly from
the Company.
(vi) All dividends paid on Stock held in the Fund shall be
reinvested in Stock as follows:
(A) Subject to Section 7(h)(vi)(B), as soon as practicable
after the payment date for dividends paid (or deemed paid) on Stock
credited (or deemed to be credited) to Participants' Bonus Accounts,
the Company shall contribute to the Fund, as
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compensation to Participants, an amount equal to 17.65% of such
dividends (or deemed dividends) (less required withholding taxes, if
any). As soon as practicable after receipt of such dividends (or
deemed dividends) and such 17.65% contribution, the Fund shall use
such dividends (or deemed dividends) and contribution to purchase
Stock.
(B) To the extent that the Committee elects by notice to the
Fund, the Company's 17.65% contribution obligation shall be
satisfied out of the unallocated Stock in the Fund. If the Committee
makes such an election, the contribution obligation shall be
satisfied (I) first from the dividends paid on unallocated shares of
Stock held in the Fund and (II) second from unallocated shares of
Stock held in the Fund, based on the Fair Market Value of the shares
on the relevant payment date. Any such share shall be deemed to have
been purchased at such Fair Market Value for allocation purposes.
(C) Shares of Stock purchased or deemed purchased pursuant to
Section 7(h)(vi)(A) or (B) shall be allocated to the Participant's
Bonus Accounts with respect to which they were purchased.
(D) As soon as practicable after receipt of dividends paid on
unallocated Stock held in the Fund, the Fund shall use the amount of
such dividends to purchase Stock. Shares of Stock purchased pursuant
to this Section 7(h)(vi)(D) (other than with dividends used to
satisfy the Company's contribution obligation pursuant to Section
7(h)(vi)(B)) shall be held unallocated in the Fund, pending
allocation.
(vii) Other Rules. It is expressly understood that this Section 7
provides general parameters with respect to the awarding of Equity Bonuses
and the making of payments in connection therewith. Without limiting the
generality of Section 2, prior to the award of any Equity Bonus, the
Committee shall adopt such additional provisions (not inconsistent with
this Section 7) relating to Equity Bonuses as it may deem necessary or
advisable to implement the purposes and intent of this Section 7, which
provisions, if and when adopted, are hereby incorporated herein by
reference.
Section 8. Performance Shares.
(a) Administration and Awards. The Committee, in its discretion, may grant
Performance Shares to one or more Participants. The terms and
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conditions of any grant of Performance Shares shall be set forth in a written
agreement between the Company and the Participant. Such written agreement may
permit a Participant to make elections thereunder with respect to the
Performance Objective(s) applicable thereto and/or the method(s) of calculating
such Performance Objective(s). Performance Shares shall be denominated in shares
of Stock and, contingent upon the attainment of specified Performance Objectives
within one or more Performance Cycles, and subject to the Company's rights as
set forth in paragraph (c) of this Section 8, represent the right to receive a
distribution of Stock and/or payment of cash following the completion of each
Performance Cycle, as provided in paragraph (b) of this Section 8. The Committee
shall determine the extent to which any one or more Performance Objectives have
been achieved by the Company in the applicable Performance Cycle. In the absence
of bad faith or manifest error, the Committee's determination shall be final and
binding upon a Participant.
Performance Shares may be granted to a Participant prior to or during a
Performance Cycle, but distributions and payments with respect thereto may only
be made following the completion of a Performance Cycle, except as otherwise
provided in paragraph (e) of this Section 8 following a Change in Control. The
number of Performance Shares subject to an award shall be allocated among the
Performance Cycle(s) covered by such award in such manner as the Committee shall
determine. The written agreement evidencing the award of Performance Shares
shall specify the number of Performance Shares subject to the award, the number
and duration of the Performance Cycles to which those Performance Shares relate,
the Performance Objectives, the identification of the Performance Cycle(s)
within which such Performance Objectives must be satisfied, the number of
Performance Shares allocated to each such Performance Cycle, and the vesting
provisions with respect to such Performance Shares (i.e., the date or, if
vesting is on an installment basis, the dates after which the Participant shall
have indefeasible right to the distribution and/or payment described in
paragraph (b) of this Section 8, if any, with respect to certain or all
Performance Shares subject to the award), subject to the limitations thereon
described below. The number of Performance Shares allocated to a Performance
Cycle under any award of Performance Shares shall not exceed 100,000.
If any change shall occur in or affect the Stock or Performance Shares on
account of any increase or decrease in the number of outstanding shares of Stock
resulting from payment of a Stock dividend on Stock, a subdivision or
combination of shares of Stock, a reclassification of Stock, a recapitalization
involving the Company or in the event of a merger or consolidation in which the
Company shall be the surviving corporation, the Committee shall make such
adjustments, if any, that it deems necessary in the number of Performance Shares
allocated to awards of Performance Shares then outstanding to reflect such
change in capitalization.
18
<PAGE>
To reflect a change in tax laws or regulations or accounting principles,
the Committee shall make such adjustments in the Performance Objectives set
forth in all outstanding awards of Performance Shares in respect of Performance
Cycles not then completed so as to reflect such change to preserve the value of
the Performance Shares consistent with the intent and the purpose of the Plan,
provided the Company's independent auditors shall have determined that such
adjustments shall not result in the Company's loss of deductibility under
Section 162(m) with respect to Participants whose compensation is, in the
reasonable belief of the Committee, subject thereto. Further, with respect to a
Participant, the deductibility of whose award of Performance Shares will not, in
the reasonable belief of the Committee, be subject to Section 162(m) of the
Code, the Committee may, in its discretion and independent of any determination
made by the Company's independent auditors, adjust the Performance Objective(s)
in respect of Performance Cycles not then completed so as to reflect a change in
tax laws or regulations or accounting principles to preserve the value of the
Performance Shares consistent with the intent and the purpose of the Plan.
Performance Shares shall be vested at such time or times as determined by
the Committee (taking into account, without limitation, Section 16 of the Act)
at the date of award, provided that acceleration of vesting may be granted by
the Committee after the date of award, but in no event shall the Committee
provide a vesting schedule which would vest fewer Performance Shares in a
Participant through the completion of a particular Performance Cycle than the
aggregate number of Performance Shares allocated to such Performance Cycle and
all Performance Cycles included in such award which have been previously
completed. If the Committee provides, in its discretion, that any award is
vested only in installments, the Committee may waive such installment vesting
provisions at any time.
Upon termination of a Participant's employment by the Company without
Cause, unvested Performance Shares awarded on or prior to January 1, 1996, shall
all vest and those awarded after January 1, 1996, shall vest pro-rata in
proportion to the percentage of the Performance Cycle for such Performance
Shares during which the Participant was employed by the Company. Upon
Retirement, unvested Performance Shares awarded on or prior to January 1, 1998,
shall all vest and those awarded after January 1, 1998, shall vest pro-rata in
proportion to the percentage of the Performance Cycle for such Performance
Shares during which the Participant was employed by the Company. In addition,
all unvested Performance Shares shall vest (i) upon death or Disability while
employed by the Company and (ii) as set forth in paragraph (e) of this Section 8
in the event of a Change in Control. Except as provided above, Performance
Shares not vested on the date of termination of employment shall be forfeited.
19
<PAGE>
(b) Distributions and Payments on Completion of Performance Cycle. In
furtherance of an election discussed in paragraph (c) of this Section 8,
distributions of shares of Stock and/or payments of cash with respect to
Performance Shares allocated to a particular Performance Cycle covered by an
award shall be made to the Participant within one hundred twenty (120) days
after the completion of such Performance Cycle in accordance with the
Committee's determination of the achievement of the applicable Performance
Objectives, unless the agreement evidencing the award provides for the deferral
of such distribution or payment, in which event the terms and conditions of the
deferral shall be set forth in the agreement. Provided a Participant who has
been granted a Performance Shares award shall have been employed by the Company
through the date on which a particular Performance Cycle shall have been
completed, or such Participant's employment with the Company shall have been
terminated prior thereto by reason of death or Disability, such Participant
shall be entitled to receive with respect to each such award:
(i) a number of shares of Stock to be determined in accordance with
the following formula:
a x b = c ; or
(ii) a cash payment in an amount to be determined in accordance with
the following formula:
a x b x d = e; or
(iii) a combination of Stock and cash in the amounts determined in
accordance with the formulae set forth in clauses (i) and (ii) above,
provided, however, that, in such event, in each such formula a shall be
multiplied by the percentage that represents the portion of the
Performance Shares allocated to such Performance Cycle to be paid in Stock
or cash, as the case may be;
where:
a = the number of Performance Shares granted in such award
allocated to the applicable Performance Cycle;
b = a percentage (which may be more than 100%), which represents
the extent to which the Performance Objectives set forth in
such award have been achieved by the Company in the applicable
Performance Cycle;
20
<PAGE>
c = the number of shares of Stock to be distributed to a
Participant at the end of the applicable Performance Cycle
pursuant to such award;
d = the Fair Market Value of a share of Stock as of the last day
of the applicable Performance Cycle or such other date as the
Committee shall specify in such award; and
e = the amount of the cash to be paid to the Participant at the
end of the applicable Performance Cycle pursuant to such
award.
The Committee may, in its sole and absolute discretion, provide that in the
event a Participant shall not have been employed by the Company through the date
on which a particular Performance Cycle covered by such Participant's award
shall have been completed, such Participant may be entitled to a distribution of
Stock and/or cash in respect of Performance Shares which have vested but with
respect to which a distribution or payment had not previously been made with
respect thereto, by allocating such vested, but unpaid, Performance Shares to
the remaining uncompleted Performance Cycles covered by such Participant's award
in such amounts as it determines, but in no event shall such Participant receive
allocations more favorable than the original allocations made in such
Participant's award.
(c) Election to Receive Stock or Cash. Subject to any deferral election
made pursuant to the terms and conditions of an agreement evidencing an award
hereunder, and the Committee's absolute and sole discretion to satisfy the
Company's obligations hereunder by payment of cash as set forth below, at least
six (6) months prior to the date on which a Performance Cycle shall be completed
with respect to a Participant's award of Performance Shares, such Participant
may make an election to receive such Participant's distribution, if any,
following completion of such Performance Cycle, in shares of Stock and/or cash.
Such election shall be made in writing and shall be delivered to the Company's
Chief Financial Officer or General Counsel, or such other officer as the
Committee shall from time to time designate. Notwithstanding any cash election,
the Committee may in its sole and absolute discretion satisfy the Company's
obligations to any Participant by delivery of shares of Stock, subject to the
availability of such Stock under the Plan. If the Participant shall fail to make
a timely election, the Committee shall have the sole discretion to deliver
shares of Stock and/or pay cash to satisfy any such obligation.
In the event Participants elect to receive shares of Stock in satisfaction
of the Company's obligations under paragraph (b) of this Section 8 with respect
to the completion of a particular Performance Cycle, and the aggregate number of
shares of Stock subject to such elections, together with the number of shares
21
<PAGE>
of Stock subject to outstanding Stock Options and outstanding Restricted Stock
awards as of the date of completion of such Performance Cycle, exceeds the
maximum number of shares of Stock reserved and available for distribution under
the Plan, other than under Section 7, the Committee shall have the absolute and
sole discretion to satisfy such obligations by reducing the number of shares of
Stock subject to such elections to that number which, when added to the number
of outstanding Stock Options and Restricted Stock awards, equals the maximum
number of shares of Stock so reserved and available for distribution under the
Plan. In such event, the Committee shall reduce the number of shares of Stock
pursuant to each Participant's election pro rata, based upon the number of
shares of Stock otherwise issuable pursuant to such elections. The Company shall
satisfy the obligations to such Participants, which remain unsatisfied following
a distribution made pursuant to the foregoing reduction, by paying cash to such
Participants in accordance with the formula, and within the time period, set
forth in paragraph (b) of this Section 8.
(d) Dividend Reinvestment. At the time an award of Performance Shares is
granted, the Committee may, in its discretion, determine that, in the event cash
dividends are paid on the Stock during any Performance Cycle, there shall be an
increase in the number of Performance Shares subject to awards under this
Section 8. The aggregate number of additional Performance Shares issuable to a
Participant holding an outstanding Performance Shares award on the date of
payment of a cash dividend shall be determined in accordance with the following
formula:
(i x j) = l
-------
k
where: i = the number of Performance Shares allocated to all
Performance Cycles included in a Participant's award which
have not been completed or which have been completed but with
respect to which payments have not been made prior to the
payment date of the cash dividend;
j = the per share of Stock cash dividend paid;
k = the Fair Market Value of a share of Stock on the payment
date of the cash dividend; and
l = the aggregate number of additional Performance Shares
allocable among all Performance Cycles included in a
Participant's award which have not been completed or which
have been completed but with respect to which payments
22
<PAGE>
have not been made prior to the payment date of the cash
dividend.
The number of Performance Shares allocated to each Performance Cycle
included in a Participant's award which has not been completed or which has been
completed but has not been paid prior to the payment date of the cash dividend
shall be increased in relative proportion to the number of Performance Shares
allocated to all such Performance Cycles prior to such adjustment. Further, all
such additional Performance Shares shall immediately vest in the Participant.
(e) Change in Control. In the event of a Change in Control, all
Participants who then hold awards of Performance Shares will immediately become
fully vested with respect thereto ("Accelerated Shares"); provided that such
accelerated vesting shall not apply to Performance Shares awarded after January
1, 1996, if a Plan Continuation shall have occurred as provided below in this
paragraph (e) ("Non-Accelerated Shares"). In the event of a Change in Control, a
Participant shall be entitled to a cash payment, or payments, pursuant to
paragraph (b) of this Section 8 with respect to all Performance Cycles completed
on or prior to the date of the Change in Control as provided in said paragraph;
in addition, the Committee shall value all Accelerated Shares in respect of
Performance Cycles which shall not have been completed on or before the date of
the Change in Control based upon the formulae set forth in paragraph (b) of this
Section 8 except that b shall be equal to a percentage (the "Minimum
Percentage") equal to the greater of (i) the average of the percentages (which
may have been more than 100%), which represented the extent to which Performance
Objectives were achieved by the Company in all Performance Cycles completed on
or before the date of the Change in Control; and (ii) 50%; provided that, in the
case of Performance Shares awarded after January 1, 1996, b shall equal (i) for
all Performance Cycles that do not include at least one completed year at the
Operative Date (as defined below), 100%, and (ii) for all Performance Cycles
that include at least one completed year at the Operative Date, a percentage
(which may be more than 100%), which represents the extent to which the
Performance Objectives set forth in such award have been achieved by the Company
in the applicable Performance Cycle assuming that the Company achieved 100% of
its Performance Objectives for each year not completed at the Operative Date.
For purposes of the foregoing, the "Operative Date" shall mean the date of the
Change in Control. On the date one year after the Change in Control (the
"One-Year Period"), the Company shall pay a Participant the cash to which such
Participant is entitled with respect to the Performance Shares whose vesting has
been accelerated based on the Change in Control unless, prior thereto, such
Participant's employment shall have been terminated by the Company for Cause or
such Participant shall have voluntarily terminated his/her employment without
Good Reason (defined below), in either of which
23
<PAGE>
events such Participant shall forfeit all rights to such Performance Shares
whose vesting has been accelerated based upon the Change in Control and which
would not otherwise have vested and all rights to payment attributable to
application of the Minimum Percentage and any distribution of Stock and/or cash
with respect thereto. In the case of any Performance Cycle completed during the
One-Year Period, payment of any amount due shall be made in accordance with
Section 8(b), provided that any incremental payment due pursuant to the
foregoing provisions of this Section 8(e) by reason of application of the
Minimum Percentage shall be payable at the end of the One-Year Period unless
forfeited.
In the event of a Change in Control, the Board of Directors may elect by
resolution prior to the Change in Control to continue the Plan (a "Plan
Continuation"), in which event all Non-Accelerated Shares shall vest and be
payable as if no Change in Control had occurred except as otherwise provided in
the next two succeeding sentences. Following a Plan Continuation, if a
Participant's employment shall be terminated by the Company without Cause or
such Participant shall voluntarily terminate his/her employment for Good Reason,
in either case prior to the completion of any Performance Cycle in respect of
any Non-Accelerated Shares, then (i) all Non-Accelerated Shares outstanding at
the date of the Change in Control and having Performance Cycles which shall not
have been completed prior to the date of termination of employment shall be
deemed to be Accelerated Shares ("Re-Accelerated Shares") for purposes of this
paragraph (e) and (ii) payment in respect of such Re-Accelerated Shares shall be
made as provided in this paragraph (e) for Accelerated Shares (except that the
"Operative Date" shall mean the date of termination of employment) and shall be
paid immediately if the One-Year Period shall have elapsed. In the event of a
Plan Continuation, the Committee shall make such adjustments, if any, to the
Performance Objectives and/or the method of calculating the Performance
Objectives as it shall deem necessary or appropriate to preserve the value of
the Non-Accelerated Shares consistent with the intent and the purpose of the
Plan.
For the purposes of this Section 8(e) "Good Reason" shall mean, in the
context of a voluntary termination by a Participant of his employment with the
Company, such termination within 90 days after the occurrence of any one of the
following events without the Participant's express written consent:
(i) the assignment to such Participant of any duties inconsistent
with the Participant's position, duties, responsibilities, and status with
the Company (or a Subsidiary) immediately prior to a Change in Control, or
a substantive change in the Participant's titles or offices as in effect
immediately prior to a Change in Control, or any removal of the
Participant from or any failure to reelect the Participant to such
positions, except in connection with the termination of the Participant's
24
<PAGE>
employment by the Company (or a Subsidiary) for Cause of by the
Participant other than for Good Reason; or
(ii) if the Participant's total cash compensation opportunities,
including salary and incentives, for any fiscal year are less than the
total cash compensation opportunities made available to the Participant in
the completed fiscal year immediately preceding the Change in Control;
(iii) the failure of the Company (or a Subsidiary) to continue in
effect any benefits or perquisites, or any pension, life insurance,
medical insurance or disability plan in which the Participant was
participating immediately prior to a Change in Control unless the Company
(or a Subsidiary) provides the Participant with a plan or plans that
provide substantially similar benefits, or the taking of any action by the
Company (or a Subsidiary) that would adversely affect the Participant's
benefits under any of such plans or deprive the Participant of any
material fringe benefit enjoyed by the Participant immediately prior to a
Change in Control; or
(iv) any relocation of the Participant from the city where the
Participant was located at the time of the Change in Control; or
(v) following a Change in Control, Financial Security Assurance Inc.
ceases to be a Subsidiary, or the Company sells or otherwise disposes of,
in one transaction or a series of related transactions, assets or earning
power aggregating more than 30% of the assets (taken at asset value as
stated on the books of the Company determined in accordance with generally
accepted accounting principles consistently applied) or earning power of
the Company (on an individual basis) of the Company and its Subsidiaries
(on a consolidated basis) to any other person or persons; or
(vi) following a Change in Control, if the Participant is employed
by a Subsidiary of the Company, such Subsidiary either ceases to be a
Subsidiary of the Company or sells or otherwise disposes of, in one
transaction or a series of related transactions, assets or earning power
aggregating more than 30% of the assets (taken at asset value as stated on
the books of the subsidiary determined in accordance with generally
accepted accounting principles consistently applied) or earning power of
such subsidiary (on an individual basis) or such Subsidiary and its
Subsidiaries (on a consolidated basis) to any other person or persons.
(f) Holders of Performance Shares Not To Be Treated As Stockholders.
Neither any Participant awarded Performance Shares hereunder, nor any person
entitled to exercise a Participant's rights thereto in the event of death,
25
<PAGE>
shall have any rights of a stockholder with respect to any share of Stock
subject to such Participant's award of Performance Shares, except to the extent
that a certificate for such shares shall have been issued as provided for
herein.
(g) Non-Transferability of Performance Shares. No Performance Share shall
be transferrable by a Participant, or otherwise subject to voluntary or
involuntary sale, pledge, anticipation, alienation, encumbrance, assignment,
garnishment or attachment, other than by will or by the laws of descent and
distribution.
(h) Funding. Prior to the award of any Performance Shares, the Committee
shall establish a funding vehicle, which may or may not be the Fund referred to
in Section 7 hereof, to assist the Company with its obligations under this
Section 8. The Committee may provide that credits and allocations otherwise
provided for by this Section 8 shall be adjusted to take into account the amount
and timing of purchases and sales of, and dividends with respect to, Stock under
such fund; the manner in which such fund otherwise operates; the amount of Stock
in such fund from time to time; and such other factors as the Committee may deem
relevant; provided that the limitation in Section 3 hereof may not be adjusted
under this sentence. Any fund shall be designed not to cause the plan to be
considered to be funded for tax purposes or for purposes of Title I of the
Employee Retirement Income Security Act of 1974, as amended.
Section 9. Transfer, Leave of Absence, etc.
For purposes of the Plan, the following events shall not be deemed a
termination of employment:
a. a transfer of an employee from the Company to a Subsidiary, or from a
Subsidiary to the Company, or from one Subsidiary to another; or
b. a leave of absence, approved in writing by the Committee, for military
service or sickness, or for any other purpose approved by the Company if the
period of such leave does not exceed ninety (90) days (or such longer period as
the Committee may approve, in its sole discretion).
Section 10. Amendments and Termination
The Board may amend, alter, or discontinue the Plan (or any portion
thereof), but no amendment, alteration or discontinuation shall be made which
would impair the rights of an optionee or recipient with respect to any Stock
Option, Restricted Stock award, Equity Bonus or Performance Shares
26
<PAGE>
theretofore granted, without the optionee's or recipient's consent; provided
that the Board may not make any amendment in the Plan that would, if such
amendment were not approved by the holders of the Stock, cause the Plan to fail
to comply with (a) Section 16 of the Act (or Rule 16b-3 under the Act), or (b)
any other requirement of applicable law or regulation, unless and until the
approval of the holders of such Stock is obtained.
The Committee may amend the terms of any award or option theretofore
granted, prospectively or retroactively, but no such amendment shall impair the
rights of any holder without his consent.
Section 11. General Provisions
a. The Committee may require each person purchasing shares pursuant to a
Stock Option under the Plan to represent to and agree with the Company in
writing that the optionee is acquiring the shares without a view toward
distribution thereof. The certificates for such shares may include any legend
which the Committee deems appropriate to reflect any restrictions on transfer.
All certificates for shares of Stock delivered under the Plan pursuant to any
Restricted Stock or Performance Shares awards shall be subject to such
stock-transfer orders and other restrictions as the Committee may deem advisable
under the rules, regulations, and other requirements of the Securities and
Exchange Commission, any stock exchange upon which the Stock is then listed, and
any applicable Federal or state securities law, and the Committee may cause a
legend or legends to be put on any such certificates to make appropriate
reference to such restrictions. The foregoing provisions of this paragraph shall
not be effective if and to the extent that the shares of Stock delivered under
the Plan are covered by an effective and current registration statement under
the Securities Act of 1933, as amended, such that application of such provisions
is no longer required, or if and so long as the Committee otherwise determines
that such application is no longer required.
b. Subject to paragraph (d) below, recipients of Restricted Stock or Stock
in respect of Equity Bonuses or Performance Shares under the Plan are not
required to make any payment or provide consideration other than the rendering
of past services and/or the commitment to render and rendering of future
services.
c. Nothing contained in the Plan shall prevent the Board of Directors from
adopting other or additional compensation arrangements, subject to stockholder
approval if such approval is required; and such arrangements may be either
generally applicable or applicable only in specific cases. The adoption of the
Plan shall not confer upon any employee of the Company or any Subsidiary any
right to continued employment with the Company, nor shall it
27
<PAGE>
interfere in any way with the right of the Company to terminate the employment
of any of its employees at any time.
d. Each Participant shall, no later than the date as of which the value of
an award first becomes includible in the gross income of the Participant for
Federal income tax purposes, pay to the Company or make arrangements
satisfactory to the Committee regarding payment of any Federal, state or local
taxes of any kind required by law to be withheld with respect to the award;
provided, however, that such tax withholding requirement may be met by the
withholding of shares of Stock otherwise deliverable to the Participant,
pursuant to procedures approved by the Committee. The obligations of the Company
under the Plan shall be conditional on such payment or arrangements and the
Company shall, to the extent permitted by law, have the right to deduct any such
taxes from any payment of any kind otherwise due to the Participant. The
Committee, in its discretion (and giving consideration to, without limitation,
Section 16 of the Act), may permit an optionee hereunder to satisfy the
withholding obligation, in whole or in part, by irrevocably electing to have the
Company withhold shares of Stock, otherwise to be obtained upon the exercise of
a Stock Option, having a Fair Market Value equal to the amount required to be
withheld.
e. At the time of grant, the Committee may provide in connection with any
grant made under the Plan that the shares of Stock received as a result of such
grant shall be subject to a right of first refusal, pursuant to which the
Participant shall be required to offer to the Company any shares that the
Participant wishes to sell, with the price being the then Fair Market Value of
the Stock, subject to such other terms and conditions as the Committee may
specify at the time of grant.
f. Notwithstanding any other provision of the Plan, if the Committee
determines that an individual entitled to take action or receive payments
hereunder is an infant or incompetent by reason of physical or mental
disability, it may permit such action to be made by or cause such payments to be
made to a legal guardian, custodian or comparable party, without any further
responsibility with respect thereto under the Plan.
Section 12. Effective Date of Plan
The Plan shall be effective on the date it is approved by a vote of the
holders of a majority of the total outstanding Stock. The Plan shall not become
effective unless it is so approved.
28
<PAGE>
Section 13. Term of Plan
No Stock Option, Restricted Stock award, Performance Shares award or
Equity Bonus shall be granted pursuant to the Plan on or after the tenth
anniversary of the date of stockholder approval, but awards theretofore granted
may extend beyond that date.
29
Exhibit 13
[Page 16 of the 1997 Annual Report to Shareholders]
Selected Financial Data
<TABLE>
<CAPTION>
Dollars in millions, except per
share data 1997 1996 1995 1994 1993
<S> <C> <C> <C> <C> <C>
Summary of Operations (a)
Gross premiums written $ 236.4 $ 177.0 $ 110.7 $ 106.4 $ 127.4
Net premiums written 172.9 121.0 77.6 77.8 65.0
Net premiums earned 109.5 90.4 69.3 65.8 63.4
Net investment income 72.1 65.1 49.0 46.6 47.9
Net income (loss) 100.5 80.8 (b)55.0 60.4 (c)(124.7)
Balance Sheet Data (a)
Total investments 1,431.6 1,154.4 1,110.7 747.2 786.7
Total assets 1,900.6 1,537.7 1,490.3 1,074.3 1,031.0
Deferred premium revenue, net 422.1 360.0 330.3 212.9 200.3
Loss and loss adjustment expense
reserve, net 44.8 42.2 50.2 35.6 36.0
Notes payable 130.0 30.0 30.0 -- --
Preferred stock 0.7 0.7 0.7 0.7 --
Common stockholders' equity 881.7 800.6 777.2 544.7 542.0
Per Common Share Data (a)
Earnings (loss) per share (e) 3.25 2.61 2.13 2.32 (5.44)
Book value per share 30.66 26.71 24.67 20.92 20.95
Dividends paid 0.41 0.35 0.32 0.16 (d) --
Additional Data
Qualified statutory capital 781.7 675.9 644.7 465.8 454.0
Total claims-paying resources (f) 1,696.1 1,372.3 1,157.1 821.8 768.1
Net par outstanding 75,478.0 59,194.0 45,979.0 28,223.0 24,659.0
Net insurance in force
(principal + interest) 117,430.0 93,704.0 75,360.0 45,825.0 41,667.0
Policyholders' leverage
(risk-to-capital ratio) 150:1 139:1 117:1 98:1 92:1
</TABLE>
(a) Prepared according to generally accepted accounting principles (GAAP).
(b) Includes the effect of a one-time general reserve charge of $15.4 million
($10.0 million after taxes) related to the Merger.
(c) Includes restructuring charge, goodwill and other non-recurring charges
totaling $193.8 million after tax, as discussed in prior Annual Reports.
(d) Dividends prior to 1994 are not comparable because the Company was not
publicly held.
(e) Represents diluted earnings per share.
(f) Statutory capital + statutory unearned premium reserve + present value of
future net installment premiums + statutory loss reserve + standby line of
credit facility.
<PAGE>
[Pages 18 through 24 of 1997 Annual Report to Shareholders]
Management's Discussion and Analysis
of Financial Condition and Results of Operations
Year Ended December 31, 1997 versus Year Ended December 31, 1996
Adjusted book value per common share of Financial Security Assurance
Holdings Ltd. (the Company) was $40.10 at December 31, 1997, up 17.4% including
dividends since year-end 1996. Excluding realized and unrealized capital gains
and losses, adjusted book value per share rose 15.0% including dividends.
Adjusted book value per common share is used by management and some equity
analysts as a proxy for the Company's intrinsic value, exclusive of franchise
value. It is defined as book value plus net deferred premium revenue plus the
present value of future net installment premiums less deferred acquisition costs
less tax effect. Adjusted book value is not a substitute for GAAP book value.
The Company discusses its financial results by breaking out various levels
of its income statement in order to present a better analysis of underlying
trends. Core net income represents net income before the after-tax effects of
refundings and prepayments, net realized capital gains and losses, the cost of
the performance share program and other non-recurring adjustments. Core net
income therefore represents the Company's normal operating results. Operating
net income is core net income plus the after-tax effect of refundings and
prepayments. This distinction between core and operating net income is important
because higher-than-normal volumes of refundings and prepayments
disproportionately increase earned premiums and could suggest a stronger
earnings trend than the pace of originations would warrant. Net income, as
reported, is operating net income plus the after-tax effects of capital gains
and losses, the cost of the performance share program and other non-recurring
adjustments, if any.
The Company now reports core, operating and reported net income per share
results in accordance with the new accounting standard SFAS No. 128. 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. Unless otherwise indicated, all earnings per
share results are diluted, and results reported in prior periods have been
restated accordingly.
The Company's 1997 net income was $100.5 million ($3.25 per share),
compared with $80.8 million ($2.61 per share) for 1996, an increase of 24.4%.
Core net income was $90.7 million ($2.93 per share) for 1997, compared with
$78.4 million ($2.54 per share) for 1996, an increase of 15.7%. Total core
revenues increased in 1997 by $26.1 million, from $145.5 million for 1996 to
$171.6 million for 1997, while total core expenses increased only $8.8 million.
Operating net income was $95.9 million ($3.10 per share) for 1997 versus $82.2
million ($2.66 per share) for 1996, an increase of $13.7 million or 16.7%.
There are two measures of gross premiums originated for a given period.
Gross premiums written captures premiums collected in the period, whether
collected up front for business originated in the period, or in installments for
business originated in prior periods. An alternative measure, the gross present
value of premiums written (gross PV premiums written) reflects future
installment premiums discounted to their present value, as well as upfront
premiums, but only for business originated in the period. The Company considers
gross PV premiums written to be the better indicator of a given period's
origination activity because a substantial part of the Company's premiums is
collected in installments, a practice typical of the asset-backed business. To
calculate PV premiums, management estimates the life of each transaction that
has installment premiums and
<PAGE>
discounts the future installment premium payments at an annual rate of 9.5%, a
rate the Company has used consistently since it began calculating PV premiums.
The markets in which Financial Security Assurance Inc. (FSA) participates
expanded during 1997, and FSA's own production was well balanced across those
markets. Gross premiums written increased 33.6% to $236.4 million for 1997 from
$177.0 million for 1996. Gross PV premiums written increased 10.6% to $250.3
million for 1997 from $226.3 million for 1996. In 1997, asset-backed gross PV
premiums written were $111.0 million, compared with $125.8 million in 1996, a
decrease of 11.8%. This decrease was attributable to several large, high-premium
transactions executed in the pooled corporate obligations sector in 1996. Volume
from FSA-insured consumer and residential mortgage securitization programs
remained strong during 1997, although FSA avoided certain residential mortgage
sectors where returns or credit characteristics were unattractive. In addition,
FSA guaranteed a number of profitable pooled corporate transactions in such
areas as collateralized bond obligations, collateralized loan obligations and
trade receivables. For the municipal business, gross PV premiums written
increased to $139.3 million for 1997 from $100.5 million for 1996, an increase
of 38.6% due to higher volume in the municipal new-issue market, increased
market penetration by bond insurance, and greater market share for FSA aided by
strong trading value for FSA-insured bonds.
In 1997, the Company insured par value of bonds totaling $37.1 billion, a
19.3% increase over par insured in 1996. FSA's asset-backed component increased
3.0% to $19.5 billion while its municipal sector increased 44.5% to $17.6
billion.
Net premiums written were $172.9 million during 1997, an increase of 42.9%
when compared with the 1996 result. Net premiums written grew at a faster pace
than gross premiums written due to the Company's efforts to reduce its
reinsurance selectively, ceding 26.9% of its 1997 gross premiums written,
compared with 31.6% in 1996. Net premiums earned in 1997 were $109.5 million,
compared with $90.4 million in 1996, an increase of 21.1%. Premiums earned from
refundings and prepayments were $11.3 million for 1997 and $10.3 million for
1996, contributing $5.2 million and $3.8 million, respectively, to after-tax
earnings. Before the effects of refundings and prepayments, net premiums earned
grew 22.5% over the comparable 1996 result. No assurance can be given that
refundings and prepayments will continue at the level experienced in 1997 or
1996.
Net investment income was $72.1 million for 1997 and $65.1 million for
1996, an increase of 10.8%. This increase was due primarily to higher invested
balances as a result of new business writings and proceeds from debt issued in
the fourth quarter. The Company's effective tax rate on investment income was
19.9% for 1997, compared with 20.0% for 1996. In 1997, the Company realized
$11.5 million in net capital gains, compared with $3.2 million in 1996. Capital
gains and losses are a by-product of the normal investment management process
and will vary substantially from period to period.
Other income was $9.3 million for 1997, compared with $0.3 million for
1996. This increase was due to the sales of two insurance subsidiaries, which
realized the value of their redundant insurance licenses. All of the
subsidiaries' insurance policy obligations were assumed by FSA.
Interest expense in 1997 was $4.4 million, an increase of $2.2 million
when compared with the 1996 result. The increase was due to the Company's
increase in debt outstanding. For further discussion, see Liquidity and Capital
Resources below.
The provision for losses and loss adjustment expenses in 1997 was $9.2
million, compared with $6.9 million in 1996, representing additions to the
Company's general loss reserve. During 1997, the Company transferred $4.5
million from its general reserve to case basis reserves associated predominantly
with certain residential mortgage transactions. The additions to the general
reserve represent management's estimate of the amount required to cover the net
cost of claims adequately. The Company will, on an ongoing basis, monitor these
reserves and may periodically adjust such reserves based on
<PAGE>
the Company's actual loss experience, its future mix of business, and future
economic conditions. At December 31, 1997, the Company's general loss reserve
was $34.3 million.
Total policy acquisition and other operating expenses (excluding the cost
of the performance share program, which was $11.5 million for 1997 and $5.3
million for 1996, and interest expense) were $38.0 million in 1997, compared
with $34.8 million in 1996, an increase of 9.0%. Further excluding the effect of
refundings, total policy acquisition and other operating expenses were $34.7
million in 1997, compared with $30.4 million in 1996, an increase of 14.1%. The
increase resulted from greater amortization of deferred acquisition costs due to
a higher level of core premiums earned, along with higher personnel costs and
bank facility fees.
Income before income taxes for 1997 was $138.5 million, up 26.2% from
$109.8 million for 1996.
The Company's effective tax rate for 1997 was 27.4%, compared with 26.4%
for 1996.
The weighted average number of diluted shares of common stock outstanding
increased to 30,913,000 for 1997 from 30,895,000 for 1996. This increase was
primarily due to an increase in the dilutive effect of the Company's convertible
preferred stock, partially offset by shares repurchased by the Company to fund
obligations under employee benefit plans and to close out a portion of its
forward purchase arrangement.
The Company has assessed its internal operating systems and software for
Year 2000 compliance. Management does not expect that the arrival of the Year
2000 will require any material upgrade to its internal systems or software. The
Company is currently assessing the impact on the Company of Year 2000 readiness
of trustees, servicers, issuers and other parties in FSA-insured transactions.
Because this assessment is ongoing, the potential impact on the Company, and
related costs to the Company, are not known at this time.
Year Ended December 31, 1996 versus Year Ended December 31, 1995
The Company's 1996 results were positively affected by the Merger on
December 20, 1995 of Capital Guaranty Corporation with a subsidiary of the
Company. Capital Guaranty Corporation's operating subsidiary, Capital Guaranty
Insurance Company (CGIC), became a subsidiary of FSA and changed its name to
Financial Security Assurance of Maryland Inc. The Merger provided for each
Capital Guaranty Corporation 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 aggregate cash of $51.3 million. The transaction
value of the Merger, including transaction costs, was $208.6 million. The Merger
was accounted for on a purchase accounting basis. In view of the short period
between the date of the Merger and year-end 1995, 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 1995 results of operations, except
for the recording of a $15.4 million general loss reserve provision discussed
below.
The Company's adjusted book value per common share at December 31, 1996
was $34.53, up 12.0%, including dividends, since year-end 1995. Excluding
realized and unrealized capital gains and losses, adjusted book value per share
rose 12.9% including dividends.
Core and operating results have been adjusted to exclude expenses related
to the performance share program. Core, operating and reported net income per
share have been restated in accordance with SFAS No. 128. The Company's net
income for 1996 was $80.8 million, compared with $55.0 million for 1995, an
increase of 46.7%. The increase was primarily attributable to higher core net
income due to the Merger and lower provisions to the Company's general reserve
for losses, partially offset by lower refundings and prepayments and lower
capital gains. Earnings per share increased to $2.61 for 1996 from $2.13 for
1995.
<PAGE>
Operating net income was $82.2 million ($2.66 per share) for 1996 versus
$61.4 million ($2.37 per share) for 1995, an increase of 33.7%. Core net income
was $78.4 million ($2.54 per share) for 1996 versus $54.8 million ($2.12 per
share) for 1995, an increase of 43.0%.
In a favorable operating environment, in which all of FSA's markets grew
in size, FSA's overall insurance originations reached record levels in 1996.
Gross PV premiums written increased 62.6% to $226.3 million from $139.1 million
for 1995. The $125.8 million of asset-backed gross PV premiums written in 1996
was 70.4% higher than the $73.9 million written in 1995. Asset-backed production
increased due to strong volume from FSA-insured securitization programs, as well
as the execution of several large, high-premium transactions in the pooled
corporate obligations sector. Asset-backed volume reached these levels even
though FSA exercised restraint in certain highly competitive asset sectors,
particularly the home equity loan sector, in order to maintain credit quality
and acceptable returns on capital. For the municipal business, gross PV premiums
increased 53.9% to $100.5 million in 1996 from $65.3 million in 1995, due to the
Merger and increased demand for FSA-insured bonds.
Gross premiums written increased 59.8% to $177.0 million for 1996 from
$110.7 million for 1995.
In 1996, the Company insured bonds totaling $31.1 billion, a 104.2%
increase over the amount insured in 1995. Compared with the combined FSA and
CGIC production in 1995, the increase would have been 68.8%. FSA's 1996
asset-backed par insured rose 91.9% to $18.9 billion while its municipal par
insured rose 126.9% to $12.2 billion. Although par originated grew faster than
PV premiums originated, average returns on equity exceeded the Company's target
rate in both the municipal and asset-backed markets. The Company calculates a
return on equity for each transaction based on a risk-weighted allocation of
capital.
Net premiums written were $121.0 million for 1996, an increase of 56.0%
when compared with 1995. The increase in net premiums written was less than that
of gross premiums written because the Company ceded increased amounts on a
facultative basis for the asset-backed business in 1996 in order to maintain the
diversity of risk in the Company's insured portfolio. This level of reinsurance
may not continue at the same rate.
Net premiums earned for 1996 were $90.4 million, compared with $69.3
million for 1995, an increase of 30.4%. Net premiums earned from refundings and
prepayments were $10.3 million for 1996 and $13.8 million for 1995, contributing
$3.8 million and $6.6 million to after-tax earnings. Core net premiums earned,
which exclude the effects of refundings and prepayments, grew 44.3% (21.4%
compared with the combined FSA and CGIC 1995 results). No assurance can be given
that refundings and prepayments will continue at the level experienced in 1996
or 1995.
Net investment income was $65.1 million for 1996 and $49.0 million for
1995, an increase of 32.9%. The increase in investment income is primarily due
to additional invested assets acquired in the Merger. The Company's effective
tax rate on investment income decreased to 20.0% for 1996 from 21.9% for 1995,
as the holdings of tax-exempt securities increased. The Company realized $3.2
million of net capital gains for 1996, compared with realized net capital gains
of $5.1 million for 1995. The net gain on the sale of a subsidiary of $2.2
million for 1995 is included in other income.
The provisions for core losses and loss adjustment expenses for 1996 were
$6.9 million, compared with $6.3 million for 1995, representing additions to the
Company's general loss reserve. During 1996, the Company reclassified $9.0
million from its general reserve to case basis reserves. These case basis
reserves were associated predominantly with certain residential mortgage
transactions. Giving effect to all the 1996 events, the general reserve totaled
$29.7 million at December 31, 1996. In 1995, the Company also recognized a
one-time charge of $15.4 million to increase its general reserve to provide for
the CGIC portfolio in a manner consistent with FSA's general reserving
methodology.
<PAGE>
Total policy acquisition and other operating expenses (excluding the cost
of the performance share program, which was $5.3 million for 1996 and $1.8
million for 1995, and interest expense) were $34.8 million for 1996, compared
with $28.8 million for 1995, an increase of 21.0%. Further eliminating the
effect of refundings and prepayments, policy acquisition and other operating
expenses would have increased 20.6%. The increase was primarily the result of
higher deferred acquisition cost amortization, due to a higher level of premiums
earned.
Income before income taxes for 1996 was $109.8 million, up from $75.0
million, or 46.3%, for 1995.
The Company's effective tax rate for 1996 was 26.4%, compared with 26.7%
for 1995.
The weighted average number of diluted shares of common stock outstanding
increased to 30,895,000 for 1996 from 25,899,000 for 1995. This increase was due
to the issuance of new shares in the Merger, partially offset by a repurchase of
shares.
Liquidity and Capital Resources
The Company's consolidated invested assets and cash equivalents at
December 31, 1997, net of unsettled security transactions, were $1,379.3
million, compared with the December 31, 1996 balance of $1,140.0 million. These
balances include the change in the market value of the investment portfolio,
which had an unrealized gain position of $38.8 million at December 31, 1997,
compared with an unrealized gain position of $14.0 million at December 31, 1996.
At December 31, 1997, the Company had, at the holding company level, an
investment portfolio of $65.0 million available to fund the liquidity needs of
its activities outside of its insurance operations. Because the majority of the
Company's operations are conducted through FSA, the long-term ability of the
Company to service its debt and to declare and pay dividends will largely depend
upon the receipt of dividends from FSA and upon external financings.
FSA's ability to pay dividends is dependent upon FSA's financial
condition, results of operations, cash requirements, rating agency approval 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 New
York State 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 (i) 10% of
policyholders' surplus as of its last statement filed with the New York
Superintendent of Insurance or (ii) adjusted net investment income during this
period. FSA paid no dividends in 1997. Based upon FSA's statutory statements for
the quarter ended December 31, 1997, and considering dividends that can be paid
by its subsidiary, the maximum amount available for payment of dividends by FSA
without regulatory approval over the following 12 months is approximately $49.8
million. The New York Superintendent has approved the repurchase by FSA of up to
$75.0 million of its shares from its parent, pursuant to which FSA has
repurchased $66.5 million of its shares through December 31, 1997, including
$39.5 million during 1997.
Dividends paid by the Company to its shareholders increased to $12.1
million in 1997 from $10.5 million in 1996 and to $0.405 per common share in
1997 from $0.35 in 1996. In addition to paying dividends, the Company uses funds
to make debt service payments and to repurchase shares of the Company's common
stock to fund employee benefit plans. During 1997, the Company purchased $5.4
million of its stock for employee benefit plans.
During the third quarter of 1997, the Company issued $130.0 million of 7
3/8% Senior Quarterly Income Debt Securities due September 30, 2097 and callable
on or after September 18, 2002. The Company used the proceeds to repay
outstanding debt of $30.0 million assumed in connection with the Merger, to
augment the capital in its insurance
<PAGE>
company subsidiaries, to repurchase shares under forward purchase agreements and
for general corporate purposes.
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. 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 $2.1 million 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 exercised rights under the forward agreements, purchasing
1,187,800 Forward Shares for a total cost of $33.9 million. At December 31,
1997, as a result of the Company's exercise, the repurchased shares were held as
treasury stock, and the remaining 562,200 Forward Shares were allocated to the
subscription program.
FSA's primary uses of funds are to pay operating expenses, to pay
dividends to its parent and to repurchase stock from its parent. FSA's funds are
also required to satisfy future claims, if any, under insurance policies in the
event of default by an issuer of an insured obligation and the unavailability or
exhaustion of other liquidity 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 through inclusion of such other
liquidity sources in transactions. The insurance policies issued by FSA 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. These policy provisions prohibiting
acceleration of certain claims are mandatory under Article 69 of the New York
Insurance Law and serve to reduce FSA's liquidity requirements.
The Company believes that FSA's expected operating liquidity needs, both
on a short-and long-term basis, can be funded from its operating cash flow. In
addition, FSA has a number of sources of liquidity that are available to pay
claims on a short- and long-term basis: cash flow from written premiums, FSA's
investment portfolio and earnings thereon, reinsurance arrangements with
third-party reinsurers, liquidity lines of credit with banks, and capital market
transactions.
A group of international Aaa/AAA-rated banks make available to FSA a
standby irrevocable limited recourse line of credit, which was increased from
$125.0 million to $240.0 million during 1997. This credit facility provides
liquidity and credit support to FSA in the event losses from municipal
obligations in FSA's insured portfolio exceed specified limits. Repayment of
amounts drawn under the line will be limited primarily to recoveries of losses
related to such municipal obligations. The facility expires on April 30, 2004
unless extended.
The Company has a credit arrangement aggregating $150.0 million at
December 31, 1997, which is provided by commercial banks and intended for
general application to transactions insured by FSA. At December 31, 1997, there
were no borrowings under this arrangement, which expires on November 23, 1999.
In addition, there are credit
<PAGE>
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
$186.9 million, of which $100.9 million was unutilized at December 31, 1997.
The Company has no material plans for capital expenditures within the next
twelve months.
<PAGE>
[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.
New York, New York
January 26, 1998
<PAGE>
[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)
<TABLE>
<CAPTION>
December 31, December 31,
ASSETS 1997 1996
------------ ------------
<S> <C> <C>
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
=========== ===========
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
2
<PAGE>
[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)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
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
========= ========= =========
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
3
<PAGE>
[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)
<TABLE>
<CAPTION>
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
----- ----- --------- ------ ---------- -------- ------------ ----- -----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
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
======== ======== ======== ======== ======== ======== ======== ======== ========
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
4
<PAGE>
[Page 29 of 1997 Annual Report to Shareholders]
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
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
=========== =========== ===========
</TABLE>
Continued
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
5
<PAGE>
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(Dollars in thousands)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
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
=========== =========== ===========
</TABLE>
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
<PAGE>
[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
<PAGE>
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
<PAGE>
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
<PAGE>
The amortized cost and estimated market value of bonds were as follows (in
thousands):
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Estimated
December 31, 1997 Cost Gains Losses Market Value
- ----------------- ---- ----- ------ ------------
<S> <C> <C> <C> <C>
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
========== ========== ========== ==========
</TABLE>
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
<PAGE>
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.
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
----------------- -----------------
Estimated Estimated
Amortized Market Amortized Market
Cost Value Cost Value
---- ----- ---- -----
<S> <C> <C> <C> <C>
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
========== ========== ========== ==========
</TABLE>
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
<PAGE>
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):
<TABLE>
<CAPTION>
Net Income: 1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
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
========= ========= =========
</TABLE>
12
<PAGE>
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
<PAGE>
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
<PAGE>
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
<PAGE>
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:
<TABLE>
<CAPTION>
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
------- -------- -------- -------- ------- ----------
<S> <C> <C> <C> <C> <C> <C>
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
</TABLE>
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
<PAGE>
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
<PAGE>
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):
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
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
<CAPTION>
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
</TABLE>
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:
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
----------------- -----------------
Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal
- ----------------- ------------ --------- ------------ ---------
<S> <C> <C> <C> <C>
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
======= ======= ======= =======
</TABLE>
18
<PAGE>
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):
<TABLE>
<CAPTION>
Net of Amounts Ceded Ceded
December 31, December 31,
------------ ------------
Types of Issues 1997 1996 1997 1996
- --------------- ---- ---- ---- ----
<S> <C> <C> <C> <C>
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
======= ======= ======= =======
</TABLE>
19
<PAGE>
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.
20
<PAGE>
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.
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
----------------- -----------------
(In thousands) Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
------ ---------- ------ ----------
<S> <C> <C> <C> <C>
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
</TABLE>
21
<PAGE>
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):
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
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
========= ========= =========
</TABLE>
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.
22
<PAGE>
18. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
<TABLE>
<CAPTION>
(In thousands, except share data) First Second Third Fourth Full Year
----- ------ ----- ------ ---------
<S> <C> <C> <C> <C> <C>
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
</TABLE>
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.
23
<PAGE>
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
<PAGE>
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
<PAGE>
[Page 48 of the 1997 Annual Report to Shareholders]
Common Stock Data
<TABLE>
<CAPTION>
Market Price
------------------------------------------
Dividends per Share High Low Close
<S> <C> <C> <C> <C>
1997
Quarter ended March 31 $0.0950 $36.7500 $32.7500 $33.1250
Quarter ended June 30 $0.0950 39.2500 31.5000 38.9375
Quarter ended September 30 $0.1075 46.9375 38.7500 46.5000
Quarter ended December 31 $0.1075 48.6875 40.3125 48.2500
1996
Quarter ended March 31 $0.0800 26.7500 24.0000 25.3750
Quarter ended June 30 $0.0800 28.3750 25.3750 27.3750
Quarter ended September 30 $0.0950 30.0000 25.7500 29.5000
Quarter ended December 31 $0.0950 32.8750 27.6250 32.8750
</TABLE>
Exhibit 21
SUBSIDIARIES
OF
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
Financial Security Assurance Inc. (incorporated in the State of New York)
FSA Insurance Company (incorporated in the State of Oklahoma)
Financial Security of Oklahoma, Inc. (incorporated in the State of Oklahoma)
Financial Security Assurance (U.K.) Limited (incorporated in the United Kingdom)
FSA Portfolio Management Inc. (incorporated in the State of New York)
Transaction Services Corp. (incorporated in the State of New York)
Exhibit 23
CONSENT OF INDEPENDENT ACCOUNTANTS
To the Shareholders and Board of Directors
of Financial Security Assurance Holdings Ltd.:
We consent to the incorporation by reference in the Registration Statements, as
amended, of Financial Security Assurance Holdings Ltd. and Subsidiaries on Form
S-8 (File No. 33-78784)(1993 Equity Participation Plan), Form S-8 (File No.
33-92648)(Deferred Compensation Plan), Form S-3 (File No. 33-80769)(in
connection with USW DECS and Forward Shares), and Form S-3 (File No.
333-34181)(Debt Securities and Common Stock) of:
1. Our report dated January 24, 1997 on our audits of the consolidated
financial statements of Financial Security Assurance Holdings Ltd.
and Subsidiaries as of December 31, 1997 and 1996, and for each of
three years in the period ended December 31, 1997, which report is
incorporated by reference in this Annual Report on form 10-K for the
fiscal year ended December 31, 1997;
2. Our report dated January 24, 1997 on our audits of the financial
statement schedule of Financial Security Assurance Holdings Ltd. and
Subsidiaries, which report is included in this Annual Report on Form
10-K for the fiscal year ended December 31, 1997; and
3. Our report dated January 24, 1997 on our audits of the consolidated
financial statements of Financial Security Assurance Inc. and
Subsidiaries as of December 31, 1997 and 1996, and for each of the
three years in the period ended December 31, 1997, which report is
included in exhibit 99 to this Annual Report on Form 10-K for the
fiscal year ended December 31, 1997.
/s/ COOPERS & LYBRAND L.L.P.
----------------------------
COOPERS & LYBRAND L.L.P.
New York, New York
March 23, 1998
Exhibit 24
Annual Reports on Form 10-K of
Financial Security Assurance Holdings Ltd.
POWER-OF-ATTORNEY
The undersigned, as a Director of Financial Security Assurance Holdings Ltd., a
New York corporation (the "Company"), does hereby constitute and appoint each of
Robert P. Cochran, Roger K. Taylor and Bruce E. Stern to be his agent and
attorney-in-fact, with the power to act fully hereunder and with full power of
substitution to act in the name and on behalf of the undersigned, (i) to sign in
the name and on behalf of the undersigned, as Director of the Company, and file
with the Securities and Exchange Commission, an Annual Report on Form 10-K for
each fiscal year for which the Company is required to file such an Annual
Report, and any amendments or supplements thereto, and (ii) to execute and
deliver any instruments, certificates or other documents which he shall deem
necessary or proper in connection with the filing of each such Annual Report on
Form 10-K, and any such amendment or supplement thereto, and generally to act
for and in the name of the undersigned with respect to each such filing as fully
as could the undersigned if then personally present and acting. The foregoing
Power-of-Attorney shall be in full force and effect for so long as the
undersigned shall be a Director of the Company, unless and until revoked by
written instrument delivered to the General Counsel of the Company.
IN WITNESS WHEREOF, the undersigned has executed this Power-of-Attorney on the
date set forth below.
Dated: February 26, 1998 /s/ Richard A. Post
-------------------------
Richard A. Post
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
CONTENTS
Page
----
A. 1997 YEAR END FINANCIAL STATEMENTS
Report of Independent Accountants.................................. F-2
Consolidated Balance Sheets as of December 31, 1997 and 1996....... F-3
Consolidated Statements of Income for the Years Ended
December 31, 1997, 1996 and 1995................................. F-4
Consolidated Statements of Changes in Shareholder's Equity for
the Years Ended December 31, 1997, 1996 and 1995................. F-5
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1997, 1996 and 1995................................. F-6
Notes to Consolidated Financial Statements for the Years Ended
December 31, 1997, 1996 and 1995................................. F-7-F-26
The New York State Insurance Department recognizes only statutory
accounting practices for determining and reporting the financial condition and
results of operations of an insurance company, for determining its solvency
under the New York Insurance Law, and for determining whether its financial
condition warrants the payment of a dividend to its stockholders. No
consideration is given by the New York State Insurance Department to financial
statements prepared in accordance with generally accepted accounting principles
in making such determinations.
F-1
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholder and Board of Directors
of Financial Security Assurance Inc.:
We have audited the accompanying consolidated balance sheets of Financial
Security Assurance Inc. and Subsidiaries as of December 31, 1997 and 1996 and
the related consolidated statements of income, changes in shareholder's 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 Inc. 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.
New York, New York
January 26, 1998
F-2
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
December 31,
-----------------------
1997 1996
---------- ----------
ASSETS
<S> <C> <C>
Bonds at market value (amortized cost of $1,192,771 and
$1,054,678) ................................................. $1,235,441 $1,068,677
Equity investments at market value (cost of $20,405 and $1,000) 20,762 1,000
Short-term investments ........................................ 103,926 55,699
---------- ----------
Total investments ........................................... 1,360,129 1,125,376
Cash .......................................................... 11,235 7,517
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 ................................ 20,535
Other assets .................................................. 72,901 69,705
---------- ----------
TOTAL ASSETS .............................................. $1,839,639 $1,529,930
========== ==========
LIABILITIES AND SHAREHOLDER'S EQUITY
Deferred premium revenue ...................................... $ 595,196 $ 511,196
Losses and loss adjustment expenses ........................... 75,417 72,079
Deferred federal income taxes ................................. 59,867 41,682
Ceded reinsurance balances payable ............................ 11,199 12,599
Payable for securities purchased .............................. 72,979 14,142
Long-term debt ................................................ 50,000
Accrued expenses and other liabilities ........................ 77,121 62,900
---------- ----------
TOTAL LIABILITIES ......................................... 941,779 714,598
---------- ----------
COMMITMENTS AND CONTINGENCIES
Common stock (528 and 660 shares authorized, issued and
outstanding;
par value of $28,391 and $22,727 per share) ................... 15,000 15,000
Additional paid-in capital .................................... 617,870 654,470
Unrealized gain on investments (net of deferred income tax
provision of $15,059 and $4,899) ............................ 27,968 9,099
Accumulated earnings .......................................... 237,022 136,763
---------- ----------
TOTAL SHAREHOLDER'S EQUITY ................................ 897,860 815,332
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY ................ $1,839,639 $1,529,930
========== ==========
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
F-3
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------
1997 1996 1995
--------- --------- ---------
<S> <C> <C> <C>
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 ...................................... 69,643 62,728 47,083
Net realized gains ......................................... 6,023 1,851 5,032
Other income ............................................... 10,774 502 4,722
--------- --------- ---------
TOTAL REVENUES ....................................... 195,951 155,529 126,184
--------- --------- ---------
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 ................................... 20,717 14,852 12,352
--------- --------- ---------
TOTAL EXPENSES ....................................... 57,835 45,555 50,898
--------- --------- ---------
INCOME BEFORE INCOME TAXES ................................. 138,116 109,974 75,286
--------- --------- ---------
Provision (benefit) for income taxes:
Current .................................................... 29,832 28,208 23,353
Deferred ................................................... 8,025 911 (3,055)
--------- --------- ---------
Total provision ............................................ 37,857 29,119 20,298
--------- --------- ---------
NET INCOME ........................................... $ 100,259 $ 80,855 $ 54,988
--------- --------- ---------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
F-4
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER'S EQUITY
(Dollars in thousands)
<TABLE>
<CAPTION>
Additional Unrealized
Common Paid-In Gains on Retained
Stock Capital Investments Earnings Total
----- ------- ----------- -------- -----
<S> <C> <C> <C> <C> <C>
BALANCE, December 31, 1994 .......... $ 15,000 $ 497,506 $ (21,364) $ 37,834 $ 528,976
Net income .......................... 54,988 54,988
Dividends paid on common stock ...... (19,000) (19,000)
Net change in unrealized gain on
investments (net of deferred income
taxes of $22,108) ................. 41,058 41,058
Capital contribution of CGIC ........ 233,964 233,964
Stock repurchase .................... (50,000) (50,000)
--------- --------- --------- --------- ---------
BALANCE, December 31, 1995 .......... 15,000 681,470 19,694 73,822 789,986
Net income .......................... 80,855 80,855
Dividends paid on common stock ...... (18,000) (18,000)
Net change in unrealized loss on
investments (net of deferred income
tax benefit of $5,705) ............ (10,595) (10,595)
Stock repurchase .................... (27,000) (27,000)
Adjustment to prior-year disposal of
subsidiary ........................ 86 86
--------- --------- --------- --------- ---------
BALANCE, December 31, 1996 .......... 15,000 654,470 9,099 136,763 815,332
Net income .......................... 100,259 100,259
Net change in unrealized gain on
investments (net of deferred income
taxes of $10,160) ................. 18,869 18,869
Stock repurchase .................... (39,500) (39,500)
Deferred equity payout by Parent .... 2,900 2,900
--------- --------- --------- --------- ---------
BALANCE, December 31, 1997 .......... $ 15,000 $ 617,870 $ 27,968 $ 237,022 $ 897,860
========= ========= ========= ========= =========
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
F-5
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------------
1997 1996 1995
----------- ----------- -----------
<S> <C> <C> <C>
Cash flows from operating activities:
Premiums received, net ............................. $ 171,145 $ 124,540 $ 85,481
Policy acquisition and other operating
expenses paid, net ............................... (50,046) (49,261) (41,730)
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 ..................... 63,207 59,923 40,160
Federal income taxes paid .......................... (27,080) (33,297) (17,295)
Interest paid ...................................... (22) (38)
Other .............................................. 2,142 1,330 2,552
----------- ----------- -----------
Net cash provided by operating activities ...... 145,276 97,953 54,757
----------- ----------- -----------
Cash flows from investing activities:
Proceeds from sales of bonds ....................... 1,075,413 1,095,929 603,545
Proceeds from maturities of bonds .................. 32,468 2,965 606
Purchases of bonds ................................. (1,220,779) (1,139,129) (685,984)
Gain on sale of subidiaries ........................ 9,486
Purchases of property and equipment ................ (2,985) (2,081) (958)
Cash of contributed subsidiary ..................... 199
Net decrease (increase) in short-term investments .. (45,661) (3,675) 94,727
----------- ----------- -----------
Net cash provided by (used for) investing
activities ................................... (152,058) (45,991) 12,135
----------- ----------- -----------
Cash flows from financing activities:
Stock repurchase ................................... (39,500) (27,000) (50,000)
Surplus notes issued ............................... 50,000
Dividends paid ..................................... (18,000) (19,000)
----------- ----------- -----------
Net cash provided by (used for) financing activities 10,500 (45,000) (69,000)
----------- ----------- -----------
Net increase (decrease) in cash .................... 3,718 6,962 (2,108)
Cash at beginning of year .......................... 7,517 555 2,663
----------- ----------- -----------
Cash at end of year ................................ $ 11,235 $ 7,517 $ 555
=========== =========== ===========
Reconciliation of net income to net cash flows
from operating activities:
Net income ......................................... $ 100,259 $ 80,855 $ 54,988
Decrease (increase) in accrued investment income ... (1,811) (842) 14
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 .......................................... (519) (5,090) 6,057
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 ...... 11,296 911 (3,055)
Net realized gains on investments .................. (6,023) (1,851) (5,032)
Depreciation and accretion of bond discount ........ (1,736) (1,616) (5,564)
Gain on sale of subsidiaries ....................... (9,486)
Change in other assets and liabilities ............. 13,331 17,217 (5,104)
----------- ----------- -----------
Cash provided by operating activities .............. $ 145,276 $ 97,953 $ 54,757
=========== =========== ===========
</TABLE>
In addition to the cash received from the contribution of the subsidiary, the
Company also received net assets of $233,765.
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
F-6
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
1. ORGANIZATION AND OWNERSHIP
Financial Security Assurance Inc. (the Company), an indirect wholly owned
subsidiary of Financial Security Assurance Holdings Ltd. (the Parent), is an
insurance company domiciled in the State of New York. The Company is engaged in
providing financial guaranty insurance on asset-backed and municipal
obligations. The Company's underwriting policy is to insure asset-backed and
municipal obligations that it determines would be of investment-grade quality
without the benefit of the Company's insurance. The asset-backed obligations
insured by the Company are generally issued in structured transactions and are
backed by pools of assets such as residential mortgage loans, consumer or trade
receivables, securities or other assets having an ascertainable cash flow or
market value. The municipal obligations insured by the Company consist primarily
of general obligation bonds that are supported by the issuers' taxing power and
special revenue bonds and other special obligations of states and local
governments that are supported by the issuers' ability to impose and collect
fees and charges for public services or specific projects. Financial guaranty
insurance written by the Company guarantees 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 Parent merged (the Merger) with
Capital Guaranty Corporation (CGC). The Merger provided for each CGC share to be
exchanged for 0.6716 share of the Parent's common stock and cash of $5.69. The
Parent issued in the aggregate 6,051,661 common shares and paid aggregate cash
consideration of $51,300,000. In conjunction with the Merger, the Parent
contributed (the Contribution) the common stock of Capital Guaranty Insurance
Company (CGIC), a subsidiary of CGC, to the Company. As a result of the
Contribution, the Company's net assets increased by $233,964,000. Net premiums
written by CGIC in 1995 prior to the Contribution were $26,070,000. At December
31, 1995, the Parent 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 Parent 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 Parent 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.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying financial statements have been prepared in accordance
with generally accepted accounting principles (GAAP), which 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 GAAP requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities in the Company's consolidated
balance sheets at December 31, 1997 and 1996 and the reported amounts of
revenues and expenses in the consolidated statements of income during the years
ended December 31,
F-7
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
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:
Basis of Presentation
The consolidated financial statements include the accounts of the Company
and its direct and indirect wholly owned subsidiaries, 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 with the 1997 presentation. The Merger, and the related
Contribution to the Company, were 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 Contribution for accounting purposes is
considered to be December 31, 1995. As a result, the accounting for the
Contribution 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 the Company's general reserve to
provide for the insured portfolio assumed by the Company as a result of the
Contribution (see Note 16).
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 shareholder's 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 resultant 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. 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 stockholder's
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.
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 that portion of premium which is
applicable to coverage of risk to be provided in the future on policies in
force.
F-8
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
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 outstanding 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 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.
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.
F-9
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
3. INVESTMENTS (Continued)
Consolidated net investment income consisted of the following (in
thousands):
Year Ended December 31,
--------------------------------------
1997 1996 1995
-------- -------- --------
Bonds ............................. $ 65,149 $ 61,130 $ 43,114
Equity securities ................. 376 14
Short-term investments ............ 5,452 3,525 5,705
Investment expenses ............... (1,334) (1,941) (1,736)
-------- -------- --------
Net investment income ............. $ 69,643 $ 62,728 $ 47,083
-------- -------- --------
The credit quality of the investment portfolio at December 31, 1997 was as
follows:
Percent of
Rating Investment Portfolio
- ------ --------------------
AAA .................................................... 74.9%
AA ..................................................... 18.8
A ...................................................... 6.0
BBB .................................................... 0.1
Other .................................................. 0.2
The amortized cost and estimated market value of bonds were as follows (in
thousands):
<TABLE>
<CAPTION>
Gross Gross Estimated
Amortized Unrealized Unrealized Market
December 31, 1997 Cost Gains Losses Value
- ----------------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
U.S. Treasury securities and obligations of
U.S. government corporations and agencies $ 120,314 $ 800 $ (436) $ 120,678
Obligations of states and political
subdivisions ............................ 777,042 40,187 (135) 817,094
Foreign securities ........................ 8,252 (562) 7,690
Mortgage-backed securities ................ 195,567 2,213 (28) 197,752
Corporate securities ...................... 72,388 1,375 (1,093) 72,670
Asset-backed securities ................... 19,208 349 19,557
---------- ---------- ---------- ----------
Total ................................... $1,192,771 $ 44,924 $ (2,254) $1,235,441
========== ========== ========== ==========
</TABLE>
<TABLE>
<CAPTION>
Gross Gross Estimated
Amortized Unrealized Unrealized Market
December 31, 1996 Cost Gains Losses Value
- ----------------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
U.S. Treasury securities and obligations of
U.S. government corporations and agencies $ 55,319 $ 1,103 $ (557) $ 55,865
Obligations of states and political
subdivisions ............................ 661,657 15,164 (2,887) 673,934
Foreign securities ........................ 15,019 196 (70) 15,145
Mortgage-backed securities ................ 177,818 1,432 (906) 178,344
Corporate securities ...................... 76,632 335 (319) 76,648
Asset-backed securities ................... 68,233 680 (172) 68,741
---------- ---------- ---------- ----------
Total ................................... $1,054,678 $ 18,910 $ (4,911) $1,068,677
========== ========== ========== ==========
</TABLE>
F-10
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
3. INVESTMENTS (Continued)
The change in net unrealized gains (losses) consisted of (in thousands):
Year Ended December 31,
-------------------------------
1997 1996 1995
-------- -------- --------
Bonds ........................................ $ 28,671 $(16,299) $ 63,166
Equity investments ........................... 357
-------- -------- --------
Change in net unrealized gains (losses) .... $ 29,028 $(16,299) $ 63,166
======== ======== ========
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.
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
-------------------------------------- --------------------------------------
Amortized Cost Estimated Market Value Amortized Cost Estimated Market Value
-------------- ---------------------- -------------- ----------------------
<S> <C> <C> <C> <C>
Due in one year or less .... $ 4,009 $ 4,007 $ 38,003 $ 38,325
Due after one year through
five years ............... 65,145 65,776 57,406 57,623
Due after five years
through ten years ........ 180,530 183,798 105,494 105,849
Due after ten years ........ 728,312 764,551 607,724 619,795
Mortgage-backed securities
(stated maturities of 4 to
39 years) ................ 195,567 197,752 177,818 178,344
Asset-backed securities
(stated maturities of 2 to
30 years) ................ 19,208 19,557 68,233 68,741
---------- ---------- ---------- ----------
Total .................. $1,192,771 $1,235,441 $1,054,678 $1,068,677
========== ========== ========== ==========
</TABLE>
Proceeds from sales of bonds during 1997, 1996 and 1995 were
$1,128,416,000, $1,096,568,000 and $587,516,000, respectively. Gross gains of
$11,735,000, $13,420,000 and $12,346,000 and gross losses of $6,014,000,
$11,569,000 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 stockholder's equity section, was not
material. The aggregate notional amount of these contracts was $83,728,000 as of
December 31, 1996.
F-11
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
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 contributed subsidiary ......... 30,807
---------
Balance, end of period .................... $ 171,098 $ 146,233 $ 132,951
========= ========= =========
5. OTHER OPERATING EXPENSES
Total salary expense and related benefits included in other operating
expenses were $15,355,000, $10,135,000 and $10,976,000 for the years ended
December 31, 1997, 1996 and 1995, respectively.
6. STATUTORY ACCOUNTING PRACTICES
GAAP for the Company differs in certain significant respects from
accounting practices prescribed or permitted by insurance regulatory
authorities. The principal differences result from the following statutory
accounting practices:
- Upfront premiums on municipal business are recognized as earned
when related principal and interest have expired rather than over the
expected coverage period;
- Acquisition costs are charged to operations as incurred rather
than as related premiums are earned;
- A contingency reserve (rather than a general 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 percent 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;
F-12
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
6. STATUTORY ACCOUNTING PRACTICES (Continued)
- 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 the Company's net income for the calendar years 1997,
1996 and 1995 and shareholder's equity at December 31, 1997, 1996 and 1995,
prepared on a GAAP basis, to the amounts reported on a statutory basis, is as
follows (in thousands):
Year Ended December 31,
-----------------------------------
Net Income 1997 1996 1995
--------- --------- ---------
GAAP BASIS ............................... $ 100,259 $ 80,855 $ 54,988
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
========= ========= =========
December 31,
-----------------------------------
1997 1996 1995
Shareholder's Equity: --------- --------- ---------
GAAP BASIS ............................... $ 897,860 $ 815,332 $ 789,986
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
========= ========= =========
F-13
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
7. FEDERAL INCOME TAXES
For periods prior to May 13, 1994, the date of initial public offering
when the Parent became less than 80% owned by U S WEST, the Parent, the Company
and its Subsidiaries joined with U S WEST and its subsidiaries in filing a
consolidated federal income tax return. For the Company, under a written 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 Company were allocated to the Company 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 Parent and all members of
its group elected to file consolidated federal tax returns. The calculation of
each member's tax benefit or liability by the Company 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
Contingency reserve .............................. 38,037 29,492
Unrealized capital gains ......................... 16,998 7,915
Market discounts ................................. 2,014 1,955
--------- ---------
Total deferred tax liabilities ............... 125,357 94,064
--------- ---------
Loss and loss adjustment expense reserves ........ (12,009) (10,381)
Deferred compensation ............................ (20,328) (9,791)
Tax credits ...................................... (1,789) (7,842)
Tax and loss bonds ............................... (30,520) (22,526)
Other, net ....................................... (844) (1,842)
--------- ---------
Total deferred tax assets .................... (65,490) (52,382)
--------- ---------
Total deferred income taxes ...................... $ 59,867 $ 41,682
========= =========
No valuation allowance was necessary at December 31, 1997 or 1996.
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) (8.3)
Other ................................... 0.3 0.4 0.3
---- ---- ----
Provision for income taxes .............. 27.4% 26.5% 27.0%
==== ==== ====
F-14
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
8. DIVIDENDS AND CAPITAL REQUIREMENTS
Under New York Insurance Law, the Company may pay a dividend 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, and the dividend, which together with all dividends declared or
distributed by it during the preceding twelve months, may not exceed the lesser
of 10% of its policyholders' surplus shown on its last filed statement, or
adjusted net investment income, as defined, for such twelve-month period. As of
December 31, 1997, the Company 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 the Company of up to $75,000,000 of its shares
from the Parent through December 31, 1998, pursuant to which the Company has
repurchased $66,500,000 of its shares through December 31, 1997.
9. 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 Company and 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, the Company entered
into a facility agreement with Canadian Global Funding Corporation and Hambros
Bank Limited. Under the agreement, the Company 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.
The Company 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 the Company after it has incurred, during the term of the facility,
cumulative municipal losses (net of any recoveries) in excess of the greater of
$230,000,000 or 5.75% of average annual debt service. 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.
On September 21, 1997, the Company borrowed $50,000,000 from its Parent in
the form of Surplus Notes. These notes carried a simple interest rate of 5.0%
per annum. Principal of and interest on the Surplus Notes may be paid at any
time at the option of the Company, subject to prior approval of the New York
Insurance Department and compliance with the conditions to such payments as
contained in the New York Insurance Laws. These notes have no stated maturity.
10. EMPLOYEE BENEFIT PLANS
The Company maintains both a qualified and a non-qualified
non-contributory defined contribution pension plan for the benefit of all
eligible employees. The Company's contributions are based upon a fixed
percentage of employee compensation. Pension expense, which is funded as
accrued, amounted to $2,312,000, $1,977,000 and $1,784,000 for the years ended
December 31, 1997, 1996 and 1995, respectively.
F-15
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
10. EMPLOYEE BENEFIT PLANS (Continued)
The Company has an employee retirement savings plan for the benefit of all
eligible employees. The plan permits employees to contribute a percentage of
their salaries up to limits prescribed by the Internal Revenue Service (IRS
Code, Section 401(k)). The Company's contributions are discretionary, and none
have been made.
During 1991, the Company established the Profit Participation Plan as a
long-term incentive compensation plan for the benefit of certain of its
employees. Prior to the closing of the initial public offering, the Parent
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 the Parent's 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 the Parent's
common stock at the public offering price under the Supplemental Restricted
Stock Plan. In settlement of an accrued balance of $7,126,000 in such Profit
Participation Plan, the Company purchased 356,345 shares of restricted stock
from the Parent and awarded the shares to employees. 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 the
Parent's 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 the Parent's 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 Parent through open-market purchases by a trust
established for such purpose.
During 1994, under the Parent's 1993 Equity Participation Plan, the Parent
granted to officers and employees, in respect of future performance,
non-qualified options to purchase an aggregate of 1,099,000 shares of the
Parent's 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 will
be 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 Parent granted 169,956 of stock options 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
F-16
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
10. EMPLOYEE BENEFIT PLANS (Continued)
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:
<TABLE>
<CAPTION>
Outstanding Granted Earned Forfeited Outstanding Market
at Beginning During the During the During at End Price at
of Year Year Year the Year of Year Grant Date
------- ---- ---- -------- ------- ----------
<S> <C> <C> <C> <C> <C> <C>
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
</TABLE>
The Company applies APB Opinion 25 and related Interpretations in
accounting for the Parent's performance shares. The Company estimates the final
cost of these performance shares and accrues for this expense over the
performance period. The accrued expense for the performance shares was
$28,439,000, $12,737,000 and $5,663,000 for the years ended December 31, 1997,
1996 and 1995, respectively. In tandem with this accrued expense, the Parent
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 Parent estimates it will settle in cash, is recorded in accrued expenses and
other liabilities. The Company recognized a benefit for the difference between
the market value of the Parent's common stock and the cost of the stock when it
was purchased by the independent trustee (which amount was reimbursed by the
Company to its Parent) for shares distributed under the performance share plan.
This benefit was recorded by the Company as a capital contribution which totaled
$2,900,000 in 1997. In 1996, the Parent adopted disclosure provisions of FASB
Statement 123. Had the compensation cost for the Parent's performance shares
been determined based upon fair value at the grant dates for the awards
consistent with the method of FASB Statement 123, there would have been no
effect on the Company's reported net income.
In November 1994, the Parent appointed an independent trustee authorized
to purchase shares of the Parent'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. During 1997, 1996 and 1995,
the total number of shares purchased by this 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 Parent 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 pensions to its employees, nor does it provide post-employment benefits to
former employees.
11. COMMITMENTS AND CONTINGENCIES
The Company leases office space and equipment under non-cancelable
operating leases, which expire at various dates through 2005.
F-17
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
11. COMMITMENTS AND CONTINGENCIES (Continued)
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
$3,708,000, $3,383,000 and $3,493,000, respectively.
During the ordinary course of business, the Company and its Subsidiaries
have become parties to certain litigation. Management believes that these
matters will be resolved with no material financial impact on the Company.
12. REINSURANCE
The Company reinsures portions of its risks with affiliated (see Note 14)
and unaffiliated reinsurers under quota share treaties and on a facultative
basis. The Company's principal ceded reinsurance program consisted in 1997 of
two quota share treaties and three automatic facultative facilities. One treaty
covered all of the Company's approved regular lines of business, except U.S.
municipal obligation insurance. Under this treaty in 1997, the Company ceded
9.75% of each covered policy, up to a maximum of $19,500,000 insured principal
per policy. At its sole option, the Company 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 Company's U.S. municipal obligation
insurance business. Under this treaty in 1997, the Company ceded 9% of each
covered policy that is classified by the Company 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 its
sole option, the Company 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
Company at its 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 Company
agreed to cede in the aggregate a specified percentage of gross par insured by
the Company. Each of the treaties and automatic facultative facilities allowed
the Company to withhold a ceding commission to defray their expenses. The
Company also employed non-treaty, quota share facultative reinsurance on various
transactions in 1997 in keeping with prior practices. In 1997, the Company also
implemented facultative first- loss reinsurance on selected asset-backed
transactions.
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
Company, the Company would be liable for such
F-18
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
12. REINSURANCE (Continued)
defaulted amounts. The Company has also assumed reinsurance of municipal
obligations from unaffiliated insurers.
Amounts reinsured were as follows (in thousands):
<TABLE>
<CAPTION>
Year Ended December 31,
-------------------------------
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
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
</TABLE>
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
13. 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
======= ======= ======= =======
F-19
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
13. OUTSTANDING EXPOSURE AND COLLATERAL (Continued)
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):
<TABLE>
<CAPTION>
Net of Amounts Ceded Ceded
December 31, December 31,
-------------------- --------------------
Types of Collateral 1997 1996 1997 1996
- ------------------- ------- ------- ------- -------
<S> <C> <C> <C> <C>
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
======= ======= ======= =======
</TABLE>
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.
F-20
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
13. OUTSTANDING EXPOSURE AND COLLATERAL (Continued)
The gross principal amount of insured obligations in the municipal insured
portfolio includes the following types of issues (in millions):
<TABLE>
<CAPTION>
Net of Amounts
Ceded Ceded
December 31, December 31,
----------------- -----------------
Types of Issues 1997 1996 1997 1996
- --------------- ------- ------- ------- -------
<S> <C> <C> <C> <C>
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
======= ======= ======= =======
</TABLE>
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:
<TABLE>
<CAPTION>
Net Par Percent of Total Ceded Par
Number Amount Municipal Net Par Amount
State of Issues Outstanding Amount Outstanding Outstanding
- ----- --------- ----------- ------------------ -----------
(in millions) (in millions)
<S> <C> <C> <C> <C>
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
===== ======= ===== =======
</TABLE>
F-21
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
14. RELATED PARTY TRANSACTIONS (Continued)
Allocable expenses are shared by the Company and its Parent on a basis
determined principally by estimates of respective usage as stated in an expense
sharing agreement. The agreement is subject to the provisions of the New York
Insurance Law. Amounts included in other assets at December 31, 1997 and 1996
are $4,702,000 and $4,205,000, respectively, for unsettled expense allocations
due from the Parent.
The Company 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 Company 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. The Company has taken credit for the
reinsurance ceded to Commercial Re.
15. 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
F-22
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
15. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)
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.
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
----------------------- -----------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
---------- ---------- ---------- ----------
(In thousands)
<S> <C> <C> <C> <C>
Assets:
Bonds .................................. $1,235,441 $1,235,441 $1,068,677 $1,068,677
Short-term investments ................. 103,926 103,926 39,570 39,570
Cash ................................... 11,235 11,235 23,646 23,646
Receivable for securities sold ......... 20,535 20,535
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 .......................... 50,000 50,000
Payable for investments purchased ...... 72,979 72,979 14,142 14,142
Off-balance-sheet instruments:
Installment premiums ................... 116,888 102,988
</TABLE>
F-23
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
16. 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):
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------
1997 1996 1995
--------- --------- ---------
<S> <C> <C> <C>
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
========= ========= =========
</TABLE>
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, the Company 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 the general reserve for transfers from general reserves 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 the general reserve for transfers from general reserves 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.
F-24
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
16. LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES (Continued)
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.
17. 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.
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
F-25
<PAGE>
FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
17. RECENTLY ISSUED ACCOUNTING STANDARDS (Continued)
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.
F-26
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FINANCIAL
SECURITY ASSURANCE HOLDINGS LTD. AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH STATEMENTS.
</LEGEND>
<RESTATED>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> MAR-31-1996
<DEBT-HELD-FOR-SALE> 1,141,261
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 10,000
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 1,151,261
<CASH> 2,299
<RECOVER-REINSURE> 62,126
<DEFERRED-ACQUISITION> 131,404
<TOTAL-ASSETS> 1,545,022
<POLICY-LOSSES> 114,024
<UNEARNED-PREMIUMS> 479,240
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 30,000
0
700
<COMMON> 696,576
<OTHER-SE> 73,107
<TOTAL-LIABILITY-AND-EQUITY> 1,545,022
22,734
<INVESTMENT-INCOME> 15,682
<INVESTMENT-GAINS> 1,534
<OTHER-INCOME> 62
<BENEFITS> 1,625
<UNDERWRITING-AMORTIZATION> 7,655
<UNDERWRITING-OTHER> 4,498
<INCOME-PRETAX> 26,234
<INCOME-TAX> 6,690
<INCOME-CONTINUING> 19,544
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 19,544
<EPS-PRIMARY> 0.62
<EPS-DILUTED> 0.62
<RESERVE-OPEN> 111,759
<PROVISION-CURRENT> 2,265
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
<PAYMENTS-PRIOR> 0
<RESERVE-CLOSE> 114,024
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FINANCIAL
SECURITY ASSURANCE HOLDINGS LTD. AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH STATEMENTS.
</LEGEND>
<RESTATED>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> JUN-30-1996
<DEBT-HELD-FOR-SALE> 1,132,858
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 6,581
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 1,139,439
<CASH> 7,432
<RECOVER-REINSURE> 35,624
<DEFERRED-ACQUISITION> 133,950
<TOTAL-ASSETS> 1,516,296
<POLICY-LOSSES> 79,501
<UNEARNED-PREMIUMS> 496,061
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 30,000
0
700
<COMMON> 695,475
<OTHER-SE> 63,825
<TOTAL-LIABILITY-AND-EQUITY> 1,516,296
42,484
<INVESTMENT-INCOME> 31,668
<INVESTMENT-GAINS> 1,512
<OTHER-INCOME> 105
<BENEFITS> 3,155
<UNDERWRITING-AMORTIZATION> 12,620
<UNDERWRITING-OTHER> 8,549
<INCOME-PRETAX> 51,455
<INCOME-TAX> 13,153
<INCOME-CONTINUING> 38,292
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 38,292
<EPS-PRIMARY> 1.23
<EPS-DILUTED> 1.22
<RESERVE-OPEN> 111,759
<PROVISION-CURRENT> 4,286
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
<PAYMENTS-PRIOR> 36,544
<RESERVE-CLOSE> 79,501
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FINANCIAL
SECURITY ASSURANCE HOLDINGS LTD. AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH STATEMENTS.
</LEGEND>
<RESTATED>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> SEP-30-1996
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<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
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0
700
<COMMON> 695,441
<OTHER-SE> 82,395
<TOTAL-LIABILITY-AND-EQUITY> 1,548,397
64,121
<INVESTMENT-INCOME> 48,135
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<EPS-PRIMARY> 1.80
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<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FINANCIAL
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<RESTATED>
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<S> <C>
<PERIOD-TYPE> YEAR
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<PERIOD-END> DEC-31-1996
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0
700
<COMMON> 695,441
<OTHER-SE> 105,119
<TOTAL-LIABILITY-AND-EQUITY> 1,537,742
90,448
<INVESTMENT-INCOME> 65,064
<INVESTMENT-GAINS> 3,189
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<INCOME-PRETAX> 109,771
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<TABLE> <S> <C>
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<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FINANCIAL
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TO SUCH STATEMENTS.
</LEGEND>
<RESTATED>
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<S> <C>
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<PERIOD-END> MAR-31-1997
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0
700
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24,774
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<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FINANCIAL
SECURITY ASSURANCE HOLDINGS LTD. AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH STATEMENTS.
</LEGEND>
<RESTATED>
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<S> <C>
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0
700
<COMMON> 694,973
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<TOTAL-LIABILITY-AND-EQUITY> 1,694,604
52,335
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<EPS-PRIMARY> 1.51
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<RESERVE-OPEN> 72,079
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<CUMULATIVE-DEFICIENCY> 0
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FINANCIAL
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TO SUCH STATEMENTS.
</LEGEND>
<RESTATED>
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<S> <C>
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<FISCAL-YEAR-END> DEC-31-1997
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<PERIOD-END> SEP-30-1997
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<NOTES-PAYABLE> 130,000
0
700
<COMMON> 695,088
<OTHER-SE> 187,204
<TOTAL-LIABILITY-AND-EQUITY> 1,968,221
79,539
<INVESTMENT-INCOME> 51,402
<INVESTMENT-GAINS> 6,648
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<UNDERWRITING-OTHER> 18,810
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<EPS-PRIMARY> 2.42
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<RESERVE-OPEN> 72,079
<PROVISION-CURRENT> 9,748
<PROVISION-PRIOR> 0
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<PAYMENTS-PRIOR> 8,715
<RESERVE-CLOSE> 73,112
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FINANCIAL
SECURITY ASSURANCE HOLDINGS LTD. AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
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0
700
<COMMON> 694,174
<OTHER-SE> 187,486
<TOTAL-LIABILITY-AND-EQUITY> 1,900,644
109,511
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<UNDERWRITING-OTHER> 26,804
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<EPS-PRIMARY> 3.35
<EPS-DILUTED> 3.25
<RESERVE-OPEN> 72,079
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<PAYMENTS-PRIOR> 6,573
<RESERVE-CLOSE> 75,417
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
