SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
AMENDMENT NO. 1 TO
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
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.
6.950% Senior Quarterly Income Debt
Securities Due 2098 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, 1999 was $1,609,291,128
(based upon the closing price of the registrant's shares on the New York Stock
Exchange on March 11, 1999, which was $53.875). For purposes of the foregoing,
only MediaOne Capital Corporation and Fund American Enterprises Holdings, Inc.
were deemed to be affiliates of the registrant.
At March 11, 1999, there were outstanding 31,533,781 shares of Common
Stock, par value $0.01 per share, of the registrant (includes 1,360,159 shares
of Common Stock owned by a trust on behalf of the Company and excludes 742,520
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, 1998 are incorporated by reference into Part II hereof.
Portions of the registrant's definitive Proxy Statement dated March 26, 1999 in
connection with the Annual Meeting of Shareholders to be held on May 13, 1999
are incorporated by reference into Part III hereof.
<PAGE>
Preliminary Note
This Amendment No. 1 to the Annual Report on Form 10-K for the fiscal year ended
December 31, 1998 (the "Form 10-K") of Financial Security Assurance Holdings
Ltd. (the "Company") is being filed by the Company to amend and restate Items 6,
7, 7A and 8, which had previously been incorporated by reference in the Form
10-K, Item 14, Financial Statement Schedule II, and Exhibits 27 and 99. In
accordance with Rule 12b-15 under the Securities Exchange Act of 1934, as
amended, the text of the amended portions are set forth in their entirety in
this Amendment No. 1. A new consent of PricewaterhouseCoopers LLP, independent
auditors for the Company, is included as an Exhibit hereto.
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................. 24
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters........................................................... 25
Item 6. Selected Financial Data............................................. 25
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................. 26
Item 7A. Qualitative and Quantitative Disclosures About Market Risk.......... 32
Item 8. Financial Statements and Supplementary Data......................... 33
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.............................................. 57
Item 10. Directors and Executive Officers of the Registrant.................. 58
Item 11. Executive Compensation.............................................. 58
Item 12. Security Ownership of Certain Beneficial Owners and Management...... 58
Item 13. Certain Relationships and Related Transactions...................... 58
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.... 59
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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. The claims-paying ability of FSA is
rated "triple-A" by the major securities ratings agencies and obligations
insured by FSA are generally awarded "triple-A" ratings by reason of such
insurance. 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, 1998, FSA had gross
premiums written of $319.3 million, of which 70% related to insurance of
municipal obligations and 30% related to insurance of asset-backed obligations.
At December 31, 1998, FSA had net insurance in force of $160.0 billion, of which
70% represented insurance of municipal obligations and 30% 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.
FSA owns FSA Insurance Company ("FSAIC"), which in turn owns Financial
Security Assurance International Ltd. ("FSA International"), Financial Security
Assurance (U.K.) Limited ("FSA-UK") and Financial Security Assurance of
Oklahoma, Inc. ("FSA Oklahoma"). FSA International is a Bermuda domiciled
insurance company that primarily provides financial guaranty insurance for
transactions outside United States and European markets as well as reinsurance
to FSA. FSA-UK is a United Kingdom domiciled insurance company that primarily
provides financial guaranty insurance for transactions in the United Kingdom and
other European markets. FSAIC is an Oklahoma domiciled insurance company that
primarily provides reinsurance to FSA. FSA Oklahoma ceased to be an operating
company in 1998. All such insurance company subsidiaries are wholly owned,
except that XL Capital Ltd owns a minority interest in FSA International as
described below.
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 affiliates.
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.
When it commenced operations in 1985, the Company was owned by a number of
large insurance companies and other institutional investors. In 1989, the
Company was acquired by U S WEST Capital Corporation ("U S WEST"), which has
since changed its name to MediaOne Capital Corporation ("MediaOne"). MediaOne is
a subsidiary of MediaOne Group, Inc., with operations and investments in
domestic cable and broadband communications and international broadband and
wireless communication. In 1990, the Company established a strategic
relationship with The Tokio Marine and Fire Insurance Co. Ltd. ("Tokio Marine"),
which acquired a minority interest in the Company. Tokio Marine is a major
Japanese property and casualty insurance company.
In 1994, the Company completed an initial public offering (the "IPO") of
common shares, at which time Fund American Enterprises Holdings, Inc. (together
with its wholly owned subsidiaries, "Fund American") made an investment in the
Company and entered into certain agreements providing, among other things, Fund
American certain rights to acquire additional shares of the Company from the
Company and MediaOne. Pursuant to these agreements, the Company issued to Fund
American 2,000,000 shares of Series A non-dividend paying voting redeemable
preferred stock having a liquidation preference of $700,000. Fund American
primarily operates businesses in insurance and mortgage banking.
In 1998, the Company and XL Capital Ltd ("XL") entered into a joint
venture, establishing two Bermuda domiciled financial guaranty insurance
companies--FSA International and XL Financial Assurance Ltd ("XLFA"). XL owns a
minority interest in FSA International and the Company owns a minority interest
in XLFA. In connection with such joint ventures, XL acquired an interest in the
Company and the Company acquired an interest in XL. XL is a major Bermuda
insurance company.
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At December 31, 1998, voting control of the Company was held 32.0% by
MediaOne, 23.1% by Fund American, 6.1% by Tokio Marine, 5.1% by XL and 33.7% by
the public and employees. MediaOne 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 MediaOne are either subject to stock options held
by Fund American or potentially deliverable in satisfaction of DECS (Debt
Exchangeable for Common Stock) securities issued by MediaOne and maturing in May
1999.
The principal executive offices of the Company are located at 350 Park
Avenue, New York, New York 10022. Subsidiaries of the Company also maintain
offices domestically in San Francisco and Dallas and abroad in London,
Singapore, Bermuda, Paris, Tokyo, Sydney and Madrid.
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. 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. 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 and municipal obligations. 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 50.8% for the year ending 1998 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 selectively pursues international opportunities and currently operates
in the European and Asia Pacific markets.
Business of FSA
General
The business of FSA is managed by its Management Committee, comprised of
its Chairman, President, Chief Operating Officer, Chief Underwriting Officer,
General Counsel and Chief Financial Officer. FSA is primarily engaged in the
business of writing financial guaranty insurance on asset-backed obligations as
described below.
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, auto loans and credit card
receivables, monoline financial guarantors also insure asset-backed obligations
secured by less diverse payment sources, such as utility mortgage bonds and
multifamily real estate.
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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 obligations 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 ... 63.3 176.0 239.5 92.6
1998 ... 132.7 178.8 311.5 N/A(5)
- ----------
(1) Information is from Inside Mortgage Securities, January 8, 1993, January
14, 1994, January 20, 1995, February 2, 1996, and Inside MBS & ABS,
February 14, 1997, January 16, 1998, and January 8, 1999, 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, January 5, 1998, and March 1 , 1999 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: (i) private placement non-residential
asset-backed obligations, (ii) asset-backed commercial paper, and (iii)
non-U.S. obligations.
(4) Information is based on data provided by the Association of Financial
Guaranty Insurors (AFGI).
(5) Not available.
The data set forth in the table above excludes privately placed
non-residential mortgage transactions as well as non-domestic issues. As a
result, the table omits information regarding most "collateralized debt
obligation" securitizations, which represented a significant sector in the
insured asset-backed market in 1998.
The issuance of asset-backed obligations of the type included in the table
experienced substantial growth in each year from 1991 to 1998, with the
exception of 1994. The combined volume of such asset-backed obligations grew
from $99.9 billion in 1991 to $311.5 billion in 1998.
The largest single component of public, non-residential asset-backed
obligations was credit card securitizations in 1991, automobile loan
securitizations in 1992 and 1993, credit card securitizations in 1994, 1995 and
1996, and home equity loan securitizations in 1997 and 1998.
The par value of new asset-backed obligations insured by monoline
financial guaranty insurance companies rose in every year from 1991 through
1997.
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
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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. Issuance
increased in 1997 and 1998 due to falling interest rates. In addition, a
substantial amount of residential first mortgage loans were securitized in the
home equity loan sector of the asset-backed market in 1996, 1997 and 1998.
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 1989 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, 1997 and 1998, 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)
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 ........ 165.0 61.5 37.3
1995 ........ 160.0 68.5 42.8
1996 ........ 185.0 85.7 46.3
1997 ........ 220.7 107.5 48.7
1998 ........ 284.2 144.4 50.8
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(1) Information is based on data provided in The Bond Buyer, January 7, 1999.
Volume is expressed in terms of principal insured.
Types of Products
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FSA's insurance is employed in both the new issue and secondary markets.
Insurance premium rates take into account the projected return to and 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 such factors and
subject to FSA's underwriting guidelines. The final premium rate is generally a
function of market factors, including the interest rate savings to the issuer
from the use of insurance.
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. Likewise, 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 insures guaranteed investment contracts ("GIC's"), GIC equivalents and
obligations under interest rate, currency and credit default swap transactions,
both alone and in connection with asset-backed and municipal transactions
employing FSA insurance. FSA 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.
FSA also issues surety bonds under its Sure-Bid(R) program, which provides
an alternative to issuers and financial advisors to traditional types of good
faith deposits on competitive municipal bond transactions.
The following table indicates the percentages of par amount (net of
reinsurance) outstanding at December 31, 1998 and 1997 with respect to each type
of asset-backed and municipal program:
Net Par Amount and Percentage Outstanding by Program Type
December 31, 1998
---------------------------------------------------------
Asset-Backed Programs Municipal Programs
---------------------------------------------------------
Percent of
Percent of Total Net
Net Total Net Par Net Par
Par Amount Amount Par Amount Amount
Outstanding Outstanding Outstanding Outstanding
----------- ----------- ----------- -----------
(dollars in millions)
New Issue ............. $34,972 93.4% $59,986 90.9%
Secondary Market ...... 2,432 6.5 6,020 9.1
Portfolio Insurance ... 19 0.1 -- 0.0
------- ----- ------- -----
Total ............ $37,423(1) 100.0% $66,006(2) 100.0%
======= ===== ======= =====
December 31, 1997
---------------------------------------------------------
Asset-Backed Programs Municipal Programs
---------------------------------------------------------
Percent of
Percent of Total Net
Net Total 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%
======= ===== ======= =====
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(1) Excludes $200 million and $231 million par amount outstanding assumed by
FSA under reinsurance agreements at December 31, 1998 and 1997,
respectively.
(2) Excludes $1,044 million and $1,361 million par amount outstanding assumed
by FSA under reinsurance agreements at December 31, 1998 and 1997,
respectively.
Insurance in Force
FSA insures a variety of asset-backed obligations, including obligations
backed by residential mortgage loans, auto loans, other consumer receivables,
corporate bonds, bank loans, government debt and multifamily mortgage loans. FSA
has insured a broad array of municipal obligations. FSA has also insured
investor-owned utility first mortgage bonds. In 1990, FSA ceased writing
insurance backed by commercial mortgage loans, and today retains only minor net
insurance in force in that sector.
FSA has selectively expanded its insured portfolio in a manner intended to
achieve diversification. At December 31, 1998, FSA and its subsidiaries had in
force 631 issues insuring approximately $46.9 billion in gross direct par amount
outstanding of asset-backed obligations and 4,768 issues insuring approximately
$89.3 billion in gross direct par amount outstanding of municipal obligations.
In addition, at December 31, 1998, FSA had assumed pursuant to certain
reinsurance contracts approximately $0.2 billion and $1.2 billion in par amount
outstanding on asset-backed and municipal obligations, respectively, resulting
in a total gross par amount outstanding of approximately $137.6 billion. At such
date, the total net par amount outstanding, determined by reducing the gross par
amount outstanding to reflect reinsurance ceded of approximately $32.9 billion,
was approximately $104.7 billion. Net par data does not distinguish between
quota share and first loss reinsurance. In light of FSA's increasing use of
first loss reinsurance in the asset-backed sector, net par data tends to
overstate FSA's net risk exposure. At December 31, 1998, 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, manufactured housing loans and
credit card receivables.
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, franchise
loans and equity securities.
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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 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. Obligations backed by commercial mortgages include (a) commercial real
estate obligations primarily backed by commercial real estate, including hotel
properties, office buildings and warehouses, and secured by property cash flow,
property values, first loss letters of credit, cash reserves and other means and
(b) corporate secured obligations secured by mortgages on properties leased to
one or more affiliated corporate tenants, and supported primarily by lease cash
flow and secondarily by property values.
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.
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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 non-domestic
national or local governmental entities.
A summary of FSA's insured portfolio at December 31, 1998 is shown below.
Please note that exposure amounts are expressed net of reinsurance but do not
distinguish between quota share reinsurance and first loss reinsurance. In
recent years, FSA has tended to employ quota share reinsurance in the municipal
sector and first loss reinsurance in the asset-backed sector.
Summary of Insured Portfolio at December 31, 1998
Percent
Number of Net Par Net of Net
Issues In Amount Par and Par and
Force Outstanding Interest Interest
--------- ----------- -------- --------
(dollars in millions)
Asset-backed obligations
Residential mortgages ............. 339 $15,647 $20,694 12.9%
Consumer receivables .............. 154 12,539 13,651 8.5
Government securities ............. 30 821 1,345 0.8
Pooled corporate obligations ...... 51 6,776 9,155 5.7
Investor-owned utility
obligations ..................... 40 757 1,592 1.0
Commercial mortgage portfolio ..... 9 57 69 0.0
Other asset-backed obligations .... 8 1,026 1,164 0.9
--------- ---------- -------- ------
Total asset-backed obligations .. 631 37,623 47,670 29.8
--------- ---------- -------- ------
Municipal obligations
General obligation bonds .......... 2,811 25,337 39,665 24.8
Housing revenue bonds ............. 229 2,509 5,066 3.2
Municipal utility revenue bonds ... 492 9,218 15,772 9.9
Health care revenue bonds ......... 139 5,812 10,473 6.5
Tax-supported (non-general
obligation) bonds ............... 607 14,731 25,205 15.8
Transportation revenue bonds ...... 55 2,937 5,532 3.5
Other municipal bonds ............. 435 6,506 10,612 6.5
--------- ---------- -------- ------
Total municipal obligations ..... 4,768 67,050 112,325 70.2
========= ========== ======== ======
Total ....................... 5,399 $104,673 $159,995 100.0%
========= ========== ======== ======
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,
------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Asset-backed obligations
Residential mortgages .................. 16% 19% 29% 26% 25%
Consumer receivables ................... 16 24 25 29 23
Government securities .................. 0 2 1 0 0
Pooled corporate obligations ........... 10 10 1 10 4
Commercial mortgage portfolio .......... 0 0 0 0 0
Investor-owned utility obligations ..... 0 0 0 0 2
Other asset-backed obligations ......... 2 0 2 1 2
9
<PAGE>
---- ---- ---- ---- ----
Total asset-backed obligations ....... 44 55 58 66 56
---- ---- ---- ---- ----
Municipal obligations
General obligations bonds .............. 22 18 20 11 12
Housing revenue bonds .................. 2 1 1 2 1
Municipal utility revenue bonds ........ 9 2 4 4 8
Health care revenue bonds .............. 6 4 2 3 4
Tax-supported (non-general
obligation) bonds .................... 10 10 9 6 11
Transportation revenue bonds ........... 2 2 1 6 1
Other municipal bonds .................. 5 8 5 2 7
---- ---- ---- ---- ----
Total municipal obligations .......... 56 45 42 34 44
---- ---- ---- ---- ----
Total ............................ 100% 100% 100% 100% 100%
==== ==== ==== ==== ====
Terms to Maturity
The table below sets forth the estimated terms to maturity of FSA's
policies at December 31, 1998 and 1997:
Estimated Terms to Maturity of Net Par of Insured Obligations(1)
December 31, 1998 December 31, 1997
---------------------- ----------------------
(in millions)
Estimated Asset- Asset-
Term to Maturity Backed Municipal Backed Municipal
---------------- ------- --------- ------- ---------
0 to 5 Years .............. $ 8,468 $ 2,756 $ 7,553 $ 2,230
5 to 10 Years ............. 7,516 7,495 5,637 5,683
10 to 15 Years ............ 5,661 12,427 2,858 8,257
15 to 20 Years ............ 670 20,265 524 14,340
20 Years and Above ........ 15,308 24,107 11,917 16,479
------- ------- ------- -------
Total .................. $37,623 $67,050 $28,489 $46,989
======= ======= ======= =======
- ----------
(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, 1998:
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 ........ 477 37.3% $ 656 1.8%
$10 to $25 million ........... 144 11.2 1,143 3.0
$25 to $50 million ........... 151 11.8 1,801 4.8
$50 million or greater ....... 508 39.7 33,823 90.4
------- ----- ------- -----
Total ..................... 1,280 100.0% $37,423 100.0%
======= ===== ======= =====
- ----------
(1) Does not include $200 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 ........ 6,644 75.9% $18,190 27.6%
$10 to $25 million ........... 1,252 14.3 13,156 19.9
$25 to $50 million ........... 427 4.9 9,782 14.8
$50 million or greater ....... 434 4.9 24,878 37.7
------- ----- ------- -----
Total ..................... 8,757 100.0% $66,006 100.0%
======= ===== ======= =====
- ----------
(1) Does not include $1,044 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 considered 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, 1998
Percent of
Total
Number Net Par Municipal Net
of Amount Par Amount
Jurisdiction Issues Outstanding Outstanding
------------ ------ ----------- -----------
(dollars in millions)
California .............. 517 $10,233 15.3%
New York ................ 388 5,836 8.7
Pennsylvania ............ 356 4,821 7.2
Texas ................... 414 4,128 6.1
Florida ................. 130 4,091 6.1
New Jersey .............. 275 3,475 5.2
Illinois ................ 359 3,125 4.7
Massachusetts ........... 126 2,259 3.4
Michigan ................ 217 2,161 3.2
Wisconsin ............... 252 1,685 2.5
Indiana ................. 103 1,461 2.2
Minnesota ............... 146 1,340 2.0
All other states ........ 1,453 20,993 31.3
Non-U.S ................. 32 1,442 2.1
------- ------- -------
Total ................ 4,768 $67,050 100.0%
======= ======= =======
11
<PAGE>
Issuer Concentration
FSA has adopted underwriting and exposure management policies designed to
limit the net par insured for any one credit. In many cases, FSA uses
reinsurance to limit net exposure to any one credit. At December 31, 1998,
insurance of asset-backed obligations constituted 35.9% of FSA's net par
outstanding and insurance of municipal obligations constituted 64.1% of FSA's
net par outstanding. At such date, FSA's ten largest net insured asset-backed
transactions represented $6.2 billion, or 6.0%, of its total net par amount
outstanding, and FSA's ten largest net insured municipal credits represented
$3.6 billion, or 3.5%, 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, 1998. Please note that exposure amounts are
expressed net of reinsurance but do not distinguish between quota share
reinsurance and first loss reinsurance. In recent years, FSA has tended to
employ quota share reinsurance in the municipal sector and first loss
reinsurance in the asset-backed sector.
Ten Largest Insured Asset-Backed Transactions at December 31, 1998
Net Par
Amount
Transaction Asset Type Outstanding
----------- ---------- -----------
(in millions)
IMC Home Equity Loan Trust 1998-3 ...... Residential Mortgages $ 816.5
New Century 1998 - NC5 ................. Residential Mortgages 816.0
WFS Financial 1998-C ................... Consumer Receivables 652.5
New Century 1998 - NC7 ................. Residential Mortgages 645.7
IMC Home Equity Loan Trust 1998-6 ...... Residential Mortgages 604.3
PAMCO CLO Series 1997-1 ................ Pooled Corporate 577.1
Americredit 1998-D ..................... Consumer Receivables 545.0
WFS Financial 1998-B ................... Consumer Receivables 541.8
Norse CBO .............................. Pooled Corporate 530.5
Arcadia Auto Receivable Trust 1998-C ... Consumer Receivables 497.8
--------
Total $6,227.2
========
Ten Largest Insured Municipal Credits at December 31, 1998
Net Par
Amount
Credit Obligation Type Outstanding
------ --------------- -----------
(in millions)
Long Island Power Authority .................... Utility Revenue $ 430.7
New York State Dormitory Agency ................ Tax-Supported 413.7
Puerto Rico Electric Power Authority ........... Utility Revenue 389.5
New York City .................................. General Obligation 363.9
Puerto Rico Municipal Finance Agency ........... Other Obligation 355.3
Washington State Public Power Supply System .... Utility Revenue 344.0
State of New Jersey Pension Obligations ........ Tax-Supported 338.2
Florida State Department of Natural Resources .. Tax-Supported 332.8
State of California ............................ General Obligation 323.2
New York City Municipal Water Finance
Authority .................................... Utility Revenue 316.6
--------
Total $3,607.9
========
Credit Underwriting Guidelines, Standards and Procedures
12
<PAGE>
Financial guaranty insurance written by FSA relies on an assessment of the
adequacy of various payment sources to meet debt service or other obligations in
a specific transaction without regard to premiums paid or income from investment
of premiums. FSA's underwriting policy is to insure asset-backed and municipal
obligations that it determines are investment grade without the benefit of FSA's
insurance. To this end, each policy written or reinsured by FSA is designed to
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 premised 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 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
13
<PAGE>
Underwriting Committee is comprised of FSA's Chief Executive Officer, President,
Chief Operating Officer, 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 Research
FSA's Corporate Research Department is comprised of a professional staff
under the direction of the Chief Underwriting Officer. The Corporate Research
Department is responsible for evaluating the credit of entities participating or
providing recourse in obligations insured by FSA. The Corporate Research
Department also provides analysis of relevant industry segments. Members of the
Corporate Research Department generally report their findings directly to the
appropriate underwriting committee in the context of transaction review and
approval.
Transaction Oversight and Transaction Services
FSA's Transaction Oversight Departments and Transaction Services
Corporation ("TSC") 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. TSC, 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 functions report to an Oversight Committee comprised of the Chairman,
the General Counsel, the Chief Underwriting Officer, the Chief Municipal
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 Departments and TSC work together with the Legal
Department and the Corporate 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 functions in
addressing legal issues, rights and remedies, as well as proposed amendments,
waivers and consents, in connection with obligations insured by FSA.
14
<PAGE>
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 an 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 its 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 the present value of its estimated ultimate liability for
losses and loss adjustment expenses with respect to obligations it has insured.
At December 31, 1998 and 1997, FSA's net loss reserves totaled $60.0 million and
$44.8 million, respectively. 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. During 1998, the Company
increased its general reserve by $3.9 million, of which $8.0 million was for
originations of new business offset by a $4.1 million decrease in the amount
needed to fund the general loss reserve because of recoveries on certain
commercial mortgage transactions. During 1998, the Company transferred $18.4
million to its general reserve from case basis reserves due to those recoveries
on commercial mortgage transactions. Also during 1998, the Company transferred
$9.4 million from its general reserve to case basis reserves associated
predominantly with certain consumer receivable transactions. Giving effect to
these transfers, the general reserve totaled $47.3 million at December 31, 1998.
Reserves for losses and loss adjustment expenses are discounted at
risk-free rates for the general reserve and for the case basis reserves at rates
between 5.5% and 6.1%. The amount of discount taken was approximately $16.0
million and $19.8 million at December 31, 1998 and 1997, 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
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.
15
<PAGE>
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 obligations and almost half of all 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 been 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 sponsored commercial paper conduits, 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 and 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. Net insurance data does not distinguish
between quota share reinsurance and first loss reinsurance. In light of FSA's
increased use of first loss reinsurance in the asset-backed sector, the data
below may tend to overstate FSA's risk leverage in comparison to its industry
counterparts.
<TABLE>
<CAPTION>
December 31,
------------------------------
1998 1997 1996
---- ---- ----
(dollars in millions)
<S> <C> <C> <C>
Financial guaranty primary insurers, excluding FSA (1)
Leverage ratio ...................................... N/A(2) 149:1 151:1
FSA
Gross insurance in force ............................ $216,564 $158,020 $125,423
Net insurance in force .............................. $159,995 $117,429 $ 93,704
Qualified statutory capital ......................... $ 1,038 $ 782 $ 676
Leverage ratio ...................................... 154:1 150:1 139:1
</TABLE>
- ----------
(1) Financial guaranty primary insurers for which data is included in this
table are Ambac, Capital Markets Assurance Corporation (1997 and 1996),
Connie Lee Insurance Company (1996 only), 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, 1997 and 1996.
16
<PAGE>
(2) Not available.
Reinsurance
Reinsurance is the commitment by one insurance company, the "reinsurer,"
to reimburse another insurance company, the "ceding company," for a specified
portion of the insurance risks underwritten by the ceding company in
consideration for a portion of the premiums received. The ceding company
typically but not always receives 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, to meet state insurance regulatory,
rating agency and internal limits, diversify risks, reduce the need for
additional capital and strengthen financial ratios. At December 31, 1998, FSA
had reinsured approximately 24.2% of its direct principal amount outstanding.
Most of FSA's reinsurance is on a quota share or first-loss basis, with a small
portion being provided on an excess of loss basis. Reinsurance arrangements
typically require FSA to retain a minimum portion of the risks reinsured.
FSA arranges reinsurance on both a facultative
(transaction-by-transaction) and treaty basis. 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
either cancelable annually upon 90 days' prior notice by either FSA or the
reinsurer or has a one-year term. In addition, the treaties are 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 1998, FSA's principal ceded reinsurance program consisted of two quota
share treaties, one first-loss treaty and automatic facultative facilities. One
quota share treaty (the "asset-backed treaty") covered all of FSA's approved
regular lines of business, except municipal bond insurance. In 1998, FSA ceded
6.75% of each covered policy under this treaty, up to a maximum of $13.5 million
insured principal per single risk. At its sole option, FSA was entitled to
increase the ceding percentage to 13.5% up to $27 million insured principal per
single risk which is defined by revenue source. The other quota share treaty
(the "municipal treaty") covered FSA's municipal bond insurance business. In
1998, FSA ceded 6% 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 $16 million insured principal per
single risk. At its sole option, FSA was entitled to increase the ceding
percentage to 30% up to $80 million insured principal per single risk. These
cession percentages under both treaties were reduced on smaller-sized
transactions. Under the first-loss treaty, FSA ceded a portion of its first-loss
exposure under specified asset-backed transactions. Under the four automatic
facultative facilities in 1998, FSA at its option could allocate up to a
specified amount for each reinsurer (ranging from $4 million to $40 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. The two quota share treaties
and automatic facultative facilities allow FSA to withhold a ceding commission
to defray expenses. In 1998, FSA also utilized facultative quota share
first-loss reinsurance on selected 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 important to FSA, and FSA's reinsurance is
placed with high quality and financially strong reinsurers. FSA's treaty
reinsurers at December 31, 1998 were Asset Guaranty Insurance Company, AXA Re
Finance S.A., Capital Credit Reinsurance Company, Ltd., Capital Reinsurance
Company, Employers Reinsurance Company, Enhance Reinsurance Company, Tokio
Marine and XL Insurance Ltd. In 1998, four reinsurers participated in the
asset-backed quota share treaty and three reinsurers participated in the
municipal quota share treaty and five reinsurers participated in the first-loss
treaty.
17
<PAGE>
FSA, FSAIC, FSA Oklahoma and FSA International have entered into a quota
share reinsurance pooling agreement pursuant to which, after reinsurance
cessions to other reinsurers, the FSA companies share in the net retained risk
insured by each of these companies. Prior to November 1, 1998, FSA, FSAIC and
FSA Oklahoma shared the net retained risk in proportion to their policyholders'
surplus and contingency reserve ("Statutory Capital") 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, 1998, FSA retained 65.63%, FSAIC retained 23.53% and FSA
Oklahoma retained 10.84% of each policy issued by these companies after cessions
to all other reinsurers. Commencing November 1, 1998, FSA Oklahoma ceased to be
a party and FSA International became a party to the agreement, with FSA
International assuming 20% of the business covered by the agreement during a
"ramp-up" period subject to applicable single risk limits. For transactions in
1998 where FSA International retained 20%, FSA's and FSAIC's shares were 58.88%
and 21.12%, respectively. For transactions in 1998 where FSA, FSAIC and FSA
International shared the risk in proportion to their Statutory Capital, the
respective shares were 66.83% for FSA, 23.96% for FSAIC and 9.21% for FSA
International. Following the ramp-up period, FSA, FSAIC and FSA International
will share in business covered by the agreement approximately in proportion to
their Statutory Capital at the end of the prior calendar quarter. 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
ratio exceeds 100%. Under this agreement, FSA-UK ceded to FSA approximately 98%
of its retention after other reinsurance of its policies issued in 1998.
FSA is party to a quota share reinsurance agreement with Commercial
Reinsurance Company ("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. Commercial Re is owned by
MediaOne and Tokio Marine and is engaged exclusively in the business of
reinsuring FSA's commercial mortgage portfolio.
Rating Agencies
The value of the insurance product sold by FSA is generally a function of
the "rating" applied to obligations insured by FSA. The insurance financial
strength, insurer financial strength and claims-paying ability, as the case may
be, of FSA and its operating insurance company subsidiaries is rated "Aaa" by
Moody's Investors Service, Inc. and "AAA" by Standard and Poor's Ratings
Services, Standard & Poor's (Australia) Pty. Ltd., Fitch IBCA, Inc. and Japan
Rating and Investment Information, Inc. Such ratings reflect only the views of
the respective rating agencies, are not recommendations to buy, sell or hold
securities and are subject to revision or withdrawal at any time by such rating
agencies. These rating agencies periodically review the business and financial
condition of FSA, focusing on the insurer's underwriting policies and procedures
and the quality of the obligations insured. Each rating agency performs periodic
assessments of the credits insured by FSA, and the reinsurers and other
providers of capital support to FSA, to confirm that FSA continues to satisfy
such rating agency's capital adequacy criteria necessary to maintain FSA's
"triple-A" rating. 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 is also subject to the
insurance laws of the other states in which it is licensed to transact an
insurance business. FSAIC and FSA Oklahoma are Oklahoma domiciled insurance
companies also licensed in New York and subject to the New York Insurance Law.
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
18
<PAGE>
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.
FSA International is a Bermuda domiciled insurance company subject to
applicable requirements of Bermuda law. FSA International maintains its
principal executive offices in Hamilton, Bermuda. FSA International does not
intend to transact business or establish a permanent place of business in the
United States or Europe. FSA-UK is a United Kingdom domiciled insurance company
subject to applicable requirements of English law. FSA-UK maintains its
principal executive offices in London. Pursuant to European Union Directives,
FSA-UK is generally authorized to write business out of its London office in
other member countries of the European Union subject to the satisfaction of
perfunctory registration requirements.
Domestic Insurance Holding Company Laws
The Company and its domestic insurance company subsidiaries (FSA, FSAIC
and FSA 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 company subsidiaries to register and file certain reports
describing, among other information, their capital structure, ownership and
financial condition. The holding company statutes also require prior approval of
changes in control, 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 FSA 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
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
19
<PAGE>
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, 1998, the maximum amount available
for payment of dividends by FSA without regulatory approval over the following
12 months is approximately $65.7 million.
Financial Guaranty Insurance Regulation in Other Jurisdictions
FSA is subject to laws and regulations of jurisdictions other than the
State of New York concerning the transaction of financial guaranty insurance.
The laws and regulations of these other jurisdictions are generally not more
stringent in any material respect than the New York Insurance Law.
The Bermuda Ministry of Finance regulates FSA International. The United
Kingdom Financial Services Authority regulates FSA-UK. Pursuant to European
Union Directives, FSA-UK has been authorized to provide financial guaranty
insurance for transactions in 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. The Monetary Authority of Singapore regulates activities of
FSA's Singapore office, which is in the process of obtaining a license to
operate as a branch office in Singapore.
Investment Portfolio
FSA manages its investments with the objectives of preserving its triple-A
ratings, 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 primarily by unaffiliated
professional investment managers, with a portion of its municipal portfolio
managed by its affiliate, FSA Portfolio Management. 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 fixed income
investments by FSA, requiring that at least 95% of such investments must be
rated at least "single A" at acquisition and the overall portfolio must be rated
"double A" on average. Fixed income 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 fixed income investments include U.S. Treasury
and agency obligations, corporate bonds, tax-exempt bonds and mortgage
pass-through instruments. The Company and FSA also invest a small portion of
their portfolios in equity securities and/or convertible debt securities.
Furthermore, the Company has investments in various strategic partners,
including XL, XLFA and Fairbanks Capital Holding Corp., which owns a residential
mortgage loan servicer. In addition, the Company has from time to time
20
<PAGE>
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, 1998 was approximately 9.9 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, 1998(1)
Percent of
Investment
Rating Portfolio
------ ----------
AAA(2) ........ 69.0%
AA ............ 21.0
A ............. 9.3
BBB ........... 0.4
Other ......... 0.3
-----
100.0%
=====
- ----------
(1) Ratings are for the long-term fixed income portfolio (95.1% of the entire
investment portfolio as of December 31, 1998) and are based on the higher
of Moody's or S&P ratings available at December 31, 1998.
(2) Includes U.S. Treasury and agency obligations, which comprised 7.9% of the
total portfolio at December 31, 1998.
Summary of Investments
<TABLE>
<CAPTION>
December 31,
---------------------------------------------------------------------------------
1998 1997 1996
----------------------- ----------------------- -----------------------
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 .................. $ 613,324 5.96% $ 453,437 6.52% $ 396,586 6.76%
Tax-exempt bonds ............... 1,041,718 5.26 777,042 5.58 661,831 5.70
---------- ---------- ----------
Total long-term investments .... 1,655,042 5.51 1,230,479 5.92 1,058,417 6.09
Short-term investments(2) ........... 74,675 4.96 110,308 6.22 56,733 5.43
---------- ---------- ----------
Total investments(3) ........... $1,729,717 5.49% $1,340,787 5.95% $1,115,150 6.06%
========== ========== ==========
</TABLE>
- ----------
(1) Yields are stated on a pre-tax basis.
(2) Includes taxable and tax-exempt investments and excludes cash equivalents
of $23.9 million, $22.6 million and $16.9 million, respectively.
(3) Excludes stocks at cost of $64.3 million, $29.4 million and $8.3 million,
respectively.
Investment Portfolio by Security Type
<TABLE>
<CAPTION>
December 31,
---------------------------------------------------------------------------------
1998 1997 1996
----------------------- ----------------------- -----------------------
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 .......... $ 148,669 5.14% $ 122,817 6.20% $ 55,619 6.63%
Mortgage-backed securities .......... 266,770 6.54 195,567 6.62 177,818 6.88
Municipal bonds ..................... 1,041,718 5.26 777,042 5.58 661,831 5.70
Asset-backed securities ............. 33,188 7.07 20,961 6.69 71,370 6.82
Corporate securities ................ 164,697 5.34 66,014 5.72 76,760 6.55
</TABLE>
21
<PAGE>
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C> <C> <C>
Foreign securities .................. -- 48,078 7.62 15,019 6.50
---------- ---------- ----------
Total fixed maturities ......... 1,655,042 5.51 1,230,479 5.92 1,058,417 6.09
Short-term investments(2) ........... 74,675 4.96 110,308 6.22 56,733 5.43
---------- ---------- ----------
Total investments(3) ........... $1,729,717 5.49% $1,340,787 5.95% $1,115,150 6.06%
========== ========== ==========
</TABLE>
- ----------
(1) Yields are stated on a pre-tax basis.
(2) Includes taxable and tax-exempt investments and excludes cash equivalents
of $23.9 million, $22.6 million and $16.9 million, respectively.
(3) Excludes stocks at cost of $64.3 million, $24.9 million and $8.3 million,
respectively.
Distribution of Investments by Maturity
<TABLE>
<CAPTION>
December 31,
---------------------------------------------------------------------------
1998 1997 1996
----------------------- ----------------------- -----------------------
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) ...... $ 75,677 $ 75,681 $ 114,317 $ 114,315 $ 95,038 $ 95,359
Due after one year through five
years ...................... 137,094 139,642 70,283 70,007 57,531 57,712
Due after five years through
ten years .................. 225,259 233,080 208,986 208,170 105,495 105,848
Due after ten years ............. 991,729 1,030,156 730,673 766,912 607,898 620,031
Mortgage-backed securities ...... 266,770 270,500 195,567 197,753 177,818 178,344
Asset-backed securities ......... 33,188 33,656 20,961 21,309 71,370 71,878
---------- ---------- ---------- ---------- ---------- ----------
Total investments(2) ....... $1,729,717 $1,782,715 $1,340,787 $1,378,466 $1,115,150 $1,129,172
========== ========== ========== ========== ========== ==========
</TABLE>
- ----------
(1) Includes short-term investments in the amount of $74.7 million, $110.3
million and $56.7 million at December 31, 1998, 1997 and 1996,
respectively, but excludes cash equivalents of $23.9 million, $22.6
million, and $16.9 million, respectively.
(2) Excludes stocks at cost of $64.3 million, $29.4 million and $8.3 million,
respectively.
Mortgage-Backed Securities
Cost and Market Value by Investment Category
<TABLE>
<CAPTION>
December 31, 1998
-----------------------------------
Amortized Estimated
Investment Category Par Value Cost Market Value
------------------- --------- --------- ------------
(in thousands)
<S> <C> <C> <C>
Pass-through securities--U.S. Government agency $171,284 $170,069 $171,247
CMO's--U.S. Government agency 32,901 32,489 33,935
CMO's--non-agency 64,003 64,212 65,318
-------- -------- --------
Total mortgage-backed securities $268,188 $266,770 $270,500
======== ======== ========
</TABLE>
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, 1998, the Company held sequential pay CMO tranches and
Planned Amortization Classes of CMO's. The CMO's held at December 31, 1998 have
stated maturities ranging from 2 to 37 years, and expected average lives ranging
from 1 to 28 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, 1998, 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
22
<PAGE>
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.
Employees
At December 31, 1998, the Company and its subsidiaries had 232 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 or its subsidiaries also maintain
leased office space in San Francisco, Dallas, Hamilton (Bermuda), London
(England), Paris (France), Madrid (Spain), Singapore, Sydney (Australia) and
Tokyo (Japan). The Company and its subsidiaries do not own any real property.
Item 3. Legal Proceedings.
23
<PAGE>
In the ordinary course of business, the Company and certain subsidiaries
have become party to certain litigation. The Company believes that none of these
matters, if decided against the Company, would have a material impact on the
Company's consolidated financial position, results of operations or cash flows.
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 1998.
24
<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 1998
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 10, 1999, there were approximately 3,500
holders of the Company's Common Stock, which is listed on the New York Stock
Exchange.
During the fourth quarter of 1998, the Company issued 1,632,653
unregistered shares of Common Stock in reliance upon an exemption from
registration under the Securities Act of 1933 (the "Act") pursuant to Section
4(2) of the Act. Further information about such issuance is contained in Item 5,
"Other Information," of the Company's quarterly report on Form 10-Q for the
quarter ended September 30, 1998.
Item 6. Selected Financial Data.
Selected financial data for the Company and its subsidiaries for each of
the last five years is set forth hereunder. Data included herein has been
restated as described in the "Restatements and Reclassifications" section of
Note 2 to the Company's consolidated financial statements:
<TABLE>
<CAPTION>
Dollars in millions, except per
share data 1998 1997 1996 1995 1994
<S> <C> <C> <C> <C> <C>
Summary of Operations (a)
Gross premiums written $ 319.3 $ 236.4 $ 177.0 $ 110.7 $ 106.4
Net premiums written 219.9 172.9 121.0 77.6 77.8
Net premiums earned 137.9 109.5 90.4 69.3 65.8
Net investment income 78.8 72.1 65.1 49.0 46.6
Net income 115.4 94.7 78.0 55.0 (b) 60.4
Balance Sheet Data (a)
Total investments $ 1,874.8 $ 1,431.6 $ 1,154.4 $ 1,110.7 $ 747.2
Total assets 2,444.2 1,931.2 1,560.2 1,501.4 1,074.3
Deferred premium revenue, net 504.6 422.1 360.0 330.3 212.9
Loss and loss adjustment expense
reserve, net 60.0 44.8 42.2 50.2 35.6
Notes payable 230.0 130.0 30.0 30.0 --
Preferred stock 0.7 0.7 0.7 0.7 0.7
Common shareholders' equity 1,065.4 875.2 797.9 777.2 544.7
Per Common Share Data (a)
Earnings per share (c) $ 3.77 $ 3.06 $ 2.52 $ 2.13 $ 2.32
Book value per share 35.63 30.44 26.62 24.67 20.92
Dividends paid 0.44 0.41 0.35 0.32 0.16
Additional Data
Qualified statutory capital $ 1,037.7 $ 781.7 $ 675.9 $ 644.7 $ 465.8
Total claims-paying resources (d) 2,119.6 1,696.1 1,372.3 1,157.1 821.8
Net par outstanding 104,673.0 75,478.0 59,194.0 45,979.0 28,223.0
Net insurance in force
(principal + interest) 159,995.0 117,430.0 93,704.0 75,360.0 45,825.0
Policyholders' leverage
(risk-to-capital ratio) 154:1 150:1 139:1 117:1 98:1
</TABLE>
(Footnotes appear on next page)
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(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 with Capital Guaranty
Corporation.
(c) Represents diluted earnings per share.
(d) Statutory capital + statutory unearned premium reserve + present value of
future net installment premiums + statutory loss reserve + standby line of
credit facility.
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 hereunder (data included herein has been restated as
described in "Restatements and Reclassifications" section of Note 2 to the
consolidated financial statements):
Results of Operations
Year Ended December 31, 1998 versus Year Ended December 31, 1997
Adjusted book value per common share of Financial Security Assurance Holdings
Ltd. (the Company) was $47.62 at December 31, 1998, up 19.5% including dividends
since year-end 1997. Excluding realized and unrealized capital gains and losses,
adjusted book value per share rose 16.2% 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 equity
compensation programs and other non-recurring adjustments. Core net income
therefore represents the Company's normal operating results on a basis
comparable to that of its industry peers. 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 equity
compensation programs and other non-recurring adjustments, if any.
The Company reports core, operating and reported net income per share results in
accordance with SFAS No. 128, which the Company adopted on December 31, 1997.
The standard defines "basic" and "diluted" earnings per share. Basic earnings
per share is 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 programs to the average common shares outstanding. Diluted
earnings per share is based on average diluted shares outstanding, which is
calculated by adding shares contingently issuable under stock options, the
performance share program and the Company's redeemable 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 1998 net income was $115.4 million ($3.77 per share), compared
with $94.7 million ($3.06 per share) for 1997, an increase of 21.8%. Core net
income was $107.5 million ($3.51 per share) for 1998, compared with $90.7
million ($2.93 per share) for 1997, an increase of 18.5%. Total core revenues
increased in 1998 by $29.8 million, from $171.6 million for 1997 to $201.4
million for 1998, while total core expenses increased only $7.6 million.
Operating net income was $114.9 million ($3.76 per share) for 1998 versus $95.9
million ($3.10 per share) for 1997, an increase of $19.0 million, or 19.8%.
The Company employs 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,
gross present value of premiums
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<PAGE>
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 portion 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 discounts the future installment premium payments. For all years
prior to 1998, the Company used a fixed discount rate of 9.5%. At the beginning
of 1998, the Company began calculating the discount rate as the average pre-tax
yield on its investment portfolio for the previous three years. This rate for
1998 was 6.31%. Management intends to revise the discount rate in future years
according to the same formula, in order to reflect interest rates more
accurately.
The Company's principal operating subsidiary, Financial Security Assurance Inc.
(FSA), benefited in 1998 from growth of its core markets and a flight to quality
created by volatility in worldwide capital markets. As credit spreads widened
for securities at all levels in the credit spectrum, the value of FSA's guaranty
increased, and the Company was able to increase production volume significantly
while maintaining pricing and underwriting standards. Business was well balanced
across U.S. municipal and asset-backed markets. International activity was
limited during 1998 because the Company found relatively few opportunities with
returns on equity and risk profiles meeting FSA standards.
Gross PV premiums written increased 56.3% to $391.2 million for 1998 from $250.3
million for 1997. (Without the discount rate revision, gross PV premiums written
would have been $379.9 million, an increase of 51.8%.) In 1998, the Company
insured $58.6 billion par value of bonds, a 58.2% increase over par insured in
1997.
Asset-backed market conditions were favorable. Securitization volume was strong,
credit spreads widened, and competition from uninsured executions decreased as
demand fell for subordinated debt and residuals. As a result, FSA found a larger
number of appropriate transactions to guarantee and was able to expand its
product lines. In addition to maintaining strong production in the consumer and
residential mortgage finance sectors, FSA significantly increased its volume of
structured financings, such as collateralized debt obligations. Asset-backed
gross PV premiums written were $162.7 million in 1998, compared with $111.0
million in 1997, an increase of 46.6%. FSA's asset-backed par insured increased
20.8% to $23.5 billion.
FSA also increased its municipal bond insurance volume, returns and market
share, aided by higher market volume for new municipal bonds, increased market
penetration by bond insurance and strong trading value for FSA-insured bonds.
For the municipal business, gross PV premiums written increased to $228.5
million for 1998 from $139.3 million for 1997, an increase of 64.1%. FSA's
municipal par insured increased 99.6% to $35.1 billion. Municipal par increased
more than municipal PV premiums written because of a reduction in international
transactions, which generally have high premium rates, and a decrease in the
average lives of domestic general obligations. In addition, the capital charges
assigned by Standard & Poor's to measure risk in FSA's municipal transactions,
which began the year at the lowest level of risk in the industry, decreased
further during the year because of the higher quality of the new business
insured.
FSA's gross premiums written increased 35.1% to $319.3 million for 1998 from
$236.4 million for 1997. Net premiums written were $219.9 million during 1998,
an increase of 27.2% when compared with the 1997 result. Gross premiums written
grew at a faster pace than net premiums written due to the Company's greater use
of reinsurance to expand capacity for large transactions and certain successful
securitization programs. Reinsurance cessions totaled 31.1% of 1998 gross
premiums written, compared with 26.9% in 1997. Net premiums earned in 1998 were
$137.9 million, compared with $109.5 million in 1997, an increase of 25.9%.
Premiums earned from refundings and prepayments were $15.8 million for 1998 and
$11.3 million for 1997, contributing $7.4 million and $5.2 million,
respectively, to after-tax earnings. Before the effects of refundings and
prepayments, net premiums earned grew 24.3% over the comparable 1997 result. No
assurance can be given that refundings and prepayments will continue at the
level experienced in 1998 or 1997.
Net investment income was $78.8 million for 1998 and $72.1 million for 1997, an
increase of 9.3%. 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 of 1998. The Company's effective tax rate on investment income was 17.6%
for 1998, compared with 19.9% for 1997. In 1998, the Company realized $20.9
million in net capital gains, compared with $11.5 million in 1997. Capital gains
and losses are a by-product of the normal investment management process and will
vary substantially from period to period.
27
<PAGE>
Other income was $0.5 million for 1998, compared with $9.3 million for 1997.
Other income in 1997 was largely due to the sale of two insurance subsidiaries
to realize the value of their redundant insurance licenses. All of the
subsidiaries' insurance policy obligations were assumed by FSA.
Interest expense in 1998 was $10.6 million, an increase of $6.2 million when
compared with 1997 results. 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 1998 was $4.0 million,
compared with $9.2 million in 1997, representing additions to the Company's
general reserve. During 1998, the Company transferred $18.4 million to its
general reserve from case basis reserves due to recoveries on certain commercial
mortgage transactions. This recovery allowed for a decrease of $4.1 million in
the amount needed to fund the general reserve for originations of new business
in 1998. Also during 1998, the Company transferred $9.4 million from its general
reserve to case basis reserves due primarily to anticipated claims on two
sub-prime auto loan programs. The additions to the general reserve represent
management's estimate of the amount required to cover the present value of the
net cost of claims adequately. The Company will, on an ongoing basis, monitor
these reserves and may periodically adjust such reserves, upward or downward,
based on the Company's actual loss experience, its future mix of business, and
future economic conditions. At December 31, 1998, the Company's general reserve
was $47.3 million.
Total policy acquisition and other operating expenses (excluding the cost of
equity based compensation programs, which was $19.9 million for 1998 and $20.5
million for 1997, and interest expense) were $45.6 million in 1998, compared
with $38.0 million in 1997, an increase of $7.6 million. Further excluding the
effect of refundings, total policy acquisition and other operating expenses were
$41.2 million in 1998, compared with $34.7 million in 1997, an increase of $6.5
million. The increase resulted from greater amortization of deferred acquisition
costs due to a higher level of core premiums earned, along with higher personnel
costs. The Company's core expense ratio fell to 33.8% from 35.3% in 1997.
Income before income taxes for 1998 was $157.3 million, up 21.4% from $129.5
million for 1997.
The Company's effective tax rate for 1998 was 26.7%, compared with 26.9% for
1997.
The weighted average number of diluted shares of common stock outstanding
decreased from 30,913,000 for 1997 to 30,599,000 for 1998. This decrease was
primarily due to stock repurchases by the Company to fund obligations under
employee benefit plans, partially offset by an increase in the dilutive effect
of the Company's redeemable preferred stock and shares unissued or contingently
issuable for employee benefit plans.
Market Risk
The main objective in managing the Company's investment portfolio is to maximize
the total return while minimizing investment credit risks. Investment strategies
are based on many factors, including the Company's tax position, fluctuation in
interest rates, regulatory and rating agency criteria and other market factors.
Investment decisions are carried out by one internal investment manager and
three external investment managers for the fixed-income investments and four
external managers for the equity portfolio. These investment decisions are based
on guidelines established by management and approved by the board of directors.
Market risk represents the potential for loss due to adverse changes in the fair
value of financial instruments. The market risks related to financial
instruments of the Company relate primarily to its investment portfolio, of
which 91% is invested in fixed-income securities. Changes in interest rates
affect the value of the Company's fixed-income portfolio. As interest rates
rise, the fair value of fixed-income securities decreases. Sensitivity to
interest rate movements can be estimated by projecting a hypothetical increase
in interest rates of 1.0%. Based on market values and interest rates at year-end
1998, this hypothetical increase in interest rates would result in an after-tax
decrease of $73.4 million in the net fair value of the Company's fixed-income
portfolio. Since the Company is able to hold these investments to maturity,
absent an unusually large demand for funds, it does not expect to recognize any
material adverse impact to income or cash flows under the above scenario.
The Company's investment portfolio holdings are primarily U.S.
dollar-denominated fixed-income securities, including municipal bonds, U.S.
government bonds, and mortgage-backed, asset-backed and corporate securities. In
calculating the sensitivity to interest rates for the taxable securities, U.S.
Treasury rates are changed instantaneously
28
<PAGE>
by 1.0%, and the option-adjusted spreads of the securities are held constant.
Tax-exempt securities are subjected to a change in the Municipal Triple-A
Obligation curve that would be equivalent to a 1.0% taxable interest rate change
based on year-end taxable/tax-exempt ratios. The simulation for tax-exempts
calculates duration by taking into account the applicable call date if the bond
is at a premium or the maturity date if the bond is at a discount.
Year 2000 Readiness Disclosure
The Company established its Year 2000 (Y2K) committee in 1997. The committee has
investigated potential effects on FSA of the Y2K problem arising from the
inability of some computers to properly recognize dates in the year 2000 and
later. The Company has examined its hardware, software, network and customer and
vendor interdependencies in FSA's information systems and has found no material
problems with any mission-critical FSA systems. It has conducted appropriate
tests on its larger hardware and networking components, personal computers and
material systems software, and all such systems are considered to be Y2K
compliant. By mid-1999, the Company expects to have completed verification of
Y2K compliance with outside vendors from which the Company purchases software.
These are generally large vendors with active Y2K programs. The cost of the
Company's Y2K compliance has been immaterial.
FSA's financial guaranty policies do not contain an exclusion for Y2K problems.
Each guaranty policy is customized for its individual transaction, so the actual
policy and other transaction documents should be consulted regarding questions
about the effect of Y2K problems of specific parties on specific policies. For
example, if an issuer fails to make an insured payment due to a Y2K problem,
FSA's insurance policy generally would cover such failure. On the other hand, if
the issuer made the payment and the trustee failed to distribute it to
bondholders due to a Y2K problem, FSA's insurance policy generally would not
cover such failure. To investigate whether certain entities connected with
transactions it insures have Y2K problems that could affect insured payments,
FSA has surveyed the servicers and trustees for FSA-insured asset-backed
transactions and has also surveyed certain companies that operate in a trustee,
paying agent or securities depository capacity for a large component of FSA's
public finance book of business. Responses to date have generally indicated
active Y2K testing and remediation programs. FSA plans to query the companies
again in 1999 to measure their progress.
While none of the parties that the Company has surveyed have informed the
Company of any material issues regarding Y2K readiness, there can be no
assurance that each party will be Y2K compliant. Failure by an issuer or
servicer in an FSA-insured transaction to be Y2K compliant may result in
unanticipated claims upon FSA. While FSA generally would be entitled to
reimbursement for any such claims paid, the liquidity and credit exposure to FSA
from such claims could be material. As a result, management is assessing the
need to increase its available liquidity facility at year end 1999 in order to
meet presently unanticipated demand for claims payments. FSA provides additional
information about its Y2K compliance program on its website at www.fsa.com/y2k.
Year Ended December 31, 1997 versus Year Ended December 31, 1996
The Company's 1997 net income was $94.7 million ($3.06 per share), compared with
$78.0 million ($2.52 per share) for 1996, an increase of 21.3%. 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%.
The markets in which 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.
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<PAGE>
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.
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 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
equity based compensation programs, which was $20.5 million for 1997 and $9.5
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 $129.5 million, up 22.7% from $105.6
million for 1996.
The Company's effective tax rate for 1997 was 26.9%, compared with 26.1% 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 redeemable
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.
Liquidity and Capital Resources
The Company's consolidated invested assets and cash equivalents at December 31,
1998, net of unsettled security transactions, were $1,770.6 million, compared
with the December 31, 1997 balance of $1,379.3 million. These balances include
the change in the market value of the investment portfolio, which had an
unrealized gain position of $58.0 million at December 31, 1998, compared with an
unrealized gain position of $38.8 million at December 31, 1997. At December 31,
1998, the Company had, at the holding company level, an investment portfolio of
$59.5 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
30
<PAGE>
and to declare and pay dividends will largely depend upon its receipt of
dividends from, or payment on convertible surplus notes by, 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 1998. Based upon FSA's statutory statements for the quarter ended
December 31, 1998, 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 $65.7 million. In
addition, the Company holds $120 million of convertible surplus notes of FSA.
Payments of principal or interest on such notes may be made with the approval of
the New York Insurance Department.
In 1998, FSA repurchased $8.5 million of its shares from its parent,
representing the balance remaining of $75.0 million that had been approved for
repurchase by the New York Insurance Department.
Dividends paid by the Company to its shareholders increased to $12.8 million in
1998 from $12.1 million in 1997 and to $0.44 per common share in 1998 from
$0.405 in 1997. 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 1998, the Company purchased $23.9 million of
its stock for employee benefit plans. During the fourth quarter of 1998, the
Company issued $100.0 million of 6.950% Senior Quarterly Income Debt Securities
due November 1, 2098 and callable on or after November 1, 2003. The proceeds
from this issuance were used to augment the capital in its insurance company
subsidiaries and for general corporate purposes. The Company also has
outstanding $130.0 million of 7.375% Senior Quarterly Income Debt Securities due
September 30, 2097 and callable on or after September 18, 2002. These securities
were issued during 1997.
In May 1996, the Company repurchased 1,000,000 shares of its common stock from
US WEST for a purchase price of $26.50 per share. At the same time, the Company
also entered into forward agreements with two financial institutions (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 1998 and 1997 were $0.7 million and $2.1 million,
respectively. By the fourth quarter of 1997, 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, 1998, 562,200 Forward Shares
remained in the program. Of these, 33,078 shares were held for the benefit of
the Company as a result of the repurchase of Forward Shares from employees and
directors, and 529,122 shares continued to be held for the benefit of employees
and directors. For each dollar change in the Company's share price, net income
will be effected by approximately $0.3 million, or $0.01 per share.
On November 3, 1998, the Company and XL Capital Ltd (XL), which was named EXEL
Limited until February 1999, closed a transaction to create two new
Bermuda-based financial guaranty insurance companies. Each of the new companies
has initially been capitalized with approximately $100 million. One company,
Financial Security Assurance International Ltd., is an indirect subsidiary of
FSA, and the other company, XL Financial Assurance Ltd, is a subsidiary of XL.
The Company has a minority interest in the XL subsidiary, and XL has a minority
interest in the FSA indirect subsidiary. In conjunction with forming the new
companies, the Company and XL exchanged $80 million of their respective common
shares, with the Company delivering to XL 1,632,653 common shares out of
treasury. Prior to the closing of the transaction with XL, the Company had
entered into an agreement with an unrelated third party to sell for cash, at no
gain or loss, $60 million of the XL shares. This $60 million was used to fund,
in part, the Company's investment in Financial Security Assurance International
Ltd.
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FSA's primary uses of funds are to pay operating expenses and to pay dividends
to its parent. FSA's funds are also required to satisfy 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 payment sources in the
transaction, such as the cash flow or collateral underlying the obligations. FSA
seeks to structure asset-backed transactions to address liquidity risks by
matching insured payments with available cash flow or other payment sources. 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.
FSA has a credit arrangement, aggregating $150.0 million at December 31, 1998,
that is provided by commercial banks and intended for general application to
transactions insured by FSA and its insurance company subsidiaries. At December
31, 1998, there were no borrowings under this arrangement, which expires on
November 23, 1999, unless extended. 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 $186.9 million, of which
$45.0 million was unutilized at December 31, 1998.
FSA has a standby line of credit commitment in the amount of $240.0 million 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 $230.0 million 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 in the covered portfolio, including certain installment
premiums and other collateral. This commitment has a term beginning on April 30,
1998 and expiring on April 30, 2005 and contains an annual renewal provision
subject to approval by the banks. No amounts have been utilized under this
commitment as of December 31, 1998.
The Company has no plans for material capital expenditures within the next
twelve months.
Item 7A. Qualitative and Quantitative Disclosures About Market Risks.
Qualitative and quantitative disclosures about market risks is set forth
in Item 7 under the caption "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Results of Operations - Market Risk".
32
<PAGE>
Item 8. Financial Statements and Supplementary Data.
The 1998 Consolidated Financial Statements, together with the Notes
thereto and the Report of Independent Accountants thereon, are set forth
hereunder:
Report of Independent Accountants
To the Shareholders and Board of Directors
of Financial Security Assurance Holdings Ltd.:
In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a)(1) present fairly, in all material respects, the
financial position of Financial Security Assurance Holdings Ltd. and
Subsidiaries (the Company) at December 31, 1998 and 1997 and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 1998, in conformity with generally accepted accounting
principles. In addition, in our opinion, the financial statement schedule listed
in the index appearing under Item 14(a)(2) presents fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements. These financial statements and
financial statement schedule are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with generally accepted auditing standards, which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
As indicated in Note 2, the consolidated financial statements at December 31,
1998 and 1997 and for each of the three years in the period ended December 31,
1998 have been revised.
/s/ PricewaterhouseCoopers LLP
------------------------------
PRICEWATERHOUSECOOPERS LLP
New York, New York
January 26, 1999, except for the
restatements and reclassifications section
in Note 2 as to which the date
is August 4, 1999
33
<PAGE>
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data)
December 31, December 31,
ASSETS 1998 1997
----------- -----------
Bonds at market value (amortized cost of
$1,655,042 and $1,230,479) $ 1,708,040 $ 1,268,158
Equity investments at market value (cost of
$64,292 and $29,430) 68,243 30,539
Short-term investments 98,554 132,931
----------- -----------
Total investments 1,874,837 1,431,628
Cash 3,490 12,475
Deferred acquisition costs 199,559 171,098
Prepaid reinsurance premiums 217,096 173,123
Reinsurance recoverable on unpaid losses 3,907 30,618
Receivable for securities sold 1,655 20,623
Investment in unconsolidated affiliates 29,496 --
Other assets 114,166 91,599
----------- -----------
TOTAL ASSETS $ 2,444,206 $ 1,913,164
=========== ===========
LIABILITIES AND MINORITY INTEREST,
REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY
Deferred premium revenue $ 721,699 $ 595,196
Losses and loss adjustment expenses 63,947 75,417
Deferred federal income taxes 87,254 82,786
Ceded reinsurance balances payable 31,502 11,199
Payable for securities purchased 105,859 72,979
Notes payable 230,000 130,000
Minority interest 20,388 --
Accrued expenses and other liabilities 117,421 87,638
----------- -----------
TOTAL LIABILITIES AND MINORITY INTEREST 1,378,070 1,055,215
----------- -----------
COMMITMENTS AND CONTINGENCIES
REDEEMABLE PREFERRED STOCK
Redeemable preferred stock (3,000,000 shares
authorized; 2,000,000 issued and outstanding;
par value of $.01 per share) 20 20
Additional paid-in capital - preferred 680 680
----------- -----------
700 700
Common stock (50,000,000 shares authorized;
32,276,301 issued; par value of $.01 per share) 323 323
Additional paid-in capital - common 733,442 695,993
Accumulated other comprehensive income (net of
deferred income tax provision of $20,288
and $13,575) 37,678 25,212
Accumulated earnings 325,150 222,571
Deferred equity compensation 43,946 26,181
Less treasury stock at cost (2,372,839 and
3,521,847 shares held) (75,103) (95,031)
----------- -----------
TOTAL SHAREHOLDERS' EQUITY 1,065,436 875,249
----------- -----------
TOTAL LIABILITIES AND MINORITY INTEREST,
REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY $ 2,444,206 $ 1,931,164
=========== ===========
The accompanying Notes to Consolidated Financial Statements are an integral part
of these statements. Each year has been revised. See Note 2 section entitled
"Restatements and Reclassifications".
34
<PAGE>
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
REVENUES: 1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Net premiums written $ 219,853 $ 172,878 $ 121,000
Increase in deferred premium revenue (81,926) (63,367) (30,552)
--------- --------- ---------
Premiums earned 137,927 109,511 90,448
Net investment income 78,823 72,085 65,064
Net realized gains 20,890 11,522 3,189
Other income 474 9,303 297
--------- --------- ---------
TOTAL REVENUES 238,114 202,421 158,998
--------- --------- ---------
EXPENSES:
Losses and loss adjustment expenses 3,949 9,156 6,874
Policy acquisition costs 35,439 27,962 23,829
Other operating expenses 40,631 35,755 22,732
--------- --------- ---------
TOTAL EXPENSES 80,019 72,873 53,435
--------- --------- ---------
Minority interest and equity in earnings of
unconsolidated affiliates (844) -- --
--------- --------- ---------
INCOME BEFORE INCOME TAXES 157,251 129,548 105,563
--------- --------- ---------
Provision (benefit) for income taxes:
Current 44,140 22,966 15,817
Deferred (2,245) 11,898 11,721
--------- --------- ---------
Total provision 41,895 34,864 27,538
--------- --------- ---------
NET INCOME 115,356 94,684 78,025
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses)
arising during period (net of
deferred income tax provision
(benefit) of $14,024, $12,701 and
$(4,708)) 26,045 23,587 (8,744)
Less: reclassification adjustment for
gains included in net income (net
of deferred income tax provision
of $7,311, $4,033 and $1,116) (13,579) (7,489) (2,073)
--------- --------- ---------
Other comprehensive income (loss) 12,466 16,098 (10,817)
--------- --------- ---------
COMPREHENSIVE INCOME $ 127,822 $ 110,782 $ 67,208
========= ========= =========
As based upon net income:
Basic earnings per common share $ 3.96 $ 3.16 $ 2.55
========= ========= =========
Diluted earnings per common share $ 3.77 $ 3.06 $ 2.52
========= ========= =========
</TABLE>
The accompanying Notes to Consolidated Financial Statements are an integral part
of these statements. Each year has been revised. See Note 2 section entitled
"Restatements and Reclassifications".
35
<PAGE>
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
Additional Unrealized
Paid-In Gain Deferred
Common Capital - (Loss) on Accumulated Equity Treasury
Stock Common Investments Earnings Compensation Stock Total
----- ------ ----------- -------- ------------ ----- -----
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE, December 31, 1995 $323 $696,253 $19,931 $72,410 $ 6,504 $(18,174) $777,247
Net income for the year 78,025 78,025
Net change in accumulated comprehensive
income (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 323 695,118 9,114 139,986 12,069 (58,785) 797,825
Net income for the year 94,684 94,684
Net change in accumulated comprehensive
income (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 settlements with
counterparties (33,910) (33,910)
---- -------- ------- -------- ------- -------- ----------
BALANCE, December 31, 1997 323 695,993 25,212 222,571 26,181 (95,031) 875,249
Net income for the year 115,356 115,356
Net change in accumulated comprehensive
income (net of deferred
income taxes of $6,713) 12,466 12,466
Dividends paid on common stock
($0.44 per share) (12,777) (12,777)
Deferred equity compensation 23,970 23,970
Deferred equity payout 750 (6,371) 204 (5,417)
Purchase of 496,940 shares of
common stock (23,907) (23,907)
Issuance of 1,632,653 shares of treasury
stock for XL stock 36,721 43,279 80,000
Issuance of 13,295 shares of treasury
stock for options exercised (22) 166 352 496
---- -------- ------- -------- ------- -------- ----------
BALANCE, December 31, 1998 $323 $733,442 $37,678 $325,150 $43,946 $(75,103) $1,065,436
==== ======== ======= ======== ======= ======== ==========
</TABLE>
The accompanying Notes to Consolidated Financial Statements are an integral part
of these statements. Each year has been revised. See Note 2 section entitled
"Restatements and Reclassifications".
36
<PAGE>
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1998 1997 1996
----------- ----------- -----------
<S> <C> <C> <C>
Cash flows from operating activities:
Premiums received, net $ 247,229 $ 171,145 $ 124,540
Policy acquisition and other operating expenses
paid, net (53,306) (43,279) (32,266)
Recoverable advances received (paid) 1,473 (7,629) 10,213
Losses and loss adjustment expenses recovered
(paid) 10,989 (6,463) (15,473)
Net investment income received 70,146 65,662 63,533
Federal income taxes paid (54,020) (19,797) (34,595)
Interest paid (9,614) (5,158) (2,115)
Other (1,623) (2,017) (4,253)
----------- ----------- -----------
Net cash provided by operating activities 211,274 152,464 109,584
----------- ----------- -----------
Cash flows from investing activities:
Proceeds from sales of bonds 1,908,098 1,074,658 1,117,473
Proceeds from sales of equity investments 33,613 3,568 --
Proceeds from maturities of bonds -- 32,468 2,965
Purchases of bonds (2,257,947) (1,229,612) (1,141,688)
Purchases of equity investments (48,475) (24,662) (8,336)
Net gain on sale of subsidiaries -- 7,986 --
Purchases of property and equipment (1,168) (3,097) (2,188)
Net decrease (increase) in short-term
investments 39,513 (55,551) (18,586)
Other investments (14,610) -- --
----------- ----------- -----------
Net cash used for investing activities (340,976) (194,242) (50,360)
----------- ----------- -----------
Cash flows from financing activities:
Issuance of notes payable, net 96,850 125,905 --
Repayment of notes payable -- (30,000) --
Dividends paid (12,777) (12,099) (10,536)
Treasury stock, net (23,686) (36,246) (41,660)
Issuance of stock for acquisition of subsidiary (a) 60,000 -- --
Other 330 (1,453) --
----------- ----------- -----------
Net cash provided by (used for) financing
Activities 120,717 46,107 (52,196)
----------- ----------- -----------
Net increase (decrease) in cash (8,985) 4,329 7,028
Cash at beginning of year 12,475 8,146 1,118
----------- ----------- -----------
Cash at end of year $ 3,490 $ 12,475 $ 8,146
=========== =========== ===========
</TABLE>
Continued
(a) The Company exchanged $20,000 of its stock at fair market value for $20,000
of XL stock at fair market value. The accompanying Notes to Consolidated
Financial Statements are an integral part of these statements. Each year has
been revised. See Note 2 section entitled "Restatements and Reclassifications".
37
<PAGE>
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(Dollars in thousands)
<TABLE>
<CAPTION>
Year Ended December 31,
--------------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Reconciliation of net income to net cash flows from
operating activities:
Net income $115,356 $ 94,684 $ 78,025
Increase in accrued investment income (3,613) (2,504) (578)
Increase in deferred premium revenue and related
foreign exchange adjustment 82,530 62,101 29,622
Increase in deferred acquisition costs (28,461) (24,865) (13,282)
Increase (decrease) in current federal income
taxes payable (1,674) 7,891 (7,368)
Increase (decrease) in unpaid losses and loss
adjustment expenses 15,240 2,596 (8,023)
Increase in amounts withheld for others 82 133 52
Provision (benefit) for deferred income taxes (2,245) 15,170 11,721
Net realized gains on investments (20,890) (11,522) (3,189)
Deferred equity compensation 17,765 14,299 5,565
Depreciation and accretion of bond discount (4,523) (2,802) (1,735)
Minority interest and equity in earnings of
unconsolidated affiliates 844 -- --
Net gain on sale of subsidiaries -- (7,986) --
Change in other assets and liabilities 40,863 5,269 18,774
-------- -------- --------
Cash provided by operating activities $211,274 $152,464 $109,584
======== ======== ========
</TABLE>
The accompanying Notes to Consolidated Financial Statements are an integral part
of these statements. Each year has been revised. See Note 2 section entitled
"Restatements and Reclassifications".
38
<PAGE>
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
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 company 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 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 Asia Pacific region.
At December 31, 1996, the Company was owned 40.4% by U S WEST Capital
Corporation (U S WEST), 11.5% by Fund American Enterprises Holdings, Inc. (Fund
American), 6.4% by The Tokio Marine and Fire Insurance Co., Ltd. (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. On November 3, 1998, the Company issued 1,632,653
common shares out of treasury to XL Capital Ltd (XL), which was named EXEL
Limited until February 1999, in exchange for $80,000,000 of XL's common stock in
conjunction with the creation of a new subsidiary (see Note 7). At December 31,
1998, the Company was owned 40.5% by MediaOne Capital Corporation (MediaOne),
formerly U S WEST, 11.6% by Fund American, 6.4% by Tokio Marine, 5.5% by XL and
36.0% 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
5). The preparation of financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities in
the Company's consolidated balance sheets at December 31, 1998 and 1997 and the
reported amounts of revenues and expenses in the consolidated statements of
income during the years ended December 31, 1998, 1997 and 1996. 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:
39
<PAGE>
Basis of Presentation
The consolidated financial statements include the accounts of the Company
and its direct and indirect subsidiaries, FSA Portfolio Management Inc.,
Transaction Services Corporation, Financial Security Assurance Inc. (FSA), FSA
Insurance Company, Financial Security Assurance International Ltd., 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 1998 presentation.
Investments
Investments in debt securities designated as available for sale are
carried at market value. Equity investments are carried at market value. Any
resulting unrealized gain or loss is reflected as a separate component of
shareholders' equity, net of applicable deferred income taxes. Except as
specified in Note 20, 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.
The Company holds derivative securities, including U.S. Treasury bond
futures contracts and call option contracts, that are not accounted for as
hedges and are marked-to-market on a daily basis. Any gains or losses are
included in capital gains or losses.
Investments in unconsolidated affiliates are carried on the equity basis
(see Note 20).
Premium Revenue Recognition
Gross and ceded premiums are earned in proportion to the amount of risk
outstanding over the expected period of coverage. The amount of risk outstanding
is equal to the sum of the par amount of debt insured. Deferred premium revenue
and prepaid reinsurance premiums represent the portion of premium that is
applicable to coverage of risk to be provided in the future on policies in
force. When an insured issue is retired or defeased prior to the end of the
expected period of coverage, the remaining deferred premium revenue and prepaid
reinsurance premium, less any amount credited to a refunding issue insured by
the Company, are recognized.
Losses and Loss Adjustment Expenses
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 ranging from 5.5% to 6.1%.
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 present value of the ultimate net cost of claims. The
reserves are necessarily based on estimates, and there can be no assurance that
the ultimate liability will not differ from such estimates. The Company will, on
an ongoing basis, monitor these reserves and may
40
<PAGE>
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 18). 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
programs 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 program
and the Company's redeemable preferred stock to the average basic shares
outstanding. All earnings per share have been restated to reflect the adoption
of SFAS No. 128.
Segment Reporting
In 1997, the Financial Accounting Standards Board issued SFAS No. 131,
Disclosure about Segments of an Enterprise and Related Information, establishing
standards for the way that public business enterprises report information about
operating segments in annual and interim financial statements and requiring
presentation of a measure of profit or loss, certain specific revenue and
expense items and segment assets. The Company has no reportable operating
segments as a monoline financial guaranty insurer.
Restatements and Reclassifications:
In May 1996, the Company entered into a forward share purchase agreement
with two financial institutions, under which it had the ability to acquire up to
1,750,000 shares of its stock for $26.50 plus accumulated financing charges. The
Company retained the economic interest in 1,000,000 shares and passed both the
economic risk and reward in the remaining 750,000 shares on to a group of the
Company's employees and directors, who were required to post collateral against
the risk of a decline in market value of the shares
The Company accounted for the 1,000,000 share obligation under the
"permanent equity" provisions of EITF 96-13, which resulted in no impact on the
Company's financial statements until the shares were acquired as treasury stock
in December 1997. With regard to the 750,000 shares made available to employees
and directors, of which 529,122 shares remain outstanding, the Company offset
the gain on the forward share agreement against the corresponding increased
liability to the employees and directors, resulting in no net impact on the
Company's financial statements until settlement. At settlement, the Company's
paid-in surplus is credited with the tax savings resulting from the transaction.
During a review of the Company's shelf registration statement in April
1999, the Securities and Exchange Commission (SEC) staff advised the Company
that, in its opinion, the gain on the forward purchase agreement should not be
used to offset the additional liability to the employees and directors. After
discussion with the SEC staff, the Company has revised its accounting to
recognize the liability as incurred and to recognize the offsetting gain on the
forward purchase agreement as an addition to paid-in surplus upon settlement
(assuming cash
41
<PAGE>
settlement).
The effect of this change in accounting for the forward share purchase
agreements was to (decrease) the amounts previously reported as shown below (in
thousands, except per share data):
1998 1997 1996
---- ---- ----
Income before income taxes ($2,495) ($8,951) ($4,208)
Net Income (1,622) (5,818) (2,735)
EPS - Basic (.06) (.19) (.09)
EPS - Diluted (.05) (.19) (.09)
Shareholder's Equity (7,300) (6,411)
In addition, the Company reclassified the redeemable preferred stock
outside of shareholder's equity, which decreased shareholder's equity as of
December 31, 1998 and 1997 by $700,000.
Historically, purchases of tax and loss bonds were treated as charges to
current tax expense with a corresponding benefit to deferred taxes by setting up
tax and loss bonds as a deferred tax asset (i.e., reduction of the deferred tax
liability). These purchases have been reclassified to be treated as prepaid
federal income taxes and, as a consequence, tax and loss bonds have been
classified as an asset on the balance sheet and not as a reduction of the
deferred tax liability. Accordingly, the change had the effect of increasing
both assets and liabilities by $38,726,000 and $30,520,000 at December 31, 1998
and 1997, respectively. This reclassification has no effect on the Company's net
income or shareholders' equity.
3. INVESTMENTS
Bonds at amortized cost of $11,481,000 and $11,025,000 at December 31,
1998 and 1997, 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,
-----------------------
1998 1997 1996
---- ---- ----
Bonds $ 71,888 $ 65,422 $ 61,740
Equity investments 1,075 1,393 928
Short-term investments 8,391 7,206 3,966
Investment expenses (2,531) (1,936) (1,570)
-------- -------- --------
Net investment income $ 78,823 $ 72,085 $ 65,064
======== ======== ========
The credit quality of the fixed-income investment portfolio at December 31, 1998
was as follows:
Percent of Fixed-Income
Rating Investment Portfolio
----------------------- ----------------------------
AAA 66.0%
AA 20.4
A 12.9
BBB 0.4
Other 0.3
42
<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, 1998 Cost Gains Losses Market Value
---- ----- ------ ------------
<S> <C> <C> <C> <C>
U.S. Treasury securities and obligations
of U.S. government corporations
and agencies $ 148,669 $ 2,432 $ (336) $ 150,765
Obligations of states and political
subdivisions 1,041,718 42,265 (637) 1,083,346
Mortgage-backed securities 266,770 3,920 (190) 270,500
Corporate securities 164,697 5,539 (463) 169,773
Asset-backed securities 33,188 494 (26) 33,656
---------- ---------- ---------- ----------
Total $1,655,042 $ 54,650 $ (1,652) $1,708,040
========== ========== ========== ==========
December 31, 1997
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
========== ========== ========== ==========
</TABLE>
The change in net unrealized gains (losses) consisted of (in thousands):
Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
Bonds $ 15,319 $ 23,657 $(16,640)
Equity investments 2,842 1,109 --
Other 1,017 -- --
-------- -------- --------
Change in net unrealized gains (losses) $ 19,178 $ 24,766 $(16,640)
======== ======== ========
43
<PAGE>
The amortized cost and estimated market value of bonds at December 31,
1998, 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>
Estimated
Amortized Cost Market Value
-------------- ------------
<S> <C> <C>
Due in one year or less $ 1,002 $ 1,006
Due after one year through five years 137,094 139,642
Due after five years through ten years 225,259 233,080
Due after ten years 991,729 1,030,156
Mortgage-backed securities (stated maturities of 1 to 30 years) 266,770 270,500
Asset-backed securities (stated maturities of 25 to 30 years) 33,188 33,656
---------- ----------
Total $1,655,042 $1,708,040
========== ==========
</TABLE>
Proceeds from sales of bonds during 1998, 1997 and 1996 were
$1,889,130,000, $1,127,749,000 and $1,118,112,000, respectively. Gross gains of
$28,322,000, $12,627,000 and $15,335,000 and gross losses of $8,585,000,
$1,433,000 and $12,146,000 were realized on sales in 1998, 1997 and 1996,
respectively.
Proceeds from sales of equity investments during 1998 and 1997 were
$33,613,000 and $3,568,000, respectively. Gross gains of $2,684,000 and $33,000
and gross losses of $1,331,000 and $7,000 were realized on sales in 1998 and
1997, respectively.
The Company held open positions in U.S. Treasury bond futures contracts
with an aggregate notional amount of $57,700,000 and $33,300,000 as of December
31, 1998 and 1997, respectively. The Company also held open positions in
Eurodollar futures contracts with an aggregate notional amount of $1,000,000 as
of December 31, 1998. Such positions are marked-to-market on a daily basis and,
for the years ended December 31, 1998, 1997 and 1996, resulted in net realized
gains of $883,000, $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,
-----------------------
1998 1997 1996
---- ---- ----
Balance, beginning of period $171,098 $146,233 $132,951
-------- -------- --------
Costs deferred during the period:
Ceding commission income (27,693) (18,956) (15,956)
Assumed commission expense 22 31 38
Premium taxes 8,081 5,554 3,718
Compensation and other acquisition costs 83,490 66,198 49,311
-------- -------- --------
Total 63,900 52,827 37,111
-------- -------- --------
Costs amortized during the period (35,439) (27,962) (23,829)
-------- -------- --------
Balance, end of period $199,559 $171,098 $146,233
======== ======== ========
44
<PAGE>
5. 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 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, including the purchase of tax and loss
bonds;
- 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 1998, 1997 and 1996
and shareholders' equity at December 31, 1998 and 1997, reported by the Company
on a GAAP basis, to the amounts reported by the Subsidiaries on a statutory
basis, is as follows (in thousands):
Net Income: 1998 1997 1996
---- ---- ----
GAAP BASIS $115,356 $ 94,684 $ 78,025
Non-insurance companies net loss (gain) 5,461 5,575 2,830
Premium revenue recognition (16,411) (23,130) (5,518)
Losses and loss adjustment expenses incurred 12,938 4,653 (2,138)
Deferred acquisition costs (28,461) (24,865) (12,482)
Deferred income tax provision 167 16,019 12,321
Current income tax (8,206) (7,994) (11,410)
Amortization of bonds -- 56 566
Accrual of deferred compensation, net 33,268 26,681 12,737
Other 100 (61) 1,404
-------- -------- --------
STATUTORY BASIS $114,212 $ 91,618 $ 76,335
======== ======== ========
45
<PAGE>
December 31,
------------
Shareholders' Equity: 1998 1997
---- ----
GAAP BASIS $1,065,436 $ 875,249
Non-insurance companies liabilities, net 39,155 22,611
Premium revenue recognition (91,297) (74,863)
Loss and loss adjustment expense reserves 47,250 34,313
Deferred acquisition costs (199,559) (171,098)
Contingency reserve (367,454) (287,694)
Unrealized gain on investments, net of tax (55,851) (43,027)
Deferred income taxes 95,398 90,387
Tax and loss bonds (38,726) (30,520)
Accrual of deferred compensation 70,022 41,451
Surplus notes 120,000 50,000
Other (14,118) (12,841)
---------- ----------
STATUTORY BASIS SURPLUS $ 670,256 $ 493,968
========== ==========
SURPLUS PLUS CONTINGENCY RESERVE $1,037,710 $ 781,661
========== ==========
6. FEDERAL INCOME TAXES
The Company and its Subsidiaries (except Financial Security Assurance
International Ltd.) file a consolidated federal income tax return. The
calculation of each member's tax benefit or liability is controlled by a tax
sharing agreement that bases the allocation of such benefit or liability upon a
separate return calculation.
Prior to 1998, purchases of tax and loss bonds were treated as charges to
current tax expense with a corresponding benefit to deferred taxes by setting up
tax and loss bonds as a deferred tax asset (i.e., reduction of the deferred tax
liability). Beginning in 1998, these purchases have been treated as prepaid
federal income taxes and, as a consequence, tax and loss bonds have been treated
as an asset on the balance sheet and not as a reduction of the deferred tax
liability. Accordingly, the change had the effect of increasing both assets and
liabilities by $38,726,000 and $30,520,000 at December 31, 1998 and 1997,
respectively. In addition, this change had the effect of increasing the deferred
tax provision and decreasing the current tax provision by $8,206,000,
$7,994,000, and $11,410,000 for the years ended December 31, 1998, 1997 and
1996, respectively.
The cumulative balance sheet effects of deferred tax consequences are (in
thousands):
December 31,
------------
1998 1997
---- ----
Deferred acquisition costs $ 69,079 $ 59,884
Deferred premium revenue adjustments 10,354 8,424
Unrealized capital gains 21,134 15,618
Contingency reserves 46,260 38,037
-------- --------
Total deferred tax liabilities 146,827 121,963
-------- --------
Loss and loss adjustment expense reserves (16,613) (12,009)
Deferred compensation (41,545) (26,109)
Other, net (1,415) (1,059)
-------- --------
Total deferred tax assets (59,573) (39,177)
-------- --------
Total deferred income taxes $ 87,254 $ 82,786
======== ========
46
<PAGE>
No valuation allowance was necessary at December 31, 1998 or 1997.
A reconciliation of the effective tax rate with the federal statutory rate
follows:
Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
Tax at statutory rate 35.0% 35.0% 35.0%
Tax-exempt interest (8.6) (8.4) (9.3)
Other 0.3 0.3 0.4
---- ---- ----
Provision for income taxes 26.7% 26.9% 26.1%
==== ==== ====
7. SHAREHOLDERS' EQUITY AND REDEEMABLE PREFERRED STOCK
On September 2, 1994, the Company issued to Fund American 2,000,000 shares
of Series A, non-dividend paying, voting, redeemable preferred stock having an
aggregate liquidation preference of $700,000. The preferred stock is redeemable,
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 redeemable 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 redeemable 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
redeemable preferred stock, except to one of its majority-owned subsidiaries.
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 two financial institutions
(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. At the same time it
entered 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. These settlements during 1998 and 1997 were
$733,000 and $2,142,000, respectively. 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, 1998, 562,200
Forward Shares remained in the program. Of these, 33,078 shares were held for
the benefit of the Company as a result of the repurchase of Forward Shares from
employees and directors, and 529,122 shares continued to be held for the benefit
of employees and directors. The Company has recognized compensation expense for
the difference between the carrying cost and the market value at December 31,
1998, 1997 and 1996 of $2,495,000, $8,951,000 and $4,208,000, respectively.
On November 3, 1998, the Company and XL closed a transaction to create two
new Bermuda-based financial guaranty insurance companies. Each of the new
companies has been initially capitalized with approximately $100,000,000. One
company, Financial Security Assurance International Ltd., is an indirect
subsidiary of FSA, and the other company, XL Financial Assurance Ltd, is a
subsidiary of XL. The Company has a minority interest in the XL subsidiary, and
XL has a minority interest in the FSA indirect subsidiary. In conjunction with
forming the new companies, the Company and XL exchanged $80,000,000 of their
respective common shares, with the Company delivering to XL 1,632,653 common
shares out of treasury. Prior to the closing of the transaction with XL, the
Company had entered into an agreement with an unrelated third party to sell for
cash, at no gain or loss,
47
<PAGE>
$60,000,000 of the XL shares. This $60,000,000 was used to fund, in part, the
Company's investment in Financial Security Assurance International Ltd.
8. 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, 1998, FSA had $65,726,000 available for the payment
of dividends over the next twelve months. In addition, the Company holds
$120,000,000 of surplus notes of FSA. Payments of principal or interest on such
notes may be made with the approval of the New York Insurance Department.
In 1998, FSA repurchased $8,500,000 of its shares from its parent,
representing the balance remaining of $75,000,000 that had been approved for
repurchase by the New York Insurance Department.
9. CREDIT ARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES
FSA has a credit arrangement aggregating $150,000,000 at December 31,
1998, which is provided by commercial banks and intended for general application
to transactions insured by the Subsidiaries. At December 31, 1998, 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, which expires in August 2004, FSA can arrange financing for
transactions subject to certain conditions. The amount of this facility was
$186,911,000, of which $44,974,000 was unutilized at December 31, 1998.
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 in the covered portfolio, 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, 1998.
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 $4,320,000 are being amortized over the life of the debt. The Company
used the proceeds to repay $30,000,000 of outstanding notes, to augment capital
in the Subsidiaries, to repurchase Forward Shares (see Note 7) and for general
corporate purposes.
On November 13, 1998, the Company issued $100,000,000 of 6.95% Senior
QUIDS due November 1, 2098 and callable without premium or penalty on or after
November 1, 2003. Interest is paid quarterly beginning on February 1, 1999. Debt
issuance costs of $3,375,000 are being amortized over the life of the debt. The
Company used the proceeds to augment capital in the Subsidiaries and for general
corporate purposes.
10. 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 $2,584,000, $2,535,000 and $2,215,000 for the years ended
December 31, 1998, 1997 and 1996, respectively.
48
<PAGE>
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.
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 December 1995. The 1993 Equity
Participation Plan also contains provisions that permit the Human Resources
Committee to pay all or a portion of employees' 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.
Performance shares are awarded under the Company's 1993 Equity
Participation Plan. The Plan authorizes the discretionary grant of performance
shares by the Human Resources Committee to key employees of the Company and its
subsidiaries. The number of shares of the Company's common stock earned for each
performance share depends upon the attainment by the Company of certain growth
rates of adjusted book value per outstanding share over a three-year period. At
each payout date, each performance share is adjusted to pay out from zero up to
two common shares. No common shares are paid out if the compound annual growth
rate of the Company's adjusted book value per outstanding share was less than
7%. Two common shares per performance share are paid out if the compound annual
growth rate was 19% or greater. Payout percentages are interpolated for compound
annual growth rates between 7% and 19%.
Performance shares granted under the 1993 Equity Participation Plan were
as follows:
<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>
1996 1,109,150 282,490 -- 17,300 1,374,340 $25.2500
1997 1,374,340 253,057 201,769 59,253 1,366,375 35.5000
1998 1,366,375 273,656 229,378 26,145 1,384,508 46.0625
</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 $40,862,000,
$29,500,000 and $13,741,000 for the years ended December 31, 1998, 1997 and
1996, 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 shareholders' 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.
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 other employee benefit
plans and are presented as treasury stock in these financial statements. During
1998, 1997 and 1996, the total number of shares purchased by the trust was
496,940, 162,573 and 529,131, respectively, at a cost of $23,907,000, $5,434,000
and $14,111,000, respectively. In 1996, the Company also repurchased stock from
its employees in satisfaction of withholding taxes on shares distributed under
its restricted stock plan.
49
<PAGE>
The Company does not currently provide post-retirement benefits, other
than under its defined contribution plans, to its employees, nor does it provide
post-employment benefits to former employees other than under its severance
plans.
11. 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,
-----------------------
1999 $ 2,489
2000 2,327
2001 2,014
2002 1,739
2003 1,739
Thereafter 3,333
-------
Total $13,641
=======
Rent expense for the years ended December 31, 1998, 1997 and 1996 was
$4,372,000, $4,067,000 and $3,816,000, respectively.
During the ordinary course of business, the Company and its Subsidiaries
become parties to certain litigation. Management believes that these matters
will be resolved with no material impact on the Company's financial position,
results of operations or cash flows.
12. REINSURANCE
The Subsidiaries reinsure portions of their risks with affiliated (see
Note 14) and unaffiliated reinsurers under quota share and first-loss treaties
and on a facultative basis. The Subsidiaries' principal ceded reinsurance
program consisted in 1998 of two quota share treaties, one first-loss treaty and
four 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 1998, the Subsidiaries ceded 6.75% of
each covered policy, up to a maximum of $13,500,000 insured principal per
policy. At their sole option, the Subsidiaries could have increased, and in
certain instances did increase, the ceding percentage to 13.5% up to $27,000,000
of each covered policy. A second treaty covered the Subsidiaries' U.S. municipal
obligation insurance business. Under this treaty in 1998, the Subsidiaries ceded
6% 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 $16,000,000 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 30% up to $80,000,000
per single risk. These cession percentages under both treaties were reduced on
smaller-sized transactions. The first-loss treaty applied to qualifying U.S.
mortgage-backed transactions. Under the four automatic facultative facilities in
1998, the Subsidiaries at their option could allocate up to a specified amount
for each reinsurer (ranging from $4,000,000 to $40,000,000 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 quota share
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 and first-loss facultative reinsurance on
various transactions in 1998.
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
50
<PAGE>
amounts. The Subsidiaries have also assumed reinsurance of municipal obligations
from unaffiliated insurers.
Amounts reinsured were as follows (in thousands):
Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
Written premiums ceded $99,413 $63,513 $55,965
Written premiums assumed 935 1,352 1,873
Earned premiums ceded 55,939 41,713 38,723
Earned premiums assumed 4,271 5,121 6,020
Loss and loss adjustment expense payments ceded 22,619 2,862 29,408
Loss and loss adjustment expense payments assumed 3 2 3
Incurred (recovered) losses and loss adjustment
expenses ceded (4,673) 3,605 (2,249)
Incurred (recovered) losses and loss adjustment
expenses assumed (139) 161 38
December 31,
------------
1998 1997
---- ----
Principal outstanding ceded $32,914,844 $24,547,361
Principal outstanding assumed 1,360,916 1,670,468
Deferred premium revenue ceded 217,096 173,123
Deferred premium revenue assumed 10,799 14,128
Loss and loss adjustment expense reserves ceded 3,907 30,618
Loss and loss adjustment expense reserves assumed 723 865
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, 1998 and 1997 (net of amounts ceded to other
insurers) and the terms to maturity are as follows:
December 31, 1998 December 31, 1997
----------------- -----------------
Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal
- ----------------- ------------ --------- ------------ ---------
0 to 5 Years $ 8,468 $ 2,756 $ 7,553 $ 2,230
5 to 10 Years 7,516 7,495 5,637 5,683
10 to 15 Years 5,661 12,427 2,858 8,257
15 to 20 Years 670 20,265 524 14,340
20 Years and Above 15,308 24,107 11,917 16,479
------- ------- ------- -------
Total $37,623 $67,050 $28,489 $46,989
======= ======= ======= =======
The principal amount ceded as of December 31, 1998 and 1997 and the terms
to maturity are as follows (in millions):
December 31, 1998 December 31, 1997
----------------- -----------------
Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal
- ----------------- ------------ --------- ------------ ---------
0 to 5 Years $ 2,727 $ 1,157 $ 3,828 $ 965
5 to 10 Years 1,859 2,143 2,118 1,693
10 to 15 Years 1,116 3,022 553 2,078
15 to 20 Years 591 4,852 257 3,005
51
<PAGE>
20 Years and Above 3,230 12,218 3,373 6,677
------- ------- ------- -------
Total $ 9,523 $23,392 $10,129 $14,418
======= ======= ======= =======
The Company limits its exposure to losses from writing financial
guarantees by underwriting investment-grade obligations, diversifying its
portfolio and maintaining rigorous collateral requirements on asset-backed
obligations, as well as through reinsurance. The gross principal amounts of
insured obligations in the asset-backed insured portfolio are backed by the
following types of collateral (in millions):
Net of Amounts Ceded Ceded
December 31, December 31,
------------ ------------
Types of Collateral 1998 1997 1998 1997
- ------------------- ---- ---- ---- ----
Residential mortgages $15,647 $12,928 $ 3,324 $ 3,665
Consumer receivables 12,539 10,659 3,663 4,601
Government securities 821 787 267 120
Pooled corporate obligations 6,776 3,004 1,388 540
Commercial mortgage portfolio:
Commercial real estate 15 98 49 418
Corporate secured 42 55 314 481
Investor-owned utility obligations 757 643 464 229
Other asset-backed obligations 1,026 315 54 75
------- ------- ------- -------
Total asset-backed obligations $37,623 $28,489 $ 9,523 $10,129
======= ======= ======= =======
The asset-backed insured portfolio, which aggregated $47,146,604,000 of
principal before reinsurance at December 31, 1998, was collateralized by assets
with an estimated fair value of $53,754,485,000. At December 31, 1997, it
aggregated $38,618,244,000 of principal before reinsurance and was
collateralized by assets with an estimated fair value of $44,382,716,000. 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, 1998,
the estimated fair value of collateral and reserves over the principal insured
averaged from 110% for commercial real estate to 181% for corporate secured
obligations. 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. 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 1998 1997 1998 1997
- --------------- ---- ---- ---- ----
<S> <C> <C> <C> <C>
General obligation bonds $25,337 $17,101 $ 4,517 $ 3,182
Housing revenue bonds 2,509 1,770 1,108 955
Municipal utility revenue bonds 9,218 5,892 5,489 2,294
Health care revenue bonds 5,812 3,924 3,348 2,175
Tax-supported bonds (non-general obligation) 14,731 11,210 5,238 3,526
Transportation revenue bonds 2,937 1,972 2,154 1,041
Other municipal bonds 6,506 5,120 1,538 1,245
------- ------- ------- -------
Total municipal obligations $67,050 $46,989 $23,392 $14,418
======= ======= ======= =======
</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
52
<PAGE>
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, 1998:
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 517 $10,233 15.3% $ 3,103
New York 388 5,836 8.7 4,137
Pennsylvania 356 4,821 7.2 834
Texas 414 4,128 6.1 1,441
Florida 130 4,091 6.1 1,616
New Jersey 275 3,475 5.2 1,486
Illinois 359 3,125 4.7 628
Massachusetts 126 2,259 3.4 976
Michigan 217 2,161 3.2 511
Wisconsin 252 1,685 2.5 228
Indiana 103 1,461 2.2 162
Minnesota 146 1,340 2.0 191
All Other States 1,453 20,993 31.3 6,812
Non-U.S 32 1,442 2.1 1,267
----- ------- ----- -------
Total 4,768 $67,050 100.0% $23,392
===== ======= ===== =======
14. RELATED PARTY TRANSACTIONS
The Subsidiaries ceded premiums of $23,838,000, $21,216,000 and
$19,890,000 to Tokio Marine for the years ended December 31, 1998, 1997 and
1996, respectively. The amounts included in prepaid reinsurance premiums at
December 31, 1998 and 1997 for reinsurance ceded to Tokio Marine were
$62,422,000 and $53,603,000, respectively. Reinsurance recoverable on unpaid
losses ceded to Tokio Marine was $612,000 and $613,000 at December 31, 1998 and
1997, respectively. The Subsidiaries ceded losses and loss adjustment expenses
of $603,000, $1,095,000 and $232,000 to Tokio Marine for the years ended
December 31, 1998, 1997 and 1996, respectively. The Subsidiaries ceded premiums
of $7,297,000 and $15,000 to X.L. Insurance Company, Ltd., a subsidiary of XL,
for the years ended December 31, 1998 and 1997, respectively. The amounts
included in prepaid reinsurance premiums at December 31, 1998 and 1997 for
reinsurance ceded to X.L. Insurance Company, Ltd. were $5,306,000 and $6,000,
respectively.
The Subsidiaries ceded premiums of $25,862,000, $16,890,000 and
$15,409,000 on a quota share basis to affiliates of MediaOne (Enhance
Reinsurance Company, Asset Guaranty Insurance Company and Commercial Reinsurance
Company) for the years ended December 31, 1998, 1997 and 1996, respectively. The
amounts included in prepaid reinsurance premiums for reinsurance ceded to these
affiliates were $61,088,000 and $51,980,000 at December 31, 1998 and 1997,
respectively. The amounts of reinsurance recoverable on unpaid losses ceded to
these affiliates at December 31, 1998 and 1997 were $1,755,000 and $24,195,000,
respectively. The Subsidiaries ceded losses and loss adjustment expenses
(recoveries) of $(11,956,000), $2,105,000 and $(3,316,000) to these affiliates
for the years ended December 31, 1998, 1997 and 1996, respectively.
15. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
53
<PAGE>
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.
Investments in unconsolidated affiliates -- The carrying amount is fair
value due to accounting for these investments on the equity basis.
Deferred premium revenue, net of prepaid reinsurance premiums -- The
carrying amount of deferred premium revenue, net of prepaid reinsurance
premiums, represents the Company's future premium revenue, net of reinsurance,
on policies where the premium was received at the inception of the insurance
contract. The fair value of deferred premium revenue, net of prepaid reinsurance
premiums, is an estimate of the premiums that would be paid under a reinsurance
agreement with a third party to transfer the Company's financial guaranty risk,
net of that portion of the premiums retained by the Company to compensate it for
originating and servicing the insurance contract.
Installment premiums -- Consistent with industry practice, there is no
carrying amount for installment premiums since the Company will receive premiums
on an installment basis over the term of the insurance contract. Similar to
deferred premium revenue, the fair value of installment premiums is the
estimated present value of the future contractual premium revenues that would be
paid under a reinsurance agreement with a third party to transfer the Company's
financial guaranty risk, net of that portion of the premium retained by the
Company to compensate it for originating and servicing the insurance contract.
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, 1998 December 31, 1997
----------------- -----------------
(In thousands) Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
------ ---------- ------ ----------
<S> <C> <C> <C> <C>
Assets:
Bonds $1,708,040 $1,708,040 $1,268,158 $1,268,158
Short-term investments 98,554 98,554 132,931 132,931
Cash 3,490 3,490 12,475 12,475
Receivable for securities sold 1,655 1,655 20,623 20,623
Investment in unconsolidated affiliates 29,496 29,496 -- --
Liabilities:
Deferred premium revenue, net of
prepaid reinsurance premiums 504,603 417,130 422,073 347,855
Losses and loss adjustment expenses,
net of reinsurance recoverable on
unpaid losses 60,040 60,040 44,799 44,799
Notes payable 230,000 232,736 130,000 131,612
Payable for investments purchased 105,859 105,859 72,979 72,979
Off-balance-sheet instruments:
Installment premiums -- 163,239 -- 116,888
</TABLE>
54
<PAGE>
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,
-----------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Balance at January 1 $ 75,417 $ 72,079 $111,759
Less reinsurance recoverable 30,618 29,875 61,532
-------- -------- --------
Net balance at January 1 44,799 42,204 50,227
Incurred losses and loss adjustment expenses:
Current year 8,049 5,400 5,300
Prior years (4,100) 3,756 1,574
Recovered (paid) losses and loss adjustment expenses:
Current year (192) (2,850) --
Prior years 11,484 (3,711) (14,897)
-------- -------- --------
Net balance December 31 60,040 44,799 42,204
Plus reinsurance recoverable 3,907 30,618 29,875
-------- -------- --------
Balance at December 31 $ 63,947 $ 75,417 $ 72,079
======== ======== ========
</TABLE>
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.
During 1998, the Company increased its general reserve by $3,949,000, of
which $8,049,000 was for originations of new business offset by a $4,100,000
decrease in the amount needed to fund the general loss reserve because of
recoveries on certain commercial mortgage transactions. During 1998, the Company
transferred $18,403,000 to its general reserve from case basis reserves due to
those recoveries on commercial mortgage transactions. Also during 1998, the
Company transferred $9,414,000 from its general reserve to case basis reserves
associated predominantly with certain consumer receivable transactions. Giving
effect to these transfers, the general reserve totaled $47,251,000 at December
31, 1998.
Reserves for losses and loss adjustment expenses are discounted at
risk-free rates for the general reserve and for the case basis reserves at rates
between 5.5% and 6.1%. The amount of discount taken was approximately
$16,029,000, $19,779,000 and $17,944,000 at December 31, 1998, 1997 and 1996,
respectively.
55
<PAGE>
17. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (1)
<TABLE>
<CAPTION>
(In thousands, except share data) First Second Third Fourth Full Year
----- ------ ----- ------ ---------
<S> <C> <C> <C> <C> <C>
1998
Gross premiums written $54,338 $89,242 $77,024 $98,662 $319,266
Net premiums written 37,947 62,121 54,462 65,323 219,853
Net premiums earned 31,921 32,452 32,618 40,936 137,927
Net investment income 18,683 19,255 19,710 21,175 78,823
Losses and loss adjustment expenses 1,047 1,047 1,046 809 3,949
Income before taxes 32,817 36,184 48,016 40,234 157,251
Net income 24,314 26,739 34,604 29,699 115,356
Basic earnings per common share 0.84 0.92 1.20 1.00 3.96
Diluted earnings per common share 0.81 0.88 1.15 0.96 3.77
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 27,054 31,517 31,680 39,297 129,548
Net income 20,113 22,931 23,183 28,457 94,684
Basic earnings per common share 0.67 0.76 0.77 0.95 3.16
Diluted earnings per common share 0.65 0.75 0.75 0.92 3.06
</TABLE>
(1) See Note 2 regarding the restatement of the financial statements relating to
the accounting for the forward share purchase agreements. The effect of the
restatement was to (decrease) increase the amounts previously reported as shown:
- --------------------------------------------------------------------------------
(in thousands, except share data)
1998 First Second Third Fourth
- --------------------------------------------------------------------------------
Income before taxes ($3,277) ($2,019) $5,566 ($2,765)
- --------------------------------------------------------------------------------
Net income (2,130) (1,313) 3,618 (1,797)
- --------------------------------------------------------------------------------
Basic earnings per common share (.07) (.05) .12 (.06)
- --------------------------------------------------------------------------------
Diluted earnings per common share (.07) (.04) .12 (.06)
- --------------------------------------------------------------------------------
1997 First Second Third Fourth
- --------------------------------------------------------------------------------
Income before taxes ($213) (3,540) (6,218) 1,020
- --------------------------------------------------------------------------------
Net income (138) (2,301) (4,041) 663
- --------------------------------------------------------------------------------
Basic earnings per common share - (.08) (.14) .02
- --------------------------------------------------------------------------------
Diluted earnings per common share (.01) (.07) (.13) .02
- --------------------------------------------------------------------------------
18. 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 programs
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 program and the
Company's redeemable preferred stock to the average basic shares outstanding.
The calculations of average basic and diluted common shares outstanding are as
follows (in thousands):
56
<PAGE>
Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
Average common shares outstanding 28,854 29,858 30,547
Shares earned but unissued under stock-based
compensation plans 248 170 80
------ ------ ------
Average basic common shares outstanding 29,102 30,028 30,627
Shares contingently issuable under:
Stock-based compensation plans 622 395 268
Redeemable preferred stock 875 490 --
------ ------ ------
Average diluted common shares outstanding 30,599 30,913 30,895
19. RECENTLY ISSUED ACCOUNTING STANDARD
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133
establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, and
hedging activities. It requires that an entity recognize all derivatives as
either assets or liabilities in the statement of financial position and measure
those instruments at fair value. SFAS No. 133 is effective January 1, 2000.
The Company is in the process of determining the effect of these standards
on its financial statements, but management does not believe that it will have a
material effect on the Company's financial condition.
20. INVESTMENTS IN UNCONSOLIDATED AFFILIATES
The Company accounts for investments in two companies on the equity basis.
In June 1998, the Company invested $10,000,000 to purchase a 25% interest in
Fairbanks Capital Holding Corp., which buys, sells and services residential
mortgages. In November 1998, the Company invested $19,900,000 to purchase a
19.9% interest in XL Financial Assurance Ltd, a financial guaranty insurance
subsidiary of XL (see Note 7). In 1998, the Company recognized equity losses of
$548,000 and goodwill amortization of $240,000 on its Fairbanks Capital Holding
Corp. investment and equity income of $332,000 on its XL Financial Assurance Ltd
investment.
21. MINORITY INTEREST IN SUBSIDIARY
In November 1998, the Company sold to XL, for $20,000,000, a 20% interest
in Financial Security Assurance International Ltd., FSA's newly formed
Bermuda-based financial guaranty subsidiary (see Note 7). This interest is in
the form of Cumulative Participating Voting Preferred Shares, which in total
have a minimum fixed dividend of $1,000,000 per annum. For the period ended
December 31, 1998, the Company recognized minority interest of $388,000.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
None.
57
<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 4,
"Section 16(a) Beneficial Ownership Reporting Compliance" on page 16, and
"Executive Officers of the Company" on pages 5 and 6 of the Company's 1999 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 9 through 12, "Report of the Human Resources Committee of the Board of
Directors of Financial Security Assurance Holdings Ltd." on pages 12 through 15,
and "Stock Price Performance" on page 16 of the Company's 1999 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 1999 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 27 through 30 of the Company's 1999 Proxy Statement. Such information
is incorporated herein by reference.
58
<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
Item 8 sets forth the following financial statements of
Financial Security Assurance Holdings Ltd. and Subsidiaries:
Report of Independent Accountants
Consolidated Balance Sheets at December 31, 1998 and 1997
Consolidated Statements of Income for the Years Ended December
31, 1998, 1997 and 1996
Consolidated Statements of Changes in Shareholders' Equity for
the Years Ended December 31, 1998, 1997 and 1996
Consolidated Statements of Cash Flows for the Years Ended December 31,
1998, 1997 and 1996
Notes to Consolidated Financial Statements
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, 1998, 1997 and 1996.
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.
59
<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 (the "Senior Debt 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 "September 1997
Form 8-K"), and incorporated herein by reference.)
4.1(A) First Supplemental Indenture dated as of November 13,
1998, between the Company and the Senior Debt Trustee.
(Previously filed as Exhibit 6 to the Company's
Current Report on Form 8-K (Commission File No.
1-12644) dated November 6, 1998 (the "November 1998
Form 8-K"), and incorporated herein by reference.)
4.1(B) Form of 7.375% Senior Quarterly Income Debt Securities
due 2097. (Previously filed as Exhibit 3 to the
September 1997 Form 8-K, and incorporated herein by
reference.)
4.1(C) 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.)
4.1(D) Form of 6.950% Senior Quarterly Income Debt Securities
due 2098. (Previously filed as Exhibit 2 to the
November 1998 Form 8-K, and incorporated herein by
reference.)
4.1(E) Officers' Certificate pursuant to Section 2.01 and
2.03 of the Senior QUIDS Indenture. (Previously filed
as Exhibit 5 to the November 1998 Form 8-K, and
incorporated herein by reference.)
4.1(F) Amended and Restated Trust Indenture dated as of
February 24, 1999 between the Company and the Trustee.
(Previously filed as Exhibit 4.1 to the Company's
Registration Statement on Form S-3 (Reg. No.
33-74165), and incorporated herein by reference.)
60
<PAGE>
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 August 31, 1998 among
FSA, each of its insurance company affiliates listed
on Schedule I attached thereto, the Banks from time to
time party thereto and Deutsche Bank AG, New York
Branch, as agent. (Previously filed as Exhibit 10 to
the Company's Quarterly Report on Form 10-Q
(Commission File No. 1-12644) for the quarterly period
ended September 30, 1998, 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.)
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+ Amended and Restated Supplemental Executive Retirement
Plan as amended and restated as of February 25, 1999.
(Previously filed as Exhibit 10.5 to the Company's
Annual Report on Form 10-K (Commission File No.
1-12644) for the fiscal period ended December 31, 1998
( the "1998 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).
(Previously filed as Exhibit 10.6 to the Company's
Annual Report on Form 10-K (Commission File No.
1-12644) for the fiscal period ended December 31, 1997
(the "1997 Form 10-K"), and incorporated herein by
reference.)
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.)
61
<PAGE>
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+ 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.)
10.15 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.)
10.16 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.)
10.17 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.)
10.18 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.)
10.19 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.)
10.20 Agreement for Management and the Provision of
Personnel, Property and Services dated as of December
23, 1993 between Commercial Re and the
62
<PAGE>
Company. (Previously filed as Exhibit 10.36 to the
Form S-1, and incorporated herein by reference.)
10.21 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.)
10.21(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.)
10.22 Registration Rights Agreement dated as of November 3,
1998 between the Company and EXEL Limited. (Previously
filed as Exhibit 10.22 to the 1998 Form 10-K, and
incorporated herein by reference.)
10.23 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.)
10.24 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.)
10.25 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, 1998. 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 Item 5 of the
1998 Form 10-K, is not to be deemed filed as part of
this Report. (Such information expressly incorporated
by reference in Item 5 of the 1998 Form 10-K was
previously filed as Exhibit 13 to the 1998 Form 10-K,
and incorporated herein by reference.)
21 List of Subsidiaries. (Previously filed as Exhibit 21
to the 1998 Form 10-K, and incorporated herein by
reference.)
23* Consent of PricewaterhouseCoopers LLP.
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 (i) for Mr. Post, which was
filed as Exhibit 24 to the 1997 Form 10-K and
incorporated herein by reference and (ii) for Messrs.
Hama and McCarthy, which were filed as Exhibit 24 to
the 1998 Form 10-K.)
27* Financial Data Schedules.
99* Financial Security Assurance Inc. and Subsidiaries
1998 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.
63
<PAGE>
(b) Reports on Form 8-K
The Company filed a Current Report on Form 8-K dated November 6, 1998,
with the Securities and Exchange Commission on November 12, 1998, which
incorporated by reference the documents included as Exhibits thereto into the
Registration Statement relating to the Company's 6.950% Senior Quarterly Income
Debt Securities due 2098.
64
<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: August 5, 1999
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 August 5, 1999
Executive Officer
and Director (Principal
Executive Officer)
/s/ JOHN J. BYRNE*
- --------------------------
John J. Byrne Vice Chairman of the August 5, 1999
Board and Director
/s/ ROGER K. TAYLOR*
- --------------------------
Roger K. Taylor President, August 5, 1999
Chief Operating Officer
and Director
/s/ SEAN W. MCCARTHY*
- --------------------------
Sean W. McCarthy Executive Vice President August 5, 1999
and Director
/s/ JOHN A. HARRISON*
- --------------------------
John A. Harrison Managing Director August 5, 1999
and Chief Financial
Officer (Principal
Financial Officer)
/s/ JEFFREY S. JOSEPH*
- --------------------------
Jeffrey S. Joseph Managing Director August 5, 1999
and Controller (Principal
Accounting Officer)
/s/ ROBERT N. DOWNEY*
- --------------------------
Robert N. Downey Director August 5, 1999
/s/ ANTHONY M. FRANK*
- --------------------------
Anthony M. Frank Director August 5, 1999
65
<PAGE>
/s/ FUDEJI HAMA*
- --------------------------
Fudeji Hama Director August 5, 1999
/s/ K. THOMAS KEMP*
- --------------------------
K. Thomas Kemp Director August 5, 1999
/s/ DAVID O. MAXWELL*
- --------------------------
David O. Maxwell Director August 5, 1999
/s/ JAMES M. OSTERHOFF*
- --------------------------
James M. Osterhoff Director August 5, 1999
/s/ JAMES H. OZANNE*
- --------------------------
James H. Ozanne Director August 5, 1999
/s/ RICHARD A. POST*
- --------------------------
Richard A. Post Director August 5, 1999
/s/ HOWARD M. ZELIKOW*
- --------------------------
Howard M. Zelikow Director August 5, 1999
- ----------
* 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
66
<PAGE>
Schedule II
Parent Company Condensed Financial Information
Condensed Balance Sheets
(Dollars in thousands)
December 31,
------------
1998 1997
---- ----
Assets:
Investments and cash $ 59,512 $ 65,044
Investment in subsidiary, at equity in net assets 1,119,235 903,421
Notes receivable from subsidiary 120,000 50,000
Deferred taxes 6,190 6,784
Other assets 66,544 33,897
---------- ----------
$1,371,481 $1,059,146
========== ==========
Liabilities and Shareholders' Equity:
Notes payable $ 230,000 $ 130,000
Other liabilities 75,345 53,197
Redeemable preferred stock 700 700
Shareholders' equity 1,065,436 875,249
---------- ----------
$1,371,481 $1,059,146
========== ==========
Condensed Statements of Income
(Dollars in thousands)
Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
Dividends received from subsidiary $ -- $ -- $ 18,000
Other revenue 11,515 3,553 2,741
-------- -------- --------
Total revenue 11,515 3,553 20,741
Interest and amortization expense 10,590 2,731 --
Other expenses 4,355 10,038 5,395
Equity in earnings of unconsolidated affiliate 333 -- --
-------- -------- --------
(3,097) (9,216) 15,346
Equity in undistributed net income of
subsidiary 117,374 100,678 61,697
-------- -------- --------
Income before income taxes 114,277 91,462 77,043
Income tax benefit 1,079 3,222 982
-------- -------- --------
Net income $115,356 $ 94,684 $ 78,025
======== ======== ========
The Parent Company Condensed Financial Information should be read in
conjunction with the Consolidated Financial Statements and Notes to Consolidated
Financial Statements as included in Item 8 Financial Statements and
Supplementary Data. Each year has been revised. See Note 2 section entitled
"Restatements and Reclassifications".
S-1
<PAGE>
Schedule II
Parent Company Condensed Financial Information (Continued)
Condensed Statements of Cash Flows
(Dollars in thousands)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities:
Other operating expenses recovered, net $ 35,168 $ 4,291 $ 14,700
Dividends from subsidiary -- -- 18,000
Net investment income received 3,510 3,448 3,078
Federal income taxes received (paid) (5,332) 7,237 (1,059)
Interest paid (9,614) (2,716) --
Other (1,089) (3,512) (1,227)
--------- --------- ---------
Net cash provided by operating activities 22,643 8,748 33,492
--------- --------- ---------
Cash flows from investing activities:
Proceeds from sales of bonds 170,513 2,812 21,544
Proceeds from sales of equity investments 73,042 -- --
Purchases of bonds (158,153) (30,224) (3,554)
Purchases of equity investments (92,087) (1,690) (7,336)
Purchases of property and equipment (3) (3) (2)
Investment in subsidiaries (96,788) (31,384) (1,600)
Net decrease (increase) in short-term securities 23,777 (9,890) (15,895)
Other investments (21,502) -- --
--------- --------- ---------
Net cash used for investing activities (101,201) (70,379) (6,843)
--------- --------- ---------
Cash flows from financing activities:
Issuance of notes payable, net 96,850 125,905 --
Surplus notes purchased (70,000) (50,000) --
Dividends paid (12,777) (12,098) (10,536)
Treasury stock, net (23,890) (36,247) (40,610)
Issuance of stock for acquisition of subsidiary 80,000 -- --
Repurchase of stock by subsidiary 8,500 39,500 27,000
Other 533 (5,567) (2,435)
--------- --------- ---------
Net cash provided by (used for) financing activities 79,216 61,493 (26,581)
--------- --------- ---------
Net increase (decrease) in cash 658 (138) 68
Cash at beginning of year (38) 100 32
--------- --------- ---------
Cash at end of year $ 620 $ (38) $ 100
========= ========= =========
Reconciliation of net income to net cash provided by
operating activities:
Net income $ 115,356 $ 94,684 $ 78,025
Equity in undistributed net income of subsidiary (117,374) (100,678) (61,697)
Decrease (increase) in accrued investment income (2,607) (1,394) 264
Increase (decrease) in accrued income taxes (5,137) 6,944 (932)
Benefit for deferred income taxes (1,275) (2,930) (1,108)
Net realized gains on investments (5,206) (1,405) (1,128)
Deferred equity compensation 17,765 14,112 5,565
Depreciation and accretion of bond discount (1,077) (1,174) (224)
Minority interest and equity in earnings of unconsolidated affiliates (333) -- --
Change in other assets and liabilities 22,531 589 14,727
--------- --------- ---------
Cash provided by operating activities $ 22,643 $ 8,748 $ 33,492
========= ========= =========
</TABLE>
The Parent Company Condensed Financial Information should be read in conjunction
with the Consolidated Financial Statements and Notes to Consolidated Financial
Statements as included in Item 8 Financial Statements and Supplementary Data.
Each year has been revised. See Note 2 section entitled "Restatements and
Reclassifications".
S-2
<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.
2. Significant Accounting Policies
The Parent Company carries its investments in subsidiaries under the
equity method.
3. Reclassification
Certain prior-year balances have been reclassified to conform to the 1998
presentation.
S-3
<PAGE>
Exhibit Index
Exhibit No. Exhibit
----------- -------
23 Consent of PricewaterhouseCoopers LLP
27 Financial data schedules
99 Financial Security Assurance Inc. and Subsidiaries 1998
Consolidated Financial Statements and Report of Independent
Accountants
All other Exhibits to Form 10-K/A are incorporated by reference, as described in
Item 14 of Form 10-K/A.
Exhibit 23
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference in the Registration Statements, as
amended, of Financial Security Assurance Holdings Ltd. 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), Form S-3 (File No. 333-34181) (Debt Securities and
Common Stock), and Form S-3 (File No. 333-74165) (Debt Securities, Common Stock,
Stock Purchase Contracts, Stock Purchase Units and Preferred Stock), of:
1. Our report dated January 26, 1999, except for the restatements and
reclassifications section in Note 2 as to which the date is August 4, 1999, on
our audits of the consolidated balance sheets of Financial Security Assurance
Holdings Ltd. and Subsidiaries as of December 31, 1998 and 1997, 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, 1998, and
financial statement schedule which appear in Financial Security Assurance
Holdings Ltd.'s Annual Report on Form 10-K, as amended, for the fiscal year
ended December 31, 1998, which report is included in Item 8 of this Annual
Report, as amended.
2. Our report dated January 26, 1999 on our audits of the consolidated balance
sheets of Financial Security Assurance Inc. and Subsidiaries as of December 31,
1998 and 1997, 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, 1998, which report is included in exhibit 99 to this Annual
Report on Form 10-K, as amended.
/s/ PricewaterhouseCoopers LLP
- -------------------------------
PricewaterhouseCoopers LLP
August 5, 1999
<TABLE> <S> <C>
<ARTICLE> 7
<S> <C>
<PERIOD-TYPE> Year
<FISCAL-YEAR-END> Dec-31-1998
<PERIOD-END> Dec-31-1998
<DEBT-HELD-FOR-SALE> 1,806,594
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 68,243
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 1,874,837
<CASH> 3,490
<RECOVER-REINSURE> 3,907
<DEFERRED-ACQUISITION> 199,559
<TOTAL-ASSETS> 2,444,206
<POLICY-LOSSES> 63,947
<UNEARNED-PREMIUMS> 721,699
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 230,000
0
700
<COMMON> 733,442
<OTHER-SE> 331,671
<TOTAL-LIABILITY-AND-EQUITY> 2,444,206
137,927
<INVESTMENT-INCOME> 78,823
<INVESTMENT-GAINS> 20,890
<OTHER-INCOME> 474
<BENEFITS> 3,949
<UNDERWRITING-AMORTIZATION> 35,439
<UNDERWRITING-OTHER> 40,631
<INCOME-PRETAX> 157,251
<INCOME-TAX> 41,895
<INCOME-CONTINUING> 115,356
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 115,356
<EPS-BASIC> 0
<EPS-DILUTED> 3.77
<RESERVE-OPEN> 75,417
<PROVISION-CURRENT> 8,049
<PROVISION-PRIOR> (8,192)
<PAYMENTS-CURRENT> 729
<PAYMENTS-PRIOR> 10,598
<RESERVE-CLOSE> 63,947
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 7
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<DEBT-HELD-FOR-SALE> 1,401,089
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 30,539
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 1,431,628
<CASH> 12,475
<RECOVER-REINSURE> 30,618
<DEFERRED-ACQUISITION> 171,098
<TOTAL-ASSETS> 1,913,164
<POLICY-LOSSES> 75,417
<UNEARNED-PREMIUMS> 595,196
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 130,000
0
700
<COMMON> 695,993
<OTHER-SE> 178,933
<TOTAL-LIABILITY-AND-EQUITY> 1,913,164
109,511
<INVESTMENT-INCOME> 72,085
<INVESTMENT-GAINS> 11,522
<OTHER-INCOME> 9,303
<BENEFITS> 9,156
<UNDERWRITING-AMORTIZATION> 27,962
<UNDERWRITING-OTHER> 35,755
<INCOME-PRETAX> 129,548
<INCOME-TAX> 34,864
<INCOME-CONTINUING> 94,684
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 94,684
<EPS-BASIC> 0
<EPS-DILUTED> 3.06
<RESERVE-OPEN> 72,079
<PROVISION-CURRENT> 5,400
<PROVISION-PRIOR> 7,361
<PAYMENTS-CURRENT> 2,850
<PAYMENTS-PRIOR> 6,573
<RESERVE-CLOSE> 75,417
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 7
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<DEBT-HELD-FOR-SALE> 1,146,080
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 8,336
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 1,154,416
<CASH> 8,146
<RECOVER-REINSURE> 29,875
<DEFERRED-ACQUISITION> 146,233
<TOTAL-ASSETS> 1,537,742
<POLICY-LOSSES> 72,079
<UNEARNED-PREMIUMS> 511,196
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 30,000
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
<OTHER-INCOME> 297
<BENEFITS> 6,874
<UNDERWRITING-AMORTIZATION> 23,829
<UNDERWRITING-OTHER> 22,732
<INCOME-PRETAX> 105,563
<INCOME-TAX> 27,538
<INCOME-CONTINUING> 78,025
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 78,025
<EPS-BASIC> 0
<EPS-DILUTED> 2.52
<RESERVE-OPEN> 111,759
<PROVISION-CURRENT> 9,123
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
<PAYMENTS-PRIOR> 48,803
<RESERVE-CLOSE> 72,079
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
Exhibit 99
FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES
Consolidated Financial Statements and
Report of Independent Accountants
December 31, 1998
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholder and Board of Directors
of Financial Security Assurance Inc.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income, changes in shareholder's equity, and cash
flows present fairly, in all material respects, the financial position of
Financial Security Assurance Inc. and Subsidiaries (the Company) at December 31,
1998 and 1997, and the results of their operations and their cash flows for each
of the three years in the period ended December 31, 1998, in conformity with
generally accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
/s/ PRICEWATERHOUSECOOPERS LLP
------------------------------
PRICEWATERHOUSECOOPERS LLP
New York, New York
January 26, 1999
1
<PAGE>
FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
ASSETS December 31, December 31,
1998 1997
---------- ----------
<S> <C> <C>
Bonds at market value (amortized cost of $1,631,094 and
$1,192,771) $1,683,928 $1,235,441
Equity investments at market value (cost of $34,250 and $20,405) 37,268 20,762
Short-term investments 92,241 103,926
---------- ----------
Total investments 1,813,437 1,360,129
Cash 2,729 11,235
Deferred acquisition costs 199,559 171,098
Prepaid reinsurance premiums 217,096 173,123
Reinsurance recoverable on unpaid losses 3,907 30,618
Receivable for securities sold 1,656 20,535
Other assets 144,105 103,421
---------- ----------
TOTAL ASSETS $2,382,489 $1,870,159
========== ==========
LIABILITIES AND MINORITY INTEREST AND SHAREHOLDER'S EQUITY
Deferred premium revenue $ 721,699 $ 595,196
Losses and loss adjustment expenses 63,947 75,417
Deferred federal income taxes 95,398 90,387
Ceded reinsurance balances payable 31,502 11,199
Payable for securities purchased 105,749 72,979
Long-term debt 120,000 50,000
Minority interest 20,388
Accrued expenses and other liabilities 119,215 77,121
---------- ----------
TOTAL LIABILITIES AND MINORITY INTEREST 1,277,898 972,299
---------- ----------
COMMITMENTS AND CONTINGENCIES
Common stock (500 and 528 shares authorized, issued and
outstanding; par value of $30,000 and $28,391 per share) 15,000 15,000
Additional paid-in capital 694,788 617,870
Accumulated other comprehensive income (net of deferred
income tax provision of $19,904 and $15,059) 36,964 27,968
Accumulated earnings 357,839 237,022
---------- ----------
TOTAL SHAREHOLDER'S EQUITY 1,104,591 897,860
---------- ----------
TOTAL LIABILITIES AND MINORITY INTEREST AND
SHAREHOLDER'S EQUITY $2,382,489 $1,870,159
========== ==========
</TABLE>
The accompanying Notes to Consolidated Financial Statements are an
integral part of these statements.
2
<PAGE>
FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
REVENUES:
Net premiums written $219,853 $172,878 $121,000
Increase in deferred premium revenue (81,926) (63,367) (30,552)
-------- -------- --------
Premiums earned 137,927 109,511 90,448
Net investment income 76,023 69,643 62,728
Net realized gains 21,667 6,023 1,851
Other income 381 10,774 502
-------- -------- --------
TOTAL REVENUES 235,998 195,951 155,529
-------- -------- --------
EXPENSES:
Losses and loss adjustment expenses 3,949 9,156 6,874
Policy acquisition costs 35,439 27,962 23,829
Other operating expenses 28,502 20,717 14,852
-------- -------- --------
TOTAL EXPENSES 67,890 57,835 45,555
-------- -------- --------
Minority interest (388)
--------
INCOME BEFORE INCOME TAXES 167,720 138,116 109,974
-------- -------- --------
Provision (benefit) for income taxes:
Current 46,736 21,838 16,798
Deferred 167 16,019 12,321
-------- -------- --------
Total provision 46,903 37,857 29,119
-------- -------- --------
NET INCOME 120,817 100,259 80,855
-------- -------- --------
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during
period (net of deferred income tax provision
(benefit) of $12,428, $12,268 and $(5,057)) 23,080 22,784 (9,392)
Less: reclassification adjustment for gains included in
net income (net of deferred income tax provision
of $7,583, $2,108 and $648) (14,084) (3,915) (1,203)
-------- -------- --------
Other comprehensive income (loss) 8,996 18,869 (10,595)
-------- -------- --------
COMPREHENSIVE INCOME $129,813 $119,128 $ 70,260
======== ======== ========
</TABLE>
The accompanying Notes to Consolidated Financial Statements are an
integral part of these statements.
3
<PAGE>
FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER'S EQUITY
(Dollars in thousands)
<TABLE>
<CAPTION>
Unrealized
Additional Gain (Loss)
Common Paid-In on Retained
Stock Capital Investments Earnings Total
----- ------- ----------- -------- -----
<S> <C> <C> <C> <C> <C>
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 accumulated comprehensive
income (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 accumulated comprehensive
income (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
Net income 120,817 120,817
Net change in accumulated comprehensive
income (net of deferred income
taxes of $4,844) 8,996 8,996
Stock repurchase (8,500) (8,500)
Capital contribution from Parent 80,000 80,000
Deferred equity payout by Parent 5,418 5,418
------- -------- -------- -------- ----------
BALANCE, December 31, 1998 $15,000 $694,788 $ 36,964 $357,839 $1,104,591
======= ======== ======== ======== ==========
</TABLE>
The accompanying Notes to Consolidated Financial Statements are an
integral part of these statements.
4
<PAGE>
FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities:
Premiums received, net $ 247,229 $ 171,145 $ 124,540
Policy acquisition and other operating expenses
paid, net (81,559) (50,046) (49,261)
Recoverable advances received (paid) 1,473 (7,629) 10,213
Losses and loss adjustment expenses recovered
(paid) 10,989 (6,463) (15,473)
Net investment income received 67,268 63,207 59,923
Federal income taxes paid (52,210) (27,080) (33,297)
Interest paid (22)
Other (877) 2,142 1,330
----------- ----------- -----------
Net cash provided by operating activities 192,313 145,276 97,953
----------- ----------- -----------
Cash flows from investing activities:
Proceeds from sales of bonds 1,735,585 1,071,845 1,095,929
Proceeds from sales of equity investments 22,571 3,568
Proceeds from maturities of bonds 32,468 2,965
Purchases of bonds (2,098,264) (1,196,117) (1,139,129)
Purchases of equity investments (37,034) (24,662)
Gain on sale of subsidiaries 9,486
Purchases of property and equipment (1,071) (2,985) (2,081)
Net decrease (increase) in short-term
investments 15,857 (45,661) (3,675)
Other investments 20,037
----------- ----------- -----------
Net cash provided by (used for) investing
activities (342,319) (152,058) (45,991)
----------- ----------- -----------
Cash flows from financing activities:
Stock repurchase (8,500) (39,500) (27,000)
Surplus notes issued 70,000 50,000
Capital contribution 80,000
Dividends paid (18,000)
----------- ----------- -----------
Net cash provided by (used for) financing
activities 141,500 10,500 (45,000)
----------- ----------- -----------
Net increase (decrease) in cash (8,506) 3,718 6,962
Cash at beginning of year 11,235 7,517 555
----------- ----------- -----------
Cash at end of year $ 2,729 $ 11,235 $ 7,517
=========== =========== ===========
</TABLE>
Continued
The accompanying Notes to Consolidated Financial Statements are an
integral part of these statements.
5
<PAGE>
FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(Dollars in thousands)
<TABLE>
<CAPTION>
Year Ended December 31,
----------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Reconciliation of net income to net cash flows
from operating activities:
Net income $ 120,817 $ 100,259 $ 80,855
Increase in accrued investment income (3,939) (1,811) (842)
Increase in deferred premium revenue and related
foreign exchange adjustment 82,530 62,101 29,622
Increase in deferred acquisition costs (28,461) (24,865) (13,282)
Increase (decrease) in current federal income
taxes payable 2,732 (519) (5,090)
Increase (decrease) in unpaid losses and loss
adjustment expenses 15,240 2,596 (8,023)
Increase in amounts withheld for others 81 133 52
Provision for deferred income taxes 167 19,290 12,321
Net realized gains on investments (21,667) (6,023) (1,851)
Depreciation and accretion of bond discount (3,540) (1,736) (1,616)
Gain on sale of subsidiaries (9,486)
Minority interest 388
Change in other assets and liabilities 27,965 5,337 5,807
--------- --------- ---------
Cash provided by operating activities $ 192,313 $ 145,276 $ 97,953
========= ========= =========
</TABLE>
The accompanying Notes to Consolidated Financial Statements are an
integral part of these statements.
6
<PAGE>
FINANCIAL SECURITY ASSURANCE INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
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 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 Asia Pacific region.
At December 31, 1996, the Parent was owned 40.4% by U S WEST Capital
Corporation (U S WEST), 11.5% by Fund American Enterprises Holdings, Inc. (Fund
American), 6.4% by The Tokio Marine and Fire Insurance Co., Ltd. (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. At December 31, 1998, the Parent was owned 40.5% by
MediaOne Capital Corporation (MediaOne), formerly U S WEST, 11.6% by Fund
American, 6.4% by Tokio Marine, 5.5% by XL Capital Ltd (XL) and 36.0% 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 5). The preparation of financial
statements in conformity with GAAP requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities in the Company's consolidated
balance sheets at December 31, 1998 and 1997 and the reported amounts of
revenues and expenses in the consolidated statements of income during the years
ended December 31, 1998, 1997 and 1996. 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
7
<PAGE>
subsidiaries, FSA Insurance Company, Financial Security Assurance International
Ltd., 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 1998 presentation.
Investments
Investments in debt securities designated as available for sale are
carried at market value. Equity investments are carried at market value. Any
resulting unrealized gain or loss is reflected as a separate component of
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.
The Company holds derivative securities, including U.S. Treasury bond
futures contracts and call option contracts, that are not accounted for as
hedges and are marked-to-market on a daily basis. 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. The amount of risk outstanding
is equal to the sum of the par amount of debt insured. Deferred premium revenue
and prepaid reinsurance premiums represent the portion of premium that is
applicable to coverage of risk to be provided in the future on policies in
force. When an insured issue is retired or defeased prior to the end of the
expected period of coverage, the remaining deferred premium revenue and prepaid
reinsurance premium, less any amount credited to a refunding issue insured by
the Company, are recognized.
Losses and Loss Adjustment Expenses
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 present value of the ultimate net cost of claims. The
reserves are necessarily based on estimates, and there can be no assurance that
the ultimate liability will not differ from such estimates. The Company will, on
an ongoing basis, monitor these reserves and may periodically adjust such
reserves based on the Company's actual loss experience, its future mix of
business, and future economic conditions.
Deferred Acquisition Costs
Deferred acquisition costs comprise those expenses that vary with and are
primarily related to the production of business, including commissions paid on
reinsurance assumed, compensation and related costs of underwriting and
marketing personnel, certain rating agency fees, premium taxes and certain other
underwriting expenses,
8
<PAGE>
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.
Segment Reporting
In 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 131, Disclosure about Segments of an
Enterprise and Related Information, establishing standards for the way that
public business enterprises report information about operating segments in
annual and interim financial statements and requiring presentation of a measure
of profit or loss, certain specific revenue and expense items and segment
assets. The Company has no reportable operating segments as a monoline financial
guaranty insurer.
Reclassification
Historically, purchases of tax and loss bonds were treated as charges to
current tax expense with a corresponding benefit to deferred taxes by setting up
tax and loss bonds as a deferred tax asset (i.e., reduction of the deferred tax
liability). These purchases have been reclassified to be treated as prepaid
federal income taxes and, as a consequence, tax and loss bonds have been
classified as an asset on the balance sheet and not as a reduction of the
deferred tax liability. Accordingly, the change had the effect of increasing
both assets and liabilities by $38,726,000 and $30,520,000 at December 31, 1998
and 1997, respectively. This reclassification has no effect on the Company's net
income or shareholder's equity.
3. INVESTMENTS
Bonds at amortized cost of $11,481,000 and $11,025,000 at December 31,
1998 and 1997, 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,
-----------------------
1998 1997 1996
---- ---- ----
Bonds $ 69,216 $ 65,149 $ 61,130
Equity investments 830 376 14
Short-term investments 7,376 5,452 3,525
Investment expenses (1,399) (1,334) (1,941)
-------- -------- --------
Net investment income $ 76,023 $ 69,643 $ 62,728
======== ======== ========
The credit quality of the fixed-income investment portfolio at December
31, 1998 was as follows:
Percent of Fixed-Income
Rating Investment Portfolio
------ -----------------------
AAA 68.7%
AA 21.3
A 9.3
BBB 0.4
9
<PAGE>
Other 0.3
The amortized cost and estimated market value of bonds were as follows (in
thousands):
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Estimated
December 31, 1998 Cost Gains Losses Market Value
- ----------------- ---- ----- ------ ------------
<S> <C> <C> <C> <C>
U.S. Treasury securities and obligations
of U.S. government corporations
and agencies $ 134,910 $ 2,297 $ (337) $ 136,870
Obligations of states and political
subdivisions 1,041,718 42,265 (637) 1,083,346
Mortgage-backed securities 261,322 3,911 (180) 265,053
Corporate securities 162,663 5,510 (463) 167,710
Asset-backed securities 30,481 493 (25) 30,949
---------- ---------- ----------- ----------
Total $1,631,094 $ 54,476 $ (1,642) $1,683,928
========== ========== =========== ==========
December 31, 1997
- -----------------
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>
The change in net unrealized gains (losses) consisted of (in thousands):
Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
Bonds $ 10,164 $ 28,671 $(16,299)
Equity investments 2,661 357
Other 1,017
-------- -------- --------
Change in net unrealized gains (losses) $ 13,842 $ 29,028 $(16,299)
======== ======== ========
10
<PAGE>
The amortized cost and estimated market value of bonds at December 31,
1998, 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>
Estimated
Amortized Cost Market Value
-------------- ------------
<S> <C> <C>
Due in one year or less $ 1,002 $ 1,006
Due after one year through five years 135,398 137,917
Due after five years through ten years 211,500 219,185
Due after ten years 991,391 1,029,818
Mortgage-backed securities (stated maturities of 1 to 30 years) 261,322 265,053
Asset-backed securities (stated maturities of 3 to 30 years) 30,481 30,949
---------- ----------
Total $1,631,094 $1,683,928
========== ==========
</TABLE>
Proceeds from sales of bonds during 1998, 1997 and 1996 were
$2,132,146,000, $1,124,848,000 and $1,096,568,000, respectively. Gross gains of
$26,373,000, $11,702,000 and $13,420,000 and gross losses of $4,156,000,
$6,007,000 and $11,569,000 were realized on sales in 1998, 1997 and 1996,
respectively.
Proceeds from sales of equity investments during 1998 and 1997 were
$22,571,000 and $3,568,000, respectively. Gross gains of $973,000 and $33,000
and gross losses of $1,323,000 and $7,000 were realized on sales in 1998 and
1997, respectively.
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,
-----------------------
1998 1997 1996
---- ---- ----
Balance, beginning of period $ 171,098 $ 146,233 $ 132,951
--------- --------- ---------
Costs deferred during the period:
Ceding commission income (27,693) (18,956) (15,956)
Assumed commission expense 22 31 38
Premium taxes 8,081 5,554 3,718
Compensation and other acquisition costs 83,490 66,198 49,311
--------- --------- ---------
Total 63,900 52,827 37,111
--------- --------- ---------
Costs amortized during the period (35,439) (27,962) (23,829)
--------- --------- ---------
Balance, end of period $ 199,559 $ 171,098 $ 146,233
========= ========= =========
5. STATUTORY ACCOUNTING PRACTICES
GAAP for the Company differs in certain significant respects from
accounting practices prescribed or permitted by insurance regulatory
authorities. The principal differences result from the following statutory
11
<PAGE>
accounting practices:
- Upfront premiums on municipal business are recognized as earned when
related principal and interest have expired rather than over the
expected coverage period;
- Acquisition costs are charged to operations as incurred rather than
as related premiums are earned;
- A contingency reserve (rather than a general reserve) is computed
based on the following statutory requirements:
(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, including the purchase of tax
and loss bonds;
- 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 1998, 1997 and 1996
and shareholder's equity at December 31, 1998 and 1997, reported by the Company
on a GAAP basis, to the amounts reported by the Subsidiaries on a statutory
basis, is as follows (in thousands):
Net Income: 1998 1997 1996
---- ---- ----
GAAP BASIS $120,817 $100,259 $ 80,855
Premium revenue recognition (16,411) (23,130) (5,518)
Losses and loss adjustment expenses incurred 12,938 4,653 (2,138)
Deferred acquisition costs (28,461) (24,865) (12,482)
Deferred income tax provision 167 16,019 12,321
Current income tax benefit (8,206) (7,994) (11,410)
Amortization of bonds 56 566
Accrual of deferred compensation, net 33,268 26,681 12,737
Other 100 (61) 1,404
-------- -------- --------
STATUTORY BASIS $114,212 $ 91,618 $ 76,335
======== ======== ========
12
<PAGE>
December 31,
-----------
Shareholder's Equity: 1998 1997
---- ----
GAAP BASIS $ 1,104,591 $ 897,860
Premium revenue recognition (91,297) (74,863)
Loss and loss adjustment expense reserves 47,250 34,313
Deferred acquisition costs (199,559) (171,098)
Contingency reserve (367,454) (287,694)
Unrealized gain on investments, net of tax (55,851) (43,027)
Deferred income taxes 95,398 90,387
Tax and loss bonds (38,726) (30,520)
Accrual of deferred compensation 70,022 41,451
Surplus notes 120,000 50,000
Other (14,118) (12,841)
----------- ---------
STATUTORY BASIS SURPLUS $ 670,256 $ 493,968
=========== =========
SURPLUS PLUS CONTINGENCY RESERVE $ 1,037,710 $ 781,661
=========== =========
6. FEDERAL INCOME TAXES
The Parent, the Company and its Subsidiaries (except Financial Security
Assurance International Ltd.) file a consolidated federal income tax return. The
calculation of each member's tax benefit or liability is controlled by a tax
sharing agreement that bases the allocation of such benefit or liability upon a
separate return calculation.
Prior to 1998, purchases of tax and loss bonds were treated as charges to
current tax expense with a corresponding benefit to deferred taxes by setting up
tax and loss bonds as a deferred tax asset (i.e., reduction of the deferred tax
liability). Beginning in 1998, these purchases have been treated as prepaid
federal income taxes and, as a consequence, tax and loss bonds have been treated
as an asset on the balance sheet and not as a reduction of the deferred tax
liability. Accordingly, the change had the effect of increasing both assets and
liabilities by $38,726,000 and $30,520,000 at December 31, 1998 and 1997,
respectively. In addition, this change had the effect of increasing the deferred
tax provision and decreasing the current tax provision by $8,206,000,
$7,994,000, and $11,410,000 for the years ended December 31, 1998, 1997 and
1996, respectively.
The cumulative balance sheet effects of deferred tax consequences are (in
thousands):
December 31,
------------
1998 1997
---- ----
Deferred acquisition costs $ 69,079 $ 59,884
Deferred premium revenue adjustments 10,354 8,424
Unrealized capital gains 20,749 16,998
Contingency reserves 46,260 38,037
--------- ---------
Total deferred tax liabilities 146,442 123,343
--------- ---------
Loss and loss adjustment expense reserves (16,613) (12,009)
Deferred compensation (34,020) (20,328)
Other, net (411) (619)
--------- ---------
Total deferred tax assets (51,044) (32,956)
--------- ---------
Total deferred income taxes $ 95,398 $ 90,387
========= =========
13
<PAGE>
No valuation allowance was necessary at December 31, 1998 or 1997.
A reconciliation of the effective tax rate with the federal statutory rate
follows:
Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----
Tax at statutory rate 35.0% 35.0% 35.0%
Tax-exempt interest (8.1) (7.9) (8.9)
Other 1.1 0.3 0.4
---- ---- ----
Provision for income taxes 28.0% 27.4% 26.5%
==== ==== ====
7. 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. In addition, the dividend, together with all dividends declared or
distributed by it during the preceding twelve months, may not exceed the lesser
of 10% of its policyholders' surplus shown on its last filed statement, or
adjusted net investment income, as defined, for such twelve-month period. As of
December 31, 1998, the Company had $65,726,000 available for the payment of
dividends over the next twelve months.
In 1998, the Company repurchased $8,500,000 of its shares from the Parent,
representing the balance remaining of $75,000,000 that had been approved for
repurchase by the New York Insurance Department.
8. CREDIT ARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES
The Company has a credit arrangement aggregating $150,000,000 at December
31, 1998, which is provided by commercial banks and intended for general
application to transactions insured by the Company and the Subsidiaries. At
December 31, 1998, 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, which expires in August 2004, the Company can
arrange financing for transactions subject to certain conditions. The amount of
this facility was $186,911,000, of which $44,974,000 was unutilized at December
31, 1998.
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 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 in the covered portfolio, 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, 1998.
At December 31, 1998, the Company has borrowed $120,000,000 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.
The Company did not pay interest in 1998 or 1997.
9. EMPLOYEE BENEFIT PLANS
The Company maintains both a qualified and a non-qualified
non-contributory defined contribution pension
14
<PAGE>
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 $2,380,000, $2,312,000 and $1,977,000 for the
years ended December 31, 1998, 1997 and 1996, respectively.
The Company has an employee retirement savings plan for the benefit of all
eligible employees. The plan permits employees to contribute a percentage of
their salaries up to limits prescribed by the Internal Revenue Service (IRS
Code, Section 401(k)). The Company's contributions are discretionary, and none
have been made.
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 December 1995.
The 1993 Equity Participation Plan also contains provisions that permit the
Human Resources Committee to pay all or a portion of employees' 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.
Performance shares are awarded under the Parent's 1993 Equity
Participation Plan. The Plan authorizes the discretionary grant of performance
shares by the Human Resources Committee to key employees of the Company. The
number of shares of the Parent's common stock earned for each performance share
depends upon the attainment by the Parent of certain growth rates of adjusted
book value per outstanding share over a three-year period. At each payout date,
each performance share is adjusted to pay out from zero up to two common shares.
No common shares are paid out if the compound annual growth rate of the Parent's
adjusted book value per outstanding share was less than 7%. Two common shares
per performance share are paid out if the compound annual growth rate was 19% or
greater. Payout percentages are interpolated for compound annual growth rates
between 7% and 19%.
Performance shares granted under the 1993 Equity Participation Plan were
as follows:
Outstanding 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
------- -------- -------- -------- ------- ----------
1996 1,109,150 282,490 -- 17,300 1,374,340 $25.2500
1997 1,374,340 253,057 201,769 59,253 1,366,375 35.5000
1998 1,366,375 273,656 229,378 26,145 1,384,508 46.0625
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
$39,480,000, $28,439,000 and $12,737,000 for the years ended December 31, 1998,
1997 and 1996, 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 shareholders' 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
$5,418,000 and $2,900,000 in 1998 and 1997, respectively. In 1996, the Parent
adopted disclosure provisions of SFAS No. 123. Had the compensation cost for the
Parent's performance shares been determined based upon the provisions of SFAS
No. 123, there would have been no effect on the Company's reported net income.
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
15
<PAGE>
intended to fund future obligations relating to equity bonuses, performance
shares and stock options under the 1993 Equity Participation Plan and other
employee benefit plans and are presented as treasury stock in these financial
statements. During 1998, 1997 and 1996, the total number of shares purchased by
the trust was 496,940, 162,573 and 529,131, respectively, at a cost of
$23,907,000, $5,434,000 and $14,111,000, respectively. In 1996, 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 under its defined contribution plans, to its employees, nor does it provide
post-employment benefits to former employees other than under its severance
plans.
10. COMMITMENTS AND CONTINGENCIES
The Company leases 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,
-----------------------
1999 $ 2,489
2000 2,327
2001 2,014
2002 1,739
2003 1,739
Thereafter 3,333
-------
Total $13,641
=======
Rent expense for the years ended December 31, 1998, 1997 and 1996 was
$4,025,000, $3,708,000 and $3,383,000, respectively.
During the ordinary course of business, the Company and its Subsidiaries
have become parties to certain litigation. Management believes that these
matters will be resolved with no material impact on the Company's financial
position, results of operations or cash flows.
11. REINSURANCE
The Company reinsures portions of its risks with affiliated (see Note 13)
and unaffiliated reinsurers under quota share and first-loss treaties and on a
facultative basis. The Company's principal ceded reinsurance program consisted
in 1998 of two quota share treaties, one first-loss treaty and four 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 1998, the Company ceded 6.75% of each covered policy, up to a maximum of
$13,500,000 insured principal per policy. At its sole option, the Company could
have increased, and in certain instances did increase, the ceding percentage to
13.5% up to $27,000,000 of each covered policy. A second treaty covered the
Company's U.S. municipal obligation insurance business. Under this treaty in
1998, the Company ceded 6% 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 $16,000,000 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 30%
up to $80,000,000 per single risk. These cession percentages under both treaties
were reduced on smaller-sized transactions. The first-loss treaty applied to
qualifying U.S. mortgage-backed transactions. Under the four automatic
facultative facilities in 1998, the Company at its option could allocate up to a
specified amount for each reinsurer (ranging from $4,000,000 to $40,000,000
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 quota
share treaties and automatic facultative facilities allowed the Company to
withhold a ceding commission to defray its expenses. The Company also employed
non-
16
<PAGE>
treaty quota share and first-loss facultative reinsurance on various
transactions in 1998.
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 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,
-----------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Written premiums ceded $ 99,413 $63,513 $ 55,965
Written premiums assumed 935 1,352 1,873
Earned premiums ceded 55,939 41,713 38,723
Earned premiums assumed 4,271 5,121 6,020
Loss and loss adjustment expense payments ceded 22,619 2,862 29,408
Loss and loss adjustment expense payments assumed 3 2 3
Incurred (recovered) losses and loss adjustment
expenses ceded (4,673) 3,605 (2,249)
Incurred (recovered) losses and loss adjustment
expenses assumed (139) 161 38
</TABLE>
<TABLE>
<CAPTION>
December 31,
------------
1998 1997
---- ----
<S> <C> <C>
Principal outstanding ceded $32,914,844 $24,547,361
Principal outstanding assumed 1,360,916 1,670,468
Deferred premium revenue ceded 217,096 173,123
Deferred premium revenue assumed 10,799 14,128
Loss and loss adjustment expense reserves ceded 3,907 30,618
Loss and loss adjustment expense reserves assumed 723 865
</TABLE>
12. OUTSTANDING EXPOSURE AND COLLATERAL
The Company's policies insure the scheduled payments of principal and
interest on asset-backed and municipal obligations. The principal amount insured
(in millions) as of December 31, 1998 and 1997 (net of amounts ceded to other
insurers) and the terms to maturity are as follows:
December 31, 1998 December 31, 1997
----------------- -----------------
Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal
- ----------------- ------------ --------- ------------ ---------
0 to 5 Years $ 8,468 $ 2,756 $ 7,553 $ 2,230
5 to 10 Years 7,516 7,495 5,637 5,683
10 to 15 Years 5,661 12,427 2,858 8,257
15 to 20 Years 670 20,265 524 14,340
20 Years and Above 15,308 24,107 11,917 16,479
------- ------- ------- -------
Total $37,623 $67,050 $28,489 $46,989
======= ======= ======= =======
17
<PAGE>
The principal amount ceded as of December 31, 1998 and 1997 and the terms
to maturity are as follows (in millions):
December 31, 1998 December 31, 1997
----------------- -----------------
Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal
- ----------------- ------------ --------- ------------ ---------
0 to 5 Years $2,727 $ 1,157 $ 3,828 $ 965
5 to 10 Years 1,859 2,143 2,118 1,693
10 to 15 Years 1,116 3,022 553 2,078
15 to 20 Years 591 4,852 257 3,005
20 Years and Above 3,230 12,218 3,373 6,677
------ ------- ------- -------
Total $9,523 $23,392 $10,129 $14,418
====== ======= ======= =======
The Company limits its exposure to losses from writing financial
guarantees by underwriting investment-grade obligations, diversifying its
portfolio and maintaining rigorous collateral requirements on asset-backed
obligations, as well as through reinsurance. The gross principal amounts of
insured obligations in the asset-backed insured portfolio are backed by the
following types of collateral (in millions):
Net of Amounts Ceded Ceded
December 31, December 31,
------------ ------------
Types of Collateral 1998 1997 1998 1997
- ------------------- ---- ---- ---- ----
Residential mortgages $15,647 $12,928 $3,324 $ 3,665
Consumer receivables 12,539 10,659 3,663 4,601
Government securities 821 787 267 120
Pooled corporate obligations 6,776 3,004 1,388 540
Commercial mortgage portfolio:
Commercial real estate 15 98 49 418
Corporate secured 42 55 314 481
Investor-owned utility obligations 757 643 464 229
Other asset-backed obligations 1,026 315 54 75
------- ------- ------ -------
Total asset-backed obligations $37,623 $28,489 $9,523 $10,129
======= ======= ====== =======
The asset-backed insured portfolio, which aggregated $47,146,604,000 of
principal before reinsurance at December 31, 1998, was collateralized by assets
with an estimated fair value of $53,754,485,000. At December 31, 1997, it
aggregated $38,618,244,000 of principal before reinsurance and was
collateralized by assets with an estimated fair value of $44,382,716,000. 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, 1998,
the estimated fair value of collateral and reserves over the principal insured
averaged from 110% for commercial real estate to 181% for corporate secured
obligations. 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. 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.
18
<PAGE>
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 1998 1997 1998 1997
- --------------- ---- ---- ---- ----
<S> <C> <C> <C> <C>
General obligation bonds $25,337 $17,101 $ 4,517 $ 3,182
Housing revenue bonds 2,509 1,770 1,108 955
Municipal utility revenue bonds 9,218 5,892 5,489 2,294
Health care revenue bonds 5,812 3,924 3,348 2,175
Tax-supported bonds (non-general obligation) 14,731 11,210 5,238 3,526
Transportation revenue bonds 2,937 1,972 2,154 1,041
Other municipal bonds 6,506 5,120 1,538 1,245
------- ------- ------- -------
Total municipal obligations $67,050 $46,989 $23,392 $14,418
======= ======= ======= =======
</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, 1998:
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 517 $10,233 15.3% $ 3,103
New York 388 5,836 8.7 4,137
Pennsylvania 356 4,821 7.2 834
Texas 414 4,128 6.1 1,441
Florida 130 4,091 6.1 1,616
New Jersey 275 3,475 5.2 1,486
Illinois 359 3,125 4.7 628
Massachusetts 126 2,259 3.4 976
Michigan 217 2,161 3.2 511
Wisconsin 252 1,685 2.5 228
Indiana 103 1,461 2.2 162
Minnesota 146 1,340 2.0 191
All Other States 1,453 20,993 31.3 6,812
Non-U.S 32 1,442 2.1 1,267
------- ------- ------- -------
Total 4,768 $67,050 100.0% $23,392
======= ======= ======= =======
19
<PAGE>
13. RELATED PARTY TRANSACTIONS
Allocable expenses are shared by the Company and its Parent on a basis
determined principally by estimates of respective usage as stated in an expense
sharing agreement. The agreement is subject to the provisions of the New York
Insurance Law. Amounts included in other assets at December 31, 1998 and 1997
are $1,625,000 and $4,702,000, respectively, for unsettled expense allocations
due from the Parent.
The Company ceded premiums of $23,838,000, $21,216,000 and $19,890,000 to
Tokio Marine for the years ended December 31, 1998, 1997 and 1996, respectively.
The amounts included in prepaid reinsurance premiums at December 31, 1998 and
1997 for reinsurance ceded to Tokio Marine were $62,422,000 and $53,603,000,
respectively. Reinsurance recoverable on unpaid losses ceded to Tokio Marine was
$612,000 and $613,000 at December 31, 1998 and 1997, respectively. The Company
ceded losses and loss adjustment expenses of $603,000, $1,095,000 and $232,000
to Tokio Marine for the years ended December 31, 1998, 1997 and 1996,
respectively. The Company ceded premiums of $7,297,000 and $15,000 to X.L.
Insurance Company, Ltd., a subsidiary of XL, for the years ended December 31,
1998 and 1997, respectively. The amounts included in prepaid reinsurance
premiums at December 31, 1998 and 1997 for reinsurance ceded to X.L. Insurance
Company, Ltd. were $5,306,000 and $6,000, respectively.
The Company ceded premiums of $25,862,000, $16,890,000 and $15,409,000 on
a quota share basis to affiliates of MediaOne (Enhance Reinsurance Company,
Asset Guaranty Insurance Company and Commercial Reinsurance Company) for the
years ended December 31, 1998, 1997 and 1996, respectively. The amounts included
in prepaid reinsurance premiums for reinsurance ceded to these affiliates were
$61,088,000 and $51,980,000 at December 31, 1998 and 1997, respectively. The
amounts of reinsurance recoverable on unpaid losses ceded to these affiliates at
December 31, 1998 and 1997 were $1,755,000 and $24,195,000, respectively. The
Company ceded losses and loss adjustment expenses (recoveries) of $(11,956,000),
$2,105,000 and $(3,316,000) to these affiliates for the years ended December 31,
1998, 1997 and 1996, respectively.
14. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following estimated fair values have been determined by the Company
using available market information and appropriate valuation methodologies.
However, considerable judgment is necessary to interpret the data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amount the Company could realize in a current
market exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
Bonds -- 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 contract.
Installment premiums -- Consistent with industry practice, there is no
carrying amount for installment premiums since the Company will receive premiums
on an installment basis over the term of the insurance contract. Similar to
deferred premium revenue, the fair value of installment premiums is the
estimated present value of the future contractual premium revenues that would be
paid under a reinsurance agreement with a third party to transfer the
20
<PAGE>
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, 1998 December 31, 1997
----------------- -----------------
Carrying Estimated Carrying Estimated
(In thousands) Amount Fair Value Amount Fair Value
-------- ---------- -------- ----------
<S> <C> <C> <C> <C>
Assets:
Bonds $1,683,928 $1,683,928 $1,235,441 $1,235,441
Short-term investments 92,241 92,241 103,926 103,926
Cash 2,729 2,729 11,235 11,235
Receivable for securities sold 1,656 1,656 20,535 20,535
Liabilities:
Deferred premium revenue, net of
prepaid reinsurance premiums 504,603 417,130 422,073 347,855
Losses and loss adjustment expenses,
net of reinsurance recoverable on
unpaid losses 60,040 60,040 44,799 44,799
Notes payable 120,000 120,000 50,000 50,000
Payable for investments purchased 105,749 105,749 72,979 72,979
Off-balance-sheet instruments:
Installment premiums 163,239 116,888
</TABLE>
15. 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,
-----------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Balance at January 1 $ 75,417 $ 72,079 $ 111,759
Less reinsurance recoverable 30,618 29,875 61,532
-------- -------- ---------
Net balance at January 1 44,799 42,204 50,227
Incurred losses and loss adjustment expenses:
Current year 8,049 5,400 5,300
Prior years (4,100) 3,756 1,574
Recovered (paid) losses and loss adjustment expenses:
Current year (192) (2,850)
Prior years 11,484 (3,711) (14,897)
-------- -------- ---------
Net balance December 31 60,040 44,799 42,204
Plus reinsurance recoverable 3,907 30,618 29,875
-------- -------- ---------
</TABLE>
21
<PAGE>
<TABLE>
<S> <C> <C> <C>
Balance at December 31 $ 63,947 $ 75,417 $ 72,079
======== ======== =========
</TABLE>
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.
During 1998, the Company increased its general reserve by $3,949,000, of
which $8,049,000 was for originations of new business offset by a $4,100,000
decrease in the amount needed to fund the general loss reserve because of
recoveries on certain commercial mortgage transactions. During 1998, the Company
transferred $18,403,000 to its general reserve from case basis reserves due to
those recoveries on commercial mortgage transactions. Also during 1998, the
Company transferred $9,414,000 from its general reserve to case basis reserves
associated predominantly with certain consumer receivable transactions. Giving
effect to these transfers, the general reserve totaled $47,251,000 at December
31, 1998.
Reserves for losses and loss adjustment expenses are discounted at
risk-free rates for the general reserve and for the case basis reserves at rates
between 5.5% and 6.1%. The amount of discount taken was approximately
$16,029,000, $19,779,000 and $17,944,000 at December 31, 1998, 1997 and 1996,
respectively.
16. RECENTLY ISSUED ACCOUNTING STANDARD
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133
establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, and
hedging activities. It requires that an entity recognize all derivatives as
either assets or liabilities in the statement of financial position and measure
those instruments at fair value. SFAS No. 133 is effective January 1, 2000.
The Company is in the process of determining the effect of these standards
on its financial statements, but management does not believe that it will have a
material effect on the Company's financial condition.
17. FINANCIAL SECURITY ASSURANCE INTERNATIONAL LTD. AND MINORITY INTEREST
On November 3, 1998, the Parent funded the Company's $80,000,000
investment in Financial Security Assurance International Ltd. (International), a
new Bermuda-based financial guaranty insurer.
In November 1998, XL made a minority investment in International for
$20,000,000. This interest is in the form of Cumulative Participating Voting
Preferred Shares, which in total have a minimum fixed dividend of $1,000,000 per
annum. For the period ended December 31, 1998, the Company recognized minority
interest of $388,000.
22
