-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, DLgstF2nAPvHhvm8zTJhXOnlfGSw7qWu0dzxrh4QmvyAZtuD1hDUD2iklTKp7VRR HHBVZMPV3ppNxufM0nLMmg== 0000092122-06-000247.txt : 20060608 0000092122-06-000247.hdr.sgml : 20060608 20060607200756 ACCESSION NUMBER: 0000092122-06-000247 CONFORMED SUBMISSION TYPE: 8-K PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20060607 ITEM INFORMATION: Other Events ITEM INFORMATION: Financial Statements and Exhibits FILED AS OF DATE: 20060608 DATE AS OF CHANGE: 20060607 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ALABAMA POWER CO CENTRAL INDEX KEY: 0000003153 STANDARD INDUSTRIAL CLASSIFICATION: ELECTRIC SERVICES [4911] IRS NUMBER: 630004250 STATE OF INCORPORATION: AL FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 8-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-03164 FILM NUMBER: 06892625 BUSINESS ADDRESS: STREET 1: 600 N 18TH ST STREET 2: P O BOX 2641 CITY: BIRMINGHAM STATE: AL ZIP: 35291 BUSINESS PHONE: 2052571000 MAIL ADDRESS: STREET 1: 600 N 18TH ST CITY: BIRMINGHAM STATE: AL ZIP: 35291 8-K 1 fgic8k2.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 8-K

 

CURRENT REPORT

PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

Date of Report

June 7, 2006

(Date of earliest event reported)

ALABAMA POWER COMPANY

(Exact name of Company as specified in its charter)

 

Alabama

1-3164

63-0004250

(State or other jurisdiction of incorporation)

(Commission File Number)

(IRS Employer

Identification No.)

 

600 North 18th Street

Birmingham, Alabama

 

35291

(Address of principal executive offices)

(Zip Code)

 

(205) 257-1000

(Company’s telephone number, including area code)

The address of the registrant has not changed since the last report.

Check the appropriate box below if the Form 8-K filing is intended to simultaneously satisfy the filing obligation of the Company under any of the following provisions:

o

Written communications pursuant to Rule 425 under the Securities Act (17 CFR 230.425)

o

Soliciting material pursuant to Rule 14a-12 under the Exchange Act (17 CFR 240.14a-12)

o

Pre-commencement communications pursuant to Rule 14d-2(b) under the Exchange Act (17 CFR 240.14d-2(b))

o

Pre-commencement communications pursuant to Rule 13e-4(c) under the Exchange Act (17 CFR 240.13e-4(c))

 

 

 

 

Item 8.01.

Other Events.

Alabama Power Company (the “Company”) plans to issue its Series JJ Senior Notes due June 15, 2046 (the “Series JJ Senior Notes”), which will be insured by Financial Guaranty Insurance Company (“FGIC”).

The audited consolidated financial statements of FGIC and subsidiaries as of December 31, 2005 and 2004, and for the years ended December 31, 2005 and 2004 and the periods from December 18, 2003 through December 31, 2003 and from January 1, 2003 through December 17, 2003 are included in this Form 8-K as Exhibit 99.1. The unaudited consolidated financial statements of FGIC and subsidiaries as of March 31, 2006 and for the three month periods ended March 31, 2006 and 2005 are included in this Form 8-K as Exhibit 99.2. The audited consolidated financial statements of FGIC and subsidiaries as of December 31, 2005 and 2004 and for the years ended December 31, 2005 and 2004 and the periods from December 18, 2003 through December 31, 2003 and from January 1, 2003 through December 17, 2003 have been audited by Ernst & Young LLP. The consent of Ernst & Young LLP to the inclusion of their audit reports on such financial statements in this Form 8-K and their being named as “experts” in the Prospectus Supplement relating to the Series JJ Senior Notes is attached hereto as Exhibit 23.1.

Item 9.01.

Financial Statements and Exhibits.

 

(d) Exhibits.

 

 

23.1       Consent of Ernst & Young LLP.

 

99.1       Audited consolidated financial statements of FGIC and subsidiaries as of December 31, 2005 and 2004, and for the years ended December 31, 2005 and 2004 and the periods from December 18, 2003 through December 31, 2003 and from January 1, 2003 through December 17, 2003.

 

 

 

2

 

 

 

 

99.2       Unaudited consolidated financial statements of FGIC and subsidiaries as of March 31, 2006 and for the three month periods ended March 31, 2006 and 2005.

 

 

SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

Date:      June 7, 2006

ALABAMA POWER COMPANY

 

 

 

By                     /s/Wayne Boston 

Wayne Boston

Assistant Secretary

 

 

 

 

 

 EX-23.1 2 x23_1.htm

Exhibit 23.1

 

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

We consent to the reference to our firm under the caption “Experts” in the Prospectus Supplement of Alabama Power Company for the registration of Alabama Power Company’s Series JJ Senior Notes due June 15, 2046, in the registration statement on Form S-3 (No. 333-126348) and to the incorporation by reference therein of our report dated January 23, 2006, with respect to the financial statements of Financial Guaranty Insurance Company, appearing in the Form 8-K of Alabama Power Company dated June 7, 2006, filed with the Securities and Exchange Commission.

 

 

/s/ Ernst & Young LLP

New York, New York

June 7, 2006

 

 

 

 

 

 EX-99.1 3 x991.txt EXHIBIT 99.1 CONSOLIDATED FINANCIAL STATEMENTS Financial Guaranty Insurance Company and Subsidiaries December 31, 2005 with Report of Independent Auditors Financial Guaranty Insurance Company and Subsidiaries Consolidated Financial Statements December 31, 2005 Contents Report of Registered Public Accounting Firm........................... 1 Consolidated Balance Sheets........................................... 2 Consolidated Statements of Income..................................... 3 Consolidated Statements of Stockholder's Equity....................... 4 Consolidated Statements of Cash Flows................................. 5 Notes to Consolidated Financial Statements............................ 6 Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholder Financial Guaranty Insurance Company We have audited the accompanying consolidated balance sheets of Financial Guaranty Insurance Company and Subsidiaries (the "Company") as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholder's equity and cash flows for the years ended December 31, 2005 and 2004 and the periods from December 18, 2003 through December 31, 2003 and from January 1, 2003 through December 17, 2003. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for the years ended December 31, 2005 and 2004 and the periods from December 18, 2003 through December 31, 2003 and from January 1, 2003 through December 17, 2003, in conformity with U.S. generally accepted accounting principles. /s/ Ernst & Young LLP New York, New York January 23, 2006 1 Financial Guaranty Insurance Company and Subsidiaries Consolidated Balance Sheets (Dollars in thousands, except per share amounts)
December 31 2005 2004 -------------------------------------- Assets Fixed maturity securities, at fair value (amortized cost of $3,277,291 in 2005 and $2,921,320 in 2004) $ 3,258,738 $ 2,938,856 Short-term investments 159,334 140,473 -------------------------------------- Total investments 3,418,072 3,079,329 Cash and cash equivalents 45,077 69,292 Accrued investment income 42,576 36,580 Reinsurance recoverable on losses 3,271 3,054 Prepaid reinsurance premiums 110,636 109,292 Deferred policy acquisition costs 63,330 33,835 Receivable from related parties 9,539 802 Property and equipment, net of accumulated depreciation of $885 in 2005 and $164 in 2004 3,092 2,408 Prepaid expenses and other assets 10,354 7,826 Federal income taxes receivable 2,158 - -------------------------------------- Total assets $ 3,708,105 $ 3,342,418 ====================================== Liabilities and stockholder's equity Liabilities: Unearned premiums $ 1,201,163 $ 1,043,334 Loss and loss adjustment expenses 54,812 39,181 Ceded reinsurance balances payable 1,615 3,826 Accounts payable, accrued expenses and other liabilities 36,359 22,874 Payable for securities purchased - 5,715 Capital lease obligations 4,262 6,446 Federal income taxes payable - 4,401 Deferred income taxes 42,463 38,765 -------------------------------------- Total liabilities 1,340,674 1,164,542 -------------------------------------- Stockholder's equity: Common stock, par value $1,500 per share; 10,000 shares authorized, issued and outstanding 15,000 15,000 Additional paid-in capital 1,894,983 1,882,772 Accumulated other comprehensive (loss) income, net of tax (13,597) 15,485 Retained earnings 471,045 264,619 -------------------------------------- Total stockholder's equity 2,367,431 2,177,876 -------------------------------------- Total liabilities and stockholder's equity $ 3,708,105 $ 3,342,418 ======================================
See accompanying notes to consolidated financial statements. 2 Financial Guaranty Insurance Company and Subsidiaries Consolidated Statements of Income (Dollars in thousands)
Successor Predecessor --------------------------------------------------- ------------ Period from Period from December 18, January 1, 2003 2003 Year ended Year ended through December through December 31, December 31, 31, December 17, 2005 2004 2003 2003 --------------------------------------------------------------------- Revenues: Gross premiums written $ 410,202 $ 323,575 $ 12,213 $ 248,112 Reassumed ceded premiums - 4,959 6,300 14,300 Ceded premiums written (29,148) (14,656) (39) (14,852) --------------------------------------------------------------------- Net premiums written 381,054 313,878 18,474 247,560 Increase in net unearned premiums (156,485) (138,929) (9,892) (105,811) --------------------------------------------------------------------- Net premiums earned 224,569 174,949 8,582 141,749 Net investment income 117,072 97,709 4,269 112,619 Net realized gains 101 559 - 31,506 Net mark-to-market losses on credit derivative contracts (167) - - - Other income 762 736 44 580 --------------------------------------------------------------------- Total revenues 342,337 273,953 12,895 286,454 Expenses: Loss and loss adjustment expenses 18,506 5,922 236 (6,757) Underwriting expenses 82,064 73,426 7,622 54,481 Policy acquisition costs deferred (38,069) (32,952) (2,931) (23,641) Amortization of deferred policy acquisition costs 8,302 2,038 10 15,563 --------------------------------------------------------------------- Total expenses 70,803 48,434 4,937 39,646 --------------------------------------------------------------------- Income before income tax expense (benefit) 271,534 225,519 7,958 246,808 Income tax expense (benefit): Current 32,370 42,510 1,191 57,071 Deferred 32,738 12,923 573 (1,612) --------------------------------------------------------------------- Total income tax expense 65,108 55,433 1,764 55,459 --------------------------------------------------------------------- Income before extraordinary item 206,426 170,086 6,194 191,349 Extraordinary gain - - 13,852 - --------------------------------------------------------------------- Net income $ 206,426 $ 170,086 $ 20,046 $ 191,349 =====================================================================
See accompanying notes to consolidated financial statements. 3 Financial Guaranty Insurance Company and Subsidiaries Consolidated Statements of Stockholder's Equity (Dollars in thousands)
Accumulated Other Additional Comprehensive Common Paid-in (Loss) Income, Retained Stock Capital Net of Tax Earnings Total ---------------------------------------------------------------------------- Predecessor Balance at January 1, 2003 $ 15,000 $ 383,511 $ 49,499 $ 1,740,885 $ 2,188,895 Net income - - - 191,349 191,349 Other comprehensive income (loss): Change in fixed maturities available-for-sale - - (424) - (424) Change in foreign currency translation adjustment - - 4,267 - 4,267 ------------- Total comprehensive income 195,192 Dividends declared - - - (284,300) (284,300) ---------------------------------------------------------------------------- Balance at December 17, 2003 15,000 383,511 53,342 1,647,934 2,099,787 Successor Purchase accounting adjustments - 1,474,261 (53,342) (1,573,447) (152,528) Net income - - - 20,046 20,046 Other comprehensive income: Change in fixed maturities available-for-sale - - 2,059 - 2,059 ------------- Total comprehensive income 22,105 Balance at December 31, 2003 15,000 1,857,772 2,059 94,533 1,969,364 ---------------------------------------------------------------------------- Net income - - - 170,086 170,086 Other comprehensive income: Change in fixed maturities available-for-sale - - 9,340 - 9,340 Change in foreign currency translation adjustment - - 4,086 - 4,086 ------------- Total comprehensive income 183,512 Capital contribution - 25,000 - - 25,000 ---------------------------------------------------------------------------- Balance at December 31, 2004 15,000 1,882,772 15,485 264,619 2,177,876 Net income - - - 206,426 206,426 Other comprehensive loss: Change in fixed maturities available-for-sale - - (23,550) - (23,550) Change in foreign currency translation adjustment - - (5,532) - (5,532) ------------- Total comprehensive income 177,344 Capital contribution - 12,211 - - 12,211 ---------------------------------------------------------------------------- Balance at December 31, 2005 $ 15,000 $1,894,983 $ (13,597) $ 471,045 $ 2,367,431 ============================================================================
See accompanying notes to consolidated financial statements. 4 Financial Guaranty Insurance Company and Subsidiaries Consolidated Statements of Cash Flows (Dollars in thousands)
Successor Predecessor ----------------------------------------------- --------------- Period from Period from December 18, January 1, 2003 2003 Year ended Year ended through through December 31, December 31, December 31, December 17, 2005 2004 2003 2003 ---------------------------------------------------------------- Operating activities Net income $ 206,426 $ 170,086 $ 20,046 $ 191,349 Adjustments to reconcile net income to net cash provided by operating activities: Extraordinary gain - (13,852) - Amortization of deferred policy acquisition costs 8,574 2,038 10 15,563 Policy acquisition costs deferred (38,069) (32,952) (2,931) (23,641) Depreciation of property and equipment 721 164 - 22 Amortization of fixed maturity securities 31,504 37,013 693 21,129 Amortization of short-term investments 481 29 Net realized gains on investments (101) (559) - (31,506) Change in accrued investment income and prepaid expenses and other assets (8,504) (5,545) (5,065) 6,292 Change in net mark-to-market losses on credit derivative contracts 167 - - - Change in federal income taxes receivable - 126 (172) (2,407) Change in reinsurance recoverable on losses (217) 5,011 (104) 410 Change in prepaid reinsurance premiums (1,344) 14,476 7,432 19,725 Changes in other reinsurance receivables - 5,295 (5,295) - Change in receivable from related parties (8,737) 8,957 (76) (9,811) Change in unearned premiums 157,829 124,452 2,460 86,250 Change in loss and loss adjustment expenses 15,631 (1,286) 236 (7,644) Change in ceded reinsurance balances payable and accounts payable and accrued expenses 8,923 7,348 6,485 1,804 Change in current federal income taxes payable (6,559) 4,401 - (97,477) Change in deferred federal income taxes 19,252 12,923 573 (1,612) ---------------------------------------------------------------- Net cash provided by operating activities 385,977 351,977 10,440 168,446 ---------------------------------------------------------------- Investing activities Sales and maturities of fixed maturity securities 122,638 284,227 1,780 1,028,103 Purchases of fixed maturity securities (520,089) (546,028) - (877,340) Purchases, sales and maturities of short-term investments, net (19,342) (126,125) (12,736) 41,504 Receivable for securities sold (20) 170 538 283 Payable for securities purchased (5,715) 5,715 - (5,333) Purchase of fixed assets (1,405) (2,572) - - ---------------------------------------------------------------- Net cash (used in) provided by investing (423,933) (384,613) (10,418) 187,217 activities ---------------------------------------------------------------- Financing activities Capital contribution 12,211 25,000 - - Dividends paid to common stockholders - - - (284,300) ---------------------------------------------------------------- Net cash provided by (used in) financing 12,211 25,000 - (284,300) activities ---------------------------------------------------------------- Effect of exchange rate changes on cash 1,530 (1,717) - - ---------------------------------------------------------------- Net (decrease) increase in cash and cash (24,215) (9,353) 22 71,363 equivalents Cash and cash equivalents at beginning of period 69,292 78,645 78,623 7,260 ---------------------------------------------------------------- Cash and cash equivalents at end of period $ 45,077 $ 69,292 $ 78,645 $ 78,623 ================================================================ Supplemental disclosure of cash flow information Income taxes paid $ 49,613 $ 40,890 $ - $ 156,800 ================================================================
See accompanying notes to consolidated financial statements. 5 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements December 31, 2005 (Dollars in thousands, except per share amounts) 1. Business and Organization Financial Guaranty Insurance Company (the "Company") is a wholly owned subsidiary of FGIC Corporation ("FGIC Corp."). The Company provides financial guaranty insurance and other forms of credit enhancement for public finance and structured finance obligations. The Company began insuring public finance obligations in 1984 and structured finance obligations in 1988. The Company's financial strength is rated "Aaa" by Moody's Investors Service, Inc., "AAA" by Standard & Poor's Rating Services, a division of The McGraw-Hill Companies, Inc., and "AAA" by Fitch Ratings, Inc. The Company is licensed to engage in writing financial guaranty insurance in all 50 states, the District of Columbia, the Commonwealth of Puerto Rico, the U.S. Virgin Islands, and, through a branch, in the United Kingdom. In addition, a United Kingdom subsidiary of the Company is authorized to write financial guaranty business in the United Kingdom and has passport rights to write business in other European Union member countries. FGIC Corp. and the Company have formed subsidiaries to facilitate geographic and business expansion. On December 18, 2003, an investor group consisting of The PMI Group, Inc. ("PMI"), affiliates of the Blackstone Group L.P. ("Blackstone"), affiliates of the Cypress Group L.L.C. ("Cypress") and affiliates of CIVC Partners L.P. ("CIVC"), collectively, the "Investor Group", completed the acquisition of FGIC Corp. from a subsidiary of General Electric Capital Corporation ("GE Capital") in a transaction valued at approximately $2,200,000 (the "Transaction"). GE Capital retained 2,346 shares of FGIC Corp. Senior Preferred Mandatorily Convertible Modified Preferred Stock ("Senior Preferred Shares") with an aggregate liquidation preference of $234,600, and approximately 5% of FGIC Corp.'s outstanding common stock. PMI is the largest stockholder of FGIC Corp., owning approximately 42% of its common stock at December 31, 2005 and 2004. Blackstone, Cypress and CIVC own approximately 23%, 23% and 7% of FGIC Corp.'s common stock, respectively, at December 31, 2005 and 2004. 2. Basis of Presentation The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances have been eliminated in consolidation. 6 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 2. Basis of Presentation (continued) The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States ("GAAP") requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes. Actual results could differ from those estimates. The accompanying financial statements have been prepared on the basis of GAAP, which differs in certain respects from the accounting practices prescribed or permitted by the New York State Insurance Department (see Note 4). Certain 2004 and 2003 information has been reclassified to conform to the 2005 presentation. 3. Summary of Significant Accounting Policies The Company's significant accounting policies are as follows: a. Investments All the Company's fixed maturity securities are classified as available-for-sale and are recorded on the trade date at fair value. Unrealized gains and losses are recorded as a separate component of accumulated other comprehensive (loss) income, net of applicable income taxes, in the consolidated statements of stockholders' equity. Short-term investments are carried at cost, which approximates fair value. Bond discounts and premiums are amortized over the remaining term of the securities. Realized gains or losses on the sale of investments are determined based on the specific identification method. Securities that have been determined to be other than temporarily impaired are reduced to realizable value, establishing a new cost basis, with a charge to realized loss at such date. b. Cash and Cash Equivalents The Company considers all bank deposits, highly liquid securities and certificates of deposit with maturities of three months or less at the date of purchase to be cash equivalents. These cash equivalents are carried at cost, which approximates fair value. 7 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 3. Summary of Significant Accounting Policies (continued) c. Premium Revenue Recognition Premiums are received either up-front or over time on an installment basis. The premium collection method is determined at the time the policy is issued. Up-front premiums are paid in full at the inception of the policy and are earned over the period of risk in proportion to the total amount of principal and interest amortized in the period as a proportion of the original principal and interest outstanding. Installment premiums are collected periodically and are reflected in income pro-rata over the period covered by the premium payment, including premiums received on credit default swaps (see Note 6). Unearned premiums represent the portion of premiums received applicable to future periods on insurance policies in force. When an obligation insured by the Company is refunded prior to the end of the expected policy coverage period, any remaining unearned premium is recognized at that time. A refunding occurs when an insured obligation is called or legally defeased prior to stated maturity. Premiums earned on advanced refundings were $54,795, $42,695, $5,013 and $39,858 for the years ended December 31, 2005 and 2004 and the periods from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, respectively. Ceded premiums are recognized in a manner consistent with the premium earned on the underlying policies. d. Policy Acquisition Costs Policy acquisition costs include only those expenses that relate directly to and vary with premium production. Such costs include compensation of employees involved in marketing, underwriting and policy issuance functions, rating agency fees, state premium taxes and certain other expenses. In determining policy acquisition costs, the Company must estimate and allocate the percentage of its costs and expenses that are attributable to premium production, rather than to other activities. Policy acquisition costs, net of ceding commission income on premiums ceded to reinsurers, are deferred and amortized over the period in which the related premiums are earned. Anticipated loss and loss adjustment expenses, future maintenance costs on the in-force business and net investment income are considered in determining the recoverability of acquisition costs. 8 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 3. Summary of Significant Accounting Policies (continued) e. Loss and Loss Adjustment Expenses Provision for loss and loss adjustment expenses fall into two categories: case reserves and watchlist reserves. Case reserves are established for the value of estimated losses on particular insured obligations that are presently or likely to be in payment default and for which future loss is probable and can be reasonably estimated. These reserves represent an estimate of the present value of the anticipated shortfall between (1) payments on insured obligations plus anticipated loss adjustment expenses and (2) anticipated cash flow from, and proceeds to be received on, sales of any collateral supporting the obligation and/or other anticipated recoveries. The discount rate used in calculating the net present value of estimated losses is based upon the risk-free rate for the time period of the anticipated shortfall. As of December 31, 2005 and 2004, discounted case-basis loss and loss adjustment expense reserves totaled $33,328 and $15,700, respectively. Loss and loss adjustment expenses included amounts discounted at an approximate interest rate of 4.5% in 2005 and 2004. The amount of the discount at December 31, 2005 and 2004 was $15,015 and $2,500, respectively. The Company establishes watchlist reserves to recognize the potential for claims against the Company on insured obligations that are not presently in payment default, but which have migrated to an impaired level, where there is a substantially increased probability of default. These reserves reflect an estimate of probable loss given evidence of impairment, and a reasonable estimate of the amount of loss given default. The methodology for establishing and calculating the watchlist reserve relies on a categorization and assessment of the probability of default, and loss severity in the event of default, of the specifically identified impaired obligations on the watchlist based on historical trends and other factors. The watchlist reserve is adjusted as necessary to reflect changes in the loss expectation inherent in the group of impaired credits. As of December 31, 2005 and 2004, such reserves were $21,484 and $23,500, respectively. The reserve for loss and loss adjustment expenses is reviewed regularly and updated based on claim payments and the results of ongoing surveillance. The Company conducts ongoing insured portfolio surveillance to identify all impaired obligations and thereby provide a materially complete recognition of losses for each accounting period. The reserves are necessarily based upon estimates and subjective judgments about the outcome of future events, and actual results will likely differ from these estimates. 9 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 3. Summary of Significant Accounting Policies (continued) Reinsurance recoverable on losses is calculated in a manner consistent with the calculation loss and loss adjustment expenses. f. Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using statutory tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period in which a change occurs. The Company is a financial guaranty insurance writer and is permitted a tax deduction, subject to certain limitations under Section 832(e) of the Internal Revenue Code, for amounts required to be set aside in statutory contingency reserves by state law or regulation. The deduction is allowed only to the extent the Company purchases U.S. Government non-interest bearing tax and loss bonds in an amount equal to the tax benefit attributable to such deductions. Purchases of tax and loss bonds are recorded as a reduction of current tax expense. For the years ended December 31, 2005 and 2004, the Company purchased $13,565 and $10,810, respectively, of tax and loss bonds. For the period from January 1, 2003 through December 17, 2003, there were no tax and loss bonds purchased and $102,540 of tax and loss bonds were redeemed. g. Property and Equipment Property and equipment consists of office furniture, fixtures, computer equipment and software and leasehold improvements that are reported at cost less accumulated depreciation. Office furniture and fixtures are depreciated straight-line over five years. Leasehold improvements are amortized over their estimated service lives or over the life of the lease, whichever is shorter. Computer equipment and software are depreciated over three years. Maintenance and repairs are charged to expense as incurred. 10 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 3. Summary of Significant Accounting Policies (continued) h. Goodwill In accounting for the Transaction in 2003, the Company applied purchase accounting, as prescribed by Statement of Financial Accounting Standards ("SFAS") No. 141, Business Combinations ("SFAS 141") and Securities and Exchange Commission Staff Accounting Bulletin 54. Under these accounting methods, the purchase price was pushed down into the accompanying consolidated financial statements, with the difference between the purchase price and the sum of the fair value of tangible and identifiable intangible assets acquired less liabilities assumed resulting in negative goodwill of $27,300 at December 18, 2003. In accordance with SFAS 141, the Company reduced the value assigned to non-financial assets, and the remaining negative goodwill of $13,852 was recorded as an extraordinary gain in the consolidated statement of income. As a result of the purchase accounting, effective December 18, 2003, the basis of the Company's assets and liabilities changed, necessitating the presentation of Predecessor Company and Successor Company columns in the consolidated statements of income, stockholder's equity and cash flows. i. Foreign Currency Translation The Company has an established foreign branch and three subsidiaries in the United Kingdom and insured exposure from a former branch in France. The Company has determined that the functional currencies of these operations are their local currencies. Accordingly, the assets and liabilities of these operations are translated into U.S. dollars at the rates of exchange at December 31, 2005 and 2004, and revenues and expenses are translated at average monthly exchange rates. The cumulative translation (loss) gain at December 31, 2005 and 2004 was $(1,446) and $4,086, respectively, net of tax benefit (expense) of $723 and $(2,200), respectively, and is reported as a separate component of accumulated other comprehensive income in the consolidated statements of stockholder's equity. 11 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 3. Summary of Significant Accounting Policies (continued) j. Stock Compensation Plan The Company has an incentive stock plan that provides for stock-based compensation, including stock options, restricted stock awards and restricted stock units of FGIC Corp. Stock options are granted for a fixed number of shares with an exercise price equal to or greater than the fair value of the shares at the date of the grant. Restricted stock awards and restricted stock units are valued at the fair value of the stock on the grant date, with no cost to the grantee. FGIC Corp. accounts for stock-based compensation using the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and, accordingly, if the exercise price is equal to the fair value of the shares at the date of the grant, no compensation expense related to stock options is allocated to the Company by FGIC Corp. For grants to employees of the Company of restricted stock and restricted stock units, unearned compensation, equivalent to the fair value of the shares at the date of grant, is allocated to the Company. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based Compensation ("SFAS 123"), as amended. Had FGIC Corp. determined compensation expense for stock options granted to employees and management based on the fair value of the options at the grant dates consistent with the method of accounting under SFAS 123, the Company's estimated pro forma net income would have been as follows:
Period from December 18, 2003 through Year ended Year ended December 31, December 31, 2005 December 31, 2004 2003 ----------------------------------------------------- Reported net income $ 206,426 $ 170,086 $20,046 Add: Allocated stock-based compensation related to restricted stock units, net of tax included in reported net income 29 49 - Less: Allocated total stock-based compensation determined under the fair value method for all awards, net of tax (2,138) (1,249) (40) ----------------------------------------------------- Pro forma net income $ 204,317 $ 168,886 $ 20,006 =====================================================
There were no stock options prior to December 18, 2003. 12 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 3. Summary of Significant Accounting Policies (continued) k. Variable Interest Entities Financial Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46-R") provides accounting and disclosure rules for determining whether certain entities should be consolidated in the Company's consolidated financial statements. An entity is subject to FIN 46-R, and is called a Variable Interest Entity ("VIE"), if it has (i) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support or (ii) equity investors that cannot make significant decisions about the entity's operations or that do not absorb the majority of expected losses or receive the majority of expected residual returns of the entity. A VIE is consolidated by its primary beneficiary, which is the party that has a majority of the expected losses or a majority of the expected residual returns of the VIE, or both. FIN 46-R requires disclosures for companies that have either a primary or significant variable interest in a VIE. All other entities not considered VIEs are evaluated for consolidation under SFAS No. 94, Consolidation of all Majority-Owned Subsidiaries. As part of its structured finance business, the Company insures debt obligations or certificates issued by special purpose entities. The Company has evaluated the transactions, and does not believe any such transactions require consolidation or disclosure under FIN 46-R. During 2004, FGIC arranged the issuance of contingent preferred trust securities by a group of special purpose trusts. These trusts are considered VIEs under FIN 46-R. However, the Company is not considered a primary beneficiary and therefore is not required to consolidate the trusts (see Note 16). l. Derivatives The Financial Accounting Standards Board ("FASB") issued and subsequently amended SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"). Under SFAS 133, as amended, all derivative instruments are recognized on the consolidated balance sheet at their fair value, and changes in fair value are recognized immediately in earnings unless the derivatives qualify as hedges. 13 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 3. Summary of Significant Accounting Policies (continued) In 2005, the Company sold credit default swaps ("CDS") to certain buyers of credit protection. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. Changes in fair value are recorded in net mark-to-market gains (losses) on credit derivative instruments in the consolidated statements of income and in other assets or other liabilities in the consolidated balance sheets. The Company uses dealer-quoted market values, when available, to determine fair value. If market prices are not available, management uses internally developed estimates of fair value. m. New Accounting Pronouncements On December 16, 2004, FASB issued SFAS 123(R) which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. Following the effective date, pro forma disclosure is no longer an alternative. In April 2005, the SEC announced the adoption of a rule allowing public companies to defer the adoption of SFAS 123(R) until the beginning of their fiscal years beginning after June 15, 2005. Non-public entities will be required to adopt the provisions of the new standard in fiscal years beginning after December 15, 2005. Under SFAS 123(R), the Company must determine the transition method to be used at the date of adoption, the appropriate fair value model to be used for valuing share-based payments and the amortization method for compensation cost. The transition methods include retroactive and prospective adoption options. Under the retroactive option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all outstanding share-based awards for which the requisite service has not yet been rendered. The retroactive method would record compensation for all unvested stock options and restricted stock beginning with the first period restated. The Company anticipates adopting the prospective method and expects that the adoption of SFAS 123(R) will have an impact similar to the current pro forma disclosure for existing options under SFAS 123(R). In addition, the Company does not expect that the expense associated with future grants (assuming grant levels consistent with 2005) derived from the fair value model selected will have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows. 14 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 3. Summary of Significant Accounting Policies (continued) n. Review of Financial Guaranty Industry Accounting Practices The FASB staff is considering whether additional accounting guidance is necessary to address loss reserving and certain other practices in the financial guaranty industry. SFAS No. 60, Accounting and Reporting by Insurance Enterprises, was developed prior to the emergence of the financial guaranty industry. As it does not specifically address financial guaranty contracts, there has been diversity in the accounting for these contracts. In 2005, the FASB added a project to consider accounting by insurers for financial guaranty insurance. The objective of the project is to develop an accounting model for financial guaranty contracts issued by insurance companies that are not accounted for as derivative contracts under SFAS 133. A financial guaranty contract guarantees the holder of a financial obligation the full and timely payment of principal and interest when due and is typically issued in conjunction with municipal bond offerings and certain structured finance transactions. The goal of this project is to develop a single model for all industry participants to apply. The FASB is expected to meet in 2006 to consider the accounting model for issuers of financial guaranty insurance. Proposed and final pronouncements are expected to be issued in 2006. When the FASB reaches a conclusion on this issue, the Company, along with other companies in the financial guaranty industry, may be required to change certain aspects of accounting for loss reserves, premium income and deferred acquisition costs. It is not possible to predict the impact the FASB's review may have on the Company's accounting practices. 4. Statutory Accounting Practices Statutory-basis surplus of the Company at December 31, 2005 and 2004 was $1,162,904 and $1,172,600, respectively. Statutory-basis net income (loss) for the years ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003, and January 1, 2003 through December 17, 2003 was $192,009, $144,100, $(1,669), and $180,091, respectively. 15 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 5. Investments The amortized cost and fair values of investments in fixed maturity securities and short-term investments classified as available-for-sale are as follows:
Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value --------------------------------------------------------------- At December 31, 2005 Obligations of states and political subdivisions $ 2,777,807 $ 12,718 $ 26,410 $ 2,764,115 Asset- and mortgage-backed securities 209,148 135 3,490 205,793 U.S. Treasury securities and obligations of U.S. government corporations and agencies 148,785 1,387 2,036 148,136 Corporate bonds 91,422 501 1,486 90,437 Debt securities issued by foreign governments 30,930 345 5 31,270 Preferred stock 19,199 427 639 18,987 --------------------------------------------------------------- Total fixed maturity securities 3,277,291 15,513 34,066 3,258,738 Short-term investments 159,334 - - 159,334 --------------------------------------------------------------- Total investments $ 3,436,625 $ 15,513 $ 34,066 $ 3,418,072 ===============================================================
Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value --------------------------------------------------------------- At December 31, 2004 Obligations of states and political subdivisions $ 2,461,087 $ 19,569 $ 3,090 $ 2,477,566 Asset- and mortgage-backed securities 214,895 1,267 695 215,467 U.S. Treasury securities and obligations of U.S. Government corporations and agencies 131,771 559 943 131,387 Corporate bonds 54,655 663 236 55,082 Debt securities issued by foreign governments 39,713 176 21 39,868 Preferred stock 19,199 311 24 19,486 --------------------------------------------------------------- Total fixed maturities 2,921,320 22,545 5,009 2,938,856 Short-term investments 140,473 - - 140,473 --------------------------------------------------------------- Total investments $ 3,061,793 $ 22,545 $ 5,009 $ 3,079,329 ===============================================================
16 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 5. Investments (continued) The following table shows gross unrealized losses and the fair value of fixed maturity securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005:
Less Than 12 Months 12 Months or More Total ------------------------------------------------------------------------- Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses ------------------------------------------------------------------------- Obligations of states and $1,622,119 $16,646 $463,156 $ 9,764 $2,085,275 $26,410 political subdivisions Asset- and mortgage-backed securities 133,196 1,839 56,824 1,651 190,020 3,490 U.S. Treasury securities and obligations of U.S. government corporations and agencies 47,872 520 76,380 1,516 124,252 2,036 Other 42,379 690 28,026 801 70,405 1,491 Preferred stock 12,860 639 - - 12,860 639 ------------------------------------------------------------------------- Total temporarily impaired $1,858,426 $20,334 $624,386 $13,732 $2,482,812 $34,066 securities =========================================================================
The unrealized losses in the Company's investments were caused by interest rate increases. The Company evaluated the credit ratings of these securities and noted no deterioration. Because the decline in market value is attributable to changes in interest rates and not credit quality and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Company did not consider these investments to be other than temporarily impaired at December 31, 2005. Investments in fixed maturity securities carried at fair value of $4,625 and $4,049 as of December 31, 2005 and 2004, respectively, were on deposit with various regulatory authorities as required by law. 17 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 5. Investments (continued) The amortized cost and fair values of investments in fixed maturity securities, available-for-sale at December 31, 2005, are shown below by contractual maturity date. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Fair Cost Value ------------------------------------- Due one year later or less $ 77,668 $ 77,071 Due after one year through five years 472,292 463,162 Due after five years through ten years 1,463,806 1,448,990 After ten years 1,263,525 1,269,515 ------------------------------------- Total $ 3,277,291 $ 3,258,738 ===================================== For the years ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, proceeds from sales of available-for-sale securities were $31,380, $178,030, $0, and $855,761 respectively. For the years ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, gross gains of $185, $1,900, $0, and $31,700, respectively, and gross losses of $84, $1,300, $0, and $200, respectively, were realized on such sales. Net investment income of the Company was derived from the following sources:
Successor Predecessor ---------------------------------------------------- --------------- Period from Period from December January 18, 2003 1, 2003 Year ended Year ended through December through December 31, December 31, 31, December 17, 2005 2004 2003 2003 --------------------------------------------------------------------- Income from fixed maturity securities $ 112,616 $ 97,720 $ 4,294 $ 111,075 Income from short-term investments 6,801 1,450 12 2,326 --------------------------------------------------------------------- Total investment income 119,417 99,170 4,306 113,401 Investment expenses (2,345) (1,461) (37) (782) --------------------------------------------------------------------- Net investment income $ 117,072 $ 97,709 $ 4,269 $ 112,619 =====================================================================
18 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 5. Investments (continued) As of December 31, 2005, the Company did not have more than 3% of its investment portfolio concentrated in a single issuer or industry; however, the Company had the following investment concentrations by state: Fair Value ------------------- New York $ 302,290 Florida 220,150 Texas 217,145 New Jersey 193,315 Massachusetts 169,635 Illinois 155,922 California 139,742 Michigan 113,040 ------------------- 1,511,239 All other states 1,326,785 All other investments 580,048 ------------------- Total investments $ 3,418,072 =================== 6. Derivative Instruments The Company provides CDSs to certain buyers of credit protection by entering into contracts that reference collateralized debt obligations from cash and synthetic structures backed by pools of corporate, consumer or structured finance debt. It also offers credit protection on other public finance and structured finance obligations in CDS form. The Company considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, and to record losses and loss adjustment expenses and changes in fair value as incurred. The Company recorded $3,036 of net earned premium, $0 in losses and loss adjustment expenses, and net mark-to-market losses of $167 in changes in fair value under these agreements for the year ended December 31, 2005. 19 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 6. Derivative Instruments (continued) The gains or losses recognized by recording these contracts at fair value are determined each quarter based on quoted market prices, if available. If quoted market prices are not available, the determination of fair value is based on internally developed estimates. Management applies judgments to estimate fair value which are based on changes in expected loss of the underlying assets as well as changes in current market prices for similar products. Consideration is given to current market spreads and on evaluation of the current performance of the assets. The Company does not believe that the fair value adjustments are an indication of potential claims under the Company's guarantees. The inception-to-date net mark-to-market loss on the CDS portfolio was $167 at December 31, 2005 and was recorded in other liabilities. 7. Income Taxes For periods subsequent to the closing date of the Transaction, the Company files its own consolidated federal income tax returns with FGIC Corp. The method of allocation between FGIC Corp. and its subsidiaries is determined under a tax sharing agreement approved by FGIC Corp.'s Board of Directors and the New York State Insurance Department, and is based upon a separate return calculation. For periods ended on or prior to December 18, 2003, the Company filed its federal income tax return as part of the consolidated return of GE Capital. Under a tax sharing agreement with GE Capital, tax was allocated to the Company based upon its contributions to GE Capital's consolidated net income. 20 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 7. Income Taxes (continued) The following is a reconciliation of federal income taxes computed at the statutory income tax rate and the provision for federal income taxes:
Successor Predecessor ---------------------------------------------------------- ---------------- Period from Period from December 18, January 1, 2003 2003 Year ended Year ended through through December 31, December 31, December 31, December 17, 2005 2004 2003 2003 ------------------------------------------------------------------------------- Income taxes computed on income $ 95,037 $ 78,932 $ 2,785 $ 86,383 before provision for Federal income taxes, at the statutory income tax rate State and local income taxes, net of Federal income taxes 453 479 - 844 Tax effect of: Tax-exempt interest (31,072) (28,015) (979) (26,112) Prior period adjustment - - - (4,978) Other, net 690 4,037 (42) (678) ------------------------------------------------------------------------------- Provision for income taxes $ 65,108 $ 55,433 $ 1,764 $ 55,459 ===============================================================================
21 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 7. Income Taxes (continued) The tax effects of temporary differences that give rise to significant portions of the net deferred tax liability at December 31, 2005 and 2004 are presented below: 2005 2004 -------------------------- Deferred tax assets: Tax and loss bonds $24,375 $10,810 Loss and loss adjustment expense reserves 6,180 7,472 AMT credit carryforward 7,140 8,107 Property and equipment 83 55 Deferred compensation 1,483 623 Capital lease 2,483 2,539 Net operating loss on foreign subsidiaries 2,948 - Other 266 233 -------------------------- Total gross deferred tax assets 44,958 29,839 -------------------------- Deferred tax liabilities: Contingency reserves 42,656 18,917 Unrealized gains on fixed maturity securities, available-for-sale 12,883 29,156 Deferred acquisition costs 19,639 11,842 Premium revenue recognition 10,359 3,076 Profit commission 1,435 2,343 Foreign currency 194 3,117 Other 255 153 -------------------------- Total gross deferred tax liabilities 87,421 68,604 -------------------------- Net deferred tax liability $42,463 $38,765 ========================== The net operating losses on foreign subsidiaries of $10,863 as of December 31, 2005 were generated by FGIC Corp.'s United Kingdom subsidiaries. The United Kingdom does not allow net operating losses to be carried back, but does permit them to be carried forward indefinitely. Based upon the level of historical taxable income, projections of future taxable income over the periods in which the deferred tax assets are deductible and the estimated reversal of future taxable temporary differences, the Company believes it is more likely than not that it will realize the benefits of these deductible differences and has not established a valuation allowance at December 31, 2005 and 2004. In the opinion of management, an adequate provision has been made for any additional taxes that may become due pending any future examinations by tax authorities. 22 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 8. 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 under policies issued by the ceding company in consideration for a portion of the related premiums received. The ceding company typically will receive a ceding commission from the reinsurer. The Company uses reinsurance to increase its capacity to write insurance for obligations of large, frequent issuers, to meet internal, rating agency or regulatory single risk limits, to diversify risk, and to manage rating agency and regulatory capital requirements. The Company currently arranges reinsurance primarily on a facultative (transaction-by-transaction) basis. Prior to 2003, the Company also had treaty reinsurance agreements, primarily for the public finance business, that provided coverage for a specified portion of the insured risk under all qualifying policies issued during the term of the treaty. The Company seeks to place reinsurance with financially strong reinsurance companies since, as a primary insurer, the Company is required to fulfill all its obligations to policyholders even where a reinsurer fails to perform its obligations under the applicable reinsurance agreement. The Company regularly monitors the financial condition of its reinsurers. Under most of the Company's reinsurance agreements, the Company has the right to reassume all the exposure ceded to a reinsurer (and receive all the remaining unearned premiums ceded) in the event of a ratings downgrade of the reinsurer or the occurrence of certain other events. In certain of these cases, the Company also has the right to impose additional ceding commissions. In recent years, some of the Company's reinsurers were downgraded by the rating agencies, thereby reducing the financial benefits of using reinsurance under rating agency capital adequacy models, because the Company must allocate additional capital to the related reinsured exposure. However, the Company still receives regulatory credit for this reinsurance. In connection with such a downgrade, the Company reassumed $0, $4,959, $6,300, and $14,300 of ceded premiums for the years ended December 31, 2005 and 2004, and the periods from December 18, 2003 through December 31, 2003, and January 1, 2003 through December 17, 2003, respectively, from the reinsurers. Under certain reinsurance agreements, the Company holds collateral in the form of letters of credit and trust agreements. Such collateral totaled $62,394 at December 31, 2005, and can be drawn on in the event of default by the reinsurer. 23 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 8. Reinsurance (continued) The effect of reinsurance on the balances recorded in the consolidated statements of income is as follows:
Successor Predecessor --------------------------------------------------- --------------- Period from Period from December 18, January 1, 2003 2003 Year ended Year ended through through December 31, December 31, December 31, December 17, 2005 2004 2003 2003 --------------------------------------------------------------------- Net premiums earned $25,921 $24,173 $1,236 $20,300 Loss and loss adjustment expenses (416) (4,759) - 1,700
9. Loss and Loss Adjustment Expenses Activity in the reserve for loss and loss adjustment expenses is summarized as follows:
Successor Predecessor --------------------------------------------------- -------------- Period from Period from December 18, January 1, 2003 2003 Year ended Year ended through through December 31, December 31, December 31, December 17, 2005 2004 2003 2003 --------------------------------------------------------------------- Balance at beginning of period $39,181 $40,467 $40,224 $47,868 Less reinsurance recoverable (3,054) (8,065) (8,058) (8,371) --------------------------------------------------------------------- Net balance 36,127 32,402 32,166 39,497 --------------------------------------------------------------------- Incurred related to: Current period 23,985 11,756 - 20,843 Prior periods (5,479) (5,834) 236 (27,600) --------------------------------------------------------------------- Total incurred 18,506 5,922 236 (6,757) --------------------------------------------------------------------- Paid related to: Current period (1,993) - - - Prior periods (1,099) (2,197) - (574) --------------------------------------------------------------------- Total paid (3,092) (2,197) - (574) --------------------------------------------------------------------- Net balance 51,541 36,127 32,402 32,166 Plus reinsurance recoverable 3,271 3,054 8,065 8,058 --------------------------------------------------------------------- Balance at end of period $54,812 $39,181 $40,467 $40,224 =====================================================================
24 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 9. Loss and Loss Adjustment Expenses (continued) During the year ended December 31, 2005, the increase in incurred expense was primarily related to issuers impacted by Hurricane Katrina. Case reserves and credit watchlist reserves at December 31, 2005 include $8,511 and $13,322, respectively, of estimated losses related to obligations impacted by Hurricane Katrina (see Note 10). During the year ended December 31, 2004, the increase in incurred expense related to several structured finance transactions of one particular issuer. During the period from January 1, 2003 through December 17, 2003, the overall decrease in incurred expense was driven by a reduction in reserves previously established on several structured finance transactions of one particular issuer. In addition, prior to the closing of the Transaction, rather than watchlist reserves, the Company established portfolio reserves based upon the aggregate average net par outstanding of the Company's insured mortgage-backed securities portfolio. 10. Hurricane Katrina At December 31, 2005, the Company insured public finance obligations with a net par in force ("NPIF") of approximately $4,011,871 in locations impacted by Hurricane Katrina. Approximately $2,023,315 of these obligations relate to locations designated by the U.S. Federal Emergency Management Administration ("FEMA") as eligible for both public and individual assistance ("FEMA-dual designated locations"); the remainder, or $1,988,556, of these obligations relate to locations designated by FEMA as eligible for individual assistance only. The Company believes that insured obligations in FEMA-dual designated locations are more likely to be impaired than obligations eligible for individual assistance only. Consequently, since the occurrence of Hurricane Katrina, the Company has focused its portfolio surveillance efforts related to Hurricane Katrina on evaluating its insured public finance obligations in the FEMA-dual designated locations. These FEMA-dual designated locations consist primarily of counties and parishes in Alabama, Mississippi and Louisiana. 25 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 10. Hurricane Katrina (continued) As a result of this evaluation, the Company placed insured public finance obligations with an NPIF totaling $979,153 on its credit watchlist of which reserves were recorded on obligations with an NPIF of $585,303. These obligations relate to locations in the Parish of Orleans (in which New Orleans is located) and the immediately surrounding parishes. At December 31, 2005, the Company recorded case reserves of $8,511, watchlist reserves of $13,322 and estimated reinsurance recoverables of $1,740 related to insured public finance obligations placed on the credit watchlist. The case reserves of $8,511 relate to an investor-owned utility, for which the Company has insured public finance obligations with an NPIF of $75,000, that has entered into bankruptcy proceedings. The watchlist reserves of $13,322 were based on management's assessment that the associated insured public finance obligations have experienced impairment due to diminished revenue sources. The NPIF for the insured public finance obligations for which watchlist reserves of $13,322 have been established totals $510,303. The $510,303 (a subset of the $979,153) is supported by the revenue sources below: Net Par Revenue Source in Force - -------------------------------------- -------------------- General obligation $ 90,079 Hotel tax 165,000 Sales tax 117,141 Municipal utility 119,657 Public higher education 18,426 -------------------- Total $510,303 ==================== Given the unprecedented nature of the events and magnitude of damage in the affected areas, the loss reserves were necessarily based upon estimates and subjective judgments about the outcome of future events, including without limitation the amount and timing of any future federal and state aid. The loss reserves will likely be adjusted as additional information becomes available, and such adjustments may have a material impact on future results of operations. However, the Company believes that the losses ultimately incurred as result of Hurricane Katrina will not have a material impact on the Company's consolidated financial position. 26 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 10. Hurricane Katrina (continued) For the year ended December 31, 2005, the Company paid claims totaling $5,910 related to insured public finance obligations impacted by Hurricane Katrina. During 2005, the Company subsequently received reimbursements of $4,855 for these claims payments. The Company's structured finance insured portfolio was not significantly impacted by Hurricane Katrina, reflecting the geographic diversification of the credits comprising the insured structured finance obligations. 11. Related Party Transactions Prior to the Transaction, the Company had various service agreements with subsidiaries of General Electric Company and GE Capital. These agreements provided for the payment by the Company of certain payroll and office expenses, investment fees pertaining to the management of the Company's investment portfolio and telecommunication service charges. In addition, as part of the Transaction, the Company entered into a transitional services agreement under which GE Capital continued to provide certain administrative and support services, in exchange for certain scheduled fees during the 12 months following the date of the agreement. Approximately $0, $179, $0 and $1,600 in expenses were incurred during the years ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, respectively, related to such agreements and are reflected in the accompanying consolidated financial statements. At the end of the first quarter of 2004, the Company transferred investment management services from GE Capital to Blackrock Financial Management, Inc. and Wellington Management Company, LLP. In connection with the Transaction, the Company entered into a capital lease agreement with a subsidiary of GE Capital. The lease agreement covers leasehold improvements made to the Company's headquarters as well as furniture and fixtures, computer hardware and software used by the Company (see Note 17). 27 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 11. Related Party Transactions (continued) In connection with the Transaction, FGIC entered into a $300,000 soft capital facility, with GE Capital as lender and administrative agent. The soft capital facility, which replaced the capital support facility that FGIC previously had with GE Capital, had an initial term of eight years. FGIC paid GE Capital $1,132 and $70 under this agreement for the year ended December 31, 2004 and the period from December 18, 2003 through December 31, 2003, respectively. This agreement was terminated by FGIC in July 2004 and was replaced by a new soft capital facility (see Note 15). The Company also insures certain non-municipal issues with GE Capital involvement as sponsor of the insured securitization and/or servicer of the underlying assets. For some of these issues, GE Capital also provides first loss protection in the event of default. Gross premiums written on these issues amounted to $3, $6, $0 and $20 for the year ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, respectively. As of December 31, 2005, par outstanding on these deals before reinsurance was $6,142. Issues sponsored by affiliates of GE accounted for approximately 1% of gross premiums written in 2003. During 2005 FGIC, in the normal course of operations, entered into reinsurance transactions with PMI-affiliated companies. Ceded premiums were $582 for the year ended December 31, 2005 and accounts payable due to PMI were $102 at December 31, 2005. As of December 31, 2005 and 2004, there were no receivables due from GE Capital. During 2005 and 2004, the Company allocated certain overhead costs to FGIC Corp. which amounted to $540 and $317, respectively. 28 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 12. Compensation Plans All employees of the Company participate in an incentive compensation plan. In addition, the Company offers a deferred compensation plan for eligible employees. Expenses incurred by the Company under compensation plans amounted to $21,824, $15,493, $3,996, and $10,087 for the years ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, respectively, and are reflected in the accompanying consolidated financial statements. During 2005 and 2004, compensation increased primarily due to an increase in employee headcount. For 2003, compensation for certain employees was part of an allocation of expenses of affiliates and was therefore recorded as an allocated expense rather than compensation expense. In 2005 and 2004, these expenses were directly recorded by the Company. In 2003, compensation levels were driven in part by Transaction-related costs, including retention bonuses and sign-on bonuses to new hires post-acquisition. Commencing effective January 1, 2004, the Company has offered a defined contribution savings plan under Section 401(k) of the Internal Revenue Code. This plan covers substantially all employees who meet minimum age and service requirements and allows participants to defer a portion of their annual compensation on a pre-tax basis (for 2005, up to $14 for employees under age 50, plus an additional "catch up" contribution of up to $4 for employees 50 and older). The Company may also make discretionary contributions to the plan on behalf of employees. The Company contributed $3,429 and $2,532 to the plan on behalf of employees for the years ended December 31, 2005 and 2004, respectively. 13. Dividends Under New York insurance law, the Company may pay dividends to FGIC Corp. only from earned surplus, subject to the following limitations: (a) statutory surplus after any dividend may not be less than the minimum required paid-in capital, which was $72,500 in 2005, 2004 and 2003, and (b) dividends may not exceed the lesser of 10% of the Company's surplus or 100% of adjusted net investment income, as defined by New York insurance law, for the twelve-month period ended on the preceding December 31, without the prior approval of the New York State Superintendent of Insurance. 29 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 13. Dividends (continued) During the years ended December 31, 2005 and 2004 and for the period from December 18, 2003 through December 31, 2003, the Company did not declare and pay dividends. During the period from January 1, 2003 through December 17, 2003, the Company declared and paid dividends to FGIC Corp. of $284,300. These dividends were approved by the New York State Superintendent of Insurance. 14. Revolving Credit Facility During December 2005, FGIC Corp. and the Company entered into a $250,000 senior unsecured revolving credit facility that matures on December 11, 2010. The facility is provided by a syndicate of banks and other financial institutions led by JPMorgan Chase, as administrative agent and sole lead arranger. In connection with the facility, $150 in syndication costs was prepaid and will be amortized into income over the term of the facility. The facility replaced a similar one-year facility that matured in December 2005. No draws have been made under either facility. 15. Preferred Trust Securities On July 19, 2004, the Company closed a $300,000 facility, consisting of Money Market Committed Preferred Custodial Trust Securities ("CPS Securities"). This facility replaced a $300,000 "Soft Capital" facility previously provided by GE Capital. Under the new facility, each of six separate newly organized Delaware trusts (the "Trusts"), issues $50,000 in perpetual CPS Securities on a rolling 28-day auction rate basis. Proceeds from these securities are invested in high quality, short-term securities and are held in the respective Trusts. Each Trust is solely responsible for its obligations and has been established for the purpose of entering into a put agreement with the Company, which obligates the Trusts, at the Company's discretion, to purchase perpetual Preferred Stock of the Company. In this way, the program provides capital support to the Company by allowing it to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put options. In connection with the establishment of the Trusts, the Company incurred $4,638 of expenses which is included in other operating expenses for the year ended December 31, 2004. The Company recorded expenses for the right to put its shares to the Trusts of $1,806 and $905 for the years ended December 31, 2005 and 2004, respectively. 30 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 16. Financial Instruments (a) Fair Value of Financial Instruments The following methods and assumptions were used by the Company in estimating the fair values of financial instruments: Fixed Maturity Securities: Fair values for fixed maturity securities are based on quoted market prices, if available. If a quoted market price is not available, fair values are estimated using quoted market prices for similar securities. Fair value disclosure for fixed maturity securities is included in the consolidated balance sheets and in Note 5. Short-Term Investments: Short-term investments are carried at cost, which approximates fair value. Cash and Cash Equivalents, Accrued Investment Income, Prepaid Expenses and Other Assets, Receivable from Related Parties, Ceded Reinsurance Balances Payable, Accounts Payable and Accrued Expenses and Payable for Securities Purchased: The carrying amounts of these items approximate their fair values. The estimated fair values of the Company's financial instruments at December 31, 2005 and 2004 were as follows:
2005 2004 ---------------------------------------------------------- ---------------------------------------------------------- Carrying Amount Fair Carrying Fair Value Amount Value ---------------------------------------------------------- Financial assets: Cash on hand and in-demand accounts $ 45,077 $ 45,077 $ 69,292 $ 69,292 Short-term investments 159,334 159,334 140,473 140,473 Fixed maturity securities 3,258,738 3,258,738 2,938,856 2,938,856
Financial Guaranties: The carrying value of the Company's financial guaranties is represented by the unearned premium reserve, net of deferred acquisition costs, loss and loss adjustment expense reserves and prepaid reinsurance premiums. Estimated fair values of these guaranties are based on an estimate of the balance that is necessary to bring the future returns for the Company's embedded book of business to a market return. The estimated fair values of such financial guaranties was $1,098,165 compared to a carrying value of $1,099,045 as of December 31, 2005, and is $965,992 compared to a carrying value of $936,334 as of December 31, 2004. 31 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 16. Financial Instruments (continued) As of December 31, 2005 and 2004, the net present value of future installment premiums was approximately $393,000 and $192,000, respectively, both discounted at 5%. Derivatives: For fair value adjustments on derivatives, the carrying amount represents fair value. The Company uses quoted market prices when available, but if quoted market prices are not available, management uses internally developed estimates. (b) Concentrations of Credit Risk The Company considers its role in providing insurance to be credit enhancement rather than credit substitution. The Company insures only those securities that, in its judgment, are of investment grade quality. The Company has established and maintains its own underwriting standards that are based on those aspects of credit that the Company deems important for the particular category of obligations considered for insurance. Credit criteria include economic and social trends, debt management, financial management and legal and administrative factors, the adequacy of anticipated cash flows, including the historical and expected performance of assets pledged to secure payment of securities under varying economic scenarios, and underlying levels of protection such as insurance or over-collateralization. In connection with underwriting new issues, the Company sometimes requires, as a condition to insuring an issue, that collateral be pledged or, in some instances, that a third-party guaranty be provided for a term of the obligation issued by a party of acceptable credit quality obligated to make payment prior to any payment by the Company. The types and extent of collateral varies, but may include residential and commercial mortgages, corporate debt, government debt and consumer receivables. As of December 31, 2005, the Company's total outstanding principal insured was $275,327,000, net of reinsurance of $22,711,000. The Company's insured portfolio as of December 31, 2005 was broadly diversified by geographic and bond market sector, with no single obligor representing more than 1% of the Company's insured principal outstanding, net of reinsurance. The insured portfolio includes exposure under credit derivatives. The par written for credit derivatives was $15,640,000 at December 31, 2005. 32 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 16. Financial Instruments (continued) As of December 31, 2005, the composition of principal insured by type of issue, net of reinsurance, was as follows: Net Principal Outstanding ---------------------- Municipal: Tax supported $ 134,762,000 Water and sewer 34,859,000 Healthcare 4,216,000 Transportation 24,956,000 Education 9,939,000 Housing 1,234,000 Other 5,153,000 Non-municipal and international 60,208,000 ---------------------- Total $ 275,327,000 ====================== As of December 31, 2005, the composition of principal insured ceded to reinsurers was as follows: Ceded Principal Outstanding ----------------------- Reinsurer: Radian Reinsurance Company $ 7,808,000 Ace Guaranty Inc. 6,367,000 American Re-Insurance Company 2,231,000 RAM Reinsurance Company 2,024,000 Other 4,281,000 ----------------------- Total $ 22,711,000 ======================= The Company did not have recoverables in excess of 3% of stockholders' equity from any single reinsurer. The Company's insured gross and net principal and interest outstanding was $472,161,000 and $433,587,000, respectively, as of December 31, 2005. 33 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 16. Financial Instruments (continued) FGIC is authorized to do business in 50 states, the District of Columbia, the Commonwealth of Puerto Rico, the U.S. Virgin Islands and in the United Kingdom. Principal insured outstanding at December 31, 2005 by state, net of reinsurance, was as follows: Net Principal Outstanding ---------------------- California $ 32,882,000 New York 21,265,000 Pennsylvania 15,952,000 Florida 15,483,000 Illinois 13,049,000 Texas 12,223,000 New Jersey 10,883,000 Michigan 8,311,000 Ohio 6,903,000 Washington 6,359,000 ---------------------- 143,310,000 All other states 71,809,000 Mortgage and asset-backed 54,262,000 International 5,946,000 ---------------------- Total $ 275,327,000 ====================== 34 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 17. Commitments The Company leases office space and equipment under operating lease agreements in the United States and the United Kingdom. Rent expense under operating leases for the years ended December 31, 2005 and 2004 and for the period from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003 was $3,631, $3,070, $90, and $3,210, respectively. Future payments associated with these leases are as follows: Operating Lease Commitment Amount ------------------------ Year: 2006 $ 3,141 2007 3,119 2008 1,968 2009 412 2010 412 2011 and thereafter 1,496 ------------------------ Total minimum future rental payments $10,548 ======================== In connection with the Transaction, the Company entered into a capital lease with a related party (an affiliate of GE Capital), covering leasehold improvements and computer equipment to be used at its headquarters. At the lease termination date of June 30, 2009, the Company will own the leased equipment. Future payments associated with this lease are as follows: Operating Lease Commitment Amount ------------------------ Year ending December 31: 2006 $1,570 2007 1,545 2008 1,391 2009 265 ------------------------ Total 4,771 Less interest 509 ------------------------ Present value of minimum lease payments $4,262 ======================== 35 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 18. Comprehensive Income Accumulated other comprehensive (loss) income of the Company consists of net unrealized gains on investment securities, foreign currency translation adjustments, and a cash flow hedge. The components of other comprehensive income for the years ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003, and January 1, 2003 through December 17, 2003 are as follows:
Year ended December 31, 2005 ------------------------------------------ Before Tax Net of Tax Tax Amount Amount ------------------------------------------ Unrealized holding losses arising during the year $ (36,050) $ 12,566 $ (23,484) Less reclassification adjustment for gains realized in net income (101) 35 (66) ------------------------------------------ Unrealized losses on investments (36,151) 12,601 (23,550) Foreign currency translation adjustment (8,454) 2,922 (5,532) ------------------------------------------ Total other comprehensive loss $ (44,605) $ 15,523 $ (29,082) ========================================== Year ended December 31, 2004 ------------------------------------------ Before Tax Net of Tax Tax Amount Amount ------------------------------------------ Unrealized holding gains arising during the year $ 14,928 $ (5,225) $ 9,703 Less reclassification adjustment for gains realized in net income (559) 196 (363) ------------------------------------------ Unrealized gains on investments 14,369 (5,029) 9,340 Foreign currency translation adjustment 6,286 (2,200) 4,086 ------------------------------------------ Total other comprehensive income $ 20,655 $ (7,229) $ 13,426 ==========================================
36 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 18. Comprehensive Income (continued)
Period from December 18, 2003 through December 31, 2003 ------------------------------------------ Before Tax Net of Tax Tax Amount Amount ------------------------------------------ Unrealized holding gains arising during the period $3,168 $(1,109) $2,059 Less reclassification adjustment for gains realized in net income - - - ------------------------------------------ Unrealized gains on investments 3,168 (1,109) 2,059 ------------------------------------------ Total other comprehensive income $3,168 $(1,109) $2,059 ========================================== Period from January 1, 2003 through December 17, 2003 ------------------------------------------ Before Tax Net of Tax Tax Amount Amount ------------------------------------------ Unrealized holding gains arising during the period $ 30,853 $ (10,798) $ 20,055 Less reclassification adjustment for gains realized in net income (31,506) 11,027 (20,479) Unrealized losses on investments (653) 229 (424) Foreign currency translation adjustment 6,565 (2,298) 4,267 ------------------------------------------ Total other comprehensive income $ 5,912 $ (2,069) $ 3,843 ==========================================
37 Financial Guaranty Insurance Company and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in thousands, except per share amounts) 19. Quarterly Financial Information (Unaudited)
Three months ended Year ended ------------------------------------------------------ March 31, June 30, September 30, December 31, December 31, 2005 2005 2005 2005 2005 ---------------------------------------------------------------------- Gross premiums written $84,404 $131,335 $96,787 $97,676 $410,202 Net premiums written 82,609 113,305 92,331 92,809 381,054 Net premiums earned 52,633 61,907 54,794 55,235 224,569 Net investment income and net realized gains 27,558 28,389 30,117 31,109 117,173 Other income (expense) 426 90 402 (323) 595 Total revenues 80,617 90,386 85,313 86,021 342,337 Losses and loss adjustment expenses (2,611) (3,066) 20,693 3,490 18,506 Income before taxes 71,100 81,377 48,783 70,274 271,534 Net income 53,306 59,992 39,407 53,721 206,426 Three months ended Year ended ------------------------------------------------------ March 31, June 30, September 30, December 31, December 31, 2004 2004 2004 2004 2004 ---------------------------------------------------------------------- Gross premiums written $56,395 $106,457 $87,869 $72,854 $323,575 Net premiums written 53,649 105,645 87,072 67,512 313,878 Net premiums earned 31,202 53,151 49,760 40,836 174,949 Net investment income and net realized gains 24,198 22,611 24,466 26,993 98,268 Other income (expense) 317 240 117 62 736 Total revenues 55,717 76,002 74,343 67,891 273,953 Losses and loss adjustment expenses 664 (1,070) 6,725 (397) 5,922 Income before taxes 48,208 64,839 56,713 55,759 225,519 Net income 38,304 48,393 41,954 41,435 170,086
38 EX-99.2 4 x992.txt EXHIBIT 99.2 FINANCIAL STATEMENTS Financial Guaranty Insurance Company and Subsidiaries March 31, 2006 Financial Guaranty Insurance Company and Subsidiaries Financial Statements March 31, 2006 Contents Balance Sheets at March 31, 2006 (Unaudited) and December 31, 2005.... 1 Statements of Income for the Three Months Ended March 31, 2006 and 2005 (Unaudited)............................................... 2 Statements of Cash Flows for the Three Months Ended March 31, 2006 and 2005 (Unaudited)............................................... 3 Notes to Financial Statements (Unaudited)............................. 4 Financial Guaranty Insurance Company and Subsidiaries Balance Sheets (Dollars in thousands, except per share amounts)
March 31 December 31 2006 2005 -------------------------------------- (Unaudited) Assets Fixed maturity securities, available for sale, at fair value (amortized cost of $3,355,155 in 2006 and $3,277,291 in 2005) $ 3,302,181 $ 3,258,738 Variable interest entity fixed maturity securities, held to maturity at amortized cost 750,000 - Short-term investments 151,806 159,334 -------------------------------------- Total investments 4,203,987 3,418,072 Cash and cash equivalents 70,719 45,077 Accrued investment income 46,465 42,576 Reinsurance recoverable on losses 2,341 3,271 Prepaid reinsurance premiums 112,546 110,636 Deferred policy acquisition costs 72,754 63,330 Receivable from related parties - 9,539 Property and equipment, net of accumulated depreciation of $1,151 in 2006 and $885 in 2005 2,850 3,092 Prepaid expenses and other assets 17,637 10,354 Federal income taxes - 2,158 -------------------------------------- Total assets $4,529,300 $ 3,708,105 ====================================== Liabilities and stockholder's equity Liabilities: Unearned premiums $1,226,597 $ 1,201,163 Losses and loss adjustment expenses 50,228 54,812 Ceded reinsurance balances payable 3,968 1,615 Accounts payable and accrued expenses and other liabilities 20,229 36,359 Payable for securities purchased 19,366 - Capital lease obligations 4,328 4,262 Variable interest entity floating rate notes 750,000 - Accrued investment income - variable interest entity 1,176 - Federal income taxes payable 16,585 - Deferred income taxes 29,350 42,463 -------------------------------------- Total liabilities 2,121,826 1,340,674 -------------------------------------- Stockholder's equity: Common stock, par value $1,500 per share; 10,000 shares authorized, issued and outstanding 15,000 15,000 Additional paid-in capital 1,896,460 1,894,983 Accumulated other comprehensive loss, net of tax (33,750) (13,597) Retained earnings 529,763 471,045 -------------------------------------- Total stockholder's equity 2,407,473 $2,367,431 -------------------------------------- Total liabilities and stockholder's equity $4,529,300 $ 3,708,105 ======================================
See accompanying notes to unaudited interim financial statements. 1 Financial Guaranty Insurance Company and Subsidiaries Statements of Income (Unaudited) (Dollars in thousands) Three months ended March 31, 2006 2005 --------------------------- Revenues: Gross premiums written $ 89,281 $ 84,404 Ceded premiums written (6,423) (1,795) ------------------------ Net premiums written 82,858 82,609 Increase in net unearned premiums (23,394) (29,976) ------------------------ Net premiums earned 59,464 52,633 Net investment income 32,319 27,440 Net realized gains - 118 Net mark to market losses on credit derivative contracts (228) - Other income 536 426 ------------------------ Total revenues 92,091 80,617 ------------------------ Expenses: Losses and loss adjustment expenses (1,933) (2,611) Underwriting expenses 24,117 20,650 Policy acquisition cost deferred (12,513) (10,671) Amortization of deferred policy acquisition costs 3,192 2,149 Other operating expenses 1,655 - ------------------------ Total expenses 14,518 9,517 ------------------------ Income before income taxes 77,573 71,100 Income tax expense 18,862 17,794 ------------------------ Net income $58,711 $ 53,306 ======================== See accompanying notes to unaudited interim financial statements. 2 Financial Guaranty Insurance Company and Subsidiaries Statements of Cash Flows (Unaudited) (Dollars in thousands)
Three months ended March 31, 2006 2005 -------------------------------------- Operating activities Net income $58,711 $ 53,306 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of deferred policy acquisition costs 3,192 2,149 Policy acquisition costs deferred (12,513) (10,671) Depreciation of property and equipment 266 143 Amortization of fixed maturity securities 8,314 9,600 Amortization of short-term investments 28 Net realized gains on investments - (118) Amortization of stock compensation expense 1,476 Change in accrued investment income, prepaid expenses and other assets (11,251) (6,716) Change in mark-to-market losses on credit derivative contracts 228 Change in reinsurance receivable 931 265 Change in prepaid reinsurance premiums (1,910) 4,378 Change in unearned premiums 25,434 25,593 Change in losses and loss adjustment expenses (4,584) (3,183) Change in receivable from related parties 9,539 802 Change in ceded reinsurance balances payable and accounts payable and accrued expenses and other liabilities (12,763) (10,936) Change in current federal income taxes receivable 2,158 - Change in current federal income taxes payable 16,585 12,676 Change in deferred federal income taxes 110 4,907 -------------------------------------- Net cash provided by operating activities 83,951 82,195 -------------------------------------- Investing activities Sales and maturities of fixed maturity securities 34,741 68,181 Purchases of fixed maturity securities (120,095) (166,715) Purchases, sales and maturities of short-term investments, net 7,528 22 Receivable for securities sold (171) Payable for securities purchased 19,366 9,320 Purchases of fixed assets (24) (86) -------------------------------------- Net cash used in investing activities (58,484) (89,449) -------------------------------------- -------------------------------------- Financing activities Capital contribution - 8,049 -------------------------------------- Net cash provided by financing activities - 8,049 -------------------------------------- -------------------------------------- Effect of exchange rate changes on cash 175 -------------------------------------- Net increase (decrease) in cash and cash equivalents 25,642 795 Cash and cash equivalents at beginning of period 45,077 69,292 -------------------------------------- Cash and cash equivalents at end of period $70,719 $ 70,087 ======================================
See accompanying notes to unaudited interim financial statements. 3 Financial Guaranty Insurance Company and Subsidiaries Notes to Financial Statements (Unaudited) (continued) (Dollars in thousands) 1. Business and Organization Financial Guaranty Insurance Company (the "Company") is a wholly owned subsidiary of FGIC Corporation ("FGIC Corp."). The Company provides financial guaranty insurance and other forms of credit enhancement for public finance and structured finance obligations. The Company began insuring public finance obligations in 1984 and structured finance obligations in 1988. The Company's financial strength is rated "Aaa" by Moody's Investors Service, Inc., "AAA" by Standard & Poor's Rating Services, a division of The McGraw-Hill Companies, Inc., and "AAA" by Fitch Ratings, Inc. The Company is licensed to engage in writing financial guaranty insurance in all 50 states, the District of Columbia, the Commonwealth of Puerto Rico, the U.S. Virgin Islands, and, through a branch, the United Kingdom. In addition, a United Kingdom subsidiary of the Company is authorized to write financial guaranty business in the United Kingdom and has passport rights to write business in other European Union member countries. 2. Basis of Presentation The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances have been eliminated. The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for fair presentation have been included. Operating results for the three-month period ended March 31, 2006 are not necessarily indicative of results that may be expected for the year ending December 31, 2006. These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2005, including accompanying notes. Certain 2005 amounts have been reclassified to conform to the 2006 presentation. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates. 4 Financial Guaranty Insurance Company and Subsidiaries Notes to Financial Statements (Unaudited) (continued) (Dollars in thousands) 3. Review of Financial Guaranty Industry Accounting Practices The Financial Accounting Standards Board ("FASB") staff is considering whether additional accounting guidance is necessary to address loss reserving and certain other practices in the financial guaranty industry. Statement of Financial Accounting Standards ("SFAS") No. 60, Accounting and Reporting by Insurance Enterprises, was developed prior to the emergence of the financial guaranty industry. As it does not specifically address financial guaranty contracts, there has been diversity in the accounting for these contracts. In 2005, the FASB added a project to consider accounting by providers of financial guaranty insurance. The objective of the project is to develop an accounting model for financial guaranty contracts issued by insurance companies that are not accounted for as derivative contracts under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The goal of this project is to develop a single model for all industry participants to apply. The FASB is expected to issue proposed and final pronouncements on this matter in 2006. When the FASB issues a final pronouncement, the Company, along with other companies in the financial guaranty industry, may be required to change certain aspects of accounting for loss reserves, premium income and deferred acquisition costs. It is not possible to predict the impact the FASB's review may have on the Company's accounting practices. 5. Premium Refundings When an obligation insured by the Company is refunded prior to the end of the expected policy coverage period, any remaining unearned premium is recognized. A refunding occurs when an insured obligation is called or legally defeased prior to the stated maturity. Premiums earned for the three months ended March 31, 2006 and 2005 include $7,311 and $15,539, respectively, related to the accelerated recognition of unearned premiums in connection with refundings. 6. Loss and Loss Adjustment Expense Reserves Loss reserves and loss adjustment expenses are regularly reviewed and updated based on claim payments and the results of ongoing surveillance. The Company's insured portfolio surveillance is designed to identify impaired obligations and thereby provide a materially complete recognition of losses for each accounting period. The reserves are necessarily based upon estimates and subjective judgments about the outcome of future events, and actual results will likely differ from these estimates. At March 31, 2006, the Company had case reserves of $30,278, credit watchlist reserves of $18,603 and an unallocated loss adjustment expense reserve of $1,347. 5 Financial Guaranty Insurance Company and Subsidiaries Notes to Financial Statements (Unaudited) (continued) (Dollars in thousands) 6. Loss and Loss Adjustment Expense Reserves (continued) At December 31, 2005, the Company had case reserves of $31,981, credit watchlist reserves of $21,484 and a loss adjustment expense reserve of $1,347. Case reserves and credit watchlist reserves at March 31, 2006 included $6,855 and $12,672, respectively, of estimated losses related to obligations impacted by Hurricane Katrina. Case reserves and credit watchlist reserves at December 31, 2005 included $8,511 and $13,322, respectively, of estimated losses related to obligations impacted by Hurricane Katrina. Given the unprecedented nature of the events and magnitude of damage in the affected areas, the loss reserves were necessarily based upon estimates and subjective judgments about the outcome of future events, including without limitation the amount and timing of any future federal and state aid. The loss reserves will likely be adjusted as additional information becomes available, and such adjustments may have a material impact on future results of operations. However, the Company believes that the losses ultimately incurred as result of Hurricane Katrina will not have a material impact on the Company's consolidated financial position. 7. Income Taxes The Company's effective federal corporate tax rates of 24.3% and 25.0% for the three months ended March 31, 2006 and 2005, respectively, were less than the statutory corporate tax rate (35%) on income due to permanent differences between financial and taxable income, principally tax-exempt interest. 8. Reinsurance Net premiums earned are shown net of ceded premiums earned of $4,868 and $6,200 for the three months ended March 31, 2006 and 2005, respectively. 9. Variable Interest Entities Financial Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46-R"), provides accounting and disclosure rules for determining whether certain entities should be consolidated in the Company's consolidated financial statements. An entity is subject to FIN 46-R, and is called a variable interest entity ("VIE"), if it has (i) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support or (ii) equity investors that cannot make significant decisions about the entity's operations or that do not absorb the majority of expected losses or receive the majority of expected residual returns of the entity. A VIE is consolidated by its 6 Financial Guaranty Insurance Company and Subsidiaries Notes to Financial Statements (Unaudited) (continued) (Dollars in thousands) 9. Variable Interest Entities (continued) primary beneficiary, which is the party that has a majority of the VIE's expected losses or a majority of its expected residual returns, or both. Additionally, FIN 46-R requires disclosures for companies that have either a primary or significant variable interest in a VIE. All other entities not considered VIEs are evaluated for consolidation under SFAS No. 94, Consolidation of all Majority-Owned Subsidiaries. As part of its structured finance business, the Company insures debt obligations or certificates issued by special purpose entities. During the first quarter of 2006, the Company consolidated a third party VIE as a result of financial guarantees provided by the Company on one transaction related to the securitization of life insurance reserves. This third party VIE had assets of $750,000 and an equal amount of liabilities at March 31, 2006, which are shown under "Assets - Variable interest entity fixed maturity securities, held to maturity at amortized cost" and "Liabilities - Variable interest entity floating rate notes," respectively, on the Company's consolidated balance sheet at March 31, 2006. In addition, accrued investment income includes $1,176 related to the variable interest entity fixed income maturity securities and the corresponding liability is shown under "Accrued investment expense-variable interest entity" on the Company's consolidated balance sheet at March 31, 2006. Although the third party VIE is included in the consolidated financial statements, its creditors do not have recourse to the general assets of the Company outside of the financial guaranty policy provided to the VIE. The Company has evaluated its other structured finance transactions and does not believe any of the third party entities involved in these transactions requires consolidation or disclosure under FIN 46-R. FGIC has arranged the issuance of contingent preferred trust securities by a group of special purpose trusts. Each Trust is solely responsible for its obligations, and has been established for the purpose of entering into a put agreement with FGIC that obligates the Trusts, at FGIC's discretion, to purchase Perpetual Preferred Stock of FGIC. The purpose of this arrangement is to provide capital support to FGIC by allowing it to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put options. These trusts are considered VIEs under FIN 46-R. However, the Company is not considered a primary beneficiary and therefore is not required to consolidate the trusts. 9. Derivative Instruments The Company provides credit default swaps ("CDSs") to certain buyers of credit protection by entering into contracts that reference collateralized debt obligations from cash and synthetic structures backed by pools of corporate, consumer or structured finance debt. It also offers credit protection on public finance and structured finance obligations in CDS form. The Company considers these agreements to be a normal extension of its financial guaranty insurance business, 7 Financial Guaranty Insurance Company and Subsidiaries Notes to Financial Statements (Unaudited) (continued) (Dollars in thousands) 9. Derivative Instruments (continued) although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, and to record losses and loss adjustment expenses and changes in fair value as incurred. The Company recorded $4,235 of net earned premium, $0 in losses and loss adjustment expenses, and net mark-to-market losses of $228 in changes in fair value under these agreements for the three months ended March 31, 2006. The gains or losses recognized by recording these contracts at fair value are determined each quarter based on quoted market prices, if available. If quoted market prices are not available, the determination of fair value is based on internally developed estimates. The inception-to-date mark-to-market gain and (loss) on the CDS portfolio were $890 and $(1,831) at March 31, 2006 and $545 and ($712) at December 31, 2005, recorded in other assets and in other liabilities, respectively. The Company did not enter into any CDS contracts during the three months ended March 31, 2005. 10. Stock Compensation Plan Employees of the Company participate in a stock incentive plan that provides for stock-based compensation, including stock options, restricted stock awards and restricted stock units of FGIC Corp. Stock options are granted for a fixed number of shares with an exercise price equal to or greater than the fair value of the shares at the date of the grant. Restricted stock awards and restricted stock units are valued at the fair value of the stock on the grant date, with no cost to the grantee. Prior to January 1, 2006, FGIC Corp. and the Company accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation. No stock-based employee compensation cost related to stock options was allocated to the Company by FGIC Corp. for the three-month period ended March 31, 2005, as all options granted through that date had an exercise price equal to the market value of the underlying common stock on the date of grant. For grants of restricted stock and restricted stock units to employees of the Company, unearned compensation, equivalent to the fair value of the shares at the date of grant, is allocated to the Company. Effective January 1, 2006, the FGIC Corp. and the Company adopted the fair value recognition provisions of SFAS No. 123(R), Share-Based Payment, using the modified-prospective-transition method. Under that transition method, compensation cost allocated to the Company for the three-month period ended March 31, 2006 included compensation cost for all share-based payments granted prior to, but not yet vested as of, January 1, 2006, based on the grant date fair value estimated in accordance with SFAS No. 123(R). Results for prior periods have not been 8 Financial Guaranty Insurance Company and Subsidiaries Notes to Financial Statements (Unaudited) (continued) (Dollars in thousands) 10. Stock Compensation Plan (continued) restated. As a result of adopting SFAS No. 123(R) effective January 1, 2006, the Company's income before income taxes and net income for the three-month period ended March 31, 2006 were reduced by $1,308 and $850, respectively, than if it had continued to account for share-based compensation under Opinion 25. The following table illustrates the effect on net income of the Company if the Company had applied the fair value recognition provisions of SFAS No. 123 to options granted under the Company's plan for all periods presented. For purposes of this pro forma disclosure, the value of the options is estimated using a Black-Scholes-Merton option pricing formula and amortized to expense over the options' vesting periods.
March 31, 2005 -------------- Net Income, as reported $ 53,306 Add: Stock-based director compensation expense included in reported net income, net of related tax effects 20 Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax effects (443) --------------- $ 52,883 Pro Forma Net Income ===============
12. Comprehensive Income Accumulated other comprehensive loss of the Company consists of net unrealized gains (losses) on investment securities, foreign currency translation adjustments and a cash flow hedge. The components of total comprehensive income for the three-month period ended March 31, 2006 and 2005 were as follows: Three Months Ended March 31, 2006 2005 -------------------- --------------- Net Income $ 58,711 $ 53,306 Other comprehensive loss (20,153) (32,222) -------------------- --------------- Total comprehensive income $ 38,558 $ 21,804 ==================== =============== 9 Financial Guaranty Insurance Company and Subsidiaries Notes to Financial Statements (Unaudited) (continued) (Dollars in thousands) 12. Comprehensive Income (continued) The components of other comprehensive loss for the three-month period ended March 31, 2006 and 20045 were as follows:
Three Months Ended March 31, 2006 ----------------------------------------------------- Before Net of Tax Tax Amount Tax Amount ----------------- ---------------- ------------------ Unrealized holding losses arising during the period $ (31,497) $11,022 $ (20,475) Foreign currency translation adjustment 494 (172) 322 ----------------- ---------------- ------------------ Total other comprehensive loss $ (31,003) $10,850 $ (20.153) ================= ================ ================== Three Months Ended March 31, 2005 ----------------------------------------------------- Before Net of Tax Tax Amount Tax Amount ----------------- ---------------- ------------------ Unrealized holding losses arising during the period $ (48,536) $ 16,988 $ (31,548) Less reclassification adjustment for gains realized in net income (118) 41 (77) ----------------- ---------------- ------------------ ----------------- ---------------- ------------------ Unrealized losses on investments (48,654) 17,029 (31,625) Foreign currency translation adjustment (918) 321 (597) ----------------- ---------------- ------------------ Total other comprehensive loss $ (49,572) $ 17,350 $ (32,222) ================= ================ ==================
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