EX-99.2 5 c39677_ex99-2.htm

EXHIBIT 99.2

XL FINANCIAL ASSURANCE LTD.
(Incorporated in Bermuda)

CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)

FOR THE THREE AND NINE MONTH PERIODS ENDED
SEPTEMBER 30, 2005 AND 2004

XL FINANCIAL ASSURANCE LTD.
CONDENSED BALANCE SHEETS
AS AT SEPTEMBER 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED)
(U.S. dollars in thousands, except per share amounts)

		2005			2004

Assets:
Investments :
Fixed maturities, at fair value
(amortized cost: 2005 - $1,009,607; 2004 - $794,190)	$	995,994		$	792,723
Short-term investments, at fair value
(amortized cost: 2005 - $32,615; 2004 - $88,227)		32,383			87,875

Total investments available for sale		1,028,377			880,598

Cash and cash equivalents		7,285			13,210
Accrued investment income		8,488			6,764
Deferred acquisition costs		97,042			83,868
Prepaid reinsurance premiums		59,235			52,486
Reinsurance balances receivable		15,966			40,859
Unpaid losses and loss expenses recoverable		67,029			55,441
Amounts due from parent and affiliates		40,316			32,708
Net receivable for investments sold		202			-
Derivative assets		17,178			17,396
Other assets		106			138

Total assets	$	1,341,224		$	1,183,468


Liabilities, Redeemable Preferred Shares and Shareholders’ Equity
Liabilities:
Unpaid losses and loss expenses	$	131,848		$	109,151
Deferred premium revenue		517,060			437,654
Reinsurance balances payable		9,243			4,022
Net payable for investments purchased		-			7
Accounts payable and accrued liabilities		1,496			2,738
Amounts due to parent and affiliates		12,944			11,482
Derivative liabilities		3,267			1,669
Dividend payable on preferred shares		-			1,950

Total liabilities	$	675,858		$	568,673


Redeemable Preferred Shares:
Series A Redeemable preferred shares (par value of $120 per share;
10,000 shares authorized; 363 issued and outstanding as at
September 30, 2005 and December 31, 2004, respectively)	$	44		$	44
Additional paid-in capital		38,956			38,956

Total redeemable preferred shares	$	39,000		$	39,000


Shareholders’ Equity:
Common shares (par value of $120 per share;
10,000 shares authorized; 2,449 issued and outstanding as at
September 30, 2005 and December 31, 2004, respectively)	$	294		$	294
Additional paid-in capital		345,606			345,606
Accumulated other comprehensive loss		(13,845	)		(1,819	)
Retained earnings		294,311			231,714

Total shareholders’ equity	$	626,366		$	575,795


Total liabilities, redeemable preferred shares and shareholders’ equity	$	1,341,224		$	1,183,468

The accompanying notes are an integral part of these condensed financial statements.

XL FINANCIAL ASSURANCE LTD.
CONDENSED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME FOR
THE THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2005 AND 2004
(UNAUDITED)
(U.S. dollars in thousands, except per share amounts)

	Three Months ended						Nine Months ended
	September 30,						September 30,

		2005			2004			2005			2004


REVENUES :
Net premiums earned	$	35,317		$	20,358		$	93,464		$	72,502
Net investment income		9,858			6,225			27,228			17,102
Net realized gains (losses) on investments		(772	)		(793	)		(2,153	)		726
Fee and other income		-			-			674			-
Net realized and unrealized gains (losses) on		(1,706	)		710			(3,545	)		9,350
derivative instruments


Total revenues	$	42,697		$	26,500		$	115,668		$	99,680


EXPENSES :
Losses and loss expenses	$	1,056		$	9,499		$	12,404		$	16,910
Acquisition costs		11,085			7,724			29,768			22,059
Operating expenses		1,716			1,366			5,367			5,551


Total expenses	$	13,857		$	18,589		$	47,539		$	44,519


NET INCOME	$	28,840		$	7,911		$	68,129		$	55,161


COMPREHENSIVE INCOME
Net income	$	28,840		$	7,911		$	68,129		$	55,161

Unrealized gains (losses)		(14,378	)		17,757			(14,179	)		14
Less: reclassification for gains (losses) realized in
income		(772	)		(793	)		(2,153	)		726


Other comprehensive gain (loss)	$	(13,606	)	$	18,551		$	(12,026	)	$	(712	)


COMPREHENSIVE INCOME	$	15,234		$	26,462		$	56,103		$	54,449

The accompanying notes are an integral part of these condensed financial statements.

XL FINANCIAL ASSURANCE LTD.
CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
FOR THE NINE MONTH PERIOD ENDED SEPTEMBER 30, 2005 AND FOR THE
YEAR ENDED DECEMBER 31, 2004
(UNAUDITED)
(U.S. dollars in thousands, except per share amounts)

		2005			2004


Common Shares – Number issued
Number of shares, beginning of year and period		2,449			2,057
Issuance of common shares		-			392


Number of shares, end of year and period		2,449			2,449


Common Shares – Issued at par
Balance - beginning of year and period	$	294		$	247
Issuance of common shares		-			47


Balance – end of year and period	$	294		$	294



Additional Paid-in Capital
Balance - beginning of year and period	$	345,606		$	220,653
Issuance of common shares		-			124,953


Balance – end of year and period	$	345,606		$	345,606



Accumulated Other Comprehensive Loss
Balance - beginning of year and period	$	(1,819	)	$	1,174
Other comprehensive loss		(12,026	)		(2,993	)


Balance - end of year and period	$	(13,845	)	$	(1,819	)



Retained Earnings
Balance - beginning of year and period	$	231,714		$	169,565
Net income		68,129			76,252
Dividends on Series A Redeemable preferred shares		(5,532	)		(14,103	)


Balance - end of year and period	$	294,311		$	231,714


TOTAL SHAREHOLDERS’ EQUITY	$	626,366		$	575,795

The accompanying notes are an integral part of these condensed financial statements.

XL FINANCIAL ASSURANCE LTD.
CONDENSED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTH PERIODS ENDED SEPTEMBER 30, 2005 AND 2004
(UNAUDITED)
(U.S. dollars in thousands, except per share amounts)

		2005			2004


Cash flows provided by operating activities:
Net income for the period	$	68,129		$	55,161
Adjustments to reconcile net income to net cash provided by operating
activities:
Realized losses (gains) on investments		2,153			(726	)
Amortization of premium on fixed maturities		2,532			3,648
Net realized gains on investment derivatives		-			(19	)
Net realized and unrealized (gains) losses on credit derivatives
excluding cash received and paid		1,870			(5,636	)
Net unrealized gain on put option		(54	)		-
Accrued investment income		(1,724	)		2,231
Unpaid losses and loss expenses		22,697			56,337
Deferred premium revenue		79,406			51,091
Unpaid losses and loss expenses recoverable		(11,588	)		(46,058	)
Deferred acquisition costs		(13,174	)		(18,906	)
Amounts due from parent and affiliates		(7,608	)		(6,938	)
Accounts payable and accrued liabilities		(1,242	)		(530	)
Amounts due to parent and affiliates		1,462			3,461
Prepaid reinsurance premiums		(6,749	)		26,832
Reinsurance balances receivable		24,893			19,638
Reinsurance balances payable		5,221			(988	)
Other assets		32			(76	)


Total adjustments		98,127			83,361


Net cash provided by operating activities		166,256			138,522


Cash flows used in investing activities:
Proceeds from sale of fixed maturities and short-term investments		642,036			2,299,403
Proceeds from redemption of fixed maturities and short-term investments		35,030			512,150
Purchase of fixed maturities and short-term investments		(841,766	)		(2,958,347	)


Net cash used in investing activities		(164,700	)		(146,794	)


Cash flows used in financing activities:
Dividends paid on Series A Redeemable preferred shares		(7,481	)		(12,003	)


Decrease in Cash and Cash Equivalents		(5,925	)		(20,275	)

Cash and Cash Equivalents – Beginning of period		13,210			26,346


Cash and Cash Equivalents – End of period	$	7,285		$	6,071

The accompanying notes are an integral part of these condensed financial statements.

XL FINANCIAL ASSURANCE LTD.
NOTES TO CONDENSED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2005 AND 2004
(UNAUDITED)
(U.S. dollars in thousands, except per share amounts)

1. Organization and Business

XL Financial Assurance Ltd. (the “Company”) was incorporated with limited liability under the Bermuda Companies Act 1981 on October 14, 1998 and is registered as a Class 3 insurer under The Insurance Act 1978, amendments thereto and related regulations (“The Act”). At September 30, 2005, the Company was approximately 87% owned by XL Insurance (Bermuda) Ltd (a wholly-owned subsidiary of XL Capital Ltd); 5% by Financial Security Assurance Inc. (a wholly-owned subsidiary of Financial Security Assurance Holdings Ltd.) and 8% by Financial Security Assurance International Ltd. (owned 20% by XL Insurance (Bermuda) Ltd and 80% by Financial Security Assurance Inc.). At September 30, 2004, the Company was approximately 85% owned by XL Insurance (Bermuda) Ltd; 6% by Financial Security Assurance Inc. and 9% by Financial Security Assurance International Ltd. The Company is an integral part of a joint venture agreement between XL Capital Ltd and Financial Security Assurance Holdings Ltd.

The Company is primarily engaged in the business of providing reinsurance of financial guaranties on asset-backed and municipal obligations underwritten by XL Insurance (Bermuda) Ltd, Financial Security Assurance Inc. and XL Capital Assurance Inc. (a wholly-owned subsidiary of XL Capital Ltd) and other monoline and multiline insurance companies. This may be in the form of traditional financial guaranty insurance or via a credit derivatives execution. The Company’s underwriting policy is to provide reinsurance of asset-backed and municipal obligations that would be of a lower investment-grade quality without the benefit of the Company’s reinsurance. The asset-backed obligations reinsured by the Company are generally issued in structured transactions and are backed by pools of assets such as residential mortgage loans, consumer or trade receivables, securities or other assets having ascertainable cash flows or market value. The municipal obligations reinsured by the Company consist primarily of general obligation bonds that are supported by the issuers' taxing power and of special revenue bonds and other special obligations of states and local governments that are supported by the issuers’ ability to impose and collect fees and charges for public services or specific projects. The Company's reinsurance guarantees payments when due of scheduled payments on an insured obligation. In the case of a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other such amounts due in accordance with the obligations’ original payment schedule or, at its option, to pay such amounts on an accelerated basis. The Company conducts surveillance on its exposures to try and ensure early identification of any loss events. In addition, in the normal course of business, the Company seeks to reduce the loss that may arise from such events by reinsuring certain levels of risks in various areas of exposure with other insurance enterprises or reinsurers.

On October 6, 1999, the Company entered into a Facultative Quota Share Reinsurance Treaty (“Treaty”) with XL Capital Assurance Inc. (“XLCA”). The Treaty was amended and restated on June 22, 2001 and May 1, 2004. Under the terms of this Treaty, the Company agrees to reinsure up to 90% of XLCA’s compliant risks. The Company is subject to ceding commissions of up to 30% on business assumed under the terms of this Treaty.

On October 3, 2001, the Company entered into an excess of loss reinsurance agreement with XL Insurance (Bermuda) Ltd, which indemnifies the Company up to an aggregate limit of liability of $500 million in excess of defined obligor losses.

Effective December 1, 2004 the Company established a trust account in accordance with Regulation 114 of the New York Insurance Department for the benefit of XLCA to secure the obligations of the Company to XLCA under the Treaty. This trust account is required for XLCA to take financial credit for statutory reporting purposes for the reinsurance cessions by XLCA to the Company under the Treaty, since the Company is not a licensed insurer or reinsurer in any state of the United States of America. At September 30, 2005, investments at an amortized cost of $1,042,222 were on deposit in the trust account.

2. Significant Accounting Policies

Basis of Preparation

The accompanying condensed financial statements have been prepared by the Company and are unaudited. In the opinion of management, all adjustments, which include only normal recurring adjustments necessary to present fairly the financial position, results of operations and cash flows at September 30, 2005 and for all periods presented, have been made.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These statements should be read in conjunction with the Company’s December 31, 2004 financial statements and notes thereto. The December 31, 2004 condensed balance sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. The results of operations for the periods ended September 30, 2005 and 2004 are not necessarily indicative of the operating results for the full year.

The preparation of condensed financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Any such adjustments are reflected in income in the period in which the adjustments are made. The financial statement estimates subject to most uncertainty are estimates for loss reserves and calculation of the fair value of credit default swap derivative instruments.

Recent Accounting Pronouncements

In March 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) FIN 46(R)-5, Implicit Variable Interests Under FASB Interpretation No. 46(R) (“FSP FIN 46(R)-5”) which requires an enterprise to consider whether it holds an implicit variable interest in a Variable Interest Entity (“VIE”) and what effect this may have on the calculation of expected losses and residual returns of the VIE and the determination of which party, if any, is considered the primary beneficiary of the VIE. FSP FIN 46(R)-5 was in effect March 3, 2005 and for the the current quarterly reporting period did not have a material impact on the Company’s financial condition or results of operations.

On June 8, 2005, the FASB unanimously agreed to add a project to its agenda to address accounting for financial guaranty insurance. The Company will continue to apply its current loss reserving methodology until further guidance is available from the FASB.

3. Derivative Instruments

Credit derivatives issued by the Company meet the definition of a derivative under Statement of Financial Accounting Stardards No. 133. The Company has recorded these products at fair value, modeled on prevailing market conditions and certain other factors relating to the structure of the transaction. The Company considers credit derivatives to be financial guarantee contracts, in substance, as the Company intends to hold them to maturity. The Company determines fair value using a model which calculates the difference between the actual remaining present value of installment premiums and an estimated remaining present value of installment premiums under current market conditions. In essence, the model estimates the cost of an offsetting position to the original credit derivatives from other comparable counterparties under the current market environment. The model is dependent upon a number of factors including changes in credit spreads, changes in credit quality, foreign exchange and other market factors.

The Company’s credit derivatives portfolio generally requires the Company to meet payment obligations for referenced credits within the portfolio in the event of specific credit events after erosion or exhaustion of various first loss protection levels. These credit events are contract specific, but generally cover bankruptcy, failure to pay and repudiation. The notional exposure of the credit derivatives portfolio as of September 30, 2005 was $6.5 billion. Approximately 97% and 2% of the portfolio is rated AAA and BBB, respectively, with the remainder being split amongst AA and A. The weighted average term of the contracts in force was 3.87 years.

In 2005, the Company amended the presentation of credit derivative transactions in the statements of income to include certain components of the transactions in “gross premiums written”, “net premiums earned”, “net losses and loss expenses incurred” and “fee and other income”, and certain components of the change in fair value in “unpaid loss and loss expenses.” Previously, components of the transactions and the change in fair value were reflected in one line item under “Net realized and unrealized gains and losses on derivative instruments”, and the fair value had been reflected in “Derivative assets” and “Derivative liabilities.” There was no effect on net income as a result of this change and prior period results have been reclassified to reflect this presentation. This change in presentation is applicable only to credit default swaps assumed by the Company that are investment grade and that the Company intends and has the ability to hold to maturity and is consistent with practices in the financial guarantee insurance industry for reporting the results of such instruments. Results of the prior period presented have been reclassified to conform to the current period presentation.

In terms of the 2005 and 2004 condensed financial statements, the effect of the reclassification is outlined as follows:

	(Unaudited)						(Unaudited)
	Three Months Ended September 30,						Nine Months Ended September 30,

		2005			2004			2005		2004

Income Statement
Net earned premiums	$	3,831		$	2,568		$	11,473	$	15,055
Net losses and loss expenses		958			2,485			2,868		3,695
Acquisition costs		95			87			110		185
Net realized and unrealized gains (losses) on derivative
instruments		(1,051	)		(1,133	)		1,823		6,278

							(Unaudited)
							As at

								September 30,		December 31,
								2005		2004

Assets
Derivative assets							$	17,178	$	17,396
							(Unaudited)
							As at

								September 30,		December 31,
								2005		2004

Liabilities
Net losses and loss expenses								12,887		10,018
Derivative liabilities								3,267		1,669

The Company is also party to a put option agreement and an asset trust expense reimbursement agreement with Twin Reefs Asset Trust (the “Asset Trust”). The put option agreement provides The Company with the irrevocable right to require the Asset Trust at any time and from time to time to purchase the Company’s non-cumulative perpetual Series B Preferred Shares with an aggregate liquidation preference of up to $200 million. The Company

is obligated to reimburse the Asset Trust for certain fees and ordinary expenses. To the extent that any Series B Preferred Shares are put to the Asset Trust and remain outstanding, a corresponding portion of such fees and ordinary expenses will be payable by the Company pursuant to the asset trust expense reimbursement agreement. The put option agreement is perpetual but would terminate on delivery of notice by the Company on or after December 10, 2009, or under certain defined circumstances, such as the failure of the Company to pay the put option premium when due or bankruptcy. The put option is recorded at fair value with changes in fair value recognized in “Net realized and unrealized gains (losses) on derivative instruments”. At September 30, 2005, the fair value adjustment was a $54 increase to income. Put option premium expense of $1,762 was recognized during the nine month period ended September 30, 2005.

4. Reinsurance

The effect of reinsurance on premiums written and earned for the three month periods ended September 30, 2005 and 2004 is shown below:

		Assumed		Ceded			Net

Three months ended September 30, 2005
Premium written	$	71,651	$	(7,594	)	$	64,057
Premium earned		40,953		(5,636	)		35,317
Losses and loss adjustment expenses		476		580			1,056

Three months ended September 30, 2004
Premium written	$	54,474	$	(9,980	)	$	44,494
Premium earned		56,840		(36,482	)		20,358
Losses and loss adjustment expenses		59,961		(50,462	)		9,499

Nine months ended September 30, 2005
Premium written	$	190,662	$	(24,542	)	$	166,120
Premium earned		111,256		(17,792	)		93,464
Losses and loss adjustment expenses		24,358		(11,954	)		12,404

Nine months ended September 30, 2004
Premium written	$	174,941	$	(24,514	)	$	150,427
Premium earned		123,849		(51,347	)		72,502
Losses and loss adjustment expenses		62,968		(46,058	)		16,910

5. Exposure Implications of Hurricanes Katrina and Rita

Set forth below is a summary of the Company’s principal exposure as of September 30, 2005 to credits located in the Alabama, Louisiana, Mississippi, and Texas counties designated by the Federal Emergency Management Agency (FEMA) for “Individual and Public Assistance” (excluding counties designated to receive only Category A: Debris Removal and Category B: Emergency Protective Measures) as of September 30, 2005 as a result of hurricanes Katrina and Rita. Such exposure consists solely of guaranteed public finance exposures. The Company has no direct exposure to the City of New Orleans or to any other issuer located in such City. The Company’s asset-backed transactions have not been included in the table set forth below as they are backed by pools of geographically diverse assets with minimal concentration in the areas affected. As of September 30, 2005, the Company has not been notified of any claims associated with Hurricane Katrina or Hurricane Rita. Further new designations and/or reclassifications of FEMA-designated counties by FEMA may occur. Accordingly, the table below is subject to revision. In addition, based on the Company’s assessment of its exposures in the affected areas and all related available information, it has not established any reserves at such date. As additional information becomes available, the Company will assess the need for reserves and make provision therefore as considered necessary.

XLFA's Public Finance Exposure in counties designated by FEMA for “Individual and Public Assistance”
As of September 30, 2005

			Gross Par

		Louisiana
		(New Orleans	Other			Total
Bond Type	Texas	area)	Louisiana	Mississippi	Alabama	Gross Par


General Obligation	26,717	11,867	26,595	35,280	30,227	130,686
Sales Tax Supported	6,813	1,170	3,875	4,815	-	16,673
Higher Education	5,463	-	-	-	-	5,463
Utility - Public	12,447	-	8,491	-	-	20,938
Utility - Private (investor-owned)	-	-	-	81,000	-	81,000

Totals	51,440	13,037	38,961	121,095	30,227	254,760


			Net Par

		Louisiana
		(New Orleans	Other			Total
Bond Type	Texas	area)	Louisiana	Mississippi	Alabama	Net Par


General Obligation	26,717	11,867	26,595	35,280	30,227	130,686
Sales Tax Supported	6,813	1,170	3,875	4,815	-	16,673
Higher Education	5,463	-	-	-	-	5,463
Utility - Public	12,447	-	8,491	-	-	20,938
Utility - Private (investor-owned)	-	-	-	81,000	-	81,000

Totals	51,440	13,037	38,961	121,095	30,227	254,760

6. Revision of Results of Operations for the Three and Six Month Periods ended June 30, 2005

After the release of the Company’s condensed financial statements for the three and six months ended June 30, 2005, management identified an error therein related to an inter-company transaction with XLCA. On a restated basis to correct the aforementioned error, acquisition costs, total expenses, net income and comprehensive income for the three and six months ended June 30, 2005, were $10.1 million, $22.8 million, $12.1 million and $26.2 million, and $18.7 million, $33.7 million, $39.3 million and $40.9 million, respectively. Shareholders’ equity at June 30, 2005, on a restated basis to correct for the aforementioned error was $610.6 million. The condensed balance sheet as of September 30, 2005, and the condensed statements of income and comprehensive income for the three and nine month periods then ended are not affected by this error.