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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File No. 1-12644
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
(Exact name of registrant as specified in its charter)
NEW YORK 13-3261323
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)
350 PARK AVENUE
NEW YORK, NEW YORK 10022
(Address of principal executive offices)
(212) 826-0100
(Registrant's telephone number,
including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes /X/ No / /
At August 9, 2002, there were 33,213,463 outstanding shares of Common Stock of
the registrant (excludes 297,658 shares of treasury stock).
INDEX
PAGE
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PART I FINANCIAL INFORMATION
Item 1. Condensed Unaudited Financial Statements
Financial Security Assurance Holdings Ltd. and Subsidiaries
Condensed Consolidated Balance Sheets - June 30, 2002
and December 31, 2001 3
Condensed Consolidated Statements of Operations and
Comprehensive Income - Three and six months ended
June 30, 2002 and 2001 4
Condensed Consolidated Statement of Changes in Shareholders'
Equity - Six months ended June 30, 2002 5
Condensed Consolidated Statements of Cash Flows - Six
months ended June 30, 2002 and 2001 6
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 9
PART II OTHER INFORMATION, AS APPLICABLE
Item 4. Submission of Matters to a Vote of Security Holders 16
Item 6. Exhibits and Reports on Form 8-K 16
SIGNATURES 17
2
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
JUNE 30, DECEMBER 31,
2002 2001
------------- ------------
ASSETS
Bonds at market value (amortized cost of $2,402,079 and $2,236,979) $ 2,525,877 $ 2,329,269
Equity investments at market value (cost of $10,006) 10,076 10,076
Short-term investments 210,430 218,727
Guaranteed investment contract bond portfolio at market value
(amortized cost of $1,350,284 and $428,016) 1,357,353 427,993
Guaranteed investment contract bond portfolio pledged as collateral
at market value (amortized cost of $165,095) 163,514
Guaranteed investment contract short-term investment portfolio 3,397 228,038
------------- ------------
Total investments 4,270,647 3,214,103
Cash 25,930 7,784
Deferred acquisition costs 256,728 240,492
Prepaid reinsurance premiums 452,738 420,798
Reinsurance recoverable on unpaid losses 50,851 28,880
Investment in unconsolidated affiliates 91,470 82,511
Other assets 303,676 312,328
------------- ------------
TOTAL ASSETS $ 5,452,040 $ 4,306,896
============= ============
LIABILITIES AND MINORITY INTEREST AND SHAREHOLDERS' EQUITY
Deferred premium revenue $ 1,197,237 $ 1,090,332
Losses and loss adjustment expenses 177,069 114,428
Guaranteed investment contracts 1,324,010 601,023
Deferred federal income taxes 109,330 101,971
Ceded reinsurance balances payable 36,283 34,961
Notes payable 330,000 330,000
Securities sold under agreements to repurchase 165,408
Deferred compensation 94,743 95,948
Minority interest 50,372 46,157
Payable for securities purchased 92,525 85,488
Accrued expenses and other liabilities 133,924 170,630
------------- ------------
TOTAL LIABILITIES AND MINORITY INTEREST 3,710,901 2,670,938
------------- ------------
Common stock (200,000,000 shares authorized; 33,517,995
issued; par value of $.01 per share) 335 335
Additional paid-in capital - common 903,494 903,494
Accumulated other comprehensive income (net of deferred income
tax provision of $45,942 and $29,394) 80,331 62,966
Accumulated earnings 756,979 669,163
Deferred equity compensation 23,716 23,716
Less treasury stock at cost (301,095 shares held) (23,716) (23,716)
------------- ------------
TOTAL SHAREHOLDERS' EQUITY 1,741,139 1,635,958
------------- ------------
TOTAL LIABILITIES AND MINORITY INTEREST
AND SHAREHOLDERS' EQUITY $ 5,452,040 $ 4,306,896
============= ============
See notes to condensed consolidated financial statements.
3
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME
(DOLLARS IN THOUSANDS)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------ ------------------------
2002 2001 2002 2001
----------- ---------- ---------- ----------
Revenues:
Net premiums written (net of premiums ceded of
$45,652, $43,180, $95,002 and $75,496) $ 125,186 $ 89,982 $ 220,427 $ 161,355
=========== ========== ========== ==========
Premiums earned (net of premiums ceded of
$34,404, $24,405, $65,716 and $46,500) 77,053 56,496 146,751 107,760
Net investment income 35,100 31,537 68,498 63,251
Net realized gains 22,874 2,260 23,957 4,190
Guaranteed investment contract net revenues 5,143 8,175
Net realized and unrealized gains (losses) on derivative
instruments (16,470) 3,737 (24,698) 3,737
Other income 1,036 135 5,104 392
----------- ---------- ---------- ----------
TOTAL REVENUES 124,736 94,165 227,787 179,330
----------- ---------- ---------- ----------
Expenses:
Losses and loss adjustment expenses 39,207 3,195 42,119 5,973
Interest expense 5,881 4,153 11,742 8,307
Policy acquisition costs 13,512 10,426 25,877 19,700
Guaranteed investment contract net expenses 2,844 5,523
Other operating expenses 10,721 11,360 20,984 19,439
----------- ---------- ---------- ----------
TOTAL EXPENSES 72,165 29,134 106,245 53,419
----------- ---------- ---------- ----------
Minority interest and equity in earnings of
unconsolidated affiliates 3,681 1,248 4,743 1,211
----------- ---------- ---------- ----------
INCOME BEFORE INCOME TAXES 56,252 66,279 126,285 127,122
Provision for income taxes (10,847) (14,478) (26,760) (27,631)
----------- ---------- ---------- ----------
NET INCOME 45,405 51,801 99,525 99,491
----------- ---------- ---------- ----------
Other comprehensive income (loss), net of tax:
Unrealized gains (losses) on securities:
Holding gains (losses) arising during period 40,435 (11,738) 34,920 (1,045)
Less: reclassification adjustment for gains
included in net income 16,779 1,487 17,555 2,832
----------- ---------- ---------- ----------
Other comprehensive income (loss) 23,656 (13,225) 17,365 (3,877)
----------- ---------- ---------- ----------
COMPREHENSIVE INCOME $ 69,061 $ 38,576 $ 116,890 $ 95,614
=========== ========== ========== ==========
See notes to condensed consolidated financial statements.
4
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
Additional Accumulated Deferred
Paid-In Other Comp- Equity
Common Capital- rehensive Accumulated Compen- Treasury
Stock Common Income Earnings sation Stock Total
------ ---------- ----------- ----------- -------- --------- -----------
BALANCE, December 31, 2001 $ 335 $ 903,494 $ 62,966 $ 669,163 $ 23,716 $ (23,716) $ 1,635,958
Net income 99,525 99,525
Dividends (11,709) (11,709)
Net unrealized gain on investments,
net of tax 17,365 17,365
------ ---------- ----------- ----------- -------- --------- -----------
BALANCE, June 30, 2002 $ 335 $ 903,494 $ 80,331 $ 756,979 $ 23,716 $ (23,716) $ 1,741,139
====== ========== =========== =========== ======== ========= ===========
See notes to condensed consolidated financial statements.
5
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
SIX MONTHS ENDED JUNE 30,
------------------------------
2002 2001
------------- -------------
Cash flows from operating activities:
Premiums received, net $ 221,449 $ 173,983
Policy acquisition and other operating expenses paid, net (93,396) (76,189)
Recoverable advances recovered (paid) 3,341 (281)
Losses and loss adjustment expenses paid, net (4,018) (16,513)
Net investment income received 76,412 60,459
Federal income taxes paid (52,718) (36,089)
Interest paid (18,944) (10,666)
Other 10,896 1,085
------------- -------------
Net cash provided by operating activities 143,022 95,789
------------- -------------
Cash flows from investing activities:
Proceeds from sales of bonds 541,205 270,885
Purchases of bonds (671,825) (359,764)
Purchases of guaranteed investment contract bonds (1,085,600)
Purchases of property and equipment (4,531) (976)
Net decrease in guaranteed investment contract short-term
investments 224,640
Net decrease in short-term investments 8,927 2,995
Other investments (1,340) (4,146)
------------- -------------
Net cash used for investing activities (988,524) (91,006)
------------- -------------
Cash flows from financing activities:
Dividends paid (11,709)
Securities sold under agreements to repurchase 165,408
Proceeds from issuance of guaranteed investment contracts 709,949
-------------
Net cash provided by financing activities 863,648
-------------
Net increase in cash 18,146 4,783
Cash at beginning of period 7,784 9,411
------------- -------------
Cash at end of period $ 25,930 $ 14,194
============= =============
In 2001, restricted treasury stock of $288 was distributed to a Director as a
deferred compensation plan payout.
See notes to condensed consolidated financial statements.
6
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2002 AND 2001
1. ORGANIZATION AND OWNERSHIP
Financial Security Assurance Holdings Ltd. (the Company) is an insurance
holding company incorporated in the State of New York. The Company is primarily
engaged (through its insurance company subsidiaries, collectively known as FSA)
in the business of providing financial guaranty insurance on asset-backed and
municipal obligations. The Company also offers guaranteed investment contracts
through its wholly owned subsidiaries, FSA Capital Markets Services LLC and FSA
Capital Management Services LLC. The Company is an indirect subsidiary of Dexia
S.A. (Dexia), a publicly held Belgian corporation.
2. BASIS OF PRESENTATION
The accompanying condensed consolidated financial statements have been
prepared in accordance with instructions to Form 10-Q and, accordingly, do not
include all of the information and disclosures required by accounting principles
generally accepted in the United States of America. These statements should be
read in conjunction with the consolidated financial statements and notes thereto
included in the Company's Annual Report on Form 10-K for the year ended December
31, 2001. The accompanying financial statements have not been audited by
independent accountants in accordance with auditing standards generally accepted
in the United States of America but, 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
June 30, 2002 and for all periods presented, have been made. The December 31,
2001 condensed balance sheet data 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 June 30, 2002 and 2001 are not necessarily indicative of the
operating results for the full year. Certain prior-year balances have been
reclassified to conform to the 2002 presentation.
3. LOSS AND LOSS ADJUSTMENT EXPENSES
In the second quarter of 2002, as part of the Company's ongoing credit review
process, management identified certain transactions not performing as expected
in its portfolio of insured collateralized debt obligations ("CDOs"). As a
result, management analyzed all CDO transactions in its insured portfolio that
breached over-collateralization triggers, which were included in such
transactions as one measure of adverse performance. A "deterministic" approach
was utilized as a basis to estimate the loss inherent in this portfolio. The
deterministic model applies a run of the collateral portfolio for each
transaction considering each CDO transaction's unique attributes (such as
reinsurance, individual collateral ratings and status, derivatives purchased,
premiums due to the guarantor, etc.) utilizing a Moody's default pattern for
frequency of defaults, an estimate of collateral recovery values for severity,
and a risk-free rate of interest. Management assumed that current default rates
on CDO collateral would improve in a manner consistent with an economic recovery
following a period of significant credit deterioration similar to that
experienced in 1991/1992 and, as a result, management selected Moody's 1992
idealized default curve as a predictor of future defaults on the CDO collateral.
The per period default rate is calculated based on the Moody's weighted average
rating factor for each piece of surviving collateral. Recovery rates are
judgmentally established by the Company. In considering the recovery rates to be
utilized, management adjusted Moody's average recovery rates (observed since
1982) downward to reflect more recent and more adverse observations. This
analysis produced a present value of expected losses of $51.5 million, net of
reinsurance recoveries and net of unearned premiums and future ceding
commissions. As described in more detail below, management addressed this net
present value of expected loss ($51.5 million) through (i) an increase in the
Company's general reserve ($31.0 million) and (b) current amounts in its general
reserve ($20.5 million), including general reserve amounts reallocated to case
basis
7
reserves ($11.3 million). The $31.0 million increase in the Company's general
reserve resulted in a corresponding increase to loss and loss adjustment expense
in the income statement of $31.0 million. At June 30, 2002, the general reserve
totaled $99.6 million and the total loss and loss adjustment expense liability
totaled $177.1 million. Management has established a methodology of recording
case basis reserves on CDO transactions to the extent that the
over-collateralization ratio (non-defaulted collateral at par value divided by
the debt insured) has fallen below 100%, since management believes that claims
on such transactions are probable and that the amount of the
undercollateralization is a reasonable estimate of such claims. Such
transactions may benefit from excess cash flow attributable in part to higher
interest rates on the underlying collateral than on the insured securities. In
addition, such transactions generally require insured payments of principal only
at the ultimate maturity of such transactions. As a result, the Company does not
expect to be required to pay claims in respect of these transactions until 2010,
but may elect to do so at an earlier date in its discretion. Over time,
management expects to reallocate amounts in its general reserve (including
accretions thereto) to case reserves as specific losses on its insured CDO
portfolio become probable and estimable in accordance with the
undercollateralization methodology described above. Application of this
methodology resulted in recording $34.5 million in gross case basis reserves and
$23.2 million in reinsurance recoverable on unpaid losses, resulting in an $11.3
million increase in net case basis reserves. Management, beginning in the second
quarter of 2002, has refined the loss factor it applies to its net par
underwritten when calculating the general reserve in order to reflect its recent
adverse experience. As a result, the general reserve accrual for the second
quarter of 2002 was $8.2 million, rather than the approximate $4.1 million that
would have been accrued using the prior assumptions. Management expects future
reserve contributions to be approximately double the amounts under the prior
practice. Since the reserves are based upon estimates, there can be no assurance
that the ultimate liability will not differ from such estimates. The Company
will continue, on an ongoing basis, to monitor these reserves and may
periodically adjust such reserves, upward or downward, based on the Company's
actual loss experience, its future mix of business and future economic
conditions.
4. RECENTLY ISSUED ACCOUNTING STANDARDS
In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 141, "Business Combinations"
(SFAS No. 141) and No. 142, "Goodwill and Other Intangible Assets" (SFAS No.
142). SFAS No. 141 requires the purchase method of accounting be used for all
business combinations initiated after June 30, 2001, establishes specific
criteria for the recognition of intangible assets separately from goodwill, and
requires unallocated negative goodwill to be written off immediately as an
extraordinary gain (instead of being deferred and amortized). These provisions
are effective for business combinations accounted for by the purchase method for
which the date of acquisition is after June 30, 2001. Certain SFAS No. 141
provisions also apply to purchase business combinations for which the
acquisition date was before July 1, 2001. SFAS No. 142 addresses how intangible
assets acquired individually or with a group of other assets (but not those
acquired in a business combination) should be accounted for in the financial
statements. This statement requires that goodwill no longer be amortized and
instead be subject to an impairment test performed at least annually. The
provisions of SFAS No. 142 are effective for fiscal years beginning after
December 31, 2001. The implementation of these standards, on January 1, 2002,
did not have a material effect on the Company's financial position, results of
operations or cash flows.
5. SUBSEQUENT EVENT
Subsequent to June 30, 2002, the Company terminated its exposure under its
single corporate name credit default swap program in exchange for a fee of $43.0
million, which will result in a third quarter 2002 pre-tax charge of $22.2
million. Through the second quarter, the Company had already recognized
aggregate charges of $20.8 million related to the program in accordance with the
mark-to-market requirements of Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No.
133).
8
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
Management and investors consider the following measures important in
analyzing the financial results of the Company: core earnings, operating
earnings , core revenues, core expenses and gross present value of premiums
written (gross PV premiums written). However, none of these measures are
promulgated in accordance with accounting principles generally accepted in the
United States of America and should not be considered as substitutes for net
income, revenues, expenses and gross premiums written.
2002 AND 2001 SECOND QUARTER RESULTS
The Company's 2002 second quarter net income was $45.4 million, compared with
net income of $51.8 million for the same period in 2001. Operating earnings (net
income less the after-tax effect of net realized capital gains or losses, the
cost of the equity-based compensation programs and other significant items,
including changes in fair value of certain insurance products as required by
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities" (SFAS No. 133) and one-time additions or
reductions to the general reserve) was $66.8 million for the second quarter of
2002 versus $52.3 million for the comparable period in 2001, an increase of
$14.5 million, or 27.8%. Core earnings (operating earnings less the after-tax
effect of refundings and prepayments) was $63.2 million, compared with $51.4
million for the same period in 2001, an increase of 22.8%. Total core revenues
increased $22.0 million, from $86.4 million in the second quarter of 2001 to
$108.5 million in the second quarter of 2002, while total core expenses
increased only $7.1 million. Following is a table reconciling core earnings to
net income:
THREE MONTHS
ENDED JUNE 30,
-----------------
(IN MILLIONS) 2002 2001
------- -------
Core earnings $ 63.2 $ 51.4
Refundings, calls or other accelerations 3.6 0.9
------- -------
Operating earnings 66.8 52.3
Realized capital gains 16.8 1.5
Equity-based compensation (5.0) (4.3)
Other (33.2) 2.3
------- -------
Net income $ 45.4 $ 51.8
======= =======
The Company employs two measures of gross premiums originated for a given
period. GROSS PREMIUMS WRITTEN captures premiums collected in the period,
whether collected up front for business originated in the period, or in
installments for business originated in prior periods. An alternative measure,
GROSS PV PREMIUMS WRITTEN, reflects future installment premiums discounted to
their present value, as well as upfront premiums, but only for business
originated in the period. Business ceded through reinsurance placed by a third
party is excluded from gross PV premiums written. The Company considers gross PV
premiums written to be the better indicator of a given period's origination
activity because a substantial portion of the Company's premiums is collected in
installments, a practice typical of the asset-backed business. To calculate
gross PV premiums written, management estimates the life of each transaction
that has installment premiums and discounts the future installment premium
payments. The Company calculates the discount rate as the average pre-tax yield
on its investment portfolio for the previous three years. Accordingly,
year-to-year comparisons of gross PV premiums written are affected by the
application of different discount factors. The rates for 2002 and 2001 were
5.91% and 5.79%, respectively. Management intends to revise the discount rate in
future years according to the same formula, in order to reflect interest rate
changes.
9
Gross premiums written increased 28.3%, to $170.8 million for the second
quarter of 2002 from $133.2 million for the second quarter of 2001. Gross PV
premiums written increased 30.1%, to $199.9 million in the second quarter of
2002 from the second quarter result of $153.7 million in 2001. In the second
quarter of 2002, U.S. asset-backed gross PV premiums written were $63.6 million
as compared with $56.4 million in the same period in 2001, an increase of 12.8%;
U.S. municipal gross PV premiums written were $74.9 million as compared with
$81.0 million in the same period in 2001, a decrease of 7.5%; and international
gross PV premiums written were $61.4 million as compared with $16.3 million in
the same period in 2001, an increase of 276.7%.
In the second quarter of 2002, FSA insured par value of bonds totaling $31.6
billion, an increase of 18.5% compared to the second quarter of 2001. In the
second quarter of 2002, FSA's U.S. asset-backed component rose 10.2% to $12.8
billion and the U.S. municipal component rose 14.4% to $12.3 billion. Volume in
the international sector increased to $6.5 billion in the second quarter of 2002
from $4.3 billion in the second quarter of 2001.
In the second quarter of 2002, in the U.S. asset-backed market, FSA's
originations were well balanced across the consumer finance, residential
mortgage, structured finance and asset management businesses. In the U.S.
municipal market, although par insured increased, gross PV premiums written
declined due to a lower proportion of health care transactions, which tend to
have higher average premiums relative to par. In the international market, FSA
closed several major infrastructure transactions, including financings for two
toll roads, a convention center and the U.K. government's Health and Safety Lab.
Net premiums written were $125.2 million for the second quarter of 2002, an
increase of 39.1% when compared with the comparable period in 2001. Net premiums
earned for the second quarter of 2002 were $77.1 million, compared with $56.5
million in the second quarter of 2001, an increase of 36.4%. Premiums earned
from refundings and prepayments were $7.0 million for the second quarter of 2002
and $1.7 million for the same period of 2001, contributing $3.6 million and $0.9
million, respectively, to after-tax earnings. Net premiums earned for the
quarter grew 27.9% relative to the same period in 2001 when the effects of
refundings and prepayments were eliminated.
Net investment income was $35.1 million for the second quarter of 2002 and
$31.5 million for the comparable period in 2001, an increase of 11.3%. The
Company's effective tax rate on investment income was 11.3% for the second
quarter of 2002 compared with 10.7% for the same period in 2001. In the second
quarter of 2002, the Company realized $22.9 million in net capital gains
compared with net capital gains of $2.3 million for the same period in 2001.
Capital gains and losses are generally a by-product of the normal investment
management process and will vary substantially from period to period.
The provision for losses and loss adjustment expenses during the second
quarter of 2002 was $39.2 million compared with $3.2 million in the second
quarter of 2001. In the second quarter of 2002, as part of the Company's ongoing
credit review process, management identified certain transactions not performing
as expected in its portfolio of insured collateralized debt obligations
("CDOs"). As a result, management analyzed all CDO transactions in its insured
portfolio that breached over-collateralization triggers, which were included in
such transactions as one measure of adverse performance. A "deterministic"
approach was utilized as a basis to estimate the loss inherent in this
portfolio. The deterministic model applies a run of the collateral portfolio for
each transaction considering each CDO transaction's unique attributes (such as
reinsurance, individual collateral ratings and status, derivatives purchased,
premiums due to the guarantor, etc.) utilizing a Moody's default pattern for
frequency of defaults, an estimate of collateral recovery values for severity,
and a risk-free rate of interest. Management assumed that current default rates
on CDO collateral would improve in a manner consistent with an economic recovery
following a period of significant credit deterioration similar to that
experienced in 1991/1992 and, as a result, management selected Moody's 1992
idealized default curve as a predictor of future defaults on the CDO collateral.
The per period default rate is calculated based on the Moody's weighted average
rating factor for each piece of surviving collateral. Recovery rates are
judgmentally established by the Company. In considering the recovery rates to be
utilized, management adjusted Moody's average recovery rates (observed since
1982) downward to reflect more recent and more adverse observations. This
analysis produced a present value of expected losses of $51.5 million, net of
reinsurance recoveries and net of unearned premiums and future ceding
commissions. As described in more detail below, management addressed this net
present value of expected loss ($51.5 million) through (i) an increase in the
Company's general reserve ($31.0 million) and (b) current amounts in its general
reserve ($20.5 million), including general reserve amounts reallocated to case
basis reserves ($11.3 million). The $31.0 million increase in the Company's
general reserve resulted in a corresponding increase to loss and loss adjustment
expense in the income statement of $31.0 million. At June 30, 2002, the general
reserve totaled $99.6 million and the total loss and loss adjustment expense
liability totaled $177.1 million. Management has established a methodology of
recording case
10
basis reserves on CDO transactions to the extent that the over-collateralization
ratio (non-defaulted collateral at par value divided by the debt insured) has
fallen below 100%, since management believes that claims on such transactions
are probable and that the amount of the undercollateralization is a reasonable
estimate of such claims. Such transactions may benefit from excess cash flow
attributable in part to higher interest rates on the underlying collateral than
on the insured securities. In addition, such transactions generally require
insured payments of principal only at the ultimate maturity of such
transactions. As a result, the Company does not expect to be required to pay
claims in respect of these transactions until 2010, but may elect to do so at an
earlier date in its discretion. Over time, management expects to reallocate
amounts in its general reserve (including accretions thereto) to case basis
reserves as specific losses on its insured CDO portfolio become probable and
estimable in accordance with the undercollateralization methodology described
above. Application of this methodology resulted in recording $34.5 million in
gross case basis reserves and $23.2 million in reinsurance recoverable on unpaid
losses, resulting in an $11.3 million increase in net case basis reserves.
Management, beginning in the second quarter of 2002, has refined the loss factor
it applies to its net par underwritten when calculating the general reserve in
order to reflect its recent adverse experience. As a result, the general reserve
accrual for the second quarter of 2002 was $8.2 million, rather than the
approximate $4.1 million that would have been accrued using the prior
assumptions. Management expects future reserve contributions to be approximately
double the amounts under the prior practice. Since the reserves are based upon
estimates, there can be no assurance that the ultimate liability will not differ
from such estimates. The Company will continue, on an ongoing basis, to monitor
these reserves and may periodically adjust such reserves, upward or downward,
based on the Company's actual loss experience, its future mix of business and
future economic conditions.
Total policy acquisition and other operating expenses (excluding the cost of
the equity-based compensation programs of $7.7 million for the second quarter of
2002 compared with $6.6 million for the same period of 2001) were $16.6 million
for the second quarter of 2002 compared with $15.2 million for the same period
in 2001. Excluding the effects of refundings, total policy acquisition and other
operating expenses were $15.1 million for the second quarter of 2002 compared
with $14.8 million for the same period in 2001.
In the fourth quarter of 2001, the Company's newly formed asset management
group began issuing FSA-insured guaranteed investment contracts (GICs). As of
June 30, 2002, the Company had recorded $1,324.0 million in GICs. For the second
quarter of 2002, these transactions resulted in a net interest margin of $2.3
million.
Over the past two years, a growing percentage of FSA's business has been in
the form of credit default swaps against diversified pools of corporate
obligations, which require periodic marking to market under SFAS No. 133. These
transactions have generally been underwritten with Triple-A or higher levels of
credit protection before our guaranty. An exception, the only transaction of its
kind in FSA's credit default swap portfolio, was a highly diversified portfolio
of 100 corporate names, with $10 million of exposure per name, to which the
Company had first-loss exposure. In the second quarter, the Company took a
charge related to the decrease in market value of this portfolio, which
represented $16.0 million of the $16.5 million mark-to-market charge for net
realized and unrealized losses on derivative instruments. The fair value used to
mark these transactions to market is defined as the amount at which an asset or
a liability could be bought or sold in a current transaction between willing
parties. The fair value is determined based upon quoted market prices. If quoted
market prices are not available, as is the case primarily with credit default
swaps on pools of assets, then the determination of fair value is based upon
internally developed estimates. Management applies judgment when developing
these estimates and considers factors such as current prices charged for similar
agreements, performance of underlying assets, changes in internal shadow
ratings, the level at which the deductible has been set and FSA's ability to
obtain reinsurance for its insured obligations. Due to changes in these factors
the gain or loss from derivative instruments can vary substantially from period
to period. For further discussion, see "Subsequent Event" below.
Income before income taxes for the second quarter of 2002 was $56.3 million,
compared with $66.3 million for the same period in 2001.
The Company's effective tax rate for the second quarter of 2002 was 19.3%
compared with 21.8% for the same period in 2001. The effective tax rate differs
from the statutory tax rate of 35.0% due primarily to tax-exempt interest
income.
2002 AND 2001 FIRST SIX MONTHS RESULTS
11
The Company's 2002 first half net income was $99.5 million, equal to net
income of $99.5 million for the same period in 2001. Core earnings was $123.0
million, compared with $100.4 million for the same period in 2001, an increase
of 22.5%. Total core revenues for the first half of 2002 increased $41.3
million, from $168.5 million in 2001 to $209.8 million in 2002, while total core
expenses increased only $11.3 million. Operating earnings was $127.7 million for
the first half of 2002 versus $101.8 million for the comparable period in 2001,
an increase of $26.0 million, or 25.5%. Following is a table reconciling core
earnings to net income:
SIX MONTHS
ENDED JUNE 30,
-----------------
(IN MILLIONS) 2002 2001
------- -------
Core earnings $ 123.0 $ 100.4
Refundings, calls or other accelerations 4.7 1.4
------- -------
Operating earnings 127.7 101.8
Realized capital gains 17.6 2.8
Equity-based compensation (9.8) (7.3)
Other (36.0) 2.2
------- -------
Net income $ 99.5 $ 99.5
======= =======
Gross premiums written increased 33.2% to $315.4 million for the first half
of 2002 from $236.9 million for the first half of 2001. Gross PV premiums
written increased 28.5%, from $291.5 million for the first half of 2001 to
$374.7 million in the first half of 2002. U.S. asset-backed gross PV premiums
written were $139.5 million in the first half of 2002, as compared with $118.5
million in the first half of 2001, an increase of 17.7%. In the U.S. municipal
business, first half gross PV premiums written increased 22.1% to $150.5 million
in 2002 from $123.3 million in 2001. For the international sector, gross PV
premiums written in the first half increased to $84.7 million in 2002 from $49.7
million in 2001, an increase of 70.4%.
In the first half of 2002, FSA insured par value of bonds totaling $60.1
billion, a 36.3% increase over the same period in 2001. FSA's first half U.S.
asset-backed and U.S. municipal sectors increased 32.8% to $24.5 billion and
28.0% to $24.0 billion, respectively, while its international volume rose 68.1%
to $11.6 billion.
Net premiums written were $220.4 million for the first half of 2002, an
increase of $59.1 million, or 36.6%, when compared with 2001. Net premiums
earned for the first half of 2002 were $146.8 million, compared with $107.8
million in the first half of 2001, an increase of 36.2%. Premiums earned from
refundings and prepayments were $9.3 million for the first half of 2002 and $2.9
million for the same period of 2001, contributing $4.8 million and $1.4 million,
respectively, to after-tax earnings. Net premiums earned for the first half grew
31.1% relative to the same period in 2001 when the effects of refundings and
prepayments were eliminated.
Net investment income was $68.5 million for the first half of 2002 and $63.3
million for the comparable period in 2001, an increase of 8.3%. The Company's
effective tax rate on investment income was 11.1% for the first half of 2002 and
2001. In the first half of 2002, the Company realized $24.0 million in net
capital gains as compared with net gains of $4.2 million for the same period in
2001. Capital gains and losses are generally a by-product of the normal
investment management process and will vary substantially from period to period.
The provision for losses and loss adjustment expenses during the first half
of 2002 was $42.1 million compared with $6.0 million for the same period in
2001, representing additions to the Company's general loss reserve.
Total policy acquisition and other operating expenses (excluding the cost of
the equity based compensation programs of $15.0 million for the first half of
2002 compared with $11.2 million for the same period of 2001) were $31.9 million
for the first half of 2002 compared with $27.9 million for the same period in
2001, an increase of 14.1%. Excluding the effects of refundings, total policy
acquisition and other operating expenses were $29.9 million for the first half
of 2002 compared with $27.2 million for the same period in 2001, an increase of
9.9%.
Income before income taxes for the first half of 2002 was $126.3 million, as
compared with $127.1 million for the same period in 2001.
12
The Company's effective tax rate for the first half of 2002 was 21.2%
compared with 21.7% for the same period in 2001. The effective tax rate differs
from the statutory tax rate of 35.0% due primarily to tax-exempt interest
income.
LIQUIDITY AND CAPITAL RESOURCES
The Company's consolidated invested assets and cash equivalents at June 30,
2002, net of unsettled security transactions, was $4,184.2 million, compared
with the December 31, 2001 balance of $3,132.6 million. These balances include
the change in the market value of the investment portfolio, which had an
unrealized gain position of $129.4 million at June 30, 2002 and $92.4 million at
December 31, 2001. The increase in the Company's consolidated invested assets
and cash equivalents is largely attributable to implementation of the Company's
asset management business, which is primarily engaged in writing GICs insured by
FSA.
At June 30, 2002, the Company had, at the holding company level, an
investment portfolio of $18.7 million available to fund the liquidity needs of
its activities outside of its insurance operations. Because the majority of the
Company's operations are conducted through FSA, the long-term ability of the
Company to service its debt will largely depend upon the receipt of dividends or
surplus note payments from FSA and upon external financings.
FSA's ability to pay dividends is dependent upon FSA's financial condition,
results of operations, cash requirements, rating agency approval and other
related factors, and is also subject to restrictions contained in the insurance
laws and related regulations of New York and other states. Under the New York
Insurance Law, FSA may pay dividends out of statutory earned surplus, provided
that, together with all dividends declared or distributed by FSA during the
preceding 12 months, the dividends do not exceed the lesser of (i) 10% of
policyholders' surplus as of its last statement filed with the Superintendent of
Insurance of the State of New York (the New York Superintendent) or (ii)
adjusted net investment income during this period. FSA paid no dividends in the
first half of 2002 or during 2001. Based upon FSA's statutory statements for the
quarter ended June 30, 2002, the maximum amount available for payment of
dividends by FSA without regulatory approval over the following 12 months would
be approximately $99.2 million. In the first half of 2001, Financial Security
Assurance International Ltd., the Company's Bermuda domiciled insurance company
subsidiary, paid a preferred dividend of $1.6 million to its minority interest
owner.
At June 30, 2002, the Company held $144.0 million of surplus notes of FSA.
Payments of principal and interest on such notes may be made only with the
approval of the New York Superintendent. FSA paid $4.6 million and $3.0 million
in interest on such notes in the first half of 2002 and 2001, respectively.
In the first half of 2002, the Company paid dividends of $11.7 million. No
dividends were paid in the first half of 2001.
FSA's primary uses of funds are to pay operating expenses and to pay
dividends to, or principal of or interest on surplus notes held by, its parent.
FSA's funds are also required to satisfy claims under insurance policies in the
event of default by an issuer of an insured obligation and the unavailability or
exhaustion of other payment sources in the transaction, such as the cash flow or
collateral underlying the obligations. FSA seeks to structure asset-backed
transactions to address liquidity risks by matching insured payments with
available cash flow or other payment sources. The insurance policies issued by
FSA provide, in general, that payments of principal, interest and other amounts
insured by FSA may not be accelerated by the holder of the obligation but are
paid by FSA in accordance with the obligation's original payment schedule or, at
FSA's option, on an accelerated basis. These policy provisions prohibiting
acceleration of certain claims absent consent of the insurer are mandatory under
Article 69 of the New York Insurance Law and serve to reduce FSA's liquidity
requirements.
The Company believes that FSA's expected operating liquidity needs, both on a
short- and long-term basis, can be funded from its operating cash flow. In
addition, FSA has a number of sources of liquidity that are available to pay
claims on a short- and long-term basis: cash flow from written premiums, FSA's
investment portfolio and earnings thereon, reinsurance arrangements with
third-party reinsurers, liquidity lines of credit with banks, and capital market
transactions.
FSA has a credit arrangement, aggregating $125.0 million at June 30, 2002,
provided by commercial banks and intended for general application to
transactions insured by FSA and its insurance company subsidiaries. At June 30,
13
2002, there were no borrowings under this arrangement, which expires April 25,
2003, unless extended.
FSA has a standby line of credit in the amount of $240.0 million with a group
of international banks to provide loans to FSA after it has incurred, during the
term of the facility, cumulative municipal losses (net of any recoveries) in
excess of the greater of $240.0 million or the average annual debt service of
the covered portfolio multiplied by 5.00%, which amounted to $633.4 million at
June 30, 2002. The obligation to repay loans made under this agreement is a
limited recourse obligation payable solely from, and collateralized by, a pledge
of recoveries realized on defaulted insured obligations in the covered
portfolio, including certain installment premiums and other collateral. This
commitment has a seven-year term that will expire on April 30, 2009 and contains
an annual renewal provision subject to approval by the banks. No amounts have
been utilized under this commitment as of June 30, 2002.
In August 1994, FSA entered into a facility agreement with Canadian Global
Funding Corporation (Canadian Global) and Hambros Bank Limited. Canadian Global
was established to provide a source of liquidity to refinance FSA-insured
transactions that experience difficulty in meeting debt service obligations. The
amount of the facility is $186.9 million, of which $125.2 million was unutilized
at June 30, 2002. The facility expires in 2004.
Standard & Poor's Ratings Services ("S&P"), Moody's Investors Service,
Inc. ("Moody's") and Fitch Inc. periodically assess the credits insured by
FSA, and the reinsurers and other providers of capital support to FSA, to
confirm that FSA continues to satisfy the rating agency's capital adequacy
criteria necessary to maintain FSA's "triple-A ratings". Capital adequacy
assessments by the rating agencies are generally based upon FSA's qualified
statutory capital, which is the aggregate of policyholders' surplus and
contingency reserves determined in accordance with statutory accounting
principles. In the case of S&P, assessments of the credits insured by FSA are
reflected in defined "capital charges", which are reduced by reinsurance and
collateral to the extent "credit" is allowed for such reinsurance and
collateral. Credit provided for reinsurance under the S&P capital adequacy
model is generally a function of the S&P rating of the reinsurer providing
the reinsurance, as well as any collateral provided by the reinsurer. Capital
charges on outstanding insured transactions and reinsurer ratings are subject
to change by S&P at any time. S&P has placed a number of the "triple-A"
reinsurers used by FSA either on "negative outlook" or "credit watch".
Downgrade of these reinsurers by S&P to the "double-A" category would result
in a decline in the credit allowed for reinsurance by S&P from 100% to 70%
under present criteria. FSA expects that S&P will make a determination
whether or not to downgrade one or more of these reinsurers during the third
quarter of 2002. S&P has also undertaken to consider an increase in the
credit allowed for "double-A" reinsurance. While a downgrade by S&P of all
such reinsurers to the double-A category would not impair FSA's "triple-A"
ratings, it may reduce the "margin of safety" by which FSA exceeds S&P's
minimum triple-A capital adequacy requirements. A reduction by S&P in credit
for reinsurance used by FSA would also be expected to ultimately reduce the
Company's return on equity to the extent that ceding commissions paid to FSA
by such reinsurers were not increased to compensate for such reduction. FSA
employs considerable reinsurance in its business to manage its "single-risk"
exposures on insured credits. Any increase in capital charges by S&P on FSA's
insured portfolio would likewise be expected to have an adverse effect upon
FSA's margin of safety under the S&P capital adequacy model and, ultimately,
the Company's return on equity. The Company may seek to raise additional
capital to replenish capital eliminated by S&P from its capital adequacy
assessment of FSA due to any such reinsurer downgrades or increased capital
charges. There will be an adverse effect upon the Company's return on equity
to the extent that any such additional capital is raised.
FSA-insured GICs subject the Company to risk associated with early withdrawal
of principal allowed by the terms of the GICs. The majority of municipal GICs
insured by FSA relate to debt service reserve funds and construction funds in
support of municipal bond transactions. Debt service reserve fund GICs may be
drawn unexpectedly upon a payment default by the municipal issuer. Construction
fund GICs may be drawn unexpectedly when construction of the underlying
municipal project does not proceed as expected. In addition, most FSA-insured
GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA,
typically below AA- by S&P or Aa3 by Moody's, unless the GIC provider posts
collateral or otherwise enhances its credit. Some FSA-insured GICs also allow
for withdrawal of GIC funds in the event of a downgrade of FSA below A- by S&P
or A3 by Moody's, with no right of the GIC provider to avoid such withdrawal by
posting collateral or otherwise enhancing its credit. The Company manages this
risk through the maintenance of liquid collateral and liquidity agreements now
being implemented.
The Company has no plans for material capital expenditures within the next
twelve months.
SPECIAL PURPOSE ENTITIES
Asset-backed and, to a lesser extent, municipal transactions insured by FSA
may employ special purpose entities (SPEs) for a variety of purposes. A typical
asset-backed transaction, for example, employs an SPE as the purchaser of the
securitized assets and as the issuer of the obligations insured by FSA. FSA's
participation is typically requested by the sponsor of the SPE or the
underwriter, either via a bid process or on a sole source basis. SPEs are
typically owned by transaction sponsors or charitable trusts, although FSA may
have an ownership interest in some
14
cases. FSA maintains certain contractual rights and exercises varying degrees of
influence over SPE issuers of FSA-insured obligations. FSA also bears some of
the "risks and rewards" associated with the performance of the SPE's assets.
Specifically, as issuer of a financial guaranty insurance policy insuring the
SPE's obligations, FSA bears the risk of asset performance (typically, but not
always, after a significant depletion of overcollateralization, excess spread, a
deductible or other credit protection). FSA's underwriting policy is to insure
only obligations that are otherwise investment grade. In addition, the SPE
typically pays a periodic premium to FSA in consideration of the issuance by FSA
of its insurance policy, with the SPE's assets typically serving as the source
of such premium, thus providing some of the "rewards" of the SPE's assets to
FSA. SPEs are also employed by FSA in connection with "repackaging" of
outstanding securities into new securities insured by FSA and with refinancing
underperforming non-investment grade transactions insured by FSA. The degree of
influence exercised by FSA over these SPEs varies from transaction to
transaction, as does the degree to which "risks and rewards" associated with
asset performance are assumed by FSA. While all transactions insured by FSA are
included in the Company's outstanding exposure, and losses under these
obligations are reflected in the Company's financial statements for June 30,
2002, the assets and liabilities of these SPEs have not been consolidated with
those of the Company for financial reporting purposes and are considered
"off-balance sheet" obligations.
On June 28, 2002, the Financial Accounting Standards Board (FASB) published
an Exposure Draft relating to consolidation of SPEs. The public comment period
ends on August 30, 2002. A finalized pronouncement containing accounting
guidance and implementation dates is expected in the fourth quarter of 2002.
Until the FASB has completed this project, the Company cannot determine the
impact on its financial statements of any new accounting standards that may be
issued regarding SPEs.
SUBSEQUENT EVENT
Subsequent to June 30, 2002, the Company terminated its exposure under the
single corporate name credit default swap program in exchange for a fee of $43.0
million, which will result in a third quarter 2002 pre-tax charge of $22.2
million. Through the second quarter, the Company had already recognized
aggregate charges of $20.8 million related to the program in accordance with the
mark-to-market requirements of SFAS No. 133. Payment of this termination fee is
not expected to have a material impact on the Company's capital or liquidity
resources.
FORWARD-LOOKING STATEMENTS
This quarterly report contains forward-looking statements regarding, among
other things, the Company's plans and prospects. Important factors, including
general market conditions and the competitive environment, could cause actual
results to differ materially from those described in such forward-looking
statements. Certain of these factors are described in more detail under the
heading "Forward-Looking Statements" in Item 1 of the Company's Annual Report on
Form 10-K for the year ended December 31, 2001. Forward-looking statements in
this report are expressly qualified by all such factors. The Company undertakes
no obligation to revise or update any forward-looking statements to reflect
changes in events or expectations or otherwise.
15
PART II OTHER INFORMATION
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
On May 24, 2002, the Company's shareholders executed a Written Consent
of Shareholders in Lieu of Annual Meeting. Under the Written Consent, the
Company's shareholders unanimously approved:
(1) the election of Directors of the Company to
hold office until the later of the next annual meeting
of shareholders or their successors shall be duly
elected and have qualified, as follows:
Robert P. Cochran
Pierre Richard
Dirk Bruneel
John J. Byrne
Bruno Deletre
Alain Delouis
Robert N. Downey
David O. Maxwell
Sean W. McCarthy
James H. Ozanne
Roger K. Taylor
Rembert von Lowis
(2) the approval of the selection by the Company's
Board of Directors of PricewaterhouseCoopers LLP as the
independent public accountants of the Company to audit
the accounts of the Company for the year 2002.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
99.1 Financial statements of Financial Security Assurance Inc.
for the quarterly period ended June 30, 2002.
99.2 Certification of Chief Executive Officer Pursuant to 18
U.S.C. Section 1350
99.3 Certification of Chief Financial Officer Pursuant to 18
U.S.C. Section 1350
(b) REPORTS ON FORM 8-K
None
16
SIGNATURES
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 thereunto duly authorized.
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
By /s/ Jeffrey S. Joseph
------------------------------------------------
August 13, 2002 Jeffrey S. Joseph
Managing Director & Controller
(Chief Accounting Officer)
17
Exhibit Index
Exhibit No. Exhibit
- ----------- -------
99.1 Financial statements of Financial Security Assurance Inc. for the
quarterly period ended June 30, 2002.
99.2 Certification of Chief Executive Officer Pursuant to 18 U.S.C.
Section 1350
99.3 Certification of Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350