Back to GetFilings.com

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004

Commission File Number 1-12644

Financial Security Assurance Holdings Ltd.
(Exact name of registrant as specified in its charter)

        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    ý No    o

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    o

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes    o No    ý

        The aggregate market value of common equity, excluding treasury shares, held by non-affiliates of the registrant at June 30, 2004 was $46,370,344. For purposes of the foregoing, directors are deemed to be affiliates of the registrant and the dollar amount shown is based on the price at which shares of the Company's common stock were valued under the Company's director share purchase program on June 30, 2004.

        At March 23, 2005, there were outstanding 33,263,259 shares of Common Stock, par value $0.01 per share, of the registrant (excludes 254,736 shares of treasury stock).

        Documents Incorporated By Reference

        None

TABLE OF CONTENTS

PART I

Item 1.    Business.

        Financial Security Assurance Holdings Ltd., through its insurance company subsidiaries, is primarily engaged in the business of providing financial guaranty insurance on asset-backed and municipal obligations in domestic and international markets. The financial strength of the Company's insurance company subsidiaries is rated "Triple-A" by the major securities rating agencies and obligations insured by them are generally awarded "Triple-A" ratings by reason of such insurance. The Company's principal insurance company subsidiary is Financial Security Assurance Inc. ("FSA"), a wholly owned New York insurance company. FSA was the first insurance company organized to insure non-municipal obligations and has been a major insurer of asset-backed and other non-municipal obligations since its inception in 1985. FSA expanded the focus of its business in 1990 to include financial guaranty insurance of municipal obligations and has since become a major insurer of municipal obligations. FSA is licensed to engage in the financial guaranty insurance business in all 50 states, the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands. In addition, the Company offers FSA-insured guaranteed investment contracts and other investment agreements ("GICs") through other subsidiaries. References to the "Company" are to Financial Security Assurance Holdings Ltd. together with its subsidiaries.

        Financial guaranty insurance written by FSA typically guarantees scheduled payments on financial obligations. Upon a payment default on an insured obligation, FSA is generally required to pay the principal, interest or other amounts due in accordance with the obligation's original payment schedule or may, at its option, pay such amounts on an accelerated basis. FSA's underwriting policy is to insure obligations that would otherwise be investment grade without the benefit of FSA's insurance.

        For the year ended December 31, 2004, the Company had gross premiums written of $832.0 million, of which 37% related to insurance of asset-backed and other non-municipal obligations and 63% related to insurance of municipal obligations. At December 31, 2004, the Company had net par outstanding of $317.7 billion, of which 39% represented insurance of asset-backed and other non-municipal obligations and 61% represented insurance of municipal obligations. These amounts exclude intercompany transactions.

        The Company provides FSA-insured GICs to municipalities and other market participants. At December 31, 2004, the Company had $8.0 billion principal amount of outstanding GICs.

Organization

        FSA wholly owns FSA Insurance Company ("FSAIC"), which in turn wholly owns Financial Security Assurance (U.K.) Limited ("FSA-UK") and owns a majority interest in Financial Security Assurance International Ltd. ("FSA International"). FSAIC is an Oklahoma insurance company that primarily provides reinsurance to FSA. FSA International is a Bermuda insurance company that provides reinsurance to FSA and financial guaranty insurance for transactions outside United States and European markets. FSA-UK is a United Kingdom insurance company that primarily provides financial guaranty insurance for transactions in the United Kingdom and other European markets. XL Capital Ltd ("XL") owns a minority interest in FSA International, as discussed further below.

        The Company conducts its GIC business through its wholly owned subsidiaries FSA Capital Management Services LLC ("FSACM"), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the "GIC Subsidiaries"). FSACM has conducted substantially all of the Company's GIC business since April 2003, following the receipt of an exemption from the requirements of the Investment Company Act of 1940. The GIC Subsidiaries lend the proceeds from their sales of GICs to FSA Asset Management LLC ("FSAM"), which invests the funds, generally in obligations that qualify for FSA insurance.

        The Company consolidates the results of certain variable interest entities ("VIEs"), including FSA Global Funding Limited ("FSA Global"), Premier International Funding Co. ("Premier"), and Canadian

2

Global Funding Corporation ("Canadian Global"). The Company refinances certain defaulted transactions by employing refinancing vehicles to raise funds for the refinancings. These refinancing vehicles are also consolidated.

        FSA Global is a special purpose funding vehicle 29% owned by the Company. FSA Global issues FSA-insured medium term notes and invests the proceeds from the sale of its notes in FSA-insured obligations with a view towards realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. At December 31, 2004, FSA Global had $2.4 billion principal amount of outstanding notes, after elimination of intercompany transactions. The majority of Canadian Global's assets were liquidated and its liabilities satisfied during the third quarter of 2004. Premier is principally engaged in debt defeasance for lease transactions.

        The Company's management believes that the assets held by FSA Global, Premier and the refinancing vehicles, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations—Variable Interest Entities."

        FSA Portfolio Management Inc. ("FSA Portfolio Management"), a wholly owned subsidiary of the Company, is engaged in the business of managing a portion of the investment portfolios of the Company and certain of its subsidiaries. FSA Portfolio Management also owns various strategic and other investments funded from time to time by the FSA group of companies.

        Transaction Services Corporation ("TSC"), a wholly owned subsidiary of the Company, is engaged in the business of managing workout transactions within the insured portfolios of FSA and its subsidiaries.

        The Company is a subsidiary of Dexia Holdings, Inc. ("Dexia Holdings"), which, in turn, is owned 90% by Dexia Crédit Local SA ("Dexia Crédit Local") and 10% by Dexia S.A. ("Dexia"). Dexia is a Belgian corporation whose shares are traded on the Euronext Brussels and Euronext Paris markets as well as on the Luxembourg Stock Exchange. Dexia is primarily engaged in the business of public finance, banking and investment management in France, Belgium, Luxembourg and other European countries, as well as in the United States. Dexia Crédit Local is a wholly owned subsidiary of Dexia.

        The Company's Management Committee manages the Company's business. The Chief Executive Officer, President, General Counsel, Chief Risk Management Officer and Chief Financial Officer are full-time members of the Management Committee, and the heads of the Municipal Finance, Corporate Finance, International Finance and Financial Products groups serve as part-time members. Bruno Deletre, a director of the Company and a member of the Executive Board of Dexia Crédit Local, is an ex officio member of the Management Committee.

History

        When the Company commenced operations in 1985, it was owned by a number of large insurance companies and other institutional investors. In 1989, the Company was acquired by U S WEST Capital Corporation, which subsequently changed its name to MediaOne Capital Corporation ("MediaOne"). MediaOne was a subsidiary of MediaOne Group, Inc., with operations and investments in domestic cable and broadband communications and international broadband and wireless communication. In 1990, the Company established a strategic relationship with The Tokio Marine and Nichido Fire Insurance Co., Ltd. ("Tokio Marine"), which acquired a minority interest in the Company. Tokio Marine is a major Japanese property and casualty insurance company.

        In 1994, the Company completed an initial public offering of common shares, at which time White Mountains Insurance Group, Ltd. ("White Mountains") (formerly known as Fund American Enterprises Holdings, Inc.) made an investment in the Company, and the chairman of White Mountains became non-executive chairman of the Company. White Mountains is an insurance holding company.

        In 1998, the Company and XL entered into a joint venture, establishing two Bermuda domiciled financial guaranty insurance companies—FSA International and XL Financial Assurance Ltd ("XLFA").

3

In connection with the joint venture, XL acquired a minority interest in the Company. XL owns a minority interest in FSA International and the Company owns a minority interest in XLFA. XL is a major Bermuda-based insurance holding company.

        On July 5, 2000, the Company completed a merger in which the Company became a direct subsidiary of Dexia Holdings. At the merger date, each outstanding share of the Company's common stock was converted into the right to receive $76.00 in cash. At December 31, 2004, approximately 99% of the Company's common stock was held by Dexia Holdings. The other holders are an affiliate of White Mountains and certain directors of the Company who own shares of the Company's common stock or economic interests therein as described under "Item 11. Executive Compensation—Director Share Purchase Program." Although the Company's common stock is no longer listed on the New York Stock Exchange ("NYSE") as a consequence of the merger, the Company continues to file periodic reports under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), because debt securities issued by the Company are listed on the NYSE.

        The principal executive offices of the Company are located at 350 Park Avenue, New York, New York 10022, but are expected to be relocated to 31 West 52^nd Street, New York, New York 10019, in mid-2005. Subsidiaries of the Company maintain offices domestically in San Francisco and Dallas and abroad in London, Madrid, Paris, Singapore, Sydney, Tokyo and Bermuda.

Business Objectives

        The Company's business objective is to remain a leading insurer of asset-backed and municipal obligations while generating premium volume at attractive returns and minimizing the occurrence and severity of credit losses in its insured portfolio. The Company believes that the demand for financial guaranty insurance will remain strong over the long term as a result of the anticipated continuation of the following trends:

•

growth of asset securitization;



•

growth of project finance in Europe through expansion of private finance for funding of infrastructure projects;



•

substantial volume of new domestic municipal bonds that are insured, due, in part, to the continued use of municipal bonds to finance repairs and improvements to the nation's infrastructure and continued demand for credit enhancement by individuals who purchase municipal bonds; and



•

growing use of financial guaranty insurance in non-U.S. markets.

The Company also anticipates continued demand over the long term for its GIC business and other financial products programs that employ financial guaranty insurance provided by FSA.

        The Company believes that short term trends for financial guaranty insurance remain uncertain due, among other things, to:

•

narrow interest rate spreads between Triple-A rated obligations and lower rated obligations;



•

potential decline in municipal financings and refundings should interest rates rise; and



•

increased competition among financial guarantors and other alternative providers of credit enhancement.

        The Company expects to continue to originate a diversified insured portfolio characterized by insurance of both asset-backed and municipal obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. In addition to its domestic business, the Company selectively pursues international opportunities primarily in Western European and Asia Pacific markets.

4

Business of the Company

        The Company is engaged in the financial guaranty business through its insurance company subsidiaries and in its financial products ("FP") business though its GIC subsidiaries.

Financial Guaranty Business

        FSA's insurance is employed in both the new issue and secondary markets. In the case of new issues, the insured obligations are sold with FSA insurance at the time the obligations are issued. For both asset-backed and municipal obligations, FSA participates in negotiated offerings, where the investment banker and often the insurer have been selected by the sponsor or issuer. In addition, FSA participates in competitive offerings, where underwriting syndicates bid for securities and submit bids that may include insurance.

        In the secondary market, FSA's Triple-A Guaranteed Secondary Securities ("TAGSS") Program provides insurance for asset-backed obligations trading in the secondary market. Likewise, FSA's Custody Receipt Program provides insurance for municipal obligations trading in the secondary market. Investors and dealers generally obtain secondary-market insurance to upgrade or stabilize the credit ratings of positions they already hold or plan to acquire or to increase the market liquidity of such positions. FSA's underwriting guidelines require the same underwriting standards on secondary market issues as on new issues, although FSA's control rights in the event of default are generally more limited.

        In many insured transactions, the issuer of insured securities is party to an interest rate, basis or currency swap that matches the issuer's funding sources to the interest rate or currency of the insured securities or otherwise hedges the issuer's exposure. In such transactions, FSA typically insures the issuer's obligations under both the insured securities and the derivative contract.

        FSA insures payment obligations of counterparties and issuers under GICs, GIC equivalents, credit-linked notes and obligations under interest rate, currency and credit default swaps ("CDS"), including guarantees issued in connection with the Company's FP business. FSA also issues surety bonds under its Sure-Bid program, which provides an alternative to traditional types of good faith deposits for competitive municipal bond transactions.

        FSA insures obligations already carrying insurance from other monoline guarantors, with FSA generally obligated to pay claims on a "second-to-pay" basis, following a default by both the underlying obligor and the first-to-pay financial guarantor. In recent years, FSA has reinsured a modest amount of business from other financial guaranty insurers.

        The following table indicates the Company's percentages of par amount (net of reinsurance) outstanding at December 31, 2004 and 2003 with respect to each type of asset-backed and municipal program:

Net Par Amount and Percentage Outstanding by Program Type

5

(1)

Excludes intercompany insurance of $7,143 million in 2004 and $4,474 million in 2003 relating to FSA-insured GICs issued by the GIC Subsidiaries.

Premiums

        FSA takes into account the risk it assumes and its projected return in setting insurance premium rates. Critical factors in assessing risk include the credit quality of the issuer, type of issue, sources of repayment, transaction structure and term to maturity. The premium rate is also a function of market factors and the competitive environment. Market factors include the value added by the use of insurance, such as the interest rate savings the issuer of an insured obligation obtains. Competition arises from other insurers and uninsured alternative executions. For insurance on GIC and medium term note transactions, transactions involving "repackaging" of outstanding securities and other transactions, FSA's premium may be arbitrage-based, based upon the difference between the effective borrowing cost at a Triple-A rate and the interest rate on the underlying securities.

Asset-Backed Obligations

        Asset-backed obligations insured by FSA are generally issued in structured transactions backed by pools of assets such as residential mortgage loans, consumer or trade receivables, securities or other assets having an ascertainable cash flow or market value. Asset-backed obligations insured by FSA also include payment obligations of counterparties and issuers under synthetic obligations such as CDS and credit- linked notes referencing asset backed securities or pools of securities or other obligations.

        Asset-backed obligations are typically issued in connection with structured financings or securitizations where the securities being issued are secured by or payable with funds from a specific pool of assets. The assets are typically held by a special purpose entity that also acts as the issuer of the insured obligations. Most asset-backed obligations are secured by or represent interests in diverse pools of assets, such as residential mortgage loans, auto loans, credit card receivables, other consumer receivables, corporate loans or bonds, government debt and small business loans. Asset- backed obligations may also be secured by less diverse payment sources, such as multifamily real estate.

        Asset-backed obligations include funded and synthetic transactions. Funded asset-backed obligations are typically payable from cash flow generated by a pool of assets and take the form of either "pass-through" obligations, which represent interests in the related assets, or "pay-through" obligations, which generally are debt obligations collateralized by the related assets. Both types of funded asset-backed obligations generally have the benefit of one or more forms of credit enhancement, such as overcollateralization or excess cash flow, to cover credit risks associated with the related assets. Synthetic asset-backed obligations generally take the form of CDS obligations or credit-linked notes that reference either an asset-backed security or pool of securities or loans, with a defined deductible to cover credit risks associated with the referenced securities or loans.

        Asset securitization often represents an efficient way for commercial banks to comply with capital requirements and for corporations to access the capital markets at more attractive rates and, frequently, with different accounting treatment. Banks have responded to increased capital requirements by selling

6

certain of their assets, such as credit card receivables and automobile loans, in securitized structures to the financial markets. Some corporations have found securitization of their assets to be a less costly funding alternative to traditional forms of borrowing or otherwise important in diversifying funding sources. Many finance companies fund consumer finance and home equity lending through securitization.

        Since the late 1990s, a significant market has developed for funded and synthetic collateralized debt obligations ("CDOs"), which are securitizations of bonds, loans or other securities. CDOs are used by financial institutions to manage their risk profiles, optimize capital utilization and improve returns on equity. CDOs are also used by dealers or portfolio managers to provide leveraged investments in bond and loan portfolios tailored to conform to differing risk appetites of investors.

        According to industry sources, the new par volume since 2000 for each type of funded asset-backed security presented, including securities distributed under Rule 144A under the Exchange Act, were as follows:

(1)

Source: Asset-Backed Alert, January 11, 2002, January 10, 2003, January 9, 2004 and January 7, 2005. Subject to revision as additional information becomes available.

(2)

Includes corporate and consumer receivable-backed issues (including home equity loan issues) but excludes private-label mortgage-backed securities, CDOs, commercial paper and private placements not made under Rule 144A.

        The data in the above table excludes synthetic transactions and therefore does not reflect the growth in the use of CDS during the years covered. According to the International Swaps and Derivatives Association, Inc. ("ISDA"), the notional principal amount of CDS outstanding in world markets were as follows at the dates indicated:

(1)

Source: ISDA, February 15, 2005.

7

        According to industry information, the annual totals of funded and synthetic asset-backed par insured of financial guaranty insurance directly originated by monoline guarantors since 2000 were as follows:

(1)

Source: Association of Financial Guaranty Insurers ("AFGI"), April 22, 2004. Includes all funded and synthetic primary-market and secondary-market U.S. insured transactions, excluding municipal obligations. Subject to revision as additional information becomes available.

(2)

Not available from the same source. According to the statistical operating supplements published by the four largest monoline guarantors, those four companies insured directly or assumed, in the aggregate, approximately $167.1 billion of U.S. asset-backed par volume and $41.4 billion of non-U.S. asset-backed par volume in 2004.

        Since 2000, the global securitization market has significantly expanded year-over-year. The relatively mature U.S. asset-backed market is expected by management to continue to grow over the long term, although not necessarily at the pace of recent years.

Municipal Obligations

        FSA insures a range of municipal obligations, including general obligation bonds supported by the issuers' taxing power and special revenue bonds and other special obligations of state and local governments supported by the issuers' ability to impose and collect fees and charges for public services or specific projects such as utility revenues. Additional municipal obligations insured by FSA include:

•

project finance obligations, consisting primarily of obligations of special purpose issuers backed by the cash flow from lease or other revenues from projects serving a substantial public purpose, including government office buildings, toll roads, healthcare facilities and utilities; and



•

payment obligations of counterparties under CDS referencing municipal obligations.

        Municipal obligations include bonds, notes and other evidences of indebtedness issued by public and quasi-public entities, including states and their political subdivisions (such as counties, cities or towns), utility districts, public universities and hospitals, and public-housing and transportation authorities. An issuer's obligation to pay is supported by the issuer's taxing power in the case of general obligation bonds, and by the issuer's ability to impose and collect fees and charges for public services or specific projects in the case of most special revenue bonds and public-private infrastructure financings. Certain municipal obligations, including most project finance obligations, include non-municipal credit risks (to swap counterparties, insurance companies, construction companies or other non-municipal credits) and operating risks (such as traffic volume or tuition revenues).

8

        According to industry sources, the total and insured volume since 2000 of long-term U.S. municipal new issues sold were as follows:

Insured U.S. Municipal Obligations(1)

(1)

Source: The Bond Buyer, February 7, 2005. Volume is expressed in terms of principal issued and insured on a sale-date basis. Subject to revision as additional information becomes available.

        In 2000, the municipal bond industry saw a decline in both total U.S. municipal bond issuance and the percentage of municipal par issued that benefited from bond insurance, attributable in part to budget surpluses reducing borrowing needs as well as the need to employ bond insurance. New issue volume increased in 2001, 2002 and 2003, as declining interest rates, diminished tax revenues and continuing needs for infrastructure investment drove municipalities to borrow on an unprecedented scale. Insurance penetration reached approximately 50% in 2002 and 2003, reaching its highest historical level in 2004. Insured par volume increased slightly in 2004 despite a decline in total market volume primarily due to generally higher interest rates.

        Outside the United States, guarantors have become increasingly active in public infrastructure finance. These transactions frequently finance public-private partnerships, such as those authorized by the U.K. Private Finance Initiative.

        Since 2000, the annual totals of non-U.S. municipal par insured of financial guaranty insurance directly originated by monoline guarantors, according to industry sources, were as follows:

Non-U.S. Municipal Obligations Insured by Monoline
Insurance Companies(1)

(1)

Source: AFGI news release, April 22, 2004. Data is subject to revision as additional information becomes available.

(2)

Not available from the same source. According to the statistical operating supplements published by the three monoline guarantors most active outside the United States, those three companies insured directly or assumed, in the aggregate, a principal amount of $11.3 billion of non-U.S. municipal obligations in 2004.

9

Variable Interest Entities

        FSA Global is a Cayman Islands domiciled issuer of FSA-insured notes and other obligations sold in international markets that are generally referred to as medium term notes ("MTNs"). FSA Global issues securities at the request of interested purchasers in a process known as "reverse inquiry," which generally results in lower interest rates and borrowing costs than would apply to direct borrowings. FSA Global also issues securities in traditional private placements to institutional investors and to participants in lease financings in which Company affiliates may play a number of financing roles. At December 31, 2004, the VIEs had $2.4 billion principal amount of outstanding notes, after elimination of intercompany transactions.

        FSA Global is managed as a "matched funding vehicle," in which the proceeds from the sale of FSA Global notes are invested in obligations chosen to provide cash flows substantially matched to those of the notes (taking into account, in some cases, dedicated third party liquidity). This matched funding structure is designed to minimize the market risks borne by FSA Global and FSA. FSA Global raises funds that are invested with a view towards realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. FSA Global generally raises funds that are U.S. dollar denominated or converted into U.S. dollars at LIBOR-based floating borrowing rates, and invests them in FSA-insured obligations that:

•

are U.S. dollar denominated or converted into U.S. dollars at LIBOR-based floating rates,



•

mature prior to the maturity of the related FSA Global notes and



•

pay a higher or equal interest rate than the interest rate on the related FSA Global notes.

Financial Product Business

GICs

        The Company's GIC business provides GICs to municipalities and other market participants. FSA insures all GICs issued by the GIC Subsidiaries. The majority of municipal GICs insured by FSA relate to debt service reserve funds or construction funds that support municipal bond transactions.

        Each GIC entitles its holder to receive the return of the holder's initial principal plus interest at a specified rate, and to withdraw principal from the GIC as permitted. Generally, a municipal bond trustee or issuer will acquire a municipal GIC in order to invest funds on deposit in a debt service reserve fund or construction fund until it needs to use such funds to service debt or fund the payment of project expenses in accordance with the underlying bond documents. Non-municipal GICs insured by FSA include GICs acquired by issuers of credit linked notes and GICs acquired by FSA Global.

        The Company is exposed to risk associated with unexpected withdrawals on its FSA-insured GICs. Debt service reserve fund GICs may be drawn unexpectedly upon a payment default by the municipal issuer. Construction fund GICs may be drawn more quickly or more slowly than anticipated to pay project expenses. In addition, most FSA-insured GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below AA- by Standard & Poor's Ratings Services ("S&P") or Aa3 by Moody's Investors Service, Inc. ("Moody's"), unless the GIC provider posts collateral or otherwise enhances its credit. The Company manages this risk through the maintenance of liquid collateral and liquidity agreements.

        The GIC Subsidiaries issue GICs and, on the same terms, lend the funds raised to FSAM. The funds are generally raised at (or converted by FSAM into) U.S. dollar LIBOR-based floating rate obligations. FSAM generally invests the funds in, or converts them into, U.S. dollar LIBOR-based floating rate investments. The investments are generally obligations that would qualify for FSA insurance from a credit perspective. The GIC Subsidiaries and FSAM generate their gross profits or losses from the difference between the rates at which the GIC Subsidiaries borrow the funds and the rates yielded by FSAM's

10

investments. These investments are owned, and the related risk management function is performed, by FSAM.

Insurance in Force

        A summary of the Company's par outstanding by type at December 31, 2004 is as follows:

(1)

Excludes direct par outstanding on intercompany insurance of $7,143 million relating to FSA-insured GICs issued by the GIC Subsidiaries.

        At December 31, 2004, the weighted average life of the direct par insured on these policies was approximately three years for asset-backed and 12 years for municipal obligations.

Asset-Backed and Other Non-Municipal Obligations

        FSA's insured portfolio of asset-backed and other non-municipal obligations is divided into five major categories, which are broadly based on the type of assets backing the insured obligations and include funded and synthetic obligations:

•

Domestic Residential Mortgage Loans.    Obligations primarily backed by residential mortgage loans generally take the form of conventional pass-through certificates or pay-through debt securities, but also include other structured products. Residential mortgage loans backing these insured obligations include closed-end first mortgage loans and closed- and open-end second mortgage loans or home equity loans on one-to-four family residential properties, including condominiums and cooperative apartments. Domestic residential mortgage loan obligations insured by FSA have tended to be concentrated in the "sub-prime" sector, characterized by lower quality borrowers and higher levels of structural credit protection through subordination and/or excess spread. FSA also insures "net interest margin" ("NIM") securities backed by the senior portion of residual cash flows from securitizations of domestic residential mortgage loans. FSA has generally declined participation in securitizations of so-called "high cost mortgage loans," characterized by very high interest rates or "points and fees" and subject to restrictive federal and state regulations.



•

Domestic Consumer Receivables.    Obligations primarily backed by consumer receivables include conventional pass-through and pay-through securities as well as more highly structured transactions. Consumer receivables backing these insured obligations include automobile loans, manufactured housing loans and credit card receivables. Consumer receivable transactions insured by FSA have tended to be concentrated in the sub-prime auto loan and credit card receivable sectors.



•

Domestic Pooled Corporate Obligations.    Obligations primarily backed by pooled corporate obligations include funded and synthetic obligations collateralized by corporate debt securities or corporate loans and obligations backed by cash flow or market value of non-consumer indebtedness, and include CDOs, such as "collateralized bond obligations," "collateralized loan obligations" and comparable risks under CDS obligations. Corporate obligations include corporate bonds, bank loan participations, trade receivables, franchise loans and equity securities. Some CDS obligations expose FSA to elements of market value risk arising from obligations to pay the difference between par and market value upon the occurrence of a payment default or other

11

defined "credit events" specified in the CDS. FSA generally addresses these risks by requiring large deductibles as a condition to payment under pooled corporate CDS insured by FSA.

•

Other Domestic Non-Municipal Obligations.    Other domestic non-municipal obligations include bonds or other securities backed by government securities, letters of credit, guarantees by other monoline insurers or repurchase agreements collateralized by government securities, securities backed by a combination of assets that include elements of more than one of the categories set forth above and unsecured corporate obligations satisfying FSA's underwriting criteria. Other domestic non-municipal obligations insured by FSA also include first mortgage bond obligations of for-profit electric or water utilities providing retail, industrial and commercial service, sale-leaseback obligation bonds supported by such utilities and other obligations backed by investor-owned utilities. These bonds are generally secured by a mortgage on property owned by or leased to an investor-owned utility.



•

International Asset-Backed Obligations.    International asset-backed obligations include obligations of non-domestic portions of funded and synthetic CDOs, securitizations of perpetual floating rate notes of non-domestic banks, obligations of non-domestic investor-owned utilities and other obligations having international aspects but otherwise within the asset-backed categories described above.

Municipal Obligations

        FSA's insured portfolio of municipal obligations is divided into eight major categories, which include funded and synthetic obligations:

•

Domestic General Obligation Bonds.    General obligation or full faith and credit bonds are issued by states, their political subdivisions and other municipal issuers, and are supported by the general obligation of the issuer to pay from available funds and by a pledge of the issuer to levy taxes according to value in an amount sufficient to provide for the full payment of the bonds.



•

Domestic Housing Revenue Bonds.    Housing revenue bonds include both multifamily and single family housing bonds, with multi-tiered security structures based on the underlying mortgages, reserve funds, and various other features such as Federal Housing Administration or private mortgage insurance, bank letters of credit, first loss guarantees and, in some cases, the general obligation of the issuing housing agency or a state's "moral obligation" (that is, not a legally binding commitment) to make up deficiencies.



•

Domestic Municipal Utility Revenue Bonds.    Municipal utility revenue bonds include obligations of all forms of municipal utilities, including electric, water and sewer utilities. Insurable utilities may be organized as municipal enterprise systems, authorities or joint-action agencies.



•

Domestic Health Care Revenue Bonds.    Health care revenue bonds include bonds of state and local municipal authorities issued on a conduit basis on behalf of not-for-profit hospitals and hospital systems for refinancings and capital acquisitions and construction, payable from amounts derived under loan agreements and notes of such health care providers with such authorities.



•

Domestic Tax-Supported (Non-General Obligation) Bonds.    Tax-supported (non-general obligation) bonds include a variety of bonds that, though not full faith and credit general obligations, are supported by a specific or discrete source of taxation of the issuer, and include tax-backed revenue bonds and general fund obligations of the issuer, such as lease revenue bonds. Tax-backed revenue bonds may be secured by a lien on pledged tax revenues, such as revenues from special taxes, including retail sales and gasoline taxes, or from tax increments (or tax allocations) generated by growth in property values within a district. FSA also insures bonds secured by special assessments levied against property owners, which benefit from covenants by the issuer to levy, collect and enforce collections and to foreclose on delinquent properties. Lease revenue bonds or certificates

12

of participation ("COPs") are usually general fund obligations subject to annual appropriation or abatement. The projects financed by lease revenue bonds or COPs are generally real property or equipment that, in the case of annual appropriation or abatement leases, FSA deems to serve an essential public purpose (e.g., schools, prisons, courts).

•

Domestic Transportation Revenue Bonds.    Transportation revenue bonds include a wide variety of revenue-supported bonds, such as bonds for airports, ports, tunnels, municipal parking facilities, toll roads and toll bridges.



•

Other Domestic Municipal Bonds.    Other domestic municipal bonds insured by FSA include college and university (primarily public or state-supported) revenue bonds, moral obligation bonds, financings for stadiums, resource recovery bonds and debt issued, guaranteed or otherwise supported by domestic state or local governmental entities.



•

International Municipal Obligations.    International municipal obligations include obligations of sovereign and sub-sovereign non-domestic municipal issuers, project finance transactions involving projects leased to or supported by payments from non-domestic governmental or quasi-governmental entities, toll road transactions supported by toll revenues, obligations arising under leases of equipment or facilities by non-domestic municipal obligors, non-domestic municipal utility revenue bonds and other obligations having international aspects but otherwise within the municipal categories described above.

Insured Portfolio

        A summary of FSA's insured portfolio at December 31, 2004 is shown below. Exposure amounts are expressed net of reinsurance but do not distinguish between quota share, first loss or excess of loss reinsurance.

Summary of Insured Portfolio
As of December 31, 2004(1)

(1)

Excludes intercompany insurance of $7,143 million in net par outstanding and $8,753 million in net par and interest outstanding relating to FSA-insured GICs issued by the GIC Subsidiaries.

13

Obligation Type

        The table below sets forth the relative percentages of net par amount insured by obligation type during each of the last five years:

Annual New Business Insured by Obligation Type

(1)

Excludes intercompany transactions of $2.7 billion in 2004, $3.6 billion in 2003, $2.0 billion in 2002 and $0.5 billion in 2001, relating to FSA-insured GICs issued by the GIC Subsidiaries.

14

Terms to Maturity

        The table below sets forth the contractual terms to maturity of the Company's policies at December 31, 2004 and 2003:

Contractual Terms to Maturity of Net Par of Insured Obligations(1)

(1)

Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties. The average expected maturities for asset-backed obligations are expected to be considerably shorter than the contractual maturities for such obligations.

(2)

Excludes intercompany insurance of $7,143 million in 2004 and $4,474 million in 2003 relating to FSA-insured GICs issued by the GIC Subsidiaries.

Issue Size

        The tables below set forth the number of policies and net par outstanding as of December 31, 2004, based on the amount of original net par written:

Asset-Backed Policy Count and Net Par Amount Outstanding(1)

(1)

Excludes intercompany insurance of $7,143 million relating to FSA-insured GICs issued by the GIC Subsidiaries.

15

Municipal—Policy Count and Net Par Amount Outstanding

Geographic Concentration

        In its asset-backed business, the Company considers geographic concentration as a factor in underwriting insurance for securitizations of pools of assets, such as residential mortgage loans or consumer receivables. However, the geographic concentration of the underlying assets may change over the life of the policy. In addition, in writing insurance for other types of asset-backed obligations, such as securities primarily backed by government or corporate debt, geographic concentration is not considered a significant credit factor given other more relevant measures of diversification, such as issuer or industry diversification.

        The Company seeks to maintain a diversified portfolio of insured municipal obligations designed to spread its risk across a number of geographic areas. The table below sets forth those jurisdictions in which municipalities issued an aggregate of 2% or more of the total net par amount outstanding of insured municipal securities:

Municipal Insured Portfolio by Jurisdiction

16

        Revenues from external customers attributed to the United States and all foreign countries during each of the Company's last three fiscal years is shown below:

        See Note 23 to the Consolidated Financial Statements in Item 8 for revenues from external customers, income before income taxes and total assets by segment.

Issuer Concentration

        The Company has adopted underwriting and exposure management policies designed to limit the net par insured or net retained credit gap for any one credit. Credit gap is a concept employed by S&P to estimate the at-risk amount (worst-case risk) on an insured exposure. FSA has also established procedures to ensure compliance with regulatory single-risk limits applicable to bonds it insured. In many cases, the Company uses reinsurance to limit net exposure to any one credit. At December 31, 2004, the ten largest net insured asset-backed transactions represented $18.9 billion, or 6.0%, of the total net par amount outstanding, and the ten largest net insured municipal credits represented $9.6 billion, or 3.1%, of the total net par amount outstanding. For purposes of the foregoing, different issues of asset-backed securities by the same sponsor have not been aggregated. However, the Company's underwriting policies establish single risk guidelines applicable to asset-backed securities of the same sponsor. In addition, individual corporate names may appear in more than one FSA-insured CDO transaction, but such exposures are not aggregated for purposes of identifying the largest exposures. Instead, FSA addresses these risks by limiting its exposure to the CDO sector in the aggregate. In addition to the single risk limits established by its underwriting guidelines, the Company is subject to regulatory limits and rating agency guidelines on exposures to single credits.

Credit Underwriting Guidelines, Standards and Procedures

        Financial guaranty insurance written by FSA generally relies on an assessment of the adequacy of various payment sources to meet debt service or other obligations in a specific transaction without regard to premiums paid or income from investment of premiums. FSA's underwriting policy is to insure asset-backed and municipal obligations that it determines are investment grade without the benefit of FSA's insurance. To this end, each policy FSA writes or reinsures is designed to satisfy the general underwriting guidelines and specific standards for particular types of obligations approved by its Board of Directors. In addition, the Company's Board of Directors has established an Underwriting Committee that reviews completed transactions, generally on a quarterly basis, to ensure conformity with underwriting guidelines and standards. In addition, FSA's underwriting policy allows for FSA to insure securities issued to refinance other securities insured by FSA as to which the issuer is or may be in default.

        FSA's underwriting guidelines for asset-backed obligations are premised on the concept of multiple layers of protection, and vary by obligation type in order to reflect different structures and types of credit support. FSA seeks to insure asset-backed obligations that generally provide for one or more forms of overcollateralization (such as excess collateral value, excess cash flow or "spread," reserves or, in the case of CDS, a deductible) or third-party protection (such as bank letters of credit, guarantees, net worth maintenance agreements, indemnity agreements or reinsurance agreements). This overcollateralization or

17

third-party protection need not protect FSA against all risk of loss, but is generally intended to assume the primary risk of financial loss.

        Asset-backed obligations insured by FSA often benefit from self-adjusting mechanisms, such as cash traps or accelerated amortization that take effect upon a failure to satisfy performance based triggers. Asset-backed obligations insured by FSA may benefit from third party protection. Overcollateralization, excess spread or third-party protection may not be required in transactions in which FSA is insuring the obligations of certain highly rated issuers that typically are regulated, have implied or explicit government support, or are short term, or in transactions in which FSA is insuring securities issued to refinance other securities insured by FSA as to which the issuer is or may be in default. FSA's general policy has been to insure 100% of the principal, interest and other amounts due in respect of funded asset-backed obligations rather than providing partial or first-loss coverage sufficient to confer a Triple-A rating on the insured obligations. In the CDS sector, however, FSA has insured risks on a "compressed" or "mezzanine" basis in which the obligations insured by FSA are subordinate to more senior uninsured obligations.

        FSA's underwriting guidelines for municipal obligations require that a transaction be rated investment grade by Moody's or S&P or, in the alternative, that the credit quality of the obligor is considered by FSA to be the equivalent of investment grade. Where the municipal obligor is a governmental entity with taxing power or providing an essential public service paid by taxes, assessments or other charges, supplemental protections may be required if such taxes, assessments or other charges are not projected to provide sufficient debt service coverage. Where appropriate, the municipal obligor may be required to provide a rate covenant and a pledge of additional security (e.g., mortgages on real property, liens on equipment or revenue pledges) to secure the insured obligation.

        The rating agencies participate to varying degrees in the underwriting process. Most asset-backed obligations insured by FSA are reviewed prior to issuance by both S&P and Moody's to evaluate the risk proposed to be insured. In the case of municipal obligations, prior rating agency review is a function of the type of insured obligation and the risk elements involved. The independent review of FSA's underwriting practices performed by the rating agencies further strengthens the underwriting process.

        The Company's Risk Management Committee reviews the Company's insured portfolio on a periodic basis. The Risk Management Committee is comprised of FSA's Chief Risk Management Officer, Chief Domestic Underwriting Officer, Chief Municipal Underwriting Officer and Chief International Underwriting Officer, with FSA's Chief Executive Officer, President, General Counsel and Chief Financial Officer as ex officio members.

        The underwriting process that implements the Company's underwriting guidelines and standards is supported by FSA's professional staff of analysts, underwriting officers, credit officers and attorneys. Moreover, the approval of senior management is required for all transactions.

        Each underwriting group in the Financial Guaranty Department is responsible for confirming that each transaction proposed by the Financial Guaranty Department conforms to the underwriting guidelines and standards. This evaluation is reviewed by the chief underwriting officer for the particular sector. This review may take place while the transaction is in its formative stages, thus facilitating the introduction of further enhancements at a stage when the transaction is more receptive to change.

        Final transaction approval is obtained from FSA's Management Review Committee (the "MRC") for asset-backed transactions and municipal international transactions and from FSA's Municipal Underwriting Committee (the "MUNC") for domestic municipal transactions. Subject to applicable limits, a subcommittee of the MRC or MUNC, as applicable, may approve guarantees of transactions in certain sectors. The MUNC and MRC jointly review certain international transactions with municipal credit elements. Approval is usually based upon both a written and an oral presentation by the underwriting group to the respective committee. Following approval, the Chair of the applicable underwriting

18

committee may approve minor transaction modifications. Major changes require the concurrence of the applicable underwriting committee.

        The MRC is comprised of FSA's Chief Executive Officer, President, Chief Risk Management Officer, Chief Domestic Underwriting Officer, Chief International Underwriting Officer, General Counsel and Associate General Counsel for Asset-Backed Transactions. The Chief Executive Officer, President and General Counsel are not required to participate in MRC meetings for transactions meeting certain criteria.

        The MUNC is comprised of FSA's Chief Executive Officer, President, Chief Municipal Underwriting Officer, a Municipal Underwriting Officer, Managing Director of Public Finance and Associate General Counsel for Municipal Transactions. The MUNC approval process generally requires approval by at least:

•

the Chief Executive Officer or President,



•

the Chief Municipal Underwriting Officer or Municipal Underwriting Officer, and



•

an Associate General Counsel for Municipal Transactions.

Subject to applicable limits, municipal transactions satisfying credit and return requirements may be approved by a committee (the "Demi-MUNC") comprised of the Chief Municipal Underwriting Officer, Municipal Underwriting Officer or Managing Director for Municipal Operations, an Associate General Counsel for Municipal Transactions, and any one of certain managing directors and directors designated by the MUNC. The Demi-MUNC approval process generally requires approval by at least two voting members, with approval by the Chief Municipal Underwriting Officer or Municipal Underwriting Officer required for transactions exceeding a certain size.

Corporate Research

        FSA's Corporate Research Department is comprised of a professional staff under the direction of the Chief Risk Management Officer. The Corporate Research Department is responsible for evaluating the credit of entities participating or providing recourse on obligations insured by FSA. It also provides analysis of industry segments. Members of the Corporate Research Department generally report their findings directly to the appropriate underwriting committee in the context of transaction review and approval.

Transaction Oversight and Transaction Services

        FSA's Transaction Oversight Departments and its workout subsidiary TSC are independent of the analysts and credit officers involved in the underwriting process. The Asset-Backed and Municipal Transaction Oversight Departments are responsible for monitoring the performance of outstanding transactions. TSC, together with the Transaction Oversight Departments, is responsible for taking remedial actions as appropriate. The managing directors responsible for the transaction oversight and transaction services functions report to the Chief Risk Management Officer. The Underwriting Committee of the Board of Directors receives quarterly reports describing the changes in the overall insured portfolio during the quarter. The Transaction Oversight Departments review insured transactions to confirm compliance with transaction covenants, monitor credit and other developments affecting transaction participants and collateral, and together with TSC determine the steps, if any, required to protect the interests of FSA and the holders of FSA-insured obligations. Reviews of asset-backed transactions typically include an examination of reports provided by, and (as circumstances warrant) discussions with, issuers, servicers, trustees and other transaction participants. Reviews of asset-backed transactions often include servicer audits, site visits or evaluations by third-party appraisers, engineers or other experts retained by FSA. The Transaction Oversight Departments review transactions to determine the level of ongoing attention

19

required. These judgments relate to current credit quality and other factors, including compliance with reporting or other requirements, legal or regulatory actions involving transaction participants and liquidity or other concerns that may not have a direct bearing on credit quality. Transactions with the highest risk profile are generally subject to more intensive review and, if appropriate, remedial action. The Transaction Oversight Departments and TSC work together with the Legal Department and the Corporate Research Department in monitoring these transactions, negotiating restructurings and pursuing appropriate legal remedies.

        The Company's Transaction Oversight Departments categorize all credits by risk of loss to facilitate appropriate allocation of resources to loss mitigation efforts and to efficiently communicate the relative credit condition of any risk exposure, as well as the overall health of the insured portfolio. Each risk in the insured portfolio is designated one of five surveillance rating categories.

        Categories I and II represent fundamentally sound transactions requiring routine monitoring. Category III represents transactions with a material deterioration in asset performance, financial health of the issuer, or other factors, but for which losses are deemed unlikely. Active monitoring and intervention is employed for Category III transactions.

        Category IV reflects transactions demonstrating sufficient deterioration to indicate that material credit losses are possible even though not yet probable. Category IV is the equivalent of "watch list" by banking industry standards.

        Category V reflects transactions where losses are probable. This category includes (1) risks where claim payments have been made and where additional payments, net of recoveries are expected, and (2) risks where claim payments are probable but none have yet been made. Category V and Category IV transactions are subject to intense monitoring and intervention.

        The table below presents the gross and net par outstanding and the gross and net reserves for risks classified as Category IV and V, as described above, as of December 31, 2004 and 2003.

Par Outstanding

Case Basis Loss Reserves

20

        The decrease in Category V reserves with no claims in 2004 compared to 2003 was due primarily to the payment of a large claim for $34.3 million and a refinancing resulting in a reclassification of $5.5 million from reserves to an asset valuation account applied to the underlying collateral acquired in connection with the refinancing. These decreases were partially offset by reassumption of previously ceded business.

        The increase in Category V reserves with previous claim payments in 2004 compared to 2003 was primarily related to the deterioration of a municipal transaction.

Legal

        The Company's Legal Department is comprised of a professional staff of attorneys and legal assistants under the direction of the General Counsel. The Company's Legal Department is divided into four sectors (asset-backed transactions, municipal transactions, regulatory/reinsurance/corporate and compliance). The Legal Department plays a major role in establishing and implementing legal requirements and procedures applicable to obligations insured by the Company. Members of the Legal Department serve on the MRC and MUNC, which provide final underwriting approval for transactions. An attorney in the Legal Department works together with a counterpart in the financial guaranty department in determining the legal and credit elements of each obligation proposed for insurance and in overseeing the execution of approved transactions. Asset-backed obligations insured by the Company are ordinarily executed with the assistance of outside counsel working closely with the Legal Department. Municipal obligations insured by the Company are ordinarily executed without employment of outside counsel. The Legal Department works closely with the transaction oversight and transaction services functions in addressing legal issues, rights and remedies, as well as proposed amendments, waivers and consents, in connection with obligations insured by the Company. The Legal Department is also responsible for domestic and international regulatory compliance, reinsurance, secondary market transactions, litigation and other matters. The Chief Compliance Officer is a member of the Legal Department responsible for preparing quarterly compliance activity reports provided to the Audit Committee of the Board of Directors of the Company.

Competition and Industry Concentration

        FSA faces competition from both other providers of and alternatives to third-party credit enhancement. Most securities are sold without third-party credit enhancement. Accordingly, each transaction FSA proposes to insure must generally compete against an alternative execution that does not employ third-party credit enhancement. FSA faces competition from other Triple-A rated monoline financial guaranty insurers, primarily Ambac Assurance Corp. ("Ambac"), Financial Guaranty Insurance Company ("FGIC"), MBIA Insurance Corp. ("MBIA"), XL Capital Assurance Inc. ("XLCA") and CDC-IXIS Financial Guaranty ("CIFG"). Although FGIC formerly limited its business primarily to underwriting certain categories of municipal risks, since its change in control in December 2003 FGIC has competed more broadly in asset-backed and municipal sectors it had not previously serviced. Competition is largely based on premium rates, capacity, underwriting requirements and trading levels.

        New entrants to the market provide increasing competition to more established market participants such as FSA as they attempt to grow their market share. Assured Guaranty Corp. and Radian Asset Assurance Inc., two market participants previously engaged primarily in reinsurance, either directly or through affiliates, recently increased their focus on the primary financial guaranty insurance market. In addition, DEPFA Bank, plc,, an Irish bank, has announced its intention to establish a monoline financial guaranty insurer to compete in the U.S. public finance market. The Company understands that other parties are considering establishing new financial guaranty insurers that may compete with it.

        Traditional credit enhancers such as bank letter of credit providers and mortgage pool insurers provide competition to FSA as providers of credit enhancement for asset-backed obligations. Actions by securities rating agencies in recent years have significantly reduced the number of Triple-A rated financial

21

institutions that can offer a product directly competitive with FSA's Triple-A guaranty and risk-based capital guidelines applicable to banks have generally increased costs associated with letters of credit that compete directly with financial guaranty insurance. Nonetheless, bank sponsored commercial paper conduits, bank letter of credit providers and other credit enhancement, such as cash collateral accounts provided by banks, continue to provide significant competition to FSA. In addition, CDS, credit-linked notes and other synthetic products provide coverage directly competitive with financial guaranty insurance, and expand the universe of participants in the financial risk market. Bank affiliates may participate in the U.S. insurance business, including the financial guaranty insurance business.

        Government sponsored entities, including Fannie Mae and Freddie Mac, compete with the monoline financial guaranty insurers, on a limited basis, in the mortgage-backed and multifamily sectors. Expansion of the business franchises by government sponsored entities, as well as potential new entrants into the financial guaranty sector such as Federal Home Loan Banks and state pension funds, present competitive challenges to private sector participants such as FSA.

        Insurance law generally restricts multiline insurance companies, such as large property/casualty insurers and life insurers, from engaging in the financial guaranty insurance business other than through separately capitalized affiliates. Entry requirements include:

•

assembling the group of experts required to operate a financial guaranty insurance business,



•

establishing claims-paying ability ratings with the credit rating agencies,



•

complying with substantial capital requirements,



•

developing name recognition and market acceptance with issuers, investment bankers and investors, and



•

organizing a monoline insurance company and obtaining insurance licenses to do business in the applicable jurisdictions.

        FSA's net insurance in force is the outstanding principal, interest and other amounts payable over the remaining life of all obligations insured by FSA, net of ceded reinsurance and refunded bonds secured by U.S. government securities held in escrow or other qualifying collateral. Qualified statutory capital, determined in accordance with statutory accounting practices, is the aggregate of policyholders' surplus and contingency reserves calculated in accordance with statutory accounting practices.

        In December 2004, FSA obtained CDS protection on an excess of loss basis (exceeding very large deductibles) providing approximately $17 billion of credit protection on a number of FSA-insured synthethic CDO transactions shadow rated "super-triple A" at inception. Given the high credit quality of the risk transferred to the CDS provider, the main effects of this CDS were to improve FSA's statutory capital ratios and increase FSA's margin under regulatory risk limits on aggregate insured exposures.

        Set forth below are FSA's aggregate gross insurance in force, net insurance in force, qualified statutory capital and capital ratio (represented by the ratio of its net insurance in force to qualified statutory capital) and the average industry capital ratio at the dates indicated. Net insurance data does not distinguish between quota share reinsurance and first-loss reinsurance. In light of FSA's use of first-loss reinsurance in the asset-backed and project finance sector, the data below tends to overstate FSA's risk leverage in comparison with its industry counterparts. Conversely, FSA also insures mezzanine risks and obtains excess-of-loss credit protection in CDS transactions, which reduces FSA's reported risk leverage. The statutory capital ratio does not reflect the underlying credit quality of the insurance in force, which diminishes the comparative value of the disclosure. Specifically, the credit quality of FSA's insured portfolio as measured by S&P and Moody's is generally higher than most of FSA's industry peers, although

22

FSA's ratio of net debt service to statutory capital is also generally higher than most of FSA's industry peers.

(1)

Financial guaranty primary insurers for which data is included in this table are Ambac, FGIC and MBIA. Information relating to the financial guaranty primary insurers is derived from data from statutory accounting financial information publicly available from each insurer at December 31, 2004, 2003 and 2002.

(2)

Includes gross and net insurance in force relating to FSA-insured GICs issued by the GIC Subsidiaries of $8,753 for 2004, $5,708 million for 2003 and $3,199 million for 2002.

Reinsurance

        Reinsurance is the commitment by one insurance company, the "reinsurer," to reimburse another insurance company, the "ceding company," for a specified portion of the insurance risks underwritten by the ceding company in consideration for a portion of the premiums received. The ceding company typically but not always receives a ceding commission to cover the costs of business generation. Because the insured party contracts for coverage solely with the ceding company, the failure of the reinsurer to perform does not relieve the ceding company of its obligation to the insured party under the terms of the insurance contract.

        At December 31, 2004, FSA reinsured approximately 27% of its principal amount outstanding. FSA obtains reinsurance to increase its policy writing capacity, both on an aggregate-risk and a single-risk basis, to:

•

meet internal, rating agency and regulatory limits,



•

diversify risks,



•

reduce the need for additional capital, and



•

strengthen financial ratios.

        FSA's reinsurance may be on a quota share, first-loss, or excess of loss basis. Quota share reinsurance generally provides protection against a fixed specified percentage of all losses incurred by FSA. First-loss reinsurance generally provides protection against a fixed specified percentage of losses incurred up to a specified limit. Excess of loss reinsurance generally provides protection against a fixed percentage of losses incurred to the extent that losses incurred exceed a specified limit. Reinsurance arrangements typically require FSA to retain a minimum portion of the risks reinsured.

        FSA arranges reinsurance on both a facultative (transaction-by-transaction) and treaty basis. Treaty reinsurance provides coverage for a portion of the exposure from all qualifying policies issued during the term of the treaty. In addition, FSA employs "automatic facultative" reinsurance that permits FSA to apply reinsurance to transactions it selects subject to certain limitations. The reinsurer's participation in a treaty

23

is either cancelable annually upon 90 days' prior notice by either FSA or the reinsurer or has a one-year term. Treaties generally provide coverage for the full term of the policies reinsured during the annual treaty period, except that, upon a financial deterioration of the reinsurer and the occurrence of certain other events, FSA generally has the right to reassume all or a portion of the business reinsured. Reinsurance agreements may be subject to other termination conditions as required by applicable state law.

        Primary insurers, such as FSA, are required to fulfill their obligations to policyholders if reinsurers fail to meet their obligations. The financial condition of reinsurers is important to FSA, and FSA endeavors to place its reinsurance with financially strong reinsurers. FSA's treaty reinsurers at December 31, 2004 were Assured Guaranty Re International Ltd. (formerly ACE Capital Re International Ltd.), Assured Guaranty Corp. (formerly ACE Guaranty Corp.), Radian Asset Reinsurance Inc. (successor to Radian Reinsurance Inc., formerly Enhance Reinsurance Company), RAM Reinsurance Co. Ltd., Swiss Reinsurance America Corporation, Tokio Marine and XLFA.

        Securities rating agencies allow FSA "credit" for reinsurance based on the reinsurer's ratings. Generally, 95-100% credit is allowed for Triple-A reinsurance and 65-90% credit is allowed for Double-A reinsurance. In recent years, a number of FSA's reinsurers have been downgraded from Triple-A to Double-A or lower by one or more rating agencies. While ceding commissions or premium allocation adjustments may compensate in part for such downgrades, the effect of such downgrades, in general, is to decrease the financial benefits of using reinsurance under rating agency capital adequacy models.

        In 2004, the New York Insurance Law was amended to allow financial guaranty insurers such as FSA to treat qualifying CDS from highly rated financial institutions as collateral for purposes of satisfying risk limits and certain reserve requirements. The effect of these amendments is to make credit defaults swaps an alternative to reinsurance. In December 2004, FSA entered into its first CDS permitted by the new legislation, obtaining approximately $17 billion of credit protection on an excess of loss basis on certain insured synthetic CDOs.

        FSA, FSAIC and FSA International are party to a quota share reinsurance pooling agreement pursuant to which, after reinsurance cessions to other reinsurers, the FSA companies share in the net retained risk insured by each of these companies. Under the pooling agreement, FSA, FSAIC and FSA International share the net retained risk in proportion to their policyholders' surplus and contingency reserves ("Statutory Capital") at the end of the prior calendar quarter. FSA-UK and FSA are party to a quota share and stop loss reinsurance agreement pursuant to which:

•

FSA-UK reinsures with FSA its retention under its policies after third party reinsurance based on an agreed-upon percentage that is substantially in proportion to the Statutory Capital of FSA-UK to the total Statutory Capital of FSA and its subsidiary insurers (including FSA-UK); and



•

subject to certain limits, FSA is required to make payments to FSA-UK when FSA-UK's annual net incurred losses and expenses exceeds FSA-UK's annual net earned premiums plus draws on FSA-UK's equalization reserves to pay incurred losses.

        Under this agreement, FSA-UK ceded to FSA approximately 99% of its retention after third party reinsurance of its policies issued in 2004.

Rating Agencies

        The value of FSA's insurance product is generally a function of the "rating" applied to the obligations it insures. The financial strength of FSA and its insurance company subsidiaries is rated "Aaa" by Moody's and "AAA" by S&P, Fitch Ratings and Rating and Investment Information, Inc. Such ratings reflect only the views of the respective rating agencies, are not recommendations to buy, sell or hold securities and are subject to revision or withdrawal at any time by such rating agencies.

24

        These rating agencies periodically review FSA's business and financial condition, focusing on the insurer's underwriting policies and procedures and the quality of the obligations insured, and publish their ratings and supporting analyses. Each rating agency performs periodic assessments of the credits insured by FSA, as well as the reinsurers and other providers of capital support to FSA, to confirm that FSA continues to satisfy such rating agency's capital adequacy criteria necessary to maintain FSA's Triple-A rating. FSA's ability to compete with other Triple-A rated financial guarantors, and its results of operations and financial condition, would be materially adversely affected by any reduction in its ratings.

        Moody's and S&P apply their own capital adequacy models in assessing the financial strength of FSA. Financial factors considered by the rating agencies in assessing capital adequacy include:

•

capital charges or other assessments of credit risks for FSA's insured portfolio, including the degree of risk embedded in FSA-insured GICs;



•

the quality of FSA's investment portfolio;



•

the credit quality of FSA's reinsurers and the type of reinsurance provided thereby;



•

credit lines and other capital support arrangements ("soft capital");



•

premium revenues expected to be generated from outstanding policies; and



•

anticipated future new business originations and anticipated future losses.

        Given the importance of its ratings to its on-going business, FSA's underwriting process generally includes an analysis of the impact on rating agency capital adequacy determinations in addition to other measures of creditworthiness. Reference is made to the published reports of Moody's, S&P and Fitch Ratings regarding the Company, capital adequacy models, the bond insurance business in general and FSA's standing relative to its industry peers on the basis of capital adequacy and profitability.

Insurance Regulatory Matters

General

        FSA is licensed to engage in insurance business in all 50 states, the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands. FSA is subject to the insurance laws of the State of New York (the "New York Insurance Law"), and is also subject to the insurance laws of the other states in which it is licensed to transact insurance business. FSAIC is an Oklahoma domiciled insurance company also licensed in New York and subject to the New York Insurance Law. FSA and its domestic insurance company subsidiary are required to file quarterly and annual statutory financial statements in each jurisdiction in which they are licensed, and are subject to statutory restrictions concerning the types and quality of investments and the filing and use of policy forms and premium rates. FSA's accounts and operations are subject to periodic examination by the Superintendent of Insurance of the State of New York (the "New York Superintendent") and other state insurance regulatory authorities. The last completed examination was conducted in 2000 for the three-year period ended December 31, 1999. FSA's accounts are currently under examination for the three-year period ended December 31, 2002; the examination is complete subject to receipt of the final examination report.

        FSA International is a Bermuda domiciled insurance company subject to applicable requirements of Bermuda law. FSA International maintains its principal executive offices in Hamilton, Bermuda. FSA International does not intend to transact business or establish a permanent place of business in the United States or Europe. FSA-UK is a United Kingdom domiciled insurance company subject to applicable requirements of English law. FSA-UK maintains its principal executive offices in London, England. Pursuant to European Union Directives, FSA-UK is generally authorized to write business out of its London office in other member countries of the European Union subject to the satisfaction of perfunctory registration requirements. FSA has a Singapore branch authorized to transact insurance business in Singapore and subject to regulation by Singapore authorities.

25

Domestic Insurance Holding Company Laws

        The Company and its domestic insurance company subsidiaries (FSA and FSAIC) are subject to regulation under insurance holding company statutes of their jurisdiction of domicile (New York and Oklahoma, respectively), as well as other jurisdictions where these insurers are licensed to do insurance business. The requirements of holding company statutes vary from jurisdiction to jurisdiction but generally require insurance holding companies and their insurance company subsidiaries to register and file certain reports describing, among other information, their capital structure, ownership and financial condition. The holding company statutes also require prior approval of changes in control, certain dividends and other intercorporate transfers of assets and transactions between insurance companies and their affiliates. The holding company statutes generally require that all transactions with affiliates be fair and reasonable and that those exceeding specified limits require prior notice to or approval by insurance regulators.

        Under the insurance holding company laws in effect in New York and Oklahoma, any acquisition of control of the Company, and thereby indirect control of FSA and FSAIC, requires the prior approval of the New York Superintendent and the Oklahoma Insurance Commissioner. "Control" is defined as the direct or indirect power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract or otherwise. Any purchaser of 10% or more of the outstanding voting securities of a corporation is presumed to have acquired control of that corporation and its subsidiaries, although the insurance regulator may find that "control" in fact does or does not exist when a person owns or controls either a lesser or greater amount of voting securities.

New York Financial Guaranty Insurance Law

        Article 69 of the New York Insurance Law (as amended, "Article 69"), a comprehensive financial guaranty insurance statute, governs all financial guaranty insurers licensed to do business in New York, including FSA. This statute limits the business of financial guaranty insurers to financial guaranty insurance and related lines (such as surety).

        Article 69 requires that financial guaranty insurers maintain a special statutory accounting reserve called the "contingency reserve" to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. Article 69 requires a financial guaranty insurer to provide a contingency reserve:

•

with respect to policies written prior to July 1, 1989 in an amount equal to 50% of earned premiums; and



•

with respect to policies written on and after July 1, 1989, quarterly on a pro rata basis over a period of 20 years for municipal bonds and 15 years for all other obligations, in an amount equal to the greater of 50% of premiums written for the relevant category of insurance or a percentage of the principal guaranteed, varying from 0.55% to 2.50%, depending on the type of obligation guaranteed, until the contingency reserve amount for the category equals the applicable percentage of net unpaid principal.

        This reserve must be maintained for the periods specified above, except that reductions by the insurer may be permitted under specified circumstances in the event that actual loss experience exceeds certain thresholds or if the reserve accumulated is deemed excessive in relation to the insurer's outstanding insured obligations. FSA has in the past sought and obtained releases of excessive contingency reserves from the New York Insurance Department. Financial guaranty insurers are also required to maintain reserves for losses and loss adjustment expenses on a case-by-case basis and reserves against unearned premiums.

26

        Article 69 establishes single risk limits for financial guaranty insurers applicable to all obligations issued by a single entity and backed by a single revenue source. For example, under the limit applicable to qualifying asset-backed securities, the lesser of:

•

the insured average annual debt service for a single risk, net of qualifying reinsurance and collateral, or



•

the insured unpaid principal (reduced by the extent to which the unpaid principal of the supporting assets exceeds the insured unpaid principal) divided by nine, net of qualifying reinsurance and collateral

may not exceed 10% of the sum of the insurer's policyholders' surplus and contingency reserves, subject to certain conditions.

        Under the limit applicable to municipal obligations, the insured average annual debt service for a single risk, net of qualifying reinsurance and collateral, may not exceed 10% of the sum of the insurer's policyholders' surplus and contingency reserves. In addition, insured principal of municipal obligations attributable to any single risk, net of qualifying reinsurance and collateral, is limited to 75% of the insurer's policyholders' surplus and contingency reserves. Single risk limits are also specified for other categories of insured obligations, and generally are more restrictive than those listed for asset-backed or municipal obligations.

        Article 69 also establishes aggregate risk limits on the basis of aggregate net liability insured as compared to statutory capital. "Aggregate net liability" is defined as outstanding principal and interest of guaranteed obligations insured, net of qualifying reinsurance and collateral. Under these limits, policyholders' surplus and contingency reserves must not be less than a percentage of aggregate net liability equal to the sum of various percentages of aggregate net liability for various categories of specified obligations. The percentage varies from 0.33% for certain municipal obligations to 4% for certain non-investment grade obligations.

Dividend Restrictions

        FSA's ability to pay dividends is dependent on FSA's financial condition, results of operations, cash requirements, rating agency confirmation of non-impairment of FSA's ratings and other related factors, and is also subject to restrictions contained in the New York Insurance Law and other states. Under 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:

•

10% of policyholders' surplus as of its last statement filed with the New York Superintendent; or



•

adjusted net investment income during this period.

        Based on FSA's statutory statements for the year ended December 31, 2004, the maximum amount available for payment of dividends by FSA without regulatory approval over the following 12 months is approximately $84.5 million.

Financial Guaranty Insurance Regulation in Other Jurisdictions

        FSA is subject to laws and regulations of jurisdictions other than the State of New York concerning the transaction of financial guaranty insurance. The laws and regulations of these other jurisdictions are generally not more stringent in any material respect than the New York Insurance Law.

        The Bermuda Ministry of Finance regulates FSA International. The United Kingdom Financial Services Authority regulates FSA-UK. Pursuant to European Union Directives, FSA-UK has been authorized to provide financial guaranty insurance for transactions in numerous European countries from its home office in the United Kingdom. FSA has received a determination from the Australian Insurance and Superannuation Commissioner that the financial guaranties issued by FSA with respect to Australian

27

transactions do not constitute insurance for which a license is required. The Monetary Authority of Singapore regulates activities of FSA's Singapore branch. FSA is in the process of seeking branch licenses in Canada (and its respective provinces) and Japan.

U.S. Bank Holding Company Act

        Dexia indirectly owns approximately 99% of the Company's common stock, as described under "Item 1. Business—Organization." Because Dexia has non-U.S. bank subsidiaries with banking offices in the U.S., Dexia and all of its subsidiaries, including the Company and its subsidiaries, are subject to the U.S. Bank Holding Company Act (the "BHC Act"). In general, the BHC Act restricts the activities of banking organizations and their affiliates to the ownership and operation of banks and to other activities that are "closely related to banking" as determined by the Board of Governors of the Federal Reserve System (the "Federal Reserve"). Insurance activities such as those conducted by certain of the Company's subsidiaries are generally not permissible under this restriction. Under the BHC Act, however, an organization that qualifies as a "financial holding company" is permitted to engage in a broader range of permissible "financial activities." "Financial activities" include insurance underwriting and agency activities as well as merchant banking. For a non-U.S. organization to qualify as a "financial holding company," it, if it has a U.S. banking office, and each of its non-U.S. bank subsidiaries with a U.S. banking office, must be both:

•

"well-capitalized," which requires a Tier I to risk-based asset ratio of at least 6% and a total capital to risk-based asset ratio of at least 10%, as calculated under home country standards (Tier I, or core, capital includes equity capital less certain intangibles), and



•

"well-managed," which requires a composite U.S. banking office examination rating by the relevant U.S. bank regulator of at least "satisfactory."

        Dexia holds its investment in, and operates, the Company and its subsidiaries under, the "financial activities" authorization permitted to "financial holding companies."

Investments

        In addition to its insurance company assets and other investments (the "Investment Portfolio"), the Company maintains investments from proceeds of FSA-insured GICs (the "GIC Portfolio") and the portfolio of securities owned by the VIEs (the "VIE Portfolio").

Investment Portfolio

        Management's primary objective in managing the Investment Portfolio is generation of an optimal level of after-tax investment income while preserving capital and maintaining adequate liquidity subject to rating agency capital adequacy criteria that reduce credit for investments based on their ratings to the extent rated less than triple A. The Investment Portfolio is managed by unaffiliated professional investment managers and the Company's affiliate FSA Portfolio Management, which manages the majority of the municipal portfolio. The investment management function is overseen by the Investment Committee established by the Company's Board of Directors.

        To accomplish its objectives, the Company has established guidelines for eligible fixed income investments by FSA, requiring that at least 95% of such investments be rated at least Single-A at acquisition and the overall portfolio be rated Double-A on average. Fixed income investments falling below the minimum quality level are disposed of at such time as management deems appropriate. For liquidity purposes, the Company's policy is to invest in readily marketable investments with no legal or contractual restrictions on resale. Eligible fixed income investments include U.S. Treasury and agency obligations, corporate bonds, tax-exempt bonds, asset backed securities and mortgage-backed securities. The current investment strategy is to invest in quality, readily marketable instruments of intermediate average duration so as to generate stable investment earnings with minimal market value or credit risk.

28

        The Company also has investments in various strategic partners, including:

•

XLFA;



•

creditex, Inc, which operates an exchange for credit-derivative products;



•

TheDebtCenter, L.L.C., which operates TheMuniCenter, L.L.C., an online exchange for municipal bonds; and



•

SPS Holding Corp. ("SPS") (formerly Fairbanks Capital Holding Corp.), a residential mortgage loan servicer.

        The Company and the other owners of SPS have entered into a binding Summary of Terms relating to the potential sale to an unaffiliated third party of their respective interests in SPS pursuant to an option, exercisable on or before July 31, 2005. The sale is subject to several conditions, including, among other things, execution of definitive agreements. There is no assurance that the proposed transaction will be consummated.

        The weighted average maturity of the Company's Investment Portfolio at December 31, 2004 was approximately 7.0 years.

        The following tables set forth certain information concerning the investment portfolio of the Company:

Investment Portfolio by Rating
As of December 31, 2004(1)(3)

(1)

Ratings are based on the lower of Moody's or S&P ratings available at December 31, 2004. Without giving effect to the FSA guaranty referred to in Note 3 below, the weighted-average rating of the FSA-insured investments was in the A+ range, and all were investment grade.

(2)

Includes U.S. Treasury obligations, which comprised 4.5% of the portfolio at December 31, 2004.

(3)

12.9% of the portfolio was rated AAA by virtue of insurance provided by FSA.

Summary of Investments

(1)

Yields are stated on a pre-tax basis.

(2)

2004 total excludes the Company's equity investment in XLFA, which has a fair value of $54.3 million.

29

Investment Portfolio by Security Type

(1)

Yields are stated on a pre-tax basis.

(2)

2004 total excludes the Company's equity investment in XLFA, which has a fair value of $54.3 million.

Distribution of Investments by Contractual Maturity

(1)

2004 total excludes the Company's equity investment in XLFA, which has a fair value of $54.3 million.

30

Mortgage-Backed Securities
Cost and Market Value by Investment Category

        The Company's investments in mortgage-backed securities consisted of pass-through certificates and collateralized mortgage obligations ("CMOs"), which are backed by mortgage loans guaranteed or insured by agencies of, or sponsored by, the federal government. These securities are highly liquid with readily determinable market prices. The Company also held, at December 31, 2004, Triple-A rated CMOs which are not guaranteed by government agencies. Secondary market quotations are available for these securities, although they are not as liquid as government agency-backed securities.

        The CMOs held at December 31, 2004 have stated maturities ranging from 1 to 40 years and expected average lives ranging from 1 to 14 years based on anticipated prepayments of principal.

        Mortgage-backed securities differ from traditional fixed income bonds because they are subject to prepayments at par value without penalty at the borrower's option. Prepayment rates on mortgage-backed securities are influenced primarily by the general level of prevailing mortgage interest rates, with prepayments increasing when prevailing interest rates are lower than the rates on the underlying mortgages. When prepayments occur, the proceeds must be reinvested at then current market rates, which may be below the yield on the prepaid securities.

GIC Portfolio

        The following tables set forth certain information concerning the GIC Portfolio:

GIC Portfolio by Rating
As of December 31, 2004(1)(2)

(1)

Ratings are based on the lower of Moody's or S&P ratings available at December 31, 2004.

(2)

9.1% of the GIC Portfolio is rated AAA by virtue of insurance provided by FSA. Without giving effect to the FSA guaranty, the weighted-average rating of the FSA-insured investments was in the Double-A range, and all of these investments were investment grade.

31

Summary of GIC Portfolio

(1)

Yields are stated on a pre-tax basis. The weighted average yield presented is net of the effects of derivative instruments used to convert interest rates from fixed to floating rate.

Investment Portfolio by Security Type

(1)

Yields are stated on a pre-tax basis. The weighted average yield presented is net of the effects of derivative instruments used to convert interest rates from fixed to floating rates.

Distribution of Investments by Contractual Maturity