Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x

 

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended September 30, 2008

 

OR

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

transition Period from                                  to                                 

 

Commission File No. 001-32141

 

ASSURED GUARANTY LTD.

(Exact name of registrant as specified in its charter)

 

Bermuda

 

98-0429991

(State or other jurisdiction of incorporation)

 

(I.R.S. employer identification no.)

 

30 Woodbourne Avenue

Hamilton HM 08

Bermuda

(address of principal executive office)

 

(441) 299-9375

(Registrants telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

YES   x         NO   o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

(Do not check if a smaller reporting company)

 

Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

 

The number of registrant’s Common Shares ($0.01 par value) outstanding as of October 31, 2008 was 90,949,662.

 

 

 



Table of Contents

 

ASSURED GUARANTY LTD.

 

INDEX TO FORM 10-Q

 

 

 

 

Page

PART I. FINANCIAL INFORMATION

 

 

Item 1.

Financial Statements:

 

 

 

Consolidated Balance Sheets (unaudited) as of September 30, 2008 and December 31, 2007

 

3

 

Consolidated Statements of Operations and Comprehensive Income (unaudited) for the Three and Nine Months Ended September 30, 2008 and 2007

 

4

 

Consolidated Statements of Shareholders’ Equity (unaudited) for Nine Months Ended September 30, 2008

 

5

 

Consolidated Statements of Cash Flows (unaudited) for Nine Months Ended September 30, 2008 and 2007

 

6

 

Notes to Consolidated Financial Statements (unaudited)

 

7

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

52

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

107

Item 4.

Controls and Procedures

 

108

PART II. OTHER INFORMATION

 

 

Item 1.

Legal Proceedings

 

109

Item 1A.

Risk Factors

 

110

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

 

111

Item 6.

Exhibits

 

111

 

2



Table of Contents

 

PART I – FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

Assured Guaranty Ltd.

Consolidated Balance Sheets

(in thousands of U.S. dollars except per share and share amounts)

(Unaudited)

 

 

 

September 30,

 

December 31,

 

 

 

2008

 

2007

 

Assets

 

 

 

 

 

Fixed maturity securities, at fair value (amortized cost: $3,273,225 in 2008 and $2,526,889 in 2007)

 

$

3,160,606

 

$

2,586,954

 

Short-term investments, at cost which approximates fair value

 

370,071

 

552,938

 

Total investments

 

3,530,677

 

3,139,892

 

Cash and cash equivalents

 

7,864

 

8,048

 

Accrued investment income

 

36,393

 

26,503

 

Deferred acquisition costs

 

292,121

 

259,298

 

Prepaid reinsurance premiums

 

19,934

 

13,530

 

Reinsurance recoverable on ceded losses

 

6,074

 

8,849

 

Premiums receivable

 

51,866

 

27,802

 

Goodwill

 

85,417

 

85,417

 

Credit derivative assets

 

179,979

 

5,474

 

Deferred income taxes

 

82,317

 

147,563

 

Current income taxes receivable

 

19,297

 

 

Salvage recoverable

 

38,035

 

8,540

 

Committed capital securities, at fair value

 

32,635

 

8,316

 

Receivables for securities sold

 

38,086

 

2,864

 

Other assets

 

21,989

 

20,838

 

Total assets

 

$

4,442,684

 

$

3,762,934

 

Liabilities and shareholders’ equity

 

 

 

 

 

Liabilities

 

 

 

 

 

Unearned premium reserves

 

$

1,231,842

 

$

887,171

 

Reserves for losses and loss adjustment expenses

 

165,943

 

125,550

 

Profit commissions payable

 

8,984

 

22,332

 

Reinsurance balances payable

 

9,890

 

3,276

 

Current income taxes payable

 

 

635

 

Funds held by Company under reinsurance contracts

 

29,490

 

25,354

 

Credit derivative liabilities

 

465,942

 

623,118

 

Senior Notes

 

197,434

 

197,408

 

Series A Enhanced Junior Subordinated Debentures

 

149,760

 

149,738

 

Payables for securities purchased

 

21,893

 

899

 

Other liabilities

 

71,558

 

60,883

 

Total liabilities

 

2,352,736

 

2,096,364

 

Commitments and contingencies

 

 

 

 

 

Shareholders’ equity

 

 

 

 

 

Common stock ($0.01 par value, 500,000,000 shares authorized; 90,948,625 and 79,948,979 shares issued and outstanding in 2008 and 2007)

 

909

 

799

 

Additional paid-in capital

 

1,281,958

 

1,023,886

 

Retained earnings

 

885,978

 

585,256

 

Accumulated other comprehensive (loss) income

 

(78,897

)

56,629

 

Total shareholders’ equity

 

2,089,948

 

1,666,570

 

Total liabilities and shareholders’ equity

 

$

4,442,684

 

$

3,762,934

 

 

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

 

3



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Assured Guaranty Ltd.

Consolidated Statements of Operations and Comprehensive Income

(in thousands of U.S. dollars except per share amounts)

(Unaudited)

 

 

 

Three Months Ended 
September 30,

 

Nine Months Ended 
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Revenues

 

 

 

 

 

 

 

 

 

Gross written premiums

 

$

112,815

 

$

68,487

 

$

534,393

 

$

195,411

 

Ceded premiums

 

(1,328

)

(8,069

)

(12,545

)

(15,138

)

Net written premiums

 

111,487

 

60,418

 

521,848

 

180,273

 

Increase in net unearned premium reserves

 

(25,971

)

(21,810

)

(337,814

)

(66,631

)

Net earned premiums

 

85,516

 

38,608

 

184,034

 

113,642

 

Net investment income

 

43,441

 

31,846

 

120,247

 

94,188

 

Net realized investment losses

 

(20,031

)

(119

)

(17,951

)

(1,938

)

Change in fair value of credit derivatives

 

 

 

 

 

 

 

 

 

Realized gains and other settlements on credit derivatives

 

29,960

 

17,751

 

89,370

 

52,116

 

Unrealized (losses) gains on credit derivatives

 

(116,247

)

(222,738

)

332,634

 

(250,929

)

Net change in fair value of credit derivatives

 

(86,287

)

(204,987

)

422,004

 

(198,813

)

Other income

 

7,171

 

370

 

24,756

 

370

 

Total revenues

 

29,810

 

(134,282

)

733,090

 

7,449

 

Expenses

 

 

 

 

 

 

 

 

 

Loss and loss adjustment expenses (recoveries)

 

82,542

 

1,990

 

175,805

 

(11,791

)

Profit commission expense

 

(1,444

)

1,140

 

758

 

3,622

 

Acquisition costs

 

19,296

 

10,390

 

43,004

 

32,116

 

Other operating expenses

 

21,609

 

19,853

 

69,912

 

59,387

 

Interest expense

 

5,821

 

5,856

 

17,462

 

17,709

 

Other expense

 

1,524

 

620

 

3,974

 

1,872

 

Total expenses

 

129,348

 

39,849

 

310,915

 

102,915

 

(Loss) income before (benefit) provision for income taxes

 

(99,538

)

(174,131

)

422,175

 

(95,466

)

(Benefit) provision for income taxes

 

 

 

 

 

 

 

 

 

Current

 

(13,092

)

2,666

 

4,233

 

7,789

 

Deferred

 

(23,106

)

(61,839

)

105,275

 

(60,053

)

Total (benefit) provision for income taxes

 

(36,198

)

(59,173

)

109,508

 

(52,264

)

Net (loss) income

 

(63,340

)

(114,958

)

312,667

 

(43,202

)

Other comprehensive (loss) income, net of taxes

 

 

 

 

 

 

 

 

 

Unrealized holding (losses) gains on fixed maturity securities arising during the year

 

(104,137

)

25,241

 

(150,323

)

(9,302

)

Reclassification adjustment for realized losses included in net (loss) income

 

17,146

 

243

 

15,857

 

1,732

 

Change in net unrealized (losses) gains on fixed maturity securities

 

(86,991

)

25,484

 

(134,466

)

(7,570

)

Change in cumulative translation adjustment

 

(645

)

204

 

(746

)

589

 

Cash flow hedge

 

(105

)

(105

)

(314

)

(314

)

Other comprehensive (loss) income, net of taxes

 

(87,741

)

25,583

 

(135,526

)

(7,295

)

Comprehensive (loss) income

 

$

(151,081

)

$

(89,375

)

$

177,141

 

$

(50,497

)

(Loss) earnings per share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.70

)

$

(1.70

)

$

3.59

 

$

(0.64

)

Diluted

 

$

(0.70

)

$

(1.70

)

$

3.55

 

$

(0.64

)

Dividends per share

 

$

0.045

 

$

0.04

 

$

0.135

 

$

0.12

 

 

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

 

4



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Assured Guaranty Ltd.

Consolidated Statements of Shareholders’ Equity

For Nine Months Ended September 30, 2008

(in thousands of U.S. dollars except per share amounts)

(Unaudited)

 

 

 

Common
Stock

 

Additional
Paid-in
Capital

 

Retained
Earnings

 

Accumulated
Other
Comprehensive
Income (Loss)

 

Total
Shareholders’
Equity

 

Balance, December 31, 2007

 

$

799

 

$

1,023,886

 

$

585,256

 

$

56,629

 

$

1,666,570

 

Net income

 

 

 

312,667

 

 

312,667

 

Dividends ($0.135 per share)

 

 

 

(11,892

)

 

(11,892

)

Dividends on restricted stock units

 

 

53

 

(53

)

 

 

Common stock issuance, net of offering costs

 

107

 

248,948

 

 

 

249,055

 

Shares cancelled to pay withholding taxes

 

(2

)

(4,433

)

 

 

(4,435

)

Stock options exercises

 

 

342

 

 

 

342

 

Tax benefit for stock options exercised

 

 

16

 

 

 

16

 

Shares issued under ESPP

 

 

377

 

 

 

377

 

Share-based compensation and other

 

5

 

12,769

 

 

 

12,774

 

Change in cash flow hedge, net of tax of $(169)

 

 

 

 

(314

)

(314

)

Change in cumulative translation adjustment

 

 

 

 

(746

)

(746

)

Unrealized loss on fixed maturity securities, net of tax of $(38,218)

 

 

 

 

(134,466

)

(134,466

)

Balance, September 30, 2008

 

$

909

 

$

1,281,958

 

$

885,978

 

$

(78,897

)

$

2,089,948

 

 

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

 

5



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Assured Guaranty Ltd.

Consolidated Statements of Cash Flows

(in thousands of U.S. dollars)

(Unaudited)

 

 

 

Nine Months Ended 
September 30,

 

 

 

2008

 

2007

 

Operating activities

 

 

 

 

 

Net income (loss)

 

$

312,667

 

$

(43,202

)

Adjustments to reconcile net income (loss) to net cash flows provided by operating activities:

 

 

 

 

 

Non-cash interest and operating expenses

 

13,647

 

16,892

 

Net amortization of premium on fixed maturity securities

 

2,400

 

2,281

 

Provision (benefit) for deferred income taxes

 

105,275

 

(60,053

)

Net realized investment losses

 

17,951

 

1,938

 

Unrealized (gains) losses on credit derivatives

 

(351,535

)

247,902

 

Fair value gain on committed capital securities

 

(24,319

)

 

Change in deferred acquisition costs

 

(32,823

)

(10,484

)

Change in accrued investment income

 

(9,890

)

(1,488

)

Change in premiums receivable

 

(24,064

)

4,992

 

Change in prepaid reinsurance premiums

 

(6,404

)

(9,430

)

Change in unearned premium reserves

 

344,671

 

76,349

 

Change in reserves for losses and loss adjustment expenses, net

 

20,287

 

(2,262

)

Change in profit commissions payable

 

(13,348

)

(16,811

)

Change in funds held by Company under reinsurance contracts

 

4,136

 

3,585

 

Change in current income taxes

 

(19,916

)

(2,606

)

Tax benefit for stock options exercised

 

(16

)

(142

)

Other changes in credit derivatives assets and liabilities, net

 

19,854

 

677

 

Other

 

11,348

 

(20,770

)

Net cash flows provided by operating activities

 

369,921

 

187,368

 

 

 

 

 

 

 

Investing activities

 

 

 

 

 

Fixed maturity securities:

 

 

 

 

 

Purchases

 

(1,196,917

)

(785,252

)

Sales

 

401,854

 

626,955

 

Maturities

 

6,350

 

23,224

 

Sales (purchases) of short-term investments, net

 

185,690

 

(17,842

)

Net cash flows used in investing activities

 

(603,023

)

(152,915

)

 

 

 

 

 

 

Financing activities

 

 

 

 

 

Net proceeds from common stock issuance

 

248,971

 

 

Dividends paid

 

(11,892

)

(8,279

)

Share activity under option and incentive plans

 

(3,664

)

(2,508

)

Tax benefit for stock options exercised

 

16

 

142

 

Debt issue costs

 

 

(425

)

Repurchases of common stock

 

 

(3,748

)

Net cash flows provided by (used in) financing activities

 

233,431

 

(14,818

)

Effect of exchange rate changes

 

(513

)

802

 

(Decrease) increase in cash and cash equivalents

 

(184

)

20,437

 

Cash and cash equivalents at beginning of period

 

8,048

 

4,785

 

Cash and cash equivalents at end of period

 

$

7,864

 

$

25,222

 

 

 

 

 

 

 

Supplementary cash flow information

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Income taxes

 

$

20,700

 

$

20,551

 

Interest

 

$

11,800

 

$

11,877

 

 

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

 

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Assured Guaranty Ltd.
Notes to Consolidated Financial Statements

September 30, 2008

(Unaudited)

 

1.  Business and Organization

 

Assured Guaranty Ltd. (the “Company”) is a Bermuda-based holding company which provides, through its operating subsidiaries, credit enhancement products to the public finance, structured finance and mortgage markets. Credit enhancement products are financial guarantees or other types of support, including credit derivatives, that improve the credit of underlying debt obligations. The Company issues policies in both financial guaranty and credit derivative form. Assured Guaranty Ltd. applies its credit expertise, risk management skills and capital markets experience to develop insurance, reinsurance and derivative products that meet the credit enhancement needs of its customers. Under a reinsurance agreement, the reinsurer, in consideration of a premium paid to it, agrees to indemnify another insurer, called the ceding company, for part or all of the liability of the ceding company under one or more insurance policies that the ceding company has issued. A derivative is a financial instrument whose characteristics and value depend upon the characteristics and value of an underlying security. Assured Guaranty Ltd. markets its products directly to and through financial institutions, serving the U.S. and international markets. Assured Guaranty Ltd.’s financial results include four principal business segments: financial guaranty direct, financial guaranty reinsurance, mortgage guaranty and other. These segments are further discussed in Note 13.

 

Financial guaranty insurance provides an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due. Financial guaranty insurance may be issued to the holders of the insured obligations at the time of issuance of those obligations, or may be issued in the secondary market to holders of public bonds and structured securities. A loss event occurs upon existing or anticipated credit deterioration, while a payment under a policy occurs when the insured obligation defaults. This requires the Company to pay the required principal and interest when due in accordance with the underlying contract. The principal types of obligations covered by the Company’s financial guaranty direct and financial guaranty assumed reinsurance businesses are structured finance obligations and public finance obligations. Because both businesses involve similar risks, the Company analyzes and monitors its financial guaranty direct portfolio and financial guaranty assumed reinsurance portfolio on a unified process and procedure basis.

 

Mortgage guaranty insurance is a specialized class of credit insurance that provides protection to mortgage lending institutions against the default of borrowers on mortgage loans that, at the time of the advance, had a loan to value in excess of a specified ratio. Reinsurance in the mortgage guaranty insurance industry is used to increase the insurance capacity of the ceding company, to assist the ceding company in meeting applicable regulatory and rating agency requirements, to augment the financial strength of the ceding company, and to manage the ceding company’s risk profile. The Company provides mortgage guaranty protection on an excess of loss basis.

 

The Company has participated in several lines of business that are reflected in its historical financial statements but that the Company exited in connection with its 2004 initial public offering (“IPO”). The results from these lines of business are included in the Company’s Other segment discussed in Note 13.

 

On April 8, 2008, investment funds managed by WL Ross & Co. LLC (“WL Ross”) purchased 10,651,896 shares of the Company’s common equity at a price of $23.47 per share, resulting in proceeds to the Company of $250.0 million. The Company contributed $150.0 million of these proceeds to its Bermuda domiciled reinsurance subsidiary, Assured Guaranty Re Ltd. (“AG Re”). In addition, the Company contributed $100.0 million of these proceeds to its subsidiary, Assured Guaranty US Holdings Inc., which in turn contributed the same amount to its Maryland domiciled insurance subsidiary, Assured Guaranty Corp. (“AGC”). The commitment to purchase these shares was previously announced on February 29, 2008. In addition, Wilbur L. Ross, Jr., President and Chief Executive Officer of WL Ross, was appointed to the Board of Directors of the Company to serve a term expiring at the Company’s 2009 annual general meeting of shareholders. Mr. Ross’s appointment became effective immediately following the Company’s 2008 annual general meeting of shareholders, which was held on May 8, 2008. WL Ross has a remaining commitment through April 8, 2009 to purchase up to $750.0 million of the Company’s common equity, at the Company’s option, subject to the terms and conditions of the investment agreement with the Company

 

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dated February 28, 2008. In accordance with the investment agreement, the Company may exercise this option in one or more drawdowns, subject to a minimum drawdown of $50 million, provided that the purchase price per common share for the subsequent shares is not greater than 17.5% above, or less than 17.5% below, the price per common share for the initial shares. The purchase price per common share for such shares will be equal to 97% of the volume weighted average price of a common share on the NYSE for the 15 NYSE trading days prior to the applicable drawdown notice. As of September 30, 2008, and as of the date of this filing, the purchase price per common share is outside of this range and therefore the Company may not, at this time, exercise its option for WL Ross to purchase additional shares. Additionally, in accordance with the investment agreement, at this time the  ratings of the Company’s operating subsidiaries, AGC and AG Re, are not “stable” (See Note 16) and therefore the Company may not exercise its option for WL Ross to purchase additional shares.

 

On September 16, 2008, the Company agreed to waive the standstill provisions of the investment agreement to permit investment funds managed by WL Ross (the “WL Ross Funds”) to purchase up to 5,000,000 additional common shares of the Company in open market transactions from time to time. The timing and amount of any such purchases are in the sole discretion of WL Ross and they are not obligated to purchase any such shares. The additional shares purchased by the WL Ross Funds, if any, will be purchased from current shareholders and therefore will not result in an increase in shareholders’ equity at the Company or its subsidiaries. If all 5,000,000 additional shares were purchased, the WL Ross Funds would beneficially own 17,166,396 shares or approximately 18.9% of the Company’s outstanding common shares based on shares outstanding as of September 30, 2008. As of the date of this filing, the Company has not been notified that WL Ross Funds purchased any additional shares of the Company.

 

The Company’s subsidiaries have been assigned the following insurance financial strength ratings:

 

 

 

Moody’s

 

S&P

 

Fitch

Assured Guaranty Corp.

 

Aaa(Exceptional)

 

AAA(Extremely Strong)

 

AAA(Extremely Strong)

Assured Guaranty Re Ltd.

 

Aa2(Excellent)

 

AA(Very Strong)

 

AA(Very Strong)

Assured Guaranty Re Overseas Ltd.

 

Aa2(Excellent)

 

AA(Very Strong)

 

AA(Very Strong)

Assured Guaranty Mortgage Insurance Company

 

Aa2(Excellent)

 

AA(Very Strong)

 

AA(Very Strong)

Assured Guaranty (UK) Ltd.

 

Aaa(Exceptional)

 

AAA(Extremely Strong)

 

AAA(Extremely Strong)

 

On July 21, 2008, Moody’s Investors Service (“Moody’s”) placed under review for possible downgrade the Aaa insurance financial strength ratings of Assured Guaranty Corp. and its wholly owned subsidiary, Assured Guaranty (UK) Ltd., as well as the Aa2 insurance financial strength ratings of Assured Guaranty Re Ltd. and its affiliated insurance operating companies. Moody’s has also placed under review for possible downgrade the Aa3 senior unsecured rating of parent company, Assured Guaranty US Holdings Inc. and the Aa3 issuer rating of the ultimate holding company, Assured Guaranty Ltd. The timing and outcome of the Moody’s review are uncertain. (See Note 16). As of the date of this filing, the Company’s rating outlook is categorized as stable from both S&P and Fitch.

 

2.  Basis of Presentation

 

The unaudited interim consolidated financial statements, which include the accounts of the Company, have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and, in the opinion of management, reflect all adjustments, which are of a normal recurring nature, necessary for a fair statement of the Company’s financial condition, results of operations and cash flows for the periods presented. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. These unaudited interim consolidated financial statements cover the three-month period ended September 30, 2008 (“Third Quarter 2008”),  the three-month period ended September 30, 2007 (“Third Quarter 2007”), the nine-month period ended September 30, 2008 (“Nine Months 2008”) and the nine-month period ended September 30, 2007 (“Nine Months 2007”). Operating results for the three- and nine-month periods ended September 30, 2008 are not necessarily indicative of the results that may be expected for a full year. These unaudited interim consolidated financial statements should be read in

 

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conjunction with the Company’s consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, filed with the Securities and Exchange Commission.

 

Certain of the Company’s subsidiaries are subject to U.S. and U.K. income tax. The provision for income taxes is calculated in accordance with Statement of Financial Accounting Standards (“FAS”) FAS No. 109, “Accounting for Income Taxes”. The Company’s provision for income taxes for interim financial periods is not based on an estimated annual effective rate due to the variability in changes in fair value of its credit derivatives, which prevents the Company from projecting a reliable estimated annual effective tax rate and pre-tax income for the full year of 2008. A discrete calculation of the provision is calculated for each interim period.

 

Reclassifications

 

Certain prior year items have been reclassified to conform to the current year presentation.

 

Effective with the quarter ended March 31, 2008, the Company reclassified the revenues, expenses and balance sheet items associated with financial guaranty contracts that the Company’s financial guaranty subsidiaries write in the form of credit default swap (“CDS”) contracts. The reclassification does not change the Company’s net income (loss) or shareholders’ equity. This reclassification is being adopted by the Company after agreement with member companies of the Association of Financial Guaranty Insurers in consultation with the staffs of the Office of the Chief Accountant and the Division of Corporate Finance of the Securities and Exchange Commission. The reclassification is being implemented in order to increase comparability of the Company’s financial statements with other financial guaranty companies that have CDS contracts.

 

In general, the Company structures credit derivative transactions such that the method for making loss payments is similar to that for financial guaranty policies and generally occurs as losses are realized on the underlying reference obligation. Nonetheless, credit derivative transactions are governed by International Swaps and Derivatives Association, Inc. (“ISDA”) documentation and operates differently from financial guaranty insurance policies. Under GAAP CDS contracts are subject to derivative accounting rules and financial guaranty policies are subject to insurance accounting rules.

 

In the accompanying unaudited interim consolidated statements of operations and comprehensive income, the Company has reclassified previously reported CDS revenues from “net earned premiums” to “realized gains and other settlements on credit derivatives.”  Loss and loss adjustment expenses and recoveries that were previously included in “loss and loss adjustment expenses (recoveries)” have been reclassified to “realized gains and other settlements on credit derivatives,” as well. Portfolio and case loss and loss adjustment expenses have been reclassified from “loss and loss adjustment expenses (recoveries)” and are included in “unrealized gains (losses) on credit derivatives,” which previously included only unrealized mark to market gains or losses on the Company’s contracts written in CDS form. In the consolidated balance sheet, the Company reclassified all CDS-related balances previously included in “unearned premium reserves,” “reserves for losses and loss adjustment expenses,” “prepaid reinsurance premiums,” “premiums receivable” and “reinsurance balances payable” to either “credit derivative liabilities” or “credit derivative assets,” depending on the net position of the CDS contract at each balance sheet date.

 

The effects of these reclassifications on the Company’s consolidated statements of operations and comprehensive income and cash flows for the three and nine months ended September 30, 2007 are as follows (dollars in thousands):

 

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Three Months Ended 
September 30, 2007

 

 

 

As previously
reported

 

As reclassified

 

Gross written premiums

 

$

89,347

 

$

68,487

 

Ceded premiums

 

(9,037

)

(8,069

)

Net written premiums

 

80,310

 

60,418

 

Increase in unearned premium reserves

 

(24,073

)

(21,810

)

Net earned premiums

 

56,237

 

38,608

 

Realized gains and other settlements on credit derivatives

 

 

17,751

 

Unrealized losses on derivative financial instruments

 

(220,965

)

 

Unrealized losses on credit derivatives

 

 

(222,738

)

Loss and loss adjustment expenses (recoveries)

 

3,734

 

1,990

 

Acquisition costs

 

10,297

 

10,390

 

Net loss

 

(114,958

)

(114,958

)

 

 

 

Nine Months Ended 
September 30, 2007

 

 

 

As previously
reported

 

As reclassified

 

Gross written premiums

 

$

250,717

 

$

195,411

 

Ceded premiums

 

(17,096

)

(15,138

)

Net written premiums

 

233,621

 

180,273

 

Increase in unearned premium reserves

 

(69,273

)

(66,631

)

Net earned premiums

 

164,348

 

113,642

 

Realized gains and other settlements on credit derivatives

 

 

52,116

 

Unrealized losses on derivative financial instruments

 

(247,902

)

 

Unrealized losses on credit derivatives

 

 

(250,929

)

Loss and loss adjustment expenses (recoveries)

 

(10,096

)

(11,791

)

Acquisition costs

 

32,038

 

32,116

 

Net loss

 

(43,202

)

(43,202

)

 

 

 

Nine Months Ended 
September 30, 2007

 

 

 

As previously
reported

 

As reclassified

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Change in unrealized losses on derivative financial instruments

 

$

247,902

 

$

 

Unrealized losses on credit derivatives

 

 

247,902

 

Other changes in credit derivative assets and liabilities, net

 

 

677

 

Change in premiums receivable

 

508

 

4,992

 

Change in prepaid reinsurance premiums

 

(9,926

)

(9,430

)

Change in unearned premium reserves

 

79,487

 

76,349

 

Change in reserves for losses and loss adjustment expenses, net

 

257

 

(2,262

)

Net cash provided by operating activities

 

187,368

 

187,368

 

 

These adjustments had no impact on net income (loss), comprehensive income (loss), earnings (loss) per share, cash flows or total shareholders’ equity.

 

3.  Recent Accounting Pronouncements

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued FAS No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value and

 

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expands disclosures about fair value measurements. FAS 157 applies to other accounting pronouncements that require or permit fair value measurements, since the FASB had previously concluded in those accounting pronouncements that fair value is the relevant measure. Accordingly, FAS 157 does not require any new fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company adopted FAS 157 effective January 1, 2008. See Note 14.

 

In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Liabilities” (“FAS 159”). FAS 159 allows entities to voluntarily choose, at specified election dates, to measure many financial assets and financial liabilities (as well as certain nonfinancial instruments that are similar to financial instruments) at fair value (the “fair value option”). The election is made on an instrument-by-instrument basis and is irrevocable. If the fair value option is elected for an instrument, FAS 159 specifies that all subsequent changes in fair value for that instrument shall be reported in the Statement of Operations and Comprehensive Income. FAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company adopted FAS 159 effective January 1, 2008. The Company did not apply the fair value option to any eligible items on its adoption date.

 

In April 2007, the FASB Staff issued FASB Staff Position No. FIN 39-1, “Amendment of FASB Interpretation No. 39” (“FSP FIN 39-1”), which permits companies to offset cash collateral receivables or payables with net derivative positions under certain circumstances. FSP FIN 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. FSP FIN 39-1 did not affect the Company’s results of operations or financial position.

 

In March 2008, the FASB issued FAS No. 161, “Disclosures About Derivative Instruments and Hedging Activities – An Amendment of FASB Statement No. 133” (“FAS 161”). FAS 161 establishes the disclosure requirements for derivative instruments and for hedging activities. FAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. Early application is encouraged. FAS 161 is not expected to have an impact on the Company’s current results of operations or financial position.

 

In May 2008, the FASB issued FAS No. 163, “Accounting for Financial Guarantee Insurance Contracts – An Interpretation of FASB Statement No. 60” (“FAS 163”). FAS 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. FAS 163 also clarifies the methodology to be used for financial guaranty premium revenue recognition and claim liability measurement, as well as requiring expanded disclosures about the insurance enterprise’s risk management activities. The provisions of FAS 163 related to premium revenue recognition and claim liability measurement are effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years. Earlier application of these provisions is not permitted. The expanded risk management activity disclosure provisions of FAS 163 are effective for the third quarter of 2008 and are included in Note 6 of these financial statements. FAS 163 will be applied to all existing and future financial guaranty insurance contracts written by the Company. The cumulative effect of initially applying FAS 163 will be recorded as an adjustment to retained earnings as of January 1, 2009. The adoption of FAS 163 is expected to have a material effect on the Company’s financial statements. The Company is in the process of estimating the impact of its adoption of FAS 163. The Company will continue to follow its existing accounting policies in regards to premium revenue recognition and claim liability measurement until it adopts FAS 163 on January 1, 2009.

 

In June 2008, the FASB issued FSP EITF 03-6-1, “Participating Securities and the Two-Class Method under FASB Statement No. 128” (“FSP”). The FSP addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and therefore need to be included in the earnings allocation in calculating earnings per share (“EPS”) under the two-class method described in FAS No. 128, “Earnings per Share.” The FSP requires companies to treat unvested share-based payment awards that have non-forfeitable rights to dividend or dividend equivalents as a separate class of securities in calculating earnings per share. The FSP is effective for fiscal years beginning after December 15, 2008; earlier application is not permitted. This FSP also requires that all prior period EPS data be adjusted retrospectively. The Company does not expect adoption of the FSP to have a material effect on its results of operations or earnings per share.

 

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On October 10, 2008, the FASB issued FASB Staff Position No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP 157-3”). FSP 157-3 clarified the application of FAS 157, “Fair Value Measurements”, in a market that is not active. FSP 157-3 was effective when issued. It did not have an impact on the Company’s current results of operations or financial position.

 

The FASB adopted FSP FAS 133-1, “Disclosures About Credit Derivatives and Certain Guarantees” and FAS 161, “Disclosures about Derivative Instruments and Hedging Activities” to address concerns that current derivative disclosure requirements did not adequately address the potential adverse effects that these instruments can have on the financial performance and operations of an entity. Companies will be required to provide enhanced disclosures about their derivative activities to enable users to better understand: (1) how and why a company uses derivatives, (2) how it accounts for derivatives and related hedged items, and (3) how derivatives affect its financial statements. These should include the terms of the derivatives, collateral posting requirements and triggers, and other significant provisions that could be detrimental to earnings or liquidity. Disclosures specific to credit derivatives must be included in the December 31, 2008 financial statements. Certain other derivative and hedging disclosures must be included in the Company’s March 31, 2009 Form 10-Q. Management believes that the Company’s current derivatives disclosures are in compliance with the items required by FSP 133-1 and FAS 161.

 

4.  Credit Derivatives

 

Credit derivatives issued by the Company, principally in the form of CDS contracts, have been deemed to meet the definition of a derivative under FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”), FAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“FAS 149”) and FAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“FAS 155”). FAS 133, FAS 149 and FAS 155 (which the Company adopted on January 1, 2007) establish accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. FAS 133 and FAS 149 require that an entity recognize all derivatives as either assets or liabilities in the consolidated balance sheets and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a fair value, cash flow or foreign currency hedge. FAS 155 requires companies to recognize freestanding or embedded derivatives relating to beneficial interests in securitized financial instruments. This recognition was not required prior to January 1, 2007. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. The Company had no derivatives that were designated as hedges during 2008 and 2007.

 

Realized gains and other settlements on credit derivatives include credit derivative premiums received and receivable for credit protection the Company has sold under its insured CDS as well as any contractual claim losses paid and payable related to insured credit events under these contracts, ceding commissions (expense) income and realized gains or losses related to their early termination. The Company generally holds credit derivative contracts to maturity. However, in certain circumstances such as for risk management purposes or as a result of a decision to exit a line of business, the Company may decide to terminate a credit derivative contract prior to maturity.

 

The following table disaggregates realized gains and other settlements on credit derivatives into its component parts for the three- and nine-month periods ended September 30, 2008 and 2007 (dollars in thousands):

 

 

 

Three Months Ended 
September 30,

 

Nine Months Ended 
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Realized gains and other settlements on credit derivatives

 

 

 

 

 

 

 

 

 

Net credit derivative premiums received and receivable

 

$

30,545

 

$

17,629

 

$

89,853

 

$

50,706

 

Net credit derivative losses recovered and recoverable

 

30

 

29

 

410

 

1,332

 

Ceding commissions (paid/payable) received/receivable, net

 

(615

)

93

 

(893

)

78

 

Total realized gains and other settlements on credit derivatives

 

$

29,960

 

$

17,751

 

$

89,370

 

$

52,116

 

 

Unrealized gains (losses) on credit derivatives represent the adjustments for changes in fair value that are

 

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recorded in each reporting period, under FAS 133. Changes in unrealized gains and losses on credit derivatives are reflected in the consolidated statements of operations and comprehensive income in unrealized gains (losses) on credit derivatives. Cumulative unrealized losses, determined on a contract by contract basis, are reflected as liabilities in the Company’s balance sheets. Cumulative unrealized gains, determined on a contract by contract basis, are reflected as assets. Unrealized gains and losses resulting from changes in the fair value of credit derivatives occur because of changes in interest rates, credit spreads, the credit ratings of the referenced entities and the issuing Company’s own credit rating and other market factors. The unrealized gains and losses on credit derivatives will reduce to zero as the exposure approaches its maturity date, unless there is a payment default on the exposure. Changes in the fair value of the Company’s credit derivative contracts do not reflect actual claims or credit losses, and have no impact on the Company’s claims paying resources, rating agency capital or regulatory capital positions.

 

The Company determines fair value of its credit derivative contracts primarily through modeling that uses various inputs such as credit spreads, based on observable market indices and on recent pricing for similar contracts, and expected contractual life to derive an estimate of the value of our contracts in our principal market (see Note 14). Credit spreads captures the impact of performance of underlying assets, among other factors, on these contracts. The Company’s pricing model takes into account not only how credit spreads on risks that it assumes affects pricing, but how the Company’s own credit spread affects the pricing of its deals. If credit spreads of the underlying obligations change, the fair value of the related credit derivative changes. Market liquidity could also impact valuations of the underlying obligations.

 

The impact of changes in credit spreads will vary based upon the volume, tenor, interest rates, and other market conditions at the time these fair values are determined. In addition, since each transaction has unique collateral and structure terms, the underlying change in fair value of each transaction may vary considerably. The fair value of credit derivative contracts also reflects the change in the Company’s own credit cost based on the price to purchase credit protection on AGC. During Third Quarter 2008 and Nine Months 2008, the Company incurred net pre-tax mark-to-market losses on credit derivative contracts of $(116.2) million and gains of $332.6 million, respectively. The Third Quarter loss includes a gain of $668.0 million associated with the change in AGC’s credit spread, which widened substantially from 900 basis points at June 30, 2008 to 1,255 basis points at September 30, 2008. Management believes that the widening of AGC’s credit spread is  due to the correlation between AGC’s risk profile and that experienced currently by the broader financial markets. Offsetting the gain attributable to the significant increase in AGC’s credit spread were declines in fixed income security market prices primarily attributable to widening spreads in certain markets as a result of the continued deterioration in credit markets and some credit rating downgrades, rather than from delinquencies or defaults on securities guaranteed by the Company. The higher credit spreads in the fixed income security market are due to the recent lack of liquidity in the high yield collateralized debt obligation and collateralized loan obligation markets as well as continuing market concerns over the most recent vintages of subprime residential mortgage backed securities.

 

The total notional amount of credit derivative exposure outstanding as of September 30, 2008 and December 31, 2007 and included in the Company’s financial guaranty exposure was $77.6 billion and $71.6 billion, respectively.

 

The components of the Company’s unrealized gain (loss) on credit derivatives as of September 30, 2008 are:

 

Asset Type

 

Net Par 
Outstanding
 (in billions)

 

Wtd. Avg. 
Credit Rating

 

3Q-08 Unrealized 
Gain (Loss) (in
 millions)

 

9 mos. 2008 
Unrealized Gain 
(Loss) (in millions)

 

Corporate collateralized loan obligations

 

$

26.6

 

AAA

 

$

(3.7

)

$

292.1

 

Market value CDOs of corporates

 

3.7

 

AAA

 

0.7

 

46.0

 

Trust preferred securities

 

6.3

 

AAA

 

11.4

 

69.8

 

Total pooled corporate obligations

 

36.6

 

AAA

 

8.4

 

408.0

 

Commercial mortgage-backed securities

 

5.9

 

AAA

 

0.7

 

79.3

 

Residential mortgage-backed securities

 

21.3

 

AA

 

(99.8

)

60.8

 

Other

 

10.6

 

AA+

 

(31.1

)

(201.1

)

Total

 

$

74.4

 

AA+

 

$

(121.8

)

$

347.0

 

Reinsurance exposures written in CDS form

 

3.2

 

AA+

 

5.6

 

(14.4

)

Grand Total

 

$

77.6

 

AA+

 

$

(116.2

)

$

332.6

 

 

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Corporate collateralized loan obligations, market value CDO’s, and trust preferred securities, which comprise the Company’s pooled corporate exposures, include all U.S. structured finance pooled corporate obligations and international pooled corporate obligations. Commercial mortgage-backed securities is comprised of commercial U.S. structured finance and commercial international mortgage backed securities. Residential mortgage-backed securities is comprised of prime and subprime U.S. mortgage-backed and home equity securities, international residential mortgage-backed and international home equity securities. Other includes all other U.S. and international asset classes, such as commercial receivables, and international infrastructure and pooled infrastructure securities.

 

The Company’s exposure to pooled corporate obligations is highly diversified in terms of obligors and industries.  Most pooled corporate transactions are structured to limit exposure to any given obligor and industry.  The majority of the Company's pooled corporate exposure in the direct segment consists of collateralized loan obligations (“CLOs”).  Most of these direct CLOs have an average obligor size of less than 1% and typically restrict the maximum exposure to any one industry to approximately 10%.  The Company's exposure also benefits from embedded credit enhancement in the transactions which allows it to sustain a certain level of losses in the underlying collateral, further insulating the Company from industry specific concentrations of credit risk on these deals.

 

The Company’s $10.6 billion exposure to Other CDS contracts is also highly diversified. It includes $5.0 billion of exposure to four pooled infrastructure deals comprised of diversified pools of international infrastructure project transactions and loans to regulated utilities. These pools were all structured with underlying enhancement sufficient for the Company to attach at super senior AAA levels. The remaining $5.6 billion of exposure in Other CDS contracts is comprised of numerous deals typically structured with significant underlying enhancement and spread across various asset classes, such as commercial receivables, infrastructure, regulated utilities and consumer receivables. Substantially all of this $10.6 billion of exposure is rated investment grade and the weighted average credit rating is AA+.

 

The Company’s exposure to the mortgage industry is discussed in Note 6.

 

The unrealized loss of $(31.1) million for the Third Quarter in the Other asset type is mainly due to widening spreads for a pooled infrastructure transaction and a wrapped film securitization transaction. The unrealized loss of $(201.1) million for Nine Months ended September 30, 2008 is primarily attributable to a change in the call date assumption and widening of spreads for a pooled infrastructure transaction during the Second Quarter 2008, that resulted in a unrealized loss of $(100.4) million, and a ratings downgrade on a wrapped film securitization transaction, that resulted in an unrealized loss of $(48.2) million. Other also includes management’s estimate of credit related impairments for the Company’s credit derivative exposures of $10.1 million and $18.9 million for the Third Quarter and Nine Months ended September 30, 2008, respectively. With considerable volatility continuing in the market, the fair value adjustment amount may fluctuate significantly in future periods.

 

The following table presents additional details about the Company’s unrealized gain on pooled corporate obligation credit derivatives, which includes collateralized loan obligations, market value CDOs and trust preferred securities, by asset type as of September 30, 2008:

 

Asset Type

 

Original
Subordination(2)

 

Current 
Subordination(2)

 

Net Par
Outstanding
(in billions)

 

Weighted Average
Credit Rating(1)

 

3Q-08 Unrealized
Gain (Loss) (in
millions)

 

9 mos. 2008
Unrealized Gain
(Loss) (in millions)

 

High yield corporates

 

36.3

%

34.3

%

$

23.5

 

AAA

 

$

(3.7

)

$

278.0

 

Trust preferred

 

46.2

%

43.2

%

6.3

 

AAA

 

11.4

 

69.8

 

Market value CDOs of corporates

 

41.6

%

37.5

%

3.7

 

AAA

 

0.7

 

46.0

 

Investment grade corporates

 

28.7

%

29.6

%

2.3

 

AAA

 

(0.6

)

6.2

 

Commercial real estate

 

49.0

%

48.9

%

0.8

 

AAA

 

0.1

 

7.5

 

CDO of CDOs (corporate)

 

1.7

%

5.1

%

0.1

 

AAA

 

0.5

 

0.4

 

Total

 

38.2

%

36.1

%

$

36.6

 

AAA

 

$

8.4

 

$

408.0

 

 


(1) Based on the Company’s internal rating, which is on a comparable scale to that of the nationally recognized rating agencies.

(2) Represents the sum of subordinate tranches and over-collateralization and does not include any benefit from excess interest collections that may be used to absorb losses.

 

The following table presents additional details about the Company’s unrealized gain on credit derivatives associated with commercial mortgage-backed securities by vintage as of September 30, 2008:

 

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Table of Contents

 

Vintage

 

Original 
Subordination(2)

 

Current 
Subordination(2)

 

Net Par 
Outstanding 
(in billions)

 

Weighted Average
 Credit Rating(1)

 

3Q-08 Unrealized 
Gain (Loss) (in 
millions)

 

9 mos. 2008 
Unrealized Gain 
(Loss) (in millions)

 

2004 and Prior

 

19.7

%

22.1

%

$

0.3

 

AAA

 

$

0.5

 

$

5.5

 

2005

 

27.6

%

28.6

%

3.4

 

AAA

 

0.4

 

50.9

 

2006

 

27.2

%

27.8

%

2.0

 

AAA

 

(0.1

)

20.6

 

2007

 

35.8

%

35.9

%

0.2

 

AAA

 

(0.1

)

2.4

 

2008

 

 

 

 

 

 

 

Total

 

27.4

%

28.3

%

$

5.9

 

AAA

 

$

0.7

 

$

79.3

 

 

The following tables present additional details about the Company’s unrealized gain on credit derivatives associated with residential mortgage-backed securities by vintage and asset type as of September 30, 2008:

 

 

 

Original 
Subordination(2)

 

Current 
Subordination(2)

 

Net Par 
Outstanding
 (in billions)

 

Weighted Average 
Credit Rating(1)

 

3Q-08 Unrealized 
Gain (Loss) (in
 millions)

 

9 mos. 2008
Unrealized Gain
(Loss) (in millions)

 

2004 and Prior

 

5.2

%

13.0

%

$

0.5

 

A+

 

$

(2.5

)

$

(8.8

)

2005

 

24.1

%

48.7

%

5.2

 

AA+

 

(7.2

)

71.4

 

2006

 

16.1

%

22.6

%

6.2

 

AA+

 

(12.5

)

131.5

 

2007

 

16.4

%

18.4

%

9.5

 

AA

 

(77.5

)

(133.3

)

2008

 

 

 

 

 

 

 

Total

 

17.9

%

26.9

%

$

21.3

 

AA

 

$

(99.8

)

$

60.8

 

 

Asset Type

 

Original
Subordination(2)

 

Current
Subordination(2)

 

Net Par
Outstanding
(in billions)

 

Weighted Average
Credit Rating(1)

 

3Q-08 Unrealized
Gain (Loss) (in
millions)

 

9 mos. 2008
Unrealized Gain
(Loss) (in millions)

 

Alt-A loans

 

20.4

%

23.5

%

$

6.6

 

AA-

 

$

(100.3

)

$

(167.6

)

Prime first liens

 

10.4

%

12.2

%

9.0

 

AAA

 

0.6

 

25.8

 

Subprime first liens

 

26.9

%

53.9

%

5.7

 

AA-

 

(0.1

)

202.6

 

Total

 

17.9

%

26.9

%

$

21.3

 

AA

 

$

(99.8

)

$

60.8

 

 

In general, the Company structures credit derivative transactions such that the method for making loss payments is similar to that for financial guaranty policies and generally occurs as losses are realized on the underlying reference obligation. Nonetheless, credit derivative transactions are governed by ISDA documentation and operates differently from financial guaranty insurance policies. For example, the Company’s control rights with respect to a reference obligation under a credit derivative may be more limited than when the Company issues a financial guaranty insurance policy. In addition, while the Company’s exposure under credit derivatives, like the Company’s exposure under financial guaranty insurance policies, have been generally for as long as the reference obligation remains outstanding, unlike financial guaranty policies, a credit derivative may be terminated for a breach of the ISDA documentation or other specific events. In some older credit derivative transactions, one such specified event is the failure of AGC to maintain specified financial strength ratings ranging from AA- to BBB-. If a credit derivative is terminated the Company could be required to make a mark-to-market payment as determined under the ISDA documentation. For example, if AGC’s rating were downgraded to A+, under market conditions at September 30, 2008, if the counterparties exercised their right to terminate their credit derivatives, AGC would have been required make payments that, under the Company’s mark-to-market methodology, was estimated to be approximately $42 million. Further, if AGC’s rating was downgraded to levels between “BBB+” and “BB+” it would have been required to make additional payments that, under the Company’s mark-to-market methodology, was estimated to be approximately $207 million at September 30, 2008. As of September 30, 2008 the Company had pre-IPO transactions with approximately $1.3 billion of par subject to collateral posting due to changes in market value. In the event AGC were downgraded from AAA to Aa2, with respect to certain of its credit derivative contracts, the amount of par subject to collateral posting requirements would increase to $1.5 billion from $1.2 billion as a result of certain collateral posting thresholds being lowered. In the event AGC were downgraded below A-, the maximum amount of par subject to collateral posting requirements would be $2.4 billion. However, at current fair market value amounts, AGC would not have to pledge additional collateral for the benefit of its counterparties. In October and November 2008, the Company posted collateral totaling approximately $68.5 million based on the unrealized mark-to-market loss position for transactions with two of its counterparties. Under current market conditions we do not anticipate a material increase in the amount posted. Currently no additional collateral posting is required or anticipated for any other transactions.

 

As of September 30, 2008 and December 31, 2007, the Company considered the impact of its own credit risk, in combination with credit spreads on risk that it assumes through CDS contracts, in determining the fair value of its credit derivatives. The Company determines its own credit risk based on quoted CDS prices traded on the Company at each balance sheet date. The quoted price of CDS contracts traded on the Company at September 30, 2008 and

 

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Table of Contents

 

December 31, 2007 was 1,255 basis points and 180 basis points, respectively. Historically, the price of CDS traded on the Company generally moves directionally the same as general market spreads. Generally, a widening of the CDS prices traded on the Company has an effect of offsetting unrealized losses that result from widening general market credit spreads, while a narrowing of the CDS prices traded on the Company has an effect of offsetting unrealized gains that result from narrowing general market credit spreads. An overall narrowing of spreads generally results in an unrealized gain on credit derivatives for the Company and an overall widening of spreads generally results in an unrealized loss for the Company.

 

The following table summarizes the estimated change in fair values on the net balance of the Company’s credit derivative positions assuming immediate parallel shifts in credit spreads at September 30, 2008:

 

(Dollars in millions)

 

Credit Spreads(1)

 

Estimated Net
Fair Value (Pre-Tax)

 

Estimated Pre-Tax 
Change in Gain / (Loss)

 

September 30, 2008:

 

 

 

 

 

100% widening in spreads

 

$

(974.8

)

$

(705.4

)

50%   widening in spreads

 

(625.5

)

(356.1

)

25%   widening in spreads

 

(449.0

)

(179.6

)

10%   widening in spreads

 

(340.6

)

(71.2

)

Base Scenario

 

(269.4

)

 

10%   narrowing in spreads

 

(213.2

)

56.2

 

25%   narrowing in spreads

 

(133.1

)

136.3

 

50%   narrowing in spreads

 

(4.8

)

264.6

 

 


(1) Includes the effects of spreads on both the underlying asset classes and the Company’s own credit spread.

 

5. Investments

 

The following table summarizes the Company’s aggregate investment portfolio as of September 30, 2008:

 

 

 

Amortized 
Cost

 

Gross 
Unrealized 
Gains

 

Gross 
Unrealized 
Losses

 

Estimated 
Fair Value

 

 

 

(in thousands of U.S. dollars)

 

Fixed maturity securities

 

 

 

 

 

 

 

 

 

U.S. government and agencies

 

$

433,179

 

$

16,841

 

$

(1,915

)

$

448,105

 

Obligations of state and political subdivisions

 

1,243,642

 

19,436

 

(62,797

)

1,200,281

 

Corporate securities

 

280,568

 

1,205

 

(31,295

)

250,478

 

Mortgage-backed securities

 

1,163,175

 

5,368

 

(58,219

)

1,110,324

 

Asset-backed securities

 

89,500

 

15

 

(2,341

)

87,174

 

Foreign government securities

 

50,536

 

1,556

 

(59

)

52,033

 

Preferred stock

 

12,625

 

 

(414

)

12,211

 

Total fixed maturity securities

 

3,273,225

 

44,421

 

(157,040

)

3,160,606

 

Short-term investments

 

370,071

 

 

 

370,071

 

Total investments

 

$

3,643,296

 

$

44,421

 

$

(157,040

)

$

3,530,677

 

 

16



Table of Contents

 

The following table summarizes the Company’s aggregate investment portfolio as of December 31, 2007:

 

 

 

Amortized 
Cost

 

Gross 
Unrealized 
Gains

 

Gross 
Unrealized 
Losses

 

Estimated 
Fair Value

 

 

 

(in thousands of U.S. dollars)

 

Fixed maturity securities

 

 

 

 

 

 

 

 

 

U.S. government and agencies

 

$

297,445

 

$

13,524

 

$

(17

)

$

310,952

 

Obligations of state and political subdivisions

 

1,043,000

 

38,612

 

(2,773

)

1,078,839

 

Corporate securities

 

179,369

 

4,759

 

(1,368

)

182,760

 

Mortgage-backed securities

 

859,666

 

9,882

 

(4,686

)

864,862

 

Asset-backed securities

 

68,148

 

341

 

(82

)

68,407

 

Foreign government securities

 

71,386

 

1,694

 

(18

)

73,062

 

Preferred stock

 

7,875

 

197

 

 

8,072

 

Total fixed maturity securities

 

2,526,889

 

69,009

 

(8,944

)

2,586,954

 

Short-term investments

 

552,938

 

 

 

552,938

 

Total investments

 

$

3,079,827

 

$

69,009

 

$

(8,944

)

$

3,139,892

 

 

Approximately 31% and 28% of the Company’s total investment portfolio as of September 30, 2008 and December 31, 2007, respectively, was composed of mortgage-backed securities, including collateralized mortgage obligations and commercial mortgage-backed securities. As of September 30, 2008 and December 31, 2007, respectively, approximately 66% and 55% of the Company’s total mortgage-backed securities were government agency obligations. As of both September 30, 2008 and December 31, 2007, the weighted average credit quality of the Company’s entire investment portfolio was AA+ and AAA, respectively. The Company’s portfolio is comprised primarily of high-quality, liquid instruments. We continue to receive sufficient information to value our investments and have not had to modify our approach due to the current market conditions.

 

Under agreements with cedants and in accordance with statutory requirements, the Company maintains fixed maturity securities in trust accounts for the benefit of reinsured companies and for the protection of policyholders, generally in states where the Company or its subsidiaries, as applicable, are not licensed or accredited. The carrying value of such restricted balances as of September 30, 2008 and December 31, 2007 was $1,019.0 million and $936.0 million, respectively.

 

The Company has a formal review process for all securities in our investment portfolio, including a review for impairment losses. Factors considered when assessing impairment include:

 

·

 

a decline in the market value of a security by 20% or more below amortized cost;

·

 

a decline in the market value of a security for a continuous period of 12 months;

·

 

recent credit downgrades of the applicable security or the issuer by rating agencies;

·

 

the financial condition of the applicable issuer;

·

 

whether scheduled interest payments are past due; and

·

 

whether we have the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value.

 

If the Company believes a decline in the value of a particular investment is temporary, it records the decline as an unrealized loss, net of tax, on the balance sheet in “accumulated other comprehensive income” in shareholders’ equity. If the Company believes the decline is “other than temporary,” it writes down the carrying value of the investment and records a realized loss in the statement of operations. The Company’s assessment of a decline in value includes management’s current assessment of the factors noted above. If that assessment changes in the future, the Company may ultimately record a loss after having originally concluded that the decline in value was temporary.

 

A focus of management’s assessment is the evaluation of securities that have been in an unrealized loss position for 12-months or more.  Management considers the nature of the investment, the cause for the impairment (interest or credit related), the severity (both as a percentage of book value and absolute dollars) and duration of the impairment  and any other available evidence, such as discussions with investment advisors, volatility of the securities fair value and recent news reports when performing its assessment.

 

As of September 30, 2008, the Company’s gross unrealized loss position stood at $157.0 million compared to $50.5 million at June 30, 2008.  The $106.5 million increase in gross unrealized losses is primarily attributable to municipal securities, $46.3 million, mortgage and asset-backed securities, $37.7 million, and corporate securities, $21.5 million.  The increase in these unrealized losses during the three months ended September 30, 2008 is related to the overall illiquidity in the financial markets and resulted in a sudden and severe depressed demand for non-cash investments.

 

17



Table of Contents

 

As of September 30, 2008, the Company had 102 securities in an unrealized loss position for greater than 12 months, representing a gross unrealized loss of $35.3 million.  Of these securities, 51 securities had unrealized losses greater than 10% of book value.  The total unrealized loss for these securities as of September 30, 2008 was $26.9 million.  The aggregate amount of unrealized loss for these 51 bonds over the past 12 months has varied between $4.1 million and $14.3 million, until September when the unrealized loss increased to $26.9 million.  This increase in unrealized losses during the quarter is attributable to the market illiquidity and volatility in the U.S. economy mentioned above and not specific to individual issuer credit.  Except as noted below, the Company has recognized no other than temporary impairment losses and has the ability and intent to hold these securities until a recovery in value.

 

The Company recognized $18.5 million of other than temporary impairment losses related to corporate securities for the three- and nine-month periods ended September 30, 2008. The Company continues to monitor the value of these investments.  Future events may result in further impairment of the Company’s investments. The Company had no write downs of investments for other than temporary impairment losses for the three- and nine-month periods ended September 30, 2007.

 

The following table summarizes the unrealized losses in our investment portfolio by type of security and the length of time such securities have been in a continuous unrealized loss position as of the dates indicated:

 

 

 

As of September 30, 2008

 

As of December 31, 2007

 

Length of Time in Continuous Unrealized Loss Position

 

Estimated 
Fair 
Value

 

Gross 
Unrealized 
Losses

 

Estimated 
Fair 
Value

 

Gross 
Unrealized 
Losses

 

 

 

($ in millions)

 

Municipal securities

 

 

 

 

 

 

 

 

 

0-6 months

 

$

429.3

 

$

(24.3

)

$

67.2

 

$

(0.6

)

7-12 months

 

208.7

 

(23.1

)

123.0

 

(1.9

)

Greater than 12 months

 

109.3

 

(15.4

)

8.6

 

(0.3

)

 

 

747.3

 

(62.8

)

198.8

 

(2.8

)

 

 

 

 

 

 

 

 

 

 

Corporate securities

 

 

 

 

 

 

 

 

 

0-6 months

 

180.0

 

(23.8

)

13.6

 

(0.3

)

7-12 months

 

21.6

 

(2.1

)

22.2

 

(0.8

)

Greater than 12 months

 

16.2

 

(5.4

)

12.8

 

(0.3

)

 

 

217.8

 

(31.3

)

48.6

 

(1.4

)

 

 

 

 

 

 

 

 

 

 

U.S. Government obligations

 

 

 

 

 

 

 

 

 

0-6 months

 

138.5

 

(1.9

)

25.4

 

 

7-12 months

 

 

 

 

 

Greater than 12 months

 

 

 

 

 

 

 

138.5

 

(1.9

)

25.4

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage and asset-backed securities

 

 

 

 

 

 

 

 

 

0-6 months

 

541.6

 

(23.5

)

37.7

 

(0.4

)

7-12 months

 

148.3

 

(22.6

)

32.0

 

(0.3

)

Greater than 12 months

 

153.1

 

(14.5

)

254.4

 

(4.0

)

 

 

843.0

 

(60.6

)

324.1

 

(4.7

)

 

 

 

 

 

 

 

 

 

 

Preferred stock

 

 

 

 

 

 

 

 

 

0-6 months

 

12.2

 

(0.4

)

 

 

7-12 months

 

 

 

 

 

Greater than 12 months

 

 

 

 

 

 

 

12.2

 

(0.4

)

 

 

Total

 

$

1,958.8

 

$

(157.0

)

$

596.9

 

$

(8.9

)

 

18



Table of Contents

 

The following table summarizes the unrealized losses in our investment portfolio by type of security and remaining time to maturity as of the dates indicated:

 

 

 

As of September 30, 2008

 

As of December 31, 2007

 

Remaining Time to Maturity

 

Estimated 
Fair 
Value

 

Gross 
Unrealized 
Losses

 

Estimated 
Fair 
Value

 

Gross 
Unrealized 
Losses

 

 

 

($ in millions)

 

Municipal securities

 

 

 

 

 

 

 

 

 

Due in one year or less

 

$

 

$

 

$

 

$

 

Due after one year through five years

 

 

 

 

 

Due after five years through ten years

 

66.2

 

(2.6

)

1.9

 

(0.1

)

Due after ten years

 

681.1

 

(60.2

)

196.9

 

(2.7

)

 

 

747.3

 

(62.8

)

198.8

 

(2.8

)

 

 

 

 

 

 

 

 

 

 

Corporate securities

 

 

 

 

 

 

 

 

 

Due in one year or less

 

8.6

 

(0.1

)

7.2

 

 

Due after one year through five years

 

67.6

 

(3.3

)

16.1

 

(0.3

)

Due after five years through ten years

 

107.0

 

(22.0

)

12.0

 

(0.2

)

Due after ten years

 

34.6

 

(5.9

)

13.3

 

(0.9

)

 

 

217.8

 

(31.3

)

48.6

 

(1.4

)

 

 

 

 

 

 

 

 

 

 

U.S. Government obligations

 

 

 

 

 

 

 

 

 

Due in one year or less

 

8.0

 

 

 

 

Due after one year through five years

 

21.2

 

(0.4

)

25.4

 

 

Due after five years through ten years

 

103.6

 

(1.5

)

 

 

Due after ten years

 

5.7

 

 

 

 

 

 

138.5

 

(1.9

)

25.4

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage and asset-backed securities

 

843.0

 

(60.6

)

324.1

 

(4.7

)

 

 

 

 

 

 

 

 

 

 

Preferred stock

 

12.2

 

(0.4

)

 

 

Total

 

$

1,958.8

 

$

(157.0

)

$

596.9

 

$

(8.9

)

 

19



Table of Contents

 

The following table summarizes, for all securities sold at a loss through September 30, 2008 and 2007, the fair value and realized loss by length of time such securities were in a continuous unrealized loss position prior to the date of sale:

 

 

 

Three Months Ended September 30,

 

 

 

2008

 

2007

 

Length of Time in Continuous Unrealized Loss Prior to Sale

 

Estimated 
Fair 
Value

 

Gross 
Realized 
Losses

 

Estimated 
Fair 
Value

 

Gross 
Realized 
Losses

 

 

 

($ in millions)

 

Municipal securities

 

 

 

 

 

 

 

 

 

0-6 months

 

$

 

$

 

$

 

$

 

7-12 months

 

 

 

 

 

Greater than 12 months

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate securities(1)

 

 

 

 

 

 

 

 

 

0-6 months

 

3.4

 

(6.0

)

10.4

 

 

7-12 months

 

0.6

 

(7.1

)

12.2

 

 

Greater than 12 months

 

0.8

 

(5.5

)

9.0

 

(0.2

)

 

 

4.8

 

(18.6

)

31.6

 

(0.2

)

 

 

 

 

 

 

 

 

 

 

U.S. Government securities

 

 

 

 

 

 

 

 

 

0-6 months

 

 

 

1.0

 

(0.1

)

7-12 months

 

 

 

0.8

 

 

Greater than 12 months

 

 

 

0.7

 

 

 

 

 

 

2.5

 

(0.1

)

 

 

 

 

 

 

 

 

 

 

Mortgage and asset-backed securities

 

 

 

 

 

 

 

 

 

0-6 months

 

21.2

 

 

41.2

 

(0.5

)

7-12 months

 

 

 

 

 

Greater than 12 months

 

 

 

 

 

 

 

21.2

 

 

41.2

 

(0.5

)

 

 

 

 

 

 

 

 

 

 

Preferred stock

 

 

 

 

 

 

 

 

 

0-6 months

 

0.2

 

(2.8

)

 

 

7-12 months

 

 

 

 

 

Greater than 12 months

 

 

 

 

 

 

 

0.2

 

(2.8

)

 

 

Total

 

$

26.2

 

$

(21.4

)

$

75.3

 

$

(0.8

)

 


(1) Includes other than temporary impairment losses of $18.5 million.

 

20



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Nine&nb