EX-99.1 3 d496487.htm FINANCIAL STATEMENTS OF FGIC Unassociated Document
 
 

 
Consolidated Financial Statements
Financial Guaranty Insurance Company and Subsidiaries
December 31, 2005
with Report of Independent Auditors
 
 
 
 

 
 
 
 

Financial Guaranty Insurance Company and Subsidiaries

Consolidated Financial Statements


December 31, 2005

 
Contents

Report of Registered Public Accounting Firm
 
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Stockholder’s Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements


 
 
 


Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholder
Financial Guaranty Insurance Company

We have audited the accompanying consolidated balance sheets of Financial Guaranty Insurance Company and Subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholder’s equity and cash flows for the years ended December 31, 2005 and 2004 and the periods from December 18, 2003 through December 31, 2003 and from January 1, 2003 through December 17, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for the years ended December 31, 2005 and 2004 and the periods from December 18, 2003 through December 31, 2003 and from January 1, 2003 through December 17, 2003, in conformity with U.S. generally accepted accounting principles.


/s/ Ernst & Young LLP


New York, New York
January 23, 2006



 
 
 

 


Financial Guaranty Insurance Company and Subsidiaries

Consolidated Balance Sheets

(Dollars in thousands, except per share amounts)


   
December 31
  
   
2005
  
2004
  
Assets
          
Fixed maturity securities, at fair value (amortized cost of
$3,277,291 in 2005 and $2,921,320 in 2004)
  
$
3,258,738
  
$
2,938,856
  
Short-term investments
    
159,334
    
140,473
  
Total investments
    
3,418,072
    
3,079,329
  
               
Cash and cash equivalents
    
45,077
    
69,292
  
Accrued investment income
    
42,576
    
36,580
  
Reinsurance recoverable on losses
   
3,271
    
3,054
  
Prepaid reinsurance premiums
    
110,636
    
109,292
  
Deferred policy acquisition costs
    
63,330
    
33,835
  
Receivable from related parties
    
9,539
    
802
  
Property and equipment, net of accumulated depreciation
of $885 in 2005 and $164 in 2004
    
3,092
    
2,408
  
Prepaid expenses and other assets
    
10,354
    
7,826
  
Federal income taxes receivable
    
2,158
    
-
  
Total assets
  
$
3,708,105
  
$
3,342,418
  
               
Liabilities and stockholder’s equity
              
Liabilities:
              
Unearned premiums
  
$
1,201,163
  
$
1,043,334
  
Loss and loss adjustment expenses
    
54,812
    
39,181
  
Ceded reinsurance balances payable
    
1,615
    
3,826
  
Accounts payable, accrued expenses and other liabilities
    
36,359
    
22,874
  
Payable for securities purchased
    
-
    
5,715
  
Capital lease obligations
   
4,262
    
6,446
  
Federal income taxes payable
    
-
    
4,401
  
Deferred income taxes
    
42,463
    
38,765
  
Total liabilities
    
1,340,674
    
1,164,542
  
               
Stockholder’s equity:
              
Common stock, par value $1,500 per share; 10,000 shares
authorized, issued and outstanding
    
15,000
    
15,000
  
Additional paid-in capital
    
1,894,983
    
1,882,772
  
Accumulated other comprehensive (loss) income, net of tax
    
(13,597
)
  
15,485
  
Retained earnings
    
471,045
    
264,619
  
Total stockholder’s equity
    
2,367,431
    
2,177,876
  
Total liabilities and stockholder’s equity
  
$
3,708,105
  
$
3,342,418
  

See accompanying notes to consolidated financial statements.


 
 
 
 
Financial Guaranty Insurance Company and Subsidiaries

Consolidated Statements of Income

(Dollars in thousands)

   
Successor
  
Predecessor
  
   
 
 
 
Year ended December 31,
  
 
 
 
Year ended December 31,
  
Period from December 18, 2003
through December 31,
  
Period from January 1, 2003
through December 17,
  
   
2005
  
2004
  
2003
  
2003
  
Revenues:
                          
Gross premiums written
  
$
410,202
  
$
323,575
  
$
12,213
  
$
248,112
  
Reassumed ceded premiums
    
-
    
4,959
    
6,300
    
14,300
  
Ceded premiums written
    
(29,148
)
  
(14,656
)
  
(39
)
  
(14,852
)
Net premiums written
    
381,054
    
313,878
    
18,474
    
247,560
  
Increase in net unearned premiums
    
(156,485
)
  
(138,929
)
  
(9,892
)
  
(105,811
)
Net premiums earned
    
224,569
    
174,949
    
8,582
    
141,749
  
                           
Net investment income
    
117,072
    
97,709
    
4,269
    
112,619
  
Net realized gains
    
101
    
559
    
-
    
31,506
  
Net mark-to-market losses on credit derivative contracts
    
(167
)
  
-
    
-
    
-
  
Other income
    
762
    
736
    
44
    
580
  
Total revenues
    
342,337
    
273,953
    
12,895
    
286,454
  
                           
Expenses:
                          
Loss and loss adjustment expenses
    
18,506
    
5,922
    
236
    
(6,757
)
Underwriting expenses
    
82,064
    
73,426
    
7,622
    
54,481
  
Policy acquisition costs deferred
    
(38,069
)
  
(32,952
)
  
(2,931
)
  
(23,641
)
Amortization of deferred policy acquisition costs
    
8,302
    
2,038
    
10
    
15,563
  
Total expenses
    
70,803
    
48,434
    
4,937
    
39,646
  
                           
Income before income tax expense (benefit)
    
271,534
    
225,519
    
7,958
    
246,808
  
                           
Income tax expense (benefit):
                          
Current
    
32,370
    
42,510
    
1,191
    
57,071
  
Deferred
    
32,738
    
12,923
    
573
    
(1,612
)
Total income tax expense
    
65,108
    
55,433
    
1,764
    
55,459
  
Income before extraordinary item
    
206,426
    
170,086
    
6,194
    
191,349
  
Extraordinary gain
    
-
    
-
    
13,852
    
-
  
Net income
  
$
206,426
  
$
170,086
  
$
20,046
  
$
191,349
  


See accompanying notes to consolidated financial statements.


 
 
 

 


Financial Guaranty Insurance Company and Subsidiaries

Consolidated Statements of Stockholder’s Equity

(Dollars in thousands)

   
 
 
Common
Stock
  
 
Additional
Paid-in
Capital
  
Accumulated Other Comprehensive
(Loss) Income,
Net of Tax
  
 
 
Retained
Earnings
  
 
 
 
Total
  
Predecessor
                                
Balance at January 1, 2003
  
$
15,000
  
$
383,511
  
$
49,499
  
$
1,740,885
  
$
2,188,895
  
Net income
    
-
    
-
    
-
    
191,349
    
191,349
  
Other comprehensive income (loss):
                                
Change in fixed maturities available-for-sale
    
-
    
-
    
(424
)
  
-
    
(424
)
Change in foreign currency translation adjustment
    
-
    
-
    
4,267
    
-
    
4,267
  
Total comprehensive income
                            
195,192
  
Dividends declared
    
-
    
-
    
-
    
(284,300
)
  
(284,300
)
Balance at December 17, 2003
    
15,000
    
383,511
    
53,342
    
1,647,934
    
2,099,787
  
Successor
                                
Purchase accounting adjustments
    
-
    
1,474,261
    
(53,342
)
  
(1,573,447
)
  
(152,528
)
Net income
    
-
    
-
    
-
    
20,046
    
20,046
  
Other comprehensive income:
                                
Change in fixed maturities available-for-sale
    
-
    
-
    
2,059
    
-
    
2,059
  
Total comprehensive income
                            
22,105
  
Balance at December 31, 2003
    
15,000
    
1,857,772
    
2,059
    
94,533
    
1,969,364
  
Net income
    
-
    
-
    
-
    
170,086
    
170,086
  
Other comprehensive income:
                                
Change in fixed maturities available-for-sale
    
-
    
-
    
9,340
    
-
    
9,340
  
Change in foreign currency translation adjustment
    
-
    
-
    
4,086
    
-
    
4,086
  
Total comprehensive income
                            
183,512
  
Capital contribution
    
-
    
25,000
    
-
    
-
    
25,000
  
Balance at December 31, 2004
    
15,000
    
1,882,772
    
15,485
    
264,619
    
2,177,876
  
Net income
    
-
    
-
    
-
    
206,426
    
206,426
  
Other comprehensive loss:
                                
Change in fixed maturities available-for-sale
    
-
    
-
    
(23,550
)
  
-
    
(23,550
)
Change in foreign currency translation adjustment
    
-
    
-
    
(5,532
)
  
-
    
(5,532
)
Total comprehensive income
                            
177,344
  
Capital contribution
    
-
    
12,211
    
-
    
-
    
12,211
  
Balance at December 31, 2005
  
$
15,000
  
$
1,894,983
  
$
(13,597
)
$
471,045
  
$
2,367,431
  

See accompanying notes to consolidated financial statements.


 
 
 

 


Financial Guaranty Insurance Company and Subsidiaries

Consolidated Statements of Cash Flows

(Dollars in thousands)

   
Successor
  
Predecessor
  
   
 
 
 
 
Year ended December 31,
  
 
 
 
 
Year ended December 31,
  
 
Period from December 18, 2003
through
December 31,
  
 
Period from January 1,
2003
through December 17,
  
   
2005
  
2004
  
2003
  
2003
  
Operating activities
                          
Net income
  
$
206,426
  
$
170,086
  
$
20,046
  
$
191,349
  
Adjustments to reconcile net income to net cash provided by operating activities:
                          
Extraordinary gain
          
-
    
(13,852
)
  
-
  
Amortization of deferred policy acquisition costs
    
8,574
    
2,038
    
10
    
15,563
  
Policy acquisition costs deferred
    
(38,069
)
  
(32,952
)
  
(2,931
)
  
(23,641
)
Depreciation of property and equipment
    
721
    
164
    
-
    
22
  
Amortization of fixed maturity securities
    
31,504
    
37,013
    
693
    
21,129
  
Amortization of short-term investments
    
481
    
29
              
Net realized gains on investments
    
(101
)
  
(559
)
  
-
    
(31,506
)
Change in accrued investment income and prepaid expenses and other assets
    
(8,504
)
  
(5,545
)
  
(5,065
)
  
6,292
  
Change in net mark-to-market losses on credit derivative contracts
    
167
    
-
    
-
    
-
  
Change in federal income taxes receivable
    
-
    
126
    
(172
)
  
(2,407
)
Change in reinsurance recoverable on losses
    
(217
)
  
5,011
    
(104
)
  
410
  
Change in prepaid reinsurance premiums
    
(1,344
)
  
14,476
    
7,432
    
19,725
  
Changes in other reinsurance receivables
    
-
    
5,295
    
(5,295
)
  
-
  
Change in receivable from related parties
    
(8,737
)
  
8,957
    
(76
)
  
(9,811
)
Change in unearned premiums
    
157,829
    
124,452
    
2,460
    
86,250
  
Change in loss and loss adjustment expenses
    
15,631
    
(1,286
)
  
236
    
(7,644
)
Change in ceded reinsurance balances payable and accounts payable and accrued expenses
    
8,923
    
7,348
    
6,485
    
1,804
  
Change in current federal income taxes payable
    
(6,559
)
  
4,401
    
-
    
(97,477
)
Change in deferred federal income taxes
    
19,252
    
12,923
    
573
    
(1,612
)
Net cash provided by operating activities
    
385,977
    
351,977
    
10,440
    
168,446
  
                           
Investing activities
                          
Sales and maturities of fixed maturity securities
    
122,638
    
284,227
    
1,780
    
1,028,103
  
Purchases of fixed maturity securities
    
(520,089
)
  
(546,028
)
  
-
    
(877,340
)
Purchases, sales and maturities of short-term investments, net
    
(19,342
)
  
(126,125
)
  
(12,736
)
  
41,504
  
Receivable for securities sold
    
(20
)
  
170
    
538
    
283
  
Payable for securities purchased
    
(5,715
)
  
5,715
    
-
    
(5,333
)
Purchase of fixed assets
    
(1,405
)
  
(2,572
)
  
-
    
-
  
Net cash (used in) provided by investing activities
    
(423,933
)
  
(384,613
)
  
(10,418
)
  
187,217
  
                           
Financing activities
                          
Capital contribution
    
12,211
    
25,000
    
-
    
-
  
Dividends paid to common stockholders
    
-
    
-
    
-
    
(284,300
)
Net cash provided by (used in) financing activities
    
12,211
    
25,000
    
-
    
(284,300
)
Effect of exchange rate changes on cash
    
1,530
    
(1,717
)
  
-
    
-
  
Net (decrease) increase in cash and cash equivalents
    
(24,215
)
  
(9,353
)
  
22
    
71,363
  
Cash and cash equivalents at beginning of period
    
69,292
    
78,645
    
78,623
    
7,260
  
Cash and cash equivalents at end of period
  
$
45,077
  
$
69,292
  
$
78,645
  
$
78,623
  
                           
Supplemental disclosure of cash flow information
                          
Income taxes paid
  
$
49,613
  
$
40,890
  
$
-
  
$
156,800
  


See accompanying notes to consolidated financial statements.



 
 
 

 
 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)




1. Business and Organization

Financial Guaranty Insurance Company (the “Company”) is a wholly owned subsidiary of FGIC Corporation (“FGIC Corp.”). The Company provides financial guaranty insurance and other forms of credit enhancement for public finance and structured finance obligations. The Company began insuring public finance obligations in 1984 and structured finance obligations in 1988. The Company’s financial strength is rated “Aaa” by Moody’s Investors Service, Inc., “AAA” by Standard & Poor’s Rating Services, a division of The McGraw-Hill Companies, Inc., and “AAA” by Fitch Ratings, Inc. The Company is licensed to engage in writing financial guaranty insurance in all 50 states, the District of Columbia, the Commonwealth of Puerto Rico, the U.S. Virgin Islands, and, through a branch, in the United Kingdom. In addition, a United Kingdom subsidiary of the Company is authorized to write financial guaranty business in the United Kingdom and has passport rights to write business in other European Union member countries. FGIC Corp. and the Company have formed subsidiaries to facilitate geographic and business expansion.

On December 18, 2003, an investor group consisting of The PMI Group, Inc. (“PMI”), affiliates of the Blackstone Group L.P. (“Blackstone”), affiliates of the Cypress Group L.L.C. (“Cypress”) and affiliates of CIVC Partners L.P. (“CIVC”), collectively, the “Investor Group”, completed the acquisition of FGIC Corp. from a subsidiary of General Electric Capital Corporation (“GE Capital”) in a transaction valued at approximately $2,200,000 (the “Transaction”). GE Capital retained 2,346 shares of FGIC Corp. Senior Preferred Mandatorily Convertible Modified Preferred Stock (“Senior Preferred Shares”) with an aggregate liquidation preference of $234,600, and approximately 5% of FGIC Corp.’s outstanding common stock. PMI is the largest stockholder of FGIC Corp., owning approximately 42% of its common stock at December 31, 2005 and 2004. Blackstone, Cypress and CIVC own approximately 23%, 23% and 7% of FGIC Corp.’s common stock, respectively, at December 31, 2005 and 2004.

2. Basis of Presentation

The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances have been eliminated in consolidation.



 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements

December 31, 2005
(Dollars in thousands, except per share amounts)




2. Basis of Presentation (continued)

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes. Actual results could differ from those estimates.

The accompanying financial statements have been prepared on the basis of GAAP, which differs in certain respects from the accounting practices prescribed or permitted by the New York State Insurance Department (see Note 4). Certain 2004 and 2003 information has been reclassified to conform to the 2005 presentation.

3. Summary of Significant Accounting Policies

The Company’s significant accounting policies are as follows:

a. Investments

All the Company’s fixed maturity securities are classified as available-for-sale and are recorded on the trade date at fair value. Unrealized gains and losses are recorded as a separate component of accumulated other comprehensive (loss) income, net of applicable income taxes, in the consolidated statements of stockholders’ equity. Short-term investments are carried at cost, which approximates fair value.

Bond discounts and premiums are amortized over the remaining term of the securities. Realized gains or losses on the sale of investments are determined based on the specific identification method.

Securities that have been determined to be other than temporarily impaired are reduced to realizable value, establishing a new cost basis, with a charge to realized loss at such date.

b. Cash and Cash Equivalents

The Company considers all bank deposits, highly liquid securities and certificates of deposit with maturities of three months or less at the date of purchase to be cash equivalents. These cash equivalents are carried at cost, which approximates fair value.

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



3. Summary of Significant Accounting Policies (continued)

c. Premium Revenue Recognition

Premiums are received either up-front or over time on an installment basis. The premium collection method is determined at the time the policy is issued. Up-front premiums are paid in full at the inception of the policy and are earned over the period of risk in proportion to the total amount of principal and interest amortized in the period as a proportion of the original principal and interest outstanding. Installment premiums are collected periodically and are reflected in income pro-rata over the period covered by the premium payment, including premiums received on credit default swaps (see Note 6). Unearned premiums represent the portion of premiums received applicable to future periods on insurance policies in force. When an obligation insured by the Company is refunded prior to the end of the expected policy coverage period, any remaining unearned premium is recognized at that time. A refunding occurs when an insured obligation is called or legally defeased prior to stated maturity. Premiums earned on advanced refundings were $54,795, $42,695, $5,013 and $39,858 for the years ended December 31, 2005 and 2004 and the periods from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, respectively.

Ceded premiums are recognized in a manner consistent with the premium earned on the underlying policies.

d. Policy Acquisition Costs

Policy acquisition costs include only those expenses that relate directly to and vary with premium production. Such costs include compensation of employees involved in marketing, underwriting and policy issuance functions, rating agency fees, state premium taxes and certain other expenses. In determining policy acquisition costs, the Company must estimate and allocate the percentage of its costs and expenses that are attributable to premium production, rather than to other activities. Policy acquisition costs, net of ceding commission income on premiums ceded to reinsurers, are deferred and amortized over the period in which the related premiums are earned. Anticipated loss and loss adjustment expenses, future maintenance costs on the in-force business and net investment income are considered in determining the recoverability of acquisition costs.

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



3. Summary of Significant Accounting Policies (continued)

e. Loss and Loss Adjustment Expenses

Provision for loss and loss adjustment expenses fall into two categories: case reserves and watchlist reserves. Case reserves are established for the value of estimated losses on particular insured obligations that are presently or likely to be in payment default and for which future loss is probable and can be reasonably estimated. These reserves represent an estimate of the present value of the anticipated shortfall between (1) payments on insured obligations plus anticipated loss adjustment expenses and (2) anticipated cash flow from, and proceeds to be received on, sales of any collateral supporting the obligation and/or other anticipated recoveries. The discount rate used in calculating the net present value of estimated losses is based upon the risk-free rate for the time period of the anticipated shortfall. As of December 31, 2005 and 2004, discounted case-basis loss and loss adjustment expense reserves totaled $33,328 and $15,700, respectively. Loss and loss adjustment expenses included amounts discounted at an approximate interest rate of 4.5% in 2005 and 2004. The amount of the discount at December 31, 2005 and 2004 was $15,015 and $2,500, respectively.

The Company establishes watchlist reserves to recognize the potential for claims against the Company on insured obligations that are not presently in payment default, but which have migrated to an impaired level, where there is a substantially increased probability of default. These reserves reflect an estimate of probable loss given evidence of impairment, and a reasonable estimate of the amount of loss given default. The methodology for establishing and calculating the watchlist reserve relies on a categorization and assessment of the probability of default, and loss severity in the event of default, of the specifically identified impaired obligations on the watchlist based on historical trends and other factors. The watchlist reserve is adjusted as necessary to reflect changes in the loss expectation inherent in the group of impaired credits. As of December 31, 2005 and 2004, such reserves were $21,484 and $23,500, respectively.

The reserve for loss and loss adjustment expenses is reviewed regularly and updated based on claim payments and the results of ongoing surveillance. The Company conducts ongoing insured portfolio surveillance to identify all impaired obligations and thereby provide a materially complete recognition of losses for each accounting period. The reserves are necessarily based upon estimates and subjective judgments about the outcome of future events, and actual results will likely differ from these estimates.

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



3. Summary of Significant Accounting Policies (continued)

Reinsurance recoverable on losses is calculated in a manner consistent with the calculation loss and loss adjustment expenses.

f. Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.

Deferred tax assets and liabilities are measured using statutory tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period in which a change occurs.

The Company is a financial guaranty insurance writer and is permitted a tax deduction, subject to certain limitations under Section 832(e) of the Internal Revenue Code, for amounts required to be set aside in statutory contingency reserves by state law or regulation. The deduction is allowed only to the extent the Company purchases U.S. Government non-interest bearing tax and loss bonds in an amount equal to the tax benefit attributable to such deductions. Purchases of tax and loss bonds are recorded as a reduction of current tax expense. For the years ended December 31, 2005 and 2004, the Company purchased $13,565 and $10,810, respectively, of tax and loss bonds. For the period from January 1, 2003 through December 17, 2003, there were no tax and loss bonds purchased and $102,540 of tax and loss bonds were redeemed.

g. Property and Equipment

Property and equipment consists of office furniture, fixtures, computer equipment and software and leasehold improvements that are reported at cost less accumulated depreciation. Office furniture and fixtures are depreciated straight-line over five years. Leasehold improvements are amortized over their estimated service lives or over the life of the lease, whichever is shorter. Computer equipment and software are depreciated over three years. Maintenance and repairs are charged to expense as incurred.


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



3. Summary of Significant Accounting Policies (continued)

h. Goodwill

In accounting for the Transaction in 2003, the Company applied purchase accounting, as prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations (“SFAS 141”) and Securities and Exchange Commission Staff Accounting Bulletin 54. Under these accounting methods, the purchase price was pushed down into the accompanying consolidated financial statements, with the difference between the purchase price and the sum of the fair value of tangible and identifiable intangible assets acquired less liabilities assumed resulting in negative goodwill of $27,300 at December 18, 2003. In accordance with SFAS 141, the Company reduced the value assigned to non-financial assets, and the remaining negative goodwill of $13,852 was recorded as an extraordinary gain in the consolidated statement of income.

As a result of the purchase accounting, effective December 18, 2003, the basis of the Company’s assets and liabilities changed, necessitating the presentation of Predecessor Company and Successor Company columns in the consolidated statements of income, stockholder’s equity and cash flows.

i. Foreign Currency Translation

The Company has an established foreign branch and three subsidiaries in the United Kingdom and insured exposure from a former branch in France. The Company has determined that the functional currencies of these operations are their local currencies. Accordingly, the assets and liabilities of these operations are translated into U.S. dollars at the rates of exchange at December 31, 2005 and 2004, and revenues and expenses are translated at average monthly exchange rates. The cumulative translation (loss) gain at December 31, 2005 and 2004 was $(1,446) and $4,086, respectively, net of tax benefit (expense) of $723 and $(2,200), respectively, and is reported as a separate component of accumulated other comprehensive income in the consolidated statements of stockholder’s equity.


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



3. Summary of Significant Accounting Policies (continued)

j. Stock Compensation Plan

The Company has an incentive stock plan that provides for stock-based compensation, including stock options, restricted stock awards and restricted stock units of FGIC Corp. Stock options are granted for a fixed number of shares with an exercise price equal to or greater than the fair value of the shares at the date of the grant. Restricted stock awards and restricted stock units are valued at the fair value of the stock on the grant date, with no cost to the grantee. FGIC Corp. accounts for stock-based compensation using the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and, accordingly, if the exercise price is equal to the fair value of the shares at the date of the grant, no compensation expense related to stock options is allocated to the Company by FGIC Corp. For grants to employees of the Company of restricted stock and restricted stock units, unearned compensation, equivalent to the fair value of the shares at the date of grant, is allocated to the Company. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), as amended.

Had FGIC Corp. determined compensation expense for stock options granted to employees and management based on the fair value of the options at the grant dates consistent with the method of accounting under SFAS 123, the Company’s estimated pro forma net income would have been as follows:
   
Year ended December 31, 2005
  
Year ended December 31, 2004
  
Period from December 18, 2003
through December 31, 2003
  
Reported net income
  
$
206,426
  
$
170,086
  
$
20,046
  
Add: Allocated stock-based compensation related to restricted stock units, net of tax included in reported net income
    
29
    
49
    
-
  
Less: Allocated total stock-based compensation determined under the fair value method for all awards, net of tax
    
(2,138
)
  
(1,249
)
  
(40
)
Pro forma net income
  
$
204,317
  
$
168,886
  
$
20,006
  

There were no stock options prior to December 18, 2003.

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



3. Summary of Significant Accounting Policies (continued)

k. Variable Interest Entities

Financial Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46-R”) provides accounting and disclosure rules for determining whether certain entities should be consolidated in the Company’s consolidated financial statements. An entity is subject to FIN 46-R, and is called a Variable Interest Entity (“VIE”), if it has (i) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support or (ii) equity investors that cannot make significant decisions about the entity’s operations or that do not absorb the majority of expected losses or receive the majority of expected residual returns of the entity. A VIE is consolidated by its primary beneficiary, which is the party that has a majority of the expected losses or a majority of the expected residual returns of the VIE, or both. FIN 46-R requires disclosures for companies that have either a primary or significant variable interest in a VIE. All other entities not considered VIEs are evaluated for consolidation under SFAS No. 94, Consolidation of all Majority-Owned Subsidiaries.

As part of its structured finance business, the Company insures debt obligations or certificates issued by special purpose entities. The Company has evaluated the transactions, and does not believe any such transactions require consolidation or disclosure under
FIN 46-R.

During 2004, FGIC arranged the issuance of contingent preferred trust securities by a group of special purpose trusts. These trusts are considered VIEs under FIN 46-R. However, the Company is not considered a primary beneficiary and therefore is not required to consolidate the trusts (see Note 16).

l. Derivatives

The Financial Accounting Standards Board (“FASB”) issued and subsequently amended SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”). Under SFAS 133, as amended, all derivative instruments are recognized on the consolidated balance sheet at their fair value, and changes in fair value are recognized immediately in earnings unless the derivatives qualify as hedges.
3. Summary of Significant Accounting Policies (continued)

In 2005, the Company sold credit default swaps (“CDS”) to certain buyers of credit protection. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes.
These agreements are recorded at fair value. Changes in fair value are recorded in net mark-to-market gains (losses) on credit derivative instruments in the consolidated statements of income and in other assets or other liabilities in the consolidated balance sheets. The Company uses dealer-quoted market values, when available, to determine fair value. If market prices are not available, management uses internally developed estimates of fair value.

m. New Accounting Pronouncements

On December 16, 2004, FASB issued SFAS 123(R) which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. Following the effective date, pro forma disclosure is no longer an alternative. In April 2005, the SEC announced the adoption of a rule allowing public companies to defer the adoption of SFAS 123(R) until the beginning of their fiscal years beginning after June 15, 2005. Non-public entities will be required to adopt the provisions of the new standard in fiscal years beginning after December 15, 2005.

Under SFAS 123(R), the Company must determine the transition method to be used at the date of adoption, the appropriate fair value model to be used for valuing share-based payments and the amortization method for compensation cost. The transition methods include retroactive and prospective adoption options. Under the retroactive option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all outstanding share-based awards for which the requisite service has not yet been rendered. The retroactive method would record compensation for all unvested stock options and restricted stock beginning with the first period restated. The Company anticipates adopting the prospective method and expects that the adoption of SFAS 123(R) will have an impact similar to the current pro forma disclosure for existing options under SFAS 123(R). In addition, the Company does not expect that the expense associated with future grants (assuming grant levels consistent with 2005) derived from the fair value model selected will have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



3. Summary of Significant Accounting Policies (continued)

n. Review of Financial Guaranty Industry Accounting Practices 

The FASB staff is considering whether additional accounting guidance is necessary to address loss reserving and certain other practices in the financial guaranty industry. SFAS No. 60, Accounting and Reporting by Insurance Enterprises, was developed prior to the emergence of the financial guaranty industry. As it does not specifically address financial guaranty contracts, there has been diversity in the accounting for these contracts. In 2005, the FASB added a project to consider accounting by insurers for financial guaranty insurance. The objective of the project is to develop an accounting model for financial guaranty contracts issued by insurance companies that are not accounted for as derivative contracts under SFAS 133. A financial guaranty contract guarantees the holder of a financial obligation the full and timely payment of principal and interest when due and is typically issued in conjunction with municipal bond offerings and certain structured finance transactions. The goal of this project is to develop a single model for all industry participants to apply.

The FASB is expected to meet in 2006 to consider the accounting model for issuers of financial guaranty insurance. Proposed and final pronouncements are expected to be issued in 2006. When the FASB reaches a conclusion on this issue, the Company, along with other companies in the financial guaranty industry, may be required to change certain aspects of accounting for loss reserves, premium income and deferred acquisition costs. It is not possible to predict the impact the FASB’s review may have on the Company’s accounting practices.

4. Statutory Accounting Practices

Statutory-basis surplus of the Company at December 31, 2005 and 2004 was $1,162,904 and $1,172,600, respectively. Statutory-basis net income (loss) for the years ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003, and January 1, 2003 through December 17, 2003 was $192,009, $144,100, $(1,669), and $180,091, respectively.


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



5. Investments

The amortized cost and fair values of investments in fixed maturity securities and short-term investments classified as available-for-sale are as follows:

       
Gross
 
Gross
     
   
Amortized
 
Unrealized
 
Unrealized
     
   
Cost
  
Gains
  
Losses
  
Fair Value
  
At December 31, 2005
                          
Obligations of states and political subdivisions
  
$
2,777,807
  
$
12,718
  
$
26,410
  
$
2,764,115
  
Asset- and mortgage-backed securities
    
209,148
    
135
    
3,490
    
205,793
  
U.S. Treasury securities and obligations of U.S. government corporations and agencies
    
148,785
    
1,387
    
2,036
    
148,136
  
Corporate bonds
    
91,422
    
501
    
1,486
    
90,437
  
Debt securities issued by foreign governments
    
30,930
    
345
    
5
    
31,270
  
Preferred stock
    
19,199
    
427
    
639
    
18,987
  
Total fixed maturity securities
    
3,277,291
    
15,513
    
34,066
    
3,258,738
  
Short-term investments
    
159,334
    
-
    
-
    
159,334
  
Total investments
  
$
3,436,625
  
$
15,513
  
$
34,066
  
$
3,418,072
  

       
Gross
 
Gross
     
   
Amortized
 
Unrealized
 
Unrealized
     
   
Cost
  
Gains
  
Losses
  
Fair Value
  
At December 31, 2004
                          
Obligations of states and political subdivisions
  
$
2,461,087
  
$
19,569
  
$
3,090
  
$
2,477,566
  
Asset- and mortgage-backed securities
    
214,895
    
1,267
    
695
    
215,467
  
U.S. Treasury securities and obligations of U.S. Government corporations and agencies
    
131,771
    
559
    
943
    
131,387
  
Corporate bonds
    
54,655
    
663
    
236
    
55,082
  
Debt securities issued by foreign governments
    
39,713
    
176
    
21
    
39,868
  
Preferred stock
    
19,199
    
311
    
24
    
19,486
  
Total fixed maturities
    
2,921,320
    
22,545
    
5,009
    
2,938,856
  
Short-term investments
    
140,473
    
-
    
-
    
140,473
  
Total investments
  
$
3,061,793
  
$
22,545
  
$
5,009
  
$
3,079,329
  


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



5. Investments (continued)

The following table shows gross unrealized losses and the fair value of fixed maturity securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005:

   
Less Than 12 Months
  
12 Months or More
  
Total
  
   
Fair
Value
  
Unrealized Losses
  
Fair
Value
  
Unrealized Losses
  
Fair
Value
  
Unrealized Losses
  
Obligations of states and political subdivisions
 
$
1,622,119
  
$
16,646
  
$
463,156
  
$
9,764
  
$
2,085,275
  
$
26,410
  
Asset- and mortgage-backed securities
    
133,196
    
1,839
    
56,824
    
1,651
    
190,020
    
3,490
  
U.S. Treasury securities and obligations of U.S. government corporations and agencies
    
47,872
    
520
    
76,380
    
1,516
    
124,252
    
2,036
  
Other
    
42,379
    
690
    
28,026
    
801
    
70,405
    
1,491
  
Preferred stock
    
12,860
    
639
    
-
    
-
    
12,860
    
639
  
Total temporarily impaired securities
  
$
1,858,426
  
$
20,334
  
$
624,386
  
$
13,732
  
$
2,482,812
  
$
34,066
  

The unrealized losses in the Company’s investments were caused by interest rate increases. The Company evaluated the credit ratings of these securities and noted no deterioration. Because the decline in market value is attributable to changes in interest rates and not credit quality and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Company did not consider these investments to be other than temporarily impaired at December 31, 2005.

Investments in fixed maturity securities carried at fair value of $4,625 and $4,049 as of December 31, 2005 and 2004, respectively, were on deposit with various regulatory authorities as required by law.


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



5. Investments (continued)

The amortized cost and fair values of investments in fixed maturity securities, available-for-sale at December 31, 2005, are shown below by contractual maturity date. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

   
Amortized
Cost
  
Fair
Value
  
               
Due one year later or less
  
$
77,668
  
$
77,071
  
Due after one year through five years
    
472,292
    
463,162
  
Due after five years through ten years
    
1,463,806
    
1,448,990
  
After ten years
   
1,263,525
    
1,269,515
  
Total
  
$
3,277,291
  
$
3,258,738
  

For the years ended December 31, 2005 and 2004 and for the periods from
December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, proceeds from sales of available-for-sale securities were $31,380, $178,030, $0, and $855,761 respectively. For the years ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, gross gains of $185, $1,900, $0, and $31,700, respectively, and gross losses of $84, $1,300, $0, and $200, respectively, were realized on such sales.

Net investment income of the Company was derived from the following sources:

   
Successor
  
Predecessor
  
   
 
 
 
Year ended December 31,
  
 
 
 
Year ended December 31,
  
Period from December
18, 2003
through December 31,
  
Period from January
1, 2003
through December 17,
  
   
2005
  
2004
  
2003
  
2003
  
                   
Income from fixed maturity securities
  
$
112,616
  
$
97,720
  
$
4,294
  
$
111,075
  
Income from short-term investments
    
6,801
    
1,450
    
12
    
2,326
  
Total investment income
    
119,417
    
99,170
    
4,306
    
113,401
  
Investment expenses
    
(2,345
)
  
(1,461
)
  
(37
)
  
(782
)
Net investment income
  
$
117,072
  
$
97,709
  
$
4,269
  
$
112,619
  


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



5. Investments (continued)

As of December 31, 2005, the Company did not have more than 3% of its investment portfolio concentrated in a single issuer or industry; however, the Company had the following investment concentrations by state:
   
Fair Value
  
         
New York
  
$
302,290
  
Florida
    
220,150
  
Texas
    
217,145
  
New Jersey
    
193,315
  
Massachusetts
    
169,635
  
Illinois
    
155,922
  
California
    
139,742
  
Michigan
    
113,040
  
     
1,511,239
  
         
All other states
    
1,326,785
  
All other investments
    
580,048
  
Total investments
  
$
3,418,072
  

6. Derivative Instruments

The Company provides CDSs to certain buyers of credit protection by entering into contracts that reference collateralized debt obligations from cash and synthetic structures backed by pools of corporate, consumer or structured finance debt. It also offers credit protection on other public finance and structured finance obligations in CDS form. The Company considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, and to record losses and loss adjustment expenses and changes in fair value as incurred. The Company recorded $3,036 of net earned premium, $0 in losses and loss adjustment expenses, and net mark-to-market losses of $167 in changes in fair value under these agreements for the year ended December 31, 2005.


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



6. Derivative Instruments (continued)

The gains or losses recognized by recording these contracts at fair value are determined each quarter based on quoted market prices, if available. If quoted market prices are not available, the determination of fair value is based on internally developed estimates. Management applies judgments to estimate fair value which are based on changes in expected loss of the underlying assets as well as changes in current market prices for similar products.

Consideration is given to current market spreads and on evaluation of the current performance of the assets. The Company does not believe that the fair value adjustments are an indication of potential claims under the Company’s guarantees. The inception-to-date net mark-to-market loss on the CDS portfolio was $167 at December 31, 2005 and was recorded in other liabilities.

7. Income Taxes

For periods subsequent to the closing date of the Transaction, the Company files its own consolidated federal income tax returns with FGIC Corp. The method of allocation between FGIC Corp. and its subsidiaries is determined under a tax sharing agreement approved by FGIC Corp.’s Board of Directors and the New York State Insurance Department, and is based upon a separate return calculation. For periods ended on or prior to December 18, 2003, the Company filed its federal income tax return as part of the consolidated return of GE Capital. Under a tax sharing agreement with GE Capital, tax was allocated to the Company based upon its contributions to GE Capital’s consolidated net income.


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



7. Income Taxes (continued)

The following is a reconciliation of federal income taxes computed at the statutory income tax rate and the provision for federal income taxes:

   
Successor
  
Predecessor
  
   
 
 
 
Year ended December 31,
  
 
 
 
Year ended December 31,
  
Period from December 18, 2003
through December 31,
  
Period from January 1,
2003
through December 17,
  
   
2005
  
2004
  
2003
  
2003
  
Income taxes computed on income before provision for Federal income taxes, at the statutory income tax rate
  
$
95,037
  
$
78,932
  
$
2,785
  
$
86,383
  
State and local income taxes, net of Federal income taxes
    
453
    
479
    
-
    
844
  
Tax effect of:
                          
Tax-exempt interest
    
(31,072
)
  
(28,015
)
  
(979
)
  
(26,112
)
Prior period adjustment
    
-
    
-
    
-
    
(4,978
)
Other, net
    
690
    
4,037
    
(42
)
  
(678
)
Provision for income taxes
  
$
65,108
  
$
55,433
  
$
1,764
  
$
55,459
  


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



7. Income Taxes (continued)

The tax effects of temporary differences that give rise to significant portions of the net deferred tax liability at December 31, 2005 and 2004 are presented below:

   
2005
  
2004
  
Deferred tax assets:
              
Tax and loss bonds
  
$
24,375
  
$
10,810
  
Loss and loss adjustment expense reserves
    
6,180
    
7,472
  
AMT credit carryforward
    
7,140
    
8,107
  
Property and equipment
    
83
    
55
  
Deferred compensation
    
1,483
    
623
  
Capital lease
    
2,483
    
2,539
  
Net operating loss on foreign subsidiaries
   
2,948
    
-
  
Other
    
266
    
233
  
Total gross deferred tax assets
    
44,958
    
29,839
  
               
Deferred tax liabilities:
              
Contingency reserves
    
42,656
    
18,917
  
Unrealized gains on fixed maturity securities,
available-for-sale
    
12,883
    
29,156
  
Deferred acquisition costs
    
19,639
    
11,842
  
Premium revenue recognition
    
10,359
    
3,076
  
Profit commission
    
1,435
    
2,343
  
Foreign currency
    
194
    
3,117
  
Other
    
255
    
153
  
Total gross deferred tax liabilities
    
87,421
    
68,604
  
Net deferred tax liability
  
$
42,463
  
$
38,765
  

The net operating losses on foreign subsidiaries of $10,863 as of December 31, 2005 were generated by FGIC Corp.’s United Kingdom subsidiaries. The United Kingdom does not allow net operating losses to be carried back, but does permit them to be carried forward indefinitely. Based upon the level of historical taxable income, projections of future taxable income over the periods in which the deferred tax assets are deductible and the estimated reversal of future taxable temporary differences, the Company believes it is more likely than not that it will realize the benefits of these deductible differences and has not established a valuation allowance at December 31, 2005 and 2004.

In the opinion of management, an adequate provision has been made for any additional taxes that may become due pending any future examinations by tax authorities.

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



8. Reinsurance

Reinsurance is the commitment by one insurance company (the reinsurer) to reimburse another insurance company (the ceding company) for a specified portion of the insurance risks under policies issued by the ceding company in consideration for a portion of the related premiums received. The ceding company typically will receive a ceding commission from the reinsurer.

The Company uses reinsurance to increase its capacity to write insurance for obligations of large, frequent issuers, to meet internal, rating agency or regulatory single risk limits, to diversify risk, and to manage rating agency and regulatory capital requirements. The Company currently arranges reinsurance primarily on a facultative (transaction-by-transaction) basis. Prior to 2003, the Company also had treaty reinsurance agreements, primarily for the public finance business, that provided coverage for a specified portion of the insured risk under all qualifying policies issued during the term of the treaty.

The Company seeks to place reinsurance with financially strong reinsurance companies since, as a primary insurer, the Company is required to fulfill all its obligations to policyholders even where a reinsurer fails to perform its obligations under the applicable reinsurance agreement. The Company regularly monitors the financial condition of its reinsurers. Under most of the Company’s reinsurance agreements, the Company has the right to reassume all the exposure ceded to a reinsurer (and receive all the remaining unearned premiums ceded) in the event of a ratings downgrade of the reinsurer or the occurrence of certain other events. In certain of these cases, the Company also has the right to impose additional ceding commissions.

In recent years, some of the Company’s reinsurers were downgraded by the rating agencies, thereby reducing the financial benefits of using reinsurance under rating agency capital adequacy models, because the Company must allocate additional capital to the related reinsured exposure. However, the Company still receives regulatory credit for this reinsurance. In connection with such a downgrade, the Company reassumed $0, $4,959, $6,300, and $14,300 of ceded premiums for the years ended December 31, 2005 and 2004, and the periods from December 18, 2003 through December 31, 2003, and January 1, 2003 through December 17, 2003, respectively, from the reinsurers.

Under certain reinsurance agreements, the Company holds collateral in the form of letters of credit and trust agreements. Such collateral totaled $62,394 at December 31, 2005, and can be drawn on in the event of default by the reinsurer.

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



8. Reinsurance (continued)

The effect of reinsurance on the balances recorded in the consolidated statements of income is as follows:

   
Successor
  
Predecessor
  
   
 
 
 
Year ended December 31,
  
 
 
 
Year ended December 31,
  
Period from December 18, 2003
through December 31,
  
Period from January 1, 2003
through December 17,
  
   
2005
  
2004
  
2003
  
2003
  
                   
Net premiums earned
  
$
25,921
  
$
24,173
  
$
1,236
  
$
20,300
  
Loss and loss adjustment expenses
    
(416
)
  
(4,759
)
  
-
    
1,700
  

9. Loss and Loss Adjustment Expenses

Activity in the reserve for loss and loss adjustment expenses is summarized as follows:

   
Successor
  
Predecessor
  
   
 
 
 
Year ended December 31,
  
 
 
 
Year ended December 31,
  
Period from December 18, 2003
through December 31,
  
Period from January 1, 2003
through December 17,
  
   
2005
  
2004
  
2003
  
2003
  
                   
Balance at beginning of period
  
$
39,181
  
$
40,467
  
$
40,224
  
$
47,868
  
Less reinsurance recoverable
    
(3,054
)
  
(8,065
)
  
(8,058
)
  
(8,371
)
Net balance
   
36,127
    
32,402
    
32,166
    
39,497
  
Incurred related to:
                          
Current period
    
23,985
    
11,756
    
-
    
20,843
  
Prior periods
    
(5,479
)
  
(5,834
)
  
236
    
(27,600
)
Total incurred
    
18,506
    
5,922
    
236
    
(6,757
)
                           
Paid related to:
                          
Current period
    
(1,993
)
  
-
    
-
    
-
  
Prior periods
    
(1,099
)
  
(2,197
)
  
-
    
(574
)
Total paid
    
(3,092
)
  
(2,197
)
  
-
    
(574
)
                           
Net balance
   
51,541
    
36,127
    
32,402
    
32,166
  
Plus reinsurance recoverable
    
3,271
    
3,054
    
8,065
    
8,058
  
Balance at end of period
  
$
54,812
  
$
39,181
  
$
40,467
  
$
40,224
  

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



9. Loss and Loss Adjustment Expenses (continued)

During the year ended December 31, 2005, the increase in incurred expense was primarily related to issuers impacted by Hurricane Katrina. Case reserves and credit watchlist reserves at December 31, 2005 include $8,511 and $13,322, respectively, of estimated losses related to obligations impacted by Hurricane Katrina (see Note 10).

During the year ended December 31, 2004, the increase in incurred expense related to several structured finance transactions of one particular issuer.

During the period from January 1, 2003 through December 17, 2003, the overall decrease in incurred expense was driven by a reduction in reserves previously established on several structured finance transactions of one particular issuer. In addition, prior to the closing of the Transaction, rather than watchlist reserves, the Company established portfolio reserves based upon the aggregate average net par outstanding of the Company’s insured mortgage-backed securities portfolio.

10. Hurricane Katrina

At December 31, 2005, the Company insured public finance obligations with a net par in force (“NPIF”) of approximately $4,011,871 in locations impacted by Hurricane Katrina. Approximately $2,023,315 of these obligations relate to locations designated by the U.S. Federal Emergency Management Administration (“FEMA”) as eligible for both public and individual assistance (“FEMA-dual designated locations”); the remainder, or $1,988,556, of these obligations relate to locations designated by FEMA as eligible for individual assistance only. The Company believes that insured obligations in FEMA-dual designated locations are more likely to be impaired than obligations eligible for individual assistance only. Consequently, since the occurrence of Hurricane Katrina, the Company has focused its portfolio surveillance efforts related to Hurricane Katrina on evaluating its insured public finance obligations in the FEMA-dual designated locations. These FEMA-dual designated locations consist primarily of counties and parishes in Alabama, Mississippi and Louisiana.


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



10. Hurricane Katrina (continued)

As a result of this evaluation, the Company placed insured public finance obligations with an NPIF totaling $979,153 on its credit watchlist of which reserves were recorded on obligations with an NPIF of $585,303. These obligations relate to locations in the Parish of Orleans
(in which New Orleans is located) and the immediately surrounding parishes. At
December 31, 2005, the Company recorded case reserves of $8,511, watchlist reserves of $13,322 and estimated reinsurance recoverables of $1,740 related to insured public finance obligations placed on the credit watchlist. The case reserves of $8,511 relate to an investor-owned utility, for which the Company has insured public finance obligations with an NPIF of $75,000, that has entered into bankruptcy proceedings. The watchlist reserves of $13,322 were based on management’s assessment that the associated insured public finance obligations have experienced impairment due to diminished revenue sources. The NPIF for the insured public finance obligations for which watchlist reserves of $13,322 have been established totals $510,303. The $510,303 (a subset of the $979,153) is supported by the revenue sources below:

 
Revenue Source
  
Net Par
in Force
  
       
General obligation
  
$
90,079
  
Hotel tax
    
165,000
  
Sales tax
    
117,141
  
Municipal utility
    
119,657
  
Public higher education
    
18,426
  
Total
  
$
510,303
  

Given the unprecedented nature of the events and magnitude of damage in the affected areas, the loss reserves were necessarily based upon estimates and subjective judgments about the outcome of future events, including without limitation the amount and timing of any future federal and state aid. The loss reserves will likely be adjusted as additional information becomes available, and such adjustments may have a material impact on future results of operations. However, the Company believes that the losses ultimately incurred as result of Hurricane Katrina will not have a material impact on the Company’s consolidated financial position.


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



10. Hurricane Katrina (continued)

For the year ended December 31, 2005, the Company paid claims totaling $5,910 related to insured public finance obligations impacted by Hurricane Katrina. During 2005, the Company subsequently received reimbursements of $4,855 for these claims payments.

The Company’s structured finance insured portfolio was not significantly impacted by Hurricane Katrina, reflecting the geographic diversification of the credits comprising the insured structured finance obligations.

11. Related Party Transactions

Prior to the Transaction, the Company had various service agreements with subsidiaries of General Electric Company and GE Capital. These agreements provided for the payment by the Company of certain payroll and office expenses, investment fees pertaining to the management of the Company’s investment portfolio and telecommunication service charges. In addition, as part of the Transaction, the Company entered into a transitional services agreement under which GE Capital continued to provide certain administrative and support services, in exchange for certain scheduled fees during the 12 months following the date of the agreement. Approximately $0, $179, $0 and $1,600 in expenses were incurred during the years ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, respectively, related to such agreements and are reflected in the accompanying consolidated financial statements.

At the end of the first quarter of 2004, the Company transferred investment management services from GE Capital to Blackrock Financial Management, Inc. and Wellington Management Company, LLP.

In connection with the Transaction, the Company entered into a capital lease agreement with a subsidiary of GE Capital. The lease agreement covers leasehold improvements made to the Company’s headquarters as well as furniture and fixtures, computer hardware and software used by the Company (see Note 17).


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



11. Related Party Transactions (continued)

In connection with the Transaction, FGIC entered into a $300,000 soft capital facility, with GE Capital as lender and administrative agent. The soft capital facility, which replaced the capital support facility that FGIC previously had with GE Capital, had an initial term of eight years. FGIC paid GE Capital $1,132 and $70 under this agreement for the year ended December 31, 2004 and the period from December 18, 2003 through December 31, 2003, respectively. This agreement was terminated by FGIC in July 2004 and was replaced by a new soft capital facility (see Note 15).

The Company also insures certain non-municipal issues with GE Capital involvement as sponsor of the insured securitization and/or servicer of the underlying assets. For some of these issues, GE Capital also provides first loss protection in the event of default. Gross premiums written on these issues amounted to $3, $6, $0 and $20 for the year ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, respectively. As of December 31, 2005, par outstanding on these deals before reinsurance was $6,142. Issues sponsored by affiliates of GE accounted for approximately 1% of gross premiums written in 2003.

During 2005 FGIC, in the normal course of operations, entered into reinsurance transactions with PMI-affiliated companies. Ceded premiums were $582 for the year ended December 31, 2005 and accounts payable due to PMI were $102 at December 31, 2005.

As of December 31, 2005 and 2004, there were no receivables due from GE Capital.

During 2005 and 2004, the Company allocated certain overhead costs to FGIC Corp. which amounted to $540 and $317, respectively.


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



12. Compensation Plans

All employees of the Company participate in an incentive compensation plan. In addition, the Company offers a deferred compensation plan for eligible employees. Expenses incurred by the Company under compensation plans amounted to $21,824, $15,493, $3,996, and $10,087 for the years ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003, respectively, and are reflected in the accompanying consolidated financial statements. During 2005 and 2004, compensation increased primarily due to an increase in employee headcount. For 2003, compensation for certain employees was part of an allocation of expenses of affiliates and was therefore recorded as an allocated expense rather than compensation expense. In 2005 and 2004, these expenses were directly recorded by the Company. In 2003, compensation levels were driven in part by Transaction-related costs, including retention bonuses and sign-on bonuses to new hires post-acquisition.

Commencing effective January 1, 2004, the Company has offered a defined contribution savings plan under Section 401(k) of the Internal Revenue Code. This plan covers substantially all employees who meet minimum age and service requirements and allows participants to defer a portion of their annual compensation on a pre-tax basis (for 2005, up to $14 for employees under age 50, plus an additional “catch up” contribution of up to $4 for employees 50 and older). The Company may also make discretionary contributions to the plan on behalf of employees. The Company contributed $3,429 and $2,532 to the plan on behalf of employees for the years ended December 31, 2005 and 2004, respectively.

13. Dividends

Under New York insurance law, the Company may pay dividends to FGIC Corp. only from earned surplus, subject to the following limitations: (a) statutory surplus after any dividend may not be less than the minimum required paid-in capital, which was $72,500 in 2005, 2004 and 2003, and (b) dividends may not exceed the lesser of 10% of the Company’s surplus or 100% of adjusted net investment income, as defined by New York insurance law, for the twelve-month period ended on the preceding December 31, without the prior approval of the New York State Superintendent of Insurance.

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



13. Dividends (continued)

During the years ended December 31, 2005 and 2004 and for the period from December 18, 2003 through December 31, 2003, the Company did not declare and pay dividends. During the period from January 1, 2003 through December 17, 2003, the Company declared and paid dividends to FGIC Corp. of $284,300. These dividends were approved by the New York State Superintendent of Insurance.
 
14. Revolving Credit Facility

During December 2005, FGIC Corp. and the Company entered into a $250,000 senior unsecured revolving credit facility that matures on December 11, 2010. The facility is provided by a syndicate of banks and other financial institutions led by JPMorgan Chase, as administrative agent and sole lead arranger. In connection with the facility, $150 in syndication costs was prepaid and will be amortized into income over the term of the facility. The facility replaced a similar one-year facility that matured in December 2005. No draws have been made under either facility.

15. Preferred Trust Securities

On July 19, 2004, the Company closed a $300,000 facility, consisting of Money Market Committed Preferred Custodial Trust Securities (“CPS Securities”). This facility replaced a $300,000 “Soft Capital” facility previously provided by GE Capital. Under the new facility, each of six separate newly organized Delaware trusts (the “Trusts”), issues $50,000 in perpetual CPS Securities on a rolling 28-day auction rate basis. Proceeds from these securities are invested in high quality, short-term securities and are held in the respective Trusts. Each Trust is solely responsible for its obligations and has been established for the purpose of entering into a put agreement with the Company, which obligates the Trusts, at the Company’s discretion, to purchase perpetual Preferred Stock of the Company. In this way, the program provides capital support to the Company by allowing it to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put options. In connection with the establishment of the Trusts, the Company incurred $4,638 of expenses which is included in other operating expenses for the year ended December 31, 2004. The Company recorded expenses for the right to put its shares to the Trusts of $1,806 and $905 for the years ended December 31, 2005 and 2004, respectively.

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



16. Financial Instruments

(a)   Fair Value of Financial Instruments

The following methods and assumptions were used by the Company in estimating the fair values of financial instruments:

Fixed Maturity Securities: Fair values for fixed maturity securities are based on quoted market prices, if available. If a quoted market price is not available, fair values are estimated using quoted market prices for similar securities. Fair value disclosure for fixed maturity securities is included in the consolidated balance sheets and in Note 5.

Short-Term Investments: Short-term investments are carried at cost, which approximates fair value.

Cash and Cash Equivalents, Accrued Investment Income, Prepaid Expenses and Other Assets, Receivable from Related Parties, Ceded Reinsurance Balances Payable, Accounts Payable and Accrued Expenses and Payable for Securities Purchased: The carrying amounts of these items approximate their fair values.

The estimated fair values of the Company’s financial instruments at December 31, 2005 and 2004 were as follows:
 
   
2005
  
 2004
  
     
Carrying Amount
    
Fair
Value
    
Carrying Amount
    
Fair
Value
  
Financial assets:
                          
Cash on hand and in-demand accounts
  
$
45,077
  
$
45,077
  
$
69,292
  
$
69,292
  
Short-term investments
    
159,334
    
159,334
    
140,473
    
140,473
  
Fixed maturity securities
    
3,258,738
    
3,258,738
    
2,938,856
    
2,938,856
  

Financial Guaranties: The carrying value of the Company’s financial guaranties is represented by the unearned premium reserve, net of deferred acquisition costs, loss and loss adjustment expense reserves and prepaid reinsurance premiums. Estimated fair values of these guaranties are based on an estimate of the balance that is necessary to bring the future returns for the Company’s embedded book of business to a market return. The estimated fair values of such financial guaranties was $1,098,165 compared to a carrying value of $1,099,045 as of December 31, 2005, and is $965,992 compared to a carrying value of $936,334 as of December 31, 2004.


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



16. Financial Instruments (continued)

As of December 31, 2005 and 2004, the net present value of future installment premiums was approximately $393,000 and $192,000, respectively, both discounted at 5%.

Derivatives: For fair value adjustments on derivatives, the carrying amount represents fair value. The Company uses quoted market prices when available, but if quoted market prices are not available, management uses internally developed estimates.

(b)   Concentrations of Credit Risk

The Company considers its role in providing insurance to be credit enhancement rather than credit substitution. The Company insures only those securities that, in its judgment, are of investment grade quality. The Company has established and maintains its own underwriting standards that are based on those aspects of credit that the Company deems important for the particular category of obligations considered for insurance. Credit criteria include economic and social trends, debt management, financial management and legal and administrative factors, the adequacy of anticipated cash flows, including the historical and expected performance of assets pledged to secure payment of securities under varying economic scenarios, and underlying levels of protection such as insurance or over-collateralization.

In connection with underwriting new issues, the Company sometimes requires, as a condition to insuring an issue, that collateral be pledged or, in some instances, that a third-party guaranty be provided for a term of the obligation issued by a party of acceptable credit quality obligated to make payment prior to any payment by the Company. The types and extent of collateral varies, but may include residential and commercial mortgages, corporate debt, government debt and consumer receivables.

As of December 31, 2005, the Company’s total outstanding principal insured was $275,327,000, net of reinsurance of $22,711,000. The Company’s insured portfolio as of December 31, 2005 was broadly diversified by geographic and bond market sector, with no single obligor representing more than 1% of the Company’s insured principal outstanding, net of reinsurance. The insured portfolio includes exposure under credit derivatives. The par written for credit derivatives was $15,640,000 at December 31, 2005.

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



16. Financial Instruments (continued)

As of December 31, 2005, the composition of principal insured by type of issue, net of reinsurance, was as follows:

   
Net Principal
 
   
Outstanding
  
Municipal:
      
Tax supported
  
$
134,762,000
  
Water and sewer
    
34,859,000
  
Healthcare
    
4,216,000
  
Transportation
    
24,956,000
  
Education
    
9,939,000
  
Housing
    
1,234,000
  
Other
    
5,153,000
  
Non-municipal and international
    
60,208,000
  
Total
  
$
275,327,000
  

As of December 31, 2005, the composition of principal insured ceded to reinsurers was as follows:

   
Ceded Principal
 
   
Outstanding
  
Reinsurer:
        
Radian Reinsurance Company
  
$
7,808,000
  
Ace Guaranty Inc.
    
6,367,000
  
American Re-Insurance Company
    
2,231,000
  
RAM Reinsurance Company
    
2,024,000
  
Other
    
4,281,000
  
Total
  
$
22,711,000
  

The Company did not have recoverables in excess of 3% of stockholders’ equity from any single reinsurer.
The Company’s insured gross and net principal and interest outstanding was $472,161,000 and $433,587,000, respectively, as of December 31, 2005.


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



16. Financial Instruments (continued)

FGIC is authorized to do business in 50 states, the District of Columbia, the Commonwealth of Puerto Rico, the U.S. Virgin Islands and in the United Kingdom. Principal insured outstanding at December 31, 2005 by state, net of reinsurance, was as follows:

   
Net Principal
 
   
Outstanding
  
       
California
  
$
32,882,000
  
New York
    
21,265,000
  
Pennsylvania
    
15,952,000
  
Florida
    
15,483,000
  
Illinois
    
13,049,000
  
Texas
    
12,223,000
  
New Jersey
    
10,883,000
  
Michigan
    
8,311,000
  
Ohio
    
6,903,000
  
Washington
    
6,359,000
  
     
143,310,000
  
         
All other states
    
71,809,000
  
Mortgage and asset-backed
    
54,262,000
  
International
    
5,946,000
  
Total
  
$
275,327,000
  


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



17. Commitments

The Company leases office space and equipment under operating lease agreements in the United States and the United Kingdom. Rent expense under operating leases for the years ended December 31, 2005 and 2004 and for the period from December 18, 2003 through December 31, 2003 and January 1, 2003 through December 17, 2003 was $3,631, $3,070, $90, and $3,210, respectively. Future payments associated with these leases are as follows:

   
Operating Lease Commitment
  
   
Amount
  
Year:
        
2006
  
$
3,141
  
2007
    
3,119
  
2008
    
1,968
  
2009
    
412
  
2010
    
412
  
2011 and thereafter
    
1,496
  
Total minimum future rental payments
  
$
10,548
  

In connection with the Transaction, the Company entered into a capital lease with a related party (an affiliate of GE Capital), covering leasehold improvements and computer equipment to be used at its headquarters. At the lease termination date of June 30, 2009, the Company will own the leased equipment. Future payments associated with this lease are as follows:

   
Operating Lease Commitment
  
   
Amount
  
Year ending December 31:
      
2006
  
$
1,570
  
2007
    
1,545
  
2008
    
1,391
  
2009
    
265
  
Total
    
4,771
  
Less interest
    
509
  
Present value of minimum lease payments
  
$
4,262
  

 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



18. Comprehensive Income

Accumulated other comprehensive (loss) income of the Company consists of net unrealized gains on investment securities, foreign currency translation adjustments, and a cash flow hedge. The components of other comprehensive income for the years ended December 31, 2005 and 2004 and for the periods from December 18, 2003 through December 31, 2003, and January 1, 2003 through December 17, 2003 are as follows:

   
Year ended December 31, 2005
  
   
Before
Tax
Amount
  
Tax
  
Net of
Tax
Amount
  
               
Unrealized holding losses arising during the year
  
$
(36,050
)
$
12,566
  
$
(23,484
)
Less reclassification adjustment for gains realized
in net income
    
(101
)
  
35
    
(66
)
Unrealized losses on investments
    
(36,151
)
  
12,601
    
(23,550
)
Foreign currency translation adjustment
    
(8,454
)
  
2,922
    
(5,532
)
Total other comprehensive loss
  
$
(44,605
)
$
15,523
  
$
(29,082
)

   
Year ended December 31, 2004
  
   
Before
Tax
Amount
  
Tax
  
Net of
Tax
Amount
  
               
Unrealized holding gains arising during the year
  
$
14,928
  
$
(5,225
)
$
9,703
  
Less reclassification adjustment for gains realized
in net income
    
(559
)
  
196
    
(363
)
Unrealized gains on investments
    
14,369
    
(5,029
)
  
9,340
  
Foreign currency translation adjustment
    
6,286
    
(2,200
)
  
4,086
  
Total other comprehensive income
  
$
20,655
  
$
(7,229
)
$
13,426
  


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



18. Comprehensive Income (continued)


   
Period from December 18, 2003 through December 31, 2003
  
   
Before
Tax
Amount
  
Tax
  
Net of
Tax
Amount
  
               
Unrealized holding gains arising during the period
  
$
3,168
  
$
(1,109
)
$
2,059
  
Less reclassification adjustment for gains realized
in net income
    
-
    
-
    
-
  
Unrealized gains on investments
    
3,168
    
(1,109
)
  
2,059
  
Total other comprehensive income
  
$
3,168
  
$
(1,109
)
$
2,059
  

   
Period from January 1, 2003
through December 17, 2003
  
   
Before
Tax
Amount
  
Tax
  
Net of
Tax
Amount
  
               
Unrealized holding gains arising during the period
  
$
30,853
  
$
(10,798
)
$
20,055
  
Less reclassification adjustment for gains realized
in net income
    
(31,506
)
  
11,027
    
(20,479
)
Unrealized losses on investments
    
(653
)
  
229
    
(424
)
Foreign currency translation adjustment
    
6,565
    
(2,298
)
  
4,267
  
Total other comprehensive income
  
$
5,912
  
$
(2,069
)
$
3,843
  


 
 
 



Financial Guaranty Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (continued)


(Dollars in thousands, except per share amounts)



19. Quarterly Financial Information (Unaudited)

   
Three months ended
  
Year ended
  
   
March 31,
2005
  
June 30,
2005
  
September 30, 2005
  
December 31, 2005
  
December 31, 2005
  
                       
Gross premiums written
  
$
84,404
  
$
131,335
  
$
96,787
  
$
97,676
  
$
410,202
  
Net premiums written
    
82,609
    
113,305
    
92,331
    
92,809
    
381,054
  
Net premiums earned
    
52,633
    
61,907
    
54,794
    
55,235
    
224,569
  
Net investment income and net realized gains
    
27,558
    
28,389
    
30,117
    
31,109
    
117,173
  
Other income (expense)
    
426
    
90
    
402
    
(323
)
  
595
  
Total revenues
    
80,617
    
90,386
    
85,313
    
86,021
    
342,337
  
Losses and loss adjustment expenses
    
(2,611
)
  
(3,066
)
  
20,693
    
3,490
    
18,506
  
Income before taxes
    
71,100
    
81,377
    
48,783
    
70,274
    
271,534
  
Net income
    
53,306
    
59,992
    
39,407
    
53,721
    
206,426
  

   
Three months ended
  
Year ended
  
   
March 31,
2004
  
June 30,
2004
  
September 30, 2004
  
December 31, 2004
  
December 31, 2004
  
                       
Gross premiums written
  
$
56,395
  
$
106,457
  
$
87,869
  
$
72,854
  
$
323,575
  
Net premiums written
    
53,649
    
105,645
    
87,072
    
67,512
    
313,878
  
Net premiums earned
    
31,202
    
53,151
    
49,760
    
40,836
    
174,949
  
Net investment income and net realized gains
    
24,198
    
22,611
    
24,466
    
26,993
    
98,268
  
Other income (expense)
    
317
    
240
    
117
    
62
    
736
  
Total revenues
    
55,717
    
76,002
    
74,343
    
67,891
    
273,953
  
Losses and loss adjustment expenses
    
664
    
(1,070
)
  
6,725
    
(397
)
  
5,922
  
Income before taxes
    
48,208
    
64,839
    
56,713
    
55,759
    
225,519
  
Net income
    
38,304
    
48,393
    
41,954
    
41,435
    
170,086