UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
S QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2007
OR
£ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 001-32950
SECURITY CAPITAL ASSURANCE LTD
(Exact name of registrant as specified in its charter)
|
|
|
BERMUDA |
NOT APPLICABLE |
26 Reid Street, Hamilton, Bermuda HM 11
(Address of principal executive offices and zip code)
(441) 295-7135
(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 S No £
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer £ Accelerated filer £ Non-accelerated filer S
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No S
As of August 10, 2007, there were 65,309,230 outstanding Common Shares, $0.01 par value per share, of the registrant.
SECURITY CAPITAL ASSURANCE LTD Page No Item 1. Interim Consolidated Balance Sheets as of June 30, 2007 (Unaudited)
and December 31, 2006 3 4 5 6 Notes to Unaudited Interim Consolidated Financial Statements 7 Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations 23 Item 3. 54 Item
4. 54 Item 4T. 54 Item 1. 55 Item 1A. 55 Item 2. Item
3. 56 Item 4. 56 Item
5. 56 Item 6. 57 58 2
INDEX TO FORM 10-Q
(Unaudited)
As of ASSETS Investments Debt securities available for sale, at fair value (amortized cost: 2007 $2,259,673; 2006 $1,755,184)
$
2,218,131
$
1,736,462 Short-term investments, at fair value (amortized cost: 2007 $57,501; 2006 $222,930)
57,279
221,901 Total investments
2,275,410
1,958,363 Cash and cash equivalents
184,512
202,548 Accrued investment income
18,188
16,515 Deferred acquisition costs
105,375
93,809 Prepaid reinsurance premiums
79,706
59,983 Premiums receivable
20,620
12,936 Reinsurance balances recoverable on unpaid losses
82,775
88,616 Intangible assets acquired licenses
11,529
11,529 Deferred income tax asset
16,201
18,182 Other assets
38,031
34,333 Total assets.
$
2,832,347
$
2,496,814 LIABILITIES, MINORITY INTEREST AND Liabilities Unpaid losses and loss adjustment expenses
$
174,528
$
178,517 Deferred premium revenue
861,880
795,906 Reinsurance premiums payable
12,518
13,952 Payable for investments purchased
5,435 Accounts payable, accrued expenses and other liabilities
89,934
82,468 Total liabilities
1,138,860
1,076,278 Commitments and contingencies Minority interest redeemable preferred shares of subsidiary.
39,000
54,016 Shareholders Equity Series A perpetual non-cumulative preference shares (Par value $0.01 per share; 250,000 shares authorized; issued and outstanding At June 30, 2007: 250,000, at
December 31, 2006: 0)
3
Common shares (Par value $0.01 per share; 500,000,000 shares authorized; shares issued and outstanding At June 30, 2007: 65,298,275, at December 31, 2006: 64,634,292)
653
646 Additional paid in capital
1,237,005
987,798 Retained earnings
458,363
397,781 Accumulated other comprehensive loss
(41,537
)
(19,705
) Total shareholders equity
1,654,487
1,366,520 Total liabilities, minority interest and shareholders equity
$
2,832,347
$
2,496,814 See accompanying Notes to Unaudited Interim Consolidated Financial Statements 3
As of
June 30,
2007
December 31,
2006
SHAREHOLDERS EQUITY
(Unaudited)
(Unaudited)
2007
2006
2007
2006 Revenues Gross premiums written
$
65,157
$
99,351
$
154,652
$
170,131 Reinsurance premiums assumed
5,504
8,292
20,967
19,695 Total premiums written
70,661
107,643
175,619
189,826 Ceded premiums
(8,564
)
(6,160
)
(28,797
)
(13,752
) Net premiums written
62,097
101,483
146,822
176,074 Change in net deferred premium revenue
(7,905
)
(45,942
)
(46,251
)
(82,720
) Net premiums earned (net of ceded premiums earned of $5,193, $10,021, $9,074 and $18,224)
54,192
55,541
100,571
93,354 Net investment income
30,263
16,129
56,388
31,191 Net
realized losses on investments
(1,654
)
(10,717
)
(1,542
)
(16,400
) Net realized and unrealized (losses) gains on derivative financial instruments
(22,175
)
301
(29,104
)
(3,549
) Fee income and other
85
971
85
2,231 Total revenues
60,711
62,225
126,398
106,827 Expenses Net losses and loss adjustment expenses
3,028
2,880
2,227
6,329 Acquisition costs, net
3,779
4,542
7,749
7,224 Operating expenses
26,553
17,492
50,623
34,587 Total expenses
33,360
24,914
60,599
48,140 Income before income tax and minority interest
27,351
37,311
65,799
58,687 Income tax expense (benefit)
632
(203
)
711
(188
) Income before minority interest
26,719
37,514
65,088
58,875 Minority interest dividends on redeemable preferred shares
804
1,126
1,918
5,738 Net income
25,915
36,388
63,170
53,137 Dividends on Series A perpetual non-cumulative preference shares
Net income available to common shareholders
$
25,915
$
36,388
$
63,170
$
53,137 Earnings per share available to common shareholders: Basic
$
0.40
$
0.79
$
0.98
$
1.15 Diluted
$
0.40
$
0.79
$
0.98
$
1.15 Weighted-average common shares outstanding: (Shares in thousands) Basic
64,136
46,127
64,136
46,127 Diluted
64,507
46,127
64,423
46,127 Comprehensive income: Net income
$
25,915
$
36,388
$
63,170
$
53,137 Change in unrealized depreciation of investments, net of deferred tax benefit of $214, $57, $181, and $57
(28,203
)
(10,859
)
(21,832
)
(29,339
) Total comprehensive (loss) income
$
(2,288
)
$
25,529
$
41,338
$
23,798 See accompanying Notes to Unaudited Interim Consolidated Financial Statements 4
Three Months Ended
June 30,
Six Months Ended
June 30,
(Unaudited)
Year Ended Series A perpetual non-cumulative preference shares Balance beginning of year
$
$
Issuance of shares
3
Balance end of period
3
Common shares Balance beginning of year
646
461 Issuance of common shares
7
185 Balance end of period
653
646 Additional Paid-In Capital Balance beginning of year
987,798
605,951 Issuance of Series A redeemable preferred shares, net of underwriting fees and issuance costs
246,580
Initial public offering proceeds, net of underwriting fees and issuance costs
(250
)
341,082 Restricted stock and stock options
2,638
827 Capital contributions
239
39,938 Balance end of period
1,237,005
987,798 Retained Earnings Balance beginning of year
397,781
281,709 Net income
63,170
117,355 Dividends on common shares
(2,588
)
(1,283
) Balance end of period
458,363
397,781 Accumulated Other Comprehensive Loss Balance beginning of year
(19,705
)
(20,307
) Net change in unrealized appreciation of investments
(21,832
)
602 Balance end of period
(41,537
)
(19,705
) Total shareholders equity
$
1,654,487
$
1,366,520 See accompanying Notes to Unaudited Interim Consolidated Financial Statements 5
Six Months
Ended June 30,
2007
December 31,
2006
(Unaudited)
2007
2006 Cash provided by operating activities: Net income available to common shareholders
$
63,170
$
53,137 Adjustments to reconcile net income to net cash provided by operating activities: Net realized (gains) losses on investments
1,542
16,400 Net realized and unrealized losses on derivative financial instruments
29,104
3,549 Amortization of premium on bonds
871
2,028 Minority interest dividends on redeemable preferred shares
1,918
5,738 Deferred tax provision (benefit)
2,163
(774
) (Increase)
in accrued investment income
(1,673
)
(1,049
) (Increase) in deferred acquisition costs
(11,566
)
(11,346
) (Increase) decrease in prepaid reinsurance premiums
(19,723
)
4,471 (Increase) in premiums receivable
(7,684
)
(3,129
) Decrease (increase) in reinsurance balances recoverable on unpaid losses
5,841
(1,245
) (Decrease) increase in unpaid losses and loss adjustment expenses
(3,989
)
6,011 Increase in deferred premium revenue
65,974
78,249 (Decrease) increase in reinsurance premiums payable
(1,434
)
1,248 Other, net
(23,398
)
(7,385
) Total adjustments
37,946
92,766 Net cash provided by operating activities
101,116
145,903 Cash flows from investing activities: Proceeds from sale of debt securities
80,243
216,757 Purchases of debt securities
(689,502
)
(331,408
) Net sales (purchases) of short-term investments
97,139
(32,022
) Proceeds from maturity of debt securities and short term investments
165,242
41,152 Net cash used in investing activities
(346,878
)
(105,521
) Cash flows from financing activities: Dividends on common shares
(2,588
)
Net cash proceeds from issuance of Series A perpetual non-cumulative preference shares
247,248
Extraordinary dividend on redeemable preferred shares
(15,016
)
Dividends on redeemable preferred shares
(1,918
)
(2,559
) Net cash provided by (used in) financing activities
227,726
(2,559
) Decrease (increase) in cash and cash equivalents
(18,036
)
37,823 Cash and cash equivalents beginning of year
202,548
54,593 Cash and cash equivalents end of period
$
184,512
$
92,416 Supplemental Cash Flow Disclosure Non-cash capital contributions
$
239
$
1,352 See accompanying Notes to Unaudited Interim Consolidated Financial Statements 6
Six Months Ended
June 30,
SECURITY CAPITAL ASSURANCE LTD 1. Organization On March 17, 2006, XL Capital Ltd (XL Capital) formed Security Capital Assurance Ltd (SCA), as a wholly owned Bermuda based subsidiary holding company. On July 1, 2006, XL Capital
contributed all its ownership interests in its financial guarantee insurance and financial guarantee reinsurance operating businesses to SCA. The aforementioned operating businesses consisted of: (i)
XL Capital Assurance Inc. (XLCA) and its wholly-owned subsidiary, XL Capital Assurance (U.K.) Limited (XLCA-UK) and (ii) XL Financial Assurance Ltd. (XLFA). XLCA was an indirect
wholly owned subsidiary of XL Capital and all of XLFA was owned by XL Capital except for a preferred stock interest which is owned by Financial Security Assurance Holdings Ltd. (FSAH), an
entity which is otherwise not related to XL Capital or SCA. SCA, XLCA, XLFA and all other subsidiaries of SCA are hereafter collectively referred to as the Company. On August 4, 2006, SCA completed the sale of 18,009,119 of its common shares through an initial public offering (the IPO). SCA received net proceeds from the IPO of $341.3 million. In
addition, XL Capital sold 5,430,774 of SCAs common shares (including 992,165 common shares pursuant to the exercise of an over-allotment option granted to underwriters) from its holdings directly
to the public in a secondary offering concurrent with the IPO. SCA did not receive any of the proceeds from the aforementioned sale by XL Capital. Immediately after the IPO and the secondary
offering, XL Capital owned 40,696,471 SCA common shares, which represented approximately a 63 percent economic interest in SCA, adjusted for restricted share awards to the Companys employees
and management granted at the effective date of the IPO. In June 2007, XL Capital completed the sale of an additional 10,627,422 common shares of SCA from its holdings (including 947,400
common shares pursuant to the exercise of an over-allotment option granted to underwriters). SCA did not receive any of the proceeds from this sale. Immediately after such sale XL Capital owned
30,069,049 common shares of SCA, which represented approximately a 46 percent voting and economic interest in SCA, adjusted for restricted share awards to the Companys employees and
management outstanding as of such date. Prior to XL Capitals sale of SCA common shares in June 2007 its voting interest in SCA was subject to limitations contained in our bye-laws. 2. Basis of Presentation and Consolidation The unaudited interim consolidated financial statements 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, consisting of normally recurring adjustments, necessary for a fair presentation of the Companys consolidated financial condition,
results of operations and cash flows for the periods presented, including the elimination of all significant inter-company accounts and transactions. In addition, certain reclassifications have been made
to prior period consolidated financial statement amounts to conform to current year presentation. There was no effect on prior period reported net income as a result of these reclassifications. Interim consolidated financial statements do not include all of the information and footnotes required by GAAP for annual financial statements. 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. In addition, the results of operations
for the interim period ended June 30, 2007 are not necessarily indicative of the results that may be expected for the year ended December 31, 2007. These interim consolidated financial statements of
the Company should be read in conjunction with the annual audited consolidated financial statements of the Company as of December 31, 2006 and 2005 and for the years ended December 31, 2006,
2005, and 2004 included in the Companys Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 15, 2007. 7
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
For the period ended June 30, 2006, certain expenses reflected in the financial statements include allocations of expenses by XL Capital related to general and administrative services provided to
the Company. These expenses were allocated based on estimates of the cost incurred by XL Capital to provide these services to the Company. Management believes that the methods used to
estimate the costs allocated to the Company are reasonable. However, these results do not necessarily represent what the historical consolidated financial position, results of operations and cash flows
of the Company would have been if the Company had been a separate stand-alone entity during the periods presented. 3. Derivative Financial Instruments The Companys derivative financial instruments principally include credit default swaps issued to its customers and guarantees of interest rate swap contracts in connection with its guarantees of
certain debt obligations. Credit default swaps and financial guarantees of interest rate swaps entered into by the Company meet the definition of a derivative instrument under Financial Accounting Standards Board
(FASB) Statement of Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), as amended by SFAS No. 149. Credit default swaps are
recognized at fair value and recorded as either assets or liabilities in the accompanying consolidated balance sheets. The Company intends to hold these derivative instruments until maturity. The fair values of derivative instruments are determined using models developed by the Company and are dependent upon a number of market factors including changes in interest rates, credit
spreads, changes in credit quality, and expected recovery rates. The change resulting from movements in these factors is unrealized as the contracts are not traded to realize this value. Other elements
of the change in fair value are based upon pricing established at the inception of the contract, as well as events triggering loss payments under the contracts by the Company. Changes in the fair value of credit default swaps attributable to earnings from premiums received by the Company from the issuance of such contracts are recorded in the line item caption
entitled net premiums earned in the accompanying consolidated statement of operations. In addition, changes in the fair value of credit default swaps attributable to losses from actual and expected
payments to counterparties under such contracts are recorded in the line item caption entitled net losses and loss adjustment expenses in the accompanying consolidated statement of operations, and
the remaining components of the change in fair value of credit default swaps, which are attributable to the market and other factors discussed above, are recorded in the line item caption entitled
net realized and unrealized gains (losses) on derivative financial instruments in the accompanying consolidated statement of operations. This presentation is applicable only to credit default swaps
issued by the Company that it has the intent and ability to hold to maturity. The Companys credit default swap portfolio generally requires the Company to meet payment obligations for referenced credits within the portfolio in the event of specific credit events after
exhaustion of various first-loss protection levels. These credit events are contract-specific, but generally cover bankruptcy, failure to pay and repudiation. The Companys credit default swap portfolio
consists of structured pools of corporate obligations that were awarded investment-grade ratings at the deals inception. At June 30, 2007, on a net par basis, approximately 97% of the portfolio was
rated AAA with the remaining 3% rated at or above investment-grade and the weighted average term of the contracts in-force was 8.4 years. The following tables present the amounts related to credit default swaps and other derivative financial instruments reflected in our financial statements as of and for the periods indicated: 8
Three Months Ended
Six Months Ended
June 30, 2007
June 30, 2006
June 30, 2007
June 30, 2006 (U.S. dollars in thousands) Statement of Operations: Net premiums earned
$
9,177
$
5,668
$
16,654
$
10,715 Net losses and loss adjustment expenses
870
724
1,887
1,274 Net realized and unrealized (losses) gains on derivative financial instruments
(22,175
)
301
(29,104
)
(3,549
)
As at
As at Balance sheet: Reinsurance balances recoverable on unpaid losses
$
960
$
1,111 Other assets
7,633
11,976 Unpaid losses and loss adjustment expenses
16,018
14,283 Deferred premium revenue
103
137 Accounts payable, accrued expenses and other liabilities
28,940
5,117 4. Recent Accounting Pronouncements Proposed Statement of Financial Accounting Standards (SFAS), Accounting for Financial Guarantee Insurance Contracts On April 18, 2007, the Financial Accounting Standards Board (FASB) issued Proposed SFAS, Accounting for Financial Guarantee Insurance Contracts an interpretation of FASB Statement
No. 60. This proposed Statement would clarify how FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises, applies to financial guarantee insurance contracts. This proposed
Statement, among other things, would change current industry practices with respect to the recognition of premium revenue and claim liabilities. In addition, this proposed Statement would require
that the measurement of the initial deferred premium revenue (liability) be the present value of the contractual premium due pursuant to the terms of the financial guarantee insurance contract,
thereby changing current industry accounting practice with respect to insurance contracts priced on an installment basis by requiring that the present value of all contractual premiums due under such
contracts, currently or in the future, be recorded on the companys balance sheet as premiums receivable. Under current industry practice such premiums are not reflected on the balance sheet. In regard to premium revenue recognition, the proposed Statement provides for premium to be recognized as revenue, for both upfront and installment paying policies, in proportion to the
insured contractual principal and interest payments made by the issuer of the insured financial obligation, rather than being recognized over the term of each maturity for upfront premium paying
policies, or over the installment period for installment premium paying policies. This change would generally result in a volatile revenue recognition pattern over the life of the insured obligation as
premium would only be recognized as the insured obligations principal or interest is paid. Furthermore, for certain bonds such as investor-owned utilities, CDOs and many other types of asset-backed
securities that do not have periodic payments, this change would result in significantly slower and back-ended revenue recognition. The volatility would be most evident for insured securities whereby
the principal payments are made at maturity but would also impact public finance insured securities with customized amortization schedules. For installment paying policies, the proposed Statement
requires that the discount, equating to the difference between gross installment premiums and the present value of installment premiums, be recognized as investment income rather than premiums.
We expect that the initial effect of applying the revenue recognition provisions of the Statement as currently proposed will be material to the Companys financial statements. 9
June 30,
2007
December 31,
2006
In regard to the recognition of claim liabilities, the proposed Statement provides that claim liabilities shall be established when the insurance enterprise expects that a claim loss will exceed the
deferred premium revenue (liability) for a contract based on expected cash flows discounted using a risk-adjusted rate at initial recognition of the claim liability and, that, the assumptions underlying
such liability be consistent with the information tracked and monitored through the companys surveillance list maintained by the insurance enterprise to evaluate credit deterioration in its insured
financial obligations. We expect that implementation of this guidance as currently proposed would cause the Company to de-recognize its reserves for unallocated losses and loss adjustment expenses
and preclude it from providing such reserves in the future. The comment period for the proposed Statement expired on June 18, 2007. A round table discussion between the FASB and interested parties who provided comments on the proposed
Statement has been rescheduled to early September 2007 from mid-July of 2007. Currently the proposed Statement is due to be effective for fiscal years beginning after December 15, 2007. The
Company is continuing to evaluate the effect of the proposed Statement on its financial statements. SFAS No. 155, Accounting for Certain Hybrid Financial Instruments In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155), which amends SFAS No. 133, Accounting for Derivative Instruments
and Hedging Activities (SFAS 133) and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140), and addresses issues raised
in SFAS 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial Interests in Securitized Financial Assets. The primary objectives of SFAS 155 are: (i) with respect to SFAS
133, to address the accounting for beneficial interests in securitized financial assets and (ii) with respect to SFAS 140, to eliminate a restriction on the passive derivative instruments that a qualifying
special purpose entity may hold. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entitys first fiscal year that begins after September 15, 2006. The
Company adopted SFAS 155 on January 1, 2007 and it has had no effect on the Companys financial condition or results of operations. FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109 In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 prescribes a
recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on
de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company
adopted FIN 48 on January 1, 2007 and it has not had any effect on the Companys financial condition or results of operations. SFAS No. 157, Fair Value Measurements In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157) which defines fair value, establishes a framework for measuring fair value in generally accepted
accounting principles, and expands disclosures about fair value measurements. This Statement is applicable in conjunction with other accounting pronouncements that require or permit fair value
measurements, where the FASB previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new
fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within these fiscal years. The Company is
currently evaluating the effect the adoption of SFAS 157 will have on its financial statements. 10
SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). SFAS 159 provides the Company an irrevocable option to
report selected financial assets and liabilities at fair value with changes in fair value recorded in earnings. The option is applied, on a contract-by-contract basis, to an entire contract and not only to
specific risks, specific cash flows or other portions of that contract. Upfront costs and fees related to a contract for which the fair value option is elected shall be recognized in earnings as incurred
and not deferred. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar
types of assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the effect, if any, the adoption of SFAS 159 will have on
its financial statements. Proposed FASB Staff Position EITF 03-6-a, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities In October 2006, the FASB issued proposed FASB Staff Position EITF 03-6-a, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities.
This FASB Staff Position (FSP) addresses whether instruments granted in share-based payment transactions may be participating securities prior to vesting and, therefore, need to be included in the
earnings allocation in computing basic earnings per share (EPS) pursuant to the two-class method described in paragraphs 60 and 61 of FASB Statement No. 128, Earnings Per Share. A share-
based payment award that contains a non-forfeitable right to receive cash when dividends are paid to common shareholders irrespective of whether that award ultimately vests or remains unvested
shall be considered a participating security as these rights to dividends provide a non-contingent transfer of value to the holder of the share-based payment award. Accordingly, these awards should be
included in the computation of basic EPS pursuant to the two-class method. The guidance in this proposed FSP would be effective in the first reporting period beginning after the FASB posts the
final FSP to its website. All prior period EPS data will have to be adjusted retrospectively to reflect the provisions of the FSP. Under the terms of the Companys restricted stock awards, grantees are
entitled to the right to receive dividends on the unvested portions of their awards. There is no requirement to return these dividends in the event the unvested awards are forfeited in the future.
Accordingly, this FSP will have an effect on the Companys EPS calculations should the FASB adopt the proposed guidance during 2007. The Company will continue to evaluate the effect of this
guidance. 5. Premiums Earned from Refunded and Called Bonds Premiums earned include $5.7 million and $23.2 million, and $7.0 million and $25.2 million for the three and six months ended June 30, 2007 and 2006, respectively, related to refunded and called
bonds. 6. Related Party Transactions Concurrent with the IPO, the Company entered into arrangements with affiliates of XL Capital: (i) to provide it protection with respect to adverse development on certain transactions, (ii) to
have exposures transferred to it or re-assume exposures under certain financial guarantee policies that were originally reinsured to, or written on behalf of, the Company by XLI, due principally to
single risk constraints and rating agency capital adequacy requirements applicable to the Company at the time that business was first written, (iii) to cancel the Companys reinsurance of certain non-
financial guarantee business ceded to it by XLI, and (iv) to govern certain aspects of Companys relationship with XL Capital after the IPO, including a series of service agreements under which
subsidiaries of XL Capital will provide certain services to the Company or receive certain services from the Company for a period of time after the IPO. The aforementioned arrangements are
discussed further below. 11
In addition, in connection with the IPO, XL Capital agreed to fund a portion of long-term compensation awarded by XL Capital to employees of SCA prior to the IPO and which remained
outstanding under XL Capitals long-term compensation plans subsequent to the IPO. In this regard, SCA reflects the full cost of the periodic charges from such long-term compensation in its
earnings each period, XL Capital charges approximately 60% of such cost to SCA, and SCA records a capital contribution from XL Capital equal to the remaining 40% of such cost. The aggregate
remaining future cost of such long-term compensation to SCA is approximately $1.3 million at June 30, 2007, of which SCA will pay XL Capital approximately $0.8 million and XL Capital will fund
$0.5 million. During the three and six months ended June 30, 2007, respectively, the Company recorded compensation expense related to such awards of $0.2 million and $0.5 million, respectively. Services Agreements with Affiliates Prior to the IPO, the Company purchased various services from affiliates of XL Capital under various agreements and continues to purchase such services under new agreements that became
effective at the date of the IPO. Such services principally include: (i) information technology support, (ii) reinsurance and retrocessional consulting and management services, (iii) actuarial, finance,
legal, internal audit services and certain investment management services. For the three and six months ended June 30, 2007 and 2006, the Company incurred costs under the aforementioned
agreements aggregating $1.5 million and $2.2 million, and $2.5 million and $4.7 million, respectively, which are reflected in operating expenses in the accompanying consolidated statements of
operations. Employee Benefit Plans The Company maintains a qualified defined contribution pension plan for the benefit of all eligible employees and a non-qualified deferred compensation plan for the benefit of certain employees
(collectively, the SCA Plans). Prior to the IPO, XL America, Inc (XLA) maintained plans, with substantially the same terms, which employees of the Company participated in (the XLA Plans).
Discretionary contributions to the SCA Plans and XLA Plans are based on a fixed percentage of employee contributions and compensation, as defined aforementioned plans. For the three and six
months ended June 30, 2007 and 2006, the Company incurred costs under the aforementioned plans aggregating $1.7 million and $0.5 million, and $3.4 million and $1.2 million, respectively, which are
reflected in operating expenses in the accompanying consolidated statements of operations. Reinsurance Agreements with Affiliates and Other Guarantees The Company has the following reinsurance agreements with affiliates. Certain of the agreements discussed below may be terminated under certain conditions, as defined in the agreements.
Effective August 4, 2006, certain subsidiaries of XL Capital indemnified the Company for all losses and loss adjustment expenses incurred in excess of its retained reserves at the effective date
of the agreement relating to an insured project financing described in Note 9 (a). In consideration for the aforementioned indemnifications the Company is obligated to pay such affiliates
approximately $9.8 million on an installment basis over the life of the aforementioned project financing. As this premium is due irrespective of any early termination of the underlying insurance
transaction, the Company recorded a liability of approximately $7.0 million at the effective date of the indemnifications (representing the present value of the obligation discounted at 5.0%,
which reflects the rate on treasury obligations with a term to maturity commensurate with that of the liability) and a corresponding deferred cost, which are reflected in the accompanying
consolidated balance sheet in reinsurance premiums payable and prepaid reinsurance premiums, respectively. For the three and six months ended June 30, 2007, the Company incurred costs
under the aforementioned 12
agreements aggregating approximately $0.2 million and $0.4 million and the balance of the aforementioned liability and deferred cost was $6.4 million at June 30, 2007. Effective August 4, 2006, XLA has undertaken to indemnify the Company for any diminution in value below their carrying value at June 30, 2006 of the notes and preferred shares described in
Note 9, which notes and preferred shares were acquired in connection with the satisfaction of a claim under a financial guarantee insurance policy issued by XLCA. In addition, pursuant to the
aforementioned indemnity, XLA agreed to indemnify the Company for any costs arising out of any litigation or future claim in connection with the aforementioned insurance policy. See Note 9
for further information regarding amounts recovered or recoverable by SCA under the indemnity. On August 4, 2006, XLFA terminated a facultative quota share reinsurance treaty with XLI that had been effective since 2001. As a result of the termination, XLI returned $26.5 million of
premiums to XLFA, XLFA returned ceding commissions of $7.8 million to XLI, and XLI paid XLFA $18.7 million. The effect on the Companys results of operations for the three and six
month periods ended June 30, 2007 and 2006 from the subject business was not material. On August 4, 2006, and XLI agreed to cancel from inception the reinsurance of certain business ceded under a facultative quota share reinsurance treaty that was effective since 1999. As a
result of this cancellation, XLFA paid XLI $0.2 million, XLI assumed XLFAs obligation for $1.2 million of reserves for losses and loss adjustment expenses, and XLFA recorded a capital
contribution of $1.0 million. In addition, on such date, XLFA assumed certain business from XLI pursuant to the aforementioned reinsurance treaty. As a result thereof, XLFA recorded
assumed premiums of approximately $8.0 million, ceding commissions of approximately $1.0 million and received cash from XLI of approximately $7.0 million. There was no effect on the
Companys results of operations from this transaction for the three and six months ended June 30, 2007 and the effect on the Companys results of operations from the subject business for the
three and six month periods ended June 30, 2006 was not material. Effective October 1, 2001, XLFA entered into an excess of loss reinsurance agreement with XLI. This agreement covers a portion of XLFAs liability arising as a result of losses on policies
written by XLFA that are in excess of certain limits and are not covered by other reinsurance agreements. This agreement provides indemnification only for the portion of any loss covered by
this agreement in excess of 10% of XLFAs surplus, up to an aggregate amount of $500 million, and excludes coverage for liabilities arising other than pursuant to the terms of an underlying
policy. The Company incurred expense under this agreement of approximately $0.1 million and $0.3 million, and $0.1 million and $0.3 million, respectively, for the three and six month periods
ended June 30, 2007 and 2006. Effective November 1, 2002, XLCA entered into a facultative reinsurance arrangement (the XL Re Treaty) with XL Reinsurance America, Inc. (XL RE AM). Under the terms of the XL Re
Treaty, XL RE AM agrees to reinsure risks insured by XLCA under financial guarantee insurance policies up to the amount necessary for XLCA to comply with single risk limitations set forth
in Section 6904(d) of the New York Insurance Laws. Such reinsurance was on an automatic basis prior to the effective date of the IPO and is on a facultative basis on and after the effective
date of the IPO. The reinsurance provided by XL RE AM may be on an excess of loss or quota share basis. The Company is allowed up to a 30% ceding commission (or such other
percentage on an arms-length basis) on ceded premiums written under the terms of this agreement. Since it commenced operations, XLFA has entered into several reinsurance arrangements with subsidiaries and affiliates of FSAH (hereafter referred to as FSA) to reinsure certain policies
issued by FSA which guarantee the timely payment of the principal of and interest on various types of debt obligations. XLFAs obligations under certain of these arrangements are guaranteed
by XLI. Effective upon the IPO, the guarantee was terminated with respect to all new business assumed by XLFA under such arrangement, but the guarantee remains in effect with respect to 13
cessions under the agreement prior to the IPO. Premiums assumed by XLFA under its reinsurance arrangements with FSA represented 26.5% and 72.9%, and 62.6% and 70.7% of the
Companys total reinsurance premiums assumed for the three and six months ended June 30, 2007 and 2006, respectively. XLFA has guaranteed certain of XLIs obligations in connection with certain transactions where XLIs customer required such credit enhancement. Each of these transactions has a double
trigger structure, meaning that XLFA does not have to pay a claim unless both the underlying transaction and XLI default. For each of these transactions, XLFA has entered into a
reimbursement agreement with XLI, pursuant to which XLI pays XLFA a fee for providing its guarantee and XLI grants XLFA a security interest in a portion of the payments received by it
from its client. As of June 30, 2007 and December 31, 2006, XLFAs aggregate net par outstanding relating to such guarantees was $522.8 million and $522.8 million, respectively. Effective May 1, 2004, XLI entered into an agreement with XLCA which unconditionally and irrevocably guarantees to XLCA the full and complete payment when due of all of XLFAs
obligations under its facultative quota share reinsurance agreement with XLCA, under which agreement XLFA has assumed business from XLCA since December 19, 2000. The gross par value
of business guaranteed by XLI under this agreement was approximately $81.9 billion and $83.1 billion as of June 30, 2007 and December 31, 2006, respectively. The XLI guarantee agreement
terminated with respect to any new business produced by XLCA and ceded to XLFA pursuant to the facultative quota share reinsurance agreement after the effective date of the IPO, but the
guarantee remains in effect with respect to cessions under the such agreement prior to the IPO. The Company provides financial guarantee insurance policies insuring timely payment of investment agreements issued by XL Asset Funding Company I LLC (XLAF), an affiliate of the
Company. As of June 30, 2007 and December 31, 2006, the aggregate face amount of such investment agreements insured by the Company was $4.5 billion and $3.9 billion, respectively. In
addition, the Company insures XLAFs obligations under certain derivative contracts issued and purchased by XLAF. As of June 30, 2007, the total notional value of such contracts insured was
$170.0 million. The Company recorded earned premiums of $1.1 million and $1.0 million, and $2.0 million and $1.9 million, respectively, in each of the three and six month periods ended
June 30, 2007 and 2006, relating to the aforementioned contracts. Other Matters In connection with the secondary offering of SCA common shares by XL Capital in June 2007 (see Note 1), SCA was obligated, pursuant to registration rights granted to XL Capital in connection
with the IPO, to pay certain offering costs of up to five secondary offerings of SCA common shares by XL Capital (of at least $50 million in value unless XL Capital holds less than such amount at
the time of its exercise of registration rights), not including the secondary offering completed by XL Capital concurrent with the IPO. Accordingly, as a result of the secondary offering completed in
June 2007, the Company incurred expenses of approximately $1.0 million, which is reflected in operating expenses in the Companys consolidated results of operations for the three and six months
ended June 30, 2007. As of June 30, 2007, SCA is obligated to pay offering costs in connection with XL Capitals sale of its SCA common share holdings in up to four more offerings of such shares. 7. Income Taxes XLFA is not subject to any taxes in Bermuda on either income or capital gains under current Bermuda law. In the event that there is a change such that these taxes are imposed, XLFA would
be exempted from any such tax until March 2016 pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966, and Amended Act of 1987. 14
XLCA is subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations. The U.S. federal income tax liability is determined in accordance with the
principles of the consolidated tax provisions of the Internal Revenue Code and Regulations. XLCA has operations in subsidiary and branch form in certain international jurisdictions that are subject
to relevant taxes in those jurisdictions. XLCA files a consolidated tax return with SCA Holdings US Inc. (the U.S. common parent of the Company) and its subsidiaries. Prior to July 1, 2006, XLCA was consolidated with XLA for
purposes of determining its income tax liability at, and prior to, such date (see Note 1). As of June 30, 2007 and December 31, 2006, the Company had a U.S. federal income tax payable of $1.2
million and $5.3 million, respectively. As of June 30, 2007 and December 31, 2006, the Company had deferred income tax assets of $16.2 million and $18.2 million, respectively. Such deferred tax assets were net of a valuation
allowance of $4.2 million and $1.9 million as of June 30, 2007 and December 31, 2006, respectively. The valuation allowance relates to net unrealized capital losses and a net realized capital loss that
may not be realized within a reasonable period. At June 30, 2007, the Company had net unrealized capital losses and a net realized capital loss carry forward of approximately $2.5 million and $1.9
million respectively, against which a valuation allowance has been established. Management believes it is more likely than not that the tax benefit relating to the Companys deferred tax assets, net of
the valuation allowance discussed above, will be realized. The net realized capital loss carry forward will expire in 2012. Deferred income taxes have not been accrued with respect to undistributed earnings of foreign subsidiaries. If the earnings were to be distributed, as dividends or otherwise, such amounts may be
subject to withholding taxation in the state of the paying entity. Currently, however, no withholding taxes have been accrued with respect to the earnings, as it is the intention of management that
such earnings will remain reinvested indefinitely. The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007. The adoption of Interpretation No. 48 had no effect on
the Companys financial statements. With few exceptions, the Company is no longer subject to tax examinations by tax authorities in the major jurisdictions in which the Company operates for years prior to 2003 in the U.S. and
2002 in the U.K. The Companys policy is to recognize any interest accrued related to unrecognized tax benefits as a component of interest expense and penalties in operating expenses. The Company does not
have any accrued liabilities relating to interest and penalties as at June 30, 2007 or December 31, 2006, respectively. 8. Segments The Companys business activities are organized and managed in two operating segments: financial guarantee insurance and financial guarantee reinsurance. These segments are managed
separately because they provide different products or services to different customers, are subject to different regulation, and require different strategies. Products comprising the financial guarantee insurance segment primarily include financial guarantee insurance of public finance and structured finance debt securities and credit default swaps.
Products comprising the reinsurance segment primarily include reinsurance of financial guarantee insurance products issued by financial guarantee insurance companies. Set forth in the table below is certain financial information with respect to the Companys operating segments for each of the three-month and six-month periods ended June 30, 2007 and 2006.
The accounting policies of the segments are the same as those described in the summary of significant accounting policies included in the notes to the Companys audited historical financial
statements as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004 included in our 15
Annual Report on Form 10-K. The Company evaluates the performance of each operating segment based on underwriting profit or loss before income taxes, nonrecurring items (e.g., items of an
unusual or infrequent nature), and inter-segment transactions. Certain costs and operating expenses are allocated to each of the segments based on: (i) a review of the nature of such costs, and (ii)
time studies analyzing the amount of employee compensation costs incurred by each segment.
Three Months Ended
Six Months Ended
2007
2006
2007
2006 (U.S. dollars in thousands) Financial guarantee insurance segment: Gross premiums written
$
65,157
$
99,351
$
154,652
$
170,131 Ceded premiums
(8,564
)
(6,160
)
(28,797
)
(13,752
) Net premiums written
56,593
93,191
125,855
156,379 Change in net deferred premium revenue
(9,583
)
(43,898
)
(39,484
)
(76,742
) Net premiums earned
47,010
49,293
86,371
79,637 Fee and other income
85
971
85
2,231 Total underwriting revenues
47,095
50,264
86,456
81,868 Net losses and loss adjustment expenses
2,961
2,311
1,743
4,847 Acquisition costs, net
2,496
3,045
5,107
4,329 Operating expenses
19,028
14,608
35,578
30,045 Total underwriting expenses
24,485
19,964
42,428
39,221 Financial guarantee insurance underwriting profit
$
22,610
$
30,300
$
44,028
$
42,647 Financial guarantee reinsurance segment: Reinsurance premiums assumed
$
5,504
$
8,292
$
20,967
$
19,695 Change in net deferred premium revenue
1,678
(2,044
)
(6,767
)
(5,978
) Net premiums earned and total underwriting revenue
7,182
6,248
14,200
13,717 Net losses and loss adjustment expenses
67
569
484
1,482 Acquisition costs, net
1,283
1,497
2,642
2,895 Operating expenses
2,688
2,884
6,390
4,542 Total underwriting expenses
4,038
4,950
9,516
8,919 Financial guarantee reinsurance underwriting profit
$
3,144
$
1,298
$
4,684
$
4,798 Total segment underwriting profit
$
25,754
$
31,598
$
48,712
$
47,445 Corporate and other: Net investment income
30,263
16,129
56,388
31,191 Net
realized losses on investments
(1,654
)
(10,717
)
(1,542
)
(16,400
) Net
realized and unrealized (losses) gains on derivative financial instruments
(22,175
)
301
(29,104
)
(3,549
) Subtotal
32,188
37,311
74,454
58,687 Corporate operating expenses
4,837
8,655
Income before income tax and minority interest
27,351
37,311
65,799
58,687 Income
tax expense (benefit)
632
(203
)
711
(188
) Income before minority interest
26,719
37,514
65,088
58,875 Minority interest dividends on redeemable preferred shares
804
1,126
1,918
5,738 Net income
25,915
36,388
63,170
53,137 Dividends on perpetual preference shares
Net income available to common shareholders
$
25,915
$
36,388
$
63,170
$
53,137 16
June 30,
June 30,
9. Liability for Losses and Loss Adjustment Expenses The Companys liability for losses and loss adjustment expenses consists of case basis reserves and unallocated reserves. Activity in the liability for losses and loss adjustment expenses is
summarized as follows:
Six Months Ended
Year Ended
Case Reserves
Unallocated Reserves
Case Reserves
Unallocated Reserves (U.S. dollars in thousands) Gross unpaid losses and loss adjustment expenses at beginning of year
$
85,351
$
93,166
$
69,382
$
77,986 Unpaid losses and loss expenses recoverable
(70,842
)
(17,774
)
(52,316
)
(16,901
) Net unpaid losses and loss adjustment expenses at beginning of year
14,509
75,392
17,066
61,085 Increase (decrease) in net losses and loss adjustment expenses incurred in respect of losses occurring in: Current year
5,891
14,307 Prior years
(3,664
)
651
Cancellation of contract assumed from affiliate
(1,177
)
Less net losses and loss adjustment expenses paid
(375
)
(2,031
)
Net unpaid losses and loss adjustment expenses at end of period
10,470
81,283
14,509
75,392 Unpaid losses and loss expenses recoverable
65,565
17,210
70,842
17,774 Gross unpaid losses and loss adjustment expenses at end of period
$
76,035
$
98,493
$
85,351
$
93,166 Set forth below is a discussion of certain case basis reserves established by the Company. The Company has been indemnified with respect to loss development relating to the insurance
transactions described under (a) and (b) below by subsidiaries of XL Capital in connection with SCAs IPO. As a result of such indemnifications, all adverse loss development on such insurance
transactions subsequent to the effective date of the IPO, which is in excess of the Companys carried reserves for such transactions at the date of the IPO, will be absorbed by the aforementioned
affiliates of XL Capital. Such protection does not relieve the Company of its obligations under the aforementioned insurance transactions. Accordingly, the Company is still liable under the insurance
transactions in the event that the affiliates of XL Capital do not meet their obligations under the indemnifications. For further information with respect to the indemnifications see Note 6.
(a)
As of June 30, 2007, the Company carried a gross case basis reserve for losses and loss adjustment expenses of approximately $74.0 million ($8.7 million after reinsurance to XLI and XL RE
AM) relating to an insured project financing. There was no change in the reserve from December 31, 2006. The total remaining par insured by the Company in connection with this
transaction is $215.8 million, net of applicable carried case reserves, as of June 30, 2007. The estimate of loss was based on assumptions and estimates extending over many years into the
future. There is currently no payment default with respect to this transaction. Management continues to monitor the exposure and will revise its loss estimate if necessary, as new information
becomes available.
17
June 30, 2007
December 31, 2006
(b) As of December 31, 2006, the Company carried a liability of $5.0 million relating to a dispute in regard to certain exposures associated with notes which were insured by the Company and
collateralized by loans to medical providers. Because the Companys liability in regard to this dispute was fully indemnified by XLA pursuant to the indemnification discussed above and in
Note 6, the Company also carried a recoverable from XLA for $5.0 million as of December 31, 2006. During the three months ended March 31, 2007, the Company reduced the liability and
corresponding recoverable from XLA by $1.1 million to reflect an agreement in principal among the parties to settle the dispute in exchange for a payment by the Company of $3.9 million.
The settlement payment was made in May 2007 reducing the reserve and related recoverable to zero. (c) As of December 31, 2006, the Company carried a case basis reserve for losses and loss adjustment expenses of $3.3 million (none of which was reinsured) representing the present value of the
loss expected to be incurred in the future with respect to an insured residential mortgage securitization. During the three months ended March 31, 2007, the insured obligation was retired as a
result of the exercise of a clean-up call by the sponsor of the securitization thereby eliminating the Companys exposure without loss. Accordingly, the Company recorded a reduction in its
provision for losses and loss adjustment expenses for the three months ended March 31, 2007 of $3.3 million resulting from the elimination of the aforementioned reserve. 10. Earnings per Common Share Basic earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period excluding the dilutive effect of stock
option and restricted stock awards outstanding. Diluted earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding including the
dilutive effect of stock option and restricted stock awards outstanding. The following table sets forth the computation of basic and diluted earnings per share:
Three Months Ended
Six Months Ended
2007
2006
2007
2006 (U.S. Dollars in thousands, except per share amounts) Net income available to common shareholders
$
25,915
$
36,388
$
63,170
$
53,137 Basic shares(1)
64,136
46,127
64,136
46,127 Common stock equivalents
371
287
Diluted shares(1)
64,507
46,127
64,423
46,127 Basic earnings per common share
$
0.40
$
0.79
$
0.98
$
1.15 Diluted earnings per common share
$
0.40
$
0.79
$
0.98
$
1.15
(1)
Per share amounts for the three and six months ended June 30, 2006 are based on 46,127,245 shares outstanding. In July 2006, immediately prior to the IPO, a stock split of the Companys outstanding common shares was effected. The
accompanying Interim Consolidated Financial Statements and share amounts have been retroactively adjusted for the effects of such stock split.
11. Exposures under Guarantees The Company provides financial guarantee insurance and reinsurance to support public and private borrowing arrangements. Financial guarantee insurance guarantees the timely payment of
principal and interest on insured obligations to third party holders of such obligations in the event of default by an 18
June 30,
June 30,
issuer. The Companys potential liability in the event of non-payment by the issuer of an insured or reinsured obligation represents the aggregate outstanding principal insured or reinsured under its
policies and contracts and related interest payable at the date of default. In addition, the Company provides credit protection on specific referenced credits or on pools of specific referenced credits
through the issuance of credit default swaps. Under the terms of credit default swaps, the seller of credit protection makes a specified payment to the buyer of credit protection upon the occurrence
of one or more specified credit events with respect to a reference obligation or entity. The Companys potential liability under credit default swaps represents the notional amount of such swaps. As of June 30, 2007, the Companys net outstanding par exposure under its in-force financial guarantee insurance and reinsurance policies and contracts aggregated to $100.9 billion and net
reserves for losses and loss adjustment expenses relating to such exposures was $76.7 million at such date. In addition, as of June 30, 2007, the Companys notional exposure under credit default swaps
aggregated to $41.7 billion and the net liability for these credit default swaps and other derivatives reflected in the Companys balance sheet as of June 30, 2007 was $36.5 million. 12. Stock-Based and Long-Term Compensation Plans Prior to the IPO, certain employees of the Company participated under XL Capitals stock-based and long-term compensation plans and expense relating thereto was reflected in the Companys
results of operations. Subsequent to the IPO, SCA adopted its own stock-based and long-term incentive plan and certain awards to employees of the Company under XL Capitals stock-based
compensation and long-term incentive plans were converted to SCAs plans. Expense relating to awards to employees of the Company under XL Capital plans that were not so converted and remain
outstanding continues to be recognized in the Companys financial statements. Set forth below is certain information in regard to stock option and restricted stock awards made under SCAs stock-based and long-term incentive plan, as well as certain information in regard
to awards to SCA employees that remain outstanding under XL Capitals stock-based compensation and long-term incentive plans. SCA Stock-Based Compensation Plans The following is a summary of stock option awards as of June 30, 2007, and related activity for the six month period then ended:
Number of
Weighted
Weighted
Aggregate Outstanding December 31, 2006
647,963
$
20.50
2.8 years
$
6,719,376 Granted
229,825
$
30.00
2.7 years
199,948 Exercised
Cancelled
Outstanding June 30, 2007
877,788
$
22.99
2.8 years
$
6,919,324 The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Companys closing stock price on June 30, 2007 and the exercise price,
multiplied by the number of in-the-money-options) that would have been received by the option holders had all option holders exercised their options on June 30, 2007. Total unrecognized stock
based compensation 19
Shares
Average
Exercise
Price
Average
Remaining
Contractual
Term
Intrinsic
Value
expense related to non-vested stock options was approximately $4.6 million as of June 30, 2007, related to 877,788 options, which is expected to be recognized over a weighted-average period of 2.8
years. The following is a summary of restricted stock awards as of June 30, 2007, and related activity for the six month period then ended:
Number of
Weighted
Weighted
Remaining Outstanding December 31, 2006
497,928
$
20.50
4.19 years
$
7,990,090 Granted
698,141
$
29.63
3.65 years
18,227,558 Exercised
Cancelled
(34,158
)
Outstanding June 30, 2007
1,161,911
$
26.59
3.82 years
$
26,217,648 Awards of restricted stock had a weighted average grant date fair value of $26.59. During the three and six months ended June 30, 2007, SCA recognized approximately $1.7 million and $2.7
million, respectively, of compensation expense related to its restricted stock awards. There were 28,645 and 34,158 shares respectively, of restricted stock forfeited and no shares vested during the
three and six months ended June 30, 2007. Total unrecognized stock based compensation expense related to non-vested restricted stock was approximately $26.2 million at June 30, 2007, which is expected to be recognized over a weighted-
average period of 3.8 years. SCA Long-Term Compensation Plans a. Deferred Cash Awards Effective August 4, 2006, all outstanding and unvested awards to employees of the Company under XL Capital plans, known as deferred cash awards, were involuntarily converted to awards
under SCAs plan. All the terms, conditions and values of the awards made under SCAs plan pursuant to such conversion were structured to mirror the terms of the awards made under XL Capitals
plan. The Awards vest as set forth in the applicable Award agreements, and the requisite service period is equivalent to the vesting period. The Awards contain certain restrictions, prior to vesting,
relating to, among other things, forfeiture in the event of termination of employment and transferability. During
the three and six months ended June 30, 2007, the Company recognized approximately
$1.6 million and $2.9 million of compensation expense, respectively, related
to deferred cash awards. Also, during the three and six months ended June
30, 2007, the Company granted deferred cash awards of approximately $0.1
million and $1.1 million, respectively. Total unrecognized compensation expense
related to non-vested deferred cash awards was approximately $11.9 million
as of June 30, 2007. The non-vested unrecognized compensation expense relating
to the deferred cash awards are expected to be recognized over a weighted-average
period of 2.0 years. b. Long Term Incentive Plan Awards In connection with the IPO, XL Capital and the Company offered eligible employees of the Company the opportunity to exchange all of their outstanding unvested restricted Class A Ordinary
Shares of XL Capital and options to purchase Class A Ordinary Shares of XL Capital, which were 20
Shares
Average
Grant
Price
Average
Remaining
Contractual
Term
Unrecognized
Compensation
Expense
At June 30,
2007
awarded to such employees under XL Capital Plans prior to the IPO, for a long term incentive plan award (the LTIP Award) from SCA to be granted under SCAs Plan (the Exchange Offer). An LTIP Award is the right to receive a cash payment, or base amount, from SCA of no less than 75% of the target amount indicated in each offerees award letter. Such target amount
will be adjusted higher or lower (but in no event lower than the base amount) based on the performance of SCA pursuant to the terms and conditions specified in the Award. The Awards vest as set
forth in the applicable Award agreements, and the requisite service period is equivalent to the vesting period. The Awards contain certain restrictions, prior to vesting, relating to, among other things,
forfeiture in the event of termination of employment and transferability. The aggregate target amount of LTIP Awards outstanding at June 30, 2007 was $13.3 million. There were no cancellations, forfeitures, or new issuances of such awards during the three and six
months ended June 30, 2007. During the three and six months ended June 30, 2007, the Company recognized $1.6 million and $3.2 million of compensation expense relating to such awards. Total
unrecognized compensation expense related to non-vested LTIP Awards based on managements best estimate of the ultimate payout or value of such awards was approximately $9.8 million as of
June 30, 2007. The non-vested unrecognized compensation expense relating to LTIP Awards are expected to be recognized over a weighted-average period of 1.5 years. Refer to Note 6 for information regarding outstanding unvested restricted Class A Ordinary Shares of XL Capital and options to purchase Class A Ordinary Shares of XL Capital that were not
exchanged under the Exchange Offer and remain outstanding under XL Capital plans. 13. Series A Perpetual Non-Cumulative Preference Shares On April 5, 2007, SCA consummated the sale of $250 million Series A Perpetual Non-Cumulative Preference Shares (the SCA Series A Preference Shares) which were offered for sale pursuant
to a private placement. Gross proceeds from the offering were $250.0 million, offering costs were $3.4 million, and net proceeds were $246.6 million. The SCA Series A Preference Shares are
perpetual securities with no fixed maturity date and, if declared by the Board of SCA, will pay a fixed dividend, on a semi-annual basis during the first and third quarters of each fiscal year, at the
annualized rate of 6.88% until September 30, 2017. After such date, the Series A Preference Shares, if declared by the Board of SCA, will pay dividends, on a quarterly basis, at a floating rate based
on three-month LIBOR plus 2.715%. Dividends on the SCA Series A Preference Shares are non-cumulative. The SCA Series A Preference Shares have a liquidation preference of $1,000 per
preference share. As of June 30, 2007 there has been no dividend declared by the Companys board of directors on the SCA Series A Preference Shares and, as such, there is no dividend reflected in
the accompanying financial statements with respect to these securities. In connection with the sale of the SCA Series A Preference Shares, the Company entered into a Replacement Capital Covenant (the Replacement Capital Covenant), whereby the Company
agreed for the benefit of holders of one or more designated series of its long-term debt securities that the Company may issue in the future that (i) the Company will not redeem, exchange or
purchase the SCA Series A Preference Shares and (ii) none of the Companys subsidiaries will purchase or exchange the SCA Series A Preference Shares, except, subject to certain limitations, to the
extent that the applicable redemption, exchange or purchase price does not exceed a specified amount of cash proceeds from the sale of certain specified qualifying replacement capital securities
raised during the period commencing on the 180th calendar day prior to the date of notice of the redemption or the date of purchase. The Company has made no decision as to whether, or when,
the Company would issue debt securities that would have the benefit of that covenant. While such provisions are in effect, there could be circumstances 21
where the Company would wish to redeem, exchange or purchase some or all of the SCA Series A Preference Shares but be restricted from doing so. The Replacement Capital Covenant may be
terminated if (i) holders of at least a majority by principal amount of the then-effective series of covered debt consent or agree in writing to terminate the Replacement Capital Covenant, (ii) the
Company no longer has outstanding any indebtedness that qualifies as covered debt or (iii) the Company no longer has any outstanding SCA Series A Preference Shares. In addition, if not earlier
terminated, the Replacement Capital Covenant will terminate on September 30, 2047; provided, however, that the September 30, 2047 termination date may be extended at the Companys option. 14. Other Matters On July 31, 2007 our board of directors declared a quarterly dividend of $.02 per common share payable on September 28, 2007 to shareholders of record on September 14, 2007. Also, on July
31, 2007 our board of directors declared a semi-annual dividend on the SCA Series A Preference Shares aggregating $8.4 million, which is payable on October 1, 2007 to shareholders of record of the
SCA Series A Preference Shares on September 28, 2007. Any future dividends will be subject to the discretion and approval of the Board of Directors. On February 27, 2007, the board of directors of XLFA approed: (i) an extraordinary dividend of $15.0 million on its Series A Redeemable Preferred Shares, and (ii) a reduction in the stated
value of the remaining outstanding Series A Redeemable Preferred Shares by a corresponding amount. Payment of the extraordinary dividend and the reduction in the stated value of the Series A
Redeemable Preferred Shares occurred on March 30, 2007. This transaction was accounted for as a redemption of the preferred shares. As a result of the decrease in stated value, the Companys
annual fixed dividend requirement on the Series A Redeemable Preferred Shares will be reduced from $4.5 million to $3.2 million. These redeemable preferred shares are reflected in the
accompanying consolidated balance sheet of the Company as minority interest redeemable preferred shares. 22
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations contains forward-looking statements that involve risks and uncertainties. Our actual results could differ
materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below. See also, Cautionary Note Regarding Forward-Looking Statements
below for a list of factors that could cause actual results to differ materially from those contained in any forward-looking statement. Overview General We are a Bermuda-domiciled holding company whose operating subsidiaries provide credit enhancement and protection products to the public finance and structured finance markets throughout
the United States and internationally. We provide credit enhancement and protection through the issuance of financial guarantee insurance policies and credit default swaps, as well as the reinsurance of financial guarantee insurance
and credit default products written by other insurers. Financial guarantee insurance provides an unconditional and irrevocable guarantee to the holder of a debt obligation of full and timely payment
of principal and interest. In the event of a default under the obligation, the insurer has recourse against the issuer and/or any related collateral (which is more common in the case of insured asset-
backed obligations or other non-municipal debt) for amounts paid under the terms of the policy. Credit default swaps are derivative contracts that offer credit protection relating to a particular
security or pools of specified securities. Under the terms of a credit default swap, the seller of credit protection makes a specified payment to the buyer of credit protection upon the occurrence of
one or more specified credit events with respect to a referenced security. Our financial guarantee reinsurance provides a means by which financial guarantee insurance companies can manage and
mitigate risks in their in-force business and/or increase their capacity to write such business. Organization Background, Initial Public Offering, and Ownership by XL Capital We were formed as an indirect wholly owned Bermuda based subsidiary of XL Capital on March 17, 2006. On July 1, 2006, XL Capital contributed all its ownership interests in its financial
guarantee insurance and financial guarantee reinsurance operating businesses to us. The aforementioned operating businesses consisted of: (i) XL Capital Assurance Inc. (XLCA) and its wholly-
owned subsidiary, XL Capital Assurance (U.K.) Limited (XLCA-UK) and (ii) XL Financial Assurance Ltd. (XLFA). XLCA was an indirect wholly owned subsidiary of XL Capital and all of
XLFA was owned by XL Capital except for a preferred stock interest which is owned by Financial Security Assurance Holdings Ltd. (FSAH), an entity which is otherwise not related to XL
Capital or us. On August 4, 2006, we completed the sale of 18,009,119 of our common shares through an initial public offering (the IPO) at $20.50 per share. We received net proceeds from the
offering of $341.3 million. In addition, XL Capital sold 5,430,774 of our common shares (including 992,165 pursuant to the exercise of an over-allotment option granted to underwriters) from its
holdings directly to the public in a secondary offering concurrent with our IPO. We did not receive any of the proceeds from the aforementioned sale by XL Capital. Immediately after the IPO and
the secondary offering, XL Capital owned 40,696,471 of our common shares which represented approximately a 63 percent economic interest in SCA, adjusted for restricted share awards to our
employees and management made at the effective date of the IPO. In June 2007, XL Capital completed the sale of an additional 10,627,422 common shares of SCA from its holdings (including
947,400 common shares pursuant to the exercise of an over-allotment option granted to underwriters). We did not receive any of the proceeds from this sale. Immediately after such sale XL Capital
owned 30,069,049 of our common shares which represented approximately a 46 percent voting and economic interest in SCA, adjusted for restricted share awards to our employees and management
outstanding as of such date. Prior to XL Capitals sale of SCA common shares in June 2007 its voting interest in SCA was subject to limitations contained in our bye-laws. See Liquidity and Capital
Resources for further details regarding the use of proceeds from our IPO. 23
Offering of Series A Perpetual Non-Cumulative Preference Shares On April 5, 2007, we consummated the sale of $250 million of our Series A Perpetual Non-Cumulative Preference Shares (the SCA Series A Preference Shares) which were offered for sale
pursuant to a private placement. Gross proceeds from the offering were $250.0 million, offering costs were $3.4 million, and net proceeds were $246.6 million. The SCA Series A Preference Shares
are perpetual securities with no fixed maturity date and, if declared by the Board of SCA, will pay a fixed dividend, on a semi-annual basis during the third and first quarters of each fiscal year, at
the annualized rate of 6.88% until September 30, 2017. After such date, the Series A Preference Shares, if declared by the Board of SCA, will pay dividends, on a quarterly basis, at a floating rate
based on three-month LIBOR plus 2.715%. Dividends on the SCA Series A Preference Shares are non-cumulative. The SCA Series A Preference Shares have a liquidation preference of $1,000 per
preference share. See Liquidity and Capital ResourcesCapital Resources. Key Factors Affecting Profitability We
believe that the financial guarantee business is significantly affected by
economic cycles. For example, a robust economy featuring a good or improving
credit environment is beneficial to the in-force portfolios of financial
guarantee insurers and reinsurers. Historically, however, when such conditions
have existed for an extended period, credit spreads tend to narrow and pricing
and demand for financial guarantee insurance and reinsurance tend to decline.
A deteriorating economic and credit environment, in contrast, is typically
marked by widening credit spreads and increasing pricing for financial guarantee
products. However, a prolonged period of weak or declining economic activity
could stress in-force financial guarantee insured portfolios and result in
claims or could adversely impact capital adequacy due to deterioration in
the credit quality of in-force insured portfolios. During the past several
years, economic conditions and the credit environment have been strong and,
as a result, credit spreads have generally narrowed and new aggregate business
production of primary insurers has generally slowed. More recently credit
spreads across most bond sectors have widened reflecting wide spread concerns
of potential credit erosion which have been caused by the widely published
problems in the subprime mortgage and collateralized debt obligation (CDO) markets.
We are exposed to subprime mortgages directly, through our guarantees of
residential mortgage-backed securities and indirectly, through our guarantees
of CDOs of asset-backed securities. As of June 30, 2007, our total exposure
to such mortgages aggregated $4.8 billion of net par outstanding, representing
approximately 3% of our total in-force guaranteed net par outstanding at
such date. Of our total direct guaranteed subprime mortgage net par exposure
at June 30, 2007, 42% was rated AAA, 13% was rated AA+,
38% was rated AA-, and 7% was rated A-. All of our
indirect subprime exposure are in CDOs where our guarantees attach at super AAA. As of June 30, 2007, there are
no guaranteed subprime mortgage exposures among our closely monitored credits,
which are discussed below. See additional information in regard to our subprime
exposure furnished to the Securities and Exchange Commission on August 3,
2007 on Form 8-K. We derive our revenues principally from: (i) premiums from our insurance and reinsurance businesses, (ii) net investment income and net realized gains and losses from our investment portfolio
supporting these businesses and (iii) realized and unrealized gains and losses on derivative financial instruments. Our premiums are a function of the amount of par or notional amount of debt obligations that we guarantee, market prices and the type of debt obligation guaranteed. We receive premiums
either on an upfront basis when the policy is issued or the contract is executed or on an installment basis over the life of the applicable transaction. Premiums are accounted for as written when due; therefore when we enter into policies that provide for upfront premium, all of the premium on the policy is accounted for as written generally
when the policy commences. The portion of the upfront premium that has been written but has not yet been earned is carried on our balance sheet as deferred premium revenue. When we enter into
policies that provide for installment premium, only that installment of the premium that is then due (generally the current monthly, quarterly or semiannual installment) is accounted for as written.
Future premium installments during the remainder of the life of the installment-based policy are not reflected on our financial statements. Therefore, the amount of total premiums written that we
report for any period will 24
be affected by the mix of policies that we wrote in that period on an upfront and, in that period and prior periods, on an installment basis. Generally, a financial guarantee insurance company
with a growing in-force book of business should recognize an increasing amount of net earned premium from policies written in prior reporting periods, whether premiums are received on an upfront
or installment basis. Future installments of premium on business written in a period are reported by financial guarantors as a component of adjusted gross premiums, a non-GAAP financial measure,
which is discussed in more detail below. The amount of installment premiums actually realized by us in the future (and that would be otherwise reflected in revenue) could be reduced due to factors
such as early termination of insurance contracts or accelerated prepayments of underlying obligations. Our investment income is a function of the amount of our invested assets and the yield that we earn on those assets. The investment yield will be a function of market interest rates at the time
of investment, as well as the type, credit quality and duration of our invested assets. In addition, we could realize gains or losses on the sale of securities in our investment portfolio or recognize an
other-than-temporary impairment as a result of changing market conditions, including changes in market interest rates, and changes in the credit quality of our invested assets. Unrealized gains and losses on credit default swaps and insurance policies that we account for as derivative contracts are a function of changes in the estimated fair value of those contracts. We
expect these unrealized gains and losses to fluctuate primarily based on changes in credit spreads and the credit quality of the referenced securities. We generally hold these derivative contracts to
maturity. When we hold a derivative contract to maturity, the cumulative unrealized gains and losses will net to zero if we incur no credit losses on that contract. In certain circumstances, we may
choose to terminate a credit derivative prior to its maturity (for example, upon a deterioration in underlying credit quality). Our expenses primarily consist of losses and loss adjustment expenses, acquisition costs, and operating expenses. Acquisition costs are related to the production of new financial guarantee
insurance business and commissions paid on reinsurance assumed. These costs are generally deferred and recognized over the period in which the related premiums are earned. Operating expenses
consist primarily of costs relating to compensation of our employees, information technology, office premises, and professional fees. Other Measures Used by Management to Evaluate Operating Performance The following are certain financial measures management considers important in evaluating the Companys operating performance: We evaluate our periodic sales performance by reviewing a non-GAAP measure known as adjusted gross premiums. Adjusted gross premiums for any period equals the sum of: (i) upfront
premiums written in such period, (ii) current installment premiums on business written in such period and (iii) expected future installment premiums on contracts written during such period that
remain in force and for which there is a binding obligation on the part of the insured to pay the future installment premiums, discounted at 7%, which we refer to as the present value of future
installment premiums, or PVFIP, on business written during such period. The 7% discount rate was established when our subsidiaries first started reporting adjusted gross premiums based upon a
view at the time that 7% was the appropriate discount for these future premiums and that rate has not been changed in order to preserve comparability among periods. This measure adjusts for the
fact, as described above, that upfront premiums are recorded in full as total premiums written at inception of the contract but future installment premiums are not. PVFIP is not reflected on our
consolidated balance sheet. PVFIP can be negatively affected by prepayments and refundings, early terminations, credit losses or other factors impacting our in-force book of business. The following is a reconciliation of total premiums written to adjusted gross premiums. Total premiums written is the most directly comparable GAAP financial measure. 25
(U.S dollars in millions)
Three Months Ended
Six Months Ended
2007
2006
2007
2006 Total upfront premiums written
$
31.9
$
74.6
$
104.7
$
127.0 Total installment premiums written
38.8
33.0
70.9
62.8 Total premiums written
70.7
107.6
175.6
189.8 Present value of estimated future installment premiums written and assumed on contracts issued in the current period, discounted at 7%
42.7
49.6
76.8
77.8 Adjusted gross premiums
$
113.4
$
157.2
$
252.4
$
267.6 We also review non-GAAP measures known as operating income and core income. While operating income and core income are not substitutes for net income available to common
shareholders computed in accordance with GAAP, they are useful measures of performance used by management, equity analysts and investors. Operating income measures net income available to
common shareholders, as determined in accordance with GAAP, excluding net realized gains (losses) on investments, net realized and unrealized gains (losses) on derivative financial instruments, and
certain other items. In addition, in determining operating income, we have made an adjustment to the amount of dividends on our perpetual non-cumulative preference shares reported in accordance
with GAAP during the period to reflect the amount of such dividends that would be attributable to the period as if such dividends were accrued ratably over the period. Core income represents
operating income excluding the impact of refundings, calls and other accelerations. The definitions of operating income and core income used by the Company may differ from definitions of operating
earnings and core earnings used by other financial guarantors. See Managements Discussion and Analysis of Financial Condition and Results of OperationsOffering of Series A Perpetual Non-
Cumulative Preference Shares. We also view our book value per share attributable to common shareholders as an additional measure of our performance. This metric is calculated by dividing common shareholders equity by
the number of outstanding common shares (excluding outstanding restricted sharessee Note 12 to the Unaudited Interim Consolidated Financial Statements) at any period end. Book value per share
attributable to common shareholders is affected primarily by our net income available to common shareholders and also by any changes in net unrealized gains and losses on our invested assets. Book
value per share attributable to common shareholders was $21.95 at June 30, 2007, as compared to $21.31 at December 31, 2006. The increase in book value was primarily attributable to net income
available to common shareholders, offset in part by an increase in net unrealized losses on our invested assets. The activities of our surveillance department are integral to the identification of specific credits that have experienced deterioration in credit quality and to the assessment of whether losses on
such credits are probable, as well as any estimation of the amount of loss expected to be incurred with respect to such credits. Closely monitored credits are divided into four categories: (i) Special
Monitoring Listinvestment grade credits where a covenant or trigger may be breached or is close to being breached and warrants closer monitoring; (ii) Yellow Flag Listcredits that we determine to
be non-investment grade but a loss or claim is unlikely; (iii) Red Flag Listcredits where we do not expect an ultimate loss but a claim is possible but not probable; and (iv) Loss Listcredits where we
have either paid a loss or expect to suffer a loss and have recorded a case reserve. Out of over 2,500 credits in our in-force portfolio only 21 credits are in one of the four above categories. Credits
that are not closely monitored credits are considered fundamentally sound, normal risk. 26
June 30,
June 30,
The following table presents our consolidated in-force financial guarantee net par outstanding at June 30, 2007 and December 31, 2006 by category of closely monitored credit:
(U.S. dollars in millions, except percentages)
As of June 30, 2007
As of December 31, 2006
Net Par
% of Net Par
Net Par
% of Net Par Fundamentally sound normal risk
$
141,482
99.2
%
$
117,318
99.4
% Closely monitored credits: Special monitoring
1,095
0.8
%
558
0.5
% Yellow flag
2
0.0
%
3
0.0
% Red flag
3
0.0
%
37
0.0
% Loss list(1)
12
0.0
%
96
0.1
% Subtotal
1,112
0.8
%
694
0.6
% Total
$
142,594
100.0
%
$
118,012
100.0
%
(1)
At June 30, 2007 and December 31, 2006, the loss list consisted of three and four guarantee contracts, respectively, with remaining net par outstanding of $11.5 million and $95.8 million, respectively, against which net reserves of $9.9 million and
$13.6 million have been established, respectively- see Note 9 to the accompanying Unaudited Interim Consolidated Financial Statements.
The following table sets forth our consolidated in-force financial guarantee net par outstanding by S&P rating category as of the dates indicated.
(U.S. dollars in millions, except percentages)
Outstanding
Percent of
Outstanding as of
Percent of S&P Rating Category(1): AAA
$
53,302
37.3
%
$
34,559
29.3
% AA
19,634
13.8
%
17,846
15.1
% A
36,414
25.5
%
35,226
29.9
% BBB
32,594
22.9
%
29,889
25.3
% Below investment grade
650
0.5
%
492
0.4
% Total
$
142,594
100.0
%
$
118,012
100.0
%
(1)
If unrated by S&P, an internal assessment of underlying credit quality is used to calculate a rating.
Segments Our businesses are organized and managed in two operating segments: financial guarantee insurance and financial guarantee reinsurance. Our financial guarantee insurance segment offers
financial guarantee insurance policies and credit default swaps. Our financial guarantee reinsurance segment reinsures financial guarantee policies and credit default swaps issued by other monoline
financial guarantee insurance companies. We evaluate the performance of each operating segment based upon underwriting profit or loss before income taxes, nonrecurring items (for example, items
of an unusual or infrequent nature) and inter-segment transactions. Certain costs and operating expenses are allocated to each of the segments based upon: (i) a review of the nature of such costs and
(ii) time studies analyzing the amount of employee compensation costs incurred by each segment. Except for the foregoing allocations, the accounting policies of the segments are the same as those
described in the summary of significant accounting policies in our consolidated financial statements presented in our Annual Report on Form 10-K. 27
Outstanding
Outstanding
Outstanding
Outstanding
as of June 30,
2007
Total Net Par
Outstanding
December 31,
2006
Total Net Par
Outstanding
Executive Overview See certain information with respect to members of our Board of Directors, Executive Officers and Key Employees in our Annual Report on Form 10-K for the fiscal year ended December 31,
2006, which was filed with the Securities and Exchange Commission on March 15, 2007. Critical Accounting Policies and Estimates See information with respect to our critical accounting policies and estimates in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, which was filed with the Securities
and Exchange Commission on March 15, 2007. Results of Operations Consolidated Results of Operations The following table presents summary consolidated statement of operations data for the three and six month periods ended June 30, 2007 and 2006:
(Unaudited)
(Unaudited)
2007
2006
2007
2006 Revenues Gross premiums written
$
65,157
$
99,351
$
154,652
$
170,131 Reinsurance premiums assumed
5,504
8,292
20,967
19,695 Total premiums written
70,661
107,643
175,619
189,826 Ceded premiums
(8,564
)
(6,160
)
(28,797
)
(13,752
) Net premiums written
62,097
101,483
146,822
176,074 Change in net deferred premium revenue
(7,905
)
(45,942
)
(46,251
)
(82,720
) Net premiums earned (net of ceded premiums earned of $5,193, $10,021, $9,074 and $18,224)
54,192
55,541
100,571
93,354 Net investment income
30,263
16,129
56,388
31,191 Net
realized losses on investments
(1,654
)
(10,717
)
(1,542
)
(16,400
) Net realized and unrealized (losses) gains on derivative financial instruments
(22,175
)
301
(29,104
)
(3,549
) Fee income and other
85
971
85
2,231 Total revenues
60,711
62,225
126,398
106,827 Expenses Net losses and loss adjustment expenses
3,028
2,880
2,227
6,329 Acquisition costs, net
3,779
4,542
7,749
7,224 Operating expenses
26,553
17,492
50,623
34,587 Total expenses
33,360
24,914
60,599
48,140 Income before income tax and minority interest
27,351
37,311
65,799
58,687 Income tax expense (benefit)
632
(203
)
711
(188
) Income before minority interest
26,719
37,514
65,088
58,875 Minority interest dividends on redeemable preferred shares
804
1,126
1,918
5,738 Net income
25,915
36,388
63,170
53,137 Dividends on Series A perpetual non-cumulative preference shares
Net income available to common shareholders
$
25,915
$
36,388
$
63,170
$
53,137 28
Three Months Ended
June 30,
Six Months Ended
June 30,
Segment Results of Operations The following table presents summary statement of operations data for our operating segments for the three and six month periods ended June 30, 2007 and 2006:
(U.S. dollars in thousands)
Three Months Ended
Six Months Ended
2007
2006
2007
2006 Financial guarantee insurance segment: Gross premiums written
$
65,157
$
99,351
$
154,652
$
170,131 Ceded premiums
(8,564
)
(6,160
)
(28,797
)
(13,752
) Net premiums written
56,593
93,191
125,855
156,379 Change in net deferred premium revenue
(9,583
)
(43,898
)
(39,484
)
(76,742
) Net premiums earned
47,010
49,293
86,371
79,637 Fee and other income
85
971
85
2,231 Total underwriting revenues
47,095
50,264
86,456
81,868 Net losses and loss adjustment expenses
2,961
2,311
1,743
4,847 Acquisition costs, net
2,496
3,045
5,107
4,329 Operating expenses
19,028
14,608
35,578
30,045 Total underwriting expenses
24,485
19,964
42,428
39,221 Financial guarantee insurance underwriting profit
$
22,610
$
30,300
$
44,028
$
42,647 Financial guarantee reinsurance segment: Reinsurance premiums assumed
$
5,504
$
8,292
$
20,967
$
19,695 Change in net deferred premium revenue
1,678
(2,044
)
(6,767
)
(5,978
) Net premiums earned and total underwriting revenue
7,182
6,248
14,200
13,717 Net losses and loss adjustment expenses
67
569
484
1,482 Acquisition costs, net
1,283
1,497
2,642
2,895 Operating expenses
2,688
2,884
6,390
4,542 Total underwriting expenses
4,038
4,950
9,516
8,919 Financial guarantee reinsurance underwriting profit
$
3,144
$
1,298
$
4,684
$
4,798 Total segment underwriting profit
$
25,754
$
31,598
$
48,712
$
47,445 Corporate and other: Net investment income
30,263
16,129
56,388
31,191 Net
realized losses on investments
(1,654
)
(10,717
)
(1,542
)
(16,400
) Net realized and unrealized (losses) gains on derivative financial instruments
(22,175
)
301
(29,104
)
(3,549
) Subtotal
32,188
37,311
74,454
58,687 Corporate operating expenses
4,837
8,655
Income before income tax and minority interest
27,351
37,311
65,799
58,687 Income
tax expense (benefit)
632
(203
)
711
(188
) Income before minority interest
26,719
37,514
65,088
58,875 Minority interest dividends on redeemable preferred shares
804
1,126
1,918
5,738 Net income
25,915
36,388
63,170
53,137 Dividends on Series A perpetual non-cumulative preference shares
Net income available to common shareholders
$
25,915
$
36,388
$
63,170
$
53,137 29
June 30,
June 30,
Discussion of Consolidated and Segment Results of Operations for the Three Months Ended June 30, 2007 Compared to the Three Months Ended June 30, 2006 Summary Discussion of Consolidated Results of Operations Comparison of three months ended June 30, 2007 to three months ended June 30, 2006. Net income available to common shareholders for the three months ended June 30, 2007 was $25.9 million,
a decrease of $10.5 million from $36.4 million reported during the same period in 2006. Net income for the three months ended June 30, 2007 included $1.7 million of net realized losses on
investments, as compared to net realized losses of approximately $10.7 million recorded during the same period in 2006. In addition, also included in net income available to common shareholders for
the three months ended June 30, 2007 was approximately $22.2 million of net unrealized losses on derivative financial instruments, as compared to net unrealized gains on derivative financial
instruments of $0.3 million recorded in the comparable period in 2006. The
decrease in net income available to common shareholders of $10.5 million
for the three months ended June 30, 2007, as compared to the same period
in 2006, was primarily driven by: (i) higher net unrealized losses on derivative
financial instruments of $22.2 million, resulting primarily from widening
credit spreads on our in-force portfolio of written credit default swaps
that guarantee senior triple-A high-grade structured finance CDOs and
CDOs of CDOs, (ii) higher operating expenses of $9.1 million resulting primarily
from increased compensation due to an increase in the number of our employees,
an increase in the volume of our credit default swap business (the costs
of which cannot be deferred under GAAP), and continued investment in our
infrastructure, (iii) lower earned premiums of $1.3 million resulting from
a significant period over period decrease in refundings of $17.5 million
(which is discussed further below), substantially offset by growth in earned
premiums in our global infrastructure and CDO lines of business, as well
as lower reinsurance cessions to XLI, and (iv) lower fee revenue of approximately
$0.9 million, offset in part by (v) an increase in investment income of $14.1
million reflecting a significant period over period increase in average invested
assets and higher yields on new money investments, (vi) lower net realized
losses on investments of $9.1 million. (during the three months ended June
30, 2007, we reported net realized losses of $1.7 million, as compared to
$10.7 of net realized losses in the same period in 2006, of which $9.0 million
related to an impairment charge on investments acquired in satisfaction of
a claim), and (vii) lower acquisition costs of $0.8 million resulting primarily
from lower period over period refundings in the our insurance segment net
of higher acquisition costs from the growth in our in-force business. Set forth below is additional information with respect to earned premiums and new business production. Net premiums earned for the three months ended June 30, 2007 of $54.2 million included $5.7 million of earnings from the early retirement of certain guaranteed obligations (e.g., refundings of
insured obligations) (or $5.1 million, net of accelerated amortization of deferred acquisition costs related to the earnings from such refundings), as compared to $23.2 million during the comparable
period in 2006 (or $21.4 million, net of accelerated amortization of deferred acquisition costs related to the earnings from such refundings). Our business production as measured by adjusted gross
premiums (which includes upfront premiums written in the period, current installment premiums due on business written in the period and expected future installment premiums on business written
during the period discounted at 7%) totaled $113.4 million for the three months ended June 30, 2007, a decrease of $43.8 million, as compared to $157.2 million reported in the comparable period in
2006. The decrease was primarily due to lower production in the Public Finance and Global Infrastructure lines of business of $47.5 million and $ 41.3 million, respectively, offset in part by higher
adjusted gross premium production in CDO line of business of $44.4 million reflecting an increase in demand. The decrease in production in the Public Finance line of business is primarily the results
of intense price competition, whereas the decrease in production in Global Infrastructure business is due largely to the opportunistic nature of this line of business. 30
Detailed Discussion of Consolidated and Segment Results of Operations by Financial Statement Line Item Gross Premiums Written All our gross premiums written are from our financial guarantee insurance segment. Gross premiums written during the period include: (i) premiums received upfront on policies or contracts
written during the period, (ii) installment premiums due during the period on in-force policies or contracts that were written prior to the period, and (iii) installment premiums due during the period
on policies and contracts written during the period. Gross premiums written during the period do not include installment premiums due in future periods. Accordingly, our premiums written during
any period are a function of the type and volume of contracts we write (upfront versus installment), as well as prevailing market prices. Factors affecting market prices include credit spreads, interest
rates, competition and new issuance. Generally, financial guarantee insurers are able to charge higher premiums when credit spreads widen. The following table presents, for the periods indicated, the
amount of gross premiums written attributable to upfront and installment policies and contracts:
(U.S dollars in thousands)
Three Months Ended
2007
2006 Gross premiums written Upfront policies/contracts
$
30,121
$
73,057 Installment policies/contracts
35,036
26,294 Total
$
65,157
$
99,351 The following table presents, for the periods indicated, the amount of gross premiums written by line of business:
(U.S dollars in thousands)
Three Months Ended
2007
2006 Gross premiums written Public finance
$
19,464
$
41,086 Structured finance
25,625
22,669 International finance
20,068
35,596 Total
$
65,157
$
99,351 Gross
premiums written were $65.2 million for the three months ended June 30, 2007,
a decrease of $34.2 million or 34.4%, as compared to $99.4 million recorded
in the comparable period in 2006. The decrease was primarily attributable
to lower gross written premium production in our global infrastructure and
public finance lines of business of $30.4 million and $15.5 million, offset
in part by a $10.1 million increase in installment premiums resulting from
the growth of such in-force business. The decrease in global infrastructure
gross premiums written reflects the opportunistic nature of this business
and the decrease in public finance gross premiums written reflects intense
price competition in this sector. The increase in installment premium business
primarily reflects growth in our in-force book of global infrastructure,
collateralized debt obligation (CDO), and power & utilities
business. Reinsurance Premiums Assumed All our reinsurance premiums assumed are from our financial guarantee reinsurance segment. The majority of our financial guarantee reinsurance business is assumed from affiliates of FSA. 31
June 30,
June 30,
The following table presents, for the periods indicated, the amount of reinsurance premiums assumed from affiliates of FSA and other third-party primary companies:
(U.S dollars in thousands)
Three Months Ended
2007
2006 Reinsurance premiums assumed Affiliates of FSA
$
1,460
$
6,368 XLI
184
Third-party companies
3,860
1,924 Total
$
5,504
$
8,292 The following table presents, for the periods indicated, the amount of reinsurance premiums assumed attributable to upfront and installment policies and contracts:
(U.S dollars in thousands)
Three Months Ended
2007
2006 Reinsurance premiums assumed Upfront policies/contracts
$
1,758
$
4,603 Installment policies/contracts
3,746
3,689 Total
$
5,504
$
8,292 The following table presents, for the periods indicated, the amount of reinsurance premiums assumed by line of business:
(U.S dollars in thousands)
Three Months Ended
2007
2006 Reinsurance premiums assumed Public finance
$
361
$
(1,249
) Structured finance
1,484
1,100 International finance
3,659
8,441 Total
$
5,504
$
8,292 Reinsurance premiums assumed were $5.5 million for the three months ended June 30, 2007, a decrease of $2.8 million or 33.7%, as compared to $8.3 million recorded in the comparable period
in 2006. The decrease was due to lower international finance assumed premiums of $4.8 million, partially offset by an increase in structured and public finance assumed premiums of $0.4 million and
$1.6 million, respectively. The changes in public finance and structured finance premiums assumed reflects an adjustment made during the three months ended June 30, 2006 to record the difference
between actual assumed premiums during the prior quarter to that estimated during such period. The decrease in International Finance is primarily due to the run-off of the in-force policies. The
amount of reinsurance ceded to us depends upon the type and amount of insurance written by primary companies, their capital needs and other factors. Such reinsurance is generally structured on a
facultative basis. The increase in public finance premiums assumed reflects an adjustment made during the three months ended June 30, 2006 to record the difference between actual assumed premiums during the
prior quarter to that estimated during such period. The amount of reinsurance ceded to us depends upon the type and amount of insurance written by primary companies, their capital needs and
other factors. Such reinsurance is generally structured on a facultative basis. Ceded Premiums We manage our in-force business based on single-risk limits to avoid concentration in single names and to mitigate event risk. For transactions that exceed these limits, we cede the excess to
XLI, XL RE AM, or third-party reinsurers. Through these cessions, we gain greater flexibility to manage large single risks and reduce concentration in specific bond sectors and geographic regions.
Part of our long-term 32
June 30,
June 30,
June 30,
strategy is to reduce reinsurance to XLI and XL RE AM, and increase our third-party reinsurance relationships. To the extent that we cede a portion of our exposure to one or more reinsurance
companies, we can reduce our concentration to particular issuers and help to control the diversification of our in-force business. In addition, use of reinsurance can increase our capacity to write new
business and strengthen our financial ratios. The following table presents, for the periods indicated, the amount of premiums ceded to XLI, XL RE AM and other third-party reinsurers:
(U.S dollars in thousands)
Three Months Ended
2007
2006 Ceded premiums XLI
$
$
(2,044
) XL RE AM
(615
)
(165
) Other third-party reinsurers
(7,949
)
(3,951
) Total
$
(8,564
)
$
(6,160
) All our ceded premiums are from our financial guaranty insurance segment. Ceded premiums were $8.6 million for the three months ended June 30, 2007, an increase of $2.4 million, as compared
to $6.2 million recorded in the comparable prior year period. The primary use of reinsurance is to meet the single risk limits established by regulatory bodies. The increase in ceded premiums is due
to the issuance of guarantees that exceeded such limits, thus, requiring reinsurance to reduce the companys exposure. Net Premiums Earned Financial guarantee upfront premiums are earned in proportion to the expiration of the related risk and financial guarantee installment premiums are earned ratably over the installment period,
generally one to three months. In addition, when an insured issue is retired early, is called by the issuer or is in substance paid in advance through a refunding accomplished by placing U.S.
Government securities in escrow, the remaining deferred premium revenue is earned at that time. While reinsurance premiums assumed are earned based on reports from the reinsured companies, we
believe that the underlying reinsured companies generally follow the revenue recognition policies and practices discussed above. The following table presents, for the periods indicated, the amount of earned premiums attributable to upfront and installment policies:
(U.S dollars in thousands)
Three Months Ended
2007
2006 Net premiums earned Upfront policies/contracts
$
21,223
$
27,506 Installment policies/contracts
32,969
28,035 Total
$
54,192
$
55,541 Net premiums earned were $54.2 million for the three months ended June 30, 2007, a decrease of $1.3 million or 2.3%, as compared to $55.5 million in the comparable period in 2006. The
decrease in earned premiums was primarily attributable to lower earned premiums in our financial guarantee insurance segment of $2.3 million, offset in part by higher earned premiums in our
financial guarantee reinsurance segment of approximately $0.9 million. Lower earned premium in our financial guarantee insurance segment was primarily attributable to a decrease in refundings,
calls, and other accelerations during the period of $17.3 million, offset in part by higher earned premiums, which was primarily attributable to growth in earned premiums from our global
infrastructure and CDO lines of business, as well as lower earned premiums ceded to XLI. Net Investment Income Net investment income was $30.3 million for the three months ended June 30, 2007, an increase of $14.2 million or 88.2% as compared to $16.1 million in the comparable period in 2006. The
increase in net investment income was due primarily to higher average invested assets and higher new money yields. 33
June 30,
June 30,
The increase in our average invested assets period over period was primarily attributable to operating cash flows since the comparable period in 2006, the net proceeds from our IPO, cash capital
contributions from XL Capital and the transfer of certain business to us from affiliates of XL Capital in connection with our IPO, and the net proceeds from the SCA Series A Preference Shares,
which were issued in April 2007. The following tables present net investment income, average invested assets, and the effective yield on our average invested assets for the three months ended June 30, 2007 and 2006, and the
average duration of our invested assets as of June 30, 2007 and 2006:
(U.S dollars in thousands, except percentages)
Three Months Ended
2007
2006 Net investment income
$
30,263
$
16,129 Average invested assets(1)
$
2,483,490
$
1,513,447 Effective yield(2)
4.9
%
4.3
%
(1)
Represents the quarterly average of the amortized cost of debt securities, short-term investments and cash and cash equivalents for the respective periods. (2) Effective yield represents net investment income, on an annualized basis, as a percentage of average invested assets during the period. The increase in the effective yield was due to the investment of operating, financing and investing cash flows
at higher interest rates.
As of June 30,
2007
2006 Weighted average duration in years
3.4
3.4 Net Realized Gains (Losses) on Investments Net realized losses on investments were $1.7 million for the three months ended June 30, 2007, as compared to $10.7 million in the comparable period in 2006. Net realized losses during the
three months ended June 30, 2007 included approximately $1.0 million of net realized losses relating to sales of certain securities which were made to lengthen the duration of our investment portfolio
and an other than temporary impairment charge of $0.3 million relating to two securities. During the three months ended June 30, 2006, net realized losses primarily consisted of an impairment
charge of $9.0 million relating to certain investments acquired in satisfaction of a claim. As a result of the aforementioned sales during the three months ended June 30, 2007, the weighted average
duration of our investment portfolio increased to 3.4 years at June 30, 2007 from 2.9 years at March 31, 2007. Net Realized and Unrealized Gains (Losses) on Derivative Financial Instruments The Companys derivative financial instruments principally include credit default swaps issued to its customers and guarantees of interest rate swap contracts in connection with its guarantees of
certain debt obligations. Changes in the fair value of credit default swaps attributable to earnings from premiums received by us from the issuance of such contracts are recorded in net premiums
earned in the consolidated statement of operations. In addition, changes in the fair value of credit default swaps attributable to losses from actual and expected payments to counterparties under such
contracts are recorded in losses and loss adjustment expense in the consolidated statement of operations, and the remaining components of the change in fair value of credit default swaps, which are
attributable to changes in interest rates, credit spreads, credit quality, expected recovery rates and other market factors, are recorded in net realized and unrealized gains (losses) on derivative
financial instruments. The Companys credit default swap portfolio consists of structured pools of corporate obligations that were awarded investment-grade ratings at the deals inception. At June 30,
2007, on a net par basis, approximately 97% of the portfolio was rated AAA with the remaining 3% rated at or above investment-grade and the weighted average term of the contracts in-force was
8.4 years. Net realized and unrealized losses on derivative financial instruments, which consisted only of unrealized amounts, were $22.2 million for the three months ended June 30, 2007, an increase of
$22.5 million, as compared to unrealized gains of $0.3 million reported in the comparable period in 2006. The net unrealized loss on derivative financial instruments reported during the three months
ended June 30, 34
June 30,
2007 primarily consisted of unrealized losses aggregating $24.4 million on investment grade credit default swaps, partially offset by unrealized gains on insured interest rate swaps aggregating $2.8
million. The unrealized loss on credit default swaps principally resulted from widening credit spreads across most sectors, particularly Senior AAA High-Grade Structured Finance CDOs, which alone
generated $13.8 million of unrealized losses on approximately $14.7 billion of par exposure. The benchmark spread used to mark these deals increased from 23 bps to 30 bps during the quarter. In
addition, our credit default swaps on CDOs of CDOs (CDOs of CDOs are securitizations of CDOs), generated unrealized losses of $5.1 million due to widening credit spreads in the specific sectors
underlying these instruments. We have only four credit default swaps in-force covering $1.2 billion of such notional exposure. In regard to insured interest rate swaps, the $2.8 million of unrealized
gains resulted from an increase in the LIBOR benchmark interest rate during the three months ended June 30, 2007. Net Losses and Loss Adjustment Expenses Net losses and loss expenses include current year net losses incurred and adverse or favorable development of prior year net loss and loss expenses reserves. The following table presents, for the
periods indicated, the activity in our reserves for losses and loss adjustment expenses, net of reinsurance:
(U.S. dollars in thousands)
Financial
Financial
Consolidated Beginning balance, April 1, 2007
$
69,976
$
18,744
$
88,720 Case reserve provision
(378
)
(378
) Loss adjustment expense reserve provision
210
5
215 Unallocated reserve provision
2,751
440
3,191 Net losses and loss adjustment expenses
2,961
67
3,028 Paid losses and loss adjustment expenses
14
(9
)
5 Ending balance, June 30, 2007
$
72,951
$
18,802
$
91,753 Beginning balance, April 1, 2006
$
62,782
$
18,158
$
80,940 Case reserve provision
154
154 Loss adjustment expense reserve provision
(30
)
144
114 Unallocated reserve provision
2,341
271
2,612 Net losses and loss adjustment expenses
2,311
569
2,880 Paid losses and loss adjustment expenses
(854
)
(49
)
(903
) Ending balance, June 30, 2006
$
64,239
$
18,678
$
82,917 Net
losses and loss adjustment expenses were $3.0 million for the three months
ended June 30, 2007, an increase of $0.1 million, or 3%, as compared to $2.9
million recorded in comparable period in 2006. The increase in net losses
and loss adjustment expenses was primarily attributable to higher net losses
and loss adjustment expenses in the insurance segment of $0.7 million, partially
offset by lower net losses and loss adjustment expenses in the reinsurance
segment of $0.5 million. Higher net losses and loss adjustment expenses in the insurance segment during the three months ended June 30, 2007 were primarily due to a period over period increase in unallocated reserves
of $0.5 million resulting from growth in our in-force business the portfolio and an increase in loss adjustment expenses of $0.2 million. A decrease in net losses and loss adjustment expenses of $0.5 million in the reinsurance segment during the three months ended June 30, 2007 as compared to the prior year period resulted from
a $0.7 million decrease in case basis provisions for losses and loss adjustment expenses (a decrease in the provision of $0.4 million in 2007 vs. an increase of $0.3 million in 2006) partially offset by an
increase in unallocated reserves of $0.2 million, driven by growth in the portfolio. 35
Guarantee
Insurance
Guarantee
Reinsurance
Total
Acquisition Costs, Net The following table presents the components of acquisition costs, net, during the periods indicated:
(U.S dollars in thousands)
Three Months Ended
2007
2006 Amortization of deferred acquisition costs and ceding commissions Financial Guarantee Insurance: Acquisition costs
$
3,866
$
5,908 Ceding commissions
(1,370
)
(2,863
) Net acquisition costs
2,496
3,045 Financial Guarantee Reinsurance: Acquisition costs
1,283
1,497 Acquisition costs, net
$
3,779
$
4,542 Capitalized acquisition costs in the financial guarantee insurance segment consist of a portion of compensation, travel and entertainment and marketing costs, as well as premium and excise taxes,
rating agency fees and legal costs associated with the production of new business. Such capitalized acquisition costs are reduced by ceding commission income on premiums ceded to reinsurers. Net acquisition costs in the financial guarantee insurance segment decreased $0.5 million, or 18.1% in the three months ended June 30, 2007, as compared to the comparable period in 2006,
primarily due to a decrease in refundings. Accelerated amortization due to refundings was $0.5 million during the three months ended June 30, 2007, as compared to $1.8 million in the year ago
quarter. Excluding the impact of refundings, net acquisition costs in the financial guarantee insurance segment increased by approximately $0.8 million during the three months ended June 30, 2007, as
compared to the same period in 2006. The increase primarily resulted from growth in our in-force business and a decrease in ceding commission revenue. The decrease in ceding commission revenue
was due to a commutation of a reinsurance arrangement with XLI in conjunction with our IPO. Acquisition costs in the financial guarantee reinsurance segment represent commissions paid to acquire assumed business. Amortization of acquisition costs in the financial guarantee reinsurance
segment was $1.3 million during the three months ended June 30, 2007, a decrease of $0.2 million, as compared to the same period in 2006. The decrease was due to higher letter of credit fees in the
year ago period. Excluding the impact of the letter of credit fees, acquisition costs in the financial guarantee reinsurance segment were slightly higher quarter over quarter, reflective of higher
reinsurance net premiums earned. Operating Expenses Operating expenses were $26.6 million for the three months ended June 30, 2007, an increase of $9.1 million or 52.0%, as compared to $17.5 million in the comparable period in 2006. Operating
expenses for the three months ended June 30, 2007 are comprised of operating expenses of our financial guarantee insurance and reinsurance segments, as well as corporate operating expenses, which
consist of costs associated with SCA being a stand-alone public company. Operating expenses of our financial guarantee insurance and reinsurance segments aggregated $21.7 million for the three
months ended June 30, 2007, an increase of 4.2 million, as compared to $17.5 million in the same period in 2006. The increase in operating expenses of our financial guarantee insurance and
reinsurance segments resulted primarily from increased compensation related to a net increase in the number of our employees, an increase in the volume of our credit default swap business (the
costs of which cannot be deferred), and continued investment in our infrastructure. During the three months ended June 30, 2007 we reported corporate operating expenses of $4.8 million, which
included approximately $1.0 million of expense incurred by the Company in connection with the secondary offering of SCA common shares by XL Capital. See Managements Discussion and
Analysis of Financial Condition and Results of OperationsOrganization Background, Initial Public Offering, and Ownership by XL Capital and Note 6 to the Unaudited Interim Consolidated
Financial Statements included elsewhere herein. 36
June 30,
Income tax expense Income tax expense was $0.6 million for the three months ended June 30, 2007, an increase of $0.8 million, as compared to a benefit of $0.2 million recorded in the comparable period in 2006.
See Note 7 to the Unaudited Interim Consolidated Financial Statements included elsewhere herein. Minority Interest Dividends on Redeemable Preferred Shares Dividends on redeemable preferred shares were $0.8 million for the three months ended June 30, 2007, a decrease of $0.3 million, as compared to $1.1 million recorded during the same period in
2006. The decrease was due to an extraordinary dividend of $15.0 million paid by XLFA on the preferred shares on March 30, 2007 and a corresponding reduction in the stated value of the
remaining outstanding Series A Redeemable Preferred Shares. As a result of the reduction in stated value, dividends on the redeemable preferred shares are $0.8 million quarterly subsequent to
March 31, 2007. See Liquidity and Capital Resources XLFA Preferred Share Dividend Requirements. Dividends on SCA Series A Preference Shares Because dividends on our SCA Series A Preference Shares are non-cumulative and the declaration of such dividends are subject to the discretion of the Companys Board of Directors, under
GAAP such dividends can only be recognized when declared by the board and may not be accreted ratably over the each fiscal year. In addition, because the governing documents underlying the
SCA Series A Preference Shares provide for semi-annual dividends, dividends will only be recognized during the third and first quarters of each fiscal year, if declared by the Board of Directors.
During the three months ended June 30, 2007 no dividends on our SCA Series A Preference Shares were declared by our Board of Directors. See Managements Discussion and Analysis of
Financial Condition and Results of OperationsOffering of Series A Perpetual Non-Cumulative Preference Shares. Discussion of Consolidated and Segment Results of Operations for the Six Months Ended June 30, 2007 Compared to the Six Months Ended June 30, 2006 Summary Discussion of Consolidated Results of Operations Comparison of six months ended June 30, 2007 to six months ended June 30, 2006. Net income available to common shareholders for the six months ended June 30, 2007 was $63.2 million, an
increase of $10.1 million from $53.1 reported during the same period in 2006. Net income for the six months ended June 30, 2007 included $1.5 million of net realized losses on investments, as
compared to net realized losses of approximately $16.4 million recorded during the same period in 2006. In addition, also included in net income available to common shareholders for the six months
ended June 30, 2007 was approximately $29.1 million of net unrealized losses on derivative financial instruments, as compared to net unrealized losses on derivative financial instruments of $3.5
million recorded in the comparable period in 2006. The increase in our net income available to common shareholders of $10.1 million for the six months ended June 30, 2007, as compared to the same period in 2006, was primarily driven by: (i)
higher net premiums earned of $7.2 million resulting from growth in earned premiums in our global infrastructure and CDO lines of business and lower reinsurance cessions to XLI, partially offset by
a significant period over period decrease in refundings of approximately $18.2 million, (ii) an increase in investment income of $25.2 million reflecting a significant period over period increase in
average invested assets and higher yields on new money investments, (iii) lower net realized losses on investments of $14.9 million (during the six months ended June 30, 2007, we reported net
realized losses of $1.5 million, as compared to $16.4 million of net realized losses in the same period in 2006, of which $14.0 million related to an impairment charge on investments acquired in
satisfaction of a claim), (iv) lower net losses and loss adjustment expenses of $4.1 million, which primarily resulted from favorable development of case basis reserves for losses and loss adjustment
expenses, and (v) lower dividends on our redeemable preferred shares, offset in part by (vi) higher net unrealized losses on derivative financial instruments of $25.6 million, resulting primarily from
widening credit spreads on our in-force portfolio of written credit default swaps that 37
guarantee senior triple-A high-grade structured finance collateralized debt obligations (CDOs) and CDOs of CDOs (CDOs of CDOs are securitizations of CDOs), (vii) higher operating expenses of
$16.0 million resulting primarily from increased compensation due to an increase in the number of our employees, an increase in the volume of our credit default swap business (the costs of which
cannot be deferred under GAAP), and continued investment in our infrastructure. Set forth below is additional information with respect to earned premiums and new business production. Net premiums earned for the six months ended June 30, 2007 of $100.6 million included $7.0 million of earnings from the early retirement of certain guaranteed obligations (e.g., refundings of
insured obligations) (or $6.1million, net of accelerated amortization of deferred acquisition costs related to the earnings from such refundings), as compared to $25.2 million during the comparable
period in 2006 (or $23.1 million, net of accelerated amortization of deferred acquisition costs related to the earnings from such refundings). Our business production as measured by adjusted gross
premiums (which includes upfront premiums written in the period, current installment premiums due on business written in the period and expected future installment premiums on business written
during the period discounted at 7%) totaled $252.3 million for the six months ended June 30, 2007, a decrease of $15.7 million, as compared to $268.0 million reported in the comparable period in
2006. The decrease was primarily due to lower production in the Public Finance and Global Infrastructure lines of business of $54.2 million and $48.3 million, respectively, offset in part by higher
adjusted gross premium production in CDO line of business of $59.9 million reflecting an increase in demand, as well as higher adjusted gross premiums in the Specialized Risk, Power & Utilities, and
Consumer ABS lines of business. The decrease in production in the Public Finance line of business is primarily the results of intense price competition, whereas the decrease in production in Global
Infrastructure business is due largely to the opportunistic nature of this line of business. Detailed Discussion of Consolidated and Segment Results of Operations by Financial Statement Line Item Gross Premiums Written All our gross premiums written are from our financial guarantee insurance segment. Gross premiums written during the period include: (i) premiums received upfront on policies or contracts
written during the period, (ii) installment premiums due during the period on in-force policies or contracts that were written prior to the period, and (iii) installment premiums due during the period
on policies and contracts written during the period. Gross premiums written during the period do not include installment premiums due in future periods. Accordingly, our premiums written during
any period are a function of the type and volume of contracts we write (upfront versus installment), as well as prevailing market prices. Factors affecting market prices include credit spreads, interest
rates, competition and the volume of new issuances. Generally, financial guarantee insurers are able to charge higher premiums when credit spreads widen. The following table presents, for the
periods indicated, the amount of gross premiums written attributable to upfront and installment policies and contracts:
(U.S dollars in thousands)
Six Months Ended
2007
2006 Gross premiums written Upfront policies/contracts
$
90,389
$
119,060 Installment policies/contracts
64,263
51,071 Total
$
154,652
$
170,131 38
June 30,
The following table presents, for the periods indicated, the amount of gross premiums written by line of business:
(U.S dollars in thousands)
Six Months Ended
2007
2006 Gross premiums written Public finance
$
51,602
$
73,881 Structured finance
47,209
36,682 International finance
55,841
59,568 Total
$
154,652
$
170,131 Gross premiums written were $154.7 million for the six months ended June 30, 2007, a decrease of $15.5 million or 9.1%, as compared to $170.1 million recorded in the comparable period in
2006. The decrease was due to the period over period decrease in the amount and relative mix of upfront, as compared to installment priced transactions. The decrease in upfront business was
primarily attributable to lower production in the public finance and global infrastructure lines of business. The decrease in public finance gross premiums written reflects intense price competition in
this sector and the decrease in global infrastructure gross premiums written reflects the opportunistic nature of this business. The increase in installment premium business primarily reflects growth in
our CDO and consumer ABS lines of businesses. Reinsurance Premiums Assumed All our reinsurance premiums assumed are from our financial guarantee reinsurance segment. The majority of our financial guarantee reinsurance business is assumed from affiliates of FSA. The following table presents, for the periods indicated, the amount of reinsurance premiums assumed from affiliates of FSA and other third-party primary companies:
(U.S dollars in thousands)
Six Months Ended
2007
2006 Reinsurance premiums assumed Affiliates of FSA
$
15,284
$
15,104 XLI
184
Third-party companies
5,499
4,591 Total
$
20,967
$
19,695 The following table presents, for the periods indicated, the amount of reinsurance premiums assumed attributable to upfront and installment policies and contracts:
(U.S dollars in thousands)
Six Months Ended
2007
2006 Reinsurance premiums assumed Upfront policies/contracts
$
14,349
$
10,949 Installment policies/contracts
6,618
8,746 Total
$
20,967
$
19,695 The following table presents, for the periods indicated, the amount of gross reinsurance premiums assumed by line of business:
(U.S dollars in thousands)
Six Months Ended
2007
2006 Reinsurance premiums assumed Public finance
$
898
$
251 Structured finance
3,735
4,800 International finance
16,334
14,644 Total
$
20,967
$
19,695 39
June 30,
June 30,
June 30,
June 30,
Reinsurance premiums assumed were $21.0 million for the six months ended June 30, 2007, an increase of $1.3 million or 6.6%, as compared to $19.7 million recorded in the comparable period in
2006. The increase was primarily higher international and public finance premiums assumed, partially offset by a decrease in structured finance assumed premiums. The increase in international finance
was primarily due to a few large upfront transactions during the current quarter in the utilities sector. The decrease in structured finance assumed premiums was due to a general decline in volume in
this sector. The amount of reinsurance ceded to us depends upon the type and amount of insurance written by primary companies, their capital needs and other factors. Such reinsurance is generally
structured on a facultative basis. Ceded Premiums We manage our in-force business based on single-risk limits to avoid concentration in single names and to mitigate event risk. For transactions that exceed these limits, we cede the excess to
XLI, XL RE AM, or third-party reinsurers. Through these cessions, we gain greater flexibility to manage large single risks and reduce concentration in specific bond sectors and geographic regions.
Part of our long-term strategy is to reduce reinsurance to XLI and XL RE AM, and increase our third-party reinsurance relationships. To the extent that we cede a portion of our exposure to one or
more reinsurance companies, we can reduce our concentration to particular issuers and help to control the diversification of our in-force business. In addition, use of reinsurance can increase our
capacity to write new business and strengthen our capital adequacy. The following table presents, for the periods indicated, the amount of premiums ceded to XLI, XL RE AM and other third-party reinsurers:
(U.S dollars in thousands)
Six Months Ended
2007
2006 Ceded premiums XLI
$
(605
)
$
(7,743
) XL RE AM
(3,763
)
(543
) Other third-party reinsurers
(24,429
)
(5,466
) Total
$
(28,797
)
$
(13,752
) All our ceded premiums are from our financial guaranty insurance segment. Ceded premiums were $28.8 million for the six months ended June 30, 2007, an increase of $15.0 million, as compared
to $13.8 million recorded in the comparable prior year period. The primary use of reinsurance is to meet the single risk limits established by regulatory bodies. The increase in ceded premiums is due
to the issuance of guarantees that exceeded such limits, thus, requiring reinsurance to reduce the companys exposure. The increase in premiums ceded to other third-party reinsurers during the six
months ended June 30, 2007 was primarily due to the placement of reinsurance relating to a large structured finance transaction written at the end of 2006, as well as our reduced reliance on
reinsurance capacity from affiliates of XL Capital. Net Premiums Earned Financial guarantee upfront premiums are earned in proportion to the expiration of the related risk and financial guarantee installment premiums are earned ratably over the installment period,
generally one to six months. In addition, when an insured issue is retired early, is called by the issuer or is in substance paid in advance through a refunding accomplished by placing U.S. Government
securities in escrow, the remaining deferred premium revenue is earned at that time. While reinsurance premiums assumed are earned based on reports from the reinsured companies, we believe that
the underlying reinsured companies generally follow the revenue recognition policies and practices discussed above. 40
June 30,
The following table presents, for the periods indicated, the amount of earned premiums attributable to upfront and installment policies:
(U.S dollars in thousands)
Six Months Ended
2007
2006 Net premiums earned Upfront policies/contracts
$
38,116
$
39,554 Installment policies/contracts
62,455
53,800 Total
$
100,571
$
93,354 Net premiums earned were $100.6 million for the six months ended June 30, 2007, an increase of $7.2 million or 7.7%, as compared to $93.4 million in the comparable period in 2006. The
increase in earned premiums was primarily attributable to higher earned premiums in the financial guarantee insurance segment of $6.7 million, which was primarily attributable to growth in earned
premiums in our global infrastructure and CDO lines of business, as well as lower reinsurance cessions to XLI, partially offset by a period over period decrease of $18.8 million in earnings from
refundings. Net Investment Income Net investment income was $56.4 million for the six months ended June 30, 2007, an increase of $25.2 million or 80.8% as compared to $31.2 million in the comparable period in 2006. The increase in
net investment income was due primarily to higher average invested assets and higher new money yields. The increase in average invested assets resulted primarily from the net proceeds from our IPO of
$341.3 million, cash capital contributions from XL Capital at the effective date of our IPO of $15.0 million, cash received in connection with the commutation and reinsurance agreement referred to
above of approximately $22.1 million, the net proceeds from our offerings of the Series A Perpetual Non-Cumulative Preference Shares of $247.3 million, and operating cash flows. See Investments for
information regarding the credit quality of our debt securities. The following tables present net investment income, average invested assets, and the effective yield on our average invested assets for the six months ended June 30, 2007 and 2006, and the
average duration of our invested assets as of June 30, 2007 and 2006:
(U.S dollars in thousands, except percentages)
Six Months Ended
2007
2006 Net investment income
$
56,388
$
31,191 Average invested assets(1)
$
2,340,912
$
1,477,765 Effective yield(2)
4.8
%
4.2
%
(1)
Represents the quarterly average of the amortized cost of debt securities, short-term investments and cash and cash equivalents for the respective periods. (2) Effective yield represents net investment income, on an annualized basis, as a percentage of average invested assets during the period. The increase in the effective yield was due to the investment of operating, financing and investing cash flows
at higher interest rates.
As of June 30,
2007
2006 Average duration in years
3.4
3.4 41
June 30,
June 30,
Net Realized Gains (Losses) on Investments Net realized losses on investments were $1.5 million for the six months ended June 30, 2007 as compared to a net realized loss of $16.4 million in the comparable period in 2006. Net realized
losses during the six months ended June 30, 2007 included approximately $1.0 million of net realized losses relating to sales of certain securities which were made to lengthen the duration of our
investment portfolio and an other than temporary impairment charge of $0.3 million relating to two securities. As a result of the aforementioned sales during the six months ended June 30, 2007, the
weighted average duration of our investment portfolio increased to 3.4 years at June 30, 2007 from approximately 3.1 at December 31, 2006. During the six months ended June 30, 2006, net realized
losses on investments included a $14.0 million impairment charge on certain investments acquired in satisfaction of a claim. Net Realized and Unrealized Gains (Losses) on Derivative Financial Instruments The Companys derivative financial instruments principally include credit default swaps issued to its customers and guarantees of interest rate swap contracts in connection with its guarantees of
certain debt obligations. Changes in the fair value of credit default swaps attributable to earnings from premiums received by us from the issuance of such contracts are recorded in net premiums
earned in the consolidated statement of operations. In addition, changes in the fair value of credit default swaps attributable to losses from actual and expected payments to counterparties under such
contracts are recorded in losses and loss adjustment expense in the consolidated statement of operations, and the remaining components of the change in fair value of credit default swaps, which are
attributable to changes in interest rates, credit spreads, credit quality, expected recovery rates and other market factors, are recorded in net realized and unrealized gains (losses) on derivative
financial instruments. The Companys credit default swap portfolio consists of structured pools of corporate obligations that were awarded investment-grade ratings at the deals inception. At June 30,
2007, on a net par basis, approximately 97% of the portfolio was rated AAA with the remaining 3% rated at or above investment-grade and the weighted average term of the contracts in-force was
8.4 years. Net realized and unrealized losses on derivative financial instruments, which consisted only of unrealized amounts, were $29.1 million for the six months ended June 30, 2007, an increase of
$25.6 million, as compared to net realized and unrealized losses of $3.5 million in the comparable period in 2006. The net unrealized loss on derivative financial instruments reported during the six
months ended June 30, 2007 primarily consisted of unrealized losses aggregating $30.0 million on investment grade credit default swaps, partially offset by unrealized gains on insured interest rate
swaps aggregating $1.8 million. The unrealized loss on credit default swaps principally resulted from widening credit spreads across most sectors, particularly Senior AAA High-Grade Structured
Finance CDOs, which generated $13.8 million of unrealized losses on approximately $14.7 billion of par exposure during the second quarter. The reference spread used to mark these deals increased
from 23 bps to 30 bps during the quarter. In addition, our credit default swaps on CDOs of CDOs (CDOs of CDOs are securitizations of CDOs), generated unrealized losses of $5.1 million during
the second quarter due to widening credit spreads in the specific sectors underlying these instruments. We have four such credit default swaps in-force covering $1.2 billion of such notional exposure as
of June 30, 2007. In regard to insured interest rate swaps, the $1.8 million of unrealized gains resulted from an increase in the LIBOR benchmark interest rate during the six months ended June 30,
2007. Net Losses and Loss Adjustment Expenses Net losses and loss adjustment expenses include current year net losses incurred and adverse or favorable development of prior year net loss and loss adjustment expenses reserves. 42
The following table presents, for the periods indicated, the activity in our reserves for losses and loss adjustment expenses, net of reinsurance:
(U.S. dollars in thousands)
Financial
Financial
Consolidated Beginning balance, January 1, 2007
$
71,574
$
18,327
$
89,901 Case reserve provision
(3,304
)
(364
)
(3,668
) Loss adjustment expense reserve provision
(5
)
9
4 Unallocated reserve provision
5,052
839
5,891 Net losses and loss adjustment expenses
1,743
484
2,227 Paid losses and loss adjustment expenses
(366
)
(9
)
(375
) Ending balance, June 30, 2007
$
72,951
$
18,802
$
91,753 Beginning balance, January 1, 2006
$
60,811
$
17,340
$
78,151 Case reserve provision
646
646 Loss adjustment expense reserve provision
462
144
606 Unallocated reserve provision
4,385
692
5,077 Net losses and loss adjustment expenses
4,847
1,482
6,329 Paid losses and loss adjustment expenses
(1,419
)
(144
)
(1,563
) Ending balance, June 30, 2006
$
64,239
$
18,678
$
82,917 For the six months ended June 30, 2007, net losses and loss adjustment expenses were $2.2 million, a decrease of $4.1 million or 65.1%, as compared to $6.3 million reported in the comparable
period in 2006. The decrease consisted of lower losses and loss adjustment expenses in our financial guarantee insurance and reinsurance segments of $3.1 million and $1.0 million, respectively. Lower net losses and loss adjustment expenses in the financial guarantee insurance segment during the six months ended June 30, 2007 resulted primarily from favorable development of case
basis reserves of $3.8 million, offset in part by an increase in unallocated reserves of $0.7 million resulting from the growth of our in-force business. The favorable development of case basis reserves
was primarily attributable to a case basis reserve relating to an insured obligation supported by subprime mortgage loans which was accelerated, fully paid, and defeased pursuant to the exercise of a
clean-up call by the sponsor of the securitization in late March of 2007 (See Note 9 (c) to the Unaudited Interim Consolidated Financial Statements elsewhere herein for details). Lower net losses and loss adjustment expenses in the financial guarantee reinsurance segment during the six months ended June 30, 2007 resulted primarily from favorable development of case
basis reserves of $1.1 million, offset in part by an increase in unallocated reserves of $0.1 million resulting from the growth of our in-force business. 43
Guarantee
Insurance
Guarantee
Reinsurance
Total
Acquisition Costs, Net The following table presents the components of acquisition costs, net, during the periods indicated:
(U.S dollars in thousands)
Six Months Ended
2007
2006 Amortization of deferred acquisition costs and ceding commissions Financial Guarantee Insurance: Acquisition costs
$
7,579
$
9,232 Ceding commissions
(2,472
)
(4,903
) Net acquisition costs
5,107
4,329 Financial Guarantee Reinsurance: Acquisition costs
2,642
2,895 Acquisition costs, net
$
7,749
$
7,224 Acquisition costs, net, increased $0.5 million, or 7% in the six months ended June 30, 2007 as compared to the six months ended June 30, 2006, primarily driven by a decrease in ceding
commission revenue in the financial gurantee insurance segment of $2.4 million, partially offset by decreased acquisition costs in the financial guarantee insurance segment of $1.7 million due to a
decrease in refunding activity from the year ago period. Accelerated amortization due to refundings was $0.9 million in the current period compared to $2.1 million in the year ago period. Excluding
the impact of refundings, the decrease of $0.5 million was due to a decrease in the amortization rate from the prior year resulting from a lengthening of the remaining life of the portfolio. The
decrease in ceding commission revenue in the financial gurantee insurance segment was driven by lower ceded reinsurance. Business previously ceded to XLI was commuted back to the Company
coincident with the IPO in the third quarter of 2006. As such, we retain more business written as compared to 2006, which resulted in a decrease of ceding commission revenue of 50%, from $4.9
million in 2006 to $2.5 million in 2007, consistent with the significant decrease in ceded premium earned observed from 2006 to 2007 ($18.2 million vs. $9.1 million). Acquisition costs in the financial guarantee reinsurance segment represent commissions paid to acquire assumed business. Amortization of acquisition costs in the financial guarantee reinsurance
segment was $2.6 million in the six months ended June 30, 2007, decreasing $0.3 million versus the comparable period in 2006, due to higher letter of credit fees in the year ago period. Excluding the
impact of the letter of credit fees, acquisition costs in the financial guarantee reinsurance segment were relatively flat quarter over quarter, consistent with only a slight increase in reinsurance net
premiums earned ($14.2 million in 2007 versus $13.7 million in 2006). Operating Expenses Operating expenses were $50.6 million for the six months ended June 30, 2007, an increase of $16.0 million or 46.2%, as compared to $34.6 million in the comparable period in 2006. Operating
expenses for the six months ended June 30, 2007 are comprised of operating expenses of our financial guarantee insurance and reinsurance segments, as well as corporate operating expenses, which
consist of costs associated with SCA being a stand-alone public company. Operating expenses of our financial guarantee insurance and reinsurance segments aggregated $42.0 million for the six
months ended June 30, 2007, an increase of 7.4 million, as compared to $34.6 million in the same period in 2006. The increase in operating expenses of our financial guarantee insurance and
reinsurance segments resulted primarily from increased compensation related to a net increase in the number of our employees, an increase in the volume of our credit default swap business (the
costs of which cannot be deferred), and continued investment in our infrastructure. During the six months ended June 30, 2007, we reported corporate operating expenses of $8.7 million, which
included approximately $1.0 million of expense incurred by the Company in connection with the secondary offering of SCA common shares by XL Capital. See 44
June 30,
Managements Discussion and Analysis of Financial Condition and Results of Operations Organization Background, Initial Public Offering, and Ownership by XL Capital and Note 6 to the
Unaudited Interim Consolidated Financial Statements included elsewhere herein. Income tax expense Income tax expense was $0.7 million for the six months ended June 30, 2007, an increase of $0.9 million, as compared to a benefit of $0.2 million recorded in the comparable period in 2006. See
Note 7 to the Unaudited Interim Consolidated Financial Statements included elsewhere herein. Minority Interest Dividends on Redeemable Preferred Shares Dividends on redeemable preferred shares were $1.9 million for the six months ended June 30, 2007, a decrease of $3.8 million, as compared to $5.7 million recorded during the same period in
2006. The decrease in dividends on the redeemable preferred shares of XLFA during the six months ended June 30, 2007, as compared to the comparable period in 2006 was due to an amendment of
the terms of the preferred shares pursuant to an agreement with the holders of such securities in April 2006 and a change in the stated value of such securities in connection with the payment of an
extraordinary dividend on March 30, 2007 of $15.0 million. In accordance with the aforementioned amendment: (i) the participating dividend of the preferred shares, which was in effect prior to 2006, was eliminated, (ii) the stated value of the redeemable
preferred shares held by FSAH was increased to $54.0 million, and (iii) the fixed dividend rate, which was in effect prior to 2006, was changed to a fixed rate of 81/4%. As a result of the
aforementioned amendments to the dividend provisions of the preferred shares, dividends on the preference shares will be $1.1 million quarterly subsequent to March 31, 2006. In connection with the extraordinary dividend the stated value of the redeemable preferred shares was reduced by $15.0 million. As a result of the reduction in stated value, dividends on the
redeemable preferred shares will be $0.8 million quarterly subsequent to March 31, 2007. See Liquidity and Capital ResourcesXLFA Redeemable Preferred Shares Extraordinary Dividend. Dividends on SCA Series A Preference Shares Because dividends on our SCA Series A Preference Shares are non-cumulative and the declaration of such dividends are subject to the discretion of the Companys Board of Directors, under
GAAP such dividends can only be recognized when declared by the board and may not be accreted ratably over the each fiscal year. In addition, because the governing documents underlying the
SCA Series A Preference Shares provide for semi-annual dividends, dividends will only be recognized during the third and first quarters of each fiscal year, if declared by the Board of Directors.
During the three and six months ended June 30, 2007 no dividends on our SCA Series A Preference Shares were declared by our Board of Directors. See Managements Discussion and Analysis of
Financial Condition and Results of Operations Offering of Series A Perpetual Non-Cumulative Preference Shares and Notes 13 and 14 to the unaudited interim consolidated financial statements. Investments The finance and risk oversight committee of our Board of Directors approves our general investment objectives and policies. Independent investment managers manage all of our consolidated
investment portfolios. Our primary investment objective is the preservation of capital, subject to an appropriate degree of liquidity, and a steady stream of investment income. A secondary objective is to optimize long-
term returns. 45
We select our investment managers on the basis of various criteria, including investment style, historical performance, internal controls, operational risk, and the ability to contribute to the
diversification of our portfolio. Changes in the valuation of our invested assets reflect changes in interest rates (for example, changes in the level, slope and curvature of yield curves, volatility of interest rates, mortgage
prepayment speeds and credit spreads) and credit quality. Market risk therefore arises due to the uncertainty surrounding the future valuations of these different assets, the factors that impact their
values and the impact that this could have on our earnings. We seek to manage the risks of our investment portfolio through a combination of asset class, industry and security level diversification. In addition, individual security and issuer exposures are
controlled and monitored at the investment portfolio level via specific investment constraints outlined in our investment guidelines and agreed with the external investment professionals. Additional
constraints are generally agreed upon with the external investment professionals and may address exposures to eligible securities, prohibited investments/transactions, credit quality and concentrations
limits. We also have a policy not to invest in any securities that we guarantee. As of June 30, 2007, our consolidated fixed-income portfolio consisted of debt securities, short-term investments and cash and cash equivalents with a carrying value of $2.2 billion, $0.1 million
and $0.2 million, respectively. Our debt securities are designated as available for sale in accordance with SFAS 115, Accounting for Certain Investments in Debt and Equity Securities. The fixed-
income portfolio is reported at fair value in accordance with SFAS 115, and the change in fair value is reported as part of accumulated other comprehensive income. Short-term investments consist of
securities with maturities equal to or greater than 90 days but less than one year at time of purchase. The average duration of our investment portfolio was 3.4 years as of June 30, 2007, as compared to 3.1 years as of December 31, 2006. Our fixed-income portfolio is exposed to credit and interest rate risk. As of June 30, 2007, the fair value of our fixed-income portfolio was approximately $2.5 billion, as compared to
approximately $2.0 billion as of December 31, 2006. The table below shows the percentage of our fixed-income portfolio (excluding cash and cash equivalents) by credit rating as of June 30, 2007:
Credit Rating(1):
Total AAA
76.9 AA
10.5 A
12.4 BBB
.2 Total
100.0%
(1)
As of June 30, 2007 the average credit quality of our fixed-income portfolio was AA+.
As of June 30, 2007, the top 10 corporate holdings, which exclude government guaranteed and government sponsored enterprises, represented 6.9% of the total fixed-income portfolio and
approximately 33.2% of all corporate holdings. As of June 30, 2007, none of our corporate holdings exceeded 1.0% of our total fixed-income portfolio. Our fixed-income portfolio is exposed to interest rate risk. Interest rate risk is the price sensitivity of a fixed-income security to changes in interest rates. We manage interest rate risk by setting
duration targets for our investment portfolio, thus mitigating the overall economic effect of interest rate risk. We remain nevertheless exposed to accounting interest rate risk since the assets are
marked-to-market, thus subject to market conditions, while liabilities are accrued at a static rate. The hypothetical case of an 46
immediate 100 basis point adverse parallel shift in global bond curves as of June 30, 2007 would have decreased the fair value of our fixed-income portfolio by approximately 3.4%, or $83.2 million. The following table summarizes our consolidated investment portfolio as of June 30, 2007:
(U.S. dollars in thousands)
Amortized
As of June 30, 2007
Fair Value
Gross
Gross Debt securities Mortgage-backed and asset-backed securities
$
1,435,308
$
891
$
(24,123
)
$
1,412,076 U.S. Government and government agencies
296,472
306
(10,015
)
286,763 Corporate
516,455
641
(9,128
)
507,968 Non-U.S. sovereign government
11,065
65
(174
)
10,956 U.S. states and political subdivisions of the states
373
(5
)
368 Total debt securities
$
2,259,673
$
1,903
$
(43,445
)
$
2,218,131 Short-term investments Total short-term investments
$
57,501
$
4
$
(226
)
$
57,279 The amortized cost and estimated fair value of debt securities and short-term investments available for sale as of June 30, 2007, by contractual maturity, are presented below. Expected maturities
will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
(U.S. dollars in thousands)
As of June 30, 2007
Amortized Cost
Fair Value Due within one year
$
57,501
$
57,279 Due after one through five years
453,392
447,329 Due after five through ten years
327,575
316,498 Due after ten years
43,398
42,228 Mortgage-backed and asset-backed securities
1,435,308
1,412,076 Total
$
2,317,174
$
2,275,410 The following table presents the aggregate gross unrealized losses and fair values by investment category and length of time that individual securities have been in a continuous unrealized loss
position at June 30, 2007.
(U.S. dollars in thousands)
As of June 30, 2007
Less than 12 months
12 months or more
Total
Fair Value
Unrealized
Fair Value
Unrealized
Fair Value
Unrealized Description of securities Mortgage and asset-backed securities.
$
755,688
$
(12,340
)
$
336,971
$
(11,783
)
$
1,092,659
$
(24,123
) U.S. Government and government agencies
84,163
(2,122
)
177,936
(7,995
)
262,099
(10,117
) Corporate
226,311
(3,047
)
205,511
(6,205
)
431,822
(9,252
) U.S. States and political subdivisions
367
(5
)
367
(5
) Non-U.S. sovereign government
495
(10
)
8,433
(164
)
8,928
(174
) Total debt securities and short-term investments
$
1,067,024
$
(17,524
)
$
728,851
$
(26,147
)
$
1,795,875
$
(43,671
) Securities in a continuous unrealized loss position for 12 months or more consist of U.S. Government and Agency securities, including mortgage-backed securities issued by U.S. Government
agencies, 47
Cost
Unrealized
Gains
Unrealized
Losses
Loss
Loss
Loss
aggregating $10.7 million and corporate, mortgage-backed, and asset-backed securities (non-government securities) aggregating $15.4 million. Of the non-government securities 57.9%, 78.7%, 98.2%
and 100% are rated AAA, AA- or better, A- or better and BBB+ or better, respectively. In addition, of the non-government securities in a continuous unrealized loss position for 12 months
or more, securities aggregating 62% of the total unrealized loss in such category have a price decline of less than 6% from their amortized cost and 38% have a price decline greater than 6% but less
than 10% of their amortized cost as of June 30, 2007. Liquidity and Capital Resources Liquidity Resources We define liquidity resources to include: our total investments in debt securities, short-term investments, cash and cash equivalents, accrued investment income, the capacity for revolving credit
loans under our Letter of Credit and Liquidity Facility (see Letter of Credit and Liquidity Facility below for details), and with respect to XLFA, our soft capital credit facility (see XLFA Soft
Capital Facility below for details). At June 30, 2007 and December 31, 2006 our total liquidity resources on a consolidated basis were $2.9 billion and $2.6 billion, respectively. Our total consolidated net cash inflows for the six months ended June 30, 2007 were $328.8 million, which consisted of $101.1 million in net cash flow generated by operations and $227.7 million
of net cash flow generated by financing activities, which is net of $19.5 million used to pay dividends to holders of our common shares and the redeemable preferred shares of our subsidiary (see
XLFA Redeemable Preferred Shares Extraordinary Dividend below for details). Net cash inflow from operations was driven by new business written and investment income and net cash inflow
from financing activities was driven from our issuance of Series A Perpetual Non-Cumulative Preference Shares discussed below. Net cash used in investing activities was $346.9 million, reflective of
the investment of cash from operations and the preference share offering. Capital Resources We manage our capital resources to maintain appropriate claims-paying resources to sustain the Triple-A claims-paying ratings of our insurance subsidiaries, while minimizing our cost of capital.
To the extent that the existing capital resources of our operating subsidiaries are insufficient to meet regulatory or rating agency requirements or cover losses, we may need to raise additional funds
through financings or curtail our insurance subsidiaries growth and reduce their insured exposure. In addition, any equity or debt financing, if available, may be on terms that are not favorable to us.
If we cannot obtain adequate capital on favorable terms or at all, our business, operating results, and financial condition could be adversely affected. On
April 5, 2007, we consummated the sale of $250 million of our SCA Series
A Preference Shares which were offered for sale
pursuant to a private placement. Gross proceeds from the offering were $250.0
million, offering costs were $3.4 million, and net proceeds were $247.2 million.
The SCA Series A Preference Shares are perpetual securities with no fixed
maturity date and, if declared by the Board of SCA, will pay a fixed dividend,
on a semi-annual basis during the first and third quarters of each fiscal
year, at the annualized rate of 6.88% until September 30, 2017. After such
date, the Series A Preference Shares, if declared by the Board of SCA, will
pay dividends, on a quarterly basis, at a floating rate based on three-month
LIBOR plus 2.715%. Dividends on the SCA Series A Preference Shares are non-cumulative
and the SCA Series A Preference Shares have a liquidation preference
of $1,000 per preference share. In connection with the sale of the SCA Series A Preference Shares, we entered into a Replacement Capital Covenant (the Replacement Capital Covenant), whereby we agreed for the benefit
of holders of one or more designated series of our long-term debt securities that we may issue in the future that (i) we will not redeem, exchange or purchase the SCA Series A Preference Shares and
(ii) none of our 48
subsidiaries will purchase or exchange the SCA Series A Preference Shares, except, subject to certain limitations, to the extent that the applicable redemption, exchange or purchase price does not
exceed a specified amount of cash proceeds from the sale of certain specified qualifying replacement capital securities raised during the period commencing on the 180th calendar day prior to the date
of notice of the redemption or the date of purchase. We have made no decision as to whether, or when, we would issue debt securities that would have the benefit of that covenant. While such
provisions are in effect, there could be circumstances where we would wish to redeem, exchange or purchase some or all of the SCA Series A Preference Shares but be restricted from doing so. The
Replacement Capital Covenant may be terminated if (i) holders of at least a majority by principal amount of the then-effective series of covered debt consent or agree in writing to terminate the
Replacement Capital Covenant, (ii) we no longer have outstanding any indebtedness that qualifies as covered debt or (iii) we no longer have any outstanding SCA Series A Preference Shares. In
addition, if not earlier terminated, the Replacement Capital Covenant will terminate on September 30, 2047; provided, however, that the September 30, 2047 termination date may be extended at our
option. SCA Liquidity As a holding company, our cash flow consists of dividends from our insurance subsidiaries (XLCA and XLFA), if declared and paid, and investment income on our invested assets, offset by
expenses incurred for employee compensation and other expenses consisting primarily of costs incurred as a stand-alone public company, including: board of directors fees, directors and officers
liability insurance, independent auditor fees, stock registrar and listing fees, legal fees, and annual report and proxy production and distribution costs. The payment of dividends or advances from our
insurance subsidiaries is subject to regulatory restrictions. In addition, the ability of our insurance subsidiaries to conduct business depends upon ratings from independent rating agencies and,
consequently, they are subject to rating agency imposed restrictions which also may affect their ability to pay dividends or make advances. As a result of the aforementioned regulatory and rating
agency restrictions, there can be no assurance that our insurance subsidiaries will be able to pay dividends or make advances, or that any dividends or advances paid by our insurance subsidiaries will
be sufficient to fund our cash requirements or that we will not be required to seek external debt or equity financing to meet our operating expenses. In
the ordinary course of business, we evaluate our liquidity resource needs
in light of our expenses, our dividend policy, and the dividend paying ability
of our insurance subsidiaries. Based on our liquidity resources (see definition
above) as of June 30, 2007, which aggregated $281.2 million, the income we
expect to receive from such liquidity resources, we believe that our holding
company will have sufficient liquidity to pay its operating expenses and
anticipated dividends over the next twelve months. During the six months
ended June 20, 2007, our board of directors declared quarterly dividends
on our common shares which were paid on March 30, 2007 and June 29, 2007,
respectively, and which aggregated approximately $2.6 million. In addition,
on July 31, 2007 our board of directors declared a quarterly dividend of
$.02 per common share payable on September 28, 2007 to shareholders of record
on September 14, 2007. Also, on July 31, 2007 our board of directors declared
a semi-annual dividend on the SCA Series A Preference Shares aggregating
$8.4 million, which is payable on October 1, 2007 to shareholders of record
of the SCA Series A Preference Shares on September 28, 2007. Any future dividends
will be subject to the discretion and approval of the Board of Directors. In connection with our IPO, our operating subsidiaries have each agreed that, until the second anniversary of the IPO each will not declare or pay dividends on its common stock other than to
fund certain parent holding company operating expenses and debt service requirements and to fund nominal dividends on our common stock. In addition, New York Insurance law contains a test
governing the amount of dividends that XLCA can pay in any year and, as a result of the application of such test, XLCA cannot currently pay dividends, without notice to, and prior approval from,
the New York Superintendent. As a U.S. company paying dividends to a Bermuda holding company, XLCAs dividends are subject to a 30% withholding tax rate. 49
Operating Subsidiaries Liquidity Liquidity resources at our operating subsidiaries are primarily used to pay their operating expenses, claims, payment obligations with respect to credit derivatives, reinsurance premiums, support in
force business, and pay dividends to us, as well as in the case of XLCA to make investments from time to time in its subsidiary, XLCA-UK. Our operating subsidiaries principal sources of liquidity
resources are their portfolio of liquid assets and their net operating cash flow, as well as, in the case of XLFA, the soft capital facility described under XLFA Soft Capital Facility below. Liquidity
resources can be affected by changes in interest rates and the amount and timing of loss payments as well as the other factors described under Managements Discussion and Analysis of Financial
Condition and Results of Operations Key Factors Affecting Profitability. Our operating subsidiaries liquid assets include substantial U.S. Treasury holdings, short-term investments and readily marketable debt securities. These liquidity resources are subject to market
conditions, regulation and rating agency requirements and we cannot guarantee that they will have sufficient liquidity resources in the future or that they will not have to seek alternative sources of
liquidity, which may be more expensive than their current liquidity resource options. We believe, however, that our operating subsidiaries sources of liquidity are adequate to meet their anticipated
needs for at least the next twelve months. XLCA Cash Flows. XLCA reported net cash (used in) operating activities of ($13.7) million for the six months ended June 30, 2007 compared to $33.8 million of net cash provided by operating
activities in the comparable period in 2006. Net cash provided by operating activities decreased by $47.5 million. The decrease in XLCAs cash flow from operations is primarily due to: (i) slightly
lower business production (particularly in the public finance sector), as compared to the comparable prior year period, and (ii) a higher proportion of installment business, as compared to upfront
business, during the six months ended June 30, 2007, as compared to the comparable period in 2006, offset in part by (iii) XLCAs higher retention of business resulting from the change in its quota
share arrangement with XLFA, whereby effective July 1, 2006 XLCA began ceding up to 75% of its business to XLFA, as compared with 90% prior thereto. XLCA reported net cash provided by used in investing activities was $20.8 million and $19.8 million for the six months ended June 30, 2007 and 2006, respectively. Cash used in investing
activities is primarily a result of investing cash generated from operating activitiessee Liquidity Resources above. As of June 30, 2007 and December 31, 2006, XLCA had readily marketable debt securities and short-term investments with a carrying value of $358.7 million and $347.2 million, respectively. In
addition, at those dates, approximately 99.9% of XLCAs fixed income portfolio was rated A or higher. XLFA Cash Flows. XLFA reported net cash provided by operating activities of $128.8 million for the six months ended June 30, 2007 compared to $125.4 million in the comparable period in 2006. Net
cash provided by operating activities increased by $3.4 million, driven by new business written and investment income. XLFA reported net cash provided by (used in) financing activities was $208.1 million and ($2.6 million) for the six months ended June 30, 2007 and 2006, respectively. The current year net inflow
reflects the contribution of $225.0 million of net proceeds of our Series A perpetual non-cumulative preference shares, partially offset by dividends paid to holders of the redeemable preferred shares of
XLFA. XLFA reported net cash provided used in investing activities was $323.8 million and $99.1 million for the six months ended June 30, 2007 and 2006, respectively. Cash used in investing activities
is primarily a result of investing cash generated from operating activities and financing activities see Liquidity Resources above. As of June 30, 2007 and December 31, 2006, XLFA had readily marketable debt securities and short-term investments with a carrying value of $1.9 billion and $1.6 billion, respectively. In
addition, at those dates, approximately 99.7% of XLFAs fixed income portfolio was rated A or higher. 50
Letter of Credit and Liquidity Facility On August 4, 2006, we and certain of our subsidiaries entered into an aggregate $500.0 million, five-year letter of credit and revolving credit facility (the $500.0 million credit facility) with a
syndicate of banks, for which Citibank N.A. is the administrative agent. The letter of credit and liquidity facility provides for letters of credit of up to $250 million and up to $250 million of revolving
credit loans with the aggregate amount of outstanding letters of credit and revolving credit loans thereunder not to exceed $500 million. Interest and fees payable under the letter of credit and liquidity facility shall be determined based upon certain spreads over defined benchmarks, principally LIBOR. The commitments under the
letter of credit and liquidity facility will expire on, and amounts borrowed under the letter of credit and liquidity facility may be borrowed, repaid and reborrowed from time to time until, the earlier
of (i) the date that is five years after the closing date of the letter of credit and liquidity facility and (ii) the date of termination in whole of the commitments upon an optional termination or
reduction of the commitments by the Account Parties or upon an event of default. The credit and liquidity facility contains financial covenants that require that SCA at any time (a) prior to August 4, 2008, maintain a minimum net worth of $857.4 million, (b) after August 4,
2008, maintain a minimum net worth equal to the greater of (1) $857.4 million (our net worth, defined as total shareholders equity before accumulated other comprehensive income, was
approximately $1,696.0 million as of June 30, 2007) or (2) an amount equal to 65% of the consolidated net worth as of the end of the then most recent fiscal year or fiscal quarter of SCA for which
financial statements shall have been delivered, and (c) maintain a maximum total funded debt-to-total capitalization ratio of 30% (as of June 30, 2007, we had no debt outstanding). The letter of
credit and liquidity facility also contains certain covenants, including restrictions on mergers, acquisitions and other business consolidations; the sale of assets; incurrence of indebtedness; liens on our
assets; and transactions with affiliates. In addition, the letter of credit and liquidity facility contains certain customary provisions regarding events of default, including payment defaults, breaches of
representations and warranties, covenant defaults, cross-default and cross-acceleration to certain other indebtedness, certain events of bankruptcy and insolvency, material judgments, certain events
under the Employee Retirement Income Security Act of 1974, as amended, and changes of control. As of June 30, 2007, the Company had letters of credit outstanding under the Facility of $176.7 million, which were established for the benefit of primary insurance companies reinsured by the
Company, as explained below. No revolving loans have been drawn by the Company under the Facility since its inception. For the three and six months ended June 30, 2007, the Company incurred
expenses of $0.2 million and $0.3 million under the Facility. In the comparable prior period in 2006, XL Capital had drawn letters of credit under its credit facility with a syndicate of commercial
banks for the benefit of primary companies reinsured by the Company. For the three and six months ended June 30, 2006, the Company incurred expenses of $0.1 million and $0.3 million related to
letters of credit drawn by XL Capital for the benefit of primary companies reinsured by the Company. Primary insurers may require collateral or letters of credit so that they can receive reinsurance credit under certain U.S. state laws. In addition, under certain of the Companys reinsurance
treaties, the Company may be required to provide collateral or letters of credit in favor of its ceding insurers in the event of a downgrade of the Companys credit ratings or other event which would
diminish the credit provided by the Companys reinsurance to such ceding insurers. Ceded Reinsurance Recoverables We manage our in-force portfolio of guaranteed obligations based on, and to comply with, regulatory and rating agency single-risk limits and internal credit guidelines. Single-risk limits are
designed to avoid concentration in single names and to mitigate event risk and are calculated as a percentage of capital. For transactions that exceed these limits or guidelines, we will cede the excess
to XLI, XL RE AM, or other third-party reinsurers. Generally, all such reinsurance is structured as facultative quota share reinsurance in which the reinsurer is liable to us for its quota share of the
applicable policies that we issue, regardless of when the loss occurs. Accordingly, related loss reserves, including unallocated loss reserves, are ceded in accordance with such contracts. Through these
facultative cessions, we gain greater flexibility to manage large single risks and reduce concentration in specific bond sectors and geographic regions. Part of our strategy is to reduce reinsurance to
XLI and XL RE AM, and increase our third-party reinsurance relationships. To the extent that we cede a portion of our exposure to one or more reinsurance 51
companies, we can reduce our concentration to particular issuers and help to control the diversification of our credit portfolio. In addition, use of reinsurance can increase our capacity to write new
business and strengthen our capital adequacy ratios. As of June 30, 2007 and December 31, 2006, we had $65.8 million and $70.8 million in reinsurance recoverables from our reinsurers relating to specific case reserves. The following table presents,
by reinsurer, the amount of our in-force principal exposure ceded to reinsurers as of June 30, 2007 and December 31, 2006:
(U.S. dollars in billions, except percentages)
As of June 30 2007
As of December 31, 2006
Ceded Par
% of Gross
Ceded Par
% of Gross XL RE AM
$
2.1
1.4
%
$
0.9
0.7
% XLI(1)
0.7
0.5
%
0.7
0.5
% AAA Companies(2)
4.0
2.6
%
2.5
2.0
% AA Companies & others(3)
4.5
2.8
%
3.2
2.5
% Total
$
11.3
7.3
%
$
7.3
5.7
%
(1)
In connection with the transfer of business from XLI to us as described under Formation Transactions in our Annual Report on Form 10-K the amount of our in-force principal exposure ceded to XLI was reduced by approximately $3.9
billion. (2) AAA Companies means those firms that have both an AAA rating from S&P and/or an Aaa rating from Moodys. (3) AA Companies and others means those firms (other than XLI) that have either an AA category rating from S&P and/or an Aa category rating from Moodys or have an investment grade rating but do not have a financial enhancement
rating from S&P. XLFA Soft Capital Facility In December 2004, XLFA entered into a put option agreement and an expense reimbursement agreement (the Asset Trust Expense Reimbursement Agreement) with Twin Reefs Asset Trust
(the Asset Trust). The put option agreement provides XLFA with the irrevocable right to require the Asset Trust at any time and from time to time to purchase XLFAs non-cumulative perpetual
Series B preferred shares with an aggregate liquidation preference of up to $200 million. There is no limit to the number of times that XLFA may exercise the put option, redeem the Series B
preferred shares from the Asset Trust and exercise the put option again. XLFA is obligated to reimburse the Asset Trust for certain fees and ordinary expenses. To the extent that any Series B
preferred shares are put to the Asset Trust and remain outstanding, a corresponding portion of such fees and ordinary expenses will be payable by XLFA pursuant to the asset trust expense
reimbursement agreement. The put option agreement is perpetual but would terminate on delivery of notice by XLFA on or after December 9, 2009, or under certain defined circumstances, such as
the failure of XLFA to pay the put option premium when due or bankruptcy. The premium payable by XLFA is the sum of certain trustee and investment managers expenses, the distribution of
income paid to holders of the pass-through trust securities, less the investment yield on the eligible assets purchased using the proceeds originally raised from the issuance of the pass-through
securities. The eligible securities (which are generally high-grade investment securities) are effectively held in trust to be used to fund the purchase of any Series B preferred shares upon exercise of
the put. The put option has not been exercised since the inception of the facility. XLFA Redeemable Preferred Shares Extraordinary Dividend On February 27, 2007, the board of directors of XLFA approved: (i) an extraordinary dividend of $15.0 million on its Series A Redeemable Preferred Shares, and (ii) a reduction in the stated
value of the remaining outstanding Series A Redeemable Preferred Shares by a corresponding amount. Payment of the extraordinary dividend and the reduction in the stated value of the Series A
Redeemable Preferred Shares occurred on March 30, 2007. This transaction was accounted for as a redemption of the preferred shares. As a result of the reduction in stated value, dividends on the
Series A Redeemable Preferred Shares will be $0.8 million quarterly subsequent to March 31, 2007. 52
Outstanding
Outstanding
Outstanding
Outstanding
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 (PSLRA) provides a safe harbor for forward-looking statements. Any prospectus, prospectus supplement, our annual report to ordinary
shareholders, any proxy statement, any other Form 10-K, Form 10Q, or Form 8-K of ours, or any other written or oral statements made by or on behalf of us may include forward-looking statements
that reflect our current views with respect to future events and financial performance. Statements that include the words expect, intend, plan, believe, project, anticipate, will, may
and similar statements of a future or forward-looking nature identify forward-looking statements. All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there
are or will be important factors that could cause actual results to differ materially from those indicated in such statements. We believe that these factors include, but are not limited to, the following:
changes in rating agency policies or practices, including adverse changes to the financial strength or financial enhancement ratings of any or all of our operating subsidiaries; ineffectiveness or obsolescence of our business strategy, due to changes in current or future market conditions or other factors; the performance of our invested assets or losses on credit derivatives; availability of capital (whether in the form of debt or equity) and liquidity (including letter of credit facilities); the timing of claims payments being faster or the receipt of reinsurance recoverables being slower than anticipated by us; increased competition on the basis of pricing, capacity, terms or other factors; greater frequency or severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than our underwriting, reserving or investment practices anticipate
based on historical experience or industry data; developments in the worlds financial and capital markets that adversely affect the performance of our investments and our access to such markets; changes in, or termination of, our ongoing reinsurance agreements with XL Capital or FSA; changes in regulation or tax laws applicable to us or our customers or suppliers such as our reinsurers; changes in the rating agencies views on third-party inward reinsurance; changes in the availability, cost or quality of reinsurance or retrocessions, including a material adverse change in the ratings of our reinsurers or retrocessionaires; changes with respect to XL Capital (including changes in its ownership percentage in us) or our relationship with XL Capital; changes that may occur in our operations as we begin operations as a public company; changes in accounting policies or practices or the application thereof; changes in the officers of our company or our subsidiaries; legislative or regulatory developments; changes in general economic conditions, including inflation, interest rates, foreign currency exchange rates and other factors; and the effects of business disruption or economic contraction due to war, terrorism or natural or other catastrophic events. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included herein or elsewhere.
We undertake no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise. 53
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Quantitative and qualitative disclosure regarding our exposures to market risk, as well as our objectives, policies and strategies relating to the management of such risks, is set forth in our Annual
Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 15, 2007. Our relative sensitivity to changes in fair value from interest rates and equity prices at June
30, 2007 is not materially different from that presented in such report. ITEM
4. CONTROLS AND PROCEDURES Not
Applicable. See Item 4T. Controls and Procedures below. ITEM 4T. CONTROLS AND PROCEDURES Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures The Company carried out an evaluation, under the supervision and with the participation of the Companys management, including the Chief Executive Officer and Chief Financial Officer, of the
effectiveness of disclosure controls and procedures pursuant to Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of the end of the period covered
by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures are effective to provide reasonable assurance
that all material information relating to the Company required to be filed in this report has been made known to them in a timely fashion. Changes in internal control over financial reporting There was no change in the Companys internal control over financial reporting, that occurred during the period covered by this quarterly report that materially affected, or is reasonably likely to
materially affect, the Companys internal control over financial reporting. 54
The Company believes that the ultimate outcome of all outstanding litigation and arbitration will not have a material adverse effect on its consolidated financial condition, future operating results
and/or liquidity, although an adverse resolution of a number of these items could have a material adverse effect on the Companys results of operations in a particular fiscal quarter or year. Risk Associated with a Recently Proposed Statement of Financial Accounting Standards (SFAS) Pertaining to Accounting for Financial Guarantee Insurance Contracts. On April 18, 2007, the
Financial Accounting Standards Board (FASB) issued Proposed SFAS, Accounting for Financial Guarantee Insurance Contractsan interpretation of FASB Statement No. 60. This proposed
Statement would clarify how FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises, applies to financial guarantee insurance contracts. This proposed Statement, among other
things, would change current industry practices with respect to the recognition of premium revenue and claim liabilities. In addition, this proposed Statement would require that the measurement of
the initial deferred premium revenue (liability) be the present value of the contractual premium due pursuant to the terms of the financial guarantee insurance contract, thereby changing current
industry accounting practice with respect to insurance contracts priced on an installment basis by requiring that the present value of all contractual premiums due under such contracts, currently or in
the future, be recorded on the companys balance sheet as premiums receivable. Under current industry practice such premiums are not reflected on the balance sheet. We expect that the initial effect
of applying the revenue recognition provisions of the Statement as currently proposed will be material to the Companys financial statements and that implementation of the proposed guidance in
regard to the recognition of claim liabilities will cause the Company to de-recognize its reserves for unallocated losses and loss adjustment expenses and preclude it from providing such reserves in the
future. The comment period for the proposed Statement expired on June 18, 2007. A round table discussion between the FASB and interested parties who provided comments on the proposed
Statement has been rescheduled to early September 2007 from mid-July of 2007. Currently the proposed Statement is due to be effective for fiscal years beginning after December 15, 2007. The
Company is continuing to evaluate the effect of the proposed Statement on its financial statements. See Note 4 to the Unaudited Interim Consolidated Financial Statements for further information. The costs of services, leasing, reinsurance, and other arrangements provided by XL Capital may increase. Effective upon our IPO, we and XL Capital entered into a series of service agreements
pursuant to which XL Capital provides us, for a period of up to two years, transitional services, including treasury, payroll and other financial services, human resources and employee benefit services,
legal services, information systems and network services, tax and treasury services, investment management and procurement and sourcing support. We also entered into a transition agreement with
XL Capital, which governs the relationship between us and XL Capital and reinsurance agreements with subsidiaries of XL Capital. Each service agreement provides that, on or before August 15, 2007, SCA shall submit to XL Capital a list of the types of services required from XL Capital for the period from January 1, 2008
through August 4, 2008. Pursuant to the service agreements, costs and services will be determined no later than September 15, 2007. There can be no assurance that our costs under the service
agreements will not materially increase as a result of this process. Refer to Risk Factors in our Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 15, 2007, for information in regard to the Companys other
Risk Factors. ITEM
2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS. See
information contained in Companys Current Reports on Form 8-K filed
on March 30, 2007 and April 10, 2007. 55
ITEM
3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. At the Annual General Meeting of holders (the Shareholders) of Common Shares held on May 4, 2007 at the Fairmont Hamilton Princess, 76 Pitts Bay Road, Pembroke HM 11 Bermuda, the
Shareholders approved the following: 1. The election of three Class II Directors to hold office until 2010:
Votes in Favor
Votes Withheld Paul S. Giordano
58,795,222
438,189 Robert M. Lichten
58,792,722
440,689 Alan Z. Senter
58,792,822
440,589 In addition, the terms of the following Directors continued after the Annual General Meeting: Michael P. Esposito, Jr., Brian OHara, E. Grant Gibbons, Bruce G. Hannon, Mary R. Hennessy,
and Coleman Ross. 2. The appointment of PricewaterhouseCoopers LLP, New York, New York, to act as the registered independent public accounting firm for the Company for the year ending December 31, 2007:
Votes In Favor
Votes Against
Abstentions
59,228,568
4,753
100 3. The Amended and Restated 2006 Long Term Incentive and Share Award Plan was approved.
Votes In Favor
Votes Against
Abstentions
56,142,862
406,930
961,312 4. The Amended and Restated Annual Incentive Compensation Plan was approved.
Votes In Favor
Votes Against
Abstentions
57,844,655
470,417
918,339 None. 56
Exhibit
Description of Document
4.1
Replacement Capital Covenant, dated April 5, 2007, incorporated by reference
to Exhibit 4.5 to the Companys Current Report on Form 8-K filed
on April 10, 2007 (File No. 001-32950).
4.2
Registration Rights Agreement, dated April 5, 2007, incorporated by reference
to Exhibit 4.6 to the Companys Current Report on Form 8-K filed
on April 10, 2007 (File No. 001-32950).
10.1
Amended and Restated Annual Incentive Compensation Plan, adopted as of
May 4, 2007, incorporated by reference to Exhibit 10.1 to the Companys
Current Report on Form 8-K filed on May 10, 2007 (File No. 001-32950).
10.2
Amended and Restated 2006 Long-Term Incentive and Share Award Plan, adopted
as of May 4, 2007, incorporated by reference to Exhibit 10.2 to the
Companys Current Report on
Form 8-K filed on May 10, 2007 (File No. 001-32950).
31
Rule 13a-14(a)/15d-14(a) Certifications.
32
Section 1350 Certification.
99.1
XL Capital Assurance Inc. and Subsidiary interim consolidated financial statements (unaudited) as of June 30, 2007 and December 31, 2006 and for the three and six month periods
ended June 30, 2007 and 2006.
99.2
XL Financial Assurance Ltd interim financial statements (unaudited) as of June 30, 2007 and December 31, 2006 and for the three and six month periods ended June 30, 2007 and 2006. 57
Number
4.3
Extract of the Minutes
of a Meeting of a Subcommittee of the Finance and Risk Oversight Committee,
incorporated by reference to Exhibit 4.1 to the Companys Current
Report on Form 8-K filed on April 10, 2007 (File No. 001-32950).
Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
SECURITY CAPITAL ASSURANCE LTD
Date: August 10, 2007
/s/ PAUL S. GIORDANO
Paul S. Giordano
(Principal Executive Officer)
Date: August 10, 2007
/s/ DAVID P. SHEA
David P. Shea
(Principal Financial Officer) 58
(Registrant)
President, Chief Executive Officer and Director
Executive Vice President and Chief Financial Officer